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 INVENTORY
MANAGEMENT

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 Inventory
? Examples
Stock of anything
necessary
to do business

Stored capacity

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 Raw material

Work-in-process Types of Finished goods

Inventory

Supplies

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Inventory Management
Balancing the cost with the benefits of Inventories
Maintain wide assortment of stocks
Increase inventory turnover
Keep stock low
Keep adequate inventory
Obtain low prices

How much to order?

When to order? ?
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 Cost of Inventories
or Carrying cost
Warehouse, Insurance, Interest,
Ch Holding Cost Obsolescence, Staffing, Damage,
or Cc
or Stockout cost Deterioration, Pilferage, etc

Cs Shortage Cost Opportunity loss,

Stoppage of production

Order processing, Clerical,

Co Ordering Cost Transport, Stationeries

Price of item, Material,

C Item Cost Purchase of product
or P

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MGT 3050 Md Asnyat Asmat 7
 Inventory Control Models

Fixed order quantity models Help

Helpanswer
answerthethe
inventory
inventoryplanning
planning
Economic Order Quantity questions!
questions!
Production Order Quantity
Quantity Discount
Probabilistic models
Fixed order period models

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Economic Order Quantity (EOQ)
Assumptions
Demand is known and constant
Lead time is known and constant
Receipt of inventory is instantaneous or at once
Quantity discount is not allowed
Only cost associated are holding and ordering
(or set up cost) [no shortages are allowed; so
there is no shortage cost (ie. no stockouts]
Inventory position is reviewed continuously

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Economic Order Quantity (EOQ)
Assumptions
All values are known with certainty and constant
over time.
Inventory usage is uniform over time.
Carrying costs change proportionally with
changes in inventory levels.
All ordering costs are fixed.
These assumptions do not hold in the real
world, so safety stocks are held.

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EOQ inventory model
When to Order
Inventory
Level
Demand
rate
Optimal
Order, Q*

Average
ReOrder
= Q*/2
Inventory
Point, R
(ROP)

0 Time
Order Lead
Order
Placed Time
Received

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 Deriving an EOQ equation

Four Steps:
Step 1: Develop an expression for the annual ordering
cost
Step 2: Develop an expression for the annual holding
cost
Step 3: Equate ordering cost expression with the
expression of holding cost
Step 4: Solve the above equation for Q

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Notations:
D = Annual Demand
Q = Quantity to be ordered
Q* = Optimum value of Q
Co = Ordering cost/order
Ch = Holding cost/unit/year
I = Holding cost rate
C = Unit price
Ch = IC
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 General equations related to
EOQ
Annual holding cost
= (Average inventory)(Annual holding
cost per unit)
= QCh
Annual ordering cost
= (Number of orders per year)(Cost per
order)
= (D/Q)Co
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 Total annual cost
= (Annual holding cost) + (Annual
ordering cost)

TC = QCh + (D/Q)Co

Ch = IC

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EOQ Inventory model
Cost
2DCo
Q* = Total Inventory Cost

Ch TC = CoD/Q + ChQ/2

Holding Cost = ChQ/2

Minimum
Cost

Ordering Cost = CoD/Q

0 Optimal Inventory Level

Order, Q*

EOQ ChQ/2 = CoD/Q Average Inventory

= Q/2

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 EOQ model equation

2DCo
EOQ = Q* =
Ch

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 Reorder point
Reorder point
= (Demand per day)(Lead time for a
new order in days)

r = dm
r = reorder point
d = demand per day
m = lead time for a new order in days

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 Cycle time
Cycle time is the period between orders
Cycle time
= (Number of working days per
year)/(Number of orders per year)
= (Number of working Days)/(D/Q*)

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Eg. Carpet Discount Store (BT)
D = 10,000 yds
Ch = $0.75 per yd Optimal Order Quantity
Q* = (2CoD/Ch) = 2,000 yds
Co = $150.00

Note: Store open everyday Total Annual Inventory Cost

Except Sundays, Thanksgiving = Total Ordering Cost + Total Holding Cost
& Christmas days (not Sunday) TC = CoD/Q* + ChQ*/2 = $1500
Thus: working days = 311 days
? Number of orders No of Orders per year
? Time between orders = D/Q* = 5 orders per year
(order cycle)
Order Cycle time
= Working days in the year/No of Orders per year
= 311/5 = 62.2 store days

