Production and

Operation
Management
(MAN406)
Lesson 8: Inventory Control and Management

By: Dr. Falak Shad Memon

Inventory System

• Inventory is the stock of any item or

resource used in an organization and
can include: raw materials, finished
products, component parts, supplies,
and work-in-process
• An inventory system is the set of
policies and controls that monitor
levels of inventory and determines
what levels should be maintained,
when stock should be replenished, and
how large orders should be
 Purposes of Inventory

1. To maintain independence of
operations
2. To meet variation in product demand
3. To allow flexibility in production
scheduling
4. To provide a safeguard for variation in
raw material delivery time
5. To take advantage of economic
purchase-order size
 Inventory Costs

• Holding (or carrying) costs

• Costs for storage, handling, insurance, etc
• Setup (or production change) costs
• Costs for arranging specific equipment
setups, etc
• Ordering costs
• Costs of someone placing an order, etc
• Shortage costs
• Costs of canceling an order, etc
 Independent vs. Dependent Demand

Independent Demand (Demand for the final end-

product or demand not related to other items)
Finished
product

Dependent
Demand
(Derived demand
items for
E(1 component
) parts,
subassemblies,
Component parts raw materials,
etc)
 Inventory Systems

• Single-Period Inventory Model

• One time purchasing decision (Example: 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 (Example: running out of stock)
• Fixed-Time Period Models
• Time triggered (Example: Monthly sales call by
sales representative)
 Multi-Period Models:
Fixed-Order Quantity Model
Model Assumptions (Part 1)

• 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

 Multi-Period Models:
Fixed-Order Quantity Model Model
Assumptions (Part 2)

• Inventory holding cost is based on

average inventory

• Ordering or setup costs are constant

• All demands for the product will be
satisfied (No back orders are allowed)
 Basic Fixed-Order Quantity Model and
Reorder Point Behavior
1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
2. Your start using L L
them up over time. 3. When you reach down to a
Time level of inventory of R, you
R = Reorder point place your next Q sized
Q = Economic order quantity order.
L = Lead time
 Cost Minimization Goal
By
Byadding
addingthe
theitem,
item,holding,
holding,andandordering
orderingcosts
costs
together,
together,we
wedetermine
determinethethetotal
totalcost
costcurve,
curve,which
whichinin
turn
turnis
isused
usedtotofind
findthe
theQQopt inventory order point that
opt inventory order point that
minimizes
minimizestotal
totalcosts
costs

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Order Quantity (Q)
 Basic Fixed-Order Quantity TC=Total
TC=Totalannual
annual
cost
(EOQ) Model Formula cost
DD=Demand
=Demand
Total Annual Annual Annual CC=Cost
=Costperperunit
unit
Annual = Purchase + Ordering + Holding QQ=Order
=Orderquantity
quantity
Cost Cost Cost Cost SS=Cost
=Costofofplacing
placing
an
anorder
orderororsetup
setup
cost
cost
RR=Reorder
=Reorderpoint
point
LL=Lead
=Leadtime
time
H=Annual
H=Annualholding
holding
D Q and
andstorage
storagecost
cost
TC = DC + S + H per
perunit
unitof
ofinventory
inventory

Q 2
 Deriving the EOQ
Using
Using calculus,
calculus, we
we take
take the
the first
first derivative
derivative
of
of the
the total
total cost
cost function
function with
with respect
respect to
to
Q,
Q, and
and set
set the
the derivative
derivative (slope)
(slope) equal
equal to
to
zero,
zero, solving
solving for
for the
the optimized
optimized (cost
(cost
minimized)
minimized) value
value of
of Q
Qopt
opt

2DS 2(Annual D em and)(Order or Setup Cost)

Q OPT = =
H Annual Holding Cost
_
We
Wealso
alsoneed
needaa
reorder
reorderpoint
pointto
totell
tellus
us
R eorder point, R = d L
when
whentotoplace
placean
an _
order
order d = average daily demand (constant)
L = Lead time (constant)
EOQ Example (1) Problem Data
Given
Giventhe
theinformation
informationbelow,
below,what
whatare
arethe
theEOQ
EOQand
andreorder
reorderpoint?
point?

Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
 EOQ Example (1) Solution
2DS 2(1,000 )(10)
Q OPT = = = 89.443 units or 90 units
H 2.50

1,000 units / year

d = = 2.74 units / day
365 days / year

_
Reorder point, R = d L = 2.74units / day (7days) = 19.18 or 20 units

In
Insummary,
summary,youyouplace
placeananoptimal
optimalorder
orderof
of9090units.
units. In
In
the
thecourse
courseof
ofusing
usingthe
theunits
unitsto
tomeet
meetdemand,
demand,when
when
you
youonly
onlyhave
have2020units
unitsleft,
left,place
placethe
thenext
nextorder
orderof
of90
90
units.
units.
EOQ Example (2) Problem Data
Determine
Determine thethe economic
economic order
order quantity
quantity
and
and the
the reorder
reorder point
point given
given the
the following…
following…

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost
per unit
Lead time = 10 days
Cost per unit = $15
 EOQ Example (2) Solution
2DS 2(10,000 )(10)
Q OPT = = = 365.148 units, or 366 units
H 1.50

