Foreign Trade University

Content
Definition and purpose of inventory
Inventory costs
Inventory systems
Economic order quantity (EOQ) models
A-B-C approach
Inventory control
Learning Objectives
 Define the term inventory and list the major
reasons for holding inventories; and list the main
requirements for effective inventory management.
 Discuss periodic and perpetual review systems.
 Discuss the objectives of inventory management.
 Describe the A-B-C approach and explain how it is
useful.
Learning Objectives
 Describe the basic EOQ model and its assumptions
and solve typical problems.
 Describe the EPQ model and solve typical
problems.
 Describe the quantity discount model and solve
typical problems.
 Describe reorder point models and solve typical
problems.
 Describe situations in which the single-period
model would be appropriate, and solve typical
problems.
What is inventory?
Examples:
Parts in a factory
Paper towels in your cupboard
Customers on hold
Paperwork in secretary’s in-box
Not limited to physical products

Inventory is DELAY in business process.

What is inventory?
Within organization:

Input Transformation Output

Raw materials Work-in-Process Finished goods
• Materials received • Semi-finished • Products waiting
• Customers waiting products to be shipped
in a bank • Customers at the • Customers
• Paperwork in in- counter leaving the bank
box • Paperwork on • Paperwork in out-
desk box

Between organizations: Goods-in-transit

Inventory
Inventory: a stock or store of goods Independent Demand
(e.g. EOQ in Ch 13)

A Dependent Demand
(MRP in Ch 12)

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
Definition
Inventory is the stock of any item or resource used
in an organization.

An inventory system is the set of policies and

controls that monitor levels of inventory and
determine what levels should be maintained, when
stock should be replenished, and how large order
should be.
Inventory: Manufacturing vs.
Service
Manufacturing inventory: raw materials, finished
products, component parts, supplies, and work-in-
progress.

Inventory in service: tangible goods to be sold and

the supplies necessary to administer the service.
Purposes of Inventory
To maintain independence of operations
To meet variation in product demand
To allow flexibility in production scheduling
To provide a safeguard for variation in raw material
delivery time
To take advantage of economic purchase order size
Objective of Inventory Control
To achieve satisfactory levels of customer
service while keeping inventory costs within
reasonable bounds
Level of customer service

Costs of ordering and carrying inventory

Inventory turnover is the ratio of annual

cost of goods sold to average inventory
investment.
Effective Inventory Management
A system to keep track of inventory
A reliable forecast of demand
Knowledge of lead times
Reasonable estimates of
Holding costs
Ordering costs
Shortage costs
A classification system
 Key Inventory Terms
Lead time: time interval between ordering and receiving
the order
Holding (carrying) costs: cost to carry an item in
inventory for a length of time, usually a year
Ordering (set-up) costs: costs of ordering and receiving
inventory
Shortage costs: costs when demand exceeds supply
Reorder point (ROP): when the quantity on hand of an item drops
to this amount, the item is reordered.
Safety stock (Ss): level that reduces risk of stock-out during lead
time or random variation.
Lead time service level (LTSL): probability that demand will not
exceed supply during lead time.
Inventory Costs
Holding (carrying) costs
Ordering (set-up)costs
Shortage costs
Inventory Costs
Holding (carrying) costs
Relate to physically having items in storage, including:
- Costs for storage facilities: rent, rate, utility costs,
equipments…
- Costs of handling, breakage, obsolescence, spoilage…;
- Costs of insurance, taxes;
- Opportunity cost of capital: associates with having
funds which could be used elsewhere tied up in inventory
To reduce holding costs, keep low inventory
levels (order small quantity in each time and increase
order times)
Inventory Costs
Ordering costs
The costs of ordering and receiving inventory:
- Costs for determining how much is needed,
- Costs for preparing invoices, goods inspection,
- Costs for shipping, moving goods to temporary
storage.

To reduce ordering costs, reduce the

number of order times and increase the quantity
in each order.
Inventory Costs
Holding costs vs. Ordering costs

How to achieve optimal inventory costs?