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 EOQ Model Equations
Optimal Order Quantity 2 D Co
= Q* =
Ch
D
Expected Number of Orders = N =
Q*
Working Days / Year
Expected Time Between Orders = T =
N
D D = Demand per year
d =
Working Days / Year Co = Setup (order) cost per order
Ch = Holding (carrying) cost
ROP = d L
d = Demand per day
L = Lead time in days
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 How would the following
factors affect an EOQ
analysis?
Just-in-time system: Eliminates the need
for using EOQ
Use of air freight for deliveries: Reduces
the need for safety stock
Computerized inventory control system:
Reduces safety stocks
Flexibility designed plants: Reduces
inventory holdings of final goods
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 Production Lot size Model

(Non-instantaneous receipt model)

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Production Order Quantity Model
or Production Run 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

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 POQ inventory model
Total Carrying Cost
Inventory
Level = CcQ(1 d/p)/2
Inventory level
With no demand Total Annual Inventory Cost
Demand
Cycle with TC = CoD/Q + CcQ(1 d/p)/2
no supply
Maximum
Inventory = Q(1 - d/p)

Optimal Q* Average
= Q(1 - d/p)/2
Inventory

0 Time
Production
Supply Supply Cycle with
Begins Ends demand

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 General equations related to
POQ inventory model
Maximum inventory
= (p d)t
d = daily demand rate
p = daily production rate
t = number of days for a production run

Q = pt
Therefore, t = Q/p days

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 Maximum inventory
= (p d)t
= (p d)(Q/p)
= (1 d/p)Q

Average inventory = (1 d/p)Q

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 Annual holding cost
= (Average inventory)(Annual cost per
unit)
= (1 d/p)QCh
Annual set up cost
= (Number of production runs per
year)(Set up cost per unit)
= (D/Q)Co/s
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 Total annual cost
TC = (1 d/p)QCh + (D/Q)Co/s

Or:
TC = (1 D/P)QCh + (D/Q)Co/s

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 POQ Model Equations
2*D*Co/s
Optimal Order Quantity = Qp * =

( )
C h* 1 -
d
p

Max. Inventory Level = Q * ( )

1 -
d
p
D C D = Demand per year
Setup Cost = * o/s Co/s = Setup cost
Q
Ch = Holding cost
Holding Cost ( )
= 0.5 * Ch * Q 1 - d
p
d = Demand per day
p = Production per day
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Eg. Carpet Discount Store (BT)
Production of Super Shag carpet
D = 10,000 yds Optimal Order Quantity
Ch = $0.75 per yd Q* = (2CoD/(Ch(1 - d/p)) = 2,256.8 yds
Co = $150.00
Total Annual Total Cost
TC = CoD/Q* + ChQ*(1 d/p)/2 = $1329
p = 150 yds (per day)
Production run length
d = D/yearly working days = Q*/p = 15.05 days
= 10,000/311
= 32.2 yds per day No of production runs
= D/Q* = 4.43 runs

Maximum Inventory level

= Q*(1 - d/p) = 1,722 yds

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 Quantity Discount Model

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Quantity Discount model
Cost 2DCo
EOQ Q* =

Ch Total Inventory Cost
TC = ChD/Q*+ CoQ/2+ CD
Note
Minimum
Ch = IC
Inventory
Cost

0 Inventory Level
Q1 Q2 Q3
Optimal
Order, Q*

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 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 with Constant Carrying Costs
Eg University Bookstore (inventory of personal computers:
Offered by Comptek computers) (BT)
Discount Discount Price Total Annual
category Quantity ($) Cost (TC) ($)

1 0 - 49 1,400
2 50 - 89 1,100 233,784
3 90 or more 900 194,105

D = 200 units Note: TC=CoD/Q*+ChQ*/2+PD

Ch = $190 per unit
Decision ?
Co = $2500 Take advantage of the discount
? Whether should take
advantage of the discount
Order 90 units
EOQ=Q*= 72.5 units
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 2DCo
Step 1: By using Q* = calculate

IC
Q* for each discount.

Step 2: Adjust Q* upward if quantity is too low

for discount.

