Inventory Management and Cost Optimization Techniques

M.
Verma: October 23-31, 2006 Faculty of Business Administration, Memorial University of Newfoundland 1
Inventory Management
Chapter 12
M. Verma: October 23-31, 2006 Faculty of Business Administration, Memorial University of Newfoundland 2
Independent and Dependent Demand
Dependent Demand
Used in the production of a final or finished product.
Is derived from the number of finished units to be produced.
E.g. For Each Car: 4-wheels. Wheels are the dependent demand.
Independent Demand
Sold to someone.
Precise determination of quantity impossible due to randomness.
Forecasting the number of units that can be sold.
Focus on management of I ndependent Demand Items.
Types of Inventory
Raw material
Components
Work-in-progress
Finished goods
Distribution Inventory
Maintenance/repair/operating supply (MRO)
1. To meet anticipated demand.
2. To smooth production requirements.
3. To decouple operations.
4. To protect against stockouts.
5. To take advantage of economic lot size.
6. To hedge against price increases or to take
advantage of quantity discounts.

Functions of Inventory
Objectives of Inventory Control
Inventory Management has two main concerns:
Level of Customer Service.
Cost of ordering and carrying inventories.

Achieve satisfactory levels of customer service while keeping inventory
costs within reasonable bounds. 2 fundamental decisions:
--Timing of Orders
--Size of Orders
Measures of effective Inventory Management:
Customer Satisfaction.
Inventory Turnover = COGS / Average Inventory.
Days of Inventory: expected number of days of sales that can be
supplied from existing inventory.

i.e. when to order and how much to order.
Characteristics of Inventory
Systems
Demand
-- Constant Vs Variable
-- Known Vs Random
Lead time - Known Vs Random
Review Time - Continuous Vs Periodic
Excess demand - Backordering Vs Lost Sales
Changing Inventory
Periodic Vs Continuous Review Systems
Periodic Review System
Inventory level monitored at constant intervals.
Decisions:
To order or not.
How much to order?
Realize economies in processing and shipping.
Risk of stockout between review periods.
Time and cost of physical count.
Continuous Review System
Inventory level monitored continuously.
Decisions:
When to order?
How much to order?
Shortages can be avoided.
Optimal order quantity can be determined.
Added cost of record keeping.
More appropriate for valuable items
Relevant Inventory Costs
Item price (Cost of an item).
Holding costs:
Variable costs dependent upon the amount of inventory held (e.g.: capital &
opportunity costs, storage & insurance, risk of obsolescence).
Expressed either as a percentage of unit price or as a dollar amount per unit.
Ordering & setup costs:
Fixed cost of placing an order (e.g.: clerical accounting & physical handling) or
setting up production (e.g.: lost production to change tools & clean equipment).
Expressed as a fixed dollar amount per order regardless of order size.
Shortage costs:
Result when demand exceeds the supply of inventory on-hand. (stock-out)
Lost profit, expediting & back ordering expenses.
Are sometimes difficult to measure, & they may be subjectively estimated.
Why Control Inventory
Cost Vs Service
Under-stock: Frequent stock-outs
Lost sales, loss of customer goodwill
Low level of customer service
Over-stock: Excess inventory
Costs of ordering and carrying inventory increase
Objective: Establish an inventory control system to
find a balance between cost and service:
When to order?
How much to order?
Lot-for-lot:
Order exactly what is needed.
Fixed order quantity:
Order a predetermined amount each time.
Min-max system:
When inventory falls to a set minimum level, order up to the
predetermined maximum level.
Order enough for n periods:
The order quantity is determined by total demand for the item for
the next n-periods.
Periodic review:
At specified intervals, order up to a predetermined target level.
Ordering Quantity Approaches
Divides on-hand inventory into 3 classes:
A class, B class, C class (very --> moderate --> least: important).
Basis is usually annual $ volume:
$ volume = Annual demand x Unit cost
Class A: 15% -20% of items but 70%- 80% dollar usage.
Class B: 30% -35% of items but 15% -20% dollar usage.
Class C: 50% -60% of items but 5% -10% dollar usage.
Policies based on ABC analysis:
Develop class A suppliers more
Give tighter physical control of A items
Forecast A items more carefully
Classification System
Example
Item Annual Demand x Unit Cost = Annual $ Value
1 1000 4300 $4,300,000
2 5000 720 $3,600,000
3 1900 500 $950,000
4 1000 710 $710,000
5 2500 250 $625,000
6 2500 192 $480,000
7 400 200 $80,000
8 500 100 $50,000
9 200 210 $42,000
10 1000 35 $35,000
11 3000 10 $30,000
12 9000 3 $27,000
Total = $10,929,000
Classify the inventory items as A,B and C based on annual dollar value.
72% of total value and
17% of items: Class A.

