Dr.

Rameez Khalid, PMP, CQSSBB

Faculty, Department of Management
Institute of Business Administration, Karachi
Independent Demand
A
B(4) C(2)
D(2) E(1) D(3) F(2)
Dependent Demand
Independent demand is uncertain.
Dependent demand is certain.
Inventory: a stock or store of goods
Inventory
2
Types of Inventories
Raw materials & purchased parts
Partially completed goods called
work in progress (WIP)
Finished-goods inventories
(manufacturing firms)
or merchandise
(retail stores)
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 3
Types of Inventories
Replacement parts, tools, & supplies
Goods-in-transit to warehouses or customers
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 4
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

Unit-8: Inventory Management rameezkhalid@iba.edu.pk 5
Objective of Inventory Control
To achieve satisfactory levels of customer service
while keeping inventory costs within reasonable
bounds
Level of customer service
Costs of ordering and carrying inventory
Inventory turnover is the ratio of:
average cost of goods sold to
average inventory investment.
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 6
A system to keep track of inventory
A reliable forecast of demand
Knowledge of lead times
Reasonable estimates of
Holding costs
Ordering costs
Shortage costs
A classification system
Effective Inventory Management
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 7
Inventory Counting Systems
Periodic System (T or P System)
Physical count of items made at periodic
intervals
Perpetual Inventory System (Q System)
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item
Unit-8: Inventory Management
Inventory Counting Systems (Contd)
Two-Bin System - Two containers of inventory;
reorder when the first is empty
Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached
0
214800 232087768
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 9
Lead time: time interval between ordering and
receiving the order
Holding (carrying) costs: cost to carry an item in
inventory for a length of time, usually a year
Ordering costs: costs of ordering and receiving
inventory
Shortage costs: costs when demand exceeds
supply
Key Inventory Terms
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 10
Holding Costs
Obsolescence
Insurance
Extra staffing
Interest
Pilferage
Damage
Warehousing
Etc.
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 11
Ordering/Setup Costs
Supplies/Freight
Incoming QC
Order processing
Clerical support
Etc.
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 12
Clean-up costs
Re-tooling costs
Adjustment costs
Etc.
ABC Classification System
Classifying inventory according to some measure of
importance and allocating control efforts
accordingly.
A - very important
B - mod. important
C - least important
0
20
40
60
80
100
0 50 100
% of Inventory Items
%

A
n
n
u
a
l

$

U
s
a
g
e

A
B
C
Class % $ Vol % Items
A 80 15
B 15 30
C 5 55
Unit-8: Inventory Management
Inventory
Process
stage
Demand
Type
Number
& Value
Other
Raw Material WIP
Finished Goods
Independent
Dependent
A Items
B Items
C Items
Maintenance
Dependent
Operating
Inventory Classifications
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 14
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?
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 15
Fixed order-quantity models
Economic order quantity (EOQ)
Economic production quantity (EPQ)
or Production order quantity (POQ)
Quantity discount
Probabilistic models
Fixed order-period models
Help answer the
inventory planning
questions!
Inventory Models
Economic order quantity (EOQ) model
The order size that minimizes total annual cost
Economic production model
Quantity discount model
Economic Order Quantity Models
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 18
Only one product is involved
Annual demand requirements known
Demand is even throughout the year
Lead time does not vary
Each order is received in a single delivery
There are no quantity discounts

Assumptions of EOQ Model
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 19
The Inventory Cycle
Profile of Inventory Level Over Time
Quantity
on hand
Q
Receive
order
Place
order
Receive
order
Place
order
Receive
order
Lead time
Reorder
point
Usage
rate
Time
Total Cost
Annual
carrying
cost
Annual
ordering
cost
Total cost =
+
TC =
Q
2
H
D
Q
S
+
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 21
Cost Minimization Goal
Order Quantity
(Q)
The Total-Cost Curve is U-Shaped
Ordering Costs
Q
O
A
n
n
u
a
l

C
o
s
t

(optimal order quantity)
TC
Q
H
D
Q
S
2
Holding Costs
22
Deriving the EOQ
Using calculus, we take the derivative of the total
cost function and set the derivative (slope) equal to
zero and solve for Q.
Q =
2DS
H
=
2(Annual Demand )(Order or Setup Cost )
Annual Holding Cost
OPT
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 23
Minimum Total Cost
The total cost curve reaches its minimum where
the carrying and ordering costs are equal.


Q
2
H
D
Q
S
=
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 24
EOQ
A local distributor for a national tire company
expects to sell approx. 9,600 steel-belted radial
tires of a certain size and tread design next year.
Annual carrying cost is $16 per tire, and ordering
cost is $75. The distributor operates 288 days a
year.
a. EOQ?
b. How many Orders?
c. Length of an order cycle?
d. Total Annual Cost?


