1

Operations
Management

Chapter 11
Inventory Management

Nicos M. Stylianou IMGT 488

 Introduction to Inventory Mgt
 Inventory is one of the most expensive assets
of many companies. Good inventory control
is crucial for business

 To reduce cost by reducing inventory may

lead to drop in the level of customer services.
Balance must be made between inventory
cost and customer services

Nicos M. Stylianou IMGT 488 2

 Inventory Management

 Inventory includes:
 Raw materials
 Work in process
 Finished goods
 All organisations have some kind of inventory
planning system e.g. bank-cash, hospital -
blood

Nicos M. Stylianou IMGT 488 3

 Inventory at Different
Stocking Points

Raw Work in Finished

materials process goods

Supplier Manufacturing plant Distribution center Retailer

Nicos M. Stylianou IMGT 488 4

 Inventory Management

 In case of physical products (goods),

organisations must decide:
 Produce or purchase
 forecast demand
 Operations managers determine inventory level
necessary to service demand

Nicos M. Stylianou IMGT 488 5

 Independent vs. Dependent
Demand
Independent Demand (not related
to other items or final end-product)

Dependent Demand
(derived from component
parts, sub-assemblies,
raw materials, etc.)

E(1
)

Nicos M. Stylianou IMGT 488 6

 Independent Demand
Inventories
 Independent demand is subject to market
forces and thus independent of operations
e.g. all finished goods and spare parts

 Focus on developing models to estimate how

much and when to order to meet customer
services at lowest cost

Nicos M. Stylianou IMGT 488 7

 Dependent demand
Inventories
 Is derived from the demand for another part
or component e.g. all work-in-progress and
raw materials
 Approaches for managing dependent
demand:
 Material Requirement Planning System (M.R.P.)
controls inventory through developing and
executing material plan. It is suitable for job-shop
or small batch environment where production is
non-repetitive in nature

Nicos M. Stylianou IMGT 488 8

 Dependent demand
Inventories

 Just - in - Time Philosophy (J.I.T.) views

inventories as a waste and attempts to

eliminate them. Best results in repetitive

production

Nicos M. Stylianou IMGT 488 9

 Inventory Costs

There are 3 important inventory costs:

 Cost of Replenishing Inventory:
 Inventories are often replenished in lots or
batches of size Q units. This cost includes:
 Cost of supply of one unit (unit cost) Co
 Cost of replenishing stock (replenishing cost or set-up
cost) C1, which includes:
 lot ordering cost (order initiation cost)
 lot delivery cost (receiving cost)

Nicos M. Stylianou IMGT 488 10

 Inventory Costs

 Cost of Holding Inventory:

 C2 per unit per year
 May include cost of (or interest on) money
invested in inventory, cost of storage space,
insurance and damage
 May be expressed as C2=α Co

Nicos M. Stylianou IMGT 488 11

 Inventory Costs

 Cost of Incurring shortage:

 This cost is associated with the inability to supply
e.g. Delay in supply - back orders case, Failure to
supply - lost sales case
 These include cost of emergency action and loss
of customer goodwill
 C3 per unit shortage cost
 C4 per unit per unit time

Nicos M. Stylianou IMGT 488 12

 Inventory Models
 Fixed order-quantity models Help
Help answer
answer the
the
inventory
inventory
 Economic order quantity
planning
planning
 Production order quantity questions!
questions!
 Quantity discount

 Probabilistic models
 Fixed order-period models

© 1984-1994
T/Maker Co.

Nicos M. Stylianou IMGT 488 13

 EOQ Assumptions
 Known and constant demand
 Known and constant lead time

 Instantaneous receipt of material

 No quantity discounts

 Only order (setup) cost and holding cost

 No stockouts

Nicos M. Stylianou IMGT 488 14

 Inventory Usage Over Time
Order quantity Usage
=Q Average
(maximum
Rate Inventory
Inventory Level

inventory (Q*/2)
level)

Minimum
inventor0
y Time

Nicos M. Stylianou IMGT 488 15

 EOQ Model
How Much to Order?
Annual Cost

ur ve
os tC ve
al C ur
Tot st C
Minimu
g Co
m total ldin
cost Ho

Order (Setup) Cost Curve

Optimal Order quantity

Order Quantity (Q*)

Nicos M. Stylianou IMGT 488 16

 Why Holding Costs Increase
 More units must be stored if more are ordered

Purchase Order Purchase Order

Descriptio Qty. Descriptio Qty.
n
Microwave 1 n
Microwave 1000
Order Order
quantity quantity
Nicos M. Stylianou IMGT 488 17
 Why Order Costs Decrease
Cost is spread over more units
Example: You need 1000 microwave ovens
1 Order (Postage $ 1000 Orders (Postage
0.33) $330)
Purchase Order PurchaseOrder
Purchase Order
Description Qty. Purchase
Descriptio
Purchase Order
Qty.
Order
Descriptio
Descriptio Qty.
Qty.1
Microwave 1000 nn
Microwave
Description Qty.
Microwave
n
Microwave 11
Microwave 1
Order
quantity
Nicos M. Stylianou IMGT 488 18
 Deriving an EOQ
1. Develop an expression for setup or ordering
costs
2. Develop an expression for holding cost
3. Set setup cost equal to holding cost
4. Solve the resulting equation for the best
order quantity

