MGMT2026 PRODUCTIONS AND OPERATIONS MANAGEMENT (POM)

LECTURE 9: INVENTORY MANAGEMENT

Mr. Andrew Eastmond

 Learning Objectives
 Students should be able to:
• Explain the nature and relevance of inventory
management and control.
• Describe the key characteristics, models and
procedures involved in inventory management.
• Apply various inventory ordering policies and
methodologies in POM.

2
 Inventory and Inventory Models
• An inventory is a stock or store of goods.
• Two models of inventory:
Independent demand items – finished goods,
items that are ready to be sold
– E.g. a computer
Dependent demand items – components of
finished products.
– E.g. parts that make up the computer.

12-3
 Types of Inventories

• Raw materials & purchased parts

• Partially completed goods called
work in progress
• Finished-goods inventories
– (manufacturing firms)
or merchandise
(retail stores)

12-4
 Types of Inventories (Cont’d)
• Replacement parts, tools, & supplies
• Goods-in-transit to warehouses or customers

12-5
 Functions of Inventory
• To meet anticipated customer demand – customers who
come into a store for a particular product
• To smooth production requirements – Firms will build up
inventories in preseason periods to meet overly high
demands in seasonal periods (e.g. Christmas cards and
gifts).
• To decouple operations – Firms can use inventories to
maintain continuity of production in cases of equipment or
production breakdowns.
• To protect against stockouts – Holding safety stocks in case
of shortages – i.e. stocks in the excess of expected
demand. 12-6
 Functions of Inventory (Cont’d)
• To take advantage of order cycles - firms often
buy in quantities that exceed immediate demand
requirements.
• To help hedge against price increases - Firms can
beat anticipated price increases by purchasing
larger-than-normal amounts of goods.
• To permit flow of production operations
• To take advantage of quantity discounts from
suppliers.

12-7
Objectives of Inventory Control
• Effective Inventory control prevents under-
and overstocking of items.
• Understocking causes missed deliveries,
lost sales, dissatisfied customer, etc.
• Overstocking ties up funds that might be
more productive elsewhere, high holding
costs, wastage, etc.

12-8
Objective of Inventory Control II
• 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
average cost of goods sold to
average inventory investment.

12-9
 Inventory Turnover Ratio
• This turnover ratio captures how many times a year
the inventory is sold:

COST OF GOODS SOLD (NET SALES) ÷ AVERAGE

INVENTORY (IN A GIVEN YEAR)
• The higher the ratio, the better and more efficient
use of inventories.
• Average inventory is the average of beginning
inventory (amount purchased at start of the year)
and ending inventory (amount end of the year).
 EXAMPLE
• Donny's Furniture Company sells industrial furniture for office
buildings. During the current year, Donny reported cost of
goods sold on its income statement of $1,000,000. Donny's
beginning inventory was $3,000,000 and its ending inventory
was $4,000,000. Donny's turnover is calculated like this:

• As you can see, Donny's turnover is 0.29. This means that

Donny only sold roughly a third of its inventory during the year.
It also implies that it would take Donny approximately 3 years
to sell its entire inventory or complete one turn. In other words,
Donny does not have very good inventory control.
 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
 Inventory Counting Systems
• Periodic System
Physical count of items made at periodic
intervals in order to decide how much to order
of each items
• Perpetual Inventory System
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item
12-13
Inventory Counting Systems (Cont’d)
• Two-Bin System - Two containers of
inventory; reorder when the first is empty
• Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached
0

214800 232087768

12-14
 Key Inventory Terms and Costs
• Lead time: time interval between ordering and receiving the
order from a supplier.
• Purchase costs: Amount paid to a vendor or supplier to buy
inventory.
• Holding (carrying) costs: cost to carry an item in inventory for
a length of time, usually a year (e.g. interest, insurance,
taxes, depreciation, spoilage, warehousing costs, etc).
• Ordering costs: costs of ordering and receiving inventory (e.g.
shipping costs, preparation of invoices, inspections of goods
upon arrival, moving goods to temporary storage).
• Shortage costs: costs when demand exceeds supply (e.g. loss
of a sale or customers, late charges, backorder costs, etc).
 ABC Classification System
Figure 12.1

Classifying inventory according to some

measure of importance and allocating
control efforts accordingly.
A - very important
B - mod. important High
A
C - least important Annual
$ value B
of items

Low C
Low High
Percentage of Items
12-16
 Cycle Counting
• A physical count of items in inventory
• Cycle counting reduces discrepancies between
the amounts indicated by inventory records
and actual quantities of inventory on hand.
• Cycle counting management
– How much accuracy is needed?
– When should cycle counting be performed?
– Who should do it?

