3.2 Inventory

Inventory Management
Ronald S. Lau, Ph.D.

HKUST ISOM
p
s
Course outline
Module 1: Strategic
Planning and Decisions
Module 2: Managing
Business Process
Flows
Demand Management
and Forecasting
Module 3:
Synchronizing Supply
and Demand
Module 4: Process
Improvement and
Quality Management
Managing Short Life

Cycle Products
Intended learning outcomes

Inventory management and control concepts
WATCH
VIDEO
not taught
List the types of inventory and their functions

Describe with examples of different inventory costs
Compare and contrast the commonly used inventory systems
Describe cycle counting and inventory control activities
Apply ABC classification to establish an appropriate degree of
control for different items
List the assumptions of the basic inventory models
Compute the optimal order size using basic inventory models
Compute the reorder point and safety stock of a probabilistic
EOQ model
inventory sometimes in some industry is a capacity
liabil
not achievi
exc
TIED-
Inventory
Required or unavoidable
(wine, collectible, p
if one slow down the other is affected,

be separated to b
(like oil)
Purposes of inventory
Regulations or customer expectations

In transit or pipeline inventory
Decoupling points
Maintain independence of operations
Buffer against uncertainty

Economic benefits
Quantity discounts or reduced overall costs

Potential increase in value
people become more careless, not care about quality

many inventory (compared to JIT, low inventory, hi
anything more than you need excess
Why avoiding excess inventory?
Excess inventory is the root of all evil (Kiyoshi Suzaki)

Tie up working capital
Implications of Littles law (I = R x T)
Hide problems (e.g., quality, scheduling, communication, etc.)
More storage, handling, damage, and admin expenses, etc.
May become obsolete and worthless
Types and examples of inventory costs

Holding (or carrying) costs [variable cost]
Material handling costs, storage space, warehousing fees
Damage, spoilage, depreciation, obsolescence of materials
Cost of capital, opportunity cost, taxes and insurance
Shortage costs [variable cost]

Lost sales and profits, customer dissatisfaction
Expedition costs, penalty charges
Ordering (or setup) costs [fixed cost]

Handling charges, preparing orders
Supplier selection, negotiations
Freight and insurance
7
Continuous review inventory system vs.

Periodic review inventory system
i.e. parknshop has 5k SKU
Continuous review system:

An order is triggered when the inventory falls to a specific level
(varied interval of time between orders)
Fixed order quantity inventory model
Decisions: How much to order (Q)? When to order (R)?
Periodic review system:

Inventory level is checked periodically (fixed interval of time
between orders)
An order is placed to bring the inventory level up to a
predetermined level (varied order quantity)
Also known as fixed time period inventory model
Decisions: How much to order (Q)? How long between orders
(T)?
8
80% Profit from 20% of the customers
ABC classification
ABC classification is based on the 80/20 principle
(critical few, trivial many)
Items are not of equal importance
A items account for a small percentage of items but a large
percentage of value
ABC example
10
Application of ABC analysis

Strategy
Inventory
Production
Distribution
Classification
(Examples)
By usage in dollar
value
By value of finished
product
By profitability of
product and customer
Strictly controlled
and counted
Make-to-order
Higher service level
Controlled reorder
point and quantity
Configure-to-order
Med/High service levels
Free issue
Make-to-stock
Lower service level
(Engines)
B
(Brackets)
C
(Nuts & bolts)
11
inste
only
s
info
univer
otherwise the stock will update continuously if n
Cycle counting
Inventory accuracy: Do inventory
records agree with physical count?
Physical count: Suspend operations and
count all stock keeping units (SKUs)
Cycle count: Systematically sample
some SKUs
Cycle counting:
How frequent? When? Which items?
By whom?
Impact of technology on inventory

management
12
Effect of inventory inaccuracy

Financial statement and tax complications
Increased stock-outs
Reduced customer service level
Increased levels of safety stock
Disruptions during replenishment

Order the wrong items
Order the wrong quantity
Errors magnified in upstream business partners

planning (more bullwhip effect)
13
Achieving the goal of zero inventory?

