hap.

9 heof'Y
426 In-Process Inventory, Ju
st-In-Time, an d Th eory Of Constraints
C
I kinds of contraints: Therefore,
T
of Constraints

emp h is on on .
427

n to tmprovmg organ izatio nal asperfo

With JIT, it is desirable to have isreliabl e local (nearby) sup pliers . c stra mts is a necesary pre-
policy of quality control at the insource extended to suppliers. They arel'exhe conditio
frequnt batches s close to their
.andcostly TOC explres. consrain ts and how th : t W. h
pected to deliver good materials mall IS de fmed as a nythin orgam.zation's
avotds mvento ry bild ups and Pe goals.pAerfoconstramt that preventc siytstean
use in production as is possible. inThismarket
mits rapid responses to changes sole sources, demand. The result IS usu ally closerr high External rmance relativ. e to its goals. gConstr from achievtng
aints a be t er extern
and large contracts . Since co
suplier econoies that result nin
supplier relations, fewer suppliers, inte rna
l. constrai nts are usually market de d hmttatl. al or
tracts are .larger and for longer time duration, voolumes ofterp:oducts that can be sold, or suppl y Iimi: n the Oavatlab
ns . on the
f raw ma Jal from suppliers. Internal constrai .ility
lower unit cost should be achieved. The clustenng of suppliers nearby short . . nts (boteecks) are usually
ens the logistical chain, with attendant economies.that blend together capacity hmJtatwns of resources (work centers) :.r maagemet operating
JIT uses a vast array of interrelated elements to bring policies that limit the output of a facility (only w 051 sft or 5 days
about improvements (easier, better, faster, and lower cost). Implementation or per week, suspending operations during the June o owmg fixed lot
JIT tends to be eclectic and should be tailored to the specific organizational sizing rules, producing to capacity at all resources, etc .) . '
environment. The means of attainment are of lesser importance than the attain The go! must be known before efforts can be made to reach the stated
ment. JIT appears to be successful because it identifies and solves (or mitigates) go al : The pnary goal of a usines firm is to make money by increasing net
problems associated with variability, which results in reduced inventory levels profit while . stmultaneously mcreasmg return on investment
Re aching this goal will allow a firm to be profitable both now and in the future.
and cash flow.
and faster response times. Each improvement is intended to eliminate or, at
least, reduce the source of variations or non-value-added activities. The major TOC uses three operational measures to guide an organization toward the goal
ity of improvements translate into smaller lot sizes. of making money:
JIT is most efficient when the demand pattern is stable and predictable.
Kanban is not appropriate for a pure job shop or a dedicated production line Thro!:$.&flput
is the quantity of money which the system generates through
-: sales over a specified period of time. It is sales generated less thecedirect less
variable cost of these sales. It is commonly calculated as sales pri con
that processes a single or very few items. Kanban is most appropriate for con
tolling the production of standard components required to feed an assembly
hne. Many production environments do not lend themselves to uniform loading materials cost which when all other costs are fixed, is equivalent to
and_ a pul system. This is particularly true when the demand is unstable, custom tribution marin. If the system produces products that are not sold, it has
engme
s invested n things
nng (engineer-to-order) is required, and product volumes are low and not produced throughput.
Inventory is the quantit y of money that the system h
eqwp.m.ent. This defi
occur mfrequently.
tI intends to sell, including plant, property, and onal eftrutwn 1 :\;
tion of inventory deviates from the traditiead
1

. It tncudes f U as
t as we
sources used for production, such as plant and eqw pmen
THEORY OF CONST RAINT S
excludes the added value of labor and overh
The theory of constraints (TOC) Is a cont mual.
pu rchased materials. by the system t o rum
aU
.
improvement philosophy that ling expensethrou is the quant1ty of needps!ent
. r d 1.0 generating throughput .
focuses on the identification and management of constraints for organizat1.0n,al ghpu t over a spec i od of time. It includes
l entory mto
oney
(global) goal a hi
straints govern he:::\eln most organizations, a small numbr of con costs other than direct. variable costs m
It focuses on conversiOn costs and :C, ;ot inc
lude spent on

relieved, the entire or aniza . onsf perfor mance. If these few constramts can e
erforance can be improved. In a systenoaucus
. th e system; inventory IS. msys
way, TOC attempts t:movehmaterals qutckly inventory purchases.
y . TOC
tem
e lth market dema and smoothly through the va
of he
one invested
resources of a plant . mt
system; and operatm x t fro the traditional fin talweonuuedw
Thr is mone com mg
TOC was devel tyah nd.
Goldratt and is also referred to as opll.
.n the oughput g e pense ts money paid out anc
mized production technolo Y PT),u sync
buffer-rope by some authoY t advo hronous manufacturing, and dsurnss t Perati onal measures are differen Outlays for the
0 evalu ate organiz ationa l per fo rm an e
acq u
n b l
organizations-(1) make moe on cates two generic goals for most bu tbn h o m etim es
the onlY) va fLxed
cost of

a Pocess of ongoing or co now and in the future, and (2) esta hS e material s tend to be the primary ret) nd overhead are coroduct
(and s .
, finished goods. Labor (direct and indi kg percentage of p
nstde

achtevement of these goalsntin costs. Since direct labor costs are a shnn
s Imp . The theory posits that t
cost

can thwartroved,ement
m

or at least impeded, by seve:al

 428 ln,Proc ss Inventory. Just,
ln-Time. end Theory Of Constraint s
Chap,g

(freqaently lcs than I O OJo ) , these as.

429

merhnnized and nutomnted facilities plant. Excesssetupscapacity at nonbottleneck resources

or other activities suc h as pre can. be ued WJthour <.;ot lc1r
.

1ot measured m ter ms of

'umption not unrealistic. Th_roughpul unats produced that are sold.unInilsa additionalamount
of time available at anY resource vent ave ma1ntenanc
arc

produced, but in gro s profit realized from

any as et tha ha not yet been trans.
The can be spent an three way:
1.
general sen e, inventory is consideredplaced n gettm_g products thr ough the uction time th
formed into throughput. Emphasis is prod e Lime spent processing a product
manufacturing process and sold in the least manusl11e possable_. 2 . setup ime-the time spent preparing to proce
3. idle time-t he time not used for setup or
TOC defines net profit as throughput operatmg expense, and re. ss a pro uct '
turn on investmentghput minus operatmg expense davaded by inv;. processing.
tory. .!!,throughput is increased .without a change !.nventory and ope
tn
aging bottleneck resources, time should not be waste
expense, all three oi the'bmo
c m-rneilleasures ( rturn on mvestm setup tame houid ?e mantmazed, whale production time shouldd.beIdle time and
d 10
and cash now) will increase. Inventory turnover IS defmed as throughput produts that provade throughput. Labor and materials should be schedule dedicated to
_ _
divitory, while prodUctivity is throughput divided by operating ex.
pense. Waste as any expense that does not turn inventory into throughpu1.
minimaze adle tame, and setup lime should be driven to zero. A quality conrrol
stage can be added before the bouleneck to ensure that it is not processing parts
'fioweve.:i'dle resource time is not considered waste;Oecause resources shoiila which are already defective. If possible, work should be ofnoaded to nonbot
lfunneeaed units are produced.
be activaeaonly when their output is needed. Resources are considered wasted tleneck resources.
contends that by using its principles the above measures will be

_Idle time can be efficient for nonbottlenecks, but not for bottlenecks.
red'ucLion in process or setup time at a bottleneck can translate direct!
improved simultaneously-throughput will be increased, inventory reduced, iii'ilrease throughput, while time reduo aon a non bottleneck 3iJnply increase
and operating expenses decreased. TOC challenges traditional cost accounting i'dfetime with little or no benefit to throughput. A plant can only produce goods
measures which frequently emphasize the efficiency of individual resources as fast as the slowest resource can process them, so lost time at the bottleneck
(departments) and result in local optimization. Systems theory reveals that the resource results in lost throughput for the entire plant. Since it can never be
sum of local optima does not ensure a global optimum. Thus, increasing pro recovered, an hour lost at a bottleneck is an hour lost for the entire plant
ductivity of individual resources in a plant does not necessarily increase the (irretrievabf loss of throughput). Therefore, productivity_ of a bottle_n:ck can
productivity of the entire plant. TOC strives to optimize the system (the com ?e increased by maintaining a queue of inventory ahead of at to ensure at as never
.. .
on .0r reActi-
plete logistical chain of activities), and its three operationa l measures provade starved for work.
" IOCdafferentiates between activata and uuhzt
a global perspective. . ---r-
vation 'is the act of p rocessang at a resource: while ,,an :s e;g r
z a resource rmust be
r a b t
.is a suse oI atn_-utteb:
s whac c n be Lurn_ed

o '!!t_tho @ TOC equires
s qtTI=
ti'li;d..:.
, ::__.:___
.::...:
Bottle neck and Nonbo ttlene ck
Resou rces
J plants have bottleneck and hctavated but a resource can be activated watho __

trces e utilized an not simp Y avatec.; (no idle rime) the non-
1 a resources are operate _at t - :: : ntory to for in front
s any resource whose capacity isnonbott leneck resources A bottleneck resource
equal to or less than the. demand placed upon
0f
c
at. It may be any department, work , or operation that restricts the flow bottlenecks will cause large_ quntataes e s nve in out put can
of roduct through the production stationsystem. In order to attain maximum uuh of the bottlenecks. Thas_ actavatan of resouresndwhen res
the result mventory.
ults in excessivesystem,
o fr botleneck resources, it is important to process only those materials not get through the bottleneck as wastefuI ah t capa rhe
Since bottleneck resources indicate the thou: eLated bility
of rhe
e through h them. When demand exceed_s capacal re ource
at a\r :C' bt;ck, manageputmethroug ou rces ll by bottleneck

t' to a u::e produc t ion

m must explore different product ml)( alterntera tili
U zation of nonboUleneck res
requirements. Thus, bottleneck resourc ar e masters
: : t: and nonbotl lene ck

tu hp t of the most benefic ial mix of produ cts. Or S

resouce and sub haeed by effec and efficienly using hhe cons rcsources should be Lhear servants. il copaciies of resourc rtiall re

--rJt,s apparent differenfiailon a he w of wor k throuh achana eslydo not

a : o_thertively traaoJO i r:;her
cats why roc attempS- to bal: :caritheousfilores
acti vities to its require e ts.
A nonbottle e
u
the demand placed on .t These resoe as any resource whose capacaty as great. er fihan

our ces. Cac;m py i :crem ent .
han
ted tobalance the capacataes of hreme:ts but usuallY arerlY smc
8

nonbottleneck resource\ apac. y urces have excess capacity. operallllhe . e product mile
plant; it will degrade perfr anceH ill no increase the throughput f thC occur in coinuous inoa nce aities, particula
by mcreasmg the amount of anventorY 1 lt as simply too difficult to bal c P
 430 ,,.p,, ,_,lOry. Jo"lo-Timo. "' Thoory Of c"'"""" p
C ho ' I""

of Coo"'""

431
resources govern then
and demand may change frequently. Since bottleneck batch sotraasnsfer
not to impede the flow throu
and inventory requirements, examining all of the batch from the bottleneck, u be:ent work centers. By having
gh
ottlenecks simultaneo
u :V small la
through the syste more quickly, since severalloatiroce ss batch can be moved
a

optimization and avOid local optimizations t

will help to promote global
.
h ns can overlap a d proc
in suboptim ization of the sstem
usually result _ .
After the bottleneck resources .are identified, resource scheduling can
commence. The simplest environment 1s whee each esource nly processes one
product or part. To illustrate basic resource mteract10n, X Will be used to rep.
resent a bottleneck resource and Y will represent a nonbottleneck resource.
Several basic interactions are as follows:
Resource X feeds resource Y (a bottleneck feeds a nonbottleneck): S nce y
can process at a faster rate than X, it will have idle time. Y should only
be activated when needed to keep up with X.
Resource Y feeds resource X (a nonbottleneck feeds a bottleneck): Y should
only be activated so as to satisfy the requirements of X.
Resource Yl feeds resource Y2 (a nonbottleneck feeds a nonbottleneck):
Both resources should be activated to meet the requirements of market
demand or some other constraint in the system.
Resource XI feeds resource X2 (a bottleneck feeds a bottleneck): The least
constrained bottleneck should be activated to meet the requirements of
the most constrained bottleneck.
Resource X and resource Yfeed assembly (a bottleneck and a nonbottleneck
feed an assembly): Assembly cannot be performed until all of the com
ponents are available, so the rates of the resources should be set to match
that of X.
Process and Transfer Batches
the same order Simultaneously. Thus, a process batch ess
a]ong its route and over time.
may be vanable both
Transfer batches refer to the movement of all
batches. Ra ther than wait for the entire process batch :r of the process
that are completed can be moved to the next downstream worko::ehn
tra nsfer batch can be equal to or less than the process batch. The advmage '0r
sm allr transfer batches than proces b atches is that the total production cycle
i tim e 1s shorter and the amount of In-process inventory is smaller.
T?C overlaps opratins by using unequ al batch sizes for transferring and
processmg. The lead lime IS shorter with variable batch sizes, because smaller
batches move faster through nonbottleneck resources. Material flows quickly
through nonbottleneck resources until it reaches the bottleneck, where work is
scheduled for maximum efficiency (larger process batches). Thereafter, material
nows quickly to finished goods. 11hus, small transfer batches now to and from
the bottleneck, with a large process batch at the bottleneck.
1DC disavows lot sizes determined by the EOQ, because their determi
nation ignores throughput, represents local optimization, and fails to make a
distinction between bottleneck and nonbottleneck resources. The implicit as
sumptions in the EOQ are that it makes no difference whether a resource is a
bottleneck or not, and each resource is independent of other resources that
process the item. Cost-based techniques that ignore throughput and tat. depen
dent resources in an independent manner usually result in global subopurruzauon.
Dependent Events and Statistical Fluctuations

:0 distinguishes between two types of batches or lot sizes. A process batch The achievement _of smooth and oont.muou nwmena of produ in concert with
: depenctsdent events and
m arket demand 1 hmdered by two basiC en being pro
stat1s_ t 1. al fluctuatiOnS. Dependent events e the resu accomplished before a
IS t e quantlty of product processed
at a resource before the resource changes lt of prod ucts
t product; a transfer batch is the quanti of units moved duced m a sequence of steps where onet: cannot the sequence cannot be
_
to produce a differen be
_ from on
at the same t1me
e esource to the next . The transfer
ty
batch need not, and previOus_ step is compleed. IndJVJ ual
. p:rations in routing have been co
frequently should not eq al the
process batch. To maintain synchronous now,
in the
performed until the prevwus opera oon s ecified two or more products requ1re
the transfer batches sh'ould be smal
Pleted. Another type of de9endency oc u s
when
1e
l.
At nonbottlenecks th e IS
setups; at bottlenecks th re
;
.
1dle time w ich can be used fo r mulllP Processing at the same resou rce.
henomenon where processes
have
no . .
Statistical tlu(ut ! ons refer :: :O al environn s, man
e ss
production time by only incurr" idle lime, so 1t is _ more efficient to conserve :
ng a few setup s or a smgle setup. Thus, a proc some degree of vanablhW nI org i are not determmsuc. lu;yui;
batch at a nonbottleneck c
it feeds, since excess capa . e less than the process batch at the botleneck d? not occur exactly as planned and ns, absenteeism, unreh: suvities. pliers,
available more time on setup s . 1 kd ow
d isturbances may stem from b:ea_ . associated with human . the ir ag -p ed ac
nonbottlenecks, pro ce ss b c
equal the transfer batches 11
:: :
e should be toas spendsmall as possible and frequent Y qua lity rejects, and the ti e v an: : e : rces,
C bottlenecks more contin ously, smaller P: Whe n statistical fluctuaoons oo
deedpenatden
a series onf su c ; i ns'resou
cess batches from no nb tt
::
batches. The transfer batch en s can be accumulated mto larger proc
an d get m
&regate effect tends to accumuJ uct flows. Negauve n
ag uctua!io rend ro
from the bottleneck can be smaller than the process eventu ally leading to lu Y P
mP
 432 In-Process Inventory, Just-In-T
ime, and Theory Of C onstraints Ohap.g I reory of constraints
433
1.
accumulate because deendency limits the ability ol positive uctuations to 8.
A transfer batch should not always equal a pro
A process batch may be variable both . cess batch.
offset negative fluctuatiOns. .. . . . th fut along its oute and
These two phenomena negate the posslblht and mdicate All of the onstraints should be ex amined simult over time.
_
ilit r

the ystem. It :Is moreydore. 9.

trying to balance the capacities of each resource I?
. are determmed. aneously when schedules
sirable to balance the flow of work through the facility. S e d pen dent eve
fcih_ty mefficient, anntsd
I

and statistical fluctuations make a capacity balanced Drum-Buffer-Rope Sch edulin g

capacity changes tend to be lumpy; the rational alternative to focus on sy n.
IS

AnY
chromzmg the flow. workable prodctin Ia? must be feasible With regard to ma deman
ca pacity, and matenal hmltatI_ Ons. This means It should not exceedketmarket d
de:
m and, there should be a sufficlen supply of materials available, and It should

I
Capacity Constraint Resources
not exceed the processmg capac1t1es of the resources.
TOC defines a capacrty constrarnt resource (CCR) as any resource which 1f not The drum-buffer-rope (DBR) log1stical system 1s a finite scheduling mech
amsm that balances the flow of the system. The DBR controls the flow of rna-
plant to
properly scheduled is likely to cause the actual flow of product through th;--
aev1ate from the planned product flow. Product flow depends terials through the plant in an attempt to produce products in accordance with
quantity and t1mmg. Bottlenecks control the quantity produce(), but there are m arket demand with a minimum of inventory and operating expense. It requires
non bottleneck resources that can interrupt the timing of the product flow. Since the identification of all the processing, resource, and marketing constraints
there can be multiple bottlenecks, the actual product flow quantity is controlled within the entire system. These constraints drive the planning, scheduling, and
tinuous flow of materials through the plant with a minimum of disruptions.
b t e most severe bottleneck and not necessarily the others. Thus, not all control of all the plant's resources. The desired result is a smooth and con-
bottlenecks are CCRs, and nonbot enecks can e CRs. A nonbottleneck can
lJeaCCR if Its ut1hzat10n close tocapacity and 1t could oecome a bottleneck
IS The essence of DBR scheduling is as follows:
1. Develop a master production schedule (MPS) consistent with the capacity
if it not scheduled carefully. This subtle but significant differentiation dictates
IS

!hat scheduhng commence not from the bottleneck resources but from the
identification of all CCRs. A specific differentiation is as follows: - constraint resources (CCRs). The drum is the master productionsystem. schedule
which establishes the cadence (production rate) for the entire
2. Protect the throughput of the factory fro statist!cal fluctuati
ons thr_ough
Bottleneck N o n bottleneck
the use of time buffers at critical locatwns.theTime buffers strategically
CCR Will constrain actual now in Will constrain timing of actual locate inventory to protect the throughput of entire system and protect
flow but not quantity
both quantity and timing
the due dates promised to customers.
3. ie the producfi?n rate ( drum) for t: e CCRs
(must be considered i n product
(must be considered in product
flow p lan ning)
to each resource by Rsusingto
s chronize all non-CC
now planning)
Non-C CR May constrain actual flow
Will not constrain flow in time-phased l ?gisll_ cal ropes. The :tesm; m at_ the
rials into the systeare
in
g_enerae the timely release of the r tions upstrea ume
now
both quantit y and timing
quantity or timing oper m of CCRs
(not considered in produc
t flow (not considered in product nght time. Ropes esure that operations downstream do not subse
plann ing)
planning) phased to CCR reqUir eme nts and
quently impede product now.
are
A summary of the generic TOC principles is as nt resources.ghAllheCCRs
follows: capacity constproraicesse
1.
d throu l.mThe
are identified
Flow, not capacity, should be balanced. In any plant, there are only a fewthat are to be
or ders potenta
Scheduled, acording to market deman :rermines he PS for th
and the variou s a d th eir capa city r:
3. Constramts deter mine
2. Canstra nts govern

flow through the c;R ction which obelytrunede t'on of

throughput and inventory. soneduled product d
4. An hour lost at a bottle
nonbottleneck utilization. if'h dr um beat, or MPS, is the rate o p:gduement r rna
JS

n ck an hour lost for the entire syste m . . finite

is the tim
5. The marginal value of a ti : . bJe

scheduling of CCRs. Buffern. Th man the timely releas
6 . Resources must be utiliz
e savmg at a non bottleneck resource is neghgl
' CCR. s from any kind of disru ptio e st zeropeof isthe buffer.
ed and not simply activated. lerials into the system; it is tied to th
434 In-Process Inventory.
Just-In-nme. and Theory Of
Constraints
Chap, 9 I iheor'f of Constraints

43')

I
schedule release poml. Tight control over a few
the flow where a det
iled chedule is necess ey shout not a ppear in the fir
In DBR, any point in ary to but th st qu arter of .
_
m the f irst half of the buff er the t1me buff
ppears . er. If a hole
maintain control is called a
schedule release points eliminat
es the need to closet control all other_ Points in a use of the
delay corrected. Exp eri
th
7
ate al shoul
n
en a Jon IS u
d be expedited and
sually required
the

. ts CCRs assembly points, and divergence pomts. Raw matenal l e P<>ints

of schedule release _ pomts
are raw matenat r y b uf fe r size is obtained. before a sat-
isfactor
0the re1 ease of the
elease
the flow. The four categories
re eas
_
The pur po s e o f the rope is to limit
- Detailed schedules may also
:: C ar' be
the requirement s o f the drum materials into the
syste m to
C Rs e always schedule release point
required for divergence points where
_
a maten can be processe mto diffe ren
t p otential of producing too fast . The rop ho f
ons efo e the CCR
.
e uu tzauon of non
have the
t h e rate dictated by the CCR
:: bottleneck

All
resources to
in the system. The timing of the release o raw
enc ) pomts where seral t ms are
products, and for assembly (conver com so e s entory does not

on the expected lea? t i e from the gateway

f uild up
the correct locations and sizes for
other pomts ill the process require nurumal contr
bined into a single item. ol.
Buffer management strives to determine
DBR s h edu h n IS de s _ gn ed to control both lead
g

:
(ent ; : : ; :
s
h s e
t f r
a sed

constraints from the uncertainty associated with nonconstrain resources. Time

at each buffer. Buffers decouple
buffers to ensure the timely arrival of parts .
CCRs are fimtely loaded, wh1le other resources are infinitely loaded,
time and inven ory.
buffers are insurance that protects the drum from disruptions. They consist of
t
_ since they
have excess capacity. DBR sch edu les backward from the CCR and then forward
.

Usually, time buffers are required at least in front of CCRs and at the end of
parts that are plarmed to arrive before they are scheduled to be proc essed. schedule s subsequent resources. The process batch from nonbottleneck re
sources can be smaller than the process batch at the CCR, since there is idle time
the process before shipping to the customer. The CCR buffer ensures the con av ai lab le in nonbottleneck resources which can be consumed by multiple

ing process and transfer batch sizes. Similarly, the transfer batch from the CCR
straint is not starved for work by preventing upstream disruptions from affect setups. Thus, non bottleneck resources are scheduled to serve the CCR by vary
ing the throughput of the constraint and therefore the system. A shipping buffer
protects the customer due dates from disruptions. Assembly buffers ensure thai can be smaller than the process batch to speed the flow through the system and

roc establishes a control mechanism that links constraint resources to

a constraint part does not have to wait on nonconstraint parts before it is reduce inventory requirements. .
processed (assembled).
Nonbottlenecks do not usually have time buffers placed in front of them, market demand and then ties the remaining work centers responsible for pro
achieved
because they have excess capacity and have the ability to catch up if they ducing the desired output to the constraint resources. Synchronization is
or produc
get behind schedule. Note that time buffers are not required before every with DBR scheduling. The drum is the constraint that sets the beat
buffers used to
tion schedule for the rest of the facility. The buffers are time
: :
assembly-only those that are fed by both CCR and non-CCR parts. The time
_
tem. The ropes are the sche s a
protect the throughput of the sys
buffers place inventory at strategic points to ensure the CCR is never halted,
_ the up a h
on

! :
plarmed throughput is achieved, and customer orders are shipped on time . gateway operations to the c onst ramt resource
schedules control
The main purpose of time buffers is to ensure that the internal syn chro straint resource to the on the downstream e
m_ ket
ar of material through the
nized flow of product is not stopped because of statistical fluctuations. Even the release of material mto the system and the
fl
with a carefully developed MPS, deviations will occur due to unforseen events. work centers.
Time buffers at selected locations
prevent these events from disrupting the
PS. The size of the buffer is determined
by the expected size of the disrup VAT Plants
tions of the resources prior to the
buffer. The size of the buffer may be one int resources.
zation's constra
fourth or
ore of the
_
total lead time of the item being manufactured. After the
_
. . . . .
1'he trut1al step in TOC IS to Identi
.
fY tbe or ani
:
ocesses are
continuous (proc
ss
lradi tion al classifications of produ ctl on
drum beat Is set and tune
e;, buffers are established for
critical points, the logis
ucal
In du str ie s and repetitive manufactunng),
Uob sho ps), and special

clas I'f'
ropes . i er mitten t
cesses or plants

oped to
conize the flow from raw material entry.
demand, the time buffer is pl ac ed UJl
. rod ucti on pro

mediately ill front of shi p /:

Proj e ct . TOC breaks with tradition and from

uffers protect against pn ontY b -

h

as either V A ' or T. The plant types defm

pro duct flows
Y constramt IS market
amilY of
. .
_
' provides the gen
. (not
pm . Shippmg
?
material through v an ou s work
d items. It

tb e en

b resources
.
capacity) disru P-tions
individua l resources are
a raw
. centers to
used to add
value to them.

: :: f
Any distur bances m the
.
bed by h
t is
hi pmg b ffer, so
throughput is not affected. If the onlY co
era! relatio nship bet ween parts an
n u i e
: chara cte risti cs that reqUJre
different

is placed in front of it to protect ca t

t t a tune buffer aCl
fe b Each co _
nfiguration has Its o
ues to find the con s ra m An A-plant has
_ ces. single raw
\: : It has a
Time buf r ld be mo utored
to determine if the allotted wn
e
lech mq_ t t res our cess fl
r ent, pro

as oles in the buffer.

appropriate. Orders
arrived are referred to
a e scheduled to be
in a time buffer but have no
b o
\
yet
e s'
': V-plant has a V-shaped:
or di verg

rna tenal (or only a few) and 3 WI de va

rietY of u m q ue end II ms.
Buffers will contain so me
 I

Chap. t'Y
436 rneo
9 437
Of C onstraints of Constraints
Just-In -Time, and Theory
In-Process Inventory,

= ou ra materia
process ow. It ha n ls
an A haped, or convergent, _
smgle end ttem (o 0 lY ) . T Plant has a
with different routings and a
proces s flow. It
_
ha a hmtted numb er of oo ponents or
T-shaped, or diverg ent, _
combined mto numerous combmattOns of end
subassembly parts that can be
assembly sc edule based upon actual cus
items. AT -plant usually has a final
charactenzed as_ V, A, or T, different
v,
tomer orders. Once a plant has been _ time buffers. Typical
and assign
methods are applied to identify constraints
A, and T plants are diagrammed in Figure
9-4.
. .
as a htghly
schedule of activities can
Interd
.

A manufacturing process can be conceptu ahzed ep en

dent chain of activities. Disruptions in the planned
cause a ripple effect which may adversely affect schedules througho ut the
system. Managerial control problems tend to result from (I) the overactivation
of resources, (2) the misallocation of resources, the n of
material. The overactivation of resources occurs when a resource is used to
and (3) misallocatio

perform work for which there is no current demand, as a result of a "keep busy"
philosophy. The misallocation of resources occurs when a resource is diverted

0.
from work necessary to satisfy current customer demand in order to process
which exceed current requirements. Misallocation of material occurs when a
unneeded material. This condition is common when large lot sizes are processed
E
iS:
"'

f-
c.

<
<(
common material can be transformed into two or more different, noninter
>
I
changeable items and material is processed into items with no current demand.
V-plants, characterized by divergence, are particularly susceptible to misallo

by misallocation of resources; andT-plants tend to suffer from misallocati on of

cations of material; A-plants, dominated by convergence, are typically plagued

material at final assembly divergence.