25% of value and
33% of items: Class B.
3% of total value and
50% of items: Class C.
1. Basic Economic Order Quantity (EOQ).
2. Economic Production Quantity (EPQ)
(EOQ with non-instantaneous delivery).
3. Quantity Discount Model.
Economic-Order Quantity Models
1. Only one product is involved.
2. Demand is known & constant - no safety stock is
required.
3. Lead time is known & constant.
4. No quantity discounts are available.
5. Ordering (or setup) costs are constant.
6. All demand is satisfied (no shortages).
7. The order quantity arrives in a single shipment.
EOQ Model Assumptions
Inventory Level (Cycle)
Q
ROP
Q
u
a
n
t
i
t
y

o
n

h
a
n
d

Receive Order
Place Order Receive Order
Lead Time
Total annual costs = Annual ordering costs + Annual holding costs
EOQ Model
Minimize the TC by ordering the EOQ:
|
.
|
\
|
+
|
|
.
|
\
|
= H
Q
S
Q
D
TC
EOQ
2
H
DS
EOQ
2
=
EOQ: Total Cost Equations
D = Annual Demand.
H= Annual Inventory Holding/Carrying Cost per Unit.
S= Ordering/Setup Cost per order.
Length of an Order Cycle (time between orders) = (Q/D) years.
Example
1. A local distributor for a national tire company expects to sell
approximately 9,600 belted radial tires for 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. What is the EOQ?
B. How many times per year does the store order?
C. What is the length of an order cycle?
D. What is the total annual cost if the EOQ quantity is ordered?

2. Pidding Manufacturing assembles security monitors. It
purchases 3,600 black-and-white cathode ray tubes a year at
$65 each. Ordering cost is $31 per order, and annual carrying
cost per unit is 20% of the purchase price. Compute the optimal
order quantity and the total annual cost of ordering and carrying
the inventory.
Assumptions: Same as the EOQ except: inventory arrives in increments & is
drawn down as it arrives.
Economic Production Quantity Model
Adjusted total cost:

Maximum inventory:

Adjusted order quantity:

Cycle Time: Q/d.
Run Time (production phase of the cycle): Q/p.

where, d = demand (usage rate); p = production rate; S = ordering / setup cost;
D = Annual demand and H = Annual Holding cost.
|
.
|
\
|
+
|
|
.
|
\
|
= H
I
S
Q
D
TC
MAX
EPQ
2
2
; 1
.
MAX
avg MAX
I
I
p
d
Q I =
|
|
.
|
\
|
=
d p
p
H
DS
p
d
H
DS
EPQ

=
|
|
.
|
\
|

=
2
1
2
EPQ Equations
Example
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. Determine the:
A. Optimal run size.
B. Minimum total annual cost for carrying and setup.
C. Cycle time for the optimal run size.
D. Run time.
Same as the EOQ, except:
Unit price depends upon the quantity ordered.
Adjusted total cost equation:
PD H
Q
S
Q
D
TC
QD
+
|
.
|
\
|
+
|
|
.
|
\
|
=
2
Quantity Discount Model
Total Costs with Purchasing Cost (PD)
C
o
s
t

EOQ
TC with PD
TC without PD
Annual purchasing cost=(PD)
0
Quantity
Adding Purchasing cost
doesnt change EOQ
Quantity Discount Representation
Order Price
Quantity per Box
1 to 44 $2.00
45 to 69 $1.70
70 or more $1.40
PD @ $2.00 each
PD @ $1.70 each
PD @ $1.40 each
0
45 70
Quantity
T
o
t
a
l

C
o
s
t

TC@ $1.70 each
TC@ $2.00 each
TC@ $1.40 each
Quantity Discount Model
The objective is to identify an order quantity that will
represent the lowest total cost for the entire set of curves.