The dilemma: Keep inventories as low as possible while
providing acceptable customer service
Performance measures
Inventory turnover = Cost of goods sold / Avg. inventory
Days of supply (inventory) = 365 / Inventory turnover
Weeks of supply (inventory) = 52 / Inventory turnover
14
Dells supply chain performance example

Dells FY2005 example
Given: COGS = $40,103M and Inventory = $459M
Inventory turnover = 40,103 / 459 = 87.4 turns per year
Days of supply = 365 / 87.4 = 4.2 days
Dells FY2013 example:

Given: COGS = $44,754M and Inventory = $1,382M
Inventory turnover = 44,754 / 1,382 = 32.4 turns per year
Days of supply = 365 / 32.4 = 11.3 days
Implications?
15
Dells stock prices as a reflection of its

business performance
Worldwide Market Share
Dell
15.0%
16.7%
18.0%
12.7%
10.5%
S&P500
2000 2001 2002 2003 2004
2005
16
Economic order quantity model

EOQ basic assumptions:
Demand for the product is constant and known
Lead time (time from ordering to receipt) is constant and known
Each order is received all at once
No back order is allowed
17
Optimal EOQ
Total annual cost =
Annual
Annual
purchase + ordering +
cost
cost
EOQ attempts to minimize TC:
D
Q
TC = DC + S + H
Q
2
TC
D
C
Q
S
R
L
H
Annual
holding
cost
Total annual cost

Demand
Cost per unit
Order quantity
Setup or ordering cost
Reorder point
Lead time
Annual holding cost
18
Optimal EOQ
Total stocking costs
C
O
S
T
Holding costs
Ordering costs
QOPT
Q
19
Annual
Annual
Annual
+
+
Purchase Cost
Holding Cost
Ordering Cost
Total Annual Cost =
TC = DC +
Q
D
H +
S
2
Q
Total Stocking Cost

# of orders placed in a year
Average inventory
Inventory Level
Q
d
Time
Economic Order Quantity

EOQ =
2DS
H
Reorder Point
R = dL
20
Economic production quantity model

Assumptions:
Similar to EOQ except that each order is received gradually
Mainly for in-house production
Inventory
p = production rate
d = usage
p>d
Q
p
I max
d
pd
Production
& Usage
Usage only
Time
21
Formulas for EPQ model

Q =
2 DS
p-d
I max =
pd
p
Average inventory =
TC = DC +
I max
2
I max
2
H +
D
Q
22
Example EPQ Model
The Dakota Electronics Corporation manufactures a certain component for its computer
products. The annual demand for the component is 10,000 units. The annual inventory
carrying cost is $10 per unit, and the cost of preparing an order and making production
setup for the order is $100. The company operates 250 days per year. The machine used
to manufacture this part has a production rate of 200 units per day and cost is $15 per unit.
a.
b.
c.
d.
e.
Find the EPQ.

How many lots are to be produced per year?
What is the maximum inventory level?
What is the total cost per year?
A supplier offers to sell a similar component for $15.20 per unit with a service charge
of $25 per order. Should the company accept the offer?
Given:
D = 10,000 units per year
H = $10 per unit per year
S = $100 per order
d = 10,000 / 250 = 40 units per day

p = 200 units per day
C = $15 per unit
d = 10,000 / 250 = 40 units per day

C = $15 per unit

S = $100 per order
a. Find the EPQ.
EPQ =
2DS
H
p
p-d
2 ( 10,000 ) ( 100 )
10
b. How many lots are to be produced per year?

No. of lots =
D
Q
10,000
= 20
500
c. What is the maximum inventory level?

I max = Q
pd
p
500
200 40
200
= 400 units
200
200 - 40
= 500 units
d = 10,000 / 250 = 40 units per day

C = $15 per unit

S = $100 per order
d. What is the total cost per year?