A V-plant contains divergence points where product differentiation take-S

of product structure networks where product divergence is the dom

place: a few raw materials are processed into a large number of end items. It

mant feature. The primary problem for a V-plant is the misallocation of

onsists

material (inventory) at each divergence point where the decision is made to

releae, dtve gence points, and CCRs. At divergence points, the primary con
make one item or another. The schedule release points occur at raw materi al
_
_
cern Is PIor ty and not capacity. Time buffers
are placed only at CCRs and
before shtppmg. The objective is not to convert
parts into end items, but in to
through?ut.The most effective way to improve e
customer service is to reduc e th
fa
points and the absence o
production lead time.
. An A-plant contains convergence (assembly)
smgle co ponent out of many may
prevent productio of the parent item

ev ral dtffeent raw materials are
processed into a few unique end item An s.
: an conststs of product structure
networks where convergence dominates.
T
:: ::
r r a A-plant is the misallocation of resources (ca :r:
release, assembly P01 d
ity e s pomts occur at raw material
before shtppmg. or
and CCR T'tme bufers should be
levels and establish a more unif
-
_ placed before CCRs before assembly, anrn
Ti o reduce inventory
438
ime, and Theory Of Constraints Chap. 9
In-Process Inventory, Just-In-T
I
ints
fheDIY of Constra

should b as small as possible. Th

e
439
material flow, process and transfer batches
constra_mt parts from waiting for
assembly (convergence) time buffer prevents
This ensures the timely co
nonconstraint parts before assembly can occur. n.
version of constraint parts into throughput.
A T-plant has a large number of end items poduced fom a limited num.
ber of common parts, subassemblies, or raw matenals. End 1tems are asse mb led
from a variety of options, many of which are common to other end items.

tional features into different configuratiOns. It IS mfeas1ble to stock end items

L iterally thousands of different end ites can e _ prodced by combining op.

expands at the top and resembles the letter T. This type of plant is found in an
because of the variety of optional combinations. The product flow diagram

assemble-to-order environment where customer lead times are short, procur e-

ment and processing time are long, and demand for individual end items is vir-
tually impossible to forecast. A final assembly schedule is required to assemble
to actual customer orders.
In a T-plant, the assembly points represent an area of divergence in the
product flow which is similar to a V-plant. However, in a T-plant the only diver
gence point is at final assembly, while a V-plant has divergence points through
out the process. The primary problem for aT-plant is the misallocation of material
(inventory) at the final assembly operation. The schedule release points occur
at raw material release, assembly, and CCRs. Time buffers should be placed
before any CCRs, before assembly, and before shipping. Stock buffers may be
placed before assembly. The nonassembly part of the process is a make-to-stock
envronment, while the assembly part of the process is an assemble-to-order
environment . A T-process is frequently at the top of a V- or A-process
.
Contin ual Improvement Is
Yes constraint No

Even wen drum-buffer-rope scheduling still active?

of the
he phl!osoph behind TOC is to
is completed the process is not over.
by mcreasmg throughput and to make ally increas the productivit yThe ob
continu
VlOUS focus for improvement ual improvem ent
FIGURE 9-5 Contin
money now and in the future.

t, as shown in Figure 9- 5, are:

mance. The basic _ in the system is the constraints that limit rfor
pe
steps for continual improvemen
1 . den tfy the most binding
! inually wbile reducing
hat llmlls_ throughp
ut.
constra int in the system. This is the constraint The Im . prove . rease throughp ut cont
ment strategy is to mc

) the constraint. Do everything po ssible to

2. timize (ecide how to exploit
Inventory and operating expense. rket demand, ateri:Us
e constraint-ma ial step is to Jdent.tfy
ut by using IOOOJo of its
A plant will always have som init
_ _ ze ts outp
3. Subordmate all othe
Xlml
_ I caP acit y.
Urnised by suppliers, or production 7:; The
on alleviating them :'
ra . . .
.
t imized constraint. Let t IVltles (deci. Sions) to the operations of t? . ? . re Pnmar y constraints and conce :raans ion . As iffip rove enttS : ce there
4 - E xpand (e Ievate) the
e constraint set the pace for
all othe r acJvltle
lll_IX of co
uced resource waste or resou rc : e terais nver-ending.
t e p rocsyessstemm,ustthebprre
ocess addressed'
nstraints may chang e an
5. When the constraint is ro
.
constr mt . . more of it.
by obtammg
U an w reali t Y that must be
back to step 1 and rep eat the P
alays be at least one const m . Y
tesery tmprovement p roducs b
cedure, so i nertia is avoi
ded

elim ated, go
en i s an d a ne
olved , and changed agarn.
 e, and Theory Of Constraints
440 Jn,Process Inventory, Just-In-Tim Ohap, 9 l Theory of Constraints
441
for continual improvem ent . Alth w
Buffer present another opportunity ough
the content of the buffer is co
differ from the pla ned buffer . If
time buffers have a predetermined length, ntin.
ually changing and the actual buffer can
Pro.
the
that matenals are being
actual buffer is larger than planned, that indicates
If the buff er is
duced earlier than required at preceding operations. always full,

RM =$5
that indicates that it can be reduced. Thus, the ual
c bufer can be expe
. cted
to be less than the planned buffer. Constantly stnvmg to ehmmate disrupions
that cause holes in the buffers is a part of ongoing improvement. Disruption
sources form a priority list for focusing productivity improvement efforts.
Maximizing the throughput per unit (gross profit per unit) of scarce re
source is the foundation of TOC. Throughput through an internal constraint
can be increased by better tooling, larger batch sizes, reduced setup time, over

ceeds the capabilities of a facility, the product mix should be evaluated . The
time, extra shifts, or additional capital investment. When product demand ex

product mix can be analyzed by examining market demand and the ratio of unit
gross profit to constraint resource hours. The most desirable products have the
largest unit contribution per constraint resource hour. At times, it may be ad
vantageous to abandon or reduce production of a given product because limited

FIGURE 9-6 Flow process charts for products Wand X

resources can be better utilized on other products with greater unit contribution
per constraint resource hour.

assembled in center D from two manufacture d parts. There are 2400 minutes of
There are some cumbersome features to TOC. Procedures have to be de
vised to split and join batches as they flow through the system.
The determi
nation of the size of time buffers at CCRs requires some capacity available at each work center per week, setup times are zero, an d oper
experimentation, as ating exp e nses are $6000 per week . What is the constraint resource ? How many
well as constant surveillance. While the inherent

P\ ;
logic is simple to understand, units f eah product should be produced ? What is the net pr ? a
the appropriate actions on the shop floor are
not readily transparent to opera
ives. It appears that the users must have some sophistication and O ; : ! ::
cap actty u t t l i zatJ_ n for each work center ? Where should time b ers

understand
Ing of aggregate operations. Gross
Market Processing Time
TOC is a type of stepwise optimiza Profit
tion that consists in attacking one Potential per Unit (min)
constraint at a time through a never-en
Selling per Unit
per Week
suboptimization and obtain measures of perfor
ding algorithmic process . It uses the sys P rice (col. 2-coi.S)
tems approach to decrease Product per Unit (units)

goal. While the principles ofTOC are suita ble for

w
mance that fulfill the system's

X
an: type of manufacturin $ 90.00 100

UJtable for .mter mitten

g environment, its schedu
ling mechanism is most 100.00 50

: .
ne ) manufactunng.
t Uob shop ) processes
TOC is purported to
or complex repetitive (assembly . .
l'he following table mdtcates the market poten
tial capacity requirem
ents for

!IT.
oc sed
sys em,
Whereas MRP is
be faster, more economical, and mo re
considered a push system and JIT a pull
each work center:
s a squeeze system
based on constraint optimization.

Example3==== Product

cts ( w and X) on
four work centers (A, 8, C, an d D)
A firm produces two produ
as show n in Pigure 9_6

with
and the ta le be
low l'he two products share a corn rnon
Jng m centers 8 and C. Product
W. d .0
manufactured par t tha
tial f 100Pun
t requires ocess . :
a weekly market poten

X, with a weekly mark

its and a selling price of $90, is assemble 11
center D from two manu

fac ur d arts
50 unit s and a selling price o $I 00
and a purchased part that costs $5 . ro d
et P 0 entlal of P us1
f '


442 In-Process Inventory,

Jusl-ln- nme, and Theory Of Constraints
Chap. 9
I fheorv of Constra ints

443

now takes 29 minutes in center B. Th 1 00 units of W would be prodced' and

!0001 29 = 3 4 . 4 8 , or 34 units of X.
Gross Profit ?er Constraint
- fit per eek
Resource Minute ($ /min)
Product Gross Profit per Unit
n et
e result tng net pro w
w
ts
profi t 1 00 (45)
6000
=
= + 34(60)
$45.00 $45.00/ 1 5 == $3.00 <--
60.00 60.00/30 == 2.00 $540.
X

and (2400 - 1 500)/30

:
Thus, 1 00 units of W should be produced
Thus, the net profit increase d from $300 t $
= 30 units of
0?
for he investment s 5 01240 =
20.S wee s. than half a year. This exam -
r week. The paybac period

X. The resulting net profit per week is
_
pie tllustrates t he stgruftcance of expandmg a constramt by obtaining
more of it.
net profit = lhroughput - operating expenses
= 100(45.00) + 30(60.00) - 6000 . 00 Example 5
$300.00. Is it desirable for the firm in Example 3 to schedule overtime at an incremental rate

W_i h e above prod ct mix , the table below indicates that the theoretical capacity
=

of $20 per hour tn order to satisfy all its weekly market potential?

utilizauon of consti3.Jll t resource B is 1000Jo while the others have excess capacity.
l
3000 - 2400 == 600 mmutes of overtime in work center B. This translates into 1 0
To sattsfy all the week y market potential for both products would require
_

hours p e r week or 2 hours p e r d a y overtime in B , which would increase operating

( i nutes)
Process Time Available Capacity Capacity expenses from $6000 to $6200. The resulting net profit per week is
k
Wo r Center Product (minutes) m Utilization (OJo)

A w
net pro fi t = throughput - operating expense
1 00( 1 5) == 1500 = 100(45.00) + 50(60.00) - 6200.00
X 30(1 0) == 300
= $ 1 300.00.
Thus, the addi tional overtime of 10 hours in work center B would increase
2400
w
1 800 75.00

X
the net

900
B 1 00 ( 1 5) == 1500
the additional
30(30) == profit from $300 to $ 1 3 00 . This option is more desirable than
tooling option outline d in Exampl
- e 4, which increase d the net profit from $300 to
2400 2400
c w
100.00
i
$540. This example ll ustrates one of many options that
can be considered in

X
there are always constraints
100(15) == 1 500 expa n ding a constr aint. The proces s is contin ual, since
30( 5) == 1 5 0
- that limit the performa nce of an organiza ion. t
w
2400
ro t per
1 650 68.7 5
The optimum product mix for Examp es
l
X by maximizi n_g the

ined from
3 through 5 can be obta
lhe simplex method of
gros
D 100(1 5) - 1 500
linear programming ). near
unit (the unit selli ng
raw matenal cost
30( 5) == 1 5 0
e
1 650 2400 68.7 5 price minus the unit
follows:
Programming form ulation of Example 3 is as
buffer should be placed beore work
-

45 W + 60X
A ume
center B to protect the output capa-
=:
l 5 W + l OX
bility (quantity) of the co . maximize:
8 are not delayed by the late arrival (tJJIUDg)
straint parts previo usly pr
well as before work center D to ens e <:<'n w: !f 2400 '

. I S W + 30
of other onconst raint Parts. subject to:
? X !f 2400,
simple pie illustrat th .
es um ortance of identifying the constraJ?t, +
subordinat mg all other decisions to constnunt
.

ap otg. the COnstraint , and X !f 2400,

15w + 5
15W 5
opturuzatton .
X !f 2400,

Example 4 w $ 1 00,
Is it d bl for the flllil in
E PIe to .
S5000 t f_ It will reduce the u
X !f 50
.
b
in wor k: center B from 15 minu es

an d J? X ' , \:t C:e ;;::
l'h e r
P urchase additional support tooling for
to ! 4 mmutes for the common .
t W's
fu esultm g o p ti m um product al o bjecti ve
s
is a u
min m anufactured Part us ed o n both W and X?
_
nit processmg lime
. fun ct n v
an

biOract olperatig expenses

I 00

t W in wor k center B it now take5 t h nc t n val ue f $6300

. T h e ?P _t eces saTY t o su t
1 4 minutes. To make all 1 00
insteadof talti.ng 1 5 _
to t

center B ow takes 1 400

ro [Jt , 11 ts n
fr u h p u t . To o btain net
u tes for Produc o
the capaci ty of 2400 minutes
ea om t hro ugh pu t .
ro p

uteS f g
es 1000 mmutes for product X will
444 In-Process Inventory,
Jusl-ln-Time, and Theory
Of Constraints
Chap.
9 I proble ms
445

8. How is lead time regulated h rough in

. ou.tpu t con trol?
P.uti
CONC LUSIO N
t
9. If an individual work center is not obtam

nts parti l compl
eted mater ial that requires fu r. be the reasons?
mg Its outpu t goals,

tO. Lis t a few of t e specifi c goals of just-i n-tim e

what may
In-process inventory represe
(liT)
es a fmtshe d product.
The type of producti on

1 1 . In o der to achteve the stated goals of JlrT, what
ther processing before it becom
the number of levels in th product s
ructure , a n th anufacturing
:
12.
process ,
of m-process mven tory. Smce tt t s a depende nt

actions are recommended?
cycle time dictate the magnitude .
control are denved from the requirements
f a JOb shop "':an s
.
reduce its in-pro cess inve
demand category, its plannin g and
ntory levels, where sh ould
1t concentra te Its mttlal reducti on efforts?

and roc are organiza tional strategi es that 13. Disti n guish between the pull and push executi On systems
products. It exists because production is time consuming and does
for its parent
not occur instantaneously. Both JIT of sh op-floor
ent. control.
result in low in-process inventory investm
JIT has two basic tenets-(!) eliminate waste
(anything that does not add 14. hat effet does a short manufacturing cycle time have on finished goods
15. How does roc attempt to attain global Optimization of a facility?
is sold (if you do not need it mven tory.
value to the product) and (2) produce only what
to reduce defects, in
now, do not make it now). It includes continual efforts
16. Differentiate between a process batch and a transfer batch.
It involves
ventory, space requirements, and labor content in the final product.
17. How do dependent events and statistical fluctuations influence the flow
designing, producing, and distributing products w i th little wasted time, mate
rial, and effort and doing all this at a minimal cost. Obviously the goals of zero

18. What are time buffers, and where should they be located?
of work through a facility?
waste, making only what is sold, and zero inventory are unachievable in the
near term, if indeed ever, but continual movement toward these goals can pro
19. Compare and contrast MRP, JIT, and TOC.
duce significant benefits. It is unlikely that a large percentage of U.S. manu
facturers can completely convert to JIT, it is likely that every manufacturer can

roc is a continual improvement philosophy that strives to improve per

find some part of its operations where JIT concepts are applicable. Problems

I. Determin e critical ratios for the following jobs and

sequence them
formance globally by optimizing the logistical chain of all activities. The pri
on calendar:
mary f?cus is on constraints that limit organizational performance. Con straints accordingly. This is the 12th day on the producti
are firutely loaded to their capacities, while nonconstraints are infinitely loaded Process Time

through the logis ical chains is synchronized, and in-process inve ntory tim e
. Date
to the reqmrements previously established at the constraints. The flow of work
Remaining (days)
Required

Job

? uffers are strtegtclly placed to protect the flow from disrupt ions. Continua
J A 13

c 6
ire 20
tmprovemnt IS attamed by elevating the constraints and reducing the requ B 4

I
15
ments for m-process inventory. 18
D

F
E 14 4

G
Questions 25 12

1. What is the difference between

22 19
y? 30
stocked and queue i n-process inve ntor
2. Use the critical ratiO tech mq ue
H arehouse
the following w
2.
Is t some of the negative consequence s in -proc
s of holding exces
es s . . to schedu le

3. N ame the five time elements e

that make up the manufacturing cyc le um
mventory.
operations:

an
Which of these usuall repr total m :
/ esents the largest fraction of the
4.
ufacturing cycle time Job

; does the priority of an order in fluence its process time and its q eue u A

S. Why is the reduct ion of

? B

6. O f what value are time

c
setup times desi rable?. D

7. H ow does the product stru

cycle charts? E

cture in uence a time cycle char ?
t
F
 313

7 o rder model is concerned with0the p1 an mg

'Jlhe sin glewhich
Item s forecl. f' me
for a sp JC
. .
.
repleni shm ent pportum ty CXa_n8l8d control fJf inVI;nt1,,1
penod and can only be used to J A n 1. tem . .Qrdtrtd
on I one
period. A t !. he end of llh e period, b he ite m is of l it' JMorynodeman

d d unng that
InventorY models ( EOQ, EOI, and EPQ) do n t read !Y apply to the singlefamil
use. The iar
.

TIT I E S order
S I NG LE OR DE R QU AN sit uan ion, since hey assume an item not conu med n one period can be used
in subseq uent periods. Tille single order model 1e t _tem with a limited
usefu l life because of supply or demand llmitabio: _ tton reslts from
eib her bhe item's inheren short life cycle (perishabi lity i: abbrev1ated de-
mand life (cessation of demand).
'J1he single order model is ery well suited to demand that is noncon
. o us, changeabl, and short-hved. It is specifically applicable
tmu_ to the fol
!owmg two_ categones of demand: _( I) demand which exists for an item at
KNOWN DEM A N D , KNOW N L.EAD T I M E
mfrequent mervals and (2) uncertam demand which exists for a short-Jived
item a frequent intervals. "rhe first category is typified by promotional and
K N O W N DEM A N D , VA RIABLE L E A D T I M E fad items ordered by retail stores and by spare parts for maintenance repair.
VARIABLE DEM A N D , KNOW N LEAD T I M E
llhe second category is associated with highly perishable items (fresh fish
Benefit (Marginal) Analysis lilowers) and short-lived, obsolescent items (newspapers, periodicals). Due t
Cost Analysis its common association with the second category, the single order quantity
problem is frequently referred to as the Christmas tree problem or the news
VARIABLE DEM A N D , VARIABLE LEAD T I M E boy problem.
CONCLUSION
Single order items have a demand pa tern wibh a limited sales (or usage)
Questions period. An item is ordered (procured or produced) at the beginning of the pe
Problems riod, and there is no opporuni y for a second order during the period. If the
Cases demand during the period considered is greater than the order size, an opportunityis
Mahematical Abbreviations and Symbo ls profit loss results. If the demand is less than the order size, the overstock might
usu ally disposed of at a toss after the sales period ends. The excess stock(new
Summa ry of Formulas be ( I) discarded beca1use of spoilage (dairy products) or obsolescence
papers), (2) sold at a reduced price (chocolate Easter rabbits), or (3)_ stored until
t e next season iFes), with each of these alterna tives incurn ng an asso-
(snow
Ciated cost.
The single order problem can be class ified accord ing o source, demand,
ans d lead b ime, as shown in Figure 7-ppl1 . yThe source of Vhe s m Je rder :;:c
z
thetfsupp ly or oubside sup ply. Self-su exiss when hea org; ;Izar ion is
e tem i n-ho use, whereas outside supplyleadexts_tts w?en ma m mpsed supply,
of pro
le s_u pply source. W ih self-supply, the assem_Y s . me W i outside
tto i
manu .facur ng , an d . An organ izat ion has
1o lean scheduling,
me also includ es ll'l ra ?fsitana ?td reseJ! fJied .
Braterdcotint.rol over the lead t me . of : mand is criitical .inIfdt eali ng with
a si 11 he determinaion or e J mat J
on h deem he d emand
le order. 1 f U'l e dem and IS _k own.' ntrl, tion , the problem can be so lved_ by
h_ robl i s si mpl fied
foUl"lg
tl t c
o ws so me specified or e mp1 ncal dtser ns W 'th no information concer mng
e h niqu es of decisio n mak: ingy und m : ket ' anal ysis o r market research.
dem an d, it becomes necessar to do
 0 emand ,
31 l(nown
Single Order Quantities

315
Variable Lead Time

. m
a la te
tf the de and is fixed regardless of when th e goods are delivered,
onlY 'delays an activity. This situ ation co uld exist in the constru delivery
bUt Jd tn g ' w he re a delivery delay would only resu lt in a c
ction of a
onstruction delay.
Exam ple 1

rfolk g fund. Local

T N Boys Club plans to sell Christm
as trees for the buildin
ch nts have placed orders for the trees to be deliver
:&
with the e a r li e s t lot on I Decem er.
ed on specified dates, tan
85 1170 chance of the trees arrivmg on tune ts desued?
.
hen should the order be
.
pl ced If
.
The lead ume dtstnbuu _on
1s
given in Thble 7- 1 .

TABLE 7-1

Lead Time (d ays ) Number of OccU! ences

10 10
ll 10
12 15
13 20
14 30
15 10
16 ____2
1 00

To satisfy all demand, the Jargest lead time of 1 6 days would b e selected.
t
ior to 1 December.
: IJlo :
Thus, the trees would be ordered 16 ys

AGUR E 7-1
.

is desired, the lead time must be 14 d Ys n this case, the trees should be order
From Thble 7-2, i t is seen that chance of trees arriving on tU
Single order problem ar;
14 days p ri o r to I December.
KNOWN DEM AND , KNOWN
LEAD TIME
TABLE 7-2

ad time are both known, there lS

Lead Time s L
When the demand and the le
L
. gle order
d and il
. no sm Probability of

emand o rigination . A condi matches th dem ' wbicb

Probability
inventory problem. The quanti Lead Time
ty of goods ordered P(L)

tion of certainty exiSts,

arriv es on the d ay of d
rarely OCCUrs in p racti ce .
with no unusual OCCUrer nces condition to exist, all planning must be perfecl
.10
For this 10
.20
II
or delays. 12
.35
.55
13 .85 +
14 .95
KNOWN DEMAND,
VARIABLE LE 15

Wben the
AD TI M E 1 .00

16
demand IS k nown,
e order 1. s known . With a vaf!
_ the SIZe
able lead e of the smgl
pnor o dmand, maker usually wants to ensure that t he o
. the decision
.

d er W hen self-supply ext. s ts ,

s result of uncertainties
rocesses. A servc .
.
_
here is no idl p
I tune dis
recetv
; :level f PERT analysts 1.8
t he variab le lead
time

uti on be
poucy on the ead

; al ysis. A des1fn::0ct t /operat o s

'o
a high prob ab
ascertain ed
t
hBl
lost sal_ <;b
_ [f S i Scheduling and in the prod u ::
.

, a lead time can be sel te

e roducti on ti me or o
_
ated, orders are plac aniva] Prior to demand I n
tt tn e
ca n be obtamed from a
ility of
w
f o stoc kouts are to b velY
!ef can be foun uc ion i n

tex b
beyon d t he scope of t his secuo
ec d . n b u t it
u
to
maximum ossible t ,
ed Prior lo the
lead t ime . A]teffi3
ooks.
 ......
316
Single Order Quantiti es . , I Va riabl e D
eman d, Known Lead Time
317

TIM E Ql = single order quantity of i units ,

KN OW N LEAD
VARI ABL E D EMA ND,
MJ = dema nd level of j units,
k n o w n , t he single ord
When the demand
''
i s varia ble and
the lead time is
one of asce rtain ing t

h e o d e r s ze . I f the deman

e
Ql - MJ = number o f units overstocked,
prob lem beco mes
inven tory nd IS a a l l a bl e, the prob lem
order s1ze t ha t result s in the
o of dema
prob abilit y distr ibuti M - Q, = size of stockout in units.
is not known but a
makin g under nsk. T e J
can be solved as decisi on
or lowe st expe cted cost IS selec ted .
When o u c o m e s are expressed i n cost o r sacrifice terms, the followl ng
largest expected profit ipS a pply:
makin g under risk is to determi n e the demand relati onsh

Ql MJ
The procedure for decisio n
d value. The proba bility t h a t t he d emand will
strategy with the optimu m expecte F(Q;M) = Q1P for (overprod uction),

F(Q1 M1) = Q1P + (M1 - Q1 ) A Ql < MJ

order quanti ty for a d i s c rete distributi on
M ._.
be less than or equal to the single for (underproduction),

P(M :S Q) = f t
M=Q+
M=O
P (M) = I - P (M) , where
I
P = unit cost.

The matrix i n Table 7-3 depicts the previously established discrete mathe
where
Q = single order quantity in u n i t s ,
matical relati o n s h i p s .
M = demand in units (a r a n d o m v a r i a b l e ) ,
TABLE 7-3
P(M) = probability of a d e m a n d o f M u n i t s ,
Probability: P (M0) P(MJ P(Mn) Expected
M max = maximum demand i n u n i t s .
Strategy Nature:
of Mo Ml Mn Value
State

M,...
T h e probability t h a t t h e demand will exceed the single order q u antity is
Q
F(QoMI ) F(QoMn) E(Qo)
Qo F(QoMol

P (M) = 1 -
F(QIMn) E(QI)
F(Q/)

M=Q+ I
F(QI Mo)

M=O
P(M > Q) = E E P (M ) .
Ql
F(QmMn)
Q
E( ,.)
Qm F(QmMo) F(QmM )
The expected value o f each discrete demand strategy Q ; i s

E(Q;) = P(M )P(Q1 M0) + p (MI ) F( QIM I ) + + P (Mn)F( Q; Mn) Example 2

g the Christmas season.
cost S :: ;/:
n

s trees for sale durin

= E P(M1)P(Q1MJ) -
merch an t es to stock Christma
There is onlywish
A
. Each treecan
$6.00. Ordenng
- expected value o f strategy Q1 , for .a .single orderunso
enou gh time negli
J=o
. costs are ord gible, and ld treesles f:e a;,: :::d
7-4 H o
where F(QIMJ) is the outcome of must . .er tresThinblemultip e
nature Mi. The determination of o u tco mes can
. tbe n:t ood. The mercha nt ason e
follow mg the demand strategy Q l when Y
actual demand is the stat o f dls n bution during the se IS g1ven m

ID
take on two forms depen th merchant order?
el MJ) . Whe n the outcomes are expressed
' on wh ethe r the a m o u n t ordered ( Q,) is les s
or greater than th e deman
profitor benefit terms , the
TAB LE 7-4

F(QI MJ) - QIJ - (M

o low mg rel ations
hips a p p l y :
for Ql :5 M
Demand M Probabi lity P(M)
.10
J - Q1 )A tion)'
F(QtM1) = M; 1 _ (Q 10
k co n di
- M1)l cor Ql > M n) ' .10
1 ( u nderstoc
20 .20
ti
30
n di o
.35
co
where 1 (oversto ck
40 .15
50
A = stocko

J = unit pro 60
ut cost per unit
, ..J.Q
I = l oss fro
fit or benefit 1 .00

. . on , of unuti lize d u nit ,

m d'ts pos ltl
318
Single Order Quantities C h..
1 T "'""'' oomond. Knowo leod Timo
319

PQ + C + A
ex ected value of each strategy IS
A payoff matnx
.
. s developed (Thble 7 - 5 ) with
the profit from each strategy
. .
obtamed by mult ipl i
EC =
[ Q
(M Q)/(M) dM'
yn
_

:
:md state o.r.nat.ure. T e . g
of its outc? me an sum mmg the

products. The fmal seIe P,Q +

.
u rr nce by the values
Its probabilities. of o c

value. The best strategy IS

ction is based on the
strategy Wi th the highe st expected
. to order 50 trees with the expected value o f $ 1 27.50.
EP = (V - f P, ) (Q - M)f(M) dM - P
Q

- C - A
0

TABLE 7-5 f '"'

Q
(M - Q)/(M) dM
Expected

P1 Q +
Probability: 0.10 0.10 0.20 0.35 0.15 0.10
10 20 30 40 50 60 Value
S trategy S tate of Nature: (V - M) -
40 40
=
P1) (Q - [(P1 - V + A)
10 40 40 40 40 $40.00

f (M - Q)/(M) dM] - PQ - C,
20 30 80 80 80 80 80 75.00

Q
X
40 60
30 20 70 1 20 120 120 120 1 05.00 '"'

10 1 10 160 1 60 1 60 125.00
ioo
90
50 0 50 1 00 150 200 1 27 . 50+-
60 - 10 40 1 40 1 90 240 1 22.50 where
A = stockout cost per unit
(a goodwill cost in addition to any lost profit) ,
C ordering cost per order,
Benefit (Marginal) Analysis

M = in units
=

order quantity to determine the lot size with the optimum expected value.
The preceding section outlined an exhaustive tabulation of each prospective demand (a random variable),
f(M) = probability density function of demand,
a tedious process when the num ber of
Although the method is applicable to single order analysis involving discrete
( integer ) units of demand, it can be
M Q size of stockout in units,
Q = single order quanti ty
_ =
alternatives is large. In this section, a simpler optimizin
. The objectiv e is to determi ne the
g relationship is derived in units,
to indi cate the most profitable order quantity
ed at the beginn ing of the period (assum Q - M = amount of excess invent
order size (Q) that should be purchas
maximize the expected profit at the end of the period:
ory in units,

p = unit purchase cost ,

ing no initial inventory) to

expected profit (EP) =

expected revenue (ER) - expected cost (EC);
p1 unit selling price,

Q) = probability of a
=
expected revenue (ER) = expe
cted sales reveue stockout
+ expected salva
P (M > greater than Q) ,
ge reven ue, ty of a demand

[
(prob abili
ER = salvage value per
= P, Q - S: < Q - M )f(M) dM
] V
unit,

M )f(M) dM =
o f excess (salvage) units,

( Q - M)f(M ) dM
r(Q expected num be
r

+ v
t 0 _

J..Q (M
in units.
cko ut quantity
0

P, Q + ( V -
_ Q)/(M) dM = expected sto

Dete
Q
J
0
dM;
=

exp ected cos t {E

P 1 ) ( Q - M)f(M ) distri bution

C)
continuous
profit for a
ining the maximum expected to the order
with respect
ected profit

ex
-
_
Purc hase teq Utre
cost + order cost s taking the derivative of the . exp

stoc kout c o st ,
QUantity
+ pecte d a nd setting it equ al to zero .
320
Si ngle Order Quantities
<>,. , T rioblo oo maod , Koowo '"' Tl m o
321

dEP
= P, + V
_ p1 + (P1 + A - V) P(M > Q) - P :: 0, TABLE 7-7

dQ Level of Deman d, M (Thousands)

Probability P(M)
P ( M > Q) = P (s) = p 1 + A
P - V ML
= 10
_ V MP + M L + A 20 .10
30 .20
= optimum stockout probability, 40 .25
50 .30

ML = p -
where .15
V = marginal loss, Shipping costs are not incurred i f trees are not sold. The historical demand
distributio n is shown in Table 7-7. How many trees should
MP = P1 - P = marginal profit.
be cut in order to
For discrete demand distributions where the optimum probability of a
maximize profit if the demand occurs in lots of 10,000?