12-17
 Cycle Counting
 Items are counted and records updated on a
periodic basis
 Often used with ABC analysis
to determine cycle
 Has several advantages
 Eliminates shutdowns and interruptions
 Eliminates annual inventory adjustment
 Trained personnel audit inventory accuracy
 Allows causes of errors to be identified and corrected
 Maintains accurate inventory records
 Inventory Models
• Fixed order-quantity models. How
Howmuch
muchand
and
– 1. Economic order quantity (EOQ). when
whentotoorder?
order?

– 2. Economic production quantity

(EPQ).
– 3. Quantity discount.
• Probabilistic models.
• Fixed order-period models.
 Fixed Order Quantity Models
• These methods allow for a specified or fixed quantity of
a given item or product to be ordered at one time.
• These models identify the optimal order quantity by
minimising the sum of certain annual costs that vary
with order size. Three order size models are described
here:
– 1. Economic order quantity model (EOQ).
– 2. Economic production quantity model (EPQ).
– 3. Quantity discount model.
1. Economic Order Quantity (EOQ)
• The economic order quantity model (EOQ) is the
simplest of the three models.
• It is used to identify a fixed order size that minimises
the total annual costs of holding inventory and
ordering inventory.
• The unit purchase price of items in inventory is not
generally included in the total cost because the unit
cost is unaffected by the order size unless quantity
discounts are a factor.
• If holding costs are specified as a percentage of unit
cost (purchase price), then unit cost is indirectly
included in the total cost as a part of holding costs.
 Total Cost
The total annual cost associated with carrying and ordering
inventory when Q units are ordered each time is:

Annual Annual
Total cost = carrying + ordering
cost cost
Q + D S
TC = H
Where 2 Q
Q = quantity to be ordered
H= holding cost per unit (carrying cost per unit) Note that D and H
must be in the
D = annual demand same units, e.g.,
months, years
S = ordering (setup cost) per order
 Total Cost

Annual Annual
Total cost = carrying + ordering
cost cost
Q + D S
TC = H
2 Q
Two basic inventory costs: Ordering Cost: are the basically the costs of
getting the items into firm inventory, therefore these costs are the cost of
replenishing inventory. Carrying or holding cost: are the basically the costs
incurred due to maintenance of inventories or are the costs of holding
items in storage.
As order size varies, one of type of cost will increase whilst the other
decreases.
The greater level of inventory over time, the higher the carrying costs.
 Key Cost Terms in EOQ
 Annual carrying (holding) cost is computed by multiplying
average amount of inventory (Q/2) on hand by cost of carrying
one unit a year (H): (Q/2)*H
 Carrying costs increase or decrease in direct proportion to
changes in order quantity, ‘Q’.
 As shown earlier ‘Q’ is the order quantity.
 Q/2 which is half of the order quantity is the average
inventory.
 Q/2 tells you the average inventory you have on hand.
 Annual ordering costs (D/Q*S) will decrease as the order size
increases because the larger the order size, the fewer the
number of orders needed.
• The number of orders per year is D/Q. Hence, annual
ordering cost is number of orders multiplied by ordering cost
 Deriving the EOQ

Using calculus, we take the derivative of the

total cost function and set the derivative
(slope) equal to zero and solve for Q (Optimal
Quantity).
2DS 2(Annual Demand )(Order or Setup Cost )
Q OPT = =
H Annual Holding Cost

OTHER METRICS USED:

-Number of orders per year= D/Q0
-Length of order cycle (time between orders) = Q0/ D
Where Q0 = QOPT
 Minimum Total Cost
The total cost curve reaches its minimum where the
carrying and ordering costs are equal. This minimum
cost can be found by substituting Q0 (optimal
quantity) for Q in the Total cost (TC) formula:

Q0 D
TC  H S
2 Q0
Where ordering and carrying costs are equal:
Q = D S
H
2 Q
 Assumptions of the EOQ Model
• Only one product is involved
• Annual demand requirements are known
• Demand is spread evenly throughout the year
so that the demand rate is reasonably constant
• Lead time does not vary (for each order)
• Each order is received in a single delivery
• There are no quantity discounts
 EOQ EXAMPLE
• Example
A local distributor for a national tire company expects to
sell approximately 9600 steel-belted radial tires of a
certain size and tread design next year. Annual
carrying cost is $16 per tire, and ordering cost is $75.
the distributor operates 288 days a year.
a. What is the EOQ - optimal quantity to order(or Q0)?
b. How many times per year does the store reorder?
c. What is the length of an order cycle?
d. What is the total annual cost if the EOQ is ordered?
 EOQ
Solution
D (demand) = 9600 tires per year
H (holding/carrying cost) = $16 per unit per year
S (ordering cost) = $75 per order