I
D
S
TC = DC + max H +
2
Q
400
10,000
= 10,000 (15) +
(10) +
(100) = $154,000 per year
2
500
Inventory
Q = 500
p = 200
I MAX = 400
d = 40
pd
Production
& Usage
Usage only
Time
e. A supplier offers to sell a similar component for $15.20 per unit with a service charge
of $25 per order. Should the company accept the offer?
S = $25 per order
EOQ =
2DS
H
TC = DC +
C = $15.2 per unit

=
2 (10000) (25)
10
= 224 units
Q
D
H +
S
2
Q
= 10000 (15.2) +
224
10000
(10) +
(25) = $154,236 per year
2
224
Inventory
Q = 224
R
Time
Summary
Total cost: To make ($154,000) vs. buy ($154,236)
Other considerations in make vs. buy decisions:
Storage requirement
Make (400) vs. Buy (224)
Use of existing equipment after production is halted
Shadow price = ?
Salvage value = ?
Quality and reliability of suppliers
Strategic implications of outsourcing
EOQ with quantity discount (price break)

model
Assumptions: Same as EOQ except that the product cost is a function of
order quantity.
Solution procedure
Step 1: Start at the lowest unit cost.
Step 2: Compute the EOQ.
Step 3: If the EOQ is not feasible: Choose the next higher unit cost and go
to step 2.
If the EOQ is feasible: Compute the total cost for the feasible EOQ.
Step 4: Compute the total costs for each and every higher price break
points. The optimal order quantity corresponds to the one which
minimizes the total cost.
(Note: The only potential candidates for optimal solution are the feasible
EOQ and its higher price break points.)
28
Example EOQ with Quantity Discount (Price-Break) Model
The annual demand for a product X is 40,000 units. The cost to process an order is $25,
and the annual inventory holding cost rate is 20% of the product cost. Given below the
price schedule for product X, find the optimal Q with the minimum total cost.
Quantity
1 - 1,499
1,500 - 2,499
2,500 - 2,999
3,000+
Unit Cost
$ 2.35
2.30
2.25
2.20
Given:
S = $25 per order
i = 0.2 (or 20%)
D = 40,000 units per year i = 0.2 (or 20%)

S = $25 per order
For C = $ 2.20
EOQ =
Quantity
1 - 1,499
1,500 - 2,499
2,500 - 2,999
3,000+
Unit Cost
$2.35
2.30
2.25
2.20
2DS
iC
2 ( 40,000 ) ( 25 )
= 2,132 units
( 0.2 ) ( 2.20 )
Infeasible EOQ !
2DS
iC
2 ( 40,000 ) ( 25 )
= 2,108 units
( 0.2 ) ( 2.25 )
Infeasible EOQ !
2DS
iC
2 ( 40,000 ) ( 25 )
= 2,085 units
( 0.2 ) ( 2.30 )
Feasible EOQ !
For C = $ 2.25
EOQ =
For C = $ 2.30
EOQ =
D = 40,000 units per year i = 0.2 (or 20%)

S = $25 per order
For C = $ 2.20, infeasible EOQ
Q = 3,000
For C = $ 2.25, infeasible EOQ
Q = 2,500
Quantity
1 - 1,499
1,500 - 2,499
2,500 - 2,999
3,000+
Unit Cost
$2.35
2.30
2.25
2.20
For C = $ 2.30, EOQ = 2,085 (feasible)

Total cost for C = $ 2.30, Q = 2,085
Q
D
TC = DC +
iC +
S
2
Q
TC = 40,000 (2.30) +
Min. total cost = $ 88,993.33 per year

Optimal Q = 3000
2,085
40,000
(0.2)(2.30) +
(25) = $ 92,959.17 per year
2
2,085
Total cost for C = $ 2.25, Q = 2,500

2,500
40,000
TC = 40,000 (2.25) +
(0.2)(2.25) +
(25) = $ 90,962.50 per year
2
2,500
Total cost for C = $ 2.20, Q = 3,000
3,000
40,000
TC = 40,000 (2.20) +
(0.2)(2.20) +
(25) = $ 88,993.33 per year
2
3,000
EOQ with quantity discount model

Cost
@ 2.35
@ 2.30
@ 2.25
@ 2.20
92,959
90,962
88,993
2,085
Optimal
2,108
2,132
1,500
2,500
3,000
Optimal solution found at the feasible EOQ
Cost
Optimal
Optimal solution found at one of the

price break point
Cost
Q
Optimal
Probabilistic demand during lead time
Average Reorder
demand
point
during LT
34
Probabilistic EOQ model

