Inventory

Components of Inventory cost

Inventory holding cost
Purchasing order cost
Shortage cost
Inventory control cost

2
Cost of Carrying/Holding Inventory

Cost of carrying or holding inventory per year

= inventory capital cost + inventory service cost +
inventory risk cost + inventory storage cost

Inventory Carrying Cost

Inventory level

0 T time

Average Inventory, I =

Little’s Law; L = W I = Arrival Rate x Cycle Time

Holding cost per year = Irc
Components of Inventory cost
Inventory holding cost
Purchasing order cost
Shortage cost
Inventory control cost

Inventory Turns

An indicator for comparing current to past

performances of inventory.
Inventory turns =
Annual sales or usage/Average inventory in $
Indication of how fast a particular sku is flowing
through the warehouse/productivity of inventory
Cash flow
Useful for benchmarking

6
 Example

The excerpt from the financial statements of Coca-

Cola in 2000 show that cost of goods sold is
$6,204,000,000. The average inventory value in 2000
is $1,071,000,000

What is the inventory turns?

6,204,000,000
5.79
1,071,000,000

Or stay approximately an average of 2 months in the warehouse

7

Inventory Turns
How to measure inventory turns for an organization with
many stock keeping unit (sku)?

Let n be the number of skus

Let Dj be the annual demand of sku j
Ij be the average inventory of sku j
Cj be the cost of goods sold for sku j

∑
Inventory turns = ∑
8
 Return on invested capital figures for select companies in the
computing industry.

Source: Business Week

The Role of Safety Inventory in a Supply Chain

Suppose you replenish monthly; and the

replenishment lead time is 0 months. If you
are now at the end of December, and you
forecast the demand for the month of
January is1000 units. How much quantity
will you place?

10
 Safety inventory
Inventory carried for the purpose of satisfying
demand that exceeds the amount forecasted in a
given period

Average inventory is therefore cycle inventory plus

safety inventory

11

Review of Economic Order

Quantity

12
Two Questions to Answer in
Planning Safety Inventory

What is the appropriate level of

safety inventory to carry?
What actions can be taken to
improve product availability while
reducing safety inventory?

13

Determining the Appropriate

Level of Demand Uncertainty
Appropriate level of safety inventory determined by:

• Demand variability
• Service level
• Lead time

14
Measuring Product Availability

Product availability: a firm’s ability to fill a

customer’s order out of available inventory
Stockout: a customer order arrives when product
is not available
Product fill rate (fr): fraction of demand that is
satisfied from product in inventory
Order fill rate: fraction of orders that are filled
from available inventory
Cycle service level: fraction of replenishment
cycles that end with all customer demand met 15

Type of Service Level

Product fill rate
• Suppose have 100 units demanded
• Inventory have 90 units in stock
• Fill rate = 90/100 = 0.9

16
 Type of Service Level
Order fill rate
• Suppose the following customer orders
Customer 1 – 20 units
Customer 2 – 30 units
Customer 3 – 35 units
Customer 4 – 5 units
Customer 5 – 10 units
• Inventory have 90 units in stock
• Order Fill rate = 4/5 = 0.8

17

Type of Service Level

Cycle service level
cycle

Reorder
Point
cycle
time
Lead time
A cycle – from time between replenishment or time between orders
Cycle service level – is the fraction of cycles that is able to satisfy
all customer demand – i.e. 4/6 or 0.67 18
Replenishment Policies
Replenishment policy: decisions regarding
when to reorder and how much to reorder
Continuous review: inventory is
continuously monitored and an order of
size Q is placed when the inventory level
reaches the reorder point ROP
Periodic review: inventory is checked at
regular (periodic) intervals and an order is
placed to raise the inventory to a specified
threshold (the “order-up-to” level)
19

Continuous Review Policy

Let s denote the reorder point (ROP)

time
Lead
time

Continuous Review Policy is also known as the (Q,s)

policy or the Reorder Point Policy 20
 Periodic Review Policy
Let R be the review period
G be the order –up - level

G-I’ G-I”

I’
I”

Lead time

R Review point

Difference between Continuous Review Policy

and Periodic Review Policy

Continuous Review Policy

• Ordering quantity is fixed
• Time between orders is random
Periodic Review Policy
• Ordering quantity is random
• Time between orders is fixed

