Chapter 13 Inventory Decision Self

To Accompany Russell and Taylor, Operations Management, 4th Edition, 2003 Prentice-Hall, Inc. All rights reserved.
Chapter 13
Inventory
Management
Inventory
Stock of items kept by an
organization to meet internal or
external customer demand.
Inventory management answers
two questions
How much to order
When to order
Types of Inventory
Raw materials
Purchased parts and supplies
Labor
In-process (partially completed) products
Component parts
Working capital
Tools, machinery, and equipment
Reasons to Hold
Inventory
Meet unexpected demand
Smooth seasonal or cyclical demand
Meet variations in supplier deliveries
Take advantage of
price discounts
Hedge against price
increases
Quantity discounts
Two Forms of Demand
Dependent
Items used internally to produce final
products

Independent
Items demanded by external customers
Inventory Costs
Carrying Cost/Holding Cost
Cost of holding an item in inventory
Ordering Cost
Cost of replenishing inventory
Shortage Cost/Stock Out cost
Temporary or permanent loss of
sales when demand cannot be met
Set Up Cost
Costs for arranging specific
equipment setups, etc


Carrying Cost

Cost of holding an item in inventory
Cost depends on
Quantity of inventory
Length of time
Cost that increases linearly the number of units
Examples
Facility of Storage ( rent, power, heat cooling etc)
Material Handling Equipment
Labor
Record keeping
Production deterioration, spoilage
Two ways to specify carrying cost
Assign total carrying cost(sum all the individual cost on per
unit per time bases. (Example Rs 10 per unit per year)
Percentage of value of an item or % of average inventory
Value

Ordering Cost

The cost of replenishing inventory
Expressed as amount/order and are
independent of the order size.
Any cost that increases linearly with
number of orders
Examples
Requisition and purchase order
Transportation and shipping
Receiving
Inspection
Handling
Accounting and auditing
Increase in order size , decrease in order cost, increase in carrying
cost
Shortage Cost

Temporary or permanent loss of
sales when demand can not be met
Result into
loss of profit
Customer dissatisfaction
Loss of goodwill
Permanent loss of customer and future
sale
Work stopage result into downtime
cost and cost of lost production

10
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)
11
Single-Period Inventory Model
u o
u
C C
C
P
+
s
sold be unit will y that the Probabilit
estimated under demand of unit per Cost C
estimated over demand of unit per Cost C
: Where
u
o
=
=
=
P
This model states that we
should continue to
increase the size of the
inventory so long as the
probability of selling the
last unit added is equal to
or greater than the ratio
of: Cu/Co+Cu
12
Single Period Model Example
Our college basketball team is playing in a
tournament game this weekend. Based on our
past experience we sell on average 2,400 shirts
with a standard deviation of 350. We make Rs100
on every shirt we sell at the game, but lose Rs50
on every shirt not sold. How many shirts should
we make for the game?
C
u
= Rs100 and C
o
= Rs50; P 100 / (100 + 50) = .667

Z
.667
= .432 (use NORMSDIST(.667) or Appendix E)
therefore we need 2,400 + .432(350) = 2,551 shirts

Inventory Control
Systems (Multi Period
Inventory Models)
Continuous system (fixed-order-
quantity Model/ Perpetual system/EOQ
or Q Model)
Periodic system (fixed-time-period/
Period Review system/P Model)
Continuous System
Constant amount ordered when inventory declines to
reorder point (predetermined level)
The order that is placed is of fixed amount that
minimize the total inventory cost. This amount is
called EOQ(Economic Order Quantity).
Positive features is continuous monitoring.
Negative aspect :: maintaining a continuous
record is costly
Check out system with a laser scanner used by
super malls
Periodic system
Order placed for variable amount after fixed
passage of time
Decision of order quantity is taken each time
when order is placed
No need to monitor inventory in between
the time intervals
Positive aspects :: no need of record
keeping, larger inventory level to guard
against unexpected stockouts
Disadvantage :: less direct control
Example :: College bookstore
ABC Classification
System
An inventory classification system where
small % of items account for most of the
inventory value
Demand volume and value of items vary
Classify inventory into 3 categories,
typically on the basis of the dollar value
to the firm
PERCENTAGE PERCENTAGE
CLASS OF UNITS OF DOLLARS

