COMM341: Operations

Management
Inventory Management
G. Pond

Agenda

Introduction
Single-Period Probabilistic Demand
Multi-Period Fixed Demand
Bulk Purchase Discounts
Safety Stock
Periodic Review
In Practice

Real Life Inventory

Introduction
Inventory Theory aims to answer two basic
questions:
1) How much should I order?
2) When should I order it?

Introduction
Objective: Minimize costs
Costs
Holding costs
Set-up costs
Ordering costs
Backorder costs

$140
$120
$100
Cost 1,000
$80
$60
$40
$20
$0

Order Size
Annual Holding Costs

Annual Ordering Costs

Introduction

We have different models for:

1)Single period
2)Multi-period
3)Probabilistic demand
4)Fixed demand

Single Period Probabilistic Demand

This is a good model for:

Orders youll make only once (e.g.,
promotional material for a special
event)
Orders related to a discrete event
(e.g., an order youll make once
annually, batch operations travel).

Single Period Probabilistic Demand

If were dealing with sufficiently large volumes (say, >30), we can use
the following formula to model the probability of failing to sell
inventory:

where:
is the cost of underestimating demand
is the cost of overestimating demand

Single Period Probabilistic Demand

Once

youve found , you can then

obtain the corresponding z-value by
using a z-table OR by using Excel:
=norm.s.inv()

Single Period Probabilistic Demand

You
can then find the corresponding
optimum inventory level:

Multi-Period Fixed Order Quantity

Assumptions
The demand rate is constant - there are no fluctuations in demand.
Therefore future demand is known precisely.
All costs related to holding stock, the unit cost of purchasing new
stock, and the cost of placing an order, are all constant.
As soon as inventory is depleted, an order of new stock arrives.
The number of units purchased on each stock order is constant each order size is the same.

Multi-Period Fixed Order Quantity

Q
Inventory

Average Inventory
Level

Q/2

0
1

Time

Multi-Period Fixed Order Quantity

Multi-Period Fixed Order Quantity

+ Purchasing Cost

Multi-Period Fixed Order Quantity

We can find the minima of this function by using
calculus and equating the result to 0
$150
Cost$100
1,000
$50
$0
Order Size

Annual Holding Costs

Multi-Period Fixed Order Quantity

Now solve for :

We call this the economic order quantity

Multi-Period Fixed Order Quantity

Great! That tells me how much to order. But when do I order it?

where:
Reorder Point () - the inventory position (not date or time) at which point
new stock should be ordered.
Lead-Time () - the time between when the order is placed and when the
ordered stock arrives on site
Average Demand () is the average demand per day/week/month (just be
sure the unit is consistent with lead-time)

Multi-Period Fixed Order Quantity

Example
Suppose the Canadian Forces expends 250,000 rounds of
7.62mm ammunition annually. The average cost of a
single round is approximately $0.50 . In consideration of
the special safety requirements of storing ammunition,
suppose that the holding rate is approximately 85% of the
unit cost. Finally, placing an order is estimated to cost
approximately $5,000 in labour and shipping charges.
What is the order size that minimizes total cost?

Multi-Period Deterministic Demand

76,69
7
$140
$120
Cost
1,000
$100
$80
$60
$40
$20
$0

Annual Holding Costs

Annual Ordering Costs

Multi-Period Fixed Order Quantity

What do I do when my supplier laughs

at me for ordering 76,697 round?
Order the closest batch size available
(or to be more accurate, compare the
total cost of the two nearest batch
sizes)

Bulk Purchase Discounts

Example
In many cases, price reductions are available for
buying in larger quantities. Reconsider the problem of
ammunition procurement. Currently, each cartridge
purchased costs 50. Now imagine that if more than
80,000 rounds are purchased, the price per round is
reduced to 45 per round, and if more than 90,000
rounds are ordered, the price per round is again
reduced to only 40 per round.

Bulk Purchase Discounts

90,000 rounds

Bulk Purchase Discounts

Now You Try One!

A casino uses 4,000 light bulbs a year. Light
bulbs are priced as follows: 1 to 499, 90 cents
each; 500 to 999, 85 cents each; and 1,000 or
more, 80 cents each. It costs approximately
$30 to prepare a purchase order, receive, and
pay for it. The holding cost rate is 40% of the
purchase price per year. Determine the optimal
order quantity and the total annual cost.

Safety Stock
Example
Consider the case where the Canadian Forces
expects that the lead-time demand for
ammunition can be modelled by a normal
distribution having a mean of 25,000 rounds
during the lead-time period, with a standard
deviation of 4,000 rounds. The department is
prepared to accept being short-stocked 1% of
the time.

Safety Stock

Using

Excel,
=norm.s.inv(.99)
yields

If I accept a stockout 1%, the

implication is that I must have
sufficient stock the remaining
99% of the time

Safety Stock

Example
Safety Stock
(SS)

Safety Stock

Remember

that variance is additive (but

standard deviation is not).

Periodic Review

30

25
Inventory
20 Level
15

Order #1
Submitte
d

Order
#2
Order
#2

Order #1
Received

10
5
0
0

10

Week

15

20

25

Periodic Review

Inventory Level
(on-hand + onorder)
Safetystock
Demand over the leadtime and inter-review
period

Evaluating Inventory Policies

Higher is typically better but this is context dependent.

Common Challenges
Accurate Forecasting
Assuming normally distributed variables
Inaccurate inventory data (cycle counting
reqd)
Limited Shelf-Life
Safe Storage
Inventory tracking (knowing its location in a
warehouse)

Typical Solutions

Cycle Counting
Minimize discrepancies in inventory
data
Determine root cause of discrepancy
and correct it.

Typical Solutions
ABC Classification
Devote the majority of your attention to your
Very Important (A) stock items

15-20% of SKUs but 70-80% of annual dollar

value

Give some attention to Moderately Important (B)

stock items
Give little attention to the Least Important (C)
50-60% of SKUs but 5-10% of annual dollar
stock items. value

Technological Solutions

RFIDs / Transponders

Live Vehicle Tracking

www.marinetraffic.com

Live Vehicle Tracking

http://tracker.geops.ch/?z=16&s=1&x=-8836519.3105&y=5411201.0721&l=transport

Technological Solutions

Bar Coding

Technological Solutions

Automated Warehouses

Inventory Management Software

Other Applications

How much should I make in a lot/batch?

Other Applications
How far should I allow myself to be shortstocked?

Before Next Week

Review Chapter 10
Try the following problems from your text:
Problem #6
Problem #18
Problem #21
Read Chapter 3 in preparation for next
week