Inventory Management

Inventory
• Any stored resource used to satisfy a
current or future need (raw materials, work-
in-process, finished goods, etc.)
• Represents as much as 50% of invested
capitol at some companies
• Excessive inventory levels are costly
• Insufficient inventory levels lead to
stockouts
Water Tank Analogy for Inventory

Inventory Level
Supply Rate

Buffers Demand Rate

from Supply Rate
Inventory Level

Demand Rate
 Reasons To Hold Inventory
• Meet variations in customer demand:
– Meet unexpected demand
– Smooth seasonal or cyclical demand
• Pricing related:
– Temporary price discounts
– Hedge against price increases
– Take advantage of quantity discounts
• Process & supply surprises
– Internal – upsets in parts of or our own processes
– External – delays in incoming goods
• Transit
Reasons To NOT Hold Inventory
• Carrying cost
– Financially calculable
• Takes up valuable factory space
– Especially for in-process inventory
• Inventory covers up “problems” …
– That are best exposed and solved
 Inventory Control Decisions
Objective: Minimize total inventory cost

Decisions:
• How much to order?
• When to order?
 Types of Inventory
• Raw Materials
• Subcomponents
• Work in progress (WIP)
• Finished products
• Defectives
• Returns
 Inventory Costs
What costs do we experience because we
carry inventory?
 Components of Total Cost
1. Cost of items
2. Cost of ordering
3. Cost of carrying or holding inventory
4. Cost of stockouts
5. Cost of safety stock (extra inventory held
to help avoid stockouts)
Holding, Ordering and Set-up
Costs
• Holding Costs are the costs associated
with holding or “carrying” inventory over
time.
• It includes costs related to Storage; such
as insurance, extra staffing, interest, and
so on.
Holding, Ordering and Set-up
Costs
• Some example holding costs are building
rent or depreciation, building operating
cost, taxes on building, insurance on
building, material handling equipment
leasing or depreciation, equipment
operating cost, handling manpower cost,
taxes on inventory, insurance, etc.
 Typical Inventory Carrying Costs
Costs as % of
Inventory Value
Housing cost: 6%
– Building rent or depreciation (3% - 10%)

– Building operating cost

– Taxes on building
– Insurance 3%
(1% - 4%)
Material handling costs:
– Equipment, lease, or depreciation
– Power 3%
– Equipment operating cost (3% - 5%)
10%
Manpower cost from extra handling and supervision (6% - 24%)

Investment costs: 5%
– Borrowing costs (2% - 10%)
– Taxes on inventory (15% - 50%)
– Insurance on inventory
Pilferage, scrap, and obsolescence

Overall carrying cost

Holding, Ordering and Set-up
Costs
• Ordering Costs include, cost of supplies,
order processing, clerical cost, etc.
• The ordering cost is valid if the products
are purchased NOT produced internally.
Holding, Ordering and Set-up
Costs
• Set-up cost is the cost to prepare a
machine for manufacturing an order.
• Set-up cost is highly correlated with set-up
time.
Holding, Ordering and Set-up
Costs
• Machines that traditionally have taken long
hours to set up Are Now being set up in
less than a minute by employing FMSs
systems.
• Reducing set up times is an excellent way
to Reduce Inventory.
Inventory Management Systems

• Functions of Inventory Management

– Track inventory
– How much to order
– When to order
• Prioritization
• Inventory Management Approach
– EOQ
– Continuous / Periodic
 ABC Prioritization

• Based on “Pareto” concept (80/20 rule)

and total usage in dollars of each item.
• Classification of items as A, B, or C often
based on Rs. volume.
• Purpose: set priorities for management
attention.
 ABC Prioritization
• ‘A’ items: 20% of SKUs, 80% of dollars
• ‘B’ items: 30 % of SKUs, 15% of dollars
• ‘C’ items: 50 % of SKUs, 5% of dollars
• Three classes is arbitrary; could be any
number.
• Percents are approximate.