2 DS 2(9600)75
a) Q0 =  300 _ tires
H 16

b) Number of orders per year: D/Q0 = 9600/300 = 32 orders

c) Length of order cycle: Q0/ D = 300/9600 =1/32 of a year ,

which is 1/32 (288 days a year) = 9 workdays
 EOQ
Solution (cont.)
d) Total annual Cost = Carrying cost + Ordering
cost:
= (Q0/2) H + (D/Q0) S
= (300/2)*16 + (9600/300)* 75
= 2400 + 2400
= $4800
2. Economic Production Quantity (EPQ)
• Economic production quantity (EPQ) is the optimal
quantity of a product that should be manufactured in
a single batch (or production run) so as to minimize
the total cost that includes setup costs for the
machines/equipment and inventory holding costs.
• A production run is a group of similar or related
goods that is produced by using a particular group of
manufacturing procedures, processes or conditions
(i.e. a batch of units).
• Every production run results in a certain (optimal)
quantity of units of a given product – optimal run size
(same as the EPQ).
 Key Terms in EPQ
• Key terms in EPQ approach are:
 Production rate: The average (or maximum) quantity of
products/items produced in a given time frame (usually
measured daily).
 Usage rate: The actual demand for a given product
measured daily. It is the daily demand.
 If daily production rate is 20 units and daily usage rate is 5
units, inventory will build up at a rate of 15 units per day
(20 minus 5).
 Run time: Length of time for a given production run. E.g: a
run time of 3 days means each run will require three days
to complete (i.e. to reach the optimal run size needed)
 Cycle time: length of time between the beginnings of runs
(or between orders). E.g. a cycle time of 4 days means that
a production run will be made every 4 days.
 Economic Production Quantity (EPQ)
• EPQ approach involves carrying (holding) costs (since
production builds up inventory) and setup costs (similar
to ordering costs).
• Because the company makes the product itself, there are
no ordering costs as such (but setup costs).
• With every production run (or phase or batch of products
produced), there are setup costs such as preparing for
equipment, cleaning, adjusting and changing tools, etc.
• As long as production is continuous, inventory will
continue to grow (leading to increased holding costs).
• The goal is to determine the optimal run size (quantity of
items to produced) to minimise these costs.
• It makes sense to periodically produce such items batches
or lots instead of producing continually.
 Setup Cost and Economic Run Size (quantity)
• In the case of EPQ, there
are no ordering costs, I max D
however there are setup TCmin carring cos t  setup cos t (
2
)H 
Qo
S
costs: the costs required
to prepare the D Q P U
TCmin  S  ( o )( )H
equipment for the job, Qo 2 P
such as cleaning, where I max max imum inventory
adjusting changing tools 2 DS P
etc. The economic run quantity  Q 
H P U
• Setup costs are analogous where p  production or delivery rate
to ordering costs because U usage rate (demand rate)
they are independent of
Q
the lot or run size. Cycle time  O (time between the orders )
u
• The larger the run size, Q
the fewer the number of Run time  O (the production phase of the cycle)
p
runs needed as well as
the lower the annual Q
I max  o ( p  u )
setup cost. p
• D/Q is the number of I
Iav  max
runs/batches per year. 2
 Economic Production Quantity Assumptions

• Only one item is involved

• Annual demand is known
• Usage rate is constant
• Usage occurs continually, but production occurs
periodically
• Production rate is constant
• Lead time does not vary
• No quantity discounts
 Economic Run Size
The Economic run size can be determined by using the following
formula:

2DS p
Q0 
H p u Note that D and H
must be in the
Where: same units, e.g.,
months, years.
P = production or delivery rate
U = usage rate
Production and usage rates should be in same units
(e.g. usually in days - e.g. daily rates )
 Economic run size
The minimum total cost is determined as follows:


TC min = carrying cost + setup cost =  I   D 
max
 H    S
 2   Q0 
Q0
I max  (P  u) = Maximum
P
inventory
Q0
cycletime  = cycle length (time
u between orders or between
beginnings of runs)
Q0
Runtime  = run length (production phase
P of a cycle
 Economic Run Size

