INVENTORY MANAGEMENT

Prof. S. K. GARG
Why Keep Inventory
Transaction Motive: Ensure synchronization in
inflow and outflow (decouple them)
Precautionary Motives: A cushion against
uncertainty
Speculative Motive: Store in anticipation of
future price rise
Economic Motive: Take advantage of
economic lot size
Purpose of Keeping Inventory
Reduce purchasing efforts and cost
Meet unexpected demand
Smooth seasonal or cyclical demand
Meet variations in customer demand
Meet uncertainty in Supply
Take advantage of price discounts
Hedge against price increases
Objectives of Inventory Management
To Decide:
When to order?
How much to order?
By considering:
Carrying/ Holding Cost
Ordering Cost/ Changeover Cost
Shortage Cost
To Provide the Desired Customer
Service
Types of Inventory
Raw Material Inventory
Purchased parts and supplies
In-process (partially completed) products
Finished Products
Lubricants, Spares and Consumables
Tools, machinery, and equipment
Working capital
Labour

6
Inventory Carrying Cost
Cost of capital
Cost of storage space
Depreciation and Deterioration cost
Pilferage cost
Handling cost
Record keeping and administration cost
Taxes and insurance
Shortage Cost
Loss of production
Loss of sales
Expediting and follow up
Loss of goodwill
Ordering Cost
Administrative cost of tendering etc
Follow up
Transport cost
Receiving, inspection cost
Administrative cost of releasing payment
9
Inventory Order Cycle Q System
Demand
rate
Time
I
n
v
e
n
t
o
r
y

L
e
v
e
l

Order quantity, Q
0
10
Inventory Order Cycle Q System
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
11
Economic Order Quantity (EOQ)
Slope = 0
Total Cost
Order Quantity, Q
A
n
n
u
a
l

c
o
s
t


Minimum
total cost
Optimal order Q
opt

Carrying Cost = C
1
Q/2
Ordering Cost = C
3
R/Q
Total inventory cost = Ordering cost + Carrying cost
Q = order size (units)
D = annual demand (units/year)
C
o
= Ordering cost (Rs/order)
C
h
= Carrying cost (Rs/unit/year)

h
o
opt
C
DC
Q
2
=
o h opt
C DC TotalCost 2 =
h o
C
Q
C
Q
D
TC
2
+ =
Assumptions
Demand is Uniform and Certain
Shortages not permitted/ Shortage Cost is
very high
Replenishment is instantaneous
Lead time is constant and certain (Receive
order quantity all at once)
No price/ quantity discount

The annual demand of an item is 2000 units.
The cost of placing an order is Rs 400 and the
cost of carrying inventory is Rs 16 per unit per
year . Calculate Economic Order Quantity,
Average Inventory, No. of Order per Year and
Total Cost.
DATA
D = 2000 units (Annual demand)
C
o
= Rs 400 per order (Order cost)
C
h
= Rs 16 per unit per year (Inventory Holding Cost)
RESULTS
EOQ= 1000 Units
Average Inventory = 500 Units
Total Cost = Rs 16,000 per annum
Number of orders per year = 16

h
o
opt
C
DC
Q
2
=
o h opt
C DC TotalCost 2 =
Illustrative Example
The annual demand of an item is 2000 units. The cost of placing an order is Rs 400
and the cost of carrying inventory is Rs 16 per unit per year . Calculate Economic
Order Quantity, Average Inventory, No. of Order per Year and Total Cost.
DATA
D = 2000 units (Annual demand)
C
o
= Rs 400 per order (Order cost)
C
h
= Rs 16 per unit per year (Inventory Holding Cost)
RESULTS
EOQ= 1000 Units
Average Inventory = 500 Units
Total Cost = Rs 16,000 per annum
Number of orders per year = 16