SKU (Stock Keeping Unit):

Warehousing item that is unique because of some characteristic (such as

brand, size, color, model) and must be stored and accounted for separate
from other items. Every SKU is assigned a unique identification number
(inventory or stock number)
 ABC Analysis Example
+Class C
100 — +Class B
90 —
Percentage of dollar value Class A
80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Percentage of items
Inventory Management Approaches
• A-items
– Track carefully (e.g. continuous review)
– Sophisticated forecasting to assure
correct levels
• C-items
– Track less frequently (e.g. periodic review)
– Accept risks of too much or too little
(depending on the item)
 Inventory Models

• Fixed order-quantity models Help

Help answer
answer the
the
inventory
inventoryplanning
planning
– Economic order quantity questions!
questions!
– Production order quantity
– Quantity discount
• Probabilistic models
• Fixed order-period models
 Inventory Models
• Demand for an item is either dependent
on the demand for other items or it is
independent.
• For example, demand for refrigerator is
independent of the demand for cars.
• But, demand for auto tires is certainly
dependent on the demand of cars.
 Inventory Models
• We will deal with the Independent
Demand Situation.
• In the independent demand situation, we
should be interested in answering:
• a) When to place an order for an item, and
• b) how much of an item to order.
 Inventory Models
• There are Three Basic Independent
Demand Inventory Models:
1) Economic Order Quantity (EOP) Model
(the most known model).
2) Production Order Quantity Model.
3) Back order inventory model.
Economic Order Quantity (EOQ):
Determining How Much to Order
• One of the oldest and most well known
inventory control techniques
• Easy to use
• Based on a number of assumptions
 Assumptions of the EOQ Model
1. Demand is known and constant
2. Lead time is known and constant
3. Receipt of inventory is instantaneous
4. Quantity discounts are not available
5. Variable costs are limited to: ordering
cost and carrying (or holding) cost
6. If orders are placed at the right time,
stockouts can be avoided
 Finding the Optimal Order Quantity
Parameters:
Q* = Optimal order quantity (the EOQ)
D = Annual demand
Co = Ordering cost per order
H= Ch = Carrying (or holding) cost per unit per yr

P = Purchase cost per unit

 EOQ
Inventory
Level

Q* Decrease Due to
Optimal Constant Demand
Order
Quantity

Time
 EOQ
Inventory
Level

Q* Instantaneous
Optimal Receipt of Optimal
Order Order Quantity
Quantity

Time
 EOQ
Inventory
Level

Q*
Optimal
Order
Quantity

Time
 EOQ w Lead Time
Inventory
Level

Q*
Optimal
Order
Quantity

Time

Lead Time
 EOQ
Inventory
Level

Q*

Reorder
Point
(ROP)

Time

Lead Time
 EOQ
Inventory
Level

Q*

Average
Inventory Q/2
Reorder
Point
(ROP)

Time

Lead Time
 Minimizing EOQ Model Costs
• Only ordering and carrying costs need to
be minimized (all other costs are assumed
constant)
• As Q (order quantity) increases:
– Carry cost increases
– Ordering cost decreases (since the
number of orders per year decreases)
 EOQ Model Total Cost

Annual Cost

Holding Cost
= H * Q/2

Order Quantity
 EOQ Model Total Cost

Annual Cost

Ordering Cost
= Co * D/Q

Holding Cost
= H * Q/2

Order Quantity
 EOQ Model Total Cost
Total Cost
Annual Cost = Holding + Ordering

Order Quantity
 Total Cost
= Holding + Ordering
EOQ Model Total Cost
At optimal order quantity (Q*):
Carrying cost = Ordering cost
Annual Cost

Optimal Q Order Quantity

 Finding the Optimal Order Quantity
Parameters:
Q* = Optimal order quantity (the EOQ)
D = Annual demand
Co = Ordering cost per order
H= Ch = Carrying (or holding) cost per unit per yr

P = Purchase cost per unit

 Two Methods for Carrying Cost
Carry cost (Ch) can be expressed either:
1. As a fixed cost, such as
Ch = Rs.0.50 per unit per year
2. As a percentage of the item’s purchase cost
(P)
Ch = I x P
I = a percentage of the purchase cost
 EOQ Total Cost
Total ordering cost = (D/Q) x Co
Total carrying cost = (Q/2) x Ch
Total purchase cost =PxD
Annual Total Costs = Holding + Ordering

