Inventory Management

Chapter 13
 Learning Objectives
• Define the term inventory
• List the different types of inventory
• Describe the main functions of inventory
• Discuss the main requirements for effective inventory
management
• Describe the A-B-C approach and explain how it is useful
• Describe the basic EOQ model and its assumptions and
solve typical problems.
• Describe the economic production quantity model and
solve typical problems
• Describe the quantity discount model and solve typical
problems
• Describe reorder point models and solve typical problems.
 Inventory Management at Cox
Hardware
• From the video, what are the elements relevant to inventory management?
 Inventory
• Definition
– A stock or store of goods
– Dependent demand items
• Items that are subassemblies or component parts to be
used in the production of finished goods.
– Independent demand items
• Items that are ready to be sold or used
• Inventories are a vital part of business:
– necessary for operations
– contribute to customer satisfaction
 Types of Inventory
• Raw materials and purchased parts
• Work-in-process (WIP)
• Finished goods inventories or merchandise
• Tools and supplies
• Maintenance and repairs (MRO) inventory
• Goods-in-transit to warehouses or customers
(pipeline inventory)
 Discussion
• Which of them are dependent demand items
and independent demand items?
– Raw materials and purchased parts
– Work-in-process (WIP)
– Finished goods inventories or merchandise
– Tools and supplies
– Maintenance and repairs (MRO) inventory
– Goods-in-transit to warehouses or customers
(pipeline inventory)
 Inventory Functions
• Inventories serve a number of functions such as:
1. To meet anticipated customer demand
2. To smooth production requirements
• Firms that experience seasonal patterns in demand often
build up inventories during preseason periods to meet
overly high requirements during seasonal periods.
3. To decouple operations
• Buffers between operations
4. To protect against stockouts
• Delayed deliveries and unexpected increases in demand
increase the risk of shortages.
 Inventory Functions
• Inventories serve a number of functions such as:
5. To take advantage of order cycles
• It is usually economical to produce in large rather than small
quantities. The excess output must be stored for later use.
6. To hedge against price increases
• Occasionally a firm will suspect that a substantial price increase is
about to occur and purchase larger-than-normal amounts to beat
the increase
7. To permit operations
• The fact that production operations take a certain amount of
time (i.e., they are not instantaneous) means that there will
generally be some work-in-process inventory.
8. To take advantage of quantity discounts
• Suppliers may give discounts on large orders.
 Objectives of Inventory Control
• Inventory management has two main
concerns:
1. Satisfactory Level of customer service
• Having the right goods available in the right quantity in
the right place at the right time

2. Costs of ordering and carrying inventories

• The overall objective of inventory management is to
achieve satisfactory levels of customer service while
keeping inventory costs within reasonable bounds
 Inventory Management
• Management has two basic functions concerning
inventory:
1. Establish a system for tracking items in inventory

2. Make decisions about

• When to order
• How much to order

MIS 373: Basic Operations Management 10

 Effective Inventory Management
• Requires:
1. A system keep track of inventory
2. A reliable forecast of demand
3. Knowledge of lead time and lead time variability
4. Reasonable estimates of
• holding costs
• ordering costs
• shortage costs
5. A classification system for inventory items

MIS 373: Basic Operations Management 11

 Measures of performance
• Measures of performance:
– Customer satisfaction
• Number and quantity of backorders
• Customer complaints

– Inventory turnover = a ratio of

(average) cost of goods sold
(average) inventory investment

during a period

MIS 373: Basic Operations Management 12

 Inventory Counting Systems
• Periodic System
• Physical count of items in inventory made at periodic intervals

• Perpetual Inventory System

• System that keeps track of removals from inventory
continuously, thus monitoring current levels of each item
– Point-of-sale (POS) systems
• A system that electronically records actual sales

– Radio Frequency Identification (RFID)

MIS 373: Basic Operations Management 13

 Inventory Costs
• Purchase cost
– The amount paid to buy the inventory
• Holding (carrying) costs
– Cost to carry an item in inventory for a length of time, usually a year
• Interest, insurance, taxes (in some states), depreciation, obsolescence,
deterioration, spoilage, pilferage, breakage, tracking, picking, and
warehousing costs (heat, light, rent, workers, equipment, security).
• Ordering costs
– Costs of ordering and receiving inventory
• determining how much is needed, preparing invoices, inspecting goods
upon arrival for quality and quantity, and moving the goods to temporary
storage.
• Shortage costs
– Costs resulting when demand exceeds the supply of inventory; often
unrealized profit per unit