A 5 - 15 70 - 80
B 30 15
C 50 - 60 5 - 10
Each class requires different level of
inventory monitoring and control
the higher the value of the inventory
the tighter the control
Rationale for ABC Classification ::
Continuous inventory monitoring was
expensive and not justified for many
items
First Step in ABC Analysis is to classify all
inventory items as either A,B or C
Assign a dollar value to each item, which is computed
by multiplying the dollar cost of one unit by the annual
demand for that item.
Rank all the items according to their annual dollar value
( the top 10% as A items, the next 30% as B items and
the last 60% as C items
Second Step is to determine the level of inventory
control for each classification
Class A ::
tight inventory control.
Inventory level should be as low as possible,
minimized safety stock
Need accurate demand forecast and detailed record
keeping
Appropriate inventory ctrl system and inventory modeling
procedure should be used to determine the order quantity
Close attention to be given to purchasing policies and
procedures

Class B and C need less stringent inventory
control
Carrying cost of Class C is usually lower,
therefore it is possible to maintain a larger
safety stock
No need to control C items beyond simple
observation
Apart from cost, the scarcity of parts
or difficulty of supply may also be
reasons for giving high priority
ABC Classification
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
PART UNIT COST ANNUAL USAGE
Example 10.1
ABC Classification
Example 10.1
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
TOTAL % OF TOTAL % OF TOTAL
PART VALUE VALUE QUANTITY % CUMMULATIVE
9 $30,600 35.9 6.0 6.0
8 16,000 18.7 5.0 11.0
2 14,000 16.4 4.0 15.0
1 5,400 6.3 9.0 24.0
4 4,800 5.6 6.0 30.0
3 3,900 4.6 10.0 40.0
6 3,600 4.2 18.0 58.0
5 3,000 3.5 13.0 71.0
10 2,400 2.8 12.0 83.0
7 1,700 2.0 17.0 100.0

$85,400
ABC Classification
Example 10.1
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
9 $30,600 35.9 6.0 6.0
8 16,000 18.7 5.0 11.0
2 14,000 16.4 4.0 15.0
1 5,400 6.3 9.0 24.0
4 4,800 5.6 6.0 30.0
3 3,900 4.6 10.0 40.0
6 3,600 4.2 18.0 58.0
5 3,000 3.5 13.0 71.0
10 2,400 2.8 12.0 83.0
7 1,700 2.0 17.0 100.0

$85,400
A
B
C
ABC Classification
Example 10.1
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
9 $30,600 35.9 6.0 6.0
8 16,000 18.7 5.0 11.0
2 14,000 16.4 4.0 15.0
1 5,400 6.3 9.0 24.0
4 4,800 5.6 6.0 30.0
3 3,900 4.6 10.0 40.0
6 3,600 4.2 18.0 58.0
5 3,000 3.5 13.0 71.0
10 2,400 2.8 12.0 83.0
7 1,700 2.0 17.0 100.0

$85,400
A
B
C
% OF TOTAL % OF TOTAL
CLASS ITEMS VALUE QUANTITY
A 9, 8, 2 71.0 15.0
B 1, 4, 3 16.5 25.0
C 6, 5, 10, 7 12.5 60.0
ABC Classification
100
80
60
40
20
0
| | | | | |
0 20 40 60 80 100
% of Quantity
%

o
f

V
a
l
u
e

A
B
C
EOQ Model
A formula to determine the optimal
order size that minimizes the sum of
carrying cost and ordering cost
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
The order quantity is received all at
once
The Inventory Order Cycle
Time
I
n
v
e
n
t
o
r
y

L
e
v
e
l

Reorder point, R
Order quantity, Q
0
Figure 10.1
The Inventory Order Cycle
Demand
rate
Time
Lead
time
Lead
time
Order
placed
Order
placed
Order
receipt
Order
receipt
I
n
v
e
n
t
o
r
y

L
e
v
e
l

Reorder point, R
Order quantity, Q
0
Figure 10.1
28
Basic Fixed-Order Quantity Model
and Reorder Point Behavior
R = Reorder point
Q = Economic order quantity
L = Lead time
L
L
Q Q Q
R
Time
Number
of units
on hand
1. You receive an order quantity
Q.
2. Your start
using them up
over time.
3. When you reach down
to a level of inventory of
R, you place your next Q
sized order.
4. The cycle then
repeats.
EOQ Cost Model
C
o
- cost of placing order D - annual demand

C
c
- annual per-unit carrying cost Q - order quantity
Annual ordering cost =
C
o
D
Q
Annual carrying cost =
C
c
Q
2
Total cost = +
C
o
D
Q
C
c
Q
2
EOQ Cost Model
C
o
- cost of placing order D - annual demand

C
c
- annual per-unit carrying cost Q - order quantity
Annual ordering cost =
C
o
D
Q
Annual carrying cost =
C
c
Q
2
Total cost = +
C
o
D
Q
C
c
Q
2
TC = +
C
o
D
Q
C
c
Q
2
= +
C
o
D
Q
2