Q D
TC (Q) = Ch * + CO *
Note: 2 Q
• (Q/2) is the average inventory level
• (D/Q) are the number of orders
• Purchase cost does not depend on Q
 Finding Q*
Recall that at the optimal order quantity (Q*):
Carry cost = Ordering cost
(D/Q*) x Co = (Q*/2) x Ch

Rearranging to solve for Q*:

Q* = ( 2 DCo / Ch )
since Q = DT
TC (Q* ) = 2Co DCh Q 1 2Co D 2Co
⇒T = = =
D D Ch DCh
 Optimal Quantity (Derivative)
Q D
Total Costs = C h * + Co *
2 Q
 Optimal Quantity
Q D
Total Costs = C h * + Co *
2 Q
Take derivative with
Ch D
respect to Q = − Co * 2
2 Q
 Optimal Quantity
Q D
Total Costs = C h * + Co *
2 Q
Take derivative with
Ch D Set equal
respect to Q = − Co * 2 = 0 to zero
2 Q
 Optimal Quantity
Q D
Total Costs = C h * + Co *
2 Q
Take derivative with
Ch D Set equal
respect to Q = − Co * 2 = 0 to zero
2 Q
Solve for Q:

Ch DCo
= 2
2 Q
 Optimal Quantity
Q D
Total Costs = C h * + Co *
2 Q
Take derivative with
Ch D Set equal
respect to Q = − Co * 2 = 0 to zero
2 Q
Solve for Q:

Ch DCo 2 DCo
= 2 Q =
2

2 Q Ch
 Optimal Quantity
Q D
Total Costs = C h * + Co *
2 Q
Take derivative with
Ch D Set equal
respect to Q = − Co * 2 = 0 to zero
2 Q
Solve for Q:

Ch DCo 2 DCo 2 DCo

= 2 Q = Q=
2

2 Q Ch Ch
 EOQ Model Equations
2 ×D ×C o
Optimal Order Quantity = Q* =
Ch
D
=N=
Expected Number of Orders
Q*
Expected Time Between Orders = T = Working Days / Year
N
D D = Demand per year
d=
Working Days / Year Co = Setup (order) cost per
order
ROP = d × L Ch = Holding (carrying) cost
d = Demand per day
L = Lead time in days
 EOQ Example: Sumco Pump Co.
Buys pump housing from a manufacturer
and sells to retailers

D = 1000 pumps annually

Co = Rs.10 per order
Ch = Rs.0.50 per pump per year
P = Rs.5
Q* = 200
 EOQ Example
Sales = 10 cases/week Co = Rs.12/order
i = 30 pct/year P = Rs.80/case
_________
EOQ = √ (2Co D)/iP = SQRT[(2*12*10*52)/(80*.3)]

= SQRT[12,480/24] = 22.8 cases/order

TC = ordering cost + holding cost
= Co *(D/Q) + iP*(Q/2) = 10(520/22.8) + 24 * 11.4
= 273.70 + 273.60 = Rs.547.28/year
If order 22 cases instead, TC = Rs.547.64; if 23, TC =
Rs.547.30
 Average Inventory Value
After Q* is found we can calculate the
average value of inventory on hand

Average inventory value = P x (Q*/2)

 A Question:
• If the EOQ is based on so many
assumptions that are never really true,
why is it the most commonly used ordering
policy?
 Sensitivity of the EOQ Formula
• The EOQ formula assumes all inputs are
know with certainty
• In reality these values are often estimates
• Determining the effect of input value
changes on Q* is called sensitivity
analysis
 Sensitivity

• Suppose we do not order optimal Q*, but

order Q instead.
• Percentage profit loss given by:
TC (Q) 1  Q * Q 
=  + 
TC (Q*) 2  Q Q * 
• Should order 100, order 150 (50% over):
0.5*(1.5 + 0.66) =1.08 an 8%cost increase
 Economic Production Quantity:
Determining How Much to Produce
• The EOQ model assumes inventory
arrives instantaneously
• In many cases inventory arrives gradually
• The economic production quantity
(EPQ) model assumes inventory is being
produced at a rate of p units per day
• There is a setup cost each time
production begins
Inventory Control With Production
 Determining Lot Size or EPQ
Parameters
Q* = Optimal production quantity (or EPQ)
Cs = Setup cost
D = annual demand
d = daily demand rate
p = daily production rate
 Average Inventory Level
• We will need the average inventory level for
finding carrying cost
• Average inventory level is ½ the maximum
We have Q = p x tp{no. of days}
tp = Q /p
Max inventory = (p-d) x tp