25
Production done in batches or lots
Capacity to produce a part exceeds the parts
usage or demand rate
Assumptions of EPQ are similar to EOQ except
orders are received incrementally during
production
Economic Production Quantity (EPQ)
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 27
EOQ EPQ Model
When To Order
Reorder
Point
(ROP)
Time
Inventory Level
Lead Time
Optimal
Order
Quantity
(Q*)
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 28
EPQ Model Inventory Levels
Inventory Level
Time
Supply
Begins
Supply
Ends
Production portion of
cycle
Demand portion of cycle with no
supply
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 29
EPQ Model Inventory Levels
Time
Inventory Level
Production
Portion of Cycle
Imax Max. Inventory
Q(1- u/p)
Q*
Supply
Begins
Supply
Ends
Inventory level with no demand
Demand portion of cycle with
no supply
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 30
Economic Run Size
Q
DS
H
p
p u
0
2

Unit-8: Inventory Management rameezkhalid@iba.edu.pk 31

D = Demand per year
S = Setup cost
H = Holding cost
u = Demand per day
p = Production per
day
EPQ Model Equations
Optimal Order Quantity
Setup Cost
Holding Cost
= =
-
=
*
= *
=
Q
H*
u
p
Q
D
Q
S
p
*
1
(
0.5 * H * Q
-
u
p
1
)
-
u
p
1
( )
2*D*S
( )
Maximum inventory level
Imax
32
EPQ
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. Setup cost for a
production run of wheels is $45. The firm operates
240 days per year.
a. EPQ or POQ or Optimal Run Size?
b. Minimum Total Annual Cost?
c. Cycle Time?
d. Run Time?
33
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
Buyers Goal:
Select the order quantity that will minimize
the total cost.
Quantity Discount Model
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 35
Total Costs with Purchasing Cost
Annual
carrying
cost
Purchasing
cost
TC = +
Q
2
H
D
Q
S
TC =
+
+
Annual
ordering
cost
PD
+
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 36
Total Costs with PD
C
o
s
t

EOQ
TC with PD
TC without PD
PD
0
Quantity
Adding Purchasing cost
doesnt change EOQ
37
Case1: Constant Holding Costs
OC
EOQ
Quantity
T
o
t
a
l

C
o
s
t

TC
a
TC
c
TC
b
Decreasing
Price
HC
a,b,c
38
Quantity Discount
When D =816 cases per year, S =$12, and
H=$4 per case per year, determine for the
following discounts:
a. Optimal Order Quantity?
b. Total Cost?

Range
Price
1 to 49
$20
50 to 79
18
80 to 99
17
100 or more 16
39
Quantity Discount
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 40
Case2: Holding Cost
as Percentage of Purchase Price
Quantity Discount
When D =4000 switches per year, S =$30,
and H=0.40P per unit per year, determine
for the following discounts:
a. Optimal Order Quantity?
b. Total Cost?

Range
Price
1 to 499
$0.90
500 to 999
0.85
1000 or more 0.80
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 42
Case2: Holding Cost
as Percentage of Purchase Price
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 43
When to Reorder with EOQ Ordering
Reorder Point - When the quantity on hand of an
item drops to this amount, the item is reordered
Safety Stock - Stock that is held in excess of
expected demand due to variable demand rate
and/or lead time.
Service Level - Probability that demand will not
exceed supply during lead time.
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 45
Determinants of the Reorder Point
The rate of demand
The lead time
Demand and/or lead time variability
Stock-out risk (safety stock)
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 46
ROP and Safety Stock
Safety
stock
reduces
risk of
Stock-out
during lead
time
ROP = d x LT
= Expected
Demand
during
Lead time
+ Safety
Stock
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 47
ROP and Safety Stock
ROP = expected demand during LT +Safety Stock
Unit10-Inventory Mgt rameez.khalid@neduet.edu.pk 48
ROP and Safety Stock
Service Level = 100% - Stock-out Risk
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 49
ROP and Safety Stock
51
Orders are placed at fixed time intervals
Order quantity for next interval?
Suppliers might encourage fixed intervals
May require only periodic checks of inventory
levels
Risk of stockout
Fill rate the percentage of demand filled by the
stock on hand

Fixed-Order-Interval Model
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 53
Time
Inventory Level
Target maximum
Period Period Period
Fixed Period Model
When to Order?
54
Benefits:
Items from same supplier may yield savings in:
Ordering
Packing
Shipping costs
May be practical when inventories cannot be
closely monitored
Disadvantages:
Requires a larger safety stock
Increases carrying cost
Costs of periodic reviews

Fixed-Interval Model
55
Too much inventory
Tends to hide problems
Easier to live with problems than to eliminate
them
Costly to maintain
Wise strategy
Reduce lot sizes
Reduce safety stock
Operations Strategy
Unit-8: Inventory Management rameezkhalid@iba.edu.pk 56
REFERENCES


Operations Management
William J . Stevenson

Operations Management
Barry Render & J ay Heizer
rameezkhalid@iba.edu.pk 58
Solution:
Slide#25 = a. 300 tires; b. 32; c. 9 working days; d. $4800
Slide#33 =a. 2400 wheels; b. $1800; c. 12 days; d. 3 days
Slide#39 =a. 100 cases; b. TC100=$13354
Slide#42 =a. 1000 switches; b. TC1000=$3480