C
c

2
cTC
cQ
0 = - +
C
0
D
Q
2

C
c

2
Q
opt
=
2C
o
D
C
c
Deriving Q
opt

Proving equality of
costs at optimal point
=
C
o
D
Q
C
c
Q
2
Q
2
=
2C
o
D
C
c
Q
opt
=
2C
o
D
C
c
31
Basic Fixed-Order Quantity
(EOQ) Model Formula
H
2
Q
+ S
Q
D
+ DC = TC
Total
Annual =
Cost
Annual
Purchase
Cost
Annual
Ordering
Cost
Annual
Holding
Cost
+ +
TC=Total annual
cost
D =Demand
C =Cost per unit
Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
L =Lead time
H=Annual holding
and storage cost
per unit of inventory
32
Deriving the EOQ
Using calculus, we take the first derivative of
the total cost function with respect to Q, and
set the derivative (slope) equal to zero,
solving for the optimized (cost minimized)
value of Q
opt

Q =
2DS
H
=
2(Annual Demand)(Order or Setup Cost)
Annual Holding Cost
OPT
Reorder point, R = d L
_
d = average daily demand (constant)
L = Lead time (constant)
_
We also need a
reorder point to
tell us when to
place an order
EOQ Cost Model
Order Quantity, Q
Annual
cost ($)
Figure 10.2
EOQ Cost Model
Figure 10.2
Order Quantity, Q
Annual
cost ($)
Ordering Cost =
C
o
D
Q
EOQ Cost Model
Order Quantity, Q
Annual
cost ($)
Carrying Cost =
C
c
Q
2
Ordering Cost =
C
o
D
Q
Figure 10.2
EOQ Cost Model
Slope = 0
Total Cost
Order Quantity, Q
Annual
cost ($)
Minimum
total cost
Optimal order
Q
opt
Carrying Cost =
C
c
Q
2
Ordering Cost =
C
o
D
Q
Figure 10.2
EOQ Example
C
c
= $0.75 per yard C
o
= $150 D = 10,000 yards
Q
opt
=
2C
o
D
C
c
Q
opt
=
2(150)(10,000)
(0.75)
Q
opt
= 2,000 yards
TC
min
= +
C
o
D
Q
C
c
Q
2
TC
min
= +
(150)(10,000)
2,000
(0.75)(2,000)
2
TC
min
= $750 + $750 = $1,500
Orders per year = D/Q
opt

= 10,000/2,000
= 5 orders/year
Order cycle time = 311 days/(D/Q
opt
)
= 311/5
= 62.2 store days
Example 10.2
EOQ with
Noninstantaneous Receipt
Q(1-d/p)
Inventory
level
(1-d/p)
Q
2
Time
0
Maximum
inventory
level
Average
inventory
level
Figure 10.3
EOQ with
Q(1-d/p)
Inventory
level
(1-d/p)
Q
2
Time
0
Order
receipt period
Begin
order
receipt
End
order
receipt
Maximum
inventory
level
Average
inventory
level
Figure 10.3
EOQ with
p = production rate d = demand rate
Maximum inventory level = Q - d

= Q 1 -
Q
p
d
p
Average inventory level = 1 -
Q
2
d
p
TC = + 1 -
d
p
C
o
D
Q
C
c
Q
2
Q
opt
=
2C
o
D

C
c
1 -

d
p
Production Quantity
C
c
= $0.75 per yard C
o
= $150 D = 10,000 yards
d = 10,000/311 = 32.2 yards per day p = 150 yards per day
Q
opt
= = = 2,256.8 yards
2C
o
D

C
c
1 -

d
p
2(150)(10,000)

0.75 1 -
32.2
150
TC = + 1 - = $1,329
d
p
C
o
D
Q
C
c
Q
2
Production run = = = 15.05 days per order
Q
p
2,256.8
150
Example 10.3
Production Quantity
C
c
= $0.75 per yard C
o
= $150 D = 10,000 yards
d = 10,000/311 = 32.2 yards per day p = 150 yards per day
Q
opt
= = = 2,256.8 yards
2C
o
D

C
c
1 -

d
p
2(150)(10,000)

0.75 1 -
32.2
150
TC = + 1 - = $1,329
d
p
C
o
D
Q
C
c
Q
2
Production run = = = 15.05 days per order
Q
p
2,256.8
150
Number of production runs = = = 4.43 runs/year
D
Q
10,000
2,256.8
Maximum inventory level = Q 1 - = 2,256.8 1 -