P (s) = = O.S S .
A =
ML 2.50
stockout is not exactly attainable, the stock level with the next lower prob ability
of a stockout is selected. This allows the above optimum expression to be used
MP + ML + 2 .00 + 2.50 + 0
for both discrete and continuous demand distributions. Frequently, in single TABLE 7-8
order problems, there will be no stockout cost associated w i t h excess demand.
In this situation, the stockout cost per unit (A) is assumed to b e zero. Level of Demand, M Probability Probability of Demand > M

Example 3
10 .10 .90
20 .20 .70

Using the marginal approach, how many Christmas trees should be ordered from 30 .25 .45+
40 .30 .15
the information given in Example 2? 50 .15 .00

A = 4+J+O = 0 20 From Thble 7-8 the optimum stockout probability is between 0. 70 ad 0.45, so the
P(s) ML I
MP + ML +
smalle r value is selected and 50 trees should bety is between 0.25 and 0.10, so the
smaller value i selected and 30,000 trees should be cut to maximize profits.
From Table 7-6, the optimum stockout probabili
ordere d.
Cost Analysis
TABLE 7-6

. IS
m.
When items are intended for tern al use w 'th no generation
:
of revenue, the

Demand >!!_
Demand M Probability selection o f the single order stze
. based he lowest expected cost. The cost
Probability of
salvage value.
a singl e order for a conti
com po nents are the orde r cost, purchas e c t stockout cost, and
;
10 .10 nuou s
20 .90 The following formula gtves. the expected cos of
.10 d ist ri bution
expected c st = order cost + purchase cost +
30 .20 .80
40 .60
50
60
.35
.15 .25 expected stockout cost

_JQ
. 1 0 +-
ge value,
1 .00
. 00 - expected salva

+ A fQ""<M - Q)f(M) dM
.
EC = C + PQ

ge of shrub trees that are harves ed and old

es
The Evergreen Company ow

and tri mmtng '.he 1e

M) dM.
- JltQ(Q - M)f(
each spring. The company ns
ippin the trees to the retailer 15 aiboleutr.
to be $2.50 per tree. The esti:e: the csts o f cutting -
V( M - Q),
tree ordered by the re = C + PQ + (A
average co o f sh
- Q)f(M) dM
d to the retailer, they are a to tal 1055.
$.50 per tree. The company
However, 1f the trees are receive:'about $5.00g per . f"" (M
+

cut and not sol - V)JQ

322
Single Order Quantities c .... 1 T "'" "' " oomood, Koowo """ nmo
323

79

Probability o f
Standard Normal Distribution
TABL E
where
o r setup cost,
Devi ate z
order cost per order
Deviate Z
al
Standard Norm Standard No rmal

p
C =
Probability of
a Stockout
unit purchase cost,
a Stockout

uni ts ,
single order quant ity in
=

- 3 .00 .999 1 .05

Q
. 1 47
=
0.00 .500 1.10 . 1 36
stockout cost per unit,
0.05 .480 1.15 . 1 25

.440
A =
.460
0.10 1 . 20 .115

.()91
demand in units (a random variable
), 0. 1 5 1 . 25 . 1 06
M =
0.20 . 421 1 . 30
M _ Q = size of stockout in units, 0.25 . 40 1 1 . 35 .088
0.30 382 1 . 40 .081
f(M) probability density function of demand,
.

1 .45

v
=
0.35 363 .073

.060
.

.344 1 . 50 .067
salvage value per unit.
0.40

Determining the minimum expected cost for a continuous distribution r

=
0.45 . 2 36 1 . 55

uires
taking the derivative of the expected cost with respect to the order quantity and
0.50 .308 1 . 60 .055
0.55 .2 91 1 .65 .049

.040
.274 1 . 70 .045
setting it equal to zero:
0.60
.2 1 .75

p - (A -
0.65 58
2
24 1 . 80 .036
0.70
dEC
.

V) P(M > Q) - V 0.75 .227 1 . 85 .032

Q
= 0,

p -
=
.029
d 0 . 80 .212 1 . 90

V
2.00 .023
0.85 . 1 98

A -
.012
P(M > Q) P(s) = optimum stockout probability. 0.90 . 1 84 2.25
V .006
= =
.171 2.50

Observe that if the purchase cost is equal to or greater

0.95 .003
. 1 59 2.75
1 . 00
than the stockout
cost, the desired stockout probability is I. Under
3.00 . 00 1

these conditions, no orders

would be instituted until a known demand
exists. Also, if an item has no salvage
of a stockout is P(s) = PIA.
as its salvage
value, the optimum probability the compressor, as well
The expression 1
.

P(s) is the service level, and P(s) is the stockou t prob cost LS ne-
by the manufactu rer. The mstall auon cost of
- .

the item is no rmall y distrib

value is assumed to be negligible.
: = :
holding
ability. Thus, if the demand for e based if the

and standard deviation a

uted with a known
H o w many compressors sho

, the following expression determines the invested , i s IOOJo

holding c
mean M
single order quantity with
glected? How many com presor b
rchased now if the
st of the mon ey f
e
:
:

year,
lowest expected cost: w h ich is mainly the opportut

+ Za = optimum
.
e single failure occurs at the end o

ures occur at equal mterv and the three failures
Q = M and 8th years,

where Z is the standard

the two failures occur at t e d o f the 4th
singl e orde r size,
d 9th years)?

stocut proba ility of

normal deviate
P(s). Th.ble 7-9 exh
obtained from the normal table for occu r at the end of the 3rd, 6th,
With holdin g costs neg1ec ::;
the cost matrix
can be deve1o
ed cost, the m
d as shown
a er should
tto which pernuts ibits the standard norm al distri bU he lo west expect

;
in lab1e 7 . I I . Since strategy 2 ;
conversio n from ent tim e.
stockout probabilit al
ies to standard norlll
ord er two spare compressors a the pres
devtates.

=p:leS==== TABLE 7-10

Pro ba bili t y
of

store bas
:: No. of Failur
es M
Prc a new central air
i1ures ,

the air condi t:

>
A large department No. o f y

ner 18 esttma
Probabilit

decide bow many spare led at 12 years. The manager

t .
The lifetime of
cooditiorung upiu t.
to Purchase for the ni If e
u t. be pu rchases01.1bil,
.70
st . 30

00 eac . If be
com . 30

the cost will be

$1000 each. lab
compressors now, they s
will :::s:t
.40 05 -

_7 IO &IV the proba bili ty distri bution o f be

purchases them when the)' fa .25 :oo
num ber of failures le .05
of the Part ed
d llnng the ---
life of the air
conditioner, as suPP
324
Single Order Quantiti es

Ex am ple 6
TABLE 7-1 1

Probabilit y: 0.30 0.40

I
0.25 0.05
Expected Cost If the demad . forofan item is normally distributed with a mean of and
Straregy State of Nature: 0 2 3
stand ard devtatwn what _should be the size of the single order if the unit cost
20,
1 00 a

is and the stockout cost ts

p - v
1000 2000 3000 $ 1 050 $ 100 $ 1 000?

100 - 0
0 0

= - O.l,
100 100 1 1 00 2 1 00 450

A - V
I
200 200 200 1 200 250 <- p (s ) =
2
1 000 - 0 -

M + Zo
300 300 300 300 300
3
- Q*

+ 1 . 29(20)
=

An easier method to obtain the same solution is the expected value approach 100 1 26 units.
as follows: = =

p -
--v
A - V
=
100 - 0
P(s) = = --- 0. 1 .
1000 - 0
VARIABLE DEMAND, VARIABLE LEAD TIME
Referring to Thble there are two failures associated with a stockout
probability and one failure with a probability, so two compressors should be
7-10, 0.05
0.30 When both demand and lead time are variable, the problem is more complex.
purchased.
In the case of a holding cost of I OOJo, the manager must correct his matrix Since no product is being used during the lead time, a delay in delivery could
result in lost demand. It is possible to treat demand and lead time as inde
costs according to the time value of money. Consulting a present value table for pendent variables. The demand can be determined independently f the lead
future single payments results in the factors shown in Thble time, as in the variable demand, constant lead time case. The lead time can be
must be made in the future must be multiplied by the respective Atimepayment that
set at its maximum level or at some acceptable s ervice level, as in xample 1 .
7-12.

factor. The cost matrix of Table results. For strategy O, the cost forcorrection
nature I is 7-13 state of 'J1he peculiarities of the problem will dictate what policy t o follow m refere_nce
+ to lead time determina tion. Contractual stipulations can simplify the lead tune
the cost for
and the cost for statestateof ofnature
nature 2 is
+
0.564(1 000) = 564;
0.683 ( 1 000)

=
0.467(1 000) = 1 1 50;

for each strategy are obtained in a

is 3 0 . 7 5 1 ( 1 000)

manner. Since strategy resultsTheincosts

0.5 +
( 1 000) 0.424{1 000) problem when outside supply is utilized.
1739.
Similar the lowest expect ager
should order two spare compressors at the present time. ed cost, the man
2

CONC LUSIO N
TABLE 7-12

The major emphasi s in inventory analysis tends to be on items forof diffic ulty,
. which there
Failure at End of Year Factor a_re repeat 1 eater source
stnce errorsorders. Single order items are frunt ing demand. Seasonal,
in ordering cannot be orrect y d foro single order inventory
religious, and cultura l events have Imposed th e nee
analysi. tory model ; repeat order
Smgle order models are referred toTas static inven or one tim e penod model ap
? d s o s l he static and.
m as dynamic inve
e
l , tor y m del
Phe w hen only a single mventory dec sion is made inamic anticipation ofr tsdem
an
TABLE 7-13
han their dyn coun erp a are

. They are, however, fa ore sensitive

StaIc models have a simpler structur: to forecasung errors, smoe
Strategy PStaroba bility
te Natu: re:
easter
there istonoapply the operatio n. .
to roer r alterorder aor
le inventory analyst. s the;.
of 0.25 0.05
2 3 Expected Cost opportunity
For several
types of actiVItle ins ops, construction , and .sec: ts
b analys t is is likelyoreto
h
i S htpbu i l d mg , space vehicles, an research
1 1 50 1 73 9 $600 .25
oe o te inventory sste m. IJ
) single _order s
567 1 088 266. 1 5
gle order m ve to
300. 00
nt than repeat ord_er aalyractice as its econorruc Sii?'gnJ fice becomes
sis. Sin
ecetvertamuc h more atte nti On ID P
200 624 22 1 .20 .... rmP?
300 300

b etter underst ood and appreciated.

 hap. s
292 Inventory System Cha n g es and li mit atio n s
C
293
ock Determination
ecess St

hen ons r mts. e ist the optimum solution tchniqu s inrease in cofll.
r a co n :tra ints are frequently inac ll ve. A n mact lve con strain requi em nts sho ld be sold or salvaged.
known futuredetermme
plexity.W Fortuc arely, nece ry to inventory . 1f excess1:e level s exist. For other items it is
I S a egat1 ve asset tht
existen e. I n other words, it ca ,
those th at m oct irn
doe not modtfy the ?Ptimum solution by itsconstramts L_fufess is dead
be ignored when s?lvmg t h e. pro blem. . Active must be are inclu ded in storage s pace, depletes workm cap1ta . l, e,hmma
. te weigh t. It uses valuable
s other opportunities, inflates
the optimum solution )' t h elr exlstence' and they
'

) s ts and reduces retur n on mvestmenl, Excess and obsolete items should
te solution to the a eted to disposal . Perio dic review can identify items that n be
d
I t is a s1mp le matter t ':termine if constraints are active or in acti ve . Pirst f stok or items whose quantity should be .reduced. . eed not be carried
determjne
. the order quan I tI s by ignoring the. constraints (assume . , .L!_ all con: e reasons for surplus and obsolete Items are vaned. They may result
r s are inactive). If the order quantities sa.ttsfy the cons ralill h s-2!_u lion
: ; I. If the unconstrained order quanttt1e do not s.at1sfy the constratn. ts, from:
e the optimal solution for one. cotramt at a .t1me (assum : only one 1. a redesign of a product;
constraint is active) and establish its su1ta 1ht If te smgly constramed rder 2 . a change in methods of production;
quantities satisfy all'constrajnts, the solutiOn IS optt.mal. If none of the stny
(
3 . a reduction in demand for a product;
(mor than on con. 4 new technological innovations;
R
constrained order quantities satisfy all the constramts
as s. forecast errors;
straint is active), solve the problem treating multiple constramts as act1ve,
in Example 5 .
The effort required to solve a problem increases rap1dly . . 6. overzealous purchasing practices;
of constraints. w1th t_he number
7. record keeping errors; or
8. the i ntroduction of new prod J L>,

EXCESS STOCK DETERM I NATION Even when thre IS a future demand for an item, its stock level may exce what
.
should be available. he accrued h !din costs for these excessivzatJ qu.anuues for
Many organizations find themsel in a situatio n where invento levels are extended periods of time can be a inanial burden to an orga m On. It may
excessive. The impact of excessivevesinvent ry
ory on the fiscal health of an organ be economically advantageous to . sell salvage a fraction of such stock levels.
ization makes it imperative that reduct ions be made . Often this condition re The benefits from such a transact iOn a the revenue generated from the salvage
in time. Reasonable or not, mater ial mana e a lower level by a given potntst
suits in a mandate to materials managers to achiev sale pl us the savings in holdin.g costs.4 current
The starting point for mventory reduction the is analysis of th vento
effort to achieve the goal with out serio us gers must respo nd with their be comp osition of the inventory. A report ; h wingquantiti quantities of m
Red uctio n of inventory can be accom disru ptio ns in operations. es should be express
outflow (dema nd) of items, (2) limit the plishe d in three ways: ( 1 ) increase t hcee . able for each item should be prepa re he . records or If the recor
avail
I n units and dollars. f t h_e data are not aval !able from
the level of surp lus item s. The outflow inflow (supp ly) of items, and (3) redu are un reliable, a phys cal mventor is necessary. Once m ventory levels ements .
are ascer
effor:s such as mar penetrati on, can be incre ased by aggressive mar ku ng tained , it is necessaryi to c? mpare\hem with current shandouldfuterehrequir jghlighted . A
The tnflo"": can be et adve ng, and spec ial sales promot!O;:d
in several waysrtisi Ite ms with significant v.an an:: f m require ments
. hmited
by dcreas t.ng serv ice . S afety levels can be rdu uld be de:elo
master list of all poten ttal e s i:ms sho orgam. at O h excess invento rY.
l evel s,
qua.h ty of m flows , an shortmain tai ning produ ctionstock
schedules, im prov n g t he
by mcreas lg the hold tng cost lead tim es Lo t si ze levels can be loi wers.ed
e ning T here are only two alte natives for an e stoz ckJ :ntil i t is dema nded . Aa
fract ion It an attem pt to sell the sto k or hold ontothethexc range from
ess, and itl can(perhap
I iocess tnven d ucing setup (orde rin g) cost g
can be lo weredandbyn?red Pnce reduction is us uall n ess ary toesell s. zro!
erICiency, emp htoasylglevels
and . ucing. lead times, im prop':, rnodest discount to a wnte ff at somexcess, m nim al sal e va ue
i the lo: r i t wiU be unul tt ts
control (sched uling) B fo controllin g quahty, and . in put nd . ndent d
lmprovmg
there should be an-o r:ll ; of. the above consi der tions are lm pJe -OUented.ir
ny . Wit h stock retention, the more the
depleted. S ome stoc leve a: excmeedis any foreseea;I e demaind epe
effect on operating proce dun; of I nve ntory p ohcy vanabies to.determ e the Th e perpetual mve inyste frequen t: :::edr qfouar nti t y (EOQ) an
an eco nom
conce rns surpl us 1. tem 5 jbThese
The third m ajor rnand i tems. This system IS d:f ed by
have excessive levels of fastand s10.w-mov mg Iteory
usually include obsoleteway .
to red uce 1vet
24 5-2 58.
Items,"

Tersine and R. A . nToell

ss Invento ry

ms. However, it is also pos leentoo

for :,\ce

Journal of e t Vol. No. 3. '

Operations Managem '
k wels
PP
um,;;;c
e, "O ptim
m ov ng ite
- i ms. Ob solete items for which th ere ar
4 R . J.
4,
 294
'""""" SyOom Choog" '"' U mi ,.lioo, C p 0 i excess
Stock Determinalion
295

an M
reachs a re rder point quant it y,
a reorder point . When the stock position
r:n axJmum mvento y for an item
he axJmum sh ou l is
order for a fixed lot size (Q) is placed. The
d be
bove
or cnsidered for dispos
the safety stock. Any quantJt
al
the lot size plus
considered as excess and reduced through aHntJOn
In the next section, an excess inventory model will ?e devloped for ;
fSituation when q = O
deterministi c perpetual inventory system. The excess model Is predicated on the
following assumptions:

1.There is an ongoing demand for the item. If any portion of the available
stock is salvaged, it must be repurchased at a fut u re date to satis fy an
M-q
ongoing demand.
2. The annual demand rate (R) is known and constant .
3. The current unit cost (P) is known, and no quantity discounts are relevant. Q
4. The ordering cost per order (C) and the annual holding cost fraction (F)
are known and constant during the relevant time period.
5. Stockouts are not permitted .
6. There are no constraints on space or capital.
7. The item is not perishable, and it does not deteriorate as a function or TIME
time. FIGURE 6-2 Excess inventory levels

An Excess Model
where
To e ta lish if there is excess of an item, it is necessar q M - tR excess inventory in units,
the econom ic time supply
y to determi ne the eco = =

nomic llme supply for the item . Any stock above

n is illustra ted in Figure 6- 2 where there are M
sh uld be sold . his Situatio
. t = time supply in years,

q
units of stock available, of which units '
are excess. It is a ssume d that there is t economic time supply in years,
c
=

an ongo1ng demand for the ite m and

an units sol as excess are repurchased ordering cost per order,

at a later date . The net benefIt (cost =

savmgs) resultmg from the sale of excess

is as follows: F = annual holding cost fraction,

+
net benefit salvage revenu e M available stock in units,
p = unit cost or ma
=
holding cost savings
=

rket value of the item,

- repurchase costs - reorde costs,
qPs
,
ps (M - tR )
r vage value of the ite m
salvage reve nue Ps = unit resale or sal

2 =
= _
- P5M - P. Rt,

q) pp
=

lot size in units,

holding cost savi ngs =
2R
-
-
(M _ QqPF
Q
R = annual dem
and in unit s.
2R
l'he resu ltant net bene fiL formula is as follows:
+ -- , + !!. I
(
= _
- MQPF
2
QPFt
+
QPF
)
Pq - =
2R 2

f!!!!_ +
2 PR - Ps R 2 Q
repurchase cos ts f(t) _
2
+
= _ P
M - PRt , CM
Q.
+
-
reorder cos ts = M2PF P, M - PM
CM CR t --zR - 2R
Q = Q - Q'
 296
'"""" S ym Ch'"" ' '"'
Ll ho <oo
m t
Ch,. o I
....,
'""" soo ok D""m '"'"'"

The graph of the previous formula is a arabola, as shown in Fig re 6-3 . 297
rak ing the first derivative of the net e?eflt w_ th r spect to t and settmg it B equ ::::;ample 6
to zero t he economic time supply 1 IS obtamed.
'
- PR - PSR + -2- +
QPF CR ) um
An item i th _
200 u ni ts i inve
ntory and
a unit cost

1 0 per od
+
(
of 100 ts . 11he ot s 1ze 1s 20 0 f $20 has
f'(t) units , the o
Q
= RPFt = 0, _ rder cost is
an ann ual
demand

p - Ps + C!Q of the
h olding cost frac tiOn IS 0 . 2 5 . If the
salvage value er, and the annua
item s be sold as excess? is $ 5 per u J
Q rut, shou ld any
t + Th e available stock repre
PF W. nomic ti me supply is
sents a 2-yea
r sup ply (200/1

p - ps + C/Q
=
00 = 2). The

+
-
eco-
It is interesting to note that when Q equals the economic order q
PF
uantity .
= 1 . 2 years.
(EOQ), the economic time supply reduces to 1* = 20 - 15 + 0.5
-s----'"
20
20(j
and there is a 2-yea
2R +

t + p - Ps Since 1 . 2 years' upply is optimal

t s15 with
=
PF . supply, or 0 uruts (0.8 x 100),
r supp ly available, 0_8 years
R are excess. The 80 of

! ; h I = 1 . 2 ; the resul bed by

units should be sold

c time supply is
a res ultant mventory level of 120
If an item can be sold at full value cPs = P), then the economi _ units. The net benef
it of the disposal is
v g o
the economic order interval (Q */R) and the optimum strategy tant cost saving obtai
is to retai n th : : i 6 ned is $ 1 60.00 as
economic order quantity. Retention of additional
units is justified when the
item cannot be sold at full value. TABLE 6-8

I (years)
f(l)
Time Supply Retained,
Net Benefit

0.00 $ - 200.00
0.25 - 65.63
0.50 37.50
0.55 54.38
0.60 70.00
0.65 84.38
0.70 97.50
0.75 109.38
0.80 120.00
0.85 129.38
0.90 137.50
0.91 1 3 8.97
0.92 140.40
0.93 1 4 1 .77
0.95 144.38
1 . 00 150.00
1 .05 1 54.38
1.10 1 5 7 . 50
1.15 1 59.38
1.19 159.97
160.00 +-

SUP PLy (t)

1 .20
r
1 .2 1 1 59.98
TI M E 1 5 9.38
1 .25
____
FIG URE 6-3 1 57.50
1 . 30

p - p ; C!Q .Q
Net ben efit 154. 38
curve 1 . 35
-------
-
2R
1 50.00

2

I' = + 1 .40

- '/,/ -
144. 38

2(P

=
1 .45
1 3 7 .50
12 = 1 . 50

.

84. 38

R
t , =
1 . 75
0.00
2.00
 It nnt1 Utnll Ilion D IOrmln lion
( ,c,tS$ S l
llll)< s
Cha
p6

69 Minimum
299

Mlnl mum E
TA BL E
ono mlc Snlv age
Vnlu

l l l l<' P, for ,
Vnh11: f', U 11<111
l ( n i l Snl\11!\<'
n11it snlvn 'l'

rhc is : ' l ll'f h mfit o

u l v \f.<' v 11ne is the

! I\ ' n l !1 '\\ 1'\t ,f\f) i lt'l'V,

t'h (
.
]II")
11 n
Ill' d < riwt1 i f n u it t' hh
0
l l l i n h t \ 1 1 1 \ 1 ,','<1 \llH\\k s
t

1
' I

tw s: 1 l : ,,,,! :tl11.'"'' ! I ns ': nine, I 1 .00

r:n1 l ll t s n l v l g d n btW <' t hi
t it<' 11<'1\l ,

:Ill m n t s l<'ll ld bt' 1 t :\ \ 1\<'d . tlms.

11l'

:'..00
:
4.
l ll'
t h e mnnun n\1 <'n"ltl l \
i th 1111 it<'ll' s h o u l d be ttl'ft'l 'd for 11 1 111&
l l v "tgc nl. 11
:.
d\,:tt,s rh I<'W< SI
10

1
4.0

4 . 00
f,". w h
J.S
nnit pri1." J . OO

l l' t l ut l t i m<' s n pp l v i\1 R lht 5 . 00

J.b

\\' I t SIIPl'IY ,q n t l t h c
$.11<'.

6.00 obi
.1.4

.1.0
n t h , ,,nt)lni t i m<'
"''1
7 .00
J.l

!.S
lnf
l'<'ll fit i, , l'hus .

. 00
' fl'.

r !R .
!:_- I - . 00
N
Q.24
l.6

u
1 0.00
l . -1

,,
o.oo
u lo.oo
l l .OO J.O

40.00

1 2 .00

90.00
1 .1 . 00 1.6
1 - L OO 1.4
1 5 . 00 l.l 160.00

0.8
1 &.00 1 .0 250.0(.)
I .00 JoO.OO

1 9 . 00
t' 7
I S.O<.l 0.6 4QO.OO

.!0.00
0.4 tHO.OO

gi' o. whnt nh \&'

lllllllk

".,I::".' II''
0. S I O.OO
inl'rnl llt<'ll n in , lllt!'l<' is l h <' minimnm <'<'l11l<'lllk
.

L i q u i d a t i o n Alternatives

nm't profiw t>l alt ntJth

.
,Lmtpt lllY is often th
rred r,, :1
i nt nn: 'tlugltt . or
l. i rt'H l n t i on w i t h i n t ill'

b u. d in .1 ditf
t h 't'' I. i' rr.utsf

l mn t i o n w h ' IT t h<'rt' i, d<'m \lid. I t ms may

Alfl.'l'lt n t i H' ut>s for th<'

t "" t> red

'rt'nt Jppli

t> Ji,';l,' m't>l

,urn:nt proctm
,'\t io n ,,r fl'Wt,rl-<'d into nnot h<'l .t<'lll. .
Sa,ncd to nsc t h e -, ss if<'lll, . ,,r lll
t'.'\C'S prt1dut nw

II .1 11"' t h
t o fl't n i n
Lead Time lnflu nee
nl
J ,u wm' '- Thl.?
IIIS.

1 n ,,, u n 'Y f' I!,,,,

pli r. Su ppli ' t rkJ
I " t'ul l't)lllJll'li<'

fl't u r n o f Ht'W n;ut us,d urpl uscs :1'

n:f l l fllt'd t <' t h' sup
,, c ss it ems 1n:w be

so,, ,, 9()11 ,, f it 'l\\ \:1111 . t r ,f .-h.tnn '-' I ,

, ,
h d n ing ;J mn l>
.<'
n l t ,' r n n t ivc 1, 1 1 \ \' i ld

3. CI-ll'r . ''f, t h

'

t i i Y yiLd l
' " ':t i l l' , al'<'<' llll'lis
S n k o f cx,,'<'Ss t ' ' <
ck. l-r ,,r s u r p 1\1,, ,tb t>_ I
',1 'til\
s1l t ' n n<>f hr t1rtll .1' ' l l :l I l t h
t y pk

it m s : Din: t 'ni<:' itlll\ld f'

to lus .

' h. !l.t'd
l
' in t h , I tn
'
'U

S hm t bt: 'll '':ll

l il
h
':-.,, . 1'1-<'
300
Inventory System Changes
and limitatio ns
Chap. 6 I problem s
301

k can i m prove ope ra t i n g pc form

grad ed stoc : ances, it is only
U iO.
Th e li q i d t n of
all classes of excess rtems a pa rtial sol ution .
can furth er red uce i
me . nvento ry while
inc reasm g mco
?
Excess inventory is a pr ble m whi ch should
n o t b e ig nored . In t h e
m r best of

10 occu r. H owev.er, reaht.y dtctates t h e establis hment of an ongoing program

all wo rlds, astute and o s e n t managem ent would
not allow excess inventory

to
m on it o r excess mventones, followed by positive management
action when a
condition o f excess i s detected.

Questions

2 . Name three l i m itations w h ic h may render the optimal inventory system

1. What are s o m e signs of an overloaded or inefficient inventory system?

ls acrual
greater !han economic yes yes
3. Describe d i fferent strategies for changing over to a new inventory system .
unacceptable.

time supply (MIR > r;.'

4. What is the net effect of reducing lot sizes due to working capital restrictions?
S. How would a global optimum d i ffer according to whether an inventory

6. H ow are individual lot sizes determined when exchange curves are in use
system i s constrained or uncon st rained ?

7. How might
for aggregate inventory planning?
. .
o p t i mal s o l u t i o n s be determined for constramed mvemory

8. I n inventory problems, what unJts 10 the Lagrange multi-

systems?
. are as si g ned

9.
plier? What do they repr s e n ?
?
H ow are problems invol w g e ua!J. t y const raints solved
1 0 . O nce a const rained so l u t J O n t s fo und , how
w q
is its optimal ity verified ?

Stop 1 1 . W h a t are a c t i v e a n d m
Swp
?
do they enter in m the
.

prob lem of f i n d i n g the optimal solut on

7 if
act ve const ints How
one of
three constrain ts exist ,

1 2. W h at i n fl ow s and o t flows ar ta ken into account when

which ; active ?
deterrninin; the
FIGURE 6-4 Excess stock determination

iJl
invent ory
c o m mo d i t y, che ical , and sal e of excess
net benefit (cost savtng) resulti ng from the
1 3 De fi n e t h e m i n i m u m econom ic salvag e value.
other i n d u stries. B of
arteri n g (an exch ange

4
.

.
veotory nems wn h anoth
er firm ) may b e

1 4 . Stat e s everal l i q u i d atio n altern t s

fe as i b l e .
l ll viab!
Sale t o m p oyees , we
altern au v s . Donat t on

as sale or aucti
to ch ari t able
o n to t h e p u b l i c , are oft en
orga niza tions is an alternative rh IS . H o w
!:
t i m e for an I t
i n uence the magni tude
n
of its e.xcess
may p rovtde surprisi ng d o es t h e lead
tax ben e f i ts .