MIS 373: Basic Operations Management 14

 ABC Classification System
• A-B-C approach
– Classifying inventory according to some measure of
importance, and allocating control efforts accordingly
– A items (very important)
• 10 to 20 percent of the number of items in inventory and about 60 to
70 percent of the annual dollar value
– B items (moderately important)
– C items (least important)
• 50 to 60 percent of the number
of items in inventory but only
about 10 to 15 percent of the
annual dollar value

MIS 373: Basic Operations Management 15

 ABC Classification System
• How to classify?
# Annual Unit Annual value Class % of % of
1. For each item, multiply demand price items value
annual volume by unit
price to get the annual 8 1,000 4,000 4,000,000 A 5.3 52.7
dollar value. 3 2,400 500 1,200,000 B
2. Arrange annual values in 6 1,000 1,000 1,000,000 B 31.4 40.8
descending order.
1 2,500 360 900,000 B

3. A items: the few with the 4 1,500 100 150,000 C

highest annual dollar 10 500 200 100,000 C
value
9 8,000 10 80,000 C
63.3 6.5
C items: the most with 2 1,000 70 70,000 C
the lowest dollar value.
5 700 70 49,000 C

7 200 210 42,000 C

B items: those in
between 18,800 7,591,000 100 100

MIS 373: Basic Operations Management 16

 ABC Classification: Cycle Counting
• Cycle counting
– A physical count of items in inventory
• Cycle counting management
– How much accuracy is needed?
• A items: ± 0.2 percent
• B items: ± 1 percent
• C items: ± 5 percent
– When should cycle counting be performed?
– Who should do it?

MIS 373: Basic Operations Management 17

 Inventory Models
• Economic Order Quantity models:
– identify the optimal order quantity
• by minimizing total annual costs that vary with order size and
frequency
1. The basic Economic Order Quantity model (EOQ)
2. The Quantity Discount model
3. The Economic Production Quantity model (EPQ)
4. Reorder Point Ordering (uncertainty, when to order)
5. Fixed-Order-Interval model
6. Single Period model (perishable items)
 Basic EOQ Model
• The basic EOQ model:
– used to find a fixed order quantity that will minimize total
annual inventory costs
– continuous monitoring system

• Assumptions:
1. Only one product is involved
2. Annual demand requirements are known
3. Demand is even throughout the year
4. Lead time does not vary
5. Each order is received in a single delivery
6. There are no quantity discounts

MIS 373: Basic Operations Management 19

 The Inventory Cycle
Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order

Lead time

MIS 373: Basic Operations Management 20

 Discussion
• What costs are associated with this model?
– (Hint: Recall the 5 types of costs)
 Purchase cost
 Holding (carrying) cost
 Ordering cost
 Setup cost
 Shortage cost (Backorder/Backlog cost)

Instructor Slides 21
 Total Annual Cost
• Total Cost = Annual Holding Cost + Annual Ordering
Cost
(TC) = Q D
H + S
2 Q
Average number of Number of
units in inventory orders

where
• Q = order quantity in units
• H = holding (carrying) cost per unit, usually per year
• D = demand, usually in units per year
• S = ordering cost per order
MIS 373: Basic Operations Management 22
 Goal: Total Cost Minimization
• The Total-Cost Curve is U-Shaped
– There is a tradeoff between holding costs and
ordering costs
Annual Cost

Q D
TC  H S
2 Q

Holding Costs

Ordering Costs

Order Quantity
Q* (optimal order quantity) (Q)
MIS 373: Basic Operations Management 23
 Deriving EOQ
• Using calculus, we take the derivative of the total
cost function and set the derivative (slope) equal
to zero and solve for Q.
• The total cost curve reaches its minimum where
the carrying and ordering costs are equal.
′
𝐻 −1 𝐷𝑆 𝐷𝑆 𝐻 𝐷𝑆 𝐻𝑄
𝑇𝐶 = + 2
=0 → 2
= → =
2 𝑄 𝑄 2 𝑄 2

2𝐷𝑆 2 𝑎𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑 𝑜𝑟𝑑𝑒𝑟 𝑐𝑜𝑠𝑡

𝑄∗ = =
𝐻 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡

MIS 373: Basic Operations Management 24

 Example: Deriving EOQ
• Tire distributer
• D (Demand)=9,600 tires per year
• H (Holding cost)=$16 per unit per year
• S (Ordering cost) = $75 per order
2𝐷𝑆 2 ∗ 9,600 ∗ 75
𝑄∗ = = = 300 𝑡𝑖𝑟𝑒𝑠
𝐻 16

𝑄 𝐷 300 9,600
𝑇𝐶 = 𝐻 + 𝑆 = ∗ 16 + ∗ 75 = 2,400 + 2,400 = 4,800
2 𝑄 2 300

MIS 373: Basic Operations Management 25

 Example: Deriving EOQ
• D (Demand)=9,600 tires per year
• H (Holding cost)=$16 per unit per year
• S (Ordering cost) = $75 per order
• Q*=300 tires
• TCmin = 4,800
Let’s verify whether the Q*
indeed gives the lowest cost.