= 1,772 yards
d
p
32.2
150
Example 10.3
Quantity Discounts
Price per unit decreases as order
quantity increases
TC = + + PD
C
o
D
Q
C
c
Q
2
where
P = per unit price of the item
D = annual demand
Quantity Discounts
Price per unit decreases as order
quantity increases
TC = + + PD
C
o
D
Q
C
c
Q
2
where
P = per unit price of the item
D = annual demand
ORDER SIZE PRICE
0 - 99 $10
100 - 199 8 (d
1
)
200+ 6 (d
2
)
Quantity Discount Model
Figure 10.4
I
n
v
e
n
t
o
r
y

c
o
s
t

(
$
)

Figure 10.4
Q
opt
Carrying cost
Ordering cost
I
n
v
e
n
t
o
r
y

c
o
s
t

(
$
)

Q(d
1
) = 100 Q(d
2
) = 200
TC (d
2
= $6 )
TC (d
1
= $8 )
TC = ($10 )
Figure 10.4
Q
opt
Carrying cost
Ordering cost
I
n
v
e
n
t
o
r
y

c
o
s
t

(
$
)

Q(d
1
) = 100 Q(d
2
) = 200
TC (d
2
= $6 )
TC (d
1
= $8 )
TC = ($10 )
Quantity Discount
QUANTITY PRICE

1 - 49 $1,400
50 - 89 1,100
90+ 900
C
o
= $2,500
C
c
= $190 per computer
D = 200
Q
opt
= = = 72.5 PCs
2C
o
D
C
c
2(2500)(200)
190
TC = + + PD = $233,784
C
o
D
Q
opt

C
c
Q
opt

2
For Q = 72.5
TC = + + PD = $194,105
C
o
D
Q
C
c
Q
2
For Q = 90
Example 10.4
When to Order
Reorder Point is the level of inventory
at which a new order is placed
R = dL
where

d = demand rate per period
L = lead time
Reorder Point Example
Demand = 10,000 yards/year
Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154 yards/day
Lead time = L = 10 days

R = dL = (32.154)(10) = 321.54 yards
Example 10.5
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
Variable Demand with
a Reorder Point
Figure 10.5
Reorder
point, R
Q
Time
I
n
v
e
n
t
o
r
y

l
e
v
e
l

0
Variable Demand with
a Reorder Point
Figure 10.5
Reorder
point, R
Q
LT
Time
LT
I
n
v
e
n
t
o
r
y

l
e
v
e
l

0
Reorder Point with
a Safety Stock
Figure 10.6
Reorder
point, R
Q
LT
Time
LT
I
n
v
e
n
t
o
r
y

l
e
v
e
l

0
Safety Stock
Reorder Point With
Variable Demand
R = dL + zo
d
L
where

d = average daily demand
L = lead time
o
d
= the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
probability
zo
d
L = safety stock

Reorder Point for
a Service Level
Probability of
meeting demand during
lead time = service level
Probability of
a stockout
R
Safety stock
dL
Demand
zo
d
L
Figure 10.7
Reorder Point for
Variable Demand
The carpet store wants a reorder point with a
95% service level and a 5% stockout probability
d = 30 yards per day
L = 10 days
o
d
= 5 yards per day
For a 95% service level, z = 1.65
R = dL + z o
d
L
= 30(10) + (1.65)(5)( 10)
= 326.1 yards

Safety stock = z o
d
L
= (1.65)(5)( 10)
= 26.1 yards
Example 10.6
Order Quantity for a
Periodic Inventory System
Q = d(t
b
+ L) + zo
d
t
b
+ L - I
where

d = average demand rate
t
b
= the fixed time between orders
L = lead time
o
d
= standard deviation of demand
zo
d
t
b
+ L = safety stock
I = inventory level
Fixed-Period Model with
Variable Demand
d = 6 bottles per day
o
d
= 1.2 bottles
t
b
= 60 days
L = 5 days
I = 8 bottles
z = 1.65 (for a 95% service level)

Q = d(t
b
+ L) + zo
d
t
b
+ L - I
= (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8
= 397.96 bottles
60
Multi-Period Models: Fixed-Time Period Model:
Determining the Value of o
T+L
( )
o o
o
o o
T+L d
i 1
T+L
d
T+L d
2
=
Since each day is independent and is constant,
= (T+ L)
i
2
=
The standard deviation of a sequence

of random events equals the square
root of the sum of the variances
61
Example of the Fixed-Time Period Model
Average daily demand for a product
is 20 units. The review period is 30
days, and lead time is 10 days.
Management has set a policy of
satisfying 96 percent of demand
from items in stock. At the
beginning of the review period there
are 200 units in inventory. The daily
demand standard deviation is 4
units.
Given the information below, how many
units should be ordered?

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The standard deviation of a sequence

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