SESSION 14 INVENTORY MANAGEMENT

1401
OVERVIEW
Objective
To understand the costs and benefits of holding inventory and determine the Economic
Order Quantity (EOQ) which minimises costs.
To appreciate other possible inventory control systems.






INVENTORY
CONTROL
OTHER
INVENTORY
SYSTEMS
EOQ MODEL
Definition
Reasons for holding inventory
Costs associated with inventory
Definition
Determination of EOQ
Complications
Quantity discounts
RE-ORDER LEVEL
Definitions
Constant demand
during lead time
Uncertain demand
during lead time
Service levels
Periodic review system
ABC system
Just-in-time (JIT)
Perpetual inventory
MRP


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1 INVENTORY CONTROL
1.1 Definition
The systematic regulation of inventory levels.

If inventory is too high

Inefficient profit reduced
If inventory is too low

Insufficient to satisfy customers profit reduced.
1.2 Reasons for holding inventory
To meet demand by acting as a buffer in times of unusually high consumption, i.e. to
reduce the risk of stockouts.
To ensure continuous production.
To take advantage of quantity discounts.
To buy in ahead of a shortage or ahead of a price rise.
For technical reasons (e.g. maturing whisky in casks or keeping oil in pipelines).
To reduce ordering costs.
1.3 Costs associated with inventory
Purchase price;
Holding costs:
cost of capital tied up;
insurance;
deterioration, obsolescence and theft;
warehousing;
stores administration.
Re-order costs:
transport costs;
clerical and administrative expenses;
batch set-up costs for goods produced internally.
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Shortage costs:
production stoppages caused by lack of raw materials;
stockout costs for finished goods anything from a delayed sale to a lost customer;
emergency re-order costs.

Systems costs people and computers.
The benefits of holding inventory must outweigh the costs.
2 EOQ MODEL
2.1 Definition
The Economic Order Quantity (EOQ) is the quantity of inventory that should be ordered
each time a purchase order is made.
EOQ aims to minimise the costs which are relevant to ordering and holding inventory.

2.2 Determination of EOQ
x = order quantity
C
H
= cost of holding one unit for one year
D = annual demand
C
O
= cost of placing an order
The total annual relevant cost to be minimised
= annual holding cost + annual order cost
= the cost of holding one
unit in inventory for one
year the average number
of units held
+ the cost of an order the
number of orders in a year
=
2
x
C
H

+
D
Co
x



The total cost is minimized when:
x =
H
0
C
D C 2


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EOQ graph








$
Cost
Total cost
holding cost
ordering cost
EOQ
x
Order quantity

Assumption of EOQ:
purchase price per unit is constant;
constant demand;
no risk of stockouts.
Example 1

Using the following data calculate the EOQ

D = 40,000 units
C
O
= $2
C
H
= $1

Solution
EOQ =
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2.3 Complications
2.3.1 Warehouse rental
The EOQ model assumes that holding costs vary with the average inventory level.
However if a warehouse is rented on a long-term contract (rather than daily) then it
needs to be large enough to hold the maximum level of stock, rather than the average.









must rent sufficient floor space to meet this quantity rather than
2
x

(x/2)
x

deal with this by doubling the floor space used by one unit when calculating holding cost,
and then use the normal EOQ formula



Example 2

Annual demand = 3,000 units
Reorder cost = $5
Holding cost = $3.33 per unit + rental of warehouse
Each unit occupies 3m
2
rented on annual contracts for $5 per m
2


Solution
D =
C
O
=
C
H
=
3,000
5


EOQ =
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2.3.2 Cost of capital
Inventory, like any other asset, must be matched by a liability. Therefore there must be a
cost of financing inventory.
This is a type of holding cost.
Illustration 1

Cost of Capital = 10%
Price per unit = $100
Holding cost = $100 0.1 = $10
This is in addition to any other holding costs you are given.


2.4 Quantity discounts
The supplier may offer a bulk-buying discount on each unit purchased for specified
quantities above the EOQ
In this case the purchase price obviously becomes a relevant factor in the decision
To deal with this, calculate

Total annual cost =
cost purchase
Annual

cost
order Annual

cost
holding Annual
+ +

for each order quantity where discounts are available and at the order level calculated
by the EOQ.