I 6 De

st oc k ? unctio ns.
o-varia ble f
d s , the costs of I . q u t. d t . on m u st be co
h on e- and tw
F o r all o f these l i q u i dar
ion met ho . n for bot
f. ne a c o n vex funcuo

:
n
si dered ; i t is possible for J J
an ite

Y
have zero o eve
n ega l l v e , sa lv ! and
value

it ems.
Many organ i zati ons ,
focu l s Pro blem s

rre n t l y
on
neglect slow-m oving items the e l l m t n au o n of dead

1 fJ fi rm
onsidering cuchang
i
e
w i t h a n i n ento rY
:s
lt se m co
u nt rint u i t i ve
s lo w- ovtnSdiscard . ms . c
erent tte
3

rded ; any s u g ge s u o n to d de
which are stil l " usefu l ,"
m lgh t n e that
v f five vdiff
IS

ento rY system. Each uem

J

an "asset" often meets d to be dtsca

wit h restst pe ua l in
. an ce.
Whi le t h e d i s p o s i t i on of d ea d a
n
fro m a p e r i odic t o a per
 205
k
Safety Stoc

5 Determ inisti c _models for indeendent demand systems were introduced in

Chapter 3. Th1s chapter deals With the same type of inventory models, except
they are describ ed in probabilist ic terms. If demand and lead time are treated

!
as constants, t hey are called teministic; if they are treated as random
variables, they are called probab1hst1c or stochastic. The models in this chapter
DE MA ND SYSTE MS:
I N D E PE ND EN T
assum e that the average demand remains approximately constant with time and
th at it is possible to state the probability distribution of the demand. In par
ticular, since the lead time is the usual period of concern, attention is focused
PR OBAB I LIS TIC MO
DE LS on the distribution of demand during the lead time. Lead time demand is a
random variable i f at least one of its primary components (demand and/or lead
time) is a random variable. . and econonuc.
Traditional inventory models (economic order quantity
roducti on quantity) take no account of risk and uncertainty in their formu
SAFETY STOCK
fation. Some of their common assumptions (limitations) are as follows:
STATISTIC AL CONSIDE RATIONS
Normal Distribution 1. The demand is known, uniform, and continuous.
2.
Poisson Distribution The production rate is known, uniform, and continuous.
3. The lead time is known and constant.
Negative Exponential Distribution
4. The order/se tup cost is known and constant.
.
KNOWN STOCKOUT COSTS

S. The holding cost is known, constant , and linear.

Constant Demand and Constant Lead Time
6. There are no resourc e limitatio ns (dollar
Variable Demand and Constant Lead Time .
Backorder Case: Stockout Cost per Unit limits or space hmlts).
7. Stockouts are usually
Backorder Case: Stockout Cost per Outage not permitt ed (infinit e stockou t cost).
8 . The cost of the invento ry analysi s is negligi
Lost Sales Case: Stockout Cost per Unit ble.
Lost Sales Case: Stockout Cost per Outage
Inventor y of independnt dem:d "terns can ted to be used durin a
Constant Demand and Variable Lead Time be divided into working
Variable Demand and Variable Lead Time stock and safety stock . Workmg sto s hat is expec
_ nt of H .
SERVICE LEVELS - alf the order q uanll_ty
g1ven time period. The averag wor in g stock is oneulah or some var1a
Service per Order Cycle EOQ form
Service per Units Deman ded
rm
(lot size), which may b: det m ed b

'fh working stock vanes With the s : root of annual usage. Safety stock ,
unhke working stock, does not usuaty de:'because
Imputed Service Level Stockout Costs not held be
end on lot sizes. It 1s!s held
FIXED ORDE R IN TERV it might. I because
AL SYSTEMS cause an organizat ion expects to use it .bu. more
an organization believes in the long r; 1 directly rom fore
e efficient (it will gene rate c

CO NCWSION
Questions e
renue or reduce costs). Safety st ; e7 k protect ined er t
Smce forecasts are seldom exact, t e safe
Problems ty stoc s aga mst high
Cases expected demand levels.
Mathematical Abbrevi ations
Summary of Formulas and SYm bols
A P PEN DIX A: PR
UTI O N C O N VO LUT I ONS
OBAB ILIT
DISTRIB
A P PE N DIX B : NO
APPEN DIX C: CHI Q
RM AL DIS
RlBU TI ON
SAF ETY STOCK

ation are
sis throgh m ::abl
es but
buffer
-S UA RE Ri. sk and uncertaint y ente t e I nventory adnaly
OOD N ES
the most prevalent are var1atwn: in de
APPE N DIX D: ORD S-OF-FIT TEST lead me. S
E R QUANG man and u stocks or
RE O RDE R POINT
absorbed by provision for sa fe Y sto
as
DEP END EN
CE UTy A ND cks , also referred to
 inde pe ndent C hap,
2.06 ! Safety Stoc
Probabilistic Mod els
Demand System s:

207
k

fluctuation stocks. Safety stcks are rbati ons of nature or the env iro shIon
extra inventory kept on hand as a CU
against stockouts due to n : pertu during the replenishm ent l ead ti me in nt
nrn
They are needed to coer t e d and e
actual deman excee s exiected demand, on a firm's cost it dec eeds e
actual lead time
tY s ock has two .effects
or exc
expected lead t1me . sa1e : reases th

IS
.
fi!Xed order
cost of stockouts, and it increases holdmg costs em! , there . a .
IS eac hed. Safety stoc
Under the fixed order size system (Q-sys
k is
needed to protect against a stockout after th.e reor er pomt IS reached and prior
quantity that is ordered every time the reorder pomt .
could occur is
known as the lead time. The fixed order quantity Q and the reorder point B
to receipt of an order. This time period dunng wh1ch a stockout

completely define the fixed order size system. Safety stock is an important con.
stituent of the reorder point. In fixed order size systems , the reorder point B is
composed of the mean lead time demand M plus the safety stock S.
In an ideal inventory system, as shown in Figure 5 - 1 , the average demand
pattern always prevails with no variance. In actual inventory systems , as shown Lead / Lead
lime Stockout lime lime
'-------v---'

in Figure 5-2, the pattern of demand over time will be discrete and i Fregular,
Figure 5-2 shows three cycles of an inventory system. I n the first cycle, the 1'JME -)

ond cycle, the demand during the lead time is less than expected and sec
demand during the lead time is so great that it results in a stockout. In the FIGURE 52 Realistic inventory model

replenishment is received before the safety stock is reached , the

than expected, but the safety stock
he dend during the lead time is greater . In the third cycle, Safety stocks are needed because forecasts or estimations are less than
ts sufftcient to absorb the demand. perfect and suppliers sometimes fail to deliver goods on time. There should be
some protection against these two unfavorable contingencies:
1. a higher rate of use than was forecast, t
2. a late delivery of goods.
j
sto ck . Each additiona mcrease in safety stoc provides Imimshing (ecreas
Either or both o f these situations can lead to a stockout in the absence of safety

Q+S
ingfbenefi t . The first unit of stock in excess of expected dem d proIdes the
largest increment of protection against stockout; the second umt provide l s
the first unit; and so on. As the size of the safety stock
:s I-
st:e:e t
Protectio n
ed , t l ethan .
! p robability ofa a tockout decreases At some s<!.fety
.cost of hold ing addition l units plus the expec.t:d stot ini
Reorder
;d result from
poinl
Q1u rn. Th is level is the optimum level, and additiOnal
I
movi ng in either direct ion.
I customer's reaction to a stockout (shorae b
) 0 dition can result in a
Safely
backThe
- - - - - - srock
rd er or a lost sale. With a bakrdr, the ost ut only
delayed
: ncy pediting order t o
!et . the item, or the customer will be serielfi.d frcoststhehand
-
i n dehvery. 'JY e
pically, a company wtll mstitute a om to
- - -
- - - - -
I next order of i tems
Order
rnve . T he backorder can result in. exped t ; t sale li ng costs, and fre'
e s
received
TI M E _,
uentJy extra custom r
placed

i los , t he
and packagmg costs: th b a co mpetitor. The stock!
Lot

FIG UR
E S-1
Crnst and for th&shipping
item is Jost and presum ably ;i: on::..:.-=-
f l e d rhe...:
sal e-
tO some unspec f edi j
I de al inv
entory mo for a lo st sale ranges from the lost pro ---
del
 208
roba bilistic Mod els
Deman d System s: P

safety
Ind ependent

209
Stoc k

. A godWI'Jl loss can result in a customer not return ing 1 e

lo s of good\\:111. future. A stockout can result i nan exy
outlet tO obtrun other ItemS in theal for duction fine. that m ust the. n be shut
hig h cost if it is in a raw maten apro
ffie

company IS so
Hig h

d Often the cost of a stockout for a manufactunng

!:;-one c a be tolerated. It can bevary conside seen t h at_ the stockout ost (w ethergreduate
to a backorder or to a lost sale) can rably for d ifferent Items, de.
pending on customer or internal usage.use c ou nter m easres to
.
In many cases, organizations can prevent , avoid,
or mitigate stockouts. comures ase expedtmg.' emergency_ ship.
ping , special handling, reduling, overtime, an subst1tut10n. The counte
measures have a revention_cost that can be cons1dered a stockout cost (evenr.
though the stockout does not occur).
Just after a shipment (order quantity) is received, the inventory le
high. Just before the next shipment is received, the inventory level is low.veThel is
average inventory level on hand just before the receipt of a replenish ment order
is the safety stock (over many cycles, the inventory level will sometimes be more
than the safety stock and sometimes l ess, but it should average to the safety Low

0.50 1.00
stock). There is no problem in giving good service just after a shipment
for stocks are high and demand can be filled promptly. The only timearrthivere;
is danger of not meeting demand is just before the next shipmen t is received SERVICE LEVEL (Probability of no stockouts)
(during the lead ti_me). Of course, the larger the order quantit y, the fewer
annual orders, which means the fewer the opportunities (lead times) for stocthek
FIGURE 5-3
Safety stock vs. service level

outs to occur.
Safety stock can be considered a fairly permanent inves
On an _ aer.ag, safety stock
determ1mst1c ftxed order size mo
S + Q/2 , where S
Q/2. When safety stock
Thus, the customer service level directly affects safety stock but does not affect
working stock. Usually the investment in working stock is determined before
is always on hand- simila r totmen t in inventory, consid
. In
ering safety stock .
de1s, t h e ave:age Inventory is approxi mated as
. a fixed as set
There is no fixed formula or rigid procedure to follow in determining the

{1.
is h ld, the rol m ate average inventory becom s safety stock. The calculations of different methods available are based on de
is the Y stock aqpupant e and, lead time, and stockout costs. The information known about these vari
Safe ty stocks- ( an d thsafeus the reorder poini tyt)and Q is the order quantity. m s determ
able the complexity of the calculations. The safety stock is simply
the differenceines
--
will be largerJor
higher stockou t cos ts or serv ice Point) between the stock available for the replenishment period (reorder
2. lower hold ing
levels ' and the
Point is definedaverage demand during the replenishment period. The reorder
the stock position at which an order is triggered. In t_he for-
3. larger vari atio
costs as
I m t atio ns developed in this chapter, it is assumed that the order quanti ty ca
ns in ,dem and u n
4. larger vari e det erm by an economic balance of the relevant inventory costs, and th at
ati ons in lead ti m . tI is in depeinedndent of the reorder point.I

The rela tion ship betwee n There are two schools of thought on how to establish safety stocks (d
re order
order size system. The first approach deals WJt
5-3. It sh ows
al ong the horizsafe ty stock or inve tmenstoc k and serv ice level is shown i n Figure k nown stockout for a : fixed
sa f ety p oints)
!fi h: :e
onta l ax is. For s t along the vert ical axis and service level PProach costs explicit costs can be allocated to shorta ent
te curve slop upward
th rog:gle tem, the relat ionship is strai gh t forward: vet base deals with unknown stockout c_osts:ofmanagem P
(tn est_ment) wtlsl alw tcati ng that addit ional safetY stock Ot h of thdeseon some probability distrib utJO_n emand n;ethrema e lead time.
o a.tio of whatay hes i ncr ea h ut,evtnd d and mvesttgated he . inder of
g iv
le : el o f cus to mer service cu rve approaches are outline
u vel e _ . The
re
the
custo me ::ice leve addl.t tonal ex pendi r nve_st_me nt sh ould be. M anageme
v
1 See A ppendix for the procedu res for obtaining optmali ty w h::e=r;'e
l Is raised by largt e l:; ust tfled in a particular cae. AS:ese Fa: : Point
D

. and reorder pomt.

er s ety stock, the investment mcrea are dependent. With depedence, the ex res::ea:cosely approximated by the
Pie r
si so y,utthe exact minimum cost soluuon based on dorder
rn atel pe
quanuty
l i on
methods based on indep endence of the
 al Consi derations
statistic

210
abilistic Mode ls
ste m s: Prob
nt Dem an d Sy
inde pende

reord er po! nt . deter nation . 1 where

the chapter emphstzes assu med indepen dent and dtstnbuted In fu ture lilllt
safety stock and M = lead time dem and in units (a
.

a =
ume are random variable),
demand and lead . nt parameters. standard deviati on of lead
periods with tim e-w vana time demand
_ f(M) = probab ility dens ,

I
ity function of lead t'
J
tme d emand
P(M) = prob ability of a lead time demand of '

Mmax = maxi mum lead time demand in units.

STATIS TICAL CON SID
ER ATIONS M unit s,

When t?e demand

. robabilistic (not determ inistic), rather than. minimizt
It ':ru
rumize the expected cost . If the . demand dist ributioo The probability o f a stock out for a given item is simply
that the dem n d umg the lead time will exceed the reorder point.
;:
os , ts n a . the probability
the d Ifrent costs for eac
ctcd cost is obtained by summing .
:
tscret t
!
When
eighte (multiplied) by their respecti
ve probab ilities and then selea. continu ous dtstnbutwn s are employed, the stockout probability is
expected cost. ! f t e demnd diJ,
te the first
th trategy (demand level) with the lowest definite integral of the probab ility density function of demand during the

in lead
expression Is obtamed time from the reorder point to infinity, or
tri ution is continuous, the minimum expected cost .
taking the derivative of expected cost with respect to the vanable and then '
P(M > B) I""B f(M) dM.
t;: :
settin t r =
.
from one time to the next because of randomness, the expected demand doe
is ed random and stationary. Although the demand diffen
The expected stockout quantity during the lead time is the second defmite
not change. This means the value of demand cannot be predice d , but the eJ integral of the probability density function of demand during the lead time

1\vo of the best-known and most widely used statistics for describing diJ.
pected value of demand over any time interval of fixed length is constant. from the reorder point to infinity, or

tributions are the arithmetic mean and the standard deviation . The arithmetic E(M > B) = I: (J:f(M) dM) dM I:(M - B)f(M) dM.
=

of dispersion of a distribution. The arithmetic mean M for a continuous diJ.

mean is a measure of central tendency, while the standard deviation is a meastm

tribution is For discrete data, the following formulas apply:

M = rMf(M) dM
0
= mean lead time demand, P(M > B) = 1:"" P(M),
M=B+ l
and the standard deviation is the square root of the variance,
= M=B+
E I (M - B)P(M),
u

r? = r(M - M )2f(M) dM = variance of lead time d emand.

E(M > B)
0
where

=
For discrete data, the follo
wing formulas app ly:2
M...,. B reorder point in units,
M = MoMP(M) = mean lead time !(M ) probability density function of deman d during
the lead time,

P(M =
=
demand ,
> B)
E(M
probability of a stockout,
r? E > B)
M o<M - M iP(M) .
=
0
= expected stockout in units during lead time.
= vanance of lead time d eman d, . . rs
in this section
A su mm ary of the relevant statistic al measu es o utlined
tions.
f
con tained distribu
:
in Thble 5 - 1 for both contin.uous an e
stri buli ons have been
I
summ ations and density fu nctio JU f(
1 Por discrete '11h e norm al, Po isson , and negattve . po e unctio ns . The normal
distrib utiom ou n d to be
.
WJth probabilities
P(M).
' replace .
I ntegrals wit h of considerabl e value in descnbmg d eman d f :-:::-:--.--
 Chap, !
212
i l istic Model s
Syste ms: P robab l Consideratio
ns
dent Dema nd s ica
stati t
indepen

a nd 99. 7 3 11Jo occur with in 3 stan

TABLE S-1
.
Stat istical Cons
iderations

Continu ous Discrete otirYonas,na lysis, the stadard deviation provides

dard d 1. n of te m n. In inven
ae:::8 f estlm atmg the safety

Distri butions req uired to provtde a specific degree of protect"
:b:e the average demad.
Distr ibu tions swck
The n o r_ma distribut on can take on an in t mber of symmetncal

b apes ab o ut
Varia ble l
tts mean, but tn all of them demand8 ar
e ally likely
to be above
10MP(M) r belown the
Mm.,.
Mean lead time deman d , mean . The shape in any indivi dual
rMj(M) dM ce IS Jctat by he
M . For low_ levels of average dem
dev iatio . . dard
and the ormal d1stnbut1on IS made-
quate, s m c e I t S s y m et nc aJ t r W O u l d d iCtatethepossil:iiJity Of" negative
0 _ ' ,
ce,
r;, O(M - M)2P(M)
Lead time demand varian
Mmax
_ ce negattve deman
cfem d Is Impossible, other distributions siiC"ilaS
ul
f<M - M)lf(M) dM M
POisson are usea for low levels of de and
- the
----Tile general formula for the norm ) distribution is cumbersome and
0

Probab ility of a stocko ut,

P(M) difficult to us . Fo untely, standardized normal distribution tables have been
Mm.,.

P(M > B) fJ(M) dM E

M-8+ 1 develope which s1mph y use. When demand is normally distributed, the re
order pom t can be obtamed from the following formula:
8

+ S
Expected stockout quantity,
I:(M - B)j(M) dM (M - B)P(M)
Mmu

E M M + Za = reorder point in units,

E(M > B)
B = =
M-B+ I

where
M average lead time demand in units,
S
=

distribution has been found to describe many deman d functions at the factory
level; the Poisson, at the retail level; and the negative exponential, at tQe whole
safety stock in units,

Saie anctrei:aTITeVe l s. Of course, these distributions s hould not be automatically Z

=

applied to any demand situation. Statistical tests should establish the basis for
= standard normal deviate,

standard deviation of lead time demand .

For
any standard distribution assumption concerning a demand function.
a =

Standard distributions should not be employed i n inventory analysis the normal distribution , the standard deviation can be estimated as 1 .25
merely for their computational efficiency. Before any standard d istri bution is times the mean absolute deviation (MAD) of forecast errors. Further elabora
tion on the normal distributi on can be found at the end of this chapter
employed, it should be verified by a goodness-o f- fi t test that t h e distribuion is in
a easonable representation for the demand or lead time. One such test is the Appendix B.
chi-square test of fit. Appendix C at the end of t h i s chapter outlines the chi
square goodness-of-fit test. Poisson Distribution

A fur-
The nor mal distribution is restrictive because of its symmetrical fo .
ther
Normal Distribution
ncl des nega_uve :
utt on IS a very likely .
disadvantage is that the range of the dis triu ton i_
mu us, the most frequently used distribution For items of low dema nd the discrete Poisson dlstnb is de fined by sl I
When demand is treated as con t" .
is the normal (also ca1l ed t he Gauss :;
ian) distribution. The normal d ist ribution date for t he demand distrl bution. The Poisson distril>utionte _ ed by .
0 defined by two parameters, the mean and can be e
is well tabulated and sy use .
the standard deviati _ It is
to
Par a me ter, the mean The mean rate of demand
the relevant hist
_
r c p d the Y
e
reasonably approximat phortan tly, the n ?r mal istributio n tends
the total nu
mber of nits demanded over
of the Ol sson ribution :
!ensigt h of the time interval. The standa rd deviat ion
IS mply the square root o f the mean ( a =
encou ntered tn practice .
measures of central tendency mmet ical bell-shape d curve with t he th;:
The norm al distributio n .
:: .J'X!>
h pect to the mean ;
and mode) equal. 1b t he th r l'he Poisson distribution is not ter than) he e than to the left. For
.
med1 an,
symmetncal WJt
:
ewe to the right.
that these three measures of
a requency distrib ution can ::
tra l te ?dency are the same or nearly ide lo th s re
t e are m ore values to the right of (grea If average
I ason , the Poisson distribution is_sai t? b s . _shable from the normal
With a normal distribution is theProXJmated s normal . A basis for predtcthe d
andard devtation of observations about s d rnand is large ' the Poisson distribu IS g
measures of central tendency ti on m
dtst m tion to the Poisson is
occur within I standard . F. o a norm al distr ibution 6 8 . 27 11Jo of al l eVent usuaibutio n . As a rule of thumb, the
nor mal approXJma
.
lstr
devtahon , 9.5. %
45 occur within 2 standard
lly adequate when the mean is 1 2 or g rea t e.r
deVI"
 ap.
Ch
S
21 4
obab ilistic Models
ystem s: Pr

215
nt Dema nd S
indepe nde out Costs
n Stock

. . is not com m onl Y app licab le to distri butions Wit

Know

d em a nd
.
The P01sson di. st nbuU ra te m u! tiplied Y the lead time. Since there i s e f ct knowl ::
mean, the greate r the degree f
- are co m monly described by thu
ow moving items edge of de
mea n values abov e 20. Only
ul h e aller the 'mand an d
le d ttme, he mvento ry reaches the zero leve h n
. of
perfect know 1ed e . s sua ly
i
the reple ms hmen t
distributi? n. As g ne ;
h re instance whe re _dema n_d is. sporadic, di. der is recetved.
Thts assumption
r . The Pots o n d tst n but on can bt
s
t i n certai n cases,

skewness m the dt st t b r some products may exhibit h tgh t u l unrealistic.
c larly symm et ical good ftt for small, mfre degree of reglanty
I ons occur. It is
conu_ nuou s, and no P d'ti a quent
:ich per mits the deterministic treatme nt as outlin d _ n Cha : d Jt . n
very helpful when the.se con
rate is fairl y cons tant .
. ven torY mo dels frequently assume constan.t deman and
i ;
iO al
demand where the dem and
Dist ribu tion varia ble D e m and and Constant Lead Time
Negative Exp onen tial
ha been . found t de_scri?e d mad for The assu mpti ? n . o f onstant _lead. time is frequently realistic for many items.
The negati ve expon ential distrib ution When t_h_e :artatlo m lead ttme ts small in relation to the average lead time,
retail and wholes ale situati ons. Thts contm u us dtstnb u tJOn IS a smg)e.
some
defined by tts mean . . The standard d. probabth sttc lead times can be closely approximated by a constant lead time.
arameter distribution, being completely
is the same as tts mean (a = M). Also, contractual stipulations can render the lead time nearly certain. When the
tion of the negative exponential distribu tion tions have been supply is from an i n ternal source (one department or division supplying items
The normal, Poisson, and negative exponen tial distribu
for anot her departme n t or division of the same organization), the lead time is
controllable. Figure 5-4 exemplifies the variable demand, constant lead time
problems. Statistical
reduced to tables, which simplify the solution to inventory
tables are introduced later in the chapter.
situat ion.
I f an historical distribution of demand is available, the safety stock can
KNOWN STOCKOUT COSTS be determined by selecting a safety stock level that results in the lowest expected
cost. It is easy to determine the safety stock using this method. The objective
Stockout cost is usually the most difficult inventory cost to ascertain . Stockout
cost may be due to backorders or lost sales, and it may be expressed on a per Q+S
unit basis, a per outage basis, or some other basis. The diversity o f ways of stat
ing stockout cost adds to the difficulty, which is compounded by uncertainty

tion develops solution techniques for establishing the reorder point and safety
about the effect of dissatisfied customers' actions on future dema n d . This sec

stock when stockout costs are known (stockout costs include backorder cost per
>
unit, backorder cost per outage, lost sales cost per unit, a n d lost sales cost per
f-
8
outage) and the demand and lead time may be constant or variable.
When d ma d and lead time are variable, it is necessary t o describe the ,- - - -
relevant vanat _ on 10 some numerical
fashion such as a frequency distribution.

J \ J

Unes dy? amtc factors are known to exist
(trends seasonal s and cyclics), the
0
varau n ts assumed satic and due to random
b Ut .tOn IS USe d tO descnbe dem a d
'
' 11 ts assu med that trends, seasonals , or eyeJ"tC
or chance causs. When a distri 1-----

Pt M>B l
--r--,,-
effects are not present 0 lh \I
; : te:
e
tam only random vartattons. Dynamtc van
niques. The distribution ho c een removed by st n ard statisti al
w
l t ons which are due to nonrando
-W L-
m causes can be treated by adaptive forecasttnS
techniqu es.
l'IME
5-4
; L cons.mnt td i:;
Constant Dem and an nd and constant
lead time
d Constant Lead Variab le dema

tf 8 po n Q
Time FIGURE

certamty and there is no nee const nt, t nventory decisions are ma d e u nd expece: l e
lf de_m and and lead time
reorder i t ;
safety stock ; 8 -. me
are . order qua ntity

=

1::,11num lead
=

8 - J
=

d for saf sto

10
S

minimu m lead u demnl

=

Y ck. The reorder point is eq ual t

time demand ; P(M > 8) probn blhty of
hl S = =
= tocl..o ut.
+3
=
 ap. s
Ch
n Stock
out Costs
f(now
System s: Probab ilistic Model s
Indepe ndent Demand
=
216
average annual dem
the safety stock n d t he c
R
o
and in units
,
. . .
m1rumue the sum of the
cost of holding . Q= lot size or order qua

::
ntity in u nits,
111creases, the h o l drn g cost
=
is
of the safety stock
10
. s in.
of the stockou ts. As h lead time dem and

= average lead time demand

t stock decreases , the st in units (a ran
decrease. As the safety oc k. dom variable),
crease but the stockout M
occurs o nJy during the lead time. There are RIQ
.
ldrng costs decrease .
out costs increase but the ho in units ,
The dange r of a stocko ut j(M) =
probabili ty density fun
ction of lead

time demand.
lead times per year.
Frequently, the de and distribution
is expressed on a time b asis that BY taking .

the d e vative o f t e expected
annual cost of safety
stock with respect
ord e r p o mt a n
U:\ ;
e
to th re d settmg

s ecifies the dem an d duri ng the ! a d tim e. The

U der these conditions , it is necessary to modi 1t equal to zero, the
different from th lea following optimizing
tionship results : 3
rela

.
the d mand dJs u ti o

> B) = P (s) =
the demand to allow for varying-length tt m e perio ds
f
;:=J % ;;;
vo o obability distribution convolutions are descri bed at tbe
P(M HQ =
.
opttmum probability
of a stockout.
AR
end of this chapter i n Appendix A .
Th e above formu la can be applied to
both discrete and continu
ous
probability distribu tio n s of lead time demand. Knowing

which has the minimum

Backorder Case: Stockout Cost per Unit the probability distri
bution permi t s the determi nation of the value of B
of the order if stock is not available. The expected safety s t o c k IS
. defined as
With backorders, there is no loss of sales, since the customer awaits the arrival expected annual c o s t . When discrete
distributi ons are employed, the exact
opti
mum stockout probabili ty is frequently
unattainable because of the discrete

r(B - M)f(M) dM the next lower attainable stockout probability is selected . A simple example
nature of t h e data. When the optimum stockout probability

will
cannot be attained,
S =
0
illustrate the procedure.

= Brf(M) dM - rMf(M) dM B - M.
Example 1
=
0 0

The expected number of backorders per

lead time is
What is the optimal reorder point for the inventory problem specified below and
E(M > B) r (M - B)f(M) dM. in Table 5-2?
= 1 800 units/year,
=

C = $30.00
8
R
The appropriate mathem atical
notatio n for a contin uous distribut
I
F = 1 5 1llo ,
when the stockout cost ion per order,
is on a per unit basis
is as folJow s:

p = $2.00/unit,
expected annu al safety
stock cost = holdi ng
cost + stock out cost ,

TC, = SH + ARJ""(M - B)f(M) dM A = $ 1 .00

per unit backordered.
Q 8
r em , it is necessary to determine the economic order
To sol ve the above p ob l

Q J (M -
quantity and then the optimum probability of a stockout.
H(B - M) +
AR
dM B)j(M}
600 units,
= ""

+
8
2(30) 1800
M)
=

H(B AR E(M B ) > 2(0. 1 5 )

Q '
= _

where
= HQ
8 =
P(s) : : 0.10.
M+ S
' See n PI'!"
rarions Researrh in Productio
AR 1 ( 1 800)

L.
Sc dufin , A. J ohnson and of Lhe d cmoon.
reo rde r
poi nt i n units
=

g and lnvenrory Conrrol,

,
D . C. Montgomery, Op;-62
= hol ding desila ble r
S safety sto ck
in Un its ,
=

1974,!
for the mechanics
Wiley,

A = backorde
.
H If >'l)'S m<:ur
cost per un
it o f inventor
y per year' back. > I, i t indicates the cost of a stocko o smalJ that it is al

ring cost
per u nit
,
 han.,
lndependanl Doma
nd Systems: Pr
obabi l istic Model e
O
218 Coeta
. the last lumn in 1'd blc 5-2 for P(s)lc (0.0 . 150,) , the
n Stockout
K now
compu ted val ue 219

woth Q 600 u n 1 tH and

=
t h e reorder oint i
.oy con&u llong c Selecting he smaller va

B + S
b n 5 e size
I

would wh ere
8
=

M
system funcuon
S =
: T fi: =
reo rder point in unit.
=

TABLE 5-2
56 units. safet y stock in units,
H holding or carryi ng cost per unit per
G
=

Probabilit y of year,
P ( M > B)
backorder ing cost per outage,
P(M)
SlOcko u t ,
Demand M
Lead Time
=

R average ann ual demand in units

Probab ility
Q = lot size or order quant ity
=

48 0.02 0.98 in uni ;s,

0.03 0.95 M avera ge lead time dema nd
f(M) = proba bility densit y functi on
49
0.06 0. 8 9
=
in units,
0.62
50
O.D7 0.82
of lead time demand.
ff the deri.vatve of the expected annual cost of safety stock
51

with respect to the

52 0.20

ip i.s obtained:
53 0.24 0.38
0.20 0. 1 8 reorder pomt JS taken and set equal to zero, the following relationsh
0.06
54
56 I
55 O.D7 0. 1 1

57
58
O.DJ
0.02
0.05 -
0.02
0.00
/(B) = ; .
The above oplimum relationship is developed for a continuous
tion, but frequently only integer values of inventory are possible. distribu
1 . 00

===== 1 1 optimum reorder point lies between two integer values, the integerWhen the
with the
For the standard normal distribution the optimum reorder point is not
larger f(B) is selected.
Backorder Case: Stockout Cost per Outage

The formulatio ns previously developed for the backorder case determine the I of scale when
obtained from the above formula, since the ordinate f(B) undergoes a change
safety stock when the stockout cost is on a per unit basis. The stockout cost may !(B) 0 . 0 5 , theit standard
is transformed to the standard normal distribution . Thus, if
also be on an outage basis. A stockout cost per outage is a fixed amount and 'T'he standard normal deviate =

Z for the optimum stockout probability can be ob

normal distribution has an ordinate of/(Z) = 0.05o .
can occur at most once during a replenis hment cycle. Since a stockouL occasion tained directly from the standard
can occur only once per lead time period, the stocko ut cost independent of normal table if af(B) is known (see Table 5-3).
the demand follows a normal distribution, the optimizing safety stock
would
t he magni. tude or duration of the stockout . One possib is I f
:0g.oh:e countrvailing actio nces.sary to avert thereta impending
le interp tion can be determined from Thble 5-3 and the following formula:
S = Za,
item is cqual to th :ube.r of limes an zauon IS exposed to a stockout or. an Where
tJmes te
a is the standard deviation of lead time demand.
organJ
stocko ut. When the stockout cost is
there arc RIQ o order is placed. In an annual perrod
constant amou n:r ; : geforWJLo
of s tock , the Followin g ror mua app referenc to the number of um ts out Example 2
1

ut
iJcs for a contm uous distri bution: Weekly demand is normally distribute d with a mean of 20 units and a standard
hol ding cost + stockout cost, eviation of 4. What is the optimum reorder point if holding costs are :ne
expected annual sa.fety stock cost
Year, the backo rder cost is $ 10.00 per outage, the order quanuty 26 u ;
= d

l'C, SH + G J:!(M) lead Lime is I week?