D
No _ of _ runs  = The number of
Qo runs/batches per year
 EPQ Example
• A toy manufacturer uses 48000 rubber wheels per year for
its popular dump truck series. The firm makes its own
wheels, which it can produce at rate of 800 per day. The toy
trucks are assembled uniformly over the entire year.
Carrying cost is $1 per wheel a year. Setup cost for a
production run of wheels is $45. the firm operates 240 days
per year. Determine the
a. Optimal run size
b. Minimum total annual cost for carrying and setup
c. Cycle time for the optimal run size
d. Run time
e. Number of runs per year
 Solution
D = 48000 wheels per year
S = $45
H = $1 per wheel per year
P = 800 wheels per day
U = 48000 wheels per 240 days, or 200 wheels per day

2 DS P 2(48000)45 800
a. Q0 =  2400
H P u 1 800  200

 I max   D
b. TC min = carrying cost + setup cost =   H    S
 2   Q0 
 Solution (cont.)
Q0 2400
I max  (P  u)  (800  200) 1800
P 800

1800 48000
TC  $1  $45 $900  $900 $1800
2 2400
Q0 2400
c. CYCLE TIME =  12 days
u 200
Q0 2400
d. RUN TIME =  3days
P 800
 Solution cont’d
e. Number of runs per year:

D 48000
No _ of _ runs   20 _ runs
Qo 2400
 NOTE: When to Reorder with EOQ Ordering

• Reorder Point - When the quantity on hand of

an item drops to this amount, the item is
reordered
• Safety Stock - Stock that is held in excess of
expected demand due to variable demand rate
and/or lead time.
• Service Level - Probability that demand will not
exceed supply during lead time.
 When to Reorder
• If delivery is not instantaneous, but there is a
lead time:
When to order?
Order
Quantity
Q
Inventory

Lead Time Time

Place Receive
order
MIS 373: Basic Operations Managem 44
ent
 When to Reorder
• EOQ answers the “how much” question
• The reorder-point (ROP) tells “when” to order

• Reorder-Point
– When the quantity on hand of an item drops to this amount
(quantity-trigger), the item is reordered.

– Determinants of the Reorder-Point

1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management
MIS 373: Basic Operations Managem 45
ent
 Reorder-Point
ROP = (Demand per day) * (Lead time for a new order in days)
= d * L
where
d = (Demand per year) / (Number of working days in a year)

Example:
– Demand = 12,000 iPads per year In other words, the
– 300 working days per year manager should place the
order when only 120 units
– Lead time for orders is 3 working days left in the inventory.
d = 12,000 / 300 = 40 units
ROP = d * L = 40 units per day * 3 days of leading time
= 120 units
46
 Exercise: EOQ & ROP
• Assume a car dealer that faces demand for 5,000 cars per
year, and that it costs $15,000 to have the cars shipped to
the dealership. Holding cost is estimated at $500 per car per
year. How many times should the dealer order, and what
should be the order size? (Assuming that the lead time to
receive cars is 10 days and that there are 365 working days
in a year)

√ √
Recall:
∗ 2 𝐷𝑆 2 ( 𝑎𝑛𝑛𝑢𝑎𝑙𝑑𝑒𝑚𝑎𝑛𝑑 )( 𝑜𝑟𝑑𝑒𝑟 𝑐𝑜𝑠𝑡 )
EOQ =𝑄 = =
𝐻 𝑎𝑛𝑛𝑢𝑎𝑙𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 h𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
ROP = (Demand per day) * (Lead time for a new order in
days)
= d * L
where
d = (Demand per year) / (Number of working days in a year)
 Exercise: EOQ & ROP
• Assume a car dealer that faces demand for 5,000 cars per year,
and that it costs $15,000 to have the cars shipped to the
dealership. Holding cost is estimated at $500 per car per year
When should the dealer reorder what should be the order
size?
*2(15,000)(5,000)
Q  548
500
Since d is given in years, first convert: 5000/365 =13.7 cars per working day

So, ROP = 13.7 * 10 = 137

So, when the number of cars on

the lot reaches 137, order 548
more cars.
 3. The Quantity Discount Model
• Quantity discounts are price reductions for large orders
offered to customers to induce them to buy in large
quantities. In this case the price per unit decreases as
order quantity increases.
• If the quantity discounts are offered, the buyer must
weigh the potential benefits of reduced purchase price
and fewer orders that will result from buying in large
quantities against the increase in carrying cost caused by
higher average inventories.
• The buyer’s goal with quantity discounts is to select the
order quantity that will minimize the total cost, where
the total cost is the sum of carrying cost, ordering cost,
and purchasing (i.e., product) cost.