Illustrative Example
The annual demand of an item is 5000 units. The
cost of placing an order is Rs 1000 and the cost of
carrying inventory is Rs 40 per unit per year .
Calculate Economic Order Quantity, Average
Inventory, No. of Order per Year and Total Cost.
DATA FORMULAS
D = units (annual demand)
C
o
= (Ordering cost)
C
h
= (Inventory Holding Cost)
RESULTS
EOQ=
Average Inventory =
Total Cost =
Number of orders per year =

h
o
opt
C
DC
Q
2
=
o h opt
C DC TotalCost 2 =
Illustrative Example
The annual demand of an item is 5000 units. The cost of placing an order is Rs
1000 and the cost of carrying inventory is Rs 40 per unit per year . Calculate
Economic Order Quantity, Average Inventory, No. of Order per Year and Total
Cost.
DATA
D = 5,000 units (annual demand)
C
o
= Rs 1,000 (Ordering cost)
C
h
= Rs 40 (Inventory Holding Cost)
RESULTS
EOQ= 500 Units
Average Inventory = 250 Units
Total Cost = Rs 20,000 per annum
Number of orders per year = 10

18
400 units:
TC = (40)(400/2) + 1,000(5,000/400)
= 8,000 + 12,500 = Rs 20,500.
Added cost = Rs20,500 Rs 20,000
= Rs 500.
What is the added cost if the firm orders
400 units or 600 units at a time
rather than the EOQ?
600 units:
TIC = (40)(600/2) + 1,000(5,000/600)
= 12,000 +8,333 = Rs 20,333.
Added cost = Rs 20,333 Rs 20,000
= Rs 333.
2
h o
QC
Q
DC
TC + =
19
Weekly usage rate = 5,000/52
= 96 units.
If order lead time = 2 weeks, firm must
reorder when:
Inventory level = 2(96) = 192 units.
Suppose delivery takes 2 weeks.
Assuming certainty in delivery and
usage, at what inventory level should
the firm reorder?
20
Weekly usage rate = 5,000/52
= 96 units.
If order lead time = 2 weeks, firm must
reorder when:
Inventory level = 2(96) = 192 units.
Suppose delivery takes 2 weeks.
Assuming certainty in delivery and
usage, at what inventory level should
the firm reorder?
21
Without safety stocks, the firms total inventory
costs = Rs 20,000.
Cost of carrying additional 200 units
= C
h
(Safety stock)
= (Rs 40)(200) = Rs 8,000.
Total inventory costs = 20,000 + 8,000
= Rs 28,000.
Assume a 200-unit safety stock is
carried. What effect would this have
on total inventory costs?
22
Discount affects operating inventory only.
Discount price = Rs 200(0.99) = Rs 198.

TC = CP(Q/2) + A(D/Q)
= 0.2(198)(1,000/2) + 1,000(5,000/1,000)
= 19,800 + 5,000 = Rs 24,800.

