Chapter 3

Inventory Management

Copyright 2009 John Wiley & Sons, Inc.

 Lecture Outline

 Elements of Inventory Management

 Inventory Control Systems
 Economic Order Quantity Models
 Quantity Discounts
 Reorder Point
 Order Quantity for a Periodic Inventory
System

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 What Is Inventory?

 Stock of items kept to meet future

demand
 Purpose of inventory management
◼ how many units to order
◼ when to order

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 Inventory and Supply Chain
Management
 Bullwhip effect
◼ demand information is distorted as it moves away
from the end-use customer
◼ higher safety stock inventories to are stored to
compensate
 Seasonal or cyclical demand
 Inventory provides independence from vendors
 Take advantage of price discounts
 Inventory provides independence between
stages and avoids work stoppages

Copyright 2009 John Wiley & Sons, Inc. 13-4

 Inventory and Quality
Management in the Supply Chain

 Customers usually perceive quality

service as availability of goods they want
when they want them
 Inventory must be sufficient to provide
high-quality customer service in QM

Copyright 2009 John Wiley & Sons, Inc. 13-5

 Types of Inventory

 Raw materials
 Purchased parts and supplies
 Work-in-process (partially completed)
products (WIP)
 Items being transported
 Tools and equipment

Copyright 2009 John Wiley & Sons, Inc. 13-6

 Two Forms of Demand
▪ Dependent
▪ Demand for items used to produce
final products
▪ Tires stored at a Goodyear plant are
an example of a dependent demand
item
▪ Independent
▪ Demand for items used by external
customers
▪ Cars, appliances, computers, and
houses are examples of independent
demand inventory

Copyright 2009 John Wiley & Sons, Inc. 13-7

 Inventory Costs

▪ Carrying cost
▪ cost of holding an item in inventory
▪ Ordering cost
▪ cost of replenishing inventory
▪ Shortage cost
▪ temporary or permanent loss of sales
when demand cannot be met

Copyright 2009 John Wiley & Sons, Inc. 13-8

 Inventory Control Systems

▪ Continuous system (fixed-

order-quantity)
▪ constant amount ordered
when inventory declines to
predetermined level
▪ Periodic system (fixed-time-
period)
▪ order placed for variable
amount after fixed passage of
time

Copyright 2009 John Wiley & Sons, Inc. 13-9

 ABC Classification
 Class A
◼ 5 – 15 % of units
◼ 70 – 80 % of value
 Class B
◼ 30 % of units
◼ 15 % of value
 Class C
◼ 50 – 60 % of units
◼ 5 – 10 % of value

Copyright 2009 John Wiley & Sons, Inc. 13-10

 ABC Classification: Example
PART UNIT COST ANNUAL USAGE
1 $ 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120

Copyright 2009 John Wiley & Sons, Inc. 13-11

 ABC Classification:
Example (cont.)
TOTAL % OF TOTAL % OF TOTAL
PART PART
VALUE UNIT
VALUECOSTQUANTITY
ANNUAL USAGE
% CUMMULATIVE
9 1
$30,600 $ 60
35.9 6.0 90 6.0
8 16,000
2 18.7
350 5.0 40 11.0
2 14,000 16.4 4.0
A 15.0
3 30 130
1 5,400 6.3 9.0 24.0
4 4
4,800 5.680 6.0 B60 30.0
3 5
3,900 4.630 10.0 100 40.0
6 6
3,600 4.220 % OF TOTAL
18.0 % OF TOTAL
180 58.0
CLASS ITEMS VALUE QUANTITY
5 3,000
7 3.510 13.0 170 71.0
10 2,400
A 9, 8,2.8
2 12.0
71.0 C 83.0
8 320 50 15.0
7 1,700
B 1, 4,2.0
3 17.0
16.5 100.0
25.0
C9
$85,400
5107
6, 5, 10, 12.5 60 60.0
10 20 120
Example 10.1

Copyright 2009 John Wiley & Sons, Inc. 13-12

 Economic Order Quantity
(EOQ) Models

 EOQ
◼ optimal order quantity that will
minimize total inventory costs
 Basic EOQ model
 Production quantity model

