STRATEGIC INVENTORY

DEFINITION AND FUNCTIONS OF INVENTORY

DIFFERENT INVENTORY COSTS
INVENTORY MODELS
SHORT TERM DISCOUNTING
 Learning Objectives

• Describe the four basic types of inventories and their functions.

• Distinguish dependent from independent demand inventories.
• Understand the costs of inventory and inventory turnovers.
• Understand ABC classification and cycle counting.
• Understand the EOQ model and its underlying assumptions.
• Understand the Quantity Discount and the EPQ Models and their
relationships with the basic EOQ model.
 What is Inventory?
“a stock or store of goods”
“a physical stock of goods kept in store to meet the anticipated
demand”
 Types of Inventories
• Raw materials & purchased parts
• Partially completed goods called
work in progress
• Finished-goods inventories
(manufacturing firms)
or merchandise
(retail stores)
• MRO- Maintenance, repair and Operating supplies
 Functions of Inventory
• To meet anticipated demand
• To smooth production requirements
• To decouple operations
• To protect against stock-outs
• To take advantage of order cycles
• To help hedge against price increases
• To permit operations
• To take advantage of quantity discounts
 Dependent Demand and Independent Demand

• Independent demand – finished goods, items

that are ready to be sold
E.g. a computer
• Dependent demand – components of
finished products
E.g. parts that make up the computer
Types of demand Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
 Inventory Control
Refers to the systematic location, storage, and recording
of goods in such a way that desired degree of service
may be rendered to operating shops at minimum
ultimate cost.

It is also concerned with the systematic receipt, storage

disbursement, and recording of materials in such a way
that provides the required degree of service to the firm
at minimum possible cost.
 Objectives of Inventory Control
• To achieve satisfactory levels of customer service while
keeping inventory costs within reasonable bounds
Two main concern of Inventory Management:
• Level of customer service
• Costs of ordering and carrying inventory
Inventory Management  important to successful
operation for most organizations because of:

• The amount of money invested in inventory

represents, and
• The impact that inventories have on daily operations
of an organization
Requirements for Effective Inventory Management
• A system to keep track of inventory
• A reliable forecast of demand
• Knowledge of lead times and lead time
variability
• Reasonable estimates of
• Holding costs
• Ordering costs
• Shortage costs
• A classification system
 Inventory Costs
• Direct Costs – those that are directly traceable to the unit produced, such as the
amount of materials and labor used to produce a unit of the finished good.
• Indirect costs - those that cannot be traced directly to the unit produced and
they are synonymous with manufacturing overhead.
• Fixed costs - are independent of the output quantity
• Variable costs- change as a function of the output level
• Order or set up costs - are the direct variable costs associated with placing an
order with the supplier
• Holding or carrying costs - are the costs incurred for holding inventory in
storage
• Setup costs – are used in place of order costs to describe the costs associated
with setting up machines and equipment to produce a batch of product
• Stock out cost – cost occur whenever insufficient stock exists to fulfill a
replenishment order
 Inventory Investment

• Inventory serves many important functions for manufacturing

and service firms; however, excessive inventory is detrimental
to a firm’s financial health and competitive edge.
• How to measure inventory investment?
- It can be measured in various ways.
1. The typical annual physical stock counts to determine the
total dollars invested in inventory
2.inventory turnover ratio or inventory turnovers. This ratio
shows how many times a company turns over its inventory
in an accounting period.
 Inventory Turnover Ratio or Inventory Turnovers
The formula for the inventory turnover ratio can be stated as:
Inventory Turnover Ratio

•
Inventory Turnover Ratios
 Cycle Counting

• A physical count of items in inventory

• Cycle counting management
• How much accuracy is needed?
• When should cycle counting be
performed?
• Who should do it?
 ABC Classification System

Classifying inventory according to some measure of

importance and allocating control efforts accordingly.
A - very important
B - mod. important
High
C - least important A
Annual
$ value B
of items

Low C
Low High
Percentage of Items
 ABC inventory classification

ABC inventory classification can be done monthly, quarterly, annually or any

fixed period.
ABC inventory classification
ABC inventory classification
Two fundamental decisions/ questions in Inventory
Management
1. The timing (When to order?)
2.Size of an order? (How much to order?)
 The Inventory Cycle
Average
Inventory
Q = 350 units (Qty on Usage rate = 50 units per day
(Q/2)
Hand)

Reorder Point = 100 units

Place order Receive order

Lead Time = 2 days
 When to Order:
The Reorder Point
• Without safety stock:

• With safety stock:

 Inventory Models
The Economic Order Quantity Model
• a classic independent demand inventory system that
provides many useful ordering decisions.
• The basic order decision is to determine the optimal
order size that minimizes total annual inventory costs—
that is, the sum of the annual order cost and the annual
inventory holding cost.
 Assumptions of EOQ Model
1. The demand is known and constant.
2. Order lead time is known and constant.
3. Replenishment is instantaneous.
4. Price is constant.
5. The holding cost is known and constant.
6. Order cost is known and constant.
7. Stockouts are not allowed.
 How Many to Order:
The Economic Order Quantity
These assumptions allow us to use a simple calculation for total costs related
to the quantity we order.
Total Cost = Annual Carrying Cost + Annual Ordering Cost

Where:
TC = Total cost
H = Carrying or holding cost per unit, on an annual basis
Q = Order quantity
S = Cost of ordering
D = Annual demand
• The relationships among the ordering cost, carrying costs, and total cost
curve:

Ordering at this quantity will

minimize the total costs

11-28
 Holding (Carrying) Costs
• Obsolescence
• Insurance
• Extra staffing
• Interest
• Damage
• Warehousing
• Etc.
Ordering Costs