IS

lhe

=
dM
uHQ 4 ( 5 ) 26
0.05 .
Gi(
-

OR P(M > 8) '

=

1-f(B +
of(B) = - ! 0(52) 20

sec
M)
1.1
ven=no:;:. ::::,:d
Cliffs.
-
Practl(.
Q Martin K. Starr and David W. Miller.
nglc:wood 1 962.
N J : PrcnliccHall, P
6 3 for 1 e m
 Chap,5 1

ms: Probabilistic Models n Stockout Costs

Dem and Syste
lndepen denl Know
220

TA BL E 53
221

--.. -
(continued)
Distribution
TABLE Standard Normal

Panial
53

f(Z ) E(Z)
Pa rtial Stan dard

z I - F(Z)
Probability

I - F(Z)
Probability

z f(Z)
Standard Ordina te Expeotati Deviate

E(Z)
Normal of a S tockout,
Normal Deviate of a Stockout, oo
Ord inate
Expectation

.0097
.000 1 1 . 95 .0256
- 4.00 .9999 .0596
. 5000 .3989 2.00 .0228

.0440
0.00 .3984 .0540 .0085
2.05 .0202

.4404
0.05 .4801 .0488
.3969 2.10 .0179 .0074
0.10 .4602
.3945 2.15 .0158 .0065
0.15 .0396 . . 0056
.4207 .3910 .3069 2.20 .0140
0.20 .0355 .0049
.4013 .3867 .28 63 2.25 .0122
0.25 .0317 .0042
.3821 .3814 .2668 2.30 .0107
0.30 .0283 .0037
.3632 .3752 .2481 2.35 .0094
0.35 .0252 .0032
.3446 .3683 .2304 2.40 .0082
0.40 .0224 .0027
0.45 .3264 .3605 .2137 2.45 .0071 .0198 .0023
0.50 .3086 .3521 . 1 978 2.50 .0062 .0175 .0020
0.55 .2912 .3429 . 1 828 2.55 .0054

.0040
.0154 .0017
0.60 .2743 .3332 . 1 687 2.60 .0047 .0136 .0015
0.65 .2579 .3229 . 1 554 2.65 .01 1 9 .0012
0.70 .2420 . 3 1 23 . 1 429 2.70 .0035 .0104 .0011
0.75 .2267 . 30 1 1 . 1 3 12 2.75 .0030 .0091

0006
.0009
0.80 .2119 .2897 . 1 202 2.80 .0026 .0079 .0008
0.85 . 1 977 .2780 . 1 100 2.85 .0022 .0069 .
0.90 . 1 84 1 .2661 .1004 2.90 . 00 1 9 .0059 .0005

.0044
0.95 .1711 .2541 .0916 2.95 .0016 .0051 .0004 5
1 . 00 . 1 587 .2420 .0833 3 . 00 . 00 1 5 .00038
1 .05 . 1 469 .2300 .0757 3.10 .0033 .00027
. 00 1 0
1.10 . 1 357 .2179 .0686 .0024 .000 1 8
3.20 .0007

.00009
1.15

.0004
. 1 25 1 .2059 .0621 3.30 . 000 5 .0017 .000 1 3

.00006
1 . 20

.00004
. 1 15 1 .0012

0006
. 1 942 .0561 3.40
1 . 25 . 1057 .0009
. 1 826 .0506 3.50

.0409
.0003
1 .30 .0968 .1714 .0455 3.60 .0002 .
1 . 35 .0886 .00002
. 1 604 3.80 . 000 1 .0003
1 .40 .0808 .000 1 . 0000 1
. 1 497 .0367 4.00 .00003

z 1 = -- ,
1 .45
B-M M-M
. 0606
.0736

u
1 . 50 . 1 394 .0328
.0669 .0293
=
1.55 . 1 29 5

/(Z)
.0261

f!(l) dt = I - P(M > 8),

1 . 60 . 1 200

= uf(B), F(Z)
.0548
1 .65 . 1 1 09 .0232

.0446

.0495
. 1 023 .0 = e - Z't>

.040]
.fh
=
1 . 70

E(M
1.75 .0940 .0 183

E(Z) r(l - Zlf(l) dt > B) .

1 . 80 .0863 .0162
. 0360
1 . 85 .0790 .0 1 41 =
.0322 = u
1 . 90 .0721 .0 126 z

(contin ued)
.0288
.0656


 Chap. 5
Stockout Costs
l(nown
Models
and S ystems: Probabilistic
Independent Dem

5-4
222

nate of 0.05 gives a Z of 2.03.

Poisson Distribution
Thus TABLE

S = Zu = 2.03(4) =
From Thble 5 3 an ordi
8.12, or 8 nits, Rrr --::-
-:--:--:---
B = M + S = 20 + 8 = 28 um
-
ts. 2
::.<::
B> ---------
.:
. --
8---M -------
m safety stock is 8 units, with a reorder point of 28 umts. -: _:_
,o-
' '-
'2:_
The optimu
.
I f demand follo ws a. Pmsso distribution the optimizing inventory policy
as Table 5-4. A simple example can
can be obtained from Pmsson t les such .
best illustrate the use of the Pmsson table.

Example
e 3 emand for an item is Poisson distributed with a mean of 5 nits.
:as ptirnum reorder point level if holding ost are $5.00 per u mt per
year, the backorder cost is $5.00 per outage, the lead time IS I week, and the order
quantity is 13 units ?

-
f(B) - - = 0.05.
GR - 5(52)5
In the Poisson table for a lead time demand of 5 units, 0.05 is .rou nd bet een 0.036
and 0.065. Selecting the larger f(B) , the optimal reorder pomt IS . 8 umts and the
safety stock is 3 units.

Lost Sales Case: Stockout Cost per Unit

The treatment of lost sales does not differ substantially from that of back
orders. With lost sales, all stockouts (shortages) are lost and not recovered. The
+ E(M > B)J.
'The exac y B
M units.
average number of annual cycles is no longar RIQ,
but is R/[Q
where E(M > B) is the expected stockout quantity per cycle. Usually E(M > B)
[ractions in the table are the probabilities associated with tl demands during a lead

average number of
time with an average demand or

is a small fraction of the quantity, so it is assumed that the

= BJ""f(M) dM - rMj(M) dM I:
annual cycles is still R IQ.
case and the backorder case is
(B M)j(M) dM
The only difference between the lost sales o
- -

amoun t o f safety stock on hand

in the safety stock expression. The expected
= B - M + J""<M - B)j(M) dM.
when a new order arrives has previo
usly been estab lished as
-
s r(B - M)f(M) dM = B Note that in the backordering case (no lost sale ), the safety stock is simply
B

M;
B - M, or the reorder poi t minus the averae /d t"me demand In
;t
. the lost
= _

B
0

however, since II stockouts are

sales case, the safety stock ?IS greater than
2: .
lost, the safety stock is zero whenever M by he expected numbr of
and the expressiOn can be rewri
tten as lost sales for each cyole. The expected nu
:;_!
r of lost sales per cycle is prect.sely
the sam e as the expected number of ckorders per cycle in the prevwus
S = r(B - M)f(M) dM ana lysis. The lead time is
0 expected number of lost sa1 es per

= r (B - M}f(M) dM - r(B - M)j(M ) E(M > B) = s: (M - B)f(M} dM.

dM
0
 hap,
C
224 S t<nown stockout Costs
Model s
System s: Probabilistic

225
Indepen dent Demand

per
follows for a co nti n
. matical notatio n is as uoUs uni is $50. Deter i n e the mini m
The appropnate m athe um cost
reorde po . t
distrib ution with stockout
cost on a p er unit basi
s: h istofY m Th b l e 5 - S d u n n g a cons tant
lead ti me
m from the demand

P (s)
perio .
= AR
_!!!l_
+ HQ I O ( I OOO)
1 0( 1 000)
expected annual
safety stock cost - holding
cost + s tockout cost '
=

The o pt i m um probability of a stockout is o

50 ( 5000 ) +
= 0 ,038.

+ A R oo
SH Q J - B)j(M) dM 038
OO \
.
h' ch between

set at 400 u n i ts pomt should be

(M of 0 . 1 0 and 0 . 03 associated with 350 and J iS the probabili ti es
TCs =
m s. The reorder .

H(B M) + (A; + H)J:(M - B)f(M)

B
.

= _ dM, TABLE 5-5

H(B - M) + (A; + H) E(M > B)

Demand Dema nd Probability

P(M > B)
Proba bility of
Stockout
TCS =
M P(M)

ISO .01
where 200 .04 .
99
.95
S = safety stock i n units, 250
300
.21
.55
.74

B = reorder point in units, 350

400
.09
. 07
.19
.10
H = holding cost per unit per year, 450 .03
.03 +

A
.00
= lost sales cost per unit,

Lost Sales Case: Stockout Cost per Outage

R = average annual demand i n units,

Q order quantity in units,

M = lead time demand in units (a random variable),

The appropriate m athematical notation for a continuous distribution with
=

stockout cost on a n o u tage basis is

+ Qtf(M)
' GR oo
TCS = SH
M = average lead time demand i n units,
dM,
f(M) probabi lity density functio n o f lead
time demand.
=

By taking t h e derivative of t h e expecte

the reorder pojnt and setting
d annual safety s t o c k c o s t w i t h respect to
it equal to zero, the follow ing relatio
nsh i p resu lts: l
TCS = H(B M) HJoo
- +
B
(M - B) ) + Q
f(M dM
GRJ""
B
j(M) dM,

P(s) = TCS = B) + GR Q
A__
P(M > B) =

R + _!!_!l___
HQ .
H(B M) + H
- E(M >
P(M > B)

is t he lost sales cost per outage. 110 mmmt

be
The above f rmula gives

app li ed to both discr
the optim u m probabi
lity of a stocko ut . I t can wh ere G ze the above expression, the
time
;: . h respect to is set equal B
to zero :
ete and conti nuou
d :,O \ s probabili ty distr ibutions of lead deri vative of the expected annual safety stock cost wit

the
n d . K WI. the probabi lity
distr ibuti on perm i t s t
v B . h e dete m on o f

dTCs
of hIC as the mirumu m r i nati
exp ected cost . GRJ(B),
Example 4 dB = 0 = H - H > B) - Q
P(M

1ots of I (}()() u . j(B) > B) -- HQ

An organi zation order
s an ite m in
m
I
.
yearly dem and. t s for which i t has a 5000- unll

dl tn-
The hold i ng
cost per unn
- GR
Lyn wood A. Johnson and Do
per year is $ 1 0 , and cost
P(M .
The above relatio nship IS cu bersome to
.

. produl
t h e lost sales
. PlanSeenmg
, lat
uas C. Montgomery, Operati
. . use excep t for tab
64-65, for the mech anics
. , Sche
of t he de rivato:n. ontrol, N ew York; J ohn W iley a nd Sons, 1 974, pP P(M > 8). Beca e
f(B ) d lvJded by
liOn
duling and lnve . the ord inate
bu tlo ns where
such as t h e nor al and Olss on,
nt ons Research m
ll o f the
= I -
lh e c um
u l ative distributiO n funct iOn F(B)
 Chap, 5
226
bilistic Models
nd Systems: Proba
Inde pendent Dema

cost per ou tage no 227

Stockout Costs
j(nown

lost sales case with stocko ut ,

infrequent application of the
further elaboration is provided. =;ample 5
le Lead Time o
An orga nizati. n has a yearly demand of 260
Constant Demand and Variab units for a prod
uct purchased in

possible to stablish the reorder poi nt in

lo ts of 25 umt s . The weekly demand is const
. .
a nt at 5 mts. The
When the lead time is variabl e, it is
per um per year I S 1 0 , and the backorder cost
. ?
er umt s $10. Wha
holding cost

terms of the minimum lead ume, av rage

. . reorder pomt 1f the weekly t is the opti
lad t1me, or maJ(Jm u m lea d tirne
b
m um lead tim e is defme
d by the distributio
. . Table 5-6? n shown in
hm1ts, the reorder p omts would
With respect to the minimum or mruomum
wou(
le d
minimum lead time
substantially different . A reorder point based on the TABLE 5-6
inadequate protection, and one based on the maxim u m
tend to provide
ime would result in exessive stock levels. If the impat o.f a variable lead ti e Lead Ti me L Probability P(L)
1s ot evaluated statlsllcall , the most com on p ac tJce . 's to base t he reorder
pomt on the average lead tu e. If substa? tJal vanat10n m lead time is experi.
.
.

enced, a more formal statistical analysis IS warranted.

0.25
. . 0.35

When the eand is constant and the lead time i s variable, the solution
0.25

ues are sm!lar to the var1able

0.10

basJC difference IS that the demand during the lead time is obtaine d lily multi.
tec mq . . demand, constant lead time case. The 0.05
.
the constant demand by the probability distribution for the lead r
1 .00
.
Te mathematical formulations and computations are similar. Figure 5-5 e :
plymg
:
11 e opt m um stckout probability for backordering with stockout cost on
plifies the constant demand, variable lead time situati o n . a per u m t bas is IS
. obtamed as follows (see Thble
5-7):

Q+s P(s)
HQ 10(25) _
= = - 0096
AR 10(260)

TABLE 5-7

Lead Time Probability of

Probabi li ty
M P(M)
Demand Stockout,
MP(M) P(M > B)

15 0.25 3.75 0.75

7.00 0.40
20 0.35
6.25 0.15
25 0.25
3.00 0:05 +-
30 0.10
1 .75 0.00
35 0.05

1 . 00 M = 2 1 .75

ut probability of 0.096,
The optimum reorder poi n t is associated with a stocko
i s associated with emand
levels of
whi c h is between the p robabi l tie 0 . 1 5 and 0.05
25 and 3 0. 11he opimum reorder point is 30 units, which
a
results m safety stock

f 8 un i t s .

Con stant dema

nd and
TIME
FIGU RE 5-5 reorder n_&
order quantit y . B _
tion, the optimizi

point s Poin t can be determ ined from Thble 5-3 and the follow
variable lead time If the lead time follows a normal distribu

Lm = maximum
ing formu lanon :
=
Q
, - reorder
lead time T. _
=
ected lead time; P(M
s ety stoc
B - S = exp
= M + Zu

>
.
ead tune demand } - probab1hty of a stockout ; B
.
= Dl + ZDuu
 228 Ch ap,
S
Probabili stic Mod els
Independ ent Demand Systems: Stockout Costs

229
l(nown

where sid ered sim .

l t neo usly, a oint probab
ility distr ibut
/
he probabthtles for vano us comb i nations of ion can be created that gtves
constant demand rate per period, .
:
D
i
=

ngth . Th e range of the j o nt probab il ty distr i

d m n level

:y
and l d time
a = standard deviation of demand during lead time ,
the p roduct of the sm allest dem and
ibu on
and the s o r : t
r m level mdicated
standard deviation of lead time, in dic ated by .te prod ct f th e largest demand
join probab hty dtst nbu tiOn IS t en used with
:; : ;-:!
aL = t l
L = average lead time in periods. .
and t la es
the formulas develope
i .
prevt ous sectt n s for the approp:tate stockout cost d in the

sistent lead times. Both conditions permit safety stock levels to be at a nunun
It is desirable for an organization to have short average lead times d con. situa tion. Figure 5_6
urn.
. plifi es the vana le dema nd, anable lead time exem
situation.
The foo':mg exam ple illustrates how
. to analytically determine
probability distnbut 10n when demand and lead time the joint
Variable Demand and Variable Lead Time distributions are indep

6
endent.
Example

complexity. As in the previous sections, however, the objeCtive IS

When both demand and lead time are variable, there is n i cre ase i n pro
. blern
From the distrib utions given below determine the lead
to set the re. time demand probability
distri bution . What is the reorder point for a probability
order point at its lowest expected cost . of a stockout of 0.20?
It is in fact rare to find a situation in practice where the lead time

variatien P(D)
is known
exactly. The factors that make up the lead time are subject to random
so that lead time is better described by a probability
distributio n than by a point
, Daily Demand
D (units)
Probability Lead Time
L (days)
Probability
P(L)
lead time uncertain ties are con.
estimate. In the case where both demand and
0.30 0.75
0.50 0.25
Q+s
0.20

From the two distributions, it is apparent that demand during the lead time can
be as low as 0 and as high as 4 (a demand of 2 units on each of 2 lead time days).
To determine the probability of each given lead time demand, it is necessary to
sum the probabilities of the various ways a specific lead time demand can occur
as illustrated in Figure S-7:

Lead time demand = 0:

I. first day 0 demand 0.75(0.30) = .2250
2. first day 0 demand 0.25(0.30)0.3 0 = .0225
second day 0 demand
Total .2475
Lead time demand = I :
1. first day 1 demand 0.75(0.5 0) = 3750
0 demand 0.25(0.3 0)0.50 = .0375
2. first day
1 demand
second day
0.25(0.50)0.30 .0375
1 deman d
=
3. first day
0 demand
-W
second day
.4500
P(M>B) Lead time demand = 2: = 1 500
Thtal

1 . first day
0 75(0. 20)
o demand
2 demand
TIM E
o : 25(0.30)o.zo = .0150
_____
FI_
G_
UR
__E_
S-_
6 Va riable
2. first day
2 demand .0625
second day
0.25 (0.50) 0.50
0.25 (0.20)0.30 = .0150
=
1 demand

expected lead time; P(M > r poi nt S . - safety 2 demand
de mand 3. first day
order quan tity; B 1 d emand
and va riable

stock; Lm
=
= reorde

d em and ; B +
lead time

. ,
second day

W = maxim um o demand
- smaxexpected
=

lea d tie il ty fa stockout; B .2425

i mu l ead ue,
B) = ro'
4. first day
i
J
= m
second day
lead ume
and, B - =
=
minim um ead time demand.
l
Thtal
 l(nown
Chap s
230 . 231
Stockout Costs
Systems: Prob abilistic Models
Independent Demand

The following table contains the . . t probab

deman d for the exam ple. A probli lty of a stoc distribution or the lead time
I deman d
ility
kout of 0 . 20 would req
uire a re-
Lead time demand = 3:
first day order pomt of 2 units:
0.25(0.50)0.20 = .0250
.1.
second day 2 deman d
2. first day 2 demand 0.25(0.20)0.50 = .0250
I demand Lead Time
second day Probability
Deman d (M) P(M)
To tal .0500
P(M > B)
Lead time demand = 4:
I. first day 2 demand 0.20(0.20 )0.25 = . 0 1 00 0 .2475
0.7525
second day 2 demand 0.45 00 0.3025

0.24 25 0.0600 +-
3M)_ 0.0500
0.01 00
0. 0 1 00
0. 0000
.2250
1 . 0000

. 3 7 50

of the demand during the 1ead time

W here the demand and lead time distributlons
_ . . ndependent, the mean
_ arearegven
and vanance by
.20
M l5I,
= +
=
0=2 . 1 500 .

L= l
.75 a2 lab J52ai ,
where
=
.0225

Iaverage lead time length in days,

.0375 l5
average demand per day,
=

25
standard deviation of demand distribution,
a = standard deviation of lead time distribution,
ao =

L=2
.0150 L

a standard deviation of demand during lead time,

=
.0375
l5I average demand during lead time.
=

If t he demand and lead time distribution s are not independent, the mean and
.0625 van_ ance of the demand during the lead time are given by
M = l5I,
.0250
a2 Vab + J52ai +

If
= C1oC1L-

approach, an
it is not desira ble to use the analytical joint probability Carlo
. 0 1 50
equaU y appropriate approa ch is Monte Carlo simulation. The Monterandom 7

method approximates the solutio n to the problem by samplintgchapte from a

r.
e Time Series.
Proce ss . Monte Carlo simul ation is outlined in a subsequen
0250 ast ng, and Predi
ctionof D cret
is
see Robert G. Brown , Smoothing, Forec i

See Claude McMillan and Richard F. Gon

h anal)1 1cal and
Computer Af!proach
.

Chapter 7, for t
Pre OliCe
- H al l , 1 963, pp. 366-367.
A
zales, Systems A nalysis:

le Ca rlo s i mulation approaches to estabh shmg JOIOI


. 0 1 00
0:2 D . lr i n. 1 68 :
UiOoO
1
wood , l L : Richard
1
ecisio _
n Mo dels, Home _ dis!rlb uno ns.

FI GU RE 5-7
o
 Chap_ 5 I

232
Probabilistic Models
and Systems:
Independent Dem

l Levels
233
Fi ed Order Size system Formulas
service

5-8
OOOJo
Cost
Known Stockout

J
TABLE
Reor der Poin t (B? mea ns some disservice or stockout: No only Is. It. extre
w_ill be far t?o _costly. A policy :Vrbvmg
guarantee that demand will always be sat f' mely difficu lt to
lso it is likely hat
Stockout Cost
t guaranteeo miC.
no t econ
Stoc kout Cost such a
_ of diminishing returns0l_ es . As theout IS gnerally
Econ omic Order
S t ocko u
Quantity ( Q )"
per Unit
per Outage'
The prm c1ple a stock
Case
s OOOJo the mvestmen se r tee
appro ache . t in . mcreases drastically_levelIt
maY not cost much to mcrease from 8S to 901170 b g to 99% rna; be pro
1
_ safety stock
GR
!!2_

/(B) ==
P (M > B) =
Backorder
hibit ively expensive. 11hus, most organizations onde :. .reasonable' number

HQ of stockouts acceptable because of the high cost of trymg
P (M > B) = AR + HQ I P(M
to eliminate them
-
HQ /(B)

> B) - OR altogether.ntory inv stm

_

Lost Sale
Inve _ent increases xponentially as service levels are in
is assumed that the deterministic EOQ crease . The determl at!On of appropnate service levels requires an analysis of
See Appendix 0 for more exact mathemat
because of 1ts tnsensitivity.
is ao adequate approXJm auon

st rateg ic and eonom1c tradeo!fs : A 1 0% service level (meeting every customer

11
ical relationships without the deterministic assum ption.

the ordinate of the distributio n is uf(B).

The formulas give the optimum reorder
point for the appropriate lead time demand distri bution.
demand frm mventory . o _w1thm a fiXed time horizon) is usually beyond the
' For the standard normal distributio n, realm of f1scal rspns1tltty. For make-to-stock or order-to-stock environ
ments, I OOOJo serv1ce 1mphes a huge inventory investment; for make-to-order or
With variable demand and variable lead time, the solutionthat procedures
they are assemble-to-order, 1 00% service implies excess productive capacity.
are the same as those previously derived. The only differenceleadis time While perfect customer service might not be attainable, lead time reduc
tion and just-in-time approaches can substantially improve customer service.
applied after the two distributions are combined into a single demand
distribution .
the
Furthermore, there are some environments where service levels at or near 100%
are necessary. In manufacturing organizations failure to provide a needed part
In summary, for fixed order size systems with known stockout cost,
order quantity and reorder point formulas for probabilistic situations are
can bring a production line to a halt. Inventory in this environment is better
contained in Table 5-8. suited to an MRP system than to a fixed order size system.

1.
The service level takes on different meanings, depending upon how it is
SERVICE LEVELS stated as a decision criterion. Two commonly used service levels are:
Quite commonly, an organization does not know its stockout costs or feels very
uneasy about estima_ting them. Under these conditions, it is customary for man
service per order cycle,
2.
ageent to set ervtce levels for which reorder points can be ascertained. A
service per units demanded.
service level 1_ndtcates the ability to meet customer demands from stook, or in l'he reorder points or safety stocks developed under the different_ ser_vice
con
some other t imely m ann er. cepts will be differe nt. The selection of the type and level of serv1ce
IS a man
. There are several _ways to measure a service level. It can be computed on agement policy decision.
:r:nsactiOns, or orders. It is _ frequently defined for some spci
:;; orders are n orm all filled from stock. It may be specified
i
p
t e f demand ftlled
ified time perio: aft: ;ce t the cu "on' time," that is, within level
in general as the a spec Servi ce per Order Cycle

measure is usually appropr ia e f ll the tome s . order. No one service ls of cycle will i d.i the
replemsm e t
The service level based on frequency of service pertheorder
control may be desirab le for differ: t cl Items m_ mventory._ Different leve Probabili ty of not runn ing out of stock during the shor u t ith :0
The establish ment of service leels sses of mv_entory Items. . ment
that is based on conve nience th e than Is a subjective management JUdg e by eye1 e (SL ). is d efi ned as the
llh'IS approach is not concerned wt'th how order
large tage IS,

SCie ntific justification. he ch oic often it can occur. The service level per c

management of a service leve Imp

tes a cost attribu ted intuitively or indirectlY fraction of replenishm ent cycles without depletiOn of stock
to service failure.
level 15
If custom ers always rece
ive orders when
. nu mber of cycles with a stockout
SLc = I of
1 OOOJo The service level a

nd the stockout level demanded, the serviceJess than
sum to I OOOJo . Anything - total n um b er ord er cycles
B
= 1 - P (M > ).
 Ch ap, 5
234 235
e Levels
c se rvic
Systems: Proba bilisti Models
Independent Demand

the lead tim e' or th e stockout By co nsulting Thble 5-9 for P(M > B )
= B = units .
p M > B) is the probab ility
It represen ts the pobabth.ty of a t , least one
0 _ 1 25 '
of a
=
stockou t during
leel robabili ty) per order cycle.
S = M.
M.

fraction of lead ttme penods dunng Which M

70

stock ! during the lead time, or t h e

safety stock
point. The magmtu de of the stockout is
=
= 70 -
-
60 = 10 unit
s

the demand will exceed the reorder The order quantity would be 1 200 unit s and
the reorder point
per order CYcle
70 nits . Then
ignored with this approac h.
(M
.
The safety stock is determine d as
follows when a serviCe E(M > B ) = - B) P(M)
= (70 - 70} ( 0 . 20)
is adopted:
safety stock = S= Ma - M,
= 1 .50 units.
+ (80 - 7 0)(0.10) + (90 - 70}(0.025 )

50 u 1
{l)T:e ;; :ocko
where
The expected stockou t quantity per cycle is 1
M0 = B lead time demand at acceptable service level in units ,
= quantity per year is E(M > B)R!Q = 1 . 50(I S OOO
, /
ut
it
M average lead time demand in units.
8
=

Example

Example 7 From the info rmation given in Example 7, what would be the
_ reorder point under
What should be the order quantity and reorder point for the inventory problem the conservative method { I OODTo service level)?
specified below and in Thble 5-9? What is the expected stockout quantity per B = M. = 90 units,
M
cycle?
S = M. - = 90 - 60 = 30.
Stockout level fraction per order cycle = 0 . 1 25 ,

C
= 1 8 ,000 units/year,

$200 per order,

Reorder point determination can be simplified considerably if the demand
=
follows some known distribution such as the normal, Poisson, or negative
level or conservative method cannot be used with them. A service level can be
exponential. Since these distributions have no upper bound, the 1000Jo service
L
H = $5 per unit per year,

1 day.
readil y used with a standard distribution.
=

Solution:
As previously indicated, the normal distribution is d ned by its mean M
H-
'

Q = 'VfiCR
. - 2(200) 1 8 ,000
- --- = 1 200 .
um s, t
and standard deviation and the reorder point is B M + Za. Thble 5 - 1 0
a,

highlights Z-values for common probabilities of stockout.