2 General Cases:
Carrying Cost is constant.
Single EOQ.
Same for all total cost curves.
Carrying Cost is a percentage of the Price.
Different EOQ for different prices.
Lower carrying cost means larger EOQ.
As unit price decreases, each curve EOQ will be to the right of the next
higher curves EOQ.
Calculate the EOQ at the lowest price.
Determine whether the EOQ is feasible at that price
Will the vendor sell that quantity at that price.
If yes, Stop if no, Continue.
Check the feasibility of EOQ at the next higher price
Continue until you identify a feasible EOQ.
Calculate the total costs (including purchase price) for
the feasible EOQ model.
Calculate the total costs of buying at the minimum
quantity allowed for each of the cheaper unit prices.
Compare the total cost of each option & choose the
lowest cost alternative.
Quantity Discount Procedure
1. The maintenance department of a large hospital uses about 816
cases of liquid cleaner annually. Ordering costs are $12, carrying
costs are $4 per case a year, and the new price schedule indicates
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 cost.

2. Surge Electric uses 4,000 toggle switches a year. Switches are
priced as follows: 1 to 499, 90 cents each; 500 to 999, 85 cents
each; and 1,000 or more, 80 cents each. It costs approximately
$30 to prepare an order and receive it, and carrying costs are 40
percent of purchase price per unit on an annual basis. Determine
the optimal order quantity and the total annual cost.
Examples
ROP =d(LT)
When to Order?
where
LT = Lead time (in days or weeks)
d = Daily or weekly demand rate
An office supply store sells floppy disk sets at a
fairly constant rate of 6,000 per year. The
accounting dept. states that it costs 8$ to place
an order and annual holding cost are 20% of the
purchase price 3$ per unit. It takes 4 days to
receive an order. Assuming a 300-day year,
find:
a) Optimal order size and ROP.
b) Annual ordering cost, annual carrying cost.
c) How many orders are given a year and what is the
time between the orders?
Example
What if Demand is Uncertain?
ROP
Time
Q
u
a
n
t
i
t
y

o
n

h
a
n
d

Uncertain Demand (Lead Time)
Safety Stock Models:
Use the same order quantity (EOQ) based on expected
(average) annual demand.
Determine ROP to satisfy a target Service Level:
Probability that demand will not exceed supply during lead
time (Lead time service level).
Percent of annual demand immediately satisfied (Annual
service level or fill-rate).
Equals: 1- stock-out risk
Safety Stock: Stock that is held in excess of expected
demand due to variable demand rate and/or lead time.
Demand variability.
Lead time variability.
Order-cycle service level:
From a managerial standpoint, determine the
acceptable probability that demand during lead time
wont exceed on-hand inventory.
Risk of a stockout: 1 (service level).
Adding Safety Stock
R = reorder point
d = average daily demand
LT = lead time in days
z = number of standard deviations associated with desired service level
= standard deviation of demand during lead time

(Assumes that any variability in demand rate or lead time can be
adequately described by a normal distribution)
LT
z LT d R o + = ) (
Adjusted Reorder Point Equation
Example
Suppose that the manager of a construction supply
house determined from historical records that demand
for sand during lead time averages 50 tons. In addition,
suppose the manager determined that demand during
lead time could be described by a normal distribution
that has a mean of 50 tons and a standard deviation of 5
tons. Answer these questions, assuming that the
manager is willing to accept a stockout risk of no more
than 3 percent.
A. What value of z is appropriate?
B. How much safety stock should be held?
C. What reorder point should be used?
Reorder Point -Continued
When data on lead time demand is not readily available,
cannot use the standard formula.
Use the daily or weekly demand and the length of the lead time
to generate lead time demand.
If only demand is variable, then use ,
and the ROP is:
d
LT z LT d ROP o + =
d dLT
LTo o =
or weeks. days in time lead
or week. day per demand of deviation standard
demand. or weekly daily average
=
=
=
LT
d
d
o
If only lead time is variable, then use , and the ROP
is:

If both demand and lead times variable, then

LT
zd LT d ROP o + =
LT dLT
do o =
2
2
2
2
2
2

: is point reorder the and

LT d
LT d dLT
d LT z LT d ROP
d LT
o o
o o o
+ + =
+ =
or weeks. days in time lead average
or weeks. days in time lead of deviation standard
demand. or weekly daily average
=
=
=
LT
d
LT
o
Example
A restaurant uses an average of 50 jars of a special
sauce each week. Weekly usage of sauce has a standard
deviation of 3 jars. The manager is willing to accept no
more than a 10 percent risk of stockout during lead
time, which is two weeks. Assume the distribution of
usage is normal.
A. Which of the above formula is appropriate for this
situation? Why?
B. Determine the value of z.
C. Determine the ROP.
Shortage and Service Level
dLT
z E n E o ) ( ) ( =
demand time lead of deviation standard
13.3 table from obtained short units of # ed standardiz ) (
cycle. order per short units of # expected ) (
=
=
=
dLT
z E
n E
o
E.g.: Suppose the standard deviation of lead time demand is known to be 20
units and lead time demand is approximately Normal.
a. For a lead time service level of 90 percent, determine the expected number
of units short for any order cycle.
b. What lead time service level would an expected shortage of 2 units imply?
Q
D
n E N E ) ( ) ( =
year. per short units of number expected ) ( = N E
Q
z E
D
N E
SL
dLT
annual
o ) (
1
) (
1 = =
Given the following information, determine the expected number of units short per
year. D=1,000; Q=250; E (n)=2.5.
Given a lead time service level of 90%, D=1,000, Q=250, and
dLT
=16, determine
(a) the annual service level, and (b) the amount of cycle safety stock that would
provide an annual service level of .98 (Given: E (z) = 0.048 for 90% lead time
service level).
Fixed-Order Interval Model
Order groupings can produce savings in ordering and shipping costs.
Can have variations in demand, lead time, or in both.
Our focus is only on demand variability, with constant lead times.
LT OI z LT OI d I
on hand - Amount I Order size
d
+ + + =
=
o ) (
max
max
OI = Order Interval (length of time between orders)
I
max
= Maximum amount of inventory (also called order-up-to-level point)
= Expected demand during protection interval + Safety stock
E.g.: Given the following information, determine the amount to order.
days 2
day per units 3
day per units 30
=
=
=
LT
d
d
o
days 7 OI
units 71 me reorder ti at hand on Amount
percent 99 level service Desired
=
=
=
Single-Period Models
Goal is to identify the order quantity, or stocking level, that will minimize
the long-run total excess and shortage cost.
unit value per - Salvage t per unit Original C C
t per unit unit - Cos venue per C C
e excess
s shortage
cos
Re
= =
= =
Used for order perishables.
Analysis focus on two costs: Shortage and Excess.
2 kinds of problems:
a) Demand can be approximated using a continuous distribution.
b) Demand can be approximated using a discrete distribution.
Continuous Stocking Levels:
Discrete Stocking Levels:
e s
s
C C
C
SL vel Service le
+
= =
E.g.: Sweet cider is delivered weekly to Cindys Cider Bar. Demand varies uniformly
between 300 liters and 500 liters per week. Cindy pays 20 cents per liter for the cider
and charges 80 cents per liter for it. Unsold cider has no salvage value and cannot
be carried over into the next week due to spoilage. Find the optimal stocking level
and its stockout risk for that quantity.
E.g.: Cindys Cider Bar also sells a blend of cherry juice and apple cider. Demand for
the blend is approximately Normal, with a mean of 200 liters per week and a
standard deviation of 10 liters per week. Cs=60 cents per liter, and Ce=20 cents per
liter. Find the optimal stocking level for the apple cherry blend.
E.g.: Historical records on the use of spare parts for several large hydraulic presses are
to serve as an estimate of usage for spares of a newly installed press. Stockout costs
involve downtime expenses and special ordering costs. These average $4,200 per unit
short. Spares cost $800 each, and unused parts have zero salvage. Determine the
optimal stocking level.
# of Spares Used Relative Frequency Cumulative Frequency
0 0.20 0.20
1 0.40 0.60
2 0.30 0.90
3 0.10 1.00
4 or more 0.00
1.00
Examples
A large bakery buys flour in 25-pound bags. The bakery uses
an average of 4,860 bags a year. Preparing an order and
