Inventory Management

Faculty of Computing, Engineering and Built Environment

School of Engineering, Design and Manufacturing Systems
What is
Inventory?
• Stock of items kept to meet future demand
for
• internal customers
• external customers
• Purpose of inventory management
• ORDERING POLICY: When and how many units
to order of each material when orders are
placed with either outside suppliers or
production departments within organizations?
Types of Inventory
• Raw materials – purchased but not
used
• Work-in-process inventory – being
worked on
• Finished goods inventory –
completed and waiting shipment
• Goods in transit – to warehouses and
customers
Activity
Think of the various stages of inventory for the
following products:

• A piece of furniture

• A pair of shoes

• A grocery product

7–4
 Importance of
Inventory
• Inventories are important to all types of firms:
• They have to be counted, paid for, used in operations,
used to satisfy customers, and managed
• too much inventory reduces profitability
• Too little inventory damages customer confidence
• It is one of the most expensive assets of many companies
representing as much as 50% of total invested capital
• It is one of the 3 most common reasons for SME bankruptcy
• Need to balance inventory investment and customer
service
The Valuable Functions of Inventory
• The functions of inventory can be
summarized as:
– meeting demand (anticipation)
– protection against stock-out (buffer)
– cutting costs by ordering in bulk
– flexibility (buffer)
– covering delays (decoupling)
– taking advantage of price changes
Problems Caused by Inventory
• Inventory takes up space
• Inventory is prone to:
– Damage, Pilferage and Obsolescence
• Inventory causes manufacturing errors to
go undetected
– Reducing inventory can make it easier to see
delays and uneven supply chains.
Inventory Management
Systems
• Independent Demand: demand is
beyond control of the organization

• Dependent Demand: demand is

driven by demand of another item
Inventory-Related Costs
• Ordering costs (unit variable costs & fixed ordering costs)
• costs of replenishing inventory, placing orders, receiving goods
• costs for to prepare a machine
• Holding or Inventory carrying costs
• cost of holding an item in inventory over time
• Shortage or Stock-out / penalty costs
• How do you handle shortages?
• Lost sales vs. backlogging
• Watch out for service level
• Outdate costs (for perishable products):This inventory has not been sold or
used for a long period of time and is not expected to be sold in the future. This type of
inventory has to be written down and can cause large losses for a company.
 ABC
Analysis
• Pay attention to your more critical products!
• Divides inventory into three classes based on
annual dollar volume
• Class A - high annual dollar volume
• Class B - medium annual dollar volume
• Class C - low annual dollar volume
• Used to establish policies that focus on the few
critical parts
 ABC
Analysis
• Concept: All items do not deserve the same
attention in terms of inventory management
• Focus on items that have the highest monetary
value

• Step 1. Start with the inventoried items ranked by

dollar value in inventory in descending order
• Step 2. Plot the cumulative dollar/euro value in
inventory versus the cumulative items in inventory
ABC Analysis
Example
ABC Calculation
(1) (2) (3) (4) (5) (6) (7)
PERCENT
OF PERCENT
ITEM NUMBER ANNUAL ANNUAL OF ANNUAL
STOCK OF ITEMS VOLUME UNIT DOLLAR DOLLAR
NUMBER STOCKED (UNITS) x COST = VOLUME VOLUME CLASS
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A
#12760 1,550 17.00 26,350 11.3% B
#10867 30% 350 42.86 15,001 6.4% 23% B
#10500 1,000 12.50 12,500 5.4%
B
#12572 600 $ 14.17 $ 8,502 3.7% C
#14075 2,000 .60 1,200 .5% C
#01036 50% 100 8.50 850 .4% 5% C
#01307 1,200 .42 504 .2% C
#10572 250 .60 150 .1% C
8,550 $232,057 100.0%
 ABC
Analysis Class C
100 — Class B
90 —
Typical Chart Using ABC Analysis
Class A
Percentage of dollar value

80 — • Class A
70 — • 5 – 15 % of units
60 — • 70 – 80 % of value

50 —
• Class B
• 30 % of units
40 —
• 15 % of value
30 —
• Class C
20 — • 50 – 60 % of units
10 — • 5 – 10 % of value
0—
10 20 30 40 50 60 70 80 90 100
Percentage of SKUs
The ABC analysis

The ABC approach states that a company should rate

items from A to C, basing its ratings on the following
rules:
– A-items are goods which annual consumption
value is the highest; the top 70-80% of the annual
consumption value of the company typically
accounts for only 10-20% of total inventory items.
The ABC analysis

The ABC approach states that a company should rate

items from A to C, basing its ratings on the following
rules:
– B-items are the interclass items, with a medium
consumption value; those 15-25% of annual
consumption value typically accounts for 30% of
total inventory items.
 The ABC analysis