Max inventory = Q x (1- d/p)

Ave inventory = ½ Q x (1- d/p)
 Average Inventory Level

Max inventory = Q x (1- d/p)

Ave inventory = ½ Q x (1- d/p)
 Total Cost
Setup cost = (D/Q) x Cs
Carrying cost = [½ Q x (1- d/p)] x Ch
Production cost =PxD
= Total cost

As in the EOQ model:

• The production cost does not depend on Q
• The function is nonlinear
 Finding Q*
• As in the EOQ model, at the optimal quantity
Q* we should have:
Setup cost = Carrying cost
(D/Q*) x Cs = [½ Q* x (1- d/p)] x Ch

Rearranging to solve for Q*:

Q* = ( 2 DCs /[Ch (1 − d / p )]
 EPQ for Brown Manufacturing
Produces mini refrigerators (has 167
business days per year)
D = 10,000 units annually
d = 1000 / 167 = ~60 units per day
p = 80 units per day (when producing)
Ch = Rs.0.50 per unit per year
Cs = Rs.100 per setup
P = Rs.5 to produce each unit
 Length of the Production Cycle
• The production cycle will last until Q* units
have been produced
• Producing at a rate of p units per day
means that it will last (Q*/p) days
• For Brown this is:
Q* = 4000 units
p = 80 units per day
4000 / 80 = 50 days
 Inventory Levels For Planned
Shortages Model
Q-K

0 TIME

-K
T1 T2
T

(Q- K) = D x T1 Q= DxT (Q − K )T
T1 = S = D x T2
Q
 EOQ Formula
• Notation
D = demand in units per year
H = Ch = holding cost in dollars/unit/year
• B = Shortages Cost in dollars/unit/year
Co = cost of placing an order in dollars
Q = order quantity in units
• K = Shortages in units
•
 Formulas for Special Models
• Model with Planned Shortages
Total ordering cost = (D/Q) x Co
Max inventory = (Q-K)
Ave inventory = ½ x (Q- K)
Total carrying cost during a cycle = ½ x(Q- K) x T1 x Ch
(Q − K ) 2 T
= Ch
2Q

(Q − K ) 2
• Total Annual carrying cost = Ch
2Q
 Formulas for Special Models
• Model with Planned Shortages
Ave Shortages in a cycle = ½ x S
Total Shortages cost during a cycle= ½ x S x T2 x B
we have Q = D x T S = D x T2
• This gives KT
T2 =
Q
TK 2
• Total Shortages cost during a cycle =B
2Q

K2
• Annual Shortages cost =B
2Q
 Formulas for Special Models
• Model with Planned Shortages
D (Q − K ) 2 K2
TCb = C0 + Ch +B
Q 2Q 2Q
2 DCo  Ch + B 
Q =
*
 
Ch  B 
 Ch 
K = Q 
* *

 Ch + B 
 Continuous Review System
• Relax assumption of constant demand.
Demand is assumed to be random.
• Check inventory position each time there
is a demand (i.e continuously).
• If inventory position drops below the
reorder point, place an order for the EOQ.
• Also called fixed-order-quantity or Q
system (the fixed order size is EOQ).
 A Continuous Review (Q) System

R = Reorder Point
Q = Order Quantity
L = Lead time
A Continuous Review (Q) System
Amount to order = EOQ
Order when inventory position = reorder point.
Reorder point = lead time * demand/period
= R = lead time demand (when demand is
constant)
Reorder point is independent of EOQ
EOQ tells how much to order.
Reorder point tells when to order.
 Periodic Review System (1)
• Instead of reviewing continuously, we review
the inventory position at fixed intervals. For
example, the bread truck visits the grocery
store on the same days every week.
• Inventory brought up to a ‘target’ level
• Also known as “P system”, “Fixed-order-
interval system” or “Fixed-order-period
system”
 Periodic Review System (2)
• Has a target inventory rather than a
reorder point.
• Does not have EOQ since quantity varies
according to demand.
• The order interval is fixed, not the order
quantity.
A Periodic Review (P) System