receiving a shipment of flour involves a cost of $4 per order.
Annual carrying costs are $30 per bag.
A. Determine the economic order quantity.
B. What is the average number of bags on hand?
C. Compute the total cost of ordering and carrying flour.
D. If ordering cost were to increase by $1 per order, how
much would that affect the minimum total annual
ordering and carrying cost?
Examples
A large law firm uses an average of 40 packages of copier
paper a day. Each package contains 500 sheets. The firm
operates 260 days a year. Storage and handling costs for the
paper are $1 a year per pack, and it costs approximately $6 to
order and receive a shipment of paper.
a) What order size would minimize total annual ordering and carrying
costs?
b) Compute the total annual cost using your order size from part a.
c) Except for rounding, are annual ordering and carrying costs always equal
at the EOQ?
d) The office manager is currently using an order size of 400 packages. The
partners of the firm expect the office to be managed in a cost-efficient
manner. Would you recommend that the office manager use the optimal
order size instead of 400 packages? Justify your answer.
Examples
A chemical form produces sodium bisulphate in 100-kg
bags. Demand for this product is 20 tons per day. The
capacity for producing the product is 50 tons per day. Setup
costs $100, and storage and handling costs are $50 per ton
per year. The firm operates 200 days a year. (Note: 1 ton =
1,000 kg)
a) How many bags per run are optimal?
b) What would the average inventory be for this lot size?
c) Determine the approximate length of a production run, in days.
d) About how many runs per year would there be?
e) How much could the company save annually if the setup cost could
be reduced to $25 per run?
Examples
A company is about to begin production of a new product. The
manager of the department that will produce one of the components
for the product wants to know how often the machine to be used to
produce the item will be available for other work. The machine will
produce the item at a rate of 200 units a day. Eighty units will be
used daily in assembling the final product. Assembly will take
place five days a week, 50 weeks a year. The manager estimates
that it will take almost a full day to get the machine ready for a
production run, at a cost of $300. Inventory holding costs will be
$10 per unit a year.
a) What run quantity should be used to minimize total annual costs?
b) What is the length of a production run in days?
c) During production, at what rate will inventory build up?
d) If the manager wants to run another job between runs of this item, and
needs a minimum of 10 days per cycle for the other work, will there be
enough time.
Examples
A mail-order company uses 18,000 boxes a year. Carrying costs are 20
cents per box per year, and ordering costs are $32 per order. The
following quantity discount is available. Determine:
a) The optimal order quantity.
b) The number of orders per year.
Number of Boxes Price per Box
1,000 to 1,999 $1.25
2,000 to 4,999 $1.20
5,000 to 9,999 $1.18
10,000 or more $1.15
Examples
A jewelry firm buys semi-precious stones to make bracelets
and rings. The supplier quotes a price of $8 per stone and
quantities of 600 stones or more, $9 per stone for orders of
400 to 599 stones, and $10 per stone for lesser quantities. The
jewelry firm operates 200 days per year. Usage rate is 25
stones per day, and ordering cost is $48 per order.
A. If carrying cost are $2 per year for each stone, find the order quantity
that will minimize total annual cost.
B. If annual carrying cost are 30 percent of unit cost, what is the optimal
order size?
C. If lead time is six working days, at what point should the company
reorder?
Examples
The housekeeping department of a motel uses approximately 400 washcloths
per day. The actual amount tends to vary with the number of guests on any
given night. Usage can be approximated by a normal distribution that has a
mean of 400 and a standard deviation of 9 washcloths per day. A linen supply
company delivers towels and washcloths with a lead time of three days. If the
motel policy is to maintain a stockout risk of 2 percent, what is the minimum
number of washcloths that must be on hand at reorder point, and how much of
that amount can be considered safety stock?