 Inventory Costs = holding costs + ordering costs min

Inventory Costs
Shortage costs
When demand exceeds the supply of inventory on hand

- Opportunity cost of not making a sale, loss of customer

goodwill;
- Cost of lost production, downtime.

Difficult to measure, subjectively estimated

Inventory Systems
Provides the organizational structure and the
operating policies for maintaining and controlling
goods to be stocked.
Two main questions:
- When to order? (Inventory Counting Systems: Fixed-
time period model (P-model) and Fixed-order quantity
model (Q-model)

- How much to order? (EOQ, EPQ, and Quantity

Discount Models)
Fixed-time Period Model
(P-model)
Periodic system, in which inventory is counted only
at particular times (every week, every month…)
Order quantity varies each time order is placed
Order when the review period arrives
Recordkeeping is counted at review period
Size of inventory is larger than fixed-order quantity
model (Q-model).
Fixed-time Period Model
(P-model)
Q

Q1 Q2 Q3
Place order

Safety
Stock t

t1 t2 t3
t1 = t2= t3; Q1≠ Q2 ≠ Q3
Fixed- order Quantity Model
(Q-model)
Perpetual system, which requires that every time a
withdrawal from inventory or an addition to
inventory is made, records must be updated to reflect
whether the reorder point (Q0) has been reached.
Order quantity is constant at each time order.
Order when inventory position drops to reorder level.
Recordkeeping when a withdrawal or addition is
made.
Size of inventory is less than P-model.
Fixed-order Quantity Model
(Q-model)
Q

Q1 Q2 Q3
Reorder Place order
point
Q0

Safety
stock t
t1 t2 t3
Q1 = Q2= Q3; t1≠ t2 ≠ t3
Requirements for Effective
Inventory Management
Keep track of the inventory on hand and on order;
Forecast demand precisely and reliably;
Understand and control lead times;
Estimates the inventory costs in reasonable manner;
Use bar code for tracking inventory…
Economic Order Quantity
(EOQ) Models
Identify the optimal order quantity by minimizing the
sum of certain annual costs that vary with order size

- The basic economic order quantity model

- The economic production quantity model
- The quantity discount model
Basic Economic Order Quantity
(EOQ) Model
Determine the optimal order size
Purpose: minimize the sum of annual costs of holding
and ordering inventory.
Assumption
- Only 1 product is involved.
- Annual demand requirements are known.
- Demand rate is reasonably constant.
- Lead time does not vary.
- Each order is received in a single delivery.
- There are no quantity discounts.
Basic Economic Order Quantity
(EOQ) Model
D: Demand given in time t (per year)
Q: Order quantity
H: Holding cost per unit
S: Ordering cost per order
TSC (total annual stocking costs): include holding
costs and ordering costs
•Annual ordering costs = D/Q * S
Number of orders (D/Q) * Ordering cost per order (S)

•Annual holding costs = Q/2 * H

An average amount of inventory (Q/2) * Holding cost per
unit (H)

•Total annual stocking costs:

Q D
 TSC  H  S
2 Q
 Determine Q to minimize total annual stocking costs

d(TSC)/d(Q) = H/2 + (- DS/Q2) = 0

EOQ  2DS/H  Q*
TSC
Costs

Holding costs

Ordering costs

Order
EOQ quantity
n: number of orders in given time t
n = D/Q
Optimal number of orders:

n *  D/EOQ  DH/2S

Optimal inventory costs:

Q* D Q*
TSC*  H S H  n * .S
2 Q* 2
Example
A company sells one product to the market. The
annual demand of this product is10000 tons. Holding
cost per unit is 4USD/year. Ordering cost per order is
55USD. Determine the optimal order quantity and
the number of orders per year.
Advantages of basic EOQ model

+ Simple, easy to calculate.