The ABC approach states that a company should

rate items from A to C, basing its ratings on the
following rules:
– C-items are, on the contrary, items with the
lowest consumption value; the lower 5% of the
annual consumption value typically accounts for
50% of total inventory items.
 ABC
Analysis
▶ Policies employed may include
• More emphasis on supplier development for A
items
• More care in forecasting A items
• A-items should have tight inventory control,
more secured storage areas and better sales
forecasts. Reorders should be frequent,
with weekly or even daily reorder. Avoiding
stock-outs on A-items is a priority.
 ABC
Analysis
▶ Policies employed may include
• Reordering C-items is made less frequently. A typically
inventory policy for C-items consist of having only 1 unit on
hand, and of reordering only when an actual purchase is
made. This approach leads to stock-out situation after each
purchase which can be an acceptable situation, as the C-items
present both low demand and higher risk of excessive
inventory costs.
• B-items benefit from an intermediate status between A and
C. An important aspect of class B is the monitoring of
potential evolution toward class A or, in the contrary, toward
the class C.
EOQ Assumptions

• Known & constant demand

• Known & constant lead time
• Instantaneous receipt of material
• No quantity discounts
• Only order (setup) cost & holding cost
• No stockouts
Economic Order Quantity
Economic Order Quantity (EOQ) order
amount that minimizes the total cost
over a whole year
Total Acquisition Costs
Total Acquisition Costs (TAC): sum of all
relevant annual inventory costs

– Holding costs: associated with storing

and assuming risk of having inventory

– Ordering costs: associated with placing

orders and receiving supply

TAC = annual ordering cost + annual carrying

cost
 Ordering and holding cost
Ordering Cost
The number of orders that occur annually can be found by dividing the annual
demand by the volume per order.

For each order with a fixed cost that is independent of the number of units, S, the
annual ordering cost is found by multiplying the number of orders by this fixed cost.
It is expressed as:

Holding Cost
storage of the inventory or the opportunity cost of holding inventory instead of
investing the money. Holding cost per unit is often expressed as the cost per unit
multiplied by the interest rate
H = iC
Annual holding cost = average inventory
level x holding cost per unit per year.
Total Acquisition Costs
TAC = annual ordering cost + annual carrying cost

TAC = Co (D/Q) + UCi * Q/2

N = D/Q
I = Q/2

Where:
N = orders per year I = average inventory level
D = annual demand Co = order cost per order
Q = order quantity U = unit cost
Ci = % carrying cost per year
Total Acquisition Costs:
Example 1 N = D/Q = 3000 / 500 = 6
If we need 3,000 orders per year
I = Q/2 = 500 / 2 = 250 average inventory
units per year at a
unit price of $20 and
we order 500 each TAC = ordering cost + carrying cost
time, at a cost of $50 = Co (D/Q) + (UCi )(Q/2)
per order with a
= $50 (3000/500) + ($20*20%)*(500/2)
carrying cost of 20%,
what is the TAC? = $300 + $1,000
= $1,300

Where:
N = D/Q D = 3,000 Q = 500
I = Q/2 U = $20 Co = $50 Ci = 20%
Total Acquisition Costs:
Another Example
If we need 3,000 N = D/Q = 3000 / 200 = 15 orders per year
units per year at a
I = Q/2 = 200 / 2 = 100 average inventory
unit price of $20 and
we order 200 each TAC = ordering cost + carrying cost
time, at a cost of $50 = Co (D/Q) + (UCi )(Q/2)
per order with a
= $50 (3000/200) + ($20*20%)*(200/2)
carrying cost of 20%,
what is the TAC? = $750 + $400
= $1,150

Where:
N = D/Q D = 3,000 Q = 200
I = Q/2 U = $20 Co = $50 Ci = 20%
Economic Order Quantity (EOQ)
 An EOQ Example
Determine the optimal number of units to
order
D = 1,000 units per year D= Annual demand (units)
S = $10 per order Q= Order quantity (units)
S= Cost per order ($)
H = $.50 per unit per year H= Holding cost ($)

2DS
Q* 
H
2(1,000)(10)
Q*   40,000  200 units
0.50
 An EOQ Example
Determine expected number of orders
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected
number of = N = = D*
Demand Q
orders
Order
1,000
quantity
N= = 5 orders per year
200
D= Annual demand (units)
Q= Order quantity (units)
S= Cost per order ($)
H= Holding cost ($)
 An EOQ
Example
Determine optimal time between orders
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year

Expected time Number of working days per year

between =T =
orders Expected number of orders

250
T= = 50 days between orders
5
D= Annual demand (units)
Q= Order quantity (units)
S= Cost per order ($)
H= Holding cost ($)
 An EOQ
Example
Determine the total annual
cost
D = 1,000 units Q* = 200 units
S = $10 per order N = 5
H = $.50 per unit per orders/year
year
Total annual cost = Setup cost + T = 50 days
Holding
cost
TC  D S  Q H
1,00 Q 2200
($.50)
0 ($10)  2
200
 (5)($10)  (100)($.50)
 $50 $50  $100
Note: the cost of materials is not included, as it is assumed that the demand will
be satisfied and therefore it is a fixed cost
Economic Order Quantity (EOQ)
• A corner store sells cans of Cola
• D = 860 cans × 250 days = 215,000 cans/year
• Ch = 1.20/6 × 10% = $0.02/can/year
• Cs = $25
• Cp = Cost to place a single order
• Ch = Cost to hold one unit inventory for a year