Assumptions: Same as EOQ except that the demand during lead time fluctuates.
Service level
e.g. SL = 98%
Z = 2.05
Order quantity
2DS
H
EOQ =
Reorder point
R= dL + Z
LT demand
Safety Stock
0
SD of demand during lead time
If
2
d1
2
d2
= =
2
dL
2
d1
z
2
d2
+ +
2
dL
35
Example Probabilistic EOQ Model
The annual demand for a product is 15,600 units. The weekly demand is 300 units with a
standard deviation of 90 units. The cost to place an order is $31.20, and the time from
ordering to receipt is four weeks. The annual inventory carrying cost is $0.10 per unit.
Find the reorder point necessary to provide a 98 percent service probability.
Suppose the production manager is asked to reduce the safety stock of this item by 50
percent. If she does so, what will the new service probability be?

d = 300 units per week
w = 90 units per week
S = $31.2 per order

H = $0.1 per unit per year
L = 4 weeks
SL = 98%
D = 15600 units per year

S = $31.2 per order

L = 4 weeks
SL = 98%

R= dL + Z
SL = 98%
Z = 2.05

S = $31.2 per order

L = 4 weeks
SL = 98%

R= dL + Z
4 (90) = 180 units
SL = 98%
Z = 2.05

S = $31.2 per order

L = 4 weeks
SL = 98%

R= dL + Z
R = 300 (4) + 2.05 (180)
4 (90) = 180 units
SL = 98%
Z = 2.05
= 1,200 + 369 = 1,569 units

S = $31.2 per order

L = 4 weeks
SL = 98%

R= dL + Z
R = 300 (4) + 2.05 (180)

= 1200 + 369 = 1569 units
Suppose the production manager is asked to reduce the safety stock of this item by 50
percent. If she does so, what will the new service probability be?
SS = Z
= 369
Reduce safety stock by 50%

Z =
SS
L
185
180
= 1.03
New SS = 369 / 2 = 184.5
185
SL = 84.8% (from the normal distribution table)
Effect of service level on safety stock
Safety
Stock
0.5
Service
Level
Other inventory models

Fixed-time period models
Time interval between orders is a constant
Order quantity is a variable
Single-period models
Newsboy problems (for short life cycle products)
Perishable or seasonal demand products
42

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Inventory Management

Ronald S. Lau, Ph.D.

Managing Short Life

Intended learning outcomes

List the types of inventory and their functions

inventory sometimes in some industry is a capacity

if one slow down the other is affected,

Regulations or customer expectations

Maintain independence of operations

Buffer against uncertainty

Quantity discounts or reduced overall costs

people become more careless, not care about quality

anything more than you need excess

Why avoiding excess inventory?

Excess inventory is the root of all evil (Kiyoshi Suzaki)

Types and examples of inventory costs

Shortage costs [variable cost]

Ordering (or setup) costs [fixed cost]

Continuous review inventory system vs.

i.e. parknshop has 5k SKU

Continuous review system:

Periodic review system:

80% Profit from 20% of the customers

Application of ABC analysis

Higher service level

Med/High service levels

Lower service level

otherwise the stock will update continuously if n

Impact of technology on inventory

Effect of inventory inaccuracy

Disruptions during replenishment

Errors magnified in upstream business partners

Achieving the goal of zero inventory?

Dells supply chain performance example

Dells FY2013 example:

Dells stock prices as a reflection of its

2000 2001 2002 2003 2004

Economic order quantity model

Total annual cost =

EOQ attempts to minimize TC:

Total annual cost

Total stocking costs

Total Annual Cost =

Total Stocking Cost

Economic Order Quantity

Economic production quantity model

Formulas for EPQ model

Example EPQ Model

Find the EPQ.

d = 10,000 / 250 = 40 units per day

d = 10,000 / 250 = 40 units per day

D = 10,000 units per year

b. How many lots are to be produced per year?

c. What is the maximum inventory level?

d = 10,000 / 250 = 40 units per day

D = 10,000 units per year

d. What is the total cost per year?

C = $15.2 per unit

EOQ with quantity discount (price break)

Example EOQ with Quantity Discount (Price-Break) Model

D = 40,000 units per year i = 0.2 (or 20%)

D = 40,000 units per year i = 0.2 (or 20%)

For C = $ 2.25, infeasible EOQ

For C = $ 2.30, EOQ = 2,085 (feasible)