+ Can be applied for different products and inventory
costs which are suitable for different types of
businesses.
+ Can avoid errors from a given data set when
determine EOQ.
Economic Production Quantity
(EPQ) Model
A company makes and uses its products itself.
Batch production used whereas the capacity to produce a part
exceeds the demand rate.
Assumptions:
- Only one item is involved.
- Annual demand is known.
- The usage rate is constant.
- Usage occurs continually, production occurs periodically.
-The production rate is constant.
- Lead time does not vary
- No quantity discounts
Economic Production Quantity
(EPQ) Model
S: Setup costs are used (no ordering cost)
p = production rate
u = usage rate
=>To meet demand: u< p

Total annual stocking costs = holding cost + setup cost

 u 
Q
1  p 

  D
TSC  H  S
2 Q
Economic Production Quantity
(EPQ) Model
- The economic run quantity (EPQ):

2DS 2 DS p
EPQ   .
 u H p u
H1- 
 p

- Cycle time = Q/u

- Run time = Q/p
- Maximum inventory level = Q/p.(p-u) = Q.(1-u/p)
- Average inventory level = Q/2.(1-u/p)
Economic Production Quantity
(EPQ) Model
Example: Annual demand of a product is 14400 tons.
The holding cost per unit is 4USD/ year. The setup
cost per run is 55 USD. The production rate of this
product is 120 tons/day. The usage rate is 40 tons.
Determine the EPQ
Quantity Discount Model
Price reductions for large orders, which induce
customers to buy in large quantities
Consider:
- Potential benefits of reduced purchase price and
fewer orders in large quantities.
- Increase in carrying costs of higher average
inventories.
Quantity Discount Model
P: purchase price per unit
TMC (total annual material cost):

TMC =TSC +D.P

TMC = (Q/2)H + (D/Q)S +

D.P
Quantity Discount Model
Example: A shop imports and resells one product to the
market. Annual demand of this product is D =10000 tons.
Holding cost is 0.2P (P is purchase cost per unit) USD/year.
Ordering cost per order is 5.5USD. The shop is offered a price
policy as follow:
Quantity (tons) Price (USD/ton)
1-399 2.2
400-699 2
>700 1.8
Finding the optimal solution for this shop?
A-B-C Approach
Classify inventory based on some measure of
importance, then locate control efforts accordingly

- Class A: very important (15-20% of number of items,

70-80% of total inventory value)
- Class B: moderately important (30% of number of
items, 15-25% of total inventory value)
- Class C: least important (50-55% number of items, only
5% of total inventory value)
A-B-C Approach
A items: close attentions with regular reviews of
amount on hand and withdrawals => ensure customer
service levels are attained.
B items: managed by applying EOQ model
C items: loose control, periodical review
Example
There are 10 different materials A, B, C, D, E, F, G, H, I, J
stocked in a company. The annual demand of each material and
their prices are as below. Classify the inventory items as A, B,
C based on annual dollar value.
Material A B C D E F G H I J
Demand 1000 500 1550 350 1000 600 2000 100 1200 250
Price 90 154 17 42.86 12.5 14.17 0.6 8.5 0.42 0.6
(USD)
Inventory Control
- Objectives: to manage and achieve cost effectiveness
- Determine
* Reorder point (ROP)
* Safety stock (Ss)
* Lead time service level (LTSL)
* Lead time (LT)
 Inventory Control
- X: expected demand during lead time
- X : average value of X
- z: number of standard deviations
- : standard deviation of lead time demand

ROP = Expected demand during LT + Safety stock

Safety Stock = z.
 Exercises

1. D = 500000 units/year, H = 40% of product value;

S = 59.5 USD and P = 5.5 USD/unit.
a. Determine EOQ, TSC
b. If we increase Q by 6000 units per order to fit the
container, how much does TSC increase?
2. A company stocks one type of product and its price is
800 USD/unit. Its annual demand is 2400 units. The
ordering cost is 1200 USD per order. The holding cost per
unit annually is 50% of the product value. The supplier of
the company offered them a price reduction of 5% if the
quantity per each order is equal to and more than 250
units. Find out the optimal solution for the company.
3. Every year a company imports 2 types of products
with following quantities and prices:
Product A: 2400 units at 800 USD/unit
Product B: 600 units 360 USD/unit
The holding cost per unit annually is equal to 50% value
of the product. The ordering cost for both products is
2000 USD/order.
Determine the optimal number of order and EOQ.