Nicos M. Stylianou IMGT 488 19

 EOQ Model
When To Order
Inventory Level
Optimal Average
Order Inventory
Quantit (Q*/2)
y
(Q*)
Reorder
Point
(ROP)

Time
Lead Time

Nicos M. Stylianou IMGT 488 20

 EOQ Model Equations
Optimal Order Quantity =Q* = 2×D ×S
H
D
=N =
xpected Number of Orders
Q*
Working Days /Year
xpected Time Between Orders =T =
N
D D = Demand per year
d=
Working Days /Year S = Setup (order) cost
per order
ROP = d × L H = Holding (carrying)
cost
Nicos M. Stylianou IMGT 488
d = Demand per day 21

L = Lead time in days

 The Reorder Point (ROP)
Curve
Q*
Slope = units/day
=d
Inventory level

ROP
(Unit
(units)

s)

Time
Lead time (days)
=L
Nicos M. Stylianou IMGT 488 22
 Production Order Quantity
Model
 Answers how much to order and when to
order
 Allows partial receipt of material
 Other EOQ assumptions apply
 Suited for production environment
 Material produced, used immediately
 Provides production lot size

 Lower holding cost than EOQ model

Nicos M. Stylianou IMGT 488 23

 EOQ POQ Model
When To Order
Both
production Usage only
Maxim and usage
take place takes place
um
invento
Inventory Level

ry level

Time

Nicos M. Stylianou IMGT 488 24

 EOQ POQ Model
When To Order
Inventory Level
Optimal Average
Order Inventory
Quantit
y
(Q*)
Reorder
Point
(ROP)

Time
Lead Time
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 Reasons for Variability in
Production

Most variability is caused by waste or by

poor management. Specific causes include:
❑ employees, machines, and suppliers produce units
that do not conform to standards, are late or are not
the proper quantity
❑ inaccurate engineering drawings or specifications
❑ production personnel try to produce before
drawings or specifications are complete
❑ customer demands are unknown

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 POQ Model Inventory Levels
Inventory Level

Production portion
of cycle

Demand portion of cycle

with no supply

Supply Supply
Time
Begins Ends

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 POQ Model
Inventory Level Inventory Levels
Inventory level with no demand

Production Max. Inventory

Portion of Q·(1- d/p)
Q*
Cycle

Time
Supply Supply Demand portion of
Begins Ends cycle with no
supply
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 POQ Model Equations
= Q* = 2*D*S
Optimal Order Quantity
p
( )
H* 1 -
d
p

= Q*
Maximum inventory level ( )
1-
d
p
D D = Demand per
Setup Cost = * S year
Q
S = Setup cost
Holding Cost =
( )
0.5 * H * Q 1 -
d
p
H = Holding cost
d = Demand per
Nicos M. Stylianou IMGT 488
day 29

p = Production
 Quantity Discount Model
 Answers how much to order &
when to order
 Allows quantity discounts
 Reduced price when item is purchased in
larger quantities
 Other EOQ assumptions apply

 Trade-off is between lower price &

increased holding cost

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 Quantity Discount Schedule
Discount Discount Quantity Discount (%) Discount Price
Number (P)
1 0 to 999 No discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75

Nicos M. Stylianou IMGT 488 31

 Quantity Discount – How
Much to Order

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 Probabilistic Models
 Answer how much & when to order
 Allow demand to vary
 Follows normal distribution
 Other EOQ assumptions apply

 Consider service level & safety stock

 Service level = 1 - Probability of stockout
 Higher service level means more safety stock
 More safety stock means higher ROP

Nicos M. Stylianou IMGT 488 33

 Probabilistic Models
When to Order? Frequen Service
Inventory Level cy
Level P(Stockout)
Optimal
Order
X
Quantit SS
y
ROP
Reorder
Point
(ROP)

Safety Stock (SS)

Place Receive Time
order Lead Time order
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 Fixed Period Model
 Answers how much to order
 Orders placed at fixed intervals
 Inventory
brought up to target amount
 Amount ordered varies

 No continuous inventory count

 Possibility of stockout between intervals
 Useful when vendors visit routinely
 Example: P&G representative calls every 2
weeks

Nicos M. Stylianou IMGT 488 35

 Inventory Level in a Fixed
Period System
Various amounts (Qi) are ordered at regular
time intervals (p) based on the quantity
necessary to bring inventory up to target
maximum
Target
maximum
Q1 Q2 Q4
Q3
Inventory
On-Hand

p p p

Time
Nicos M. Stylianou IMGT 488 36
 Fixed Period Model
When to Order?
Inventory Level Target maximum

Time
Period Period Period
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