Suppose the firm could receive a
discount of 1% on orders of 1,000
or more. Should the firm take the
discount?
(More...)
23
Savings (discount) = 0.01(200)(5,000) = Rs 10,000
Added costs = Rs 24,800 Rs 20,000 = Rs 4,800
Net savings = Rs 10,000 Rs 4,800 = Rs 5,200
Firm should take the discount.
Price-Break Another Example
A company has a chance to reduce their inventory ordering
costs by placing larger quantity orders using the price-break
order quantity schedule below. What should their optimal
order quantity be if this company purchases this single
inventory item with an e-mail ordering cost of Rs 40, a
carrying cost rate of 20% of the inventory cost of the item,
and an annual demand of 10,000 units?
Order Quantity(units) Price/unit(Rs)
0 to 2,499 Rs1.20
2,500 to 3,999 1.00
4,000 or more .98
Price-Break Example Solution
units 1,826 =
0.2(1.20)
40) 2(10,000)(
=
iC
2DCo
= Q
OPT
Annual Demand (D)= 10,000 units
Cost to place an order (S)= Rs 40
First, plug data into formula for each price-break value of C
units 2,000 =
0.2(1.00)
40) 2(10,000)(
=
iC
2DCo
= Q
OPT
units 2,020 =
0.2(0.98)
40) 2(10,000)(
=
iC
2DCo
= Q
OPT
Carrying cost % of total cost (i)= 20%
Cost per unit (C) = Rs1.20, Rs1.00, Rs0.98
Interval from 0 to 2499, the
Q
opt
value is feasible
Interval from 2500-3999, the
Q
opt
value is not feasible
Interval from 4000 & more,
the Q
opt
value is not feasible
Next, determine if the computed Q
opt
values are feasible or not
Price-Break Example Solution (Part 3)
Since the feasible solution occurred in the first price-
break, it means that all the other true Q
opt
values occur
at the beginnings of each price-break interval. Why?
0 1826 2500 4000 Order Quantity
Total
annual
costs
So the candidates
for the price-
breaks are 1826,
2500, and 4000
units
Because the total annual cost function is
a u shaped function
Price-Break Example Solution (Part 4)
iC
2
Q
+ S
Q
D
+ DC = TC
Next, we plug the true Q
opt
values into the total cost annual cost
function to determine the total cost under each price-break
TC(0-2499)=(10000*1.20)+(10000/1826)*40+(1826/2)(0.2*1.20)
= Rs12,438.18
TC(2500-3999) = Rs10,410.00
TC(4000&more) = Rs 10292.00
Finally, we select the least costly Q
opt
, which is this problem occurs
in the 4000 & more interval. In summary, our optimal order quantity
is 4000 units
28
I
n
v
e
n
t
o
r
y

t
p
t
Time
PRODUCTION MODEL
29
D=5,000 P=25,000 C
h
= Rs 40 C
o
= 1000
|
.
|

\
|
= =
|
.
|

\
|

=
|
.
|

\
|
=
P
D
C DC C C Dk TC
P
D
C
DC
q
P
D
k
h o o h opt
h
o
opt
1 2 2
1
2
1
1
1
K
1
= 1-5000/25000 = 0.8
2(5,000)(1000)
0.8(40)
\
30
I
n
v
e
n
t
o
r
y

Time
t
t1
t2
R
q
I
S
MODEL WITH SHORTAGE PERMITTED
31
opt
s h
s
opt
q
C C
C
I
(

+
=
2
2
k C
DC
q
h
o
opt
=
s h opt
C C Dk TC
2
2 =
(

+
=
s h
s
C C
C
K
2
Formulas for Inventory Model Under Shortages
32
opt
s h
s
opt
q
C C
C
I
(

+
=
2
2
k C
DC
q
h
o
opt
=
s h opt
C C Dk TC
2
2 =
(

+
=
s h
s
C C
C
K
2
Illustration for Inventory Model Under Shortages
D=5,000
C
h
= Rs 40
C
s
= Rs 200
C
o
= 1000

K
2
= 200/ (40+200)
=5/6

Q
opt
=

I
opt
=

TC
opt
=

33
O
A
B
C
D
F
q
S
P - R
R
t1 t2
t3 t4
I
n
v
e
n
t
o
r
y

Time
General Case Production and Shortages
34
2 1
*
2
k k C
DC
q
h
o
=
o h
C C k Dk TC
2 1
*
2 =
Formulas for Production Model Under Shortages
35
Holding Cost =
( )
1
2 1
2
C
t
t t S +
Where t=(t
1
+t
2
+t
3
+t
4
)
Shortage Cost =
( )
2
4 3
2
1
C
t
t t
h
+
Set-up Cost =
3
C
q
R
Derivation
36
Total Cost =
( )
+
+
1
2 1
2
C
t
t t S ( )
+
+
2
4 3
2
1
C
t
t t
h
3
C
q
R
1 2 1
3 2
*
) (
) ( 2
C C C
C C
P
R P R
S
+

=
2 2 1
3 1
*
) (
) ( 2
C C C P
C C R P R
h
+

=
2 1
2 1 3
) (
) ( 2
*
C C P R
C C RPC
q

+
=
Derivation
37
Selective Inventory Control
Prioritize items on some logical basis
Prioritize managerial efforts
Monitor and control selectively


