Chapter 3

Inventory Management
 Lecture Outline
• Elements of Inventory Management
• Inventory Control Systems
• Economic Order Quantity Models
• Quantity Discounts
• Reorder Point
• Order Quantity for a Periodic Inventory System

13-2
 What Is Inventory?
• Stock of items kept to meet future demand
• Purpose of inventory management
• how many units to order
• when to order

13-3
 Supply Chain Management
• Bullwhip effect
• demand information is distorted as it moves away
from the end-use customer
• higher safety stock inventories to are stored to
compensate
• Seasonal or cyclical demand
• Inventory provides independence from vendors
• Take advantage of price discounts
• Inventory provides independence between
stages and avoids work stoppages

13-4
 Quality Management in the Supply Chain

• Customers usually perceive quality service as

availability of goods they want when they want
them
• Inventory must be sufficient to provide high-
quality customer service in QM

13-5
 Types of Inventory
• Raw materials
• Purchased parts and supplies
• Work-in-process (partially completed) products
(WIP)
• Items being transported
• Tools and equipment

13-6
 Two Forms of Demand
• Dependent
• Demand for items used to produce final
products
• Tires for autos are a dependent demand item
• Independent
• Demand for items used by external customers
• Cars, appliances, computers, and houses are
examples of independent demand inventory

13-7
 Inventory Costs
• Carrying cost
• cost of holding an item in inventory
• Ordering cost
• cost of replenishing inventory
• Shortage cost
• temporary or permanent loss of sales when
demand cannot be met

13-8
 Inventory Control Systems

• Continuous system (fixed-order-quantity)

• constant amount ordered when inventory declines to
predetermined level
• Periodic system (fixed-time-period)
• order placed for variable amount after fixed passage
of time

13-9
 ABC Classification
• Class A
• 5 – 15 % of units
• 70 – 80 % of value
• Class B
• 30 % of units
• 15 % of value
• Class C
• 50 – 60 % of units
• 5 – 10 % of value

13-10
 ABC Classification
PART UNIT COST ANNUAL USAGE
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

13-11
 ABC Classification
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
A 15.0
1 5,400 6.3 9.0 24.0
4 4,800 5.6 6.0 B 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 C 83.0
7 1,700 2.0 17.0 100.0
$85,400

Example 10.1
13-12
 ABC Classification

% 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

Example 10.1
13-13
 Economic Order Quantity
(EOQ) Models
• EOQ
• optimal order quantity that will minimize
total inventory costs
• Basic EOQ model
• Production quantity model

13-14
 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
• Order quantity is received all at once

13-15
 Inventory Order Cycle

Order quantity, Q
Demand Average
rate inventory
Inventory Level

Q
2

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
placed receipt placed receipt

13-16
 EOQ Cost Model

Co - cost of placing order D - annual demand

Cc - annual per-unit carrying cost Q - order quantity

Co D
Annual ordering cost =
Q
CcQ
Annual carrying cost =
2
Co D CcQ
Total cost = +
Q 2

13-17
 EOQ Cost Model

Deriving Qopt Proving equality of

costs at optimal point
CoD CcQ
TC = +
Q 2 C oD CcQ
=
TC Co D
Cc Q 2
=– +
Q Q 2
2 2CoD
Q =2
C0D Cc Cc
0=– +
Q2 2
2CoD
2CoD Qopt =
Qopt = Cc
Cc

13-18
 EOQ Cost Model
Annual
cost ($) Total Cost
Slope = 0

CcQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost =
Q

Optimal order Order Quantity, Q

Qopt

13-19
 EOQ Example

Cc = $0.75 per gallon Co = $150 D = 10,000 gallons

2CoD CoD CcQ

Qopt = TCmin = +
Cc Q 2
2(150)(10,000) (150)(10,000) (0.75)(2,000)
Qopt = TCmin = +
(0.75) 2,000 2

Qopt = 2,000 gallons TCmin = $750 + $750 = $1,500

Orders per year = D/Qopt Order cycle time = 311 days/(D/Qopt)

= 10,000/2,000 = 311/5
= 5 orders/year = 62.2 store days

13-20
 Production Quantity Model
• Order is received gradually, as inventory is
simultaneously being depleted
• AKA non-instantaneous receipt model
• assumption that Q is received all at once is relaxed
• p - daily rate at which an order is received over
time, a.k.a. production rate
• d - daily rate at which inventory is demanded