10,000 units / year

d= = 27.397 units / day
365 days / year

_
R = d L = 27.397 units / day (10 days) = 273.97 or 274 units

Place
Placeananorder
orderfor
for366
366units.
units. When
Whenininthe
thecourse
courseofofusing
usingthe
the
inventory
inventoryyou
youare
areleft
leftwith
withonly
only274
274units,
units,place
placethe
thenext
nextorder
orderof
of366
366
units.
units.
 Price-Break Model Formula
Based on the same assumptions as the EOQ model, the price-break
model has a similar Qopt formula:

2DS 2(Annual Demand)(Order or Setup Cost)

Q OPT = =
iC Annual Holding Cost

i = percentage of unit cost attributed to carrying inventory

C = cost per unit

Since “C” changes for each price-break, the formula

above will have to be used with each price-break cost
value
 Price-Break Example Problem Data
(Part 1)
AA company
company has has aa chance
chance to to reduce
reduce their
their
inventory
inventory ordering
ordering costs costs by by placing
placing
larger
larger quantity
quantity ordersorders usingusing the
the price-
price-
break
break order
order quantity
quantity schedule
schedule below.
below.
What
What should
should theirtheir optimal
optimal orderorder quantity
quantity
be
be if
if this
this company
company purchases
purchases this this single
single
inventory
inventory item item withwith anan e-mail
e-mail ordering
ordering
cost
cost ofof $4,
$4, aa carrying
carrying cost cost rate
rate of
of 2%
2% of
of
the
the inventory
inventory
Order
cost
cost
Quantity(units)
of
of the
the item,
Price/unit($) item, and
and anan
annual
annual 0demand
demand
to 2,499 of
of 10,000
10,000 units?
$1.20 units?
2,500 to 3,999 1.00
4,000 or more .98
 Price-Break Example Solution (Part 2)
First, plug data into formula for each price-break value of “C”
Annual Demand (D)= 10,000 units Carrying cost % of total cost (i)= 2%
Cost to place an order (S)= $4 Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 2499, the 2DS 2(10,000)( 4)

Qopt value is feasible Q OPT = = = 1,826 units
iC 0.02(1.20)
Interval from 2500-3999, the 2DS 2(10,000)( 4)
Qopt value is not feasible Q OPT = = = 2,000 units
iC 0.02(1.00)
Interval from 4000 & more, the 2DS 2(10,000)( 4)
Qopt value is not feasible Q OPT = = = 2,020 units
iC 0.02(0.98)
 Price-Break Example Solution (Part 3)
Since
Sincethe
thefeasible
feasiblesolution
solutionoccurred
occurredininthe
thefirst
firstprice-break,
price-break,ititmeans
meansthat
that
all
allthe
theother
othertrue
trueQQopt values occur at the beginnings of each price-break
opt values occur at the beginnings of each price-break
interval.
interval. Why?
Why?

Because
Becausethe
thetotal
totalannual
annualcost
costfunction
functionis
isaa“u”
“u”shaped
shaped
function
function
Total
annual
costs So
Sothe
thecandidates
candidatesfor
for
the
theprice-breaks
price-breaksare
are
1826,
1826,2500,
2500,and
and4000
4000
units
units

0 1826 2500 4000 Order Quantity

 Price-Break Example Solution (Part 4)
Next,
Next,we
weplug
plugthe
thetrue
trueQQopt values into the total cost annual cost function to
opt values into the total cost annual cost function to
determine
determinethe
thetotal
totalcost
costunder
undereach
eachprice-break
price-break

D Q
TC = DC + S+ iC
Q 2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
==$12,043.82
$12,043.82
TC(2500-3999)=
TC(2500-3999)=$10,041
$10,041
TC(4000&more)=
TC(4000&more)=$9,949.20
$9,949.20

Finally,
Finally,we
weselect
selectthe
theleast
leastcostly
costlyQQopt , which is this problem occurs in the
opt, which is this problem occurs in the
4000
4000&&more
moreinterval.
interval. In
Insummary,
summary,ourouroptimal
optimal order
orderquantity
quantityis
is4000
4000units
units
 Miscellaneous Systems:
Optional Replenishment System
Maximum Inventory Level, M

q=M-I

Actual Inventory Level, I

M

Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.

 Miscellaneous Systems:
Bin Systems
Two-Bin System

Order One Bin of

Inventory
Full Empty
One-Bin System

Order Enough to
Refill Bin
Periodic Check
 ABC Classification System

• Items kept in inventory are not of

equal importance in terms of:
60
% of
• dollars invested
$ Value 30 A
• profit potential 0 B
• sales or usage volume % of 30 C
• stock-out penalties Use 60

So, identify inventory items based on percentage of total dollar value, where
“A” items are roughly top 15 %, “B” items as next 35 %, and the lower 65%
are the “C” items
Inventory Accuracy and Cycle Counting

• Inventory accuracy refers to how well

the inventory records agree with
physical count
• Cycle Counting is a physical inventory-
taking technique in which inventory is
counted on a frequent basis rather than
once or twice a year