Managing Inventory

Five uses of Inventory

1. The decoupling functions – inventory can act as a buffer.
2. Storing resources – inventory can be stored in work-in-process.
3. Irregular supply and demand – inventory can lessen irregular demand and supply
patterns.
4. Quantity discount – buying in bulk can be economic advantage.
5. Avoiding stockouts and shortages – carrying safety stock can increase customer
satisfaction.

Economic Order Quantity

- is a tool used to determine the volume and frequency of orders required to satisfy a given
level of demand while minimizing the cost per order.
- is a set point designed to help companies minimize the cost of ordering and
holding inventory. The cost of ordering inventory falls with the increase in ordering
volume due to purchasing on economies of scale. However, as the size of inventory
grows, the cost of holding the inventory rises. EOQ is the exact point that minimizes both
inversely related costs.

Economic Order Quantity Formula

Components of the EOQ Formula:

D: Annual Quantity Demanded Q: Volume per Order
S: Ordering Cost (Fixed Cost) C: Unit Cost (Variable Cost)
H: Holding Cost (Variable Cost) i: Carrying Cost (Interest Rate

Ordering Cost
Number of orders = D / Q Annual ordering cost = (D / Q) * S

Holding Cost
Opportunity cost (H) = I * C Annual holding cost = (Q / 2) * H

Annual Total Cost

ATC = [(D / Q) * S] + [(Q / 2) * H]

EOQ

Time Between Orders

T = working days / expected number of orders
Reorder Point
ROP = (Demand per day of average demand) * Lead time for new order
Daily Demand
d = D / Number of working days in a year
Example:
1. SOM Incorporated, a company that sells pump housing to other manufacturers, would
like to reduce its inventory cost by determining the optimal number of pump housings to
obtain per order. The annual demand is 360 units the ordering cost is PHP100 per order,
and the average carrying cost (holding cost) per year is PHP1.0o. What is EOQ?

2. Given the data from Problem 1, and assuming a 300-day work year; how many orders
should be processed per year? What is the expected time between orders?
3. What is the total cost for the inventory policy used in Problem 1?
4. Assume that the demand was higher than estimated (i.e., 500 units instead of 360 units).
What will be the actual annual total cost?
5. If demand for an item is 3 units per day, and delivery lead-time is 15 days, what should
we use for a re-order point?
Solutions:
2 * Demand * Order cost 2 * 360 * 100
EOQ    72000  268 items
1. Holding cost 1

Demand 360
N   134
. orders per year
2. Q 268

Working days
T  300 / 134
.  224 days between orders
Expected number of orders
3.
Demand * Order Cost (Quantity of Items) * (Holding Cost ) 360 * 100 268 * 1
TC      134  134  $268
Q 2 268 2
4. Note that while demand was underestimated by nearly 50%, annual cost increases by
only 20% (320 / 268  1.20) an illustration of the degree to which the EOQ model is
relatively insensitive to small errors in estimation of demand.

Demand * Order Cost (Quantity of Items) * (Holding Cost ) 500 * 100 268 * 1
TC      186.57  134  $320.57
Q 2 268 2
5. ROP = 3 * 15 = 45 units. – it means that if the inventory level of the company reaches 45
units, the company should place order equivalent to computed EOQ.
Economic Production Quantity (EPQ)
- determines the quantity a company or retailer should order to minimize the total
inventory costs by balancing the inventory holding cost and average fixed ordering cost.
Variable:

Q = Number of pieces per order, p = Daily production rate, H = Holding cost per unit per year,
d =Daily demand/usage rate t = Length of the production run in days

Formula:

Example:
1. Assume that our firm produces type C fire extinguishers. We make 30,000 of these fire
extinguishers per year. Each extinguisher requires one handle (assume a 300-day work
year for daily usage rate purposes). Assume an annual carrying cost of $1.50 per handle;
production setup cost of $150, and a daily production rate of 300. What is the optimal
production order quantity?
Solution