38
Selective Inventory Control :
Pareto Analysis or ABC analysis
Pareto analysis (sometimes referred to as the
80/20 rule and as ABC analysis) is a method of
classifying items, events, or activities according
to their relative importance (Annual Usage
Value).
It is frequently used in inventory management
where it is used to classify stock items into
groups based on the total annual expenditure or
total stockholding cost of each item. Companies
often concentrate on the high value/important
items.
Procedure of ABC Analysis
List all the items to be kept in Inventory
Determine the Unit Price and annual demand
(Consumption) in previous year.
Calculate Annual Usage Value by multiplying
Annual Demand by Unit Price
Arrange the items in descending order of Annual
Usage value.
Calculate Cumulative Annual Usage Value
Plot the graph between Item number and
cumulative annual usage value
Divide the curve into 3 parts, where there is a
major change in slope
Item No Description Unit Price Annual Demand Annual Usage Value
1 AAA1 4 100 400
2 AAA2 200 25 5000
3 AAA3 1 50 50
4 AAA4 150 10 1500
5 AAA5 300 40 12000
6 AAA6 15 20 300
7 AAA7 100 5 500
8 AAA8 50 40 2000
9 AAA9 20 50 1000
Item No Description Unit Price Annual Demand Annual Usage Value Cumulative
1 AAA5 300 40 12000 12000
2 AAA2 200 25 5000 17000
3 AAA8 50 40 2000 19000
4 AAA4 150 10 1500 20500
5 AAA9 20 50 1000 21500
6 AAA7 100 5 500 22000
7 AAA1 4 100 400 22400
8 AAA6 15 20 300 22700
9 AAA3 1 50 50 22750
0
5000
10000
15000
20000
25000
30000
1 2 3 4 5 6 7 8 9 10
Series1
Series2
43
% of Inventory Items
Classifying Items as ABC
0
20
40
60
80
100
0 50 100
% Annual Rs Usage
A
B
C
Class % Rs Vol % Items
A 80 15
B 15 30
C 5 55
44
Pareto (ABC) Analysis
Vital few/ Trivial many !
10 20 30 40 50 60 70 80 90 100
Percentage of items
P
e
r
c
e
n
t
a
g
e

o
f

d
o
l
l
a
r

v
a
l
u
e

100
90
80
70
60
50
40
30
20
10
0
Class C
Class A
Class B
45
Selective Inventory Control

- ABC (Based on Price and volume of use)
- VED (Vital, Essential, and Desirable)
- FSN (Fast, Slow, and Normal).
- HML (High, Medium, and Low)
- SDE (Scarce, Difficult, and Easy to Obtain)
- GOLF (Government, Ordinary, Local, and
Foreign)

VED Classification
Criteria Criticality of Item

V- Vital
E- Essential
D- Desirable
V E D
A 99 80
B
c 99.9999 99.999
Service Level Requirements for
Different Category of Items
48
Periodic Inventory System
for B and C Class items
S
s
0 1 2 3 4 5
Review Periods
Decision Rule:
If the stock level q at review time is more than small s,
no order is placed.
If the q is less than small s, then order quantity Q = Big S-q
q
q
q
q
49
Inventory System
With Multi Items from a Vendor
EXAMPLE
Item
No.
D H DH
1 350 Rs 7 2450
2 800 4 3200
3 1000 8 8000
TOTAL 13650
Ordering Cost S = Rs 100 per order
50
CASE I - INDEPENDENT EOQ AND TC
H
2DS
= Q
OPT
2DSH = TC
OPT
Item No. Q
OPT
TC
OPT
1 100 700
2 200 800
3 100 2000
TOTAL 3500
51
CASE II - COMBINED DECISION
HD all of Sum
2S
D = Q
OPT
DH) all of 2S(sum = TC
OPT
Item No. Q
OPT
1 42
2 97
3 121
TOTAL COST = 1300
No. of Orders per year = 8.25
52
Multi Item Inventory System under
Budget Constraints
Space Constraint (in Area)
Space Constraint (in No. of units)