Q D 250 9,600
TC 250  H  S  16  75  2,000  2,880  4,880
2 Q 2 250
Q D 400 9,600
TC 400  H S 16  75  3,200  1,800  5,000
2 Q 2 400

MIS 373: Basic Operations Management 26

 Exercise
• A local distributor for a national tire company
expects to sell approximately 9,600 tires per year.
Annual carrying cost is $16 per tire, and ordering
cost is $75 per order. The distributor operates
288 working days a year.
• a. What is the optimal order size?
• b. How many times per year the store reorder?
• c. What is the length of an order cycle?
• d. What is the total annual cost if EOQ is placed?

Instructor Slides 27
 Solution
2DS 2  (9,600)  75
• a EOQ    300(tires )
H 16

D 9,600
• b   32(times)
EOQ 300

• c # of working days 288

Length   9
# of reorder times 32

• d Total Cost  (Q / 2) H  ( D / Q) S
（300/ 2） 16  (9,600/ 300)75
 $4800 Instructor Slides 28
 Economic Production Quantity
(EPQ)
• The batch mode is widely used in production. In certain
instances, the capacity to produce a part exceeds its usage
(demand rate)
– Assumptions
1. Only one item is involved
2. Annual demand requirements are known
3. Usage rate is constant (= even demand throughout the year)
4. Usage occurs continually, but production occurs periodically (batch
production)
5. The production rate is constant
6. Production rate is greater than usage rater
7. Lead time does not vary
8. There are no quantity discounts

13-29
Instructor Slides
 EPQ: Inventory Cycle
Q
Production Usage Production Usage Production
and usage only and usage only and usage
Qp
Cumulative
production
Imax

Amount
on hand

Time

13-30
Instructor Slides
 Discussion
• What costs are associated with this model?
– (Hint: Recall the 5 types of costs)
 Purchase cost
 Holding (carrying) cost
 Ordering cost
 Setup cost
 Shortage cost (Backorder/Backlog cost)

• Our decision making in EPQ model is to

determine the size of order (Q) each time.
Why?
Instructor Slides 31
 EPQ Model
Q  Batch size for production
I  Maximum Inventory Level
H  Holding (carrying) cost per unit per year
D  Annual Demand
S  Setup cost per order
p  production rate (unit per day)
u  usage rate (unit per day)

Instructor Slides 32
 EPQ – Total Cost
TC min  Carrying Cost  Setup Cost
I  D
  max  H  S
 2  Q
where
I max  Maximum inventory
Qp
  p  u
p
p  Production or delivery rate
u  Usage rate

13-33
Instructor Slides
 EPQ

2 DS p
Qp 
H p u
Optimal Batch size a.k.a Economic Produciton Quantity (EPQ)

Instructor Slides 13-34

 Exercise
• A toy manufacturer uses 48,000 wheels per year for
toy trucks. The firm produces 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 is $45 per production
run. The firm operates 240 days per year.
• a. What is the optimal batch size?
• b. What is the total annual cost if EPQ is produced each
run?
• c. What is cycle time (production stage + usage stage)?
• d. What is the production cycle time?
Instructor Slides 35
 Solution
u  48,000 / 240  200 wheels per day

2  (48,000)  45
• a EPQ 
2 DS p

800
 2,400( wheels )
H p u 1 800  200

EPQ 2,400
• b I max  ( p  u)  (800  200)  1,800( wheels )
p 800
Total Cost  ( I max / 2) H  ( D / Q) S
（1,800/ 2）
1  (48,000/ 2,400)45
 $1,800

Instructor Slides 36
 Solution

EPQ 2,400
• c CycleTime    12(days)
u 200
EPQ 2,400
Pr oductionCycle    3(days)
• d p 800

Instructor Slides 37
 Quantity Discount Model
• Quantity discount
– Price reduction for larger orders offered to customers
to induce them to buy in large quantities
Total Cost  Carrying Cost  Ordering Cost  Purchasing Cost
Q D
 H  S  PD
2 Q
where
P  Unit price

13-38
Instructor Slides
 When to Reorder
• If delivery is not instantaneous, but there is a
lead time:
When
Order to order?
Quantity
Q
Inventory

Lead Time Time

Place Receive
order
MIS 373: order
Basic Operations Management 39
 When to Reorder
• EOQ answers the “how much” question
• The reorder-point (ROP) tells “when” to order

• Reorder-Point
– When the quantity on hand of an item drops to this
amount (quantity-trigger), the item is reordered.