22
 Example: Two Bin Systems

23

Heuristic treatment for reorder point

inventory systems

Assumptions
• Demand follows a stationary and iid
process
• All shortages are backordered
• Lead time is constant
• Backlog orders are small and satisfied
immediately by a replenishment order

24
 Example
Assume lead time is one week
Order quantity is 20 units
Determine the reorder point based on
• Cycle service level, P1 = 0.9
Determine the reorder point based on cost
• Fixed order cost, S = $18
• Inventory holding cost, h=rc = $10/unit/year
• Shortage cost,  = $20/unit short
• Assume 50 working weeks
25

Example
Lead time demand Fraction of Occurrences Cumulative Fraction
at this value at this value or lower

0 0.1
1 0.2
2 0.3
3 0.2
4 0.2

What is the reorder point at P1 = 0.9?

What is the reorder point at P1 = 0.8?

26
How to Measure Cycle Service Level?
Let X be the random variable of demand during the
lead time
Cycle service level is the fraction of cycles that is
able to satisfy all customer demands
This is similar finding the probability that a cycle is
able to satisfy all customer demands
A cycle that is able to satisfy all customer demand is
X≤s
Hence, P(X ≤ s) is the probability that a cycle is able
to satisfy all customer demands

27

Example P(X ≤ s)

Lead time demand Fraction of Occurrences Cumulative Fraction

at this value at this value or lower

0 0.1 0.1
1 0.2 0.3
2 0.3 0.6
3 0.2 0.8
4 0.2 1.0

What is the reorder point at P1 = 0.9?

s=4

28
 Example P(X ≤ s)

Lead time demand Fraction of Occurrences Cumulative Fraction

at this value at this value or lower

0 0.1 0.1
1 0.2 0.3
2 0.3 0.6
3 0.2 0.8
4 0.2 1.0

What is the reorder point at P1 = 0.8?

s=3

What is the expected demand per week?

0x0.1 + 1x0.2 + 2x0.3 + 3x0.2 + 4x0.2 = 2.2 29

Example
Assume lead time is one week
Order quantity is 20 units
Determine the inventory cost
• Fixed order cost, S = $18
• Inventory holding cost, h=rc = $10/unit/year
• Shortage cost,  = $20/unit short
• Assume 50 working weeks
Reorder point is 3

30
 Inventory Cost Model
Expected Inventory Cost
= Ordering cost per year + Holding cost
per year + Shortage cost per year

31

Example
Ordering cost per year
• Cost per order = S = 18
• Expected number of orders per year = D/Q
= 2.2 x 50/20 = 5.5
• Expected Order cost per year = SD/Q =
18x5.5 = $99

D = Weekly demand × No. weeks

32
 Example
Average holding cost per year, I
• h = rc = $10 per unit per year
• Average inventory = cycle stock + safety
stock
• Reorder point(s) = expected demand
during the leadtime (DL)+ safety stock (ss)
• ss = s - DL
• I= Q/2+ s - DL
• 20/2 + 3 – 2.2 = 10.8
• I= rc(Q/2+ s - DL ) = 10 x 10.8 = $108 33

Example – Shortage
Reorder Point = 3
Lead time demand Probability Amount of shortage just
before replenishment arrive

0 0.1 0
1 0.2 0
2 0.3 0
3 0.2 0
4 0.2 1

Average shortage per cycle

= 0x0.1 + 0x0.2 + 0x0.3 + 0x0.2 + 1x0.2 = 0.2
Note that the formula for shortage per cycle is p(x)
34
 Example
Average shortage cost per year
• πD/Q× p(x)
• 20 × 5.5 × 0.2 = 22

Average total cost

• SD/Q + rc(Q/2+ s - DL ) + πD/Q × ∑ 𝑥 𝑠 p(x)
• 99 + 108+ 22 = $229

35

Reorder Point (s,Q) Policy

Notation
D - expected demand per year
DL - expected demand during the lead time
c - unit cost
 - backlogged cost per unit
r - carrying cost rate
S - setup cost per order
f(x) - probability density distribution of
demand during the lead time

36
 Reorder Point (s,Q) Policy
Ordering cost = SD/Q

Average inventory holding cost =

Average shortage cost =

37

Optimal Reorder Point Policy

Optimal Q ≈ EOQ

Optimal s* ≈:F’(s*) = rcQ/D where F’(s*) is the right

cumulative distribution function or F’(s*) = 1 - F(s*)
The random variable x is the demand during the lead time
Note