The motel in the preceding example uses approximately 600 bars of soap each
day, and this tends not to vary by more than a few bars either way. Lead time
for soap delivery is normally distributed with a mean of six days and a
standard deviation of two days. A service level of 90 percent is desired. Find
the ROP.

Examples
A distributor of large appliances needs to determine the order quantities and reorder
points for the various products it carries. The following data refers to a specific
refrigerator in its product line:
Cost to place an order: $100
Holding Cost: 20 percent of product cost per year.
Cost of refrigerator: $500 each.
Annual demand: 500 refrigerators.
Standard deviation during lead time: 10 refrigerators.
Lead time: 7 days.
Consider an even daily demand and a 365-day year.
A. What is the economic order quantity?
B. If the distributor wants a 97% service probability, what reorder point R should be used?
What is the corresponding safety stock?
C. If the current reorder point is 26 refrigerators, what is the possibility of stock-out?

Examples
A local service station is open 7 days a week, 365 days per year. Sales of
10W40 grade premium oil average 20 cans per day. Inventory holding costs
are $0.50 pre can per year. Ordering costs are $10 per order. Lead time is
two weeks. Backorders are not practical -- the motorist drives away.
A. Based on these data, choose the appropriate inventory model and
calculate the economic order quantity and reorder point. ( Demand is
deterministic).
B. The boss is concerned about this model because demand really varies.
The standard deviation of demand was determined from a data sample
to be 6.15 cans per day. The manager wants a 99.5% service
probability. Determine the new reorder point? Use Q
opt
from Part-A.

Examples
A small copy centre uses five boxes of copy paper a day. Each
box contains 10 packages of 500 sheets. Experience suggests
that usage can be well approximated by a Normal distribution
with a mean of five boxes per day and a standard deviation of
one-half box per day. Two days are required to fill an order
for paper. Ordering cost is $10 per order, and annual holding
cost is $10 per box per year.
a) Determine the economic order quantity, assuming 250 work days a
year.
b) If the copy center reorders when the supply on hand is 12 boxes,
compute the risk of a stockout.
c) If fixed interval of seven days, instead of ROP, is used for reordering,
what risk does the copy center incur that it will run out of stationery
before this order arrives if it orders 36 boxes when the amount on hand
is 12 boxes?
Examples
Regional Supermarket is open 360 days per year. Daily use of
cash register tape averages 10 rolls. Usage appears Normally
distributed with a standard deviation of 2 rolls per day. The cost
of ordering tape is $5 per order, and carrying costs are 40 cents
per roll a year. Lead time is three days.
a) What is the EOQ?
b) What ROP will provide a lead time service level of 96 percent?
c) What is the expected number of units short per cycle with 96 percent
service level? Per year?
d) What is the annual service level?
Examples
A depot operates 250 days a year. Daily demand for diesel fuel
at the depot is Normal with an average of 250 liters and a
standard deviation of 14 liters. Holding cost for the fuel is
$0.30 per liter per year, and it costs $10 in administrative time
to submit an order for more fuel. It takes one day to receive a
delivery of diesel fuel.
a) Calculate the EOQ.
b) Determine the amount of safety stock that would be needed if the
manager wants.
i. An annual service level of 99.5 percent.
ii. The expected amount of fuel short per order cycle to be no more than 5
liters.
Examples
A drugstore uses fixed-order-interval model for many of the items it
stocks. The manager wants a service level of 0.98. Determine the order
size that will be consistent with this service level for the items in the
following table for an order interval of 14 days and a lead time of 2 days.
Item Average Daily Demand Daily Standard Deviation Quantity on Hand
K033 60 5 420
K144 50 4 375
L700 8 2 160

Inventory Management and Cost Optimization Techniques

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Inventory Management and Cost Optimization Techniques

Uploaded by

Copyright:

Available Formats

M.

You might also like