53
EXAMPLE
ITEMS 1 2 3
Holding Cost H 20 20 20
Setup Cost S 50 40 60
Cost per unit C 6 7 5
Annual Demand D 10,000 12000 7500
Determine Q
OPT
when total value of average
inventory levels of three items is Rs 1000.
54
CASE I NO BUDGET CONSTRAINTS
Item No. Q
OPT
1 223
2 219
3 212
Average Inventory Value = (62232) + (62232) + (62232)
= Rs 1965.50

Amount required is greater than the budgets of Rs 1000.
55
CASE II UNDER BUDGET CONSTRAINTS
k 2C D H
S 2D
= Q
OPT(i)
(i) (i) (i)
(i) (i)
+
K is Lagrange multiplier
Item No. K=4

K=5

K=4.7

1 121 111 114
2 112 102 105
3 123 113 116
Average Inventory
Cost
1062.50 972.50 999
The most suitable value of k is 4.7 by interpolation
Inventory Models under Uncertainty
Single Period/ Static/ Newspaper Boy Problem
For Spares/ Perishable items/ Items which can
be procured only once
Multi Period/ Dynamic Safety Stock
Uncertainty in Demand
Uncertainty in Lead Time
Both
57
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

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

l
e
v
e
l

0
58
Safety Stocks
Prevent stockout under uncertain demand

Reorder
point, R
Q
LT
Time
LT
I
n
v
e
n
t
o
r
y

l
e
v
e
l

0
Safety Stock
59
Reorder Point with Variable Demand
Reorder point with safety stock
Service level = probability of NO stockout

L z L d R
d
o + =
stock safety
y probabilit level service the
to ing correspond deviations standard of number
demand daily of deviation standard
time lead
demand daily average
= o
=
=
=
=
L z
z

L
d
d
d
Reorder Point with Deterministic Demand
and Variable Lead Time
Reorder point with safety stock
Service level = probability of NO stockout

L
zd L d RoP o + =
stock safety
y probabilit level service the
to ing correspond deviations standard of number
time lead of deviation standard
time lead average
demand daily
=
=
=
=
=
L
L
zd
z

L
d
o
Reorder Point with Variable Demand and
Variable Lead Time
Reorder point with safety stock
Service level = probability of NO stockout
2
2
2
L d
d L z L d RoP o o + + =
y probabilit level service the
to ing correspond deviations standard of number
time lead of deviation standard
demand of deviation standard
time lead average
demand daily average
=
=
=
=
=
z

L
d
L
d
ABC VED ANALYSIS
A B C
V 95 99 99.999 %
E 90 95 99
D 50% 90 95
Single-Period Inventory Model
u o
u
C C
C
q) P(d
+
= s
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
Where
Cu is the cost of under stocking
Co is the cost of over stocking
P (d<=q) is the probability that the demand d during season is
less than q.
Single Period Probabilistic Inventory Model
Example1
A newspaper boy buys papers for Re 1.00
each and sells them at Rs. 1.50 each. He
canot return unsold newspapers. Daily
demand has the following distribution:

No of Customers : 225 250 275 300 325 350 370
Probability : 0.05 0.15 0.20 0.30 0.15 0.10 0.05

If each day demand is independent to the
previous days demand, how many papers
should he order each day?



Single Period Probabilistic Inventory Model
Example2
An item sells for Rs 25 per unit and costs Rs.
10. Unsold items can be sold for Rs4 each. It
is assumed that there is no shortage penalty
cost besides the lost revenue. The demand is
known to be any value between 600 and
1000 items. Determine the optimal number of
units of the item to be stocked?

Ans. 886 units

Single Period Probabilistic Inventory Model
Example3
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 Rs10 on every shirt we sell at the
game, but lose Rs 5 on every shirt not sold.
How many shirts should we make for the
game?

C
u
= Rs10 and C
o
= Rs5; P 10 / (10 + 5) = .667

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

Vendor Managed Inventory

Supporting/ Proactive Approaches
Standardization
Vendor management
Lead time management
Use of IT
Spoke vs Rim System
JIT
Kanban