38
 𝑑 𝑆𝐷 𝑄 𝜋𝐷
𝑟𝑐 𝑠 𝐷 𝑥 𝑠 𝑓 𝑥 𝑑𝑥
𝑑𝑠 𝑄 2 𝑄

𝜋𝐷 𝑑
𝑟𝑐 𝑥 𝑠 𝑓 𝑥 𝑑𝑥
𝑄 𝑑𝑠

39

a s
𝑓 𝑥, 𝑠 𝑥 𝑠 𝑓 𝑥

𝑑 𝑑 𝑑∞ 𝑑𝑠
𝑥 𝑠 𝑓 𝑥 𝑑𝑥 𝑥 𝑠 𝑓 𝑥 𝑑𝑥 ∞ s 𝑓 ∞ 𝑠 𝑠 𝑓 𝑠
𝑑𝑠 𝑑𝑠 𝑑𝑠 𝑑𝑠

𝑓 𝑥 𝑑𝑥

F’(s)

𝐹′ 𝑠
s
40
 𝑑 𝑆𝐷 𝑄 𝜋𝐷
𝑟𝑐 𝑠 𝐷 𝑥 𝑠 𝑓 𝑥 𝑑𝑥
𝑑𝑠 𝑄 2 𝑄

𝜋𝐷 𝑑
𝑟𝑐 𝑥 𝑠 𝑓 𝑥 𝑑𝑥
𝑄 𝑑𝑠
𝜋𝐷
𝑟𝑐 𝐹′ 𝑠
𝑄

At stationary point
𝜋𝐷
𝑟𝑐 𝐹 𝑠 0
𝑄

𝑟𝑐𝑄
𝐹 𝑠
𝜋𝐷
41

Example
A manufacturer of textile product uses a certain chemical
in its finishing process at an expected annual rate of
10,000 gallons. This expected rate is constant over time;
however, the actual demand in a period may vary
randomly. The chemical is purchased and the demand
during the procurement lead time is estimated to be
normally distributed with a mean of 300 gallons and a
standard deviation of 40 gallons. The fixed procurement
cost is $70 per order and the variable procurement cost
is $3 a gallon. The company uses an annual inventory
carrying cost rate of 0.20. Shortages result in
rescheduling production, with the resulting cost assumed
proportional to the size of the shortage. This loss is
estimated at a backlogged cost of  of $1.50 per gallon. A
fixed reorder quantity systems is to be used.
42
 D = 10,000 gallons/year
DL= 300 gallons
σL= 40 gallons
S = $70 per order
c = $3 per gallon
r = 0.2 $/$/year
π = $1.50 per gallon

43

Order Quantity

Q* = EOQ =

=
.

=1528

Reorder Point
F’(s) =
0.06112
.
=
.

= s?
44
 = 0.06112
From unit normal table
u = 1.55

𝑠 𝐷𝐿
u= σ𝐿

s = 300 + 1.55x40 = 362

45

Example
An (s, Q) policy is being used. To set the safety stock
as low as possible, the management decide to set
backlogged cost of $1.50 per unit. The replenishment
quantity is fixed at 85 units with an ordering cost is
$21.50. The annual inventory carrying cost is
charged at 20%. The unit cost is $2. Annual demand
is forecasted to be 200 units. The demand and
standard deviation over the lead time are respectively
50 units and 10 units. Determine the reorder point
and the total cost of the inventory policy.

46
 Q = 85 units
D = 200 units/year
DL= 50 units
σL= 10 units
S = $21.50 per order
c = $2/unit
r = 0.20 $/$/year
π = $1.50 per unit

47

Reorder Point

F’(s) =

.
F’(s) =
.