• Supplies
• Forms
• Order processing
• Clerical support
• etc.
 How Many to Order:
The Economic Order Quantity
The EOQ Formula:
 How Many to Order:
The Economic Order Quantity
Sample Problem:

1. A local distributor for a national tire company expects to sell 9,600 steel
belted radial tires of a certain size and trade design next year. Annual carrying
cost is P 16 per tire, and ordering cost is P 75. The distributor operates 288
days a year.

a. What is the EOQ?

b. How many times per year does the store reorder?
c. What is the length of an order cycle?
d. What is the total annual cost if the EOQ quantity is ordered?
 How Many to Order:
The Economic Order Quantity
Given:
D = 9,600 tires
H = P16/tire
S = P75/order
n = 288 days

Solution:

a. EOQ = = = 300 tires/order

 How Many to Order:
The Economic Order Quantity

b. Number of orders = = = 32 orders /year

c. Length of an Order Cycle = = = 9 days/order

d. TC = H(Q/2) + S(D/Q) = (300/2)(P16) + (9,600/300)(P75)

= P2,400 + P2,400

= P 4,800
 How many to produce:
Economic Production Quantity (EPQ)

• Production done in batches or lots

• Capacity to produce a part exceeds the part’s usage
or demand rate
• Assumptions of EPQ are similar to EOQ except
orders are received incrementally during production
 How Many to Produce:
The Economic Production Quantity
The EPQ model makes the following assumptions:

o Annual demand is known

o Lead time is constant
o No quantity discounts
o Only one item is involved
o The usage rate is constant
o Usage occurs continually, but production occurs periodically
o The production rate is constant
EPQ Model Inventory Levels (1 of 2)
Inventory Level

Production portion of Maximum

inventory level
cycle

Demand portion of cycle with

no supply

Time
Supply Supply
Begins Ends
 EPQ Model Inventory Levels (2 of 2)
Inventory Level
Inventory level with no demand

Production Max. Inventory

Q* Portion of Q·(1- d/p)
Average inventory
Cycle Q/2(1- d/p)

Time
Supply Supply Demand portion of
Begins Ends cycle with no supply
 How Many to Produce:
The Economic Production Quantity
The EPQ Formula:

Where:
H = Carrying or holding cost per unit, on an annual basis
S = Set up Cost
D = Annual demand
d = usage rate/demand rate
p = production rate
 How Many to Produce:
The Economic Production Quantity

Cycle time = (the time between beginning of runs) for the economic run size
model is a function of run size and usage rate.

Run time = (the production phase of the cycle) is a function of run size and
production rate.
 How Many to Produce:
The Economic Production Quantity
Sample Problem:

1. A toy manufacturer uses 48,000 rubber wheels per year for its popular
dump truck series. The firm makes its own wheels, which it can produce
at a rate of 800 per day. The toy trucks are assembled uniformly over the
entire year. Carrying cost is $ 1 per wheel a year. Set up cost for a
production run of wheels is $ 45. The firm operates 240 days per year.

Determine the following:

a. Optimal run size

b. Cycle time for the optimal run size
c. Run time
d. Minimum total annual cost for carrying and set up.
 How Many to Produce:
The Economic Production Quantity
Given:

D = 48,000 wheels; d = D/n = 48,000 wheels/240 days = 200 wheels/day

p = 800 wheels/day
H = $1/wheel
S = $45/order
n = 240 days/year

Solution:

a. = 2,400 wheels
 How Many to Produce:
The Economic Production Quantity
Solution:

b. Cycle Time = 12 days

c. Run time = = 3 days

d. =

$900 + $900 = $1,800

 Quantity Discount Model

Quantity Discounts – are price reductions for large orders offered to

customers to induce them to buy in large quantity.

Total Cost = Carrying Cost + Ordering Cost + Purchasing Cost

Where: P = unit price, D= Annual Demand

 Quantity Discount Model
Procedures for Computing the EOQ:

1. Compute the common minimum point.

2. Only one of the unit prices will have the minimum in its feasible range
since the ranges do not overlap. Identify that range.

a. If the feasible minimum point is on the lowest price range, that is the
optimal order quantity.

b. If the feasible minimum point is in any other range, compute the total
cost for the minimum point and for the price breaks of all lower unit costs.
Compare the total costs; the quantity (minimum point or price breaks) that
yields the lowest total cost is the optimal order quantity.
 Quantity Discount Model
Sample Problem:

1. The maintenance department of a large hospital uses about 816

cases of liquid cleanser annually. Ordering costs are $12, carrying
costs are $4 per case a year, and the new price schedule that orders
of less than 50 cases will cost $20 per case, 50 to 79 cases will cost
$18 per case, 80 to 99 cases will cost $17 per case and larger orders
will cost $16 per case. Determine the optimal order quantity and the
total costs.
 Quantity Discount Model
Given:

D = 816 cases per year; H = $4 per year; S = $ 12

Range Price
1 to 49 $20
50 to 79 $18
80 to 99 $17
100 or more $16
 Quantity Discount Model
• EOQ = = =69.97 / 70 cases
• The 70 cases can be bought at $18,

• Total cost at lower prices:

TC(69.97) = (69.97/2)(4) + (816/69.97)(12) + (18)(816) = $14,967.86

TC(80) = (80/2)(4) + (816/80)(12) + (17)(816) = $14,154.4

TC(100) = (100/2)(4) + (816/100)(12) + (16)(816) = $13,354

Answer: Overall Optimal Order Quantity = 100 cases per order

Total Costs = $13,353.92
Questions??