=

5
average demand = M E MP(M) = 60 units.
=

5-9
TABLE 5-1 0
Standard Normal Distribution
TABLE

z
Standard Normal Deviate Probability of Stockou t ,
Lead Time Dema nd P(M > B)
Prob ability
in Units, M Probability of Stockout ,
P(M) MP(M ) 0.001
P(M > B ) 3.09

40
0.005
30 2.58
0.025 0.75
0.010
0.975 2.33
0 . 1 00 0.025
50 4.00 0.875 1 .96
0.200 1 0 .00 0.050
60 0.675 1 . 64 0 . 1 00
0.35 0 2 1 . 00
70 1 . 28

90
0. 200 0.325 0 . 1 50
80 14.00 0. 1 25 +-- 1 .04
0. 1 00 0.200
8.00
0.025 0.85 0.250
1 . 000 0 .000 0.67
60.00
 Chap. 5
236
l
Systems: Proba bi istic Models

237
Independent Demand e Leve ls
servic

5-1 1
E:-.:ample 9
Cumulati,,e Poisson D
TA BLE istribut ion

If the distrib ution given in Exam

a standard Reorder
ple 7 is assum ed normal_ with deviation

of 20 units, what will be the 8

level per order cycle is Poi nt -----
safety stock if a 95% servtce M = 2

Ma Za = 60
desired? 10 12
B M + 1 . 64(20) = 92.8, .323

s
= = +
. 1 43 .353
= B-M = 92.8 - 60 = 32.8 :::: 3 3 units. .053 . 1 85 .371

Enmple 10
.017 .084
004 .
.215 3 84
. .033 .III .23 8 .394
random variable with
I f the annual demand for an item is a normally distributed 7 . 00 1 .012 .051
004
.133 .256
units, what should the .401
a mean of 8000 units and a _ stand d deviation _ of 1_oop 8 . .021 .068 . 1 53 .271 .407
safety stock and reorder pomt be tf the lead orne ts 2 month? (Assume man 9 .001 .008 .032

II
.084 . 1 69 .2 83 .41 3
agement has decided it is willing to be out of stock in 5o/o of cycles .) the order 10 . 003 .014 .043 .098 . 1 84 .294 .417
a
Sin e the mean p d standard deviation are expressed on an annual basis and . 00 1 .005

.064
.020 .053 .112 . 1 97 .303
the lead tune ts on a 2-month basts, they must be convoluted to the lead time 12 .002 .009 .027 . 1 24 .208 .424
period: l3 .001 .004 .013

M
.034 .074 . 1 35 .319
- R
14 .001 .006 .0 1 8 .041 .083 .228
= = 333, 15 .002 .008 .022 .049 . 1 56
2 ( 1 2) 16 .001

.004 .Oi l .027 . 101
(J = 1 000 = 204 . 1 2 , 17 .002 .005 .014 .063

Ma Za 3 3 3 + 1 .64(204 . 1 2)
18 . 00 1 .002 .007 .037
B M 19 .001 .003

S =
= = + = = 668, .021
20
B-M
.002 .012
= 668 - 333 = 335 units. 21 .001 . 006
The safety stock is 335 units, and the reorder point is 668 units. 22 .003
23 .002
is:n sributi is completely defined by its mean. The standard 24 .001
deviatiog n is the square root of its mean, so
k nowled e of the av;e detiosuff _ . to d scr. be h e distribution. To
are the stockout probabilities associated with a given reorder point and an average
e n 'The fractions
lead time demand.
use an order cycle service level wit the lctet dtst nbuttOn assumption re-
b
distribution . Th le
quires the use of a statistical t bl0.f the POisson mean. The
is also specified by its
5- 1 1 is an abbreviated cumulatve OlSson summed The negative exponential distribution
_
Potsson
table. To use the cumulative Poisson stan dard deviation of the distributio n is equal to its mean . To service use a level
tabl e , descend on the avera : column until the desired stockout prob
of statistical use a
s then read from the corresponding value 5 - 1 2 is useful in determining the reorder
poli cy with the negative exponential distribution requires the
bility is obtained. The reor:r table. Thble point when the demand
tn the first column . foll ows a negative exponential distribu tion.

Example 1 1
Exa mple 1 2
ruts, and the lead time demand is
The average daily deman d for e demand is
_ nbuted.
POisson dtst _
. 2u .
a n item ts I f the average daily demand for an item is 2 units and the lead ti
What shoul pomt tf a 95o/o
negative-exponentially distrib uted, what should be the reorder days.
se rvice level per
order cycle _ts desired? ( Assu d b: the _reorder point if a 96.6% service level per
from Thble 5-12; thus
of
me a l a tme of 4
\/
n t b : r ; average lead time demand of 8
cycle is desired? Assume a lead time 4

units, 8 ts 1 3 untts for a A stockout level of O.OS gives BIM = 3.00

From the umulative Poisso days.) order
= 24 units ,
stockout level
safety stock = S - reorder poin t = B = 3M
16
.
B M 1 3 ( 2)4 units. 24 - 4(2)
0 .

S
3(2)4

safety stock
=

= = B-M =
= units.
 ap,
Ch
S
238
Probabilis t ic Mod els
Dem and Systems:
Independe nt

239
Levels
servi ce

ntial Distrib ution

Negative Expone

earher m t h e chapter as
TABLE 5 1 2
S tockout The expete n umber of stoc kouts
during an order

P(M > B)
has already been
Pro bability
Stoc kout cycle
P ro bab ili ty develo ped
BiM
: s: (M - B)f(M)
P(M > B)
dM.
BiM
E (M > B)
2.80 0.06 !
0 1 .000
2.90 0.055
0.10 0.905
0.20 0.81 9
0.607
3 . 00
3.10
0.050
0.045
To ob tai n the stockout level for units dem d d dun. g
necessary to divide by the quantity dema e
he order cycle, it is
0 . 50 3 . 20 0.041 unng the order cycle.
( Q)
.
J . OO
0.75 0.472 Therefore, the service level for units demanded IS as follows:
0.368 3.30 0.037
0.333 3 .40 0.033
1.10 3 . 50 0.030
1 . 20 0.301
0.273 3 . 60 0.027
1 . 30
1 . 40 0.247 ' 3.70 0.025
For a ormal d i tribution , he expected number of stockouts during
1 . 50 0.223 3 . 80 0.022 an
4.00 0.018 order cycle IS t h e partial expectatiOn E(Z) times the standard deviation, or
1 .60 0.202
1 . 70 0 . 1 83 4.20 0.015
4.40 0.012 E(M > B) : aE(Z ),
1 . 80 0 . 1 65
1 . 90 0.149 4.60 0.010 which results i n
2.00 0.135 4.80 0.008
2.10 0 . 1 22 5.00 0.007
2.20 0. 1 1 1 5.20 0.006 : aE(Z)
5.40
SL u I -
2.30 0.100 0.005 Q
2.40 0.091 5 .60 0.004
2.50
2.60
0.082
0.074
5 .80 0.003
for a normal distribution. E(Z) is the partial expectation or standardized
stockout quantity for a standard normal distribution. By knowing the stockout
6.00 0.002
2.70 0.067 level fraction, the standard deviation of the lead time demand, and the order

. . A service level based on t e frequency of service per order cycle does not standard normal table (see Table 5-3), the standard normal deviate
quantity, t h e partial expectation E(Z ) can be determined. By consulting a
? can be Z
time period for all
obtained for the derived partial expectation, and the reorder point can be

the order cycle will vary

mdtcate how frequently stockouts will occur over a given
.

replenishes stock monthly with

products. This unfortunate situation exists because obtained from the following formula:

X 0 . 1 ) expected stocko u t cycles in a

from prod ct to product. If an organizatio
n B : M+ Za.
a 90070 service level, there will be 1 . 2 ( 1 2
; to the case of complete

x 0 I ) expected stockout cycles

The form ulation s developed in this section apply

Y w e eas if a firm replenishes

1 b 52. stock weekly with a 900Jo service level , there
per year. T h e more frequently
bac kord ering . For comple te lost sales, the units demanded during
the order

s oc k IS rep erushed , the greater cycle are Q + E(M > B), which results in

E(M > B)
the numbe r of expect ed stocko u t cycles.

E(M > B)
Service per Units Dem ande
d 1 S Lu :
+
A service level based on
-
Q

expected num er . of
B(M > B), the co
.
se
:
e per order cycle does
not a l l o w for unif
or Since the lot size Q is usual ly much larger than the
t :::: :
WI ou a
treatme nt of differen t ee

dem and that will be satis fied . A servtc

produ ' smce prod ucts have . s. stockou ts
also does not indica te
d 1 fferent cycle len gth .
durin g the order cycle,
the lost sales case
if

an
the pe c ntage of formul ation
level based on uni ts dem can usuall y be applied to
a di ffere nce.
that will be satisfi ed

(SL u) d es indi
and ll ws for
? cate the percentage of dem .
u mform treatment of di ffere nt pro du cts.
Example 13
. 0r the following problem (see Thble
num ber of stockouts
y
SL u : I

5- 1 3) :
-
total num ber Wha t are the order qu an t i t and reorder pomt
of units demand e d
 Ohap. s
240
Indep ende nt Dem
and Syste ms: Prob
abilisti c Models

l
S LII = 0.99,
Reord er Point Proba bility
R
C
=

=
1 800 units /year,

$ 3 . 00 per order,
B P(B)
MJ;.,(M - B)P(M) = E(M > B)
58 .02

I
H = $ 3 . 00 per unit per year? 0
57 .03

I (0. 03)
1 (0.02) = 0.02

Z(J);BOO
Solutio n: 56

.06
= 0.03
= 60 units, 2(0.02)
Q* = = = 0.04

I (0.06)
0.07
E(M > B) = Q( l - SLJ 55 .07
2(0.03)
== 0.06
= 60(0.01) = 0.60 units 0.06
3(0.02) = 0.06
TABLE 5-13 OJ8
t
54 .20 1 (0.07) = O.Q7
Lead Time De and Probability 2(0.06) = 0.12
M P(M) P(M > B) 3(0.03) = 0.09
4(0.02) = 0.08
48 0.02 0.98
0.03 0.95 0.36 +-
49
50 0.06 0.89 53 .24 1 (0.20) = 0.20
51 0.07 0.82 2(0.07) = 0.14
52 0.20 0.62 3(0.06) = 0.18
53 0 . 24 0.38 4(0.03) = 0. 1 2
54 0.20 0. 1 8 5(0.02) = 0.10

I (0.24)
55 O.D7 0.1 I 0.74
56 0.06 0.05
57 52 .20 = 0.24
0.03 0.02
58 2(0.20) = 0.40
0.02 0.00
3(0.07) = 0.21
1 . 00 0.24

.
4(0.06) =

u n i t s which m Table 5 - 1 4 is between 0.36

0. 1 5
,
5(0.03) =

and 0. 74 units. Selecting the s rna 11 er value,

The expected lead time stockout is 0 60 . . 6(0.02) = 0.12
the reorder point is 5 4 units. The order 1 . 36
quantit y is 60 units ' and the reorder
point is 54 units.

th 1 ead t _
The service level per cycle indicates the probability of no stockouts during
Examp le 14
w t me . It is t h e proporti on of cycles without
a stockout. It is appropriate

given in Exam le I
. ssumed normally distributed wit h a
en the s hortage nce independent of its time
occurre nce has the same conseque
I f the distri bution

from stock. I t IS genera

!n o f : :
,
mean o f 53 and a sta ndard dev iati ou nt . Th e service level per units deman ded, also known as_ the fill rate,
n Its, what should be t h e reorder poi nt? lly a

- SLJ - -
e ures t he
proportion of deman ds that are met
2 = 0.30.
E(Z ) = Q( l 60(0.0 1 )
_ lllo re me an
ingful measu re for managers, since it is
consistent among different
a Product
s.

S
caution is in order.

e org an i atio n s set safety stock levels at some average time

C n s u lting the normal
table for . Be fore leavi g the topic of service levels , a word of

it
the l
aexpecta d n
n r E(Z ) = 0 . 3 0, a standar supply for each
:! . as :
devi ate Z of : ll tion
0. 22 is o btai e
foil T he reor _z
der point can be obtain ed week s of suppl as the

M
Th at I S , er of days or
. they use a specified numb

shOU ]d
poor pracuce that
B crite _ stock . This is a

--======-
= + Za = 53 + 0 22(2) = 5 3 . 4 units. n on fo r determining the amou nt of safety
be avo ided . The fallacy in using a fixed time
supply is that safety
stock
 ap !
C
242
Systems: Probabil istic Mod els
inde pendent Demand der I nterval Systems

243
fixed Or

of deman d , whereas i should be set as fu n cti

o
b
. o f the level
IS. set as a un.c wn a e iJn putetcestocko t cost is a convenient way to deter . .
tection Th r level IS approp riate.
le demands a n d not enou gh lo fo
.A
I
fiXed time su pply gives too m uch pro
of the vanabl ty of demand the serv mm e 1f the value chn
hig volume It::t ::
. lively predictab
pra: 1 6
h

tectiOn to lo 0 '
it with more variab le d.e m? d s . In actu al

high volume ttems tend xhibit

am ple
to e less relative vanabrlity of d em and .
From the inf rmaton given in Example 7 , what is unputed
per unit?
backorder cost per
IS
unit ? What IS the tmputed lost sales cost the .

weekly demand or
Example

The demand for two items is normally distributed .withofa mean

120 units . Each item has a replenishment
lead ttme 4 wee.ks : Item A has A = R__P(M > B) 1 8 ,000(0. 125) -- $2.67 per urut backordered;
_ !_Q_ __! = .
while item B has a standard de"_lallon of 40 units. HQ[ I - P(_M > B)]
a

standard deviation of 30 units, A = R P(M > B)

If the firm's safety stock policy is a one-week supply on all Items, what is the 5 ( 1 200)( 1 - 0 . 1 25)
$2 .33 per unit lost.
probability of a stockout for each item? 1 8 ,000 (0. 125)

s 17
Item A: Z - = J<N4 = 2.00,
=
1 20
Example

Frm the information given in Example 1 3 , what is the inJputed backorder cost per
llem B: Z = s = 4{k!4 1 20
urut? What IS the Imputed lost sales cost per unit?
= 1 .50. E(M > =
B) Q(l - SL.) = 60(0.01) = 0.60.
From the normal distribution table, a Z of 2 . 00 equates to a stockout p
of 0.0288, while a Z of 1 . 50 equates to a stockout probability of 0 . 0669. robability
From the information in
hu s, the is 54 units, which has a stockoutExample 1 3 , the reorder point associated with 0.6
probability of 0 . 1 8 . Thus,
probability of a stockout is much larger for the item with the greaterTdemand
variability. A = R P(M > B ) = 1 8 00(0.
HQ 3(60)
$.56 per urut backordered ;
=
.

HQ[ I -
I 8)

A= P(M > B)] 3(60)(1 - 0 . 1 8)

$ .46 per unit lost.
Imputed Service Level Stockout Costs R P(M > B)
=
1 800(0. 1 8)

Whenever an organization uses a service level to establish a reorder poinl

because of an inability to determin e stockout cost, it really does establish FIXE D ORDER INTERVAL SYSTEMS
service level is an i m p uted or im plicit
stockout cost. Associated with a given a

the impute d stockout cost for

sto kout cot . lt is a simple matter to determ
probability of a stockout . For backorder cost per m formulations for the dsizei systems with an emphasis on the reorder point and the demand distnbuuon
a gJven servtce level from previously developedineoptimu So far, all of t h e models developed in this chapter have focused on t.Xe oer
unit, u r ng the lead
time period . With minor modifications the models
can also be
applied to fixed
P(M > B) = HQ In
order interval systems .
(T-system ), there ar a ft.Xed 0 der p.en d
AR ' and a varythei nfixed order interval system
g order size. At predetermined in erva!s, the
v nto ;:;:.
eX order period is
and an is placed. The size of the order ts det:r;t.X
s u t he
A = R P(MHQ> B) ' amountorder on hand from a pre eterrrun ed total (wh e

E
and for lost sales per unit , hout ner lead time penod, th e stock o
d must include unitsd ontotal order
:d the predetermine
than
no t yet the .
.
received). The order mterval ; under
: g doctrine
lh ts s yst m
P(M > B) = co mp let ely define the fixed order interval system.
Th peratin 0

E.
to
th e fixed order interval system, th e 10 ::0:
is sometimes called the "order . up
can-
AR + HQ ' e
ored only
sition is monitrder
1 1, anot her
. In
de r 15
HQ[l - P(M > B) at dts cr ete poi Once an r . :e
=
A R P(M > ] not be pl aced until t + T, and the second order 'll not be filled unul the Lead
nts in time . o P

B) WI
 hap
C
244 S
d Systems: Probab ilistic Models
conclusion
245
Inde pendent Deman

' L 1 the order interval T. I n the fixed orde r size u om the fi ed order .
t + T + L.
mterval
. Thus, safety tock Protection
time penod has elap e
d at time . Im pu te stockout costs can be deri ved fr
n eeded for : : :
the lead t m
needed only for
the ead time perio d , bec a serv ice
levels JUSt as they are for the fiXed ord . IX
er Size servt. ce lev
els.

J' !
to
tern _ (Q-system), t
with each transaction. I the fiXed order s
n s moni tored

the result would be a larger order size.

:
the mvento
demand causes a shorter time between order;,
n tt fiXed order interval system,
han normal coNCLU SION
!
sys

_Probabi.
wh

in Table 5 - 1_ 5 . Th serviCe levels are Sim ilar, With

um invent ory lee l formulas f? r size system i completely specifie
The order interval and maxim The fixed orde r_ d by the order quantity Q
and
listie conditions are contained the reo rder pomt B. The n k of lockout occurs after the reorder point is
the reorder point (B) replaced by the
maxlm_um mventory level (E).'
the se rvice nd before the next mcomm
tu:ne emand rea ched g order i received. Although the risk of
per order cycle replaced by service per
order mter:al, and t h e lead
stockou t IS e.pendent o n both the order quantity and reorder point (with large
_
time plus order mterval deman d d1st nbution.
distribution replaced by the lead ord er quant1t1es, there IS less exposure over a time horizon to potential stock
The revised service levels are as follows, with M
qual to the demand during the outs ), near-opt imum results can usually be obtained by treating the order quan
lead time and the order interval (a random vanable): tity and reorder point as independen t. In this marmer, risk is only considered
in establishing t h e reorder point. The order quantity does not enter into the risk
service level per order interval
adjustment, and it is set by deterministic procedures (EOQ and EPQ) outlined
= I- number of order intervals with a stockout in previous chapters. The safety stock is the risk adjustment to the reorder point
total number of order intervals to protect against stockouts. The reorder point consists of the mean lead time
= 1 -
demand plus t h e safety stock. Safety stock levels can be obtained by the mini
P(M > E), mization of the expected cost of safety stock (holding and stockout costs) or by

matically represented in Figure 5-8.

service level per units demanded the creation of service levels. The fixed order size system under risk is sche

1 - total number o f units demanded

number of stockouts
There are two approaches to establishing risk-adjusted reorder points,

1 are known or can be ascertained, optimizing formulas can be denved depending
depe nding on whether stockout costs are known or unknown. I stockout csts

=
_ E(M > E)
cost per unit or per outage), as outlined in Thble 5-8. If st kout _costs are
TR on the stockout case (backorder or lost sale) and on the cost catego ry (stockout

51 5
TABLE Fixed Order Interval System (Probabilist
ic Case) unknown managem ent can set service levels indicating the abibty to meet cs

tomer de ands from stock. The more typical kinds of service levels are serv
e
are -
Known Stockout Costa per order cycle and service per units demanded. Since stockout costs

\
Economic
Maximum I nventory Level Eb

P = Q0/R
ORD ER QUANTI'fY (Q) SET BY MANAGE MENT
Stockout Order Interval EOQ
Stockout Cost Stock out Cost
Case <
per Unit per Outage

Hf Foss

EPQ
{R_ PER CYCLE

< < UNITS

Backorder
'\/ Ri{ P(M > E) = J<El "' a
PER UNIT
SE RVICE LEVEL

REORDE R POIN'T (BJ

PER DEM ANDED
Lost sale
P(M > E ) = __!!I__ f(E ) "' !!I
G
< LOSTSALE < PER OUTAG E
E)
UNIT
RH

:: :sum d that the deterministic EO! is an adequat A HT I P(M >

COST
KNOWN STOC KOUT PER
t e approximation because of its insensitivitY BACKORDE R< PER OUTAGE

during t:e: ::e u:ret: inven tor level for th appropriate dema n di:;;
nual dma nd in units; c ordering cost .'ls.T H order
holdmg cost per year; R a kout -
a7 Symbo
per unn; G stockout mterval n years; A "' stoc h ord'' 58 1 fixed Q _
EP

cost per outage er order

ms

mtervat; /() ordinate;

=
=
order size syste

FOss
economic produc-
coli
= R"sk:

probability of a stockout du n n8 teelval. - fixed . systems,.

=
FIGURE

a;d d aton)of demand : economic order

<For the standard normal distribstand

= -
for lead time and order i
qua nury;

quantity. order s1ze

= 0 =

uuon 1s of().
EOQ
ution ' the od mate of the d1stnb I"10 0
 ha . s
C p
246
Systems: Prob abilistic Mod els
I ndepe ndent Demand s
problem

ficult w det ermine , service levels aretry, orgaruzauo

more co monl y used . !h_e type of ser\lic!
nal pecuhar ltles, ease or ap. tim urn stockout probability cannot be atta%at. l. y selected :Vhn the op-
9. Why is the next lower attainable stockout

10 .
level adopted depends on the indus
can be either b c kord ere d or lost; Y stock .m clude holding
of produ cts involved . . Why does the expected annual cost of safet dtscrete dLStnbution?
plication, and t ype
atical standpoint th
!
Demand when an item is out-of- stock on the expected stockout quantity for a lost
sales case but not for a
costs

case of complete backordering is usuallyns under any reasonable p hcy, the rela.
Fr m a mathem
1 1.
in fact, a combination of the two is likely. ? backordering case?
easiest to model . Because f th
ti ely low frequen use
is the consta
simil ar to the variable demand and con stant 1ead time
Ho w nt demand and variable lead
leads to a pohcy that Pro.
. solution technique
t lme
1 2.
cy of stockou t occasio e _ solution .

exact lost sales model , even when
What methods can be used to determine the lead time deman techruque. ?
of the simpler "complete backorders" model usually _ vary? d when both
duces a negligible cost increase over the more
1 3.
demand and lead t1me
The treatment of risk in fixed order size systems involves t he analysis or
all demands in an out-of-stock situatio n are lost. What is the limitati on of a service level based on the frequency .
of service
14.
per order cycle?
the demand distribution (continuou s or discrete) over the relevant lead time.
15.
Which service lev! approach is more meaningful to managers? Why?
Empirically derived distribution s or standard distrib tions (normal, Poisson, .
Does an orgaruzat10n really establish a stockout cost when it uses a service
negative exponential, etc.) can be employed to descnbe the demand pattern.
calculation and development. Of course, standard distributions should not he 16.
Standard distributions that are well tabulated provide the benefit of easy level approach?
How does the service level approach for fixed order interval systems differ

In establishing optimal solutions, numerous assumptions were made

employed unless they adequately describe the demand phenomenon. from the approach for fixed order size systems?

which rendered the models mere approximations to the optimal solution. While
these approximations cast some doubt on the models, they should not limit
their use. Within the range of parameter estimates required to utilize any in
Problems

ventory model, the assumptions establish an excellent first approximation. In
many cases, because of the insensitivity of total inventory cost to changes in
parameters and variables, the approximations are near optimal.
Questions
1. For what period of time are safety stocks necessary in a fixed order size
Wh?' is be most conservative approach to establishing reorder points not
system? Are they carried only during this period of time?
1. An industrial distributor sells water pumps and other related supplies. A
particular water pump is purchased for $60 from the manufacturer. The
average sales per day are 5 units, and the annual holding cost is 250Jo of
quantity is 300 u nits. The backorder cost per unit is $50, and the lead time
unit cost. The annual demand for the pump is 1500 units, and the order
is 20 days. The demand during lead time is given in the table below:
Occurrences
Demand Number of

ordmy the optimum approach? In what situation would the most con
2. 3
70
3
80

3 What effect would ordering

servauve approach be desirable? 4
90 80

4. What condit ions generally call

in larger quantiti es have on stockouts? 1 00 6

5. What three statistica l distribu
1 10

used to describe demand ? In

for larger safety stock s? 1 20

most likely be used ' and would an)

100
wa demad situations would they were
tions
should be
6. What level of safety s toc
How much safety stockstock?
(b )
o t em be madequate in certain situa
k s h ould be maintained when both demand and
tions ? (a) W hat is the reorder pomt . . ?
o f the safety
a l cos t
2
ted annu
I
. are car ried? (c) What is the expec
7. Whe n stock out costs An automotive p arts dealer sells 1 2<>? carbu_re / i-:order quantity is
Each carburetor
are unk nown, how are reorder points establl Shed?
lead t1me constant? rs
8 Wh Y and wh en 1s
d tn
rder costt.iper unit is 2,
;:ckThe
probabilistic systems? n v 1Utlon of a demand distributio n requlre
costs $ 25 ' and the avege ema nd ts
1 20 units, and the lead tJI e I S 25 da[s
. . .
the co lead me demand I
and annual holding cost IS 200lo 0

nit cost.
 Ch ap. 5 5
summary
ems: Prob abili
stic Models of Formulas in Chapter
Demand Syst
Inde pend ent
258
r
1. How does Radi
ems whic h result fro m the Economic order interval in years
?
. Hut add res the initia l probl

z
. TC5 Expected annual cost of safety stock
. tants' recom end atJO ns. Standard normal deviate
assis ? I f so, ho w?
;
h' 'l follow-up sugg
estions likel y to help Standard deviation of lead time demand in units

3. Disc uss the ef.fe

2. Are M r. H'Ig safety stock levels
,
cts o f com petitio n and seaso nality on aD Standard deviation of daily demand in units
aL Standard deviation of lead time in days

S USED IN
IATIO NS AND SYM BOL SU MMA RY OF FORMULAS
IN CHAPTER 5
MATHEMATICAL ABB REV
CHAPTER 5
Formula
M ode l
Stockout cost per unit
= \/{2CR
A
Reorder point in units
B
c Ordering cost per order
Basic EOQ Q
}{
variabl e)
D Daily demand in units (a random
Reorder point with
l5 Average daily demand in units
P(M > B) =
known stocko ut costs:
E Maximu m inventory level in units
ts Backor der case
E(M > E) Expected order interval stockout quantity i n u ni

F f(B) =
E(M > B) Expected lead t i m e stockout in units
Annual holding cost fraction
f(M) Probability density function of lead time demand
G Stockout cost per outage

P(M > B) = AR + HQ
H Holding cost per unit per year HQ
L Lead time in days

B = M + S = M + Zu
Lost sales case
I Average lead time in days
Lm Maximum lead time in days
M Lead time demand in units (a random variable)
M Average lead time demand in units Reorder point with
MD service levels:

= I P(M > B)
Lead -time demand at acceptable service level i n units
Mmax Maximum lead time demand in units Service level per

>-B) - I uE(QZ)
SLC -

--'--
p

= I E(M
Unit purchase cost

Q
order cycle
-
P(D) Probability of a daily demand of D units
Service level per SL.
-
P(L) Probab ility of a lead time of L days
units demanded
P(M) Prob ability of a lead time demand of units M P = '\J{2c
P(s)
P(M > B)
Optimum probability of a stockout
Prob abiHty of a stocko ut during Basic EO!
Rii
lead time
P(M > E) Prob ability of a sto ckout d
uring order interval

QQR
Order quant ity in units
Economic order qu antity in
Average annual dem and in
units
Maximum inventory level
With known stockout cost:"
P(M > E) = A
HT

s units Backorder case

J<E> = a
Safety stock in units HT
SLC Service level per cycle
Zu
E=M+ s=M+
SL1
Serv ce l evel per order

T
SefVlc level per Units
interval
SL U
deman ded
Order mtervai in years
 B.
260 1
261
Systems: Probab ilistic Mode:ls nd ix Normal Distribution
Indepe ndent Deman d C ha
p, Appe

M ode l
Formu la TABLE > 1 6

+ HT
HT
P(M > E) =
Lost sales case A

M M .40
.10
E = + S = + Zo
.30
Maximum inventory level .20
with service levels:
ad te results are read using the same convention . Thus, the demand dis
tnbutlon for two weeks IS. obtam_ ed as follows:
Service level per

(. I +
order interval SL, = I - P(M > E)

SLu = I - I + .08X + .22X2 + .28X3 + .25X4

.4X + .3X2 + .2XJ)2
+
E) = + .04_x6,
Service level per E(M > oE(Z )
units demanded TR
-
TR
= .0 1 .1
which results in the two-week demand distribution shown in ThbJe 5-17. The 1l5e
M and for the of the binomial expansion in developing convolutions, while correct,
n tht
'Por t he reorder point mod e l , o apply to the demand during the lead time period; can

maximum inventory level model, M and o apply ro dem a d d u r i n g the lead t i m e period and become mathematically tedious. For this reason it is desirable to use standard
o rd er interval. distributions (normal, binomial, and Poisson) which are weU behaved in
relation to convolutions. When normal, binomial, or Poisson distributions are
convoluted, the same respective distribution results.
APPENDIX A. PROBABILITY DISTRIBUTIO N C O N V O W T I O N S For a stationary distribution with mean X and standard deviation n o,

convolutions will result in a mean of nX and a standard deviation of ../n o .