13-21
 Production Quantity Model

Inventory
level

Maximum
Q(1-d/p) inventory
level

Average
Q inventory
(1-d/p)
2 level

0
Begin End Time
order order
Order
receipt receipt
receipt period

13-22
 Production Quantity Model

p = production rate d = demand rate

Q
Maximum inventory level = Q - d
p
d
=Q1-
p 2CoD
Qopt = d
Q d Cc 1 - p
Average inventory level = 1-
2 p

CoD CcQ d
TC = + 1- p
Q 2

13-23
 Production Quantity Model

Cc = $0.75 per gallon Co = $150 D = 10,000 gallons

d = 10,000/311 = 32.2 gallons per day p = 150 gallons per day

2CoD 2(150)(10,000)
Qopt = = = 2,256.8 gallons
32.2
Cc 1 - d 0.75 1 -
p 150

CoD CcQ d
TC = + 1- p = $1,329
Q 2

Q 2,256.8
Production run = = = 15.05 days per order
p 150

13-24
 Production Quantity Model

D 10,000
Number of production runs = = = 4.43 runs/year
Q 2,256.8

d 32.2
Maximum inventory level = Q 1 - = 2,256.8 1 -
p 150
= 1,772 gallons

13-25
Solution of EOQ Models With Excel

The optimal order

size, Q, in cell D8

13-26
Solution of EOQ Models With Excel

The formula for Q

in cell D10

=(D4*D5/D10)+(D3*D10/2)*(1-(D7/D8))

=D10*(1-(D7/D8))

13-27
Solution of EOQ Models With OM Tools

13-28
 Quantity Discounts

Price per unit decreases as order

quantity increases

CoD CcQ
TC = + + PD
Q 2
where
P = per unit price of the item
D = annual demand

13-29
 Quantity Discount Model
ORDER SIZE PRICE
0 - 99 $10 TC = ($10 )
100 – 199 8 (d1)
200+ 6 (d2) TC (d1 = $8 )

TC (d2 = $6 )
Inventory cost ($)

Carrying cost

Ordering cost

Q(d1 ) = 100 Qopt Q(d2 ) = 200

13-30
 Quantity Discount

QUANTITY PRICE
Co = $2,500
1 - 49 $1,400
Cc = $190 per TV
50 - 89 1,100
D = 200 TVs per year
90+ 900

2CoD 2(2500)(200)
Qopt = = = 72.5 TVs
Cc 190

For Q = 72.5
Co D CcQopt
TC = + + PD = $233,784
Qopt 2

For Q = 90
Co D CcQ
TC = + + PD = $194,105
Q 2
Copyright 2011 John Wiley & Sons, Inc. 13-31
Quantity Discount Model With Excel

=IF(D10>B10,D10,B10) =(D4*D5/E10)+(D3*E10/2)+C10*D5

13-32
 Reorder Point
• Inventory level at which a new order is placed

R = dL
where

d = demand rate per period

L = lead time

13-33
 Reorder Point

Demand = 10,000 gallons/year

Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154
gallons/day
Lead time = L = 10 days

R = dL = (32.154)(10) = 321.54 gallons

13-34
 Safety Stock
• 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
• P(Demand during lead time <= Reorder Point)

13-35
Variable Demand With Reorder Point

Q
Inventory level

Reorder
point, R

0
LT LT
Time

13-36
 Reorder Point With Safety Stock
Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Time

13-37
Reorder Point With Variable Demand

R = dL + zd L
where
d = average daily demand
L = lead time
d = the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
probability
zd L = safety stock

13-38
Reorder Point For a Service Level
Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
zd L

dL R
Demand

13-39
 Reorder Point For Variable Demand

The paint store wants a reorder point with a 95%

service level and a 5% stockout probability
d = 30 gallons per day
L = 10 days
d = 5 gallons per day

For a 95% service level, z = 1.65

R = dL + z d L Safety stock = z d L
= 30(10) + (1.65)(5)( 10) = (1.65)(5)( 10)
= 326.1 gallons = 26.1 gallons

13-40
Determining Reorder Point with Excel

The reorder point

formula in cell E7

13-41
Periodic Inventory System

13-42
Fixed-Period Model with Excel

Formula for order

size, Q, in cell D10

13-43