14

Operations and
Supply Chain
Management
CHASE | SHANKAR | JACOBS
20–1
 INVENTORY
MANAGEMENT

Chapter Twenty
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20–2
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Learning Objectives
• LO20–1: Explain how inventory is
used and understand what it costs

• LO20–2: Analyze how different

inventory control systems work

• LO20–3: Analyze inventory using the

Pareto principle

20–3
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Inventory
• Inventory can be visualized as stacks of money
sitting on forklifts, on shelves, and in trucks and
planes while in transit.
• For many businesses, inventory is the largest
asset on the balance sheet at any given time.
• Inventory can be difficult to convert back into
cash.
• It is a good idea to try to get your inventory
down as far as possible.
– The average cost of inventory in the United States is
30 to 35 percent of its value. 20–4
 Supply Chain
Inventory Models

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 Copyright © 2014 by McGraw Hill Education (India) Private Limited. All rights
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Inventory Models
Single-period model

• Used when we are making a one-time purchase of

an item

Fixed-order quantity model

• Used when we want to maintain an item “in-stock,”

and when we restock, a certain number of units
must be ordered

Fixed–time period model

• Item is ordered at certain intervals of time

20–6
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Definitions
• Inventory: the stock of any item or resource
used in an organization
– Includes raw materials, finished products, component
parts, supplies, and work-in-process
– Manufacturing inventory: refers to items that
contribute to or become part of a firm’s product
• Inventory system: the set of policies and
controls that monitor levels of inventory
– Determines what levels should be maintained, when
stock should be replenished, and how large orders
should be
20–7
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Purposes of Inventory

To maintain To allow flexibility

To meet variation
independence of in production
in product demand
operations scheduling

To provide a
To take advantage
safeguard for
of economic
variation in raw
purchase order
material delivery
size
time

20–8
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Inventory Costs
Holding (or carrying) Setup (or production
costs change) costs
• Costs for storage, handling, • Costs for arranging specific
insurance, and so on equipment setups, and so on

Costs

Ordering costs Shortage costs

• Costs of placing an order • Costs of running out

20–9
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Demand Types
Independent demand – the
demands for various items are
unrelated to each other
• For example, a workstation may
produce many parts that are
unrelated but meet some external
demand requirement

Dependent demand – the

need for any one item is a
direct result of the need for
some other item
• Usually a higher-level item of which it
is part

20–10
 Design Matrix
Inventory Control-System

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20–11

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Inventory Systems –

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Comparison
Single-period inventory
model
• One-time purchasing decision
(e.g., vendor selling T-shirts at
a football game)
• Seeks to balance the costs of
inventory overstock and under
stock

Multi-period inventory models

• Fixed-order quantity models
• Event triggered (e.g., running out of
stock)
• Fixed-time period models
• Time triggered (e.g., monthly sales
call by sales representative)

20–12
 Single Period

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Inventory Model
Consider the problem of
deciding how many
newspapers to put in a hotel
lobby
Too few papers and some
Too many papers and the
customers will not be
price paid for papers that
able to purchase a paper,
were not sold during the
and profits associated
day will be wasted,
with these potential sales
lowering profit.
are lost.

20–13
 Solving the

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Newspaper Problem
• Consider how much risk we are willing to take of running
out of inventory.
• Assume a mean of 90 papers and a standard deviation of
10 papers.
• Assume we want an 80 percent chance of not running
out.
• Assume that the probability distribution associated of
sales is normal, stocking 90 papers yields a 50 percent
chance of stocking out.

20–14
 Solving the

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Newspaper
• From Appendix E, Problem
we see that we need
approximately 0.85 standard deviation of
extra papers to be 80 percent sure of not
stocking out.
• Therefore .85X10 = 8.5 or say 9
news paper in addition to
average 90 added i.e 99 papers
will assure 80% sure of not
stocking out.

20–15
 Single-Period

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Inventory Models
𝐶𝑢
𝑃≤
𝐶 𝑜 +𝐶𝑢
Where:
Co = cost per unit of demand over stocking level
Cu = cost per unit of demand under stocking level
P = probability that a given unit will be sold

• We should increase the size of the

inventory so long as the probability
of selling the last unit added is equal
to or greater than the ratio
𝐶𝑢
𝐶 𝑜 + 𝐶𝑢
20–16
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Example 20.1
𝐶𝑢 80
𝑃≤ ¿
𝐶 𝑜 +𝐶𝑢 200 + 80 ¿ 0.2857
Hotel Booking problem
• Mean demand is 5
– Standard deviation of demand is 3
– Room rate is $80 (this is the cost if overbookings
are less than cancelations - Cu)
– Penalty for overbooking is $200 (this is the cost
if overbookings are more than cancelations - Co)

For the Excel template visit Excel: Overbo

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Example 20.1
• From Appendix E, we see that our
desired level falls about 0.55
standard deviations below the mean
(z = -0.55)
– Using Excel,
“=NORMSINV(0.2857)” = 0.56599

20–18
Example 20.1 – Overbooking

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Table
If we overbook by 1
and we have zero no-
shows, we incur the
penalty of $200 – one
person must be
compensated for
having no room.

If we overbook by 1
and we have three no-
shows, we have lost
sales of $80.