Choose the order quantity with the lowest total cost.
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Example 3

Annual demand = 5,000
Holding cost = $7.50
Reorder cost = $30
Purchase price = $1.10
A discount of 3% is available on orders of 300 units or more.
Required:
Determine whether or not the discount is worthwhile.

Solution
EOQ =

Total cost at EOQ $
Holding
2
x
C
H
=


Reorder
x
D
C
O
=

Purchase cost

Total
_____



Total cost at order quantity = 300 units


Holding
2
x
C
H
=

Reorder
x
D
C
O
=

Purchase cost

_____


Conclusion:
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3 RE-ORDER LEVEL
3.1 Definitions
Re-order level (ROL) is the level to which inventory should fall before a purchase order
is made.
Lead time is the time between placing and receiving an order.
There are two possible situations to be dealt with:

(1) Constant demand in lead time
(2) Uncertain demand in lead time
3.2 Constant demand during lead time
Re-order level (ROL) = lead time (days) demand per day
For example if demand is 40 units per day and lead time is two days - when inventory
levels fall to 80 units then inventory would be re-ordered. This can be shown
graphically:







INVENTORY
LEVEL
ROL
TIME
{
Lead
time

3.3 Uncertain demand during lead time
There will be an expected level of demand, not a known level of demand.
A buffer or safety inventory will need to be held to reduce the risk of a stockout.



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Method
(1) Calculate expected demand in the lead time.
Expected lead time demand = x
i
p(x
i
)
where
x
i =
level of demand
p (x
i
) = probability of level of demand
(2) Take each level of demand expected lead time demand as a possible
reorder level and calculate the expected annual stockout cost.

(3) For each possible ROL calculate the expected annual buffer holding
cost.

(4) Choose the ROL with the lowest sum of stock out and holding cost.


Example 4

The following information relates to inventory levels of component XL5:
Holding cost = $8
Stockout cost = $3
Lead time = 1 week
EOQ = 150

The company operates for 50 weeks per annum and weekly demand is given
by:
xi p(xi)
Demand Probability
40 0.1
50 0.2
60 0.4
70 0.2
80 0.1

Required:
Calculate the optimum reorder level.


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Solution
Average demand in the lead time =
Average annual demand =
orders per annum =
ROL Buffer Demand Units
short
Probability Ave
units
short
Exp annual
stock-out
cost
Exp
annual
buffer
holding
cost
Total
annual
cost
$
60 0 70 0
80

__

___

___

Average =

__

___

___


70 10

___

___

Average =

___

___


80 20

___

___



___

___


The optimum ROL is therefore
3.4 Service levels
Setting a service level of 98% implies that the firm accepts a 2% chance of a stock-out
Example 5

Average weekly demand for an item of inventory is 300 units with a standard
deviation of 40 units. The lead time is one week.
Required:
What ROL is needed to provide a service level of 95%? Normal distribution
tables show that 5% of observations lie 1.645 standard deviations above the
mean.


Solution

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4 OTHER INVENTORY SYSTEMS
4.1 Periodic review system
The inventory levels are reviewed at fixed time intervals, and variable quantities will be ordered
as appropriate.
The order size made is sufficient to return inventory levels to a pre-determined level.
A very simple method of inventory control ideal where inventory control is only one of a
persons responsibilities.
4.2 ABC system of inventory control
The aim is to reduce the work involved in inventory control in a business which may have
several thousand types of inventory items.
The inventory is categorised into class A, B or C according to the annual cost of the usage of
that inventory item, or the difficulty of obtaining replacements, or the importance to the
production process.
Class A will then take most of the inventory control effort, Class B less and Class C less still.
Commentary

Whilst this seems acceptable for inventory of finished goods, it may cause problems for
raw materials. There may be an item which has a very small cost but which is vital for
the manufacture of the finished product. Such an item would have to be included in
with the Class A items because of its inherent importance, rather than its cost.