Thus, the demand distribution for any multiple of a time period be ob

tained by convolution if the stationary distribution is defmed by its
Frequen ly, it is necessary to know the probability distribution of the demand can

fr vary mg-len h tie perio. If the demand is stationary with no integral mean

ttme se n. es modlfi cat10ns and tf the demand in subseque nt periods is i,ndepen and/or standard deviation (such as the normal distribution).
n.tth fdeman
the demand level _ in previous _periods, then the probabil distrib ution
re-: l sed ob bll t_Y dlsnutin of the demand is derived by convolutions o. fThe
_ for _var:lng-length t1me periods can be easily ityobtained TABLE 5- 1 7

. r a t he Demand Probability

:ee:S n t!Y dlstnb ab

_u_uon _wit_h ielf.8 The convolu tion process permits
l ty d st but .01

period to the dema:t t buIOn _
t l anyi O n n of dem and for a given f ed me
lx ti .08

For a discrete d ' t o for integral multip le of that time p eriod . .22

obtain the desired con / l theexam binom ial exp ansion can be utilized to .2 8

shown in Table 5 - 1 6 applies ne fo ple, suppose te demand distrib utt_on .25

. 04
.12

?em_and distributi on for a 2- wee k i aTwee kly penod. What would b the
rn bmomial expansion terms as fo ow he ! -week demand can be wntte0

.I + +
.4X +
earlier in the
. JX 2 . 2X3, APP EN D IX B. N O RMAL DIST RIB UTIO N
wh ere the exponent . .0I
n that are use
ch apter.
_IS _the probabil ity ofof Xtheequa ls the demand (Xo I ) , and the coeffic1en T'he nor mal distrib utio n I. S descn. bed m.:; general terms utio d to
d tst n b u ti On o f demand for resp ecti ve emand le:'el. To btain the pro bablli
n wee ks, t _
=

T'hre are three functi ns related to t h . al dist rib .

pro bab ility density
They are tbe
e expressJOn IS ra1sed to the n t h pow denve decision rules i n J nvento n: m na fun ction D. the c:xpecta u n
is f(M} at any pom
fu nct i (pdf), t b t on
(cd and
t
on cu m u l a ti ve d J s n J
of Inventory Systems, Englew A noiP
T'he ordinate (heithegh t) of the p ro babll! tY (enM)sity fun ction
under the pdf to
OOd Cliffs ' N J . ullru see G.
the

A1. Th e cu m u l tive distri b utio n fun cuon

1 Por a more

is the area
complete disou
sion of convol .
Hadley and T. M . Wbiti n ,
Pre ntoce- Ha l l ,
1 963 . a
> :;: r.
 C hap, 5
264
Models
d Systems: Proba bilistic ndix C. Chi-Square GoodnesS-<>f-Fit Test
Independen t Deman APpe

Dm
TES T
RE GOO DNE SS-O F-FIT TAB LE
5-2 0

APP END IX C. CHI-S QUA
Frequency of Demand
b Uo - f.f
ed in inventory analysis,

J.
distributions can be u

fo - f.
they
p onenti aJ are
When the standard statistical
Uo
an per
f.>2.
d

f.
e
effo . However,
r uc he o pu tiOnal
s and ed e t c m ta before Day, D fo"

40
can simplify the analysi

tri
e
the normal, P01sson, and negati

standard distribu tions such as
the Istnbution . A
eal dif erence exists be.

)
the goodn s-o f-fit of test 36. 8

3.2
employed, it is necessary to establish _ 30 36.8
10.24 0.28
bu io can determme tf any
- 6.8 46.24
based on the chi-square dis t n _ 20 1 .25

goodness-of-fit test will mdicate If the

1 8.4
the standd dis tnbutwn it is assumed
1.6 2.56 0.14
tween an empirical (act u al) distribution and . _ _ 10 6 1 2.0 4 . 00 0.50
to represent. The chi-square difference 0 1.5

es,
ll 8.0
between two distributions (empirical and theoretical) is statistica y significant. 0 0.3
and theoretical (expected) 0 0.1
To measure the compatibility of actual (observed)

gni can a
to calculate the chi-square statistic. The calculated chi.

100 days.
u nc
freq e i it is necessary 2.17
value obtained from a chi-square table

"/, = I OOP(D).
is compared with
square statistic a for 'For
given level of si fi ce and number of degrees of freed o m . If the calculated chi

_ es es
squar e statistic is less than the value obtained from the statistical table, the theo

A hisquare statistic of zero rep r e nts a perfect fit; the larger the chi-square
retical distribution is accepted as an adequate surrogate for the actual distribution. We have

statistic , the poorer the fit. Chi-square tab l can be found in any statistics book. f.jD = = I .
l5 =

-
The chi-square statistic is obtained from the following formula: f./ I OO

2 - -. J;i
!.-
Uo- l5
X = i.J = .
chi-square ,
The arithmetic mean theofabove distribution i s I unit. By consulting a
Poisson distribution table for a mean of I unit, the probabilities of each

in Table 5-20.
expected demand level are obtained and transformed to the expected frequencies

- -
where

2
fo =
of freedom (k 2 = 4 2), we find X = 4.605. Since the computed value
observed frequencies, e 0.10 and 2 degrees
Consulting a chi-squar e table for level of significanc

f. = expected frequencies.

The most frequently used levels of significance are 0.05 and 0 . 1 0. The degrees
(2.I 7) is less than the table value, the Poisson distribut ion can be used to

. and k - 2 for the Poisson

d esc rib e daily demand.
o f freedom are k - 3 for the n orma! d'Istn'b utwn
distribution (k is th e num ber of frequency classes). A few simple examples can Norm al Distributi on Example

i
illustrate the test.
the data were
The lead time demand for an item is shown in Table 5-2 I . Before
to be 52.5 and 6.6

Poisson Distribu tion Exampl e grou ped, the mean and standard dev ation were calculated
' Table 5 - 1 9 . Determine whether the dcrilY
The demand per day for an item is . ven . .

ed at the 0 . 1 0 level of si_ grufica

demand can be considered Poisso dLStnbut _
TABLE 5-21

f
nce.
freq uency
l...ead Time
TABL E 51 9 Dem and M

Dem an per Day Observed

:S 3 9
40-44
12
26
Freq uency 80

40
45 -49
130
50- 54

60-64
1 04

55- 59
30 42

_JQ 400
20
2: 65

1 00
 Ch ap, ,
266
: Probabi list iC Models
Indepen dent Demand Systems

umt respecti vely. Determi ne i f the

lead time demand can be approxim ated by TA BLE 5-- 22
Freq uency of Demand
0.05 level of confid ence.
Time
a norma l distrib ution at the
d i n the fol l o w i ng m a nn er:
oem and M J,)
The expected frequen cies are obtaine
!. /,, - f.
t..ead

1.Z=M-M= 6. 6 = - 1 .97. 9.8

4{)-44 I .'A
s39 12

90 2 5
0

Z 1 .97 0. 4 7558; 26
3.2 1 0.24

2U
From the normal table a of gives 35.5
.
I 1 6.6
- 9.5

1 79.56
45-49 80 2.42
fe = (0.5 000 - 0. 4 7558)400 9. 7 68. = 50- 54 1 30
85.3 - 5 .3
1 .539
lJ.32.'J

60-64
1 3 .4
55-59 1 04

2. z fJ.lifJ
95.0
42 13 8
9.0

- 7.8
=M-M= 6.6 = - 1 . 2 1 .
44. 1
. -2.1
l .(fJ

60.84
1J.'S3

400
___Q
65 4.41

1o.a17
0
4.4f:N
Z 1 .21 0.38686;
From the normal table a of gives

fe = (0.47558 - 0.38686)400 35.488. =

3. 2
= M - M = 49.5 6.-6 52.5 = 0. 45 . freedo (K - we find x2
_
Con.sult i n g a ch i-square table for level of significance 0.05
3 = 7 - 3), Since the computed value
= 9.488. a n d degree. 4
LS greatJ than the table value, the normal distribution does nnt
0
of
Z 0.45 0.17364;
From the normal table a of gives (10.817)
= (0. 3 8686 - 0.17364)400 85. 2 88. =
adeq uately d es cn be t h e actual distribution.
f.

M 52.5
4. z
= - M = 54. 5 6.-6 - 0. 3 0. _

Z 0.30 0.1 1791 ;

From the normal table a of gives
APPENDIX D. O R D E R QUANTITY AND REORDER POINT
DE P E N D E N C E
f. = (0.173 64 - 0.11791)400 = 1 16.62. I n fixed o r d e r size i n ventory models involving uncertainty, it becomes apparent
- M
s. z
=M 59.5 ---
-- -
52 . 5
6 . 6 = 1.06. frequen t l y a n d ju.stifiabJy ignored to simplify inventory control. Analysis is
_ that the order q uantity and reorder point are interdependent. The interaction is

neede d , h o wever, to check this assumption. The risk of stockout occu r> only
0

a fter the reorder point is reached. The size of the ord er q uan t i ty will determine
Z 1. 06 0.3554 3;
From the norma l table a of gives
f. = (0. 3 5543 - 0.1 1791)400 = 95. 00 8. ti t , the
quan y
-
t l y t h e reorder point is reached. The larger the
eplet
ho w freq u e n order

z
freq uen t t h e exposur e to stockouts (the risk of d
W i t h t h e size of t h e order quant ity).
6. = M - -- 64 .5---52.5- = 1.82 .
M _
ion varies inversely

6 .6
Z of 1.82 0.46562;
From the norm al table

Bac korder Case: Stocko ut Cost per Unit

a gives
- f. = (0.46562 - 0.355 43)40 0 = 44.0 8.
7. z . time ( : 1:::::
e
=M-M- 64 5 - 52. 5 = 1.82. P ssi bilit y of a stocko ut only oc rs d uring tb : lead
l n t IS reac hed) . In an a n n u al pe od , .Jf there . 15 no d uring ""lucb a

Th e
n
_
.

the norm al table a Z um:o: ed by the ord

0

of 1 . iv
tbe
From ts tan d ing .at any given time, tbe number of
.8 2 0.46562' J cko ut i
betw oreuroisbuuoo
d d

- .,tb
gives
een
annual dem
or
f. = (0.50000 0.46562)400 co u l d occur is R IQ,
q unt ity. To accou n t for the depe nden ce
r.i t . and reord

Poi nt , th e ex cooun
= 13. 752.
k rdering can be written as
for a
H en ce w e have Tabl e
5-22. pected annual cost formu la
bac o
 C h ap, S
268
s: Probab ilistic Models

269
Indepe ndent Deman d System ndix D . Order Quantity and Reorder Point
APpe Depende
nce

expec ted annual cost - - ++ order cost

al co t w th
res pect to
urcha se cost By taking artial derivat ives of the
and
CX Dected annu

Q nd 8 can
stockou t cost ,
Q
be
holding cost an ettmg them equa l to zero, optim um expression s i
RP + RCQ + H [g2 Joo(B - M)f(M)+
] o btam ed. s for a
- QlR A E(M [C +
dM

> B )] +
TC
aQ
aTe
o,
=

H2 =
+
o

A RIoo(M - B)j(M) dM,

=

Q 8

Q* '\ff2R[C + A E(M
=

> B )]
where H

R average annual demand i n units, econ omic order quantity

p
=

RA
=
in units,
= purchase cost per urtit, aTe
= -
P(M > B) + H =
C = ordering cost per order,
aJi Q 0,

Q = order quantity in units,

P(M > B) P(s)
HQ optimum
H = holding cost per unit per year,
= =
AR = probability of a stockout.
B = reorder point in urtits,
Lost Sales Case: Stockout Cost per Unit
M = lead time demand in units (a random variable),

A = stockout cost per urtit, When stockouts result i n lost sales, the expected annual
modified as follows:
cost formula is
f(M) probability density function o f lead time demand,

s
=

= B-M TC = RP + !iQ [C + A E(M > B)] + H[ + (B - M) + E(M 8)] .

>

= Joo0 (B - M)f(M) dM = expected safety stock in uni , ts The first term gives the purchase cost 0f an item times the units demanded.cost)The
second term gives t h e fixed cost per order c1 e (0rder cost plus stockoutslightly
E(M > B) s: B)f(M) dM
less than
times the number of annual order cycl ber of order cycles is
ta ;:
= (M -

third and final term is the holdm g cost, which includes onehalf
R/ Q
because of lost sal s, bu f t is assumed negligible). The

when Q arrives is expected to

expected lead time stockou t in units, the order

will
=

A E(M > B) = expected lead time

Quantit y plus safety stock . The stock re aJ :
. .
be l ess than
B - M ; h o wever, i f shortages
stocko ut cost . r, cted depl etion
The expected annual cost formula
can be simplifi ed to t h e following:9 M by the expected numb er of : : E(M >
h rt,
B). Thus, the average

can
RP + [C + A E(M > B)] + H[ + B - M] inventory will b e larger by the sho
. .
e q uantity.

he ex pected ann u
.
cost WJ th ::;
t to
for Q
TC

=
By taking partial denva uves
Q nd an d setting them equal to ero' optim ssiOns
be ob tai ned :
um expre
a B
The first term gives the annua l
purchase cost of the item.
Warren
The seco nd ter m gi

Charles Bonini . and

the fixed cost per order cycle

. an.
JL: Irwin . 1969.
(order cost plus stocko
ut cost) time s t he n um
(RIQ).
li. liausm an, Quantifallve Analyt.S or Business Decisions,
Harol d Sterm P
of annua l cycles

ThfJ' 1111d p,.gcm:e.

. al ressions , see
The final term is the to
holdin g cost, w h ich am ounts 1 For derivations of opttm
n Doug! roJ
Miller, Inventory Co

169- 17 7;
A John.IOD and
half the order quant ity plus the
- M ). (B C.
Man in K. Starr and DaVId
safety stock

9The formul a developed assumes "'0od Cliffs, W. 12().. 24; an d Lynwoodu attd /nvtllfOf)' Conr
that sales are delayed (not NJ: PrenticeHall, 1 9 1 li g'
I n most situati ons the differences between resul lost ) in a backo rder situati : Montgom ion Planning, Sch
New Yor k : Wiley, 1 74, pp. 59-66.
ts obtai ned from backorders and from lost s l ery, Operati,ons Research ::ducr
small. a es
9
 Chap, 5 PPend ix D. Order Q uantity and
270 Independent Demand Systems:
Probabilistic Model s
A Reorder Point Dependence

aTC
H J. Use computed Q to obtain P(M > B)
J; [C 2 = O ,
4.
+ A E(M > B)] + and B.
E(M > B ).
_ _

aQ - Use comput ed B to obtain a value for

-------:;-;--;
s. Recompute Q with E(M > B ) .
Q

6. Rep eat steps 3, 4, and 5 until convergence

Q*
. j2R[C
= 'V
+ A E(M >
B))
occurs .
H
= economic order quantity in units, The above procedure is a cumbersome but simple task, and usual
than one iteration is required to obtain convergence.
ly not more
aTe
=
Because of insen
an
_ _____ sitivity, the independe nce assumption usually provides an excellent approx
tion to optimality. A simple example can best illustrate the technique. ima
P(M > B) = P(s)
D-1
=
Example
HQ
AR + HQ Determine the parameters for a fiXed order size system from the data given below
=
and in Thble 5- 23 :
optimum probability of a stockout.
R = 1 800 units/yeo.r,
F = 1 511lo,
Summary C $30/order
= ,

For the backordering case, the optimum formulas for the fixed order size system p = $200/unit,
with dependence have been derived and are as follows: A = $8.00 pe r unit backordered.

Q = -v2R[C : + A (M > B)]

= EOQ,
TABLE 5-23

Time
P(M > B) = P(s)
Probability of Stockout
Lead
Demand M
Probability
P(M) P(M > B)

=
48 .02 .98

AR
HQ .95
49 .03
.06 .89

=
50
.82
51 .07
probability of a stockout. 52 .20
.62
.38

.II
For the lost sales case, the optimum formula 53 .24
system with dependence have been derived s for the fixed o rder size 54 .20
.18

and are as follows : 55 .07

.05

Q =
2R[C : + A (M > B))
= EOQ,
56
57
58
.06
.03
.02
.00

P(M > B) = P(s)

1 . 00

AR + HQ
= --..!!.2:__ = probability of a stockout. To solve the above prob :: ;nomic
use the proced ure outli
ned in the previous
orde r quantity:
To obtain the optimum values sectio n and find the determm
60 units.
dependent, an iterative proced when order quan tity and reorde poi t
ure can be used whic h conv erges to ther o p nm
'V(iCR
2 (30) 1 800
u
=
solut ion. The procedure, which TF
=
uses the formulas devel oped, is as folloW Q 200 (0. 1 5 )

1. Select appropr iate case

S
=

2 . Comp ute Q with E(M

(backorder or lost sales formulas HQ 0. 125.
> B) = P(s) AR -
_ =

> B ) == 0.
). P(M = 8 ( 1800)
 Chap.
\

6
d Syste ms: Proba bilistic Models
Indepe ndent D e m a n
272

.
on u1ung Thble 5-23 fo .
r P(s) = 0 . 1 25 , we see that the computed v ue is
M > B) t e expected lead time stockout
B)

i.s
7
reorder pot nt o
aller value we obtatn a
. ng 1 h e
h
f
bet,,een 0 . 1 I and 0 . 1 8 . Selecu
step to compu te
55 units. The next

E(M > B)
i.n units:

'E' ) (M - B)P(M)
55)0.06 + (57 - 55)0.03 + ( 5 8 - 55)0 . 02
I N VE NTORY SYSTE M CH AN GES
=

8-T 0. 1 8.

as
=

i.s
=

now necessary to recompute the order

quantity using E(M > B ) follows: AND L I M ITATIO N S
2 ( 1 800) [30 + 8(0. 1 8)]
It

2 00 (0 . 1 5)

= 6 1 .4, or 61 units, INVENTORY SYSTEM REDESIGN

HQ 30(61) CHANGEOVER STRATEGIES
P(M > B) = = = 0.127.
AR 8 ( 1 800)
RELEASING WORKING CAPITAL

bas n ot changed, It will
Consulting Table 5-23 for P(s)
0 . 1 27 , we obtain the reorder po t o f 55 again.
=
INVENTORY SYSTEM CONSTRAINTS

r b e same economic order quantity, 61 units. Convergence bas b e e n obtatned. The

.
The problem is solved. Since the reorder point result tn
Exchange Curves
Working Capital Restrictions
optimum inventory policy for the ft.xed order size system is Q* = 6 1 and B = 55
Storage Space Restrictions
units.
Working Capital and Storage Space Restrictions
Overview of Constraints
exampl,
the independent treatment is frequently an excellent approximation to the opn
Although convergence will not always be as easy as in t h e above

An Excess Model
EXCESS STOCK DEiERMINATION

mum solution. I n the above example, the independent s o l u t i o n was Q* = 60

55. =
If the stockout cost per order cycle, A E(M > B ) , approaches or exce eds the
Minimum E c o n o mic Salvage Value
and B = 5 5 , while the optimum dependent solution was Q* 61 and B =

order cost per cycle, C, then the assumption of independence betwee n the order
Lead Time I n fluence

CO CWSIO N
t h e order quantity and
Liquidation Alternatives

quantity Q and the reorder point B weakerts. In that case

reorder point should be determined jointly. Ques tions
Proble ms
Cases
Math em atical A b b reviations and Sym bols
Summary of Formulas
A. PP EN DIX STRAINED FUNCTI ONS
A: OPTIMIZING CON
 Fixed Order Size Systems

3
91

one of the maj r reaons for having inventory is to enable an or an'

bu Y produce Item s m economic lot sizes. Organizations which se : .
lot szmg often o so hen th want to maintain a regular inventory of items ':n
whih have a a1rly umform : dependent demand. This chapter introduces
ectal coll:ctiOn of determ1mstic models that apply directly to unifor a
DE M N D SV.S TE MS spmand oond J tJ..o s. Thee model s determine the economic lot sizes (optim m de
IN DE P EN D EN1i inventory pohcte s) for mdependent demand items, whethe r they are purchas
um
ed
from a vendor or produced internally.
MI NI Sl" IC M OD EL S To determ
DET ER ine an optimu
following parameters is required:
m invento ry policy, informa tion on each of the
1. demands,
2. appropriate inventory costs,
EMS
FIXED ORDER SIZE SYST
.
3. lead times.
Economic Order Quantity (EOQ)-Smgle Items
EOQ Sensitivity '
"'8ackordering In cleterministic models, all of the parameters and variables are known or an
Quantity Discounts be calculated with certainty. 'J1he rate of demand for units and the appropriate
All-Units Quantity Discounts inventory costs are assumed to be known with assurance. The replenishment
Incremental Quantity Discounts lead time also is presumed constant and independent of demand. The real world
Special Sale Prices is seldom as well behaved as described by deterministic models and is more
Known Price Increases reasonably depicted in probabilistic erms (i.e. in stochastic models, where
BATCH-TYPE PRODUCTION SYSTEMS
Economic Production Quantity (EPQ)-Single Items some or all of the variables are probabilistic). However, deterministic models ,
Backordering are frequently excellent approximations, or at least, good starting points for
describing inventory phenomena.
It usually is easier to work analytically with inventory models the van-
Make or Buy Decisions . .

Economic Production Quantity (EPQ)-Multiple Items

Runout Time (Raf) Method abies can be treated as continuous rather than discrete. In cases where mvenor:
demand is sufficiently high, variables can be considerd cntinuous, an Jt IS
Aggregate Runout Time (AROf) Method
FIXED ORDER INTERVAL
possible to take derivatives instead of having to work w1th d1fferenes. This co
SYSTEMS
Econo c Order Interval (EOI lection of models assumes continuous properties and thereby simplifies the tas
)-Single Items
Econonuc Order Interval (EOl)-M of finding optimizing inventory policies.
CONCWSION
ultiple Items
Questions FIX ED ORDER SIZE SYSTEMS
. posed to inventory system are how many
Problems
Cases The two fundamental quest1ons
when to otder. The ansers depend on
Mathematical Abbreviations and and nature of inventory demand md
SYmbols the parameters used to defme the syste . As previously described, demand
IS ass:med to be known and
Summary of Formulas
presumed
. <>
APP END IX A .
SINGL E-V
DETERMIN
ARIABLE MAXJMll"'
ATIO N O
a deter ministic fixed order size system always is
A N D MINIMUM
POI NTS F to the same num r 0 f units (how many)

(when t expected to vary.

be continuous. Therefor e, The stock
N 0F EOQ
APPENDIX B. DE
level is reviewed with each transaction, an :ednever
or en order
WITH BACKORDE RING
RIVATI O
dere d, and the time betwe the inventory position.
:: f'
APPENDI X C. r of units is placed
R SITUATI e: are the reorderedpoint
COMP OSI numbe
ONAL
TE es a predeter ned poin r
Thus, the two defmmg parameters 0 . Ysystem
DECOMP OSITI EOQ FO re ach t, an or (B) and
ON
the size of the order (Q). The fixed order stze also is term a Q-system,
 3
tems: Deterministic Models C hap,
ndent Demand Sys Fied Order Size Systems
lndepe
92 93

----- ---- ----- - -- ---- - - -- - - - ------

d
TIME

FIGURE 3-2

reorder point; ac ce
Classical inventory model

cd ej =
FIGURE 31 Fixed order size system
Q = lot size; Q/2 = average inventory; B = = = interval between orders;
ab = = lead time.
since the size of the order (Q) is fixed for each replenishment. A typical examplr
is depicted in Figure 3 - 1 . where
=
p =
Economic Order Quantity (EOQ)-Single Items Rannual demand in units,
purchase cost of an item,
The order size that minimizes the total inventory cost is known as the economk C =
ordering cost per order,
order quantity (EOQ). The classical inventory model assumes the idealized H = PF = holding cost per unit per year,
inventory al a
situation shown in Figure 3-2, where Q is the order size. Upon receipt of
=
Q lot size or order quantity in units, .
an
order, the inventory level is Q units. Units are withdrawn
constant demand rate, which is represented by the negative from lines. When F = annual holding cost as a fraction of urut ost.
the inventory reaches the reorder point B, a new order is sloping placed for Q units. The annual purchase cost is the purhas c.ost er unitcost(P)totimes the
After a fixed time period, the order is received all at once and placed into annual demand (R). The annual order cost ts o ame/as the holding place an
inventory. The vertical lines indicate the receipt of a lot into inventory. The ne\ order (C) times the num er of orders per R Theinvento annual cost
ot is received just as the inventory level reaches zero, so is the holding cost per urut per year (H) tJ t e a ge ry (Q/2). The
(Q + 0)12, or Q/2. the average inventory
sum of the three costs (purchase, order, and holding) is the total inventory cost
inventory cost per year il
IS

f stockots are not permitted, the total per year for ny given. urchased :t
graphically deptcte d by Figure 3-3 and by the following s size (EOQ) , take the first derivati:e of
total :n:s :i::,: the Jot size (Q) and set it equal to zero..
formula :2 h
total annual cost purchase cost +
=
order cost + holding cost
TC(Q) PR + + HQ dTC(Q) !!_ 0.

--;JQ - 2 Q
_ =
_
=

Q 2 '
the eri1 =:;::ory model is frequently referred a sawtooth diagram because ol Solving the equation for Q, we get the EOQ formula:
tion of a continuous sinal
Although a ti e
and H are on the m Ptriod ' See Appendix A for further clarification of the minimiza
s

I
is is selected, any time period be used toni
to as

same time Ptri0:

2
f IJ
can as variab le function.
 Chap,l 95
Deterministic Models
d Syste ms: Fixed O rder Size
Systems

94
nt Deman
lndepende

B
RL
= 12 = reorder point in units.

TC(Ql I f the lead

time L is expressed
B
RL
in weeks, the reorder point is expressed as
52 reorder point in units.
= =

The replenishment order arrives just as the last item leaves the inventory,
l;;
which restores the inventory level to the amount ordered. If the reorder point
0 is less than the lot size (B < Q), there will never be more than a single order
. outstanding; if the reorder point is greater than the lot size (B > Q), there will
u

always be at least one order outstanding.

The minimum total cost per year is obtained by substituting Q for Q in
the total annual cost equation. A simplified formula for the minimum total cost
suits:
TC(Q) = PR + HQ.
Qhe classical EOQ model is based on the following assumptions:
Q*
ORDER QUANTITY (Q) -

1. The demand rate is known, constant, and continuous.

FIGURE 33 Annual inventory costs

2. The lead time is known and constant.

\/fiCR Pi economic order quant'tY:_;)
\/fiCR 3. The entire lot size is added to inventory at the same time.
Q
.
4. No stockouts are permitted; since demand and lead time
H
= = =

are known,
Q results in an item with a high unit cost being ordered frequentl) stockouts can be avoided.
s. The cost structure is fixed; order/setu p costs are the
The EO
in small quantities (the saving in inventory investment pays for the extra orders); same regardless oflt
an item with a low unit cost is ordered in large quantities (the inventory
size, holding cost is a linear function. basd on average inventory, and umt
investment is small and the repeated expense of orders can be avoided). If tht purchase cost is constant (no quantity discounts).
6. There is sufficien t space, capacity, and capital
.
results in no holding cost. I h he holding cost H is zero, an order
order cost C is zero, orders are placed to satisfy each demand as it occurs, whid to procure the desued
placed for an amount that will satisfy the
(only one) i1 quantity. .
7. The item is a single produc t; it does not interact
.
Oe th e economic orde r quantity is
lifetime demand for the item. wtth any other mventory
during e ear, m, and the time . between known,
orders, T, can be determined :
the number of orders placed 1
items (there are no joint order

I
nu ber of orders during year = m = !!_
Q - 'V. {iiR
2C '
Example

The Williams Manufa ctunng . Company purebases 8000 units

of a product each
. 00 per order and the holdin
g
year at a u it cost of $ 1 0. 00 . The order o ts $30
order intervai T = _.!_
. mic order uantity, the tOial
= . $3 . 00. What ar t e econ
m
cost per umt per year ts when
and the reorder point
=
.

during the lead time perioobd.ta' b determining the demand that will oc
an nual cost, vhe numbe r of orders to place 1 0 one year,
=

poin R HR
The reorder t is
-thebaeconckorders) reaches the reorder nPOtnte stock position (on hand + on or.
the lead time is two weeks?
{2cR 2(30)8000

400 units,
\/ }{ -
_ =

when the leadc ortime

omi der Quanti ty. The _ ollo, n order will be placed for Q untU; Q = 3
L is expressed tfn m wmg formul a gives the reorder poJP + HQ* 10(8000) + 3(400) = $81 .200,
onths : TC( Q *) = PR =
 nistic Models Chap. 3
tems: Determi Fixed Order Size Systems
Dem and Sys 97
Indepe nden t
I
order cost + holding cost
96

R
TVC(Q )

400
=

+ HQ
20 orders/year,
Q- _
-
:

0i
m :

RL
B :
=

307. 7 units.
Q 2 '

+
5z :
:
52
TVC(Q*) 0i HQ
HQ .
=
=
Q 2

. uantity minimizes
the total cost function un der a
Assume there are errors in the estimation of parameters R, C, and H with the
The ecnorruc order
: t is based on a given cost
structure. It may be more respective error factors XR, Xc, and XH. The model becomes
outlined in C hapter 9.
. of ctrCum s ances .
gtven se such as the order/setup cosl
approprtate t nd aYs
to reduce cost parameters,
f the "just-in-time'' philosophy 2CR XcXR Q rx;x-; Q*
;:; o r :iucst will reduce the EOQ and conseq \1 --x:
.s l Q =
uently the average =

=
H XH XH '

inventory as well.

Q - Q*
= 'Vrx;x;
---;-: - I = . error fraction,
order quanttty .

