Inventory Management

MBA512E- Production and Operations Management

Dr. Dilay elebi

stanbul Technical University

T MBA512E- Production and Operations Management Inventory Control 1

 Inventory Management

The objective of inventory management is to

strike a balance between inventory
investment and customer service

T MBA512E- Production and Operations Management Inventory Control 2

 Importance of Inventory

One of the most

expensive assets of
many companies
representing as
much as 50% of total
invested capital

T MBA512E- Production and Operations Management Inventory Control 3

 Reasons for Inventory Management

Lags in Supply Chain

Time
Lead Time Issues

Demand
Uncertainty
Supply

Economies Bulk buying

of Scale Storage

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 Importance of Inventory

Inventory
Costs

Customer
Service

Operations managers must balance inventory

investment and customer service
T MBA512E- Production and Operations Management Inventory Control 5
 Functions of Inventory
1. To decouple or separate various parts
of the production process
2. To decouple the firm from fluctuations
in demand and provide a stock of goods
that will provide a selection for
customers
3. To take advantage of quantity discounts
4. To hedge against inflation

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 Types of Inventory

T MBA512E- Production and Operations Management Inventory Control 7

 Types of Inventory
Raw material
Purchased but not processed

Raw materials are inventory items that are

used in the manufacturer's conversion process
to produce components, subassemblies, or
finished products.

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 Types of Inventory

Work-in-process
Undergone some change but not
completed
A function of cycle time for a
product

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 Types of Inventory
Finished goods
The stock of completed products that is ready for a customer
order.

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 Types of Inventory
Maintenance/repair/operating (MRO)
Necessary to keep machinery and processes productive

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 The Material Flow Cycle

Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time

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 Managing Inventory

1. How inventory items can be classified

2. How accurate inventory records can be
maintained

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 ABC Analysis
Divides inventory into three classes
based on annual dollar volume
Class A - high annual dollar volume
Class B - medium annual dollar volume
Class C - low annual dollar volume
Used to establish policies that focus on
the few critical parts and not the many
trivial ones

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 ABC Analysis

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 ABC Analysis
Item Stock Annual
Number Volume (units) Unit Cost
#01036 100 8,5
#01307 1200 0,42
#10286 1000 90
#10500 1000 12,5
#10572 250 0,6
#10867 350 42,86
#11526 500 154
#12572 600 14,17
#12760 1550 17
#14075 2000 0,6
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 ABC Analysis

Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

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 ABC Analysis

Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

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 ABC Analysis
A Items
80
Percent of annual dollar usage

70
60
50
40
30
20 B Items
10 C Items
0 | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percent of inventory items
Figure 12.2

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 ABC Analysis

Other criteria than annual dollar volume

may be used
Anticipated engineering changes
Delivery problems
Quality problems
High unit cost

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 ABC Analysis

Policies employed may include

More emphasis on supplier development
for A items
Tighter physical inventory control for A
items
More care in forecasting A items

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 Measurement of Inventory (1)

Inventory turnover
cost of goods sold

avg. inventory

It tells how many times the inventory can

be used up in a year.
The higher the turnover the more efficient
the inventory.

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 Measurement of Inventory (2)

Weeks of Supply
avg. inventory on hand

avg. weekly usage

It tells how many weeks on average the

inventory can sustain.
The smaller the more efficient.

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 Measurement of Inventory (3)

Relationship between weeks of supply

and inventory turnover:
number of weeks per year
Turnover
weeks of supply

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 Fruit Lovers Problem

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 Inventory Models for Independent Demand

Need to determine when and how much

to order

Basic economic order quantity

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 BASIC EOQ Model
1. Production is instantaneous there is no capacity constraint and the entire
lot is produced simultaneously.
2. Delivery is immediate there is no time lag between production and
availability to satisfy demand.
3. Demand is deterministic there is no uncertainty about the quantity or
timing of demand.
4. Demand is constant over time in fact, it can be represented as a straight
line, so that if annual demand is 365 units this translates into a daily demand
of one unit.
5. A production run incurs a fixed setup cost regardless of the size of the lot or
the status of the factory, the setup cost is constant.
6. Products can be analyzed singly either there is only a single product or
conditions exist that ensure separability of products.

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 Model Assumptions
Demand Orders and Shipments

Inventory Level

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 Inventory Usage Over Time

Usage rate Average

Order quantity inventory
= Q (maximum on hand
Inventory level

inventory
Q
level)
2

Minimum
inventory

0
Time

T MBA512E- Production and Operations Management Inventory Control 29

 Inventory vs Time in EOQ Model
Inventory

Time

T T

T MBA512E- Production and Operations Management Inventory Control 30

 Relevant Costs
Holding Costs - Costs proportional to the quantity of
inventory held. Includes, for example:

Physical Cost of Space (3 %)

Taxes and Insurance (2 %)
Breakage Spoilage and Deterioration (1 %)
Opportunity Cost of alternative investment (18 %)
(Total: 24 %)

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 Relevant Costs (continued)

Ordering (Setup) Cost: The costs of placing

an order and receiving goods or cost to
prepare a machine or process for
manufacturing an order