Step 3: Compute total cost for each discount

and select the best Q*

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 Quantity Discount with Constant Carrying Costs
As a Percentage of Price
Discount Discount Price ($)
category Quantity Decision ?
Q* is 86.1, less than 90
1 0-49 1,400 to take advantage of discount

2 50-89 1,000 Optimal Order Size

3 90 or more 900 is 90 units

Discount Carrying Optimal Total Annual

category Cost (@15%) Quantity Cost (TC) ($)
1 210 69
2 165 77.8 232,845
3 135 86.1 191,630
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 A Single Period Inventory Model
with Probabilistic Demand
(RI p76)

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 A Single Period Inventory Model
with Probabilistic Demand
Order is placed only at one time for a
specified period
Demand is uncertain but the probability
distribution is known

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 When demand is uncertain, two
possibilities:
Demand exceeds order quantity, or
Order quantity exceeds demand
Cu = cost of underestimation per unit
Co = cost of overestimation per unit
Method: marginal analysis or incremental
analysis

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Expected Loss: optimal situation occurs
when:
EL(Q* + 1) = EL(Q*)
P(demandQ*)+P(Demand>Q*=1
EL(Q* + 1) = CoP(demand Q*)
EL(Q*) = CuP(demand > Q*)
= Cu[1 P(demand Q*)]
= Cu CuP(demand Q*)

Therefore:
P(demand Q*) = Cu/(Cu + Co)

Service level = 1 probability of stockout

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 Example: DCaf Restaurant (discrete
distribution) (RI p77)
DCafe produces a food item, which costs $6
per unit and sells at $15. DCafe knows that if
it cannot sell the food item within the day of
production, then it has to discard it, in which
case it will lose the production cost.
From the previous selling experience, DCafe
knows that the demand follows the following
probability distribution:

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 Daily Probability
Demand
14 0.05
15 0.15
16 0.15
17 0.20
18 0.25
19 0.10
20 0.10

How many units should DCafe produce each day?

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Service level
Service level is the probability that there
will not be any stock out at any instant of
time
Cu/(Cu + Co) = 0.6

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 Stock Probability Service Level
14 0.05 0.05
15 0.15 0.05+0.15=0.20
16 0.15 0.20+0.15 = 0.35
17 0.20 0.35+0.20=0.55
18 0.25 0.55+0.25 = 0.80

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 Example: Fatimas shop (continuous
distribution) (RI p81)
Fatima orders a perishable product daily at a super
market. It costs her $1.20 and sells for $1.65/unit. Any
unit unsold at the end of the day can be returned for a
$1.00. Demand at her shop is normally distributed with
= 150 and = 30. How many units she should place
order every day?
If the disposal price is just 35 cents, then how many
units she should order?

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Cu = 1.65 1.20 = 0.45
Co = 1.20 1.00 = 0.20
P(demand Q*) = Cu/(Cu + Co)
= 0.45/(0.45 + 0.20) = 0.6933
Z = (x )/ = (Q* - 150)/30
Q* = 165 units

If disposal price is 0.35, Co = 1.20 0.35 = 0.85

P(demand Q*) = 0.3461
Z = -0.39
Q* = 138 units

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 An Order-Quantity Reorder
Point Model with
Probabilistic Demand

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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

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Service Level
Frequency

Service
Level
p(stockout)

SS X
ROP

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 Probabilistic Models
When to Order?
Freq Service
Inventory Level
Level P(Stockout)
Optimal
Order
Quantity X
SS
Reorder ROP
Point
(ROP)

Safety Stock (SS)

Place Receive Time
order Lead Time order
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 Example: Hospital Supplies at GH (RI p81)
Aminah is in-charge of maintaining hospital
supplies at General Hospital. During the past
year, she has observed that in the lead time the
demand for bandage AX-7 has been normally
distributed with mean = 75 units with standard
deviation = 12 units.
If Aminah intends to maintain 98% service
level, then what should be the reorder point?

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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

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 Fixed Period Model
When to Order?
Inventory Level Target maximum

Time
Period Period Period
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ABC Analysis

Profit
Inventories are divided into
three categories, A, B & C
depending on the
importance of the items
Category A make up
70% profit, 10% of
inventory
Category B make up
20% profit, 20% of
inventory
Category C make up
10% profit, 70% of A B C
inventory Inventory
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 Wassalaam

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 z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09

0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879

0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2518 0.2549
0.7 0.2580 0.2612 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389

1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319

1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767

2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936

2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
MGT 3050
3.0 0.4986 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990