Copyright 2009 John Wiley & Sons, Inc. 13-13

 Assumptions of Basic
EOQ Model

▪ Demand is known with certainty and

is constant over time
▪ No shortages are allowed
▪ Lead time for the receipt of orders is
constant
▪ Order quantity is received all at once

Copyright 2009 John Wiley & Sons, Inc. 13-14

 Inventory Order Cycle
Order quantity, Q
Demand Average
rate inventory
Inventory Level

Q
2

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
placed receipt placed receipt

Copyright 2009 John Wiley & Sons, Inc. 13-15

 EOQ Cost Model
Co - cost of placing order D - annual demand
Cc - annual per-unit carrying cost Q - order quantity

CoD
Annual ordering cost =
Q
CcQ
Annual carrying cost =
2
C oD CcQ
Total cost = +
Q 2

Copyright 2009 John Wiley & Sons, Inc. 13-16

 EOQ Cost Model

Deriving Qopt Proving equality of

costs at optimal point
CoD CcQ
TC = +
Q 2 CoD CcQ
=
TC CoD Cc Q 2
= – Q2 +
Q 2
2CoD
C0 D Cc Q2 =
Cc
0 = – Q2 +
2
2CoD
2CoD Qopt =
Qopt = Cc
Cc

Copyright 2009 John Wiley & Sons, Inc. 13-17

 EOQ Cost Model (cont.)
Annual
cost ($) Total Cost
Slope = 0
CcQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost = Q

Optimal order Order Quantity, Q

Qopt

Copyright 2009 John Wiley & Sons, Inc. 13-18

 EOQ Example
Cc = $0.75 per gallon Co = $150 D = 10,000 gallons

2CoD CoD CcQ

Qopt = TCmin = +
Cc Q 2
2(150)(10,000) (150)(10,000) (0.75)(2,000)
Qopt = (0.75) TCmin = 2,000 + 2

Qopt = 2,000 gallons TCmin = $750 + $750 = $1,500

Orders per year = D/Qopt Order cycle time = 311 days/(D/Qopt)

= 10,000/2,000 = 311/5
= 5 orders/year = 62.2 store days
Copyright 2009 John Wiley & Sons, Inc. 13-19
 Production Quantity
Model

 An inventory system in which an order is

received gradually, as inventory is
simultaneously being depleted
◼ AKA non-instantaneous receipt model
◼ assumption that Q is received all at once is relaxed
 p - daily rate at which an order is received over
time, a.k.a. production rate
 d - daily rate at which inventory is demanded

Copyright 2009 John Wiley & Sons, Inc. 13-20

 Production Quantity Model
(cont.)
Inventory
level

Maximum
Q(1-d/p) inventory
level

Average
Q inventory
(1-d/p)
2 level

0
Begin End Time
order order
Order
receipt receipt
receipt period

Copyright 2009 John Wiley & Sons, Inc. 13-21

 Production Quantity Model
(cont.)
p = production rate d = demand rate

Maximum inventory level = Q - Q d

p

=Q1- d 2CoD
p
Qopt = d
Q d Cc 1 -
Average inventory level = 1- p
2 p

CoD CcQ d
TC = Q + 2 1 - p

Copyright 2009 John Wiley & Sons, Inc. 13-22

 Production Quantity Model:
Example
Cc = $0.75 per gallon Co = $150 D = 10,000 gallons
d = 10,000/311 = 32.2 gallons per day p = 150 gallons per day

2CoD 2(150)(10,000)
Qopt = = = 2,256.8 gallons
Cc 1 - d 0.75 1 -
32.2
p 150

CoD CcQ d
TC = Q + 2 1 - p = $1,329

Q 2,256.8
Production run = = = 15.05 days per order
p 150

Copyright 2009 John Wiley & Sons, Inc. 13-23

 Production Quantity Model:
Example (cont.)