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 Minimizing Costs

Objective is to minimize total costs

Total cost of
holding and setup
(order)

Minimum
total cost
Annual cost

Holding cost

Setup (or order)

cost
Optimal order Order quantity
quantity (Q*)
T MBA512E- Production and Operations Management Inventory Control 33
 Notation
D demand rate (units per year)
c unit production cost, not counting setup or inventory costs
(dollars per unit)
K fixed or setup cost to place an order (dollars)
h holding cost (dollars per year); if the holding cost is consists
entirely of interest on money tied up in inventory, then h =
ic where i is an annual interest rate.
Decision variable

Q the unknown
size of the order
or lot
T MBA512E- Production and Operations Management Inventory Control 34
 Relationships
Ordering Costs: (Order amount Q)
C(Q) = K + cQ
Holding Cost:
h = ic =(Interest Rate)(Cost of Inv.)
Average Inventory Size?
Under constant demand: Q/2
Time Between Orders:
Rate of consumption
D Q/T D
T = Q/D Q

T MBA512E- Production and Operations Management Inventory Control 35

 Costs
Holding Cost: Q
average inventory
2
hQ
annual holding cost
2
hQ
unit holding cost
2D
K
Ordering Costs: unit ordering cost
Q

Production Cost: unit prod. cost c

Cost Function: hQ KD
TRC cD
2 Q

T MBA512E- Production and Operations Management Inventory Control 36

 Example
Annual demand of widgets is 2,000. The cost of placing an order is 500
TL. Widgets are procured for 50 TL each and are sold for 95 TL each.
Holding cost for the company is estimated to be 25%.

Find the following:

1. Optimal Order Quantity (EOQ)
2. Total cost under the EOQ policy? (relevant and total)
3. Optimal Cycle Time for replenishment under EOQ?

Approaches:
1. Solve for all possible values of Q and pick lowest TC
2. Graph each component and pick the minimum value
3. Solve analytically

T MBA512E- Production and Operations Management Inventory Control 37

 Example
Q* =400
25000
TRC*=5000 TL
TC=105000 TL
20000 T=0.2 years
Total Cost

15000

10000

5000

Holding Cost Ordering Cost Total Cost

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 Minimize Annual Costs

TRC non linear function of Q

Take the derivative ofTRC
KD hQ
TRC Dc
Q 2
dTRC KD h
2

dQ Q 2

EOQ:
KD h 2 KD
2
0 Q*
Q 2 h

T MBA512E- Production and Operations Management Inventory Control 39

 Robust Model

The EOQ model is robust

It works even if all parameters and
assumptions are not met
The total cost curve is relatively flat
in the area of the EOQ

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 Sensitivity Analysis of EOQ

How sensitivite is my inventory policy to ...

Order size (larger or smaller than optimal)?
Demand (higher or lower than expected)?
Order Cycle Time (shorter or longer than
optimal)?

We will take an analytical approach to

quantify the impact

T MBA512E- Production and Operations Management Inventory Control 41

 How sensitive is total cost to order quantity?
KD hQ

TRC (Q ) Q 2
1 Q *
Q
*
*
TRC (Q ) 2 KDh 2Q Q
Holding Ordering
Q Cost Cost TRC Q/Q* TRC/TRC*
20 125 50000 50125 5% 1003%
200 1250 5000 6250 50% 125%
400 2500 2500 5000 100% 100%
600 3750 1666,67 5416,67 150% 108%
2000 12500 500 13000 500% 260%
T MBA512E- Production and Operations Management Inventory Control 42
 How sensitive is total cost to order quantity?
TRC/TRC*
300%

250%

200%
TRC/TRC*

150%

100%

50%

0%

Q/Q*

T MBA512E- Production and Operations Management Inventory Control 43

 How sensitive is TRC to change in actual demand?
D Actual
E
D' Estimated
2 KD ' Q*
Q' E
h Q'

TRC (Q ' )
1 Q *
Q 1 1
* E
*
TRC (Q ) 2Q Q 2 E

T MBA512E- Production and Operations Management Inventory Control 44

 How sensitive is TRC to change in actual demand?

So, for D=2000, if the actual demand was:

D E TRC/TRC*
200 0,1 174%
1000 0,5 106%
1500 0,75 101%
1800 0,9 100%
2000 1 100%
3000 1,5 102%
4000 2 106%
20000 10 174%

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 How sensitive is TRC to T*?

Why do we care?
How do I find the best T that is also
practical?

T MBA512E- Production and Operations Management Inventory Control 46

 Insights from EOQ
There is a direct trade off between order size and
average inventory
Total cost is relatively insensitive to changes in . . .
Q rounding of order quantities
D errors in forecasting
A, r, verrors in cost parameters
Thus, EOQ is widely used despite its highly restrictive
assumptions

EOQ is a good starting point in most inventory

systems

T MBA512E- Production and Operations Management Inventory Control 47

 References
Heizer, J. and Render, B., Operations Management,
9/E, Prentice Hall, 2009, ISBN-10: 0136073662,
Chapter 12
Inventory Management and Production Planning
and Scheduling by E.A. Silver, D.F. Pyke, R.
Peterson
Production & Operations Analysis by S.Nahmias

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