4.3 Just-in-time (JIT)
In a JIT system production and purchasing are linked closely to sales demand on a week-to-
week basis. The aim is to create a continuous flow of raw materials inventory into work in
progress, which becomes finished goods to go immediately to the customer. This means
that negligible inventory needs to be held.
Conditions necessary include the following:
Flexibility of both suppliers and internal workforce to expand and contract output at
short notice.
Raw material inventory must be of guaranteed quality indeed, quality must be
maintained at every stage.
Close working relationship with suppliers and, if possible, geographically proximity in
order to make immediate deliveries.
A low inventory level normally requires short production runs. This is only
appropriate, therefore, where set-up costs are low. High-technology production
methods have made this easier to achieve.
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The workforce must be willing to increase or decrease its working hours from one
period to another. This could be done by having a core workforce with a group of part-
time or freelance workers.
The design of the factory must be such that JIT deliveries to all areas are possible.
Total reliance on suppliers for quality and delivery, and therefore very tight contracts
with penalty clauses.
Significant investment by suppliers, and therefore long-term contracts.
4.4 Perpetual inventory methods
Where a firm keeps perpetual inventory records, there will frequently be a replenishment
point that triggers an order. Such a system relies upon the accuracy of the records, not on
physical counts.
It is possible to use point of sale (POS) terminals that automatically update inventory
records as each successive sale is made.
One advantage of such a system is the data it provides to management to determine which
product lines are moving rapidly. Sales managers may also use the data to make tactical
decisions on special prices to sell slow-moving items.
4.5 Material requirements planning (MRP)
A system that uses the production schedule to decide what is needed and when. This is then
linked in with suppliers discounts, lead times, etc to devise an optimal inventory holding
and ordering policy.

Key points

They formula for the Economic order Quantity is provided in the exam
the key is to identify the relevant data.
Do not confuse the Economic Order Quantity (EOQ) with the Re Order
Level (ROL). EOQ tells us how large each order should be, ROL tells us
when we should place on order for inventory
Just-In-Time (JIT) is the other main inventory system to be familiar with


FOCUS
You should now be able to:

apply the tools and techniques of inventory management.
SESSION 14 INVENTORY MANAGEMENT
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EXAMPLE SOLUTIONS
Solution 1 EOQ
EOQ =
1 $
000 , 40 2 $ 2

x = 400 units
Solution 2 Floor space
D =
C
O
=
C
H
=
3,000
5
$3.33 + (2 3 5) = $33.33

EOQ =
33 . 33
000 , 3 5 2
= 30 units
Solution 3 Quantity discount
EOQ =
50 . 7
000 , 7 30 2
= 200 units

Total cost at EOQ $
Holding
2
x
C
H
=
2
200
7.50
750

Reorder
x
D
C
O
=
200
5,000
30

750

Purchase cost 5,000 1.10

5,500

Total
_____
7,000
_____

Total cost at order quantity = 300 units
Holding
2
x
C
H
=
2
300
7.50
1,125

Reorder
x
D
C
O
=
300
5,000
30

500

Purchase cost 5,000 1.10 0.97

5,335

_____
6,960
_____

The discount is therefore worthwhile.
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Solution 4 Re-order level
Average demand in the lead time = 60 units
Average annual demand = 60 50 = 3,000 units
Since the EOQ = 150, there will be
150
000 , 3
= 20 orders per annum.
ROL Buffer Demand Units
short
Prob Ave
units
short
Exp
annual
inventory out
cost
Exp
annual
buffer
holding
cost
Total
annual
cost
$
60 0 70 10 0.2 2 2 $3 20 0
80 20 0.1 2 2 $3 20

__

___

___

Average 4 240 0 240

__

___

___


70 10 80 10 0.1 1 1 $3 20 10 $8

___

___

Average 1 60 80 140

___

___


80 20 80 0 20 $8

___

___

0 160 160

___

___


The optimum ROL is therefore 70 units.
Solution 5 Service level





ROL
SD = 40
300
45%
5%

z = 1.645 (using normal distribution tables)
ROL = 300 + (1.645 40) = 300 + 65.8 = 366