D 10,000
Number of production runs = = = 4.43 runs/year
Q 2,256.8

d 32.2
Maximum inventory level = Q 1 - = 2,256.8 1 -
p 150
= 1,772 gallons

Copyright 2009 John Wiley & Sons, Inc. 13-24

 Solution of EOQ Models with
Excel

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 Solution of EOQ Models with
Excel (Con’t)

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 Solution of EOQ Models with OM
Tools

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 Quantity Discounts

Price per unit decreases as order

quantity increases
CoD CcQ
TC = + + PD
Q 2

where

P = per unit price of the item

D = annual demand

Copyright 2009 John Wiley & Sons, Inc. 13-28

 Quantity Discount Model (cont.)
ORDER SIZE PRICE
0 - 99 $10 TC = ($10 )
100 – 199 8 (d1)
200+ 6 (d2) TC (d1 = $8 )

TC (d2 = $6 )
Inventory cost ($)

Carrying cost

Ordering cost

Q(d1 ) = 100 Qopt Q(d2 ) = 200

Copyright 2009 John Wiley & Sons, Inc. 13-29
 Quantity Discount: Example
QUANTITY PRICE
Co = $2,500
1 - 49 $1,400 Cc = $190 per TV
50 - 89 1,100 D = 200 TVs per year
90+ 900

2CoD 2(2500)(200)
Qopt = = = 72.5 TVs
Cc 190

For Q = 72.5 CoD CcQopt

TC = + 2 + PD = $233,784
Qopt

For Q = 90 CoD CcQ

TC = + 2 + PD = $194,105
Q

Copyright 2009 John Wiley & Sons, Inc. 13-30

 Quantity-Discount Model Solution
with Excel

Copyright 2009 John Wiley & Sons, Inc. 13-31

 Reorder Point

Level of inventory at which a new order

is placed
R = dL
where
d = demand rate per period
L = lead time

Copyright 2009 John Wiley & Sons, Inc. 13-32

 Reorder Point: Example

Demand = 10,000 gallons/year

Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154
gallons/day
Lead time = L = 10 days

R = dL = (32.154)(10) = 321.54 gallons

Copyright 2009 John Wiley & Sons, Inc. 13-33

 Safety Stocks

▪ Safety stock
▪ buffer added to on hand inventory during lead
time
▪ Stockout
▪ an inventory shortage
▪ Service level
▪ probability that the inventory available during
lead time will meet demand

Copyright 2009 John Wiley & Sons, Inc. 13-34

 Variable Demand with
a Reorder Point
Q
Inventory level

Reorder
point, R

0
LT LT
Time

Copyright 2009 John Wiley & Sons, Inc. 13-35

 Reorder Point with
a Safety Stock
Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Time
Copyright 2009 John Wiley & Sons, Inc. 13-36
 Reorder Point With
Variable Demand

R = dL + zd L
where
d = average daily demand
L = lead time
d = the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
probability
zd L = safety stock

Copyright 2009 John Wiley & Sons, Inc. 13-37

 Reorder Point for
a Service Level
Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
zd L

dL R
Demand
Copyright 2009 John Wiley & Sons, Inc. 13-38
 Reorder Point for
Variable Demand
The paint store wants a reorder point with a 95%
service level and a 5% stockout probability
d = 30 gallons per day
L = 10 days
d = 5 gallons per day

For a 95% service level, z = 1.65

R = dL + z d L Safety stock = z d L
= 30(10) + (1.65)(5)( 10) = (1.65)(5)( 10)
= 326.1 gallons = 26.1 gallons

Copyright 2009 John Wiley & Sons, Inc. 13-39

 Determining Reorder Point with
Excel

Copyright 2009 John Wiley & Sons, Inc. 13-40

 Order Quantity for a
Periodic Inventory System

Q = d(tb + L) + zd tb + L - I

where
d = average demand rate
tb = the fixed time between orders
L = lead time
d = standard deviation of demand
zd tb + L = safety stock
I = inventory level

Copyright 2009 John Wiley & Sons, Inc. 13-41

 Periodic Inventory System

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 Fixed-Period Model with
Variable Demand
d = 6 packages per day
d = 1.2 packages
tb = 60 days
L = 5 days
I = 8 packages
z = 1.65 (for a 95% service level)

Q = d(tb + L) + zd tb + L - I
= (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8
= 397.96 packages

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 Fixed-Period Model with Excel

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