Total cost of a policy of

overbooking by 9
rooms is the weighted
average of the events
(number of no-shows)
and the outcome of
those events.
20–19
Single Period Model

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Applications
Overbooking of airline flights

Ordering of clothing and other fashion items

One-time order for events – e.g., t-shirts for a

concert

20–20
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Multi-Period Models
Fixed-order quantity models
- Also called the economic
order quantity, EOQ, and Q-
model
- Event triggered

Fixed–time period models

- Also called the periodic system,
periodic review system, fixed-
order interval system, and P-mode
- Time triggered

20–21
 Multi-Period Models –

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Comparison
• Fixed-Order Quantity • Fixed-Time Period
– Inventory remaining
– Counting takes place only
must be continually at the end of the review
monitored period
– Has a smaller average – Has a larger average
inventory inventory
– Favors more expensive – Favors less expensive items
items – Is sufficient for less-
important items
– Is more appropriate for
– Requires less time to
important items maintain
– Requires more time to – Is less expensive to
maintain – but is usually implement
more automated
– Is more expensive to
implement 20–22
 Comparison
Multi-Period Models –

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20–23

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 Process
Multi-Period Models –

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Fixed-Order Quantity Models –

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Assumptions
• Demand for the product is constant and
uniform throughout the period.
• Lead time (time from ordering to receipt) is
constant.
• Price per unit of product is constant.
• Inventory holding cost is based on average
inventory.
• Ordering or setup costs are constant.
• All demands for the product will be satisfied.
20–25
 Fixed-Order Quantity

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Model
Always order Q units when Inventory is consumed at
inventory reaches reorder a constant rate, with a
point (R). new order placed when
the reorder point (R) is
reached once again.

Inventory arrives after

lead time (L). Inventory
is raised to maximum
level (Q).

20–26
Economic Order

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Quantity (EOQ)
The optimal order
quantity (Qopt) occurs
where total costs are at
their minimum

20–27
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Example 20.2
• Annual demand (D) =
1,000 units
– Average daily demand
= = 2.74 units
– Ordering cost (S) = $5 per
order
– Holding cost (H) = $1.25
per unit per year
– Lead time (L) = 5 days
– Cost per unit (C) = $12.50
What is EOQ and what is
reorder point?
What is total cost? Excel: Economi
c Order Quantit
For the Excel template visit y
www.mhhe.com/sie-chase14e
20–28
 Establishing Safety

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Stock Levels
Safety stock – refers to the amount of inventory
carried in addition to expected demand.

• Safety stock can be determined based on many different criteria.

A common approach is to simply keep a certain

number of weeks of supply.

A better approach is to use probability.

• Assume demand is normally distributed.

• Assume we know mean and standard deviation.
• To determine probability, we plot a normal distribution for expected demand
and note where the amount we have lies on the curve.

20–29
 Fixed-Order Quantity Model

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with Safety Stock
Demand is variable,
but follows a known
distribution/

After the reorder is placed,

demand during the lead time
may be higher than expected,
consuming some (or all) of the
safety stock/

20–30
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Example 20.4
• Average daily demand
() = 60
For 95%
• Annual demand (D) = 60(365) = probabilit
21,900 y, z =
• Standard deviation of demand 1.64.
during lead time (σD) = 7
• Ordering cost (S) = $10 per order Policy – place a new
• Holding cost (H) = $0.50 per unit order for 936 units
per year whenever stock
falls to 388 units on
• Lead time (L) = 6 days hand. This results in
• Find the order quantity and a 95% probability of
reoder point tof satisfy a not stocking out
95% probability of not during the lead
stocking out time. Excel: Reorde
For the Excel template visit r Point
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20–31
 Fixed-Time Period

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Model
• q = quantity to be ordered
• T = number of days between reviews
• L = lead time in days
• = forecast average daily demand
• Z = number of standard deviations required for
specific service level
• σT+L = standard deviation of demand during the
review and lead time
• I = current inventory level (including items on
order)
𝑞=𝑑 ( 𝑇 + 𝐿) + 𝑧 𝜎 𝑇 + 𝐿
20–32
 Fixed-Time Period

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Model

Time periods
are equal, Reorder quantity varies,
but ending depending upon ending
inventory inventory level. Beginning
varies. inventory is always the
same.
20–33
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Example 20.5
• Daily demand () of 10
units
• Daily standard deviation () of 3
units
• Review period (T) of 30 days
• Lead time (L) of 14 days
• 98 percent of demand should be
met from items in stock
• 150 units in inventory (I)
How many units should be ordered

Excel: Fixed Ti
me Period Mod
For the Excel template visit
el
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20–34
 Inventory Control and Supply

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Chain Management
• Average inventory
– expected
amount of
inventory over
time

• Inventory turns –
number of times
inventory is cycled
through over time
– a measure of
how efficiently 20–35
 Inventory Models with Price

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Breaks
• Price varies with the order size.

• To find the lowest-cost, calculate the order

quantity for each price and see if the
quantity is feasible.
– Sort prices from lowest to highest and calculate the
order quantity for each price until a feasible order
quantity is found.
– If the first feasible order quantity is the lowest price,
this is best; otherwise, calculate the total cost for the
first feasible quantity and calculate total cost at each
price lower than the first feasible order quantity. 20–36
 Breaks
Inventory Models with Price

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Example 20.8
• Annual demand (D ) =
10,000
• Ordering cost (S ) = $20
per order
• Interest/carrying cost (i )
= 20%
• Cost per unit (C )
– 1–499 → $5.00
– 500–999 → $4.50
– 1000 or more → $3.90
Find the best option

20–38
 Example 20.8

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 ABC Classification

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• A items tightly controlled weekly
order
• B items bi weekly order
• C items monthly order

20–41
 Inventory

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Management
Cycle
counting – a
Inventory physical
accuracy – inventory-
refers to how taking
well the technique in
inventory which
records inventory is
agree with counted on a
physical frequent
count basis rather
than once or
twice a year

20–42