=
From unit normal table
u = 1.21
0.1133
u= 1.21
s = 50 + 1.21x10 = 62
s?
48
 Expected Inventory cost
𝑆𝐷 𝑄 𝜋𝐷
𝑟𝑐 𝑠 𝐷 𝑥 𝑠 𝑓 𝑥 𝑑𝑥
𝑄 2 𝑄

𝑆𝐷 𝑄 𝜋𝐷
𝑟𝑐 𝑠 𝐷 σ 𝐿′ 𝑢
𝑄 2 𝑄 𝐿

Where u = 1.21

21.50 200 85 1.50 200 10

0.2 2 62 50 𝐿′ 1.21
85 2 85

From Unit Loss Normal Integral Table

𝐿′ 1.21 = 0.054962

Expected Inventory cost = $74.33

Criteria for establishing safety stock

or Product Availability
Safety stocks based on the costing of shortages
• Fixed cost per stockout ocassion, B
• Fractional charge per unit short, 
• Fractional charge per unit short per unit time
•
Safety stocks based on customer service
• Cycle service level , P1
• Fill rate, P2

50
 Performance Criteria
Service level versus Cost criteria
• Mature product – cost and delivery performance is
important
• New product – delivery performance may be more
important than cost
• Difficult to measure cost
Type of shortage measure being used
• expedites to avert impending stockout
• units short are made during overtime production
• item consideration is a spare and each unit short
results in a machine being idle

51

Safety stocks based on costing of

shortages
Specific fractional charge per unit short, 

• The expected number of unit short per

replenishment cycle

52
 Safety stocks based on customer
service (Continuous Review Policy)
Cycle service level P1
• P1 = uwhere u = (s-DL)/L

Fill rate, P2

• P2 =

53

Continuous Review Policy

0 b1 b2 T time
Lead
time
,
Fill rate =1 -
,

Fill rate =1 -
, 54
 Continuous Review Policy
Q

0 b1 b2 T time
Lead
time
Fill rate =1 -

Fill rate =
55

Example
The weekly demand has a mean and standard
deviation of 100 units and 23.5 units respectively.
The unit cost of an item is $5. Weekly inventory
carrying cost rate is 5% and backlogged carrying cost
is $25 per unit. The replenishment lead time is 2
weeks. Assume that t = 1√t, where t is the
standard deviation of demand during t periods. For a
policy of Q = 50, and s = 275, find the following
– Cycle service level, P1
– Fill rate, P2

56
 Cycle Service l
Determine the expected and standard deviation
during the lead time

𝐷𝐿 100 2 200
σ𝐿 23.5 2 33.23

Cycle Service Level = P(X ≤ s)

 =
σ .

=  2.257

=0.988 57

Fill rate
Fill rate =

=
where u = 2.257
From Unit Loss Normal Integral Table
𝐿′ 2.257 = 0.004114
. .
Fill rate = 1 =1

= 0.997 58
 Periodic Review Policy

Optimal G* : F’(G*) = rcR/where F’(G*) is the

right cumulative distribution function
Note that the random variable x is now the demand
during the lead time and review period

59

Periodic Review Policy

Let R be the review period
G be the order –up - level

G-I’ G-I” Y = I”’ –Demand during L

I”’ = G – Demand during R
I’ I’”
I” Y = G – Demand during R
–Demand during L
Y = G – Demand during R+L
Lead time
Y

R Review point
Safety Stock ~ E[Y] = G – DR+ L
Expected Order Quantity = DR/2
 Example
A periodic review is being used. The mean
demand rate is 500 units per year. The lead
time, L, is 3 months. The demand during R+L
follows a normal distribution with mean
500(R+L) and variance 800(R+L). The cost of
each unit is $10, the annual inventory
carrying rate, r = 0.1, the cost of making the
review and placing an order is $15, and the
backorder carrying rate, , is $3 per unit.
Given that R = 3 months, what is the optimal
G?

61

D = 500 units/year
L = 3 months or 0.25 years
R = 3 months or 0.25 years
S = $15 per order
c = $10/unit
r = 0.10 $/$/year
π = $3 per unit
DL+R= 500(0.25 + 0.25) = 250 units
σL+R= 800 0.25 0.25 20 units

62
Order up to G level

F’(G) =

. .
F’(G) =

=
From unit normal table
u = 1.38
0.0833
u= 1.38

G = 250 + 1.38x20 = 278 G?

63

Demand during Lead Time

Assume stationary increment
Denote D is the expected demand per
period and  is the standard deviation of
demand per period
Denote L period is the duration of the
lead time
Then DL = DL
L = 
64
Summary of Learning Objectives

What is the cost of inventory?

Why inventory turns is important?
What is the role of safety inventory in a supply chain?
What are the common types of inventory policies?
What are the factors that influence the required level
of safety inventory?
What are the different measures of product
availability?

65