– Determinants of the Reorder-Point

1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management

MIS 373: Basic Operations Management 40

 Reorder-Point
ROP = (Demand per day) * (Lead time for a new order in days)
= d * L
where
d = (Demand per year) / (Number of working days in a year)

Example:
– Demand = 12,000 iPads per year In other words, the
– 300 working day year
manager should place the
order when only 120 units
– Lead time for orders is 3 working days
left in the inventory.
d = 12,000 / 300 = 40 units
ROP = d * L = 40 units per day * 3 days of leading time = 120 units

MIS 373: Basic Operations Management 41

 The Inventory Cycle
Profile of Inventory Level Over Time Q: When shall we order?
A: When inventory = ROP
Q: How much shall we order?
A: Q = EOQ
Q Usage
Quantity rate
on hand

Reorder
point
ROP = LxD
Time
Receive Place Receive Place Receive
order order order order order
D: demand per period
L: Lead time in periods Lead time
MIS 373: Basic Operations Management 42
 Exercise: EOQ & ROP
• Assume a car dealer that faces demand for 5,000 cars per year, and that it costs
$15,000 to have the cars shipped to the dealership. Holding cost is estimated at
$500 per car per year. How many times should the dealer order, and what
should be the order size? (Assuming that the lead time to receive cars is 10
days and that there are 365 working days in a year)
Recall:

∗
2𝐷𝑆 2 𝑎𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑 𝑜𝑟𝑑𝑒𝑟 𝑐𝑜𝑠𝑡
EOQ = 𝑄 = =
𝐻 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡

ROP = (Demand per day) * (Lead time for a new order in days)
= d * L
where
d = (Demand per year) / (Number of working days in a year)
 Exercise: EOQ & ROP
• Assume a car dealer that faces demand for 5,000 cars per year, and that it costs
$15,000 to have the cars shipped to the dealership. Holding cost is estimated at
$500 per car per year. How many times should the dealer order, and what
should be the order size?

2(15,000)(5,000)
Q 
*
 548
500
Since d is given in years, first convert: 5000/365 =13.7 cars per working day

So, ROP = 13.7 * 10 = 137

So, when the number of cars on the lot

reaches 137, order 548 more cars.
 But demand is rarely predictable!
Inventory
Level
When Actual Demand < Expected Demand

Order
Quantity
Lead Time Demand

ROP

Inventory at time of receipt

Time
Place Receive
order Lead Time order
MIS 373: Basic Operations Management 45
 But demand is rarely predictable!
Inventory
Level
When Actual Demand > Expected Demand

Order
Quantity

Stockout Point

ROP

Unfilled demand Time

Place
order Lead Time Receive
order
MIS 373: Basic Operations Management 46
 But demand is rarely predictable!
Inventory
Level
If ROP = expected demand,
Order inventory left 50% of the time, stock outs 50% of the time.
Quantity
ROP = Expected Demand

Average Uncertain Demand

Time

MIS 373: Basic Operations Management 47

 Safety Stock
Inventory
Level
To reduce stockouts we add safety stock

Order
Quantity

Order Quantity
ROP = Q = EOQ
Safety
Stock +
Expected Expected
LT LT Demand
Demand
Safety Stock
Place Time
order Lead Time Receive
order
MIS 373: Basic Operations Management 48
 How Much Safety Stock?
• The amount of safety stock that is appropriate for a given
situation depends upon:
1. The average demand rate and average lead time
2. Demand and lead time variability
3. The desired service level
• Service level = probability of NOT stocking out

• Reorder point (ROP) =

Expected demand during lead time + z*σdLT
Where
z = number of standard deviations
σdLT = the standard deviation of lead time demand

MIS 373: Basic Operations Management 49

 Reorder Point
• The ROP based on a normal distribution of
lead time demand

Risk of stockout
Service
level
(probability of
not stockout)
Quantity
Safety
Stock
Expected ROP
demand

MIS 373: Basic0 Z

Operations Management Z scale 50
Recap