Quantity Discount Model

1. For each discount, calculate EOQ
2. If EOQ for a discount doesn’t qualify, choose the smallest possible order size to get the
discount
3. Compute the total cost for each EOQ or adjusted value from Step 2
4. Select the EOQ that gives the lowest total cost
 Demand * Order Cost (Quantity of Items) * ( Holding cos t )
Total cos t  Demand * Cost  
Q 2
Example:
1. CBA Department Stores stocks toy race cars. Recently, the store was given a quantity
discount schedule for the cars. The normal cost for the toy race cars is PHP5.00. For
orders between 1,000 to 1,999 units, the unit cost is PHP4.80, and for orders of 2,000 or
more units, the unit cost is PHP4.75. Furthermore, the ordering cost is PHP49 per order,
the annul demand is 5,000 race cars, and the inventory carrying charge as percentage of
cost, I is 20 percent or 0.20.
What order quantity will minimize the total inventory cost?
Step 1: Compute the EOQ for every discount
EOQ (1) = SQRT [(2*5000*49) / (0.2 * 5.00)] = 700 cars per order
EOQ (2) = SQRT [(2*5000*49) / (0.2 * 4.80)] = 714 cars per order
EOQ (3) = SQRT [(2*5000*49) / (0.2 * 4.75)] = 718 cars per order
Step 2: To adjust those qualities that are below the allowable discount rate.
EOQ (1) is between 0 and 999 it does not have to be adjusted
EOQ (2) is below the allowable range of 1,000 to 1,999 and therefore it must be adjusted
to 1,000
EOQ (3) is below the allowable range 2,000 or more and therefore it must be adjusted
to 1,000
Step 3: Compute the total cost for each order quantiles
Discount Unit Order Annual Annual Annual
Number Price Quantity Material Cost Ordering Cost Carrying Cost Total
=D*C (D/Q) * S (Q/2) * H Cost
1 5 700 25,000 350 350 25,700.00
2 4.80 1,000 24,000 245 480 24,725.00
3 4.75 2,000 23,750 122.50 950 24,822.50

Step 4: Select the order quantity with the lowest total cost.
An order of 1,000 toy car race minimize the total costs.

Probability model and Safety Stock

- Used when demand is not constant or certain
- Use safety stock to achieve a desired service level and avoid stockouts
- is a term used by logisticians to describe a level of extra stock that is maintained to
mitigate risk of stockouts (shortfall in raw material or packaging) caused by uncertainties
in supply and demand.
 - Adequate safety stock levels permit business operations to proceed according to their
plans.
Formula:
ROP = d x L + ss
Annual stockout costs = the sum of the units short * the probability *
the stockout cost/unit * the number of orders per year
Example:
Litely Corp sells 1,350 of its special decorator light switch per year, and places orders for 300 of
these switches at a time. Assuming no safety stocks, Litely estimates a 50% chance of no
shortages in each cycle, and the probability of shortages of 5, 10, and 15 units as 0.2, 0.15, and
0.15 respectively. The carrying cost per unit per year is calculated as $5 and the stockout cost is
estimated at $6 ($3 lost profit per switch and another $3 lost in goodwill, or future sales loss).
What level of safety stock should Litely use for this product? (Consider safety stock of 0, 5, 10,
and 15 units)
Solution:
Safety stock  0 units:

Carrying cost equals zero.

Annual stockout costs = the sum of the units short * the probability *
the stockout cost/unit * the number of orders per year
1350 1350 1350
S0  6 * 5* 0.2 *  6 * 10 * 015
. *  6 * 15* 015
. *  $128.25
300 300 300

Safety stock  5 units:

Carrying cos t  $5 per unit * 5 units  $25

1350 1350
S5  6 * 5* 0.15*  6 * 10 * 0.15*  $60.75
Stockout cost: 300 300

Total cos t  carrying cos t  stockout cos t  $25  $60.75  $85.75

Safety stock  10 units:

Carrying cos t  10 * 5  $50.00

1350
S10  6 * 5* 015
. *  $20.25
Stockout cost: 300
Total cos t  carrying cos t  plus stockout cos t  $50.00  $20.25  $70.25
Safety stock  15:

Carrying cos t  15* 5  $75.00

Stockout cos ts  0 (there is no shortage if 15 units are maintained)
Total cos t  carrying cos t  stockout cos t  $75.00  $0  $75.00
Therefore: Minimum cost comes from carrying a 10-unit safety stock.