Q = 23,184 cans or 3,864 cases (6 in a case)

Worked Example: Economic
Order Quantity (EOQ)
• The average stock held is
• The cost of holding this stock will be
• The number of orders they will place a year is
• The cost of placing all the orders in a year will be
• The total cost of operating the inventory system will be
Worked Example: Economic Order
Quantity (EOQ)
• The average stock held is Q/2 = 11,592 cans.
• The number of orders they will place a year is D/Q = 9.3
times a year, or every 39 days (365 days in a year
divided by 9.3 orders).
• The cost of holding this stock will be Q/2 × Ch =
$231.84 per year.
• The cost of placing all the orders in a year will be D/Q × Cs
= $232.50 per year
• The total cost of operating the inventory system will be Ch
+Cs = $231.84 + $232.5 = $464.34 per year.
 Calculating
EOQ
EXAMPLE 1
A museum of natural history opened a gift shop which operates 52
weeks per year. Managing inventories has become a problem.
Top-selling SKU is a bird feeder. Sales are 18 units per week,
the supplier charges $60 per unit. Ordering cost is $45. Annual
holding cost is 25 percent of a feeder’s value. Management
chose a 390-unit lot size.

What is the annual cycle-inventory cost of the current policy of

using a 390-unit lot size?

Would a lot size of 468 be better?

Calculating
EOQ
SOLUTION
We begin by computing the annual demand and holding cost as

D = (18 units/week)(52 weeks/year) = 936 units H =

0.25($60/unit) = $15
The total annualQcycle-inventoryDcost for the current policy936
390 is
C = 2 (H) + Q (S) = ($15) +
($45) 2 390
= $2,925 + $108 = $3,033

The total annual cycle-inventory cost for the alternative lot size is

468 936
C= ($15) + ($45) = $3,510 + $90 =
$3,600 2 468
Measures of Inventory Performance:
Days, Service Level, Stock outs

• Days of Supply: length of time operations can

be supported with inventory on-hand
• Service Level: ability to meet customer
demand without a stock out
• Stockout: no inventory is available
Measures of Inventory Performance:
Days of Supply – Example 7.2
Suppose there are
currently 2,000,000 = Current Inventory /
finished automobiles Expected daily sales
sitting in dealer or
manufacturing facility = 2,000,000/25,000
lots. If expected sales
of automobiles are = 80 days
25,000 units per day,
how many days of
supply are there?
 Thank you!

Questions, comments?
Example 1

Meyer Stores carries a specialty line of flavoured syrups.

One of the most popular of these is raspberry syrup which
sells, on average, 30 bottles per week. Meyer’s cost is $8
per bottle. Meyer has determined its order cost to be $50
and inventory carrying cost is 20%. Meyer is open for
business 52 weeks per year. What is the EOQ for raspberry
syrup? If Meyer orders the EOQ quantity each time, what
will be the inventory turnover rate for raspberry syrup?
Example 1 solution

• Annual demand = 30 units x 52 weeks = 1,560 units

• EOQ = √(2(1,560)$50/($8(.20))) = √(156,000/1.60) =

√97,500 = 312.25 units, rounded 313 units.

• Average inventory = 313/2 = 156.5 units

• Inventory turnover = 1,560/156.5 = 9.97 times. Note, if
EOQ is rounded down to 312 units, then average
inventory is 156 units and inventory turnover is 10 times.
Example 2
Johnson Corporation has the following information about a
product that it carries in stock:
• Average demand = 40 units per day
• Average lead time = 15 days
• Item unit cost = $55 for orders of less than 400 units
• Item unit cost = $50 for orders of 400 units or more
• Ordering cost = $30
• Inventory carrying cost = 20%
• The business year is 300 days
• a. What is the annual total acquisition cost of
ordering at the $55 price?
• b. What is the annual total acquisition cost of
ordering at the $50 price?
Example 2 solution
• Annual Demand = 40 units/day x 300 days = 12,000 units

• EOQ at the $55 price = √((2(12,000)$30))/($55(.20))) =

√(720,000/11) = √65,454.56 = 255.85, rounded to 256 units

• Total Product cost = $55(12,000) = $660,000

• Total Ordering Cost = $30(12,000/256) = $1,406.25
• Total Inventory carrying cost = $55(.20)(256/2) = $1,408

• TAC = $662,814.25
Example 2 solution
• EOQ at $50 price = √((2(12,000)($30))/($50(.20))) = 268.33 units.
• In order to qualify for the $50 price, Johnson must order a minimum
of 400 units.
• Therefore, the following costs are calculated based on this order
quantity.

• Total Product cost = $50(12,000) = $600,000

• Total Ordering cost =$30(12,000/400) = $900
• Total Inventory carrying cost = $50(.20)400/2 = $2,000
• TAC = $602,900