EOQ Sensitivity
by
where
model will be influenced
Sensitivity analysis determines how the output of a Q =
order quantity with parameter errors,
input can assume a de
changes or errors in the input data (parameters). If an
wi
range of values withoufa output, the model is insensitive.
ppreciably affecting the Q* economic order quantity,
=

tive. The sensitivity of a model will dictate the

the output, the model is s nsi
If a small change in an input can appreciably affect e
estimated demand demand error factor,
H,
precision of parameters required
the annual demand R, holding cost
for XR =
=

the model. The EOQ model assumes that

actual demand
in determining these parameters will
variation. Errors by mana e nl
and order cost C are deterministic and without g me
Xc
estimated order cost order cost error factor,
variable cost). This section will analyze the impact
= =

cause variations in output (EOQ and total actual order cost

all
of estimation errors. estimated holding cost holding cost error factor.
errors of
nsitivity analis can be useful in
several ways. First, the param eters XH = = .
- actuiil holding cost
can
are
used m _mventory decrsions estimated, so it is desirable
to know how
estimation could affect decisions and the resulting variable cost per ye to errors in
:::= costs. Sensitivity analysis
en t ation procedu es are adequate,
or different proced_ures

To determine the sensitivity of the total
input parameters, a similar p ro ced ure of insertin g error
.
factors mto the cost
t
m ding at what point it will
?
revtse
eed . o.nd , mput
Parameters may change

formula i s used:
over tue,
ect n mput values . Third,
so sensitivit analys can elp d

inventory d
t be necessary to
di e an
CR HQ
z
ra:;
o o
conditions may ctat +

HXH Q l , .<\{,
TVC(Q)
Q
=

&0
order quantity is a e or elow the EOQ
;a
capacity limitations t _ account of factors such
po uon efficiencies, or
to take
packaging restrictions. j)ensJ +
=
'
tivity analysis can used t _ CRXcXRXH

h
e the cost effe
In a fiXed order size such adjust nts
of making me = 2XH
minimizes- flle!otal
q..JXcXRXH

+ H
Y e order q anhty which
van. able cost per Year dicta
':
mathemat ical relationsh
tes
ips are as f

The p runenl
m mventory policy. e _
-
(0!._
Q
Q
2
)
-.fXcXRXH

= TVC(Q)-.fXcXRXH,

TVC(Q) - TVC(Q* )
TVC (Q) - TVC(Q )
= TVC(Q *)
TVC(Q*) .
1 TVC error fraction
,fxc.XRXH _ =
==-
 Chap. 3
lndependen l Dem
Dete rmini stic Models r Size Systems
and Syste ms: Fixed Orde
I
ual to . I , the TV
C rror fractio n is
98

factors are eq le paramete 80

When a ll . the ror ulatiO n that for smg
. v the above form :
: : : : t he mfl ue ce of errors in
e irresp e tive of the para mete
is the an:
70
ot TVC( Q*)
3-1 Absolute TVC erro_L% I
i n h
meter vartatwns, _
h single para ts sho wn m Thb le
(C, R, or H). Wit itivity of TVC
and
ates of c, R, or H on the sens -
estim

60
---
4 atte nuated d ampened)
;
Fi gur in para mete rs are
errors

1 . 4), it results in onl y

eadil y apparent that
t incremental cost . !For example , if the
their impact on total
=
\
when trans lated into
the hi gh side (Xc
50 C. R, or
error by 400Jo on

order ing cost that is in

ordering cost is in
possib le minim um total variable cost. '
an 1 8 . 3 % increa
se over the theoretically ,

error 400Jo on the low side (Xc

,
somew hat more costly. An ,
Errors on the low side are absolu te error of 22.50Jo.
stimation errors in
= 0.6) results in an

40
of the curve for undere
As revealed by the steeper slope
Figure 3-4, it is more desirable for estimates to be
on the high side to avoid the
I '\
/
'
EOQerrors
.

30
larger absolute cost penalty for low estimates
,
'

Q, the procedure of inserting an error factor into the cosl

year to rounding
To determine the sensitivity of the total variable cost per
;: : :
,
n h
1 i se

in C, R, or H on TVC(Q")

Error Factor
TABLE 3-1 Effects of Errors

Error in TVC(Q)
x, (OJo)

:
- 68.4

1.4 1.6 1.8 2.0 2.2

' I

.8 1.0 1.2
,
- 55 . 3 ,
0.3

0.5
-45.2

e:::;=i:iue
0.4 - 36.8

0.6
- 29.3
- 22.5
;
Er or factor =
0.7 - 16.3

FIGURE 3-4 Effect of error

0.8

1 .0
- 10.6 s on TVC( O")
0.9
-5.1
0.0
1.2 HQ *
"Q. + 2 =
+ 9. 5 CR
1 .4
1.6 + 1 8.3 TVC (Q* ) = HQ *,
+ 26.5

+ -2- '
1 .8
2.0 + 34. 2 CR HQ*XQ
2.2 + 4 1 .4
+ 48.3 TVC(Q) =
Q*XQ

he e
2.4
2.6 + 54.9

estimated EOQ EOQ error factor.

2.8 + 6 1 .2 w r

actual EOQ
3 .0 + 67 .3

(estima .{)/
1 actual
other two. Thus ' were ,), where 1 ;. an
_ =
+ 73.2

follows:
4.0

1 cost is
/ XQ

C, then R and ; :o e npoarae mr eters and there are no errors in tht The error fraction in the total variable
x, = + I 00.0 -

r.
as

e r o s
 Chap. 3
101
Models
stems: Dete rministic Fixed Or
der Size Systems
Demand Sy
independent
1 00

__!!__ + - HQ * orde r quantity is in error by 40% on the high side (X t e only

a 5 .7% i crease over the theoreticallyJ;0Ss i ble u t! r arlable
slts m c
_ .

Once agam,_ errors _o the low side are somewhat more cost :
2
Q *XQ
TVC(Q) - TVC(Q*)
HQ* order q uantity that IS 1 error by 40% on the low side (XQ 66) es:;mic
increase o f 1 3 . '!_!1Jo over the theoretically possible
=

I )2
=
TVC(Q*)
able s
an

+ I
_ co to
t.

(XQ
This i ndi cates the general .Qesirability for estimam::;!gh
Xb - 2XQ
ates.
-
=

2XQ 2XQ
avoid the larger cost enalt for
- OQ sensitivity provides insight into the economic behavior of inventory
error fraction.
as measured b turnover. The EOQ formula indicates that inventory should
TVC

I , the TVC error fractio n is zero nd

=

When the EOQ error factor is equal to in_rease oly w1J? te square root of demand. Thus, a constant inventory turn
TVC(Q *). over rate 1s not JUstified as demand (sales) increases. As demand increases, a
o f TVC(Q*) is sho
The influence of errors in the EOQ on the sensitivity are dampened w wn
TVC(Q)
higher turnover rate should be expected.
=

in Table 3-2 and Figure 3-4. EJ;rors in the

order guantity hen
2
size errors
translated into their impact on total cost. Fairly sizable lot
result in comparatively small increases in total variable ts. For example, if I Example

In a fiXed order size system, the estimated and actuaJ parameter vaJues are given
the lot size is in error by a factor of two or less in either direction (0.5 Q
s Q s 2Q ), the TVC will be no more than 250Jo higher than the minimum.
below. What is (a) the individuaJ effect of the holding cost error on TVC(Q*), (b)

This seemingly trivial result is an important cornerstone of operational in

the combined effect of the parameter errors on Q*, and (c) the combined effect
of the parameter errors on TVC(Q)?
ventory control.
As shown in F igure 3-4, the cost penalty is greater for errors of under Parameter Estimate ActuaJ

1000 units
estimation than for errors of overestimation. For example, if the economic

o
R 2000 units
TABLE 3-2 Effect of Errors in on TVC(Q) H $10 $20
c $50 $25

XQ
EOQ Error Factor Increase in TVC(Q)
(OJo) Solution:
demand = 1 000 = 0 _ 50 ,
0.1
0.2
405 .0 XR - _ estimateddemand 2000
1 60 . 0 actuaJ
0.3
81.7
0.4 45.0
estimated holding cos t = .!.Q = O.SO,
0.5 XH -
_
20
25.0 actuaJ holding cost
0.6
estimated order cost =
13.4
0.7
6.4 = 2 _ 00 .
0.8 Xc _
25
2. 5
-
actuaJ order cost
0.9

-
l .O .6
0. 0
1.2
1 .4 1.7 TVC(Q) - TVC(Q*) = ,fXc XR XH _ 1 = {1 (1 ) 0.50 - l

5.7 TVC(Q *)
1.6 = - 0.293 or - 29.30/o .
1.8 1 1.3
17.8
b:
2.0
25 .0 2. 00{0.50) _
1 = 0.41 4 or 4I .411Jo .
2.2
2.4 32.8 0.50
2.6 40.9
2.8 49.3
- I
57.9 .fXc XR XH - I =
=:'I 0 .293 or - 29.30/o .
3.0 TVC(Q) - . TVC(Q *}
4.0 66.7
TVC(Q)
':

__ _ J to?"'
..J_L
 eterm in istic Models Chap, 3
Systems: D er Size Systems
t Dem and Fi xed Ord 1 03
Ind ependen
1 02
r is an unde resti
f variable
mation
In this treatment o backorde ring, it is assumed that all shorta es are
eror param:ters 1s an the next sht met . This is referred to as a captive
on of TVC(Q )
!din cost erro

costs by 29. 3o/o.

satis fie. d fromosed
of th ee over-
by demad
where unsatisfied demand is totally or situ
The individual effec t d effect of all thr 29. 3 % .
to the Ituatton
i
ation, as opF1gure
The com

tially _ lo t. pla ed wh3-5 ndepicts

an d an underesti mati
by 4 1 .4%
estimation of Q *
-. .
dels sometimes arecanview
.s ventorymmtons situa tion rarely be and
. A
par
the backordering inventory modei!An order for
--..:::
ed with susp icion becausede.or QtheumstotsckoIS .ut IS 1 umts,
the stock on hand reaches the reorder poi;rt. The size of
foun d where both ad the maxmum inventory level is Q 1 units. The
_

r c as
theJr I;; :e fnown precisely and where d is trul constant, ba ckor deFlng o o
. st per umt per year IS K, and it is directly proportional to the
d ts
tory models re nmt very sensJtJve to errors m the mea. length of the the time delay.
;ounately, basic inven twns demand level and cost param eters During time period t3 one order is placed, so the order cost is c. There
. .
surement of param eters. Wide varia . is a posit ive invntory. ba_lance during the time period t1 , and the average
do not result in wide varia tions in model ou!Jl.ut cost IS fa1rl flat, whi h hol ding cost dunng 1s giVen _as follows:
, th total variable ccurve cost t 1
@vera considerable range es m demand, order st, estima or holdmg w1u H(Q -
indicates that stantial chang computed with imprec 1se _ tes, the errors
H(Q - 1)t1 1)2

be attenuated1en EOQsof are

=

ess I
2 , 2R
f nct ion. Ther:fore, tpe usefuln
where t1 ( Q - 1)/R.
are muted bytbe presence theifsquare root _
of these models is not diluted exact _ n IS not avail
preciSIO
er errors is a The stockout time period is t2, and the average backordering cost during
=

fue insensitivity of the basic inventory models to paramet slightly increased by t2 is as follow s:
very advantageous property. Since the total cost istheonly
substantial departures from optimum conditions, basic models do not re
quire frequent revision (recalculation). Many components of cost parameters
are difficult to. measure, but the insensitivity renders broad .estimates opera ""'
tionally useful All that is needed is to get into the "right ballpark," and good where
solutions can be obtained with fairly crude cost data. EOQs can be rounded off
without a significant loss in economies. Order sizes can be increased or de
t2 = 1/R.

creased to the nearest pack or container size; orde.; intervals can be lengthened
or shortened to the next convenient time interialJ

r
Backordering
'
A backorder is demand that 11 be fllr ed late2 th n deir_!_In the backordering
situation, a firm does not 107 the sale hen l. iS :mve tory is depleted. Instead,
loyal, patient, or captive custo t.;, hav
firm receives its next order. Ho:r wait .e the1r demand filled when the
bac
than _routine order processing , si Jtordenng deand may b.e .more cosly

r
handhng). Backorders may require r expens often_ requu s expedJtmg (spelal
or a shorter lead time from an altern ttv iVe routmg or premiu m pnceds
Items, backordering may necessitate 0 t external source . For manu factu re
If there were no c associ ated ;:thu"?e expnses.
would be eld. If backorosts murnng backorders, no inventorY
Cutomanl_Y. there is anders were ver :pensive,
intermediat erange they would never be incure
optimal to mcur some backor de:t;ards t.heofendbackor dering costs whe,re 1t 15
TIM E
t h ackordering cost is i
f nite, of an inventory cycleQV heO
stockots to occur. In many c:mtc dvntage may be gained by pecer
tortage he
ts more than compensated' Increase i cot due to accep Bac korderln
g Inventory m
odel

Y the red uctiOn m holding co st._. FIGUR E 3

5
 Chap, 3
1 04
Deter ministic Models

105
Dem and Systems: Fixed Order Size Systems
independe nt
I
d of length /3 is
Therefore, tlte tot al cost of one tjme perio 2 K12 approac es one, so the number of
"+: K)
economiC order quantity (in the extre I eman
H!(H
backorders approaches the
H( Q - 1)
The minimum total cost per yeai 0amed byd subsis backordered).
the total annuals: cost equation. A simP l1' fIei d formula for thetituting Q for Q in
PQ + C + + zR '

Since there are RIQ order periods of length 13 in a which

year, th total ann al cost mirumum total cost
results m per year result
is obtained by multiplying the above equation by R/Q, TC(Q,J) = PR + HKQ -_,.PR + KJ.
total annual cost purcha se cost + order cost +
holding cost H + K
+ backorder cost,
=

When backorders are permitted the reorderlom. t al ulation is modified

H(Q - 1) K12 2 (reduced by the size of the backorde) Th r er
TC(Q,J) = PR +
CR
Q + -- 2-
Q - + 2Q , mand minus the number of units backord:r; or pomt Is the lead time de-
where reorder point lead time demand - backorders,
=

annual requirement in uruts, B =

RL
R
N - r.
=

P purchase cost of an item,

where
=

ordering cost per order,

N =
C
number of operating days per year,
=

lot size or order quantity,

L =
Q
lead time in days.
=

holding cost per urut per year,

J
H =

maximum backordering quantity in units, Observe that the reorder point could be negative if the lead time demand
=
were less than the size of the backorder. This situation would result in an order
K backordering cost per urut per year.,
= not being placed until a certain number of backorders were obtained. Although
To obtain optimal values Q and J' partial . derivatives of the total the reorder point may be positive or negative with backordering, there will
annual cost function with respectfor
to Q and 1 are equated to zero. The following
always be a period in which there is no stock available. When the backordering
cost is firlite, the reorder pomTwiii always be less than the lead-time demand.
optimum formulas result:S
With a backordering policy, the longest time a customer will have to wait
is a vital piece of information. The longest delay time in years for a backorder
is calculated as follows:
longest delay time R =
]*

If the longest delay time is longer than desired, it can e shortened by asincreasin g
K un til the longest delay time is acceptable. In effect, K s treated
a man- -
agem ent policy variable in arriving at a maximum delay tune on backorders .
Exa mple 3

Fro m the information given in Exam ple I, what ha

ppens to the ec nomic 0::
out cost per umt per ye
quan tity if backordering is p ossible and the stock
$ 1 . ()()?

Q = #- = # soo uruts,
 Chap. 3

1 06
ms: Determ inistic Models
ema nd Syste Fied O rder
Size Systems
Independent D

r =
600 units,
- J + l
HQ

_ =

RL - 9 units,
B = =
22 '---:---
N-I
_ 600 =

)
K l - 10(800)0 + I (600

52
TC( Q,J) = P R +
= $80,600 . 00 ,
: _...,.... TC IQ
:...--- /
600 = 0.075 years or 3.9 weeks. !;;
longest delay = R - 8000 0
u
J _

. ed the EOQ doubles in size from 400 to 800 units,

= ;es from 400 to 200 units. No orde is placed
Wbeo backord . =
::=order units accumul
S80,600.00 = S600 .00 with e backordenng policy.
are ated. The optimum ual cst 1s reduced
by $8! ,200 . 00
_
However,
the longest delay time a customer has to wait rncreases from }ero to 3 .9 weeks.

ul
ORDER QUANTITY (Q) -
Quantity Discounts

larger quantities as an economic incentive to buyers to purchase in larger lot

It is a common practice for suppliers to offer lower unit prices on orders for
sizes . The seller benefits from sales of ler quantities by reducingoer unit order
FIGURE 3-6 Inventory costs: all-units quantity discounts

cost point will be either a point

sts and by (at least temporarily) increasing vcliime: The situation with two price breaks. The minimum
as determined by the EOQ.
buyer benefits both byhaving reduc:ed unit ordering costs and b

y
processin
of discon erivative e uaiS zero

l ower unit pri ce , b @!._e co t o aving to bold m rentoryJ T

i: With all-units quantity discounts, the buyer is presen e e supp er

for all unitsin an order and decreases. with increasing order size. The unu

. h e problem with a price schedul coruisting of )quantity ranges such that the unit price
There are two general types of quantity discount schedules offered by
faced by the buyer IS to tdennfy e lot siZe that rrunimizes total costs. equal

U0 Q < VI ,
purchase cost is defined as follows:
suppliers: t he all-units discount and the incremental
discount . W i t h t h e all-unit5

U1 Q < U2 ,

I
discount, purcbasg larger quantitjes for
however, apply the lower unit price only to units
results in a lower unit price for the entire P
lot. Incremental discots, - for
the all-unit s discou nt results in the
purc bas a ov P;

U1 Q < U; .. I
e a specified quantity. Thus, =

ental discount can J

same t pn C for every item in
: a given lot, while the increm

q u antities at

: fo r

where VI < U2 < . . . < U; is the seqHence of integer quantities at which price
tn t le unit prices for

item within the same lot. The

:
ri e e ed pnce-?r quantities for
OnlY breaks occur. u0 is the minimum quantity that c b purchased ( all o ::
may contain o n e or mort
one sc edule usu both schedules .

i
app ed to a given

tn e e 'al U1 to U1 + I
and U + I is the maximum quantity (usually unluntt.ed h p d e
ttem,

le tO OrderS WhOSe (Ot SIZe tails

p ri ce- b reak quantit es and it e
J .
PUrchase

'
COSt applicab
All-Units Quanti

Figure 3- i shows three possible conclitwns that

ty Disco unts with Po > P I > . . . > P; .
.. migh t exist with single
t
a
Tb_e basic economic lot size

form l assumes a
discounts are offere naJ EQ formulatiOn IS not adeq uate.
levllll t ' the dashed
fixed purchase price per untl Price brea k . Only the solid portion of the total os c
u;:
Wah uanti . .
qquanttty y discounts, the tra i o
the c st
function

func tion is still to ftnd tbe

. PO o n o f the curve is not alizab le . The so
urn cost point on th
li
W h t c b applies over tire en ue uant tty ran e
.


dashed curve represents
cont uo , so t he ftrst e tot al cost rve . Hwever, the . ns
d he obJ ecti. ve .

total cost curve s ool

J
oos.
f, ed by the solid poru
lem
c ble gioru. The prob
as .does withou t
re

minim um cost p0 1nt

r:
exten stO

aiWQS
napp
:ea_di!Y
on mto no
Clerivative does of the cost funcu

U!ty or disJunctio
.
ot tndi te the ducect to finding the lowest point 00 the

discounts
c cann ot

rve . Ftgure 3-6

q Beca use of . e, t e ::as:st quan tity
cot
n in the total uan tty discount
creates a disco?ll the discontinu ity of the curv
be fou nd by differentiation':
sho etical
ws a hypoth
 rmin istic Models C hap, 3 er Size Systems
tem s: Dete Fixed Ord
Demand Sys
Independe nt
1 08

Case 2
Case
Case 3 I

)
I

...... ..._: _ _ _ ...... .....

_ _ _ _ .,

Select theEOQ
asthe orderquan tity

QUANTITY -

U,; Case 2: U1;

FIGUR E 37 All-units quantity discounts

d order

Case 3: or r < U,.

with Lhe lowest cost. Case 1: or
er > =
Decision rule: Order the quantity
de No
Is the EOQ

With all-units quantity discounts, there is a separate total cost curve for
valid?

each unit price. Each curve applies. to only a portion of the quantity range
where the respective price is valid The result is a total cost curve with steps
Yes

(discontinuities) at the price-break quantities. Although the curve for each unil
price has a minimum point (EOQ), it is not necessarily valid (feasible). An Calculate Lhe total cost for

economic order quantity. is valid if it is within the quantity range corresponding the valid EOQ and all larger

to its unit purchase cost When holding costs are specified as a fraction of unit price-break quantities

purchase cost, each curve will have a different EOQ. Lower unit purchase cosl
results in lower unit holding costs and larger EOQs. Since each portion of the
relevan_t total cost curve is minimized either at an economic ord.er quantity or
at a _pnce-break _quantity, the overall optimum Jot size can be-narrowed to te I
feastble economt order quantities and the price-break quantities .
The fol_lo_wmg procedure, as outlined in Figure 3-8, indicates how to
o?trun. the mtrum
unt logic

_um cost order quantity when one or more all-units quantity

FIGURE 3-8 All-units quantity disco

discounts are avatlable:6

1. Starting with the low sl
until a va I'd EOQ . obtamruted.cost, calculate the EOQ at each unit co
est
2. Calculate the total a ua1 4
year. The supplier
1 IS

ost ak
..00
500 units and at $9
quant ities larger tha e altd OQ. for the valid EOQ and all price-bre Example

quantity for which e pnc e dtsco (A price- break quantity is the lowest Th e Smith Company $ 1 0.00
purchases 8000 u
.t f a product each
o orders up to

3. Select the quant ity with er unit for orders of 500 units or m i s 300Jo of per unit
unt is availa )
the 1owest total cost inblestep
per un tity
offers the units for sale at o ic order quan
;h
Wh t ,. the econ m
00f1
t f t he order cost is $30.00 per order an
o

2 above. e h di g cost

analysis see R ersm

. e
Wi t h Quan !l ty Discounts," Production and I v n o and R . A. oe l l e , " Lot Size Determinau l
f
..... r1 3>,
r

t ry Management Journal, Vol. 26, No. 3, 19S

For a more detailed
. .
: T .
on
per }'e
price is as follows : /
/... -..,...
e EOQ for each unit
 Chap. 3
111
ems: Dete rministic .Models ' Fixed O rder
Size Systems
Demand Syst
Independent
110

Q : c;ase D,
Since al units are not purchased a t the same uni t ur .
2{30)8000
= =
9(0.3)
= 422 units, purchasmg cost for not purchasi ng each of unit at
Q
c:ost,

U;+
U:ms
IS the extra

extra purchasing

is, 1.11 effect , an additiOnal ordering cost, since it is ncurred each time
D,
@ s t IS a constant f r ordering any lot
= 400
size wi thi n
co .
t herefore,
_
i
1

2(30)8000 units.
is placed. The purchasing cost per unit is
an order

1
= =
10(0.3)

J1 D.
f?.o

id, since it is not avail Q + P;.

titiless th n 500 units. M
able for quan
Q
=
The EOQ at $9 is inval valid EOQ I S compared
total cost of the
valid . Therefore, the
The EOQ at $I O is
Thus, the total cost per year of a lot size of Q units is
.
break quan t.tty :

PFQ
price-

+ CR + 2
the larger
with the total cost at

purchase cost + order cost + holding cost

= PR
TC(Q) =

Q
[ ] rp.

= P; + !l..i R + Q!_ +
TC(Q)

TC(4?0) = 10(800)0 + ---:wo- + --

30Q!OO)O 1 0(0.3)400
2
- = $81 ,200.00 ,......- Q Q 2 + !l..iQ) I

P;R + (C
+ D;)R + P;FQ + FD;
9(8000) + 500 + Q 2 2 .
30Q!OOO) 9(0.3)500 = $73, 1 55 .00. =
TC(500) =
" 2
and the valid EOQ, Since the total cost curve for each unit purchase cost is convex the
Comparing the total costs of the single price-break quantity
the minimum cost order quantity is 500
units .
- minimum cost lot size is obtained by setting the fust derivative of total ual
cost with respect to the lot size equal to zero, which results in

Because quantity discounts do not alter demand or lead time, they do not dTC(Q) _ _ (C + D;)R + P1F O
affect reorder point calculations. dQ - Q2 2
=
'

In thi situation, the buyer is presented with a price schedule consisting of

Incremental Quantity Discounts
[
2R c + .t1(U. - l ){P, _ t - P.>]
es 10 the PartJcular dJScount quantity interval. The price schedule is as
quant ges sue that t ?e lowe unit purchase costs only apply to t h
e
f::; for i = 1 , 2, . . . , j. Thus, the above formulation is nothing more
than a
o

fJ
EOQ formula with the extra material cost added
to the order cost.
Po for each U0 U1 modified
discoun ts is continu ous, he
fo< oaoh of tho n<xt u, to u,
to Since the total cost curve with increme ntal
I,
_ 1 ,

P,
"
-
minim um total cost will always occur at a valid EOQ. However,
is valid , it is not necptimal , and ger valid EOQ -e_
even if all EQ
not necsa r
for each .of the next uj to U ,
1gure 3-9, any vali
PJ more desirable than smalle r YaliO EOQs. As showi1TrlF
where ul < u2 < . . . < u
s enc of .Integer quantues at which p :
must be checked. The
> 1>is .the
EO Q may be the optim um lot size, and every valid EOQ
.. >
;+ I

br ks occur, and p0
urut purchase cost is not co ta
p1

J Wtth the above discount schedule , the
nce
EOQ. EOQ U1s <
opti m um lot size is deter mined by calculating the total
Q; (the EOQ U;+ 1
cost per year or each
ust faU
thm _ t

nt o a lot size where u s; u,
<
valid is valid if
f mg proc ure wt l
-,-
An
purchase cost for a lot size Q Q The Quantity range requi red for the price break ). The foUow
quantity disco unts.
Q uruts I_ S as follows :
t
dete rm ine the optim um lot size with incremental
M, = D, + P,Q, 1 . Calculate the EOQ for ach unit purchase cost.
2 . Determine which EOQs are valid.
where

3. Cal culate the total cost for each valid

EOQ.

4. Select the valid EOQ with the lowe

st total cost.
 3
112
term inistic Models Ch ap,
and System s: De Size Systems
Indepen dent Dem Fied O rder

= 392 (vali d),

(not valid),

i
Q = / 2(4800) (40 + 998.5)

-y 8.50(0.25) 2166
=
(valid),

Qj = 2(4800) (40 + 3398)

8.00(0.25) = 4062 (not vali d) .
Calculating the total cost for each valid EOQ,

(C + D;)R + -
- p; R + -
TC(QI) - P,FQ, + FD .
QUANTITY w- 2 2 ,
FIGURE 3-9 Incremental quantity discounts TC(392) = 1 0 (4800) + + - 10(.25)392
-- + - (0.25)0
-= $48,979.80,
392 2 2
TC(2166) = 8.50(4800) + (40 + 998.50)4800 8.50(0.25)2166 0.25(998.50)
----
Example 5
+ . +
2166 . 2 2
= $45,527 .57.
The annual demand for an item is 4800 uni ts , the ordering
cost is $40 per order,
!he optimum l o t size i s t h e vali d E O Q with the least annual cost . The best policy
firm faces the .mcremental discount schedule
.
and the annual holding cost fraction is 0.25. What is the optimum lot size if the
IS to order 2 1 6 6 units at a unit price of $8.50.
below?

The advantages of quantity discount purchases are lower unit cost, lower
orderi ng cost per year, fewer stockouts, lower shipping costs, and a hedge
against price increases. The disadvantages of quantity discount purchases are
<400
400- J 199 a l arger inventory, increased risk of obsolescence, slower inventory turnover,
1 200-4799 and an older stock.
> 4799
Sp ecial Sale Prices
A supplie r may
Solution:
temporari ly discount the unit price of an item
during a reg ar
.
reple nish compeuuve
Reasons for such a price reduction range from
rice wars to attempted tion to nding an
ment cycle .
inventory reduction. The logical re
1 0n ruts to take
P,
Ite m on sale
d u ri n g a regular replenishment is to order add1t
$10.00 advan tag order IS Issued, then
e o f t h e short-liv ed price reductio n. If a special
9.00 of the order to place.

managemen
8 .50
0
3 99 ($ 1 0.00 - 9.00) = 399.00
t m ust determin e the optimum size

that the up
8.00
Ass ume t hat when an order is being placed, it is discovere

18 P,
. of t e lt m
+
l i 99 (9.00 - 8.50) = 998. 50
9983. + 4799 lter is tem porarily reducin g the price of the item. The regular nee
(8.50 - 8.00) = 3398.00 bu t curre n t purcha ses can be made at P- d, where d IS the u t pnce m
 3
nistic Models
nd Systems: Determi C hap,
independent Dema System s
114 Fixed Order Size

he price of the item will return I

the temporary sale,
115

p - d and all when th fi

P. Order q uantitie
decrease. Subsequent to no speci al order is placed during (l/R
o
ease are
after the pn ce decr
Jf
' the total cost
:srder is
s p rior to and
made at subs equent ord
ers are mad e at
P is as f ll
TCn =
Q* = \j(2cR
pji (P -
d)Q
+ P(Q _ Q -Q2 - d) F2RQ
) + (P
ord!lr siz , it is neessary to m axi mize t he
!
Q PF (Q - Q*) CQ
-
To obtain the optim specia +

cost difference during the time penod

Q/R .
w1th and w1thou t t h e spec 1al ord
c::;
2 R +

p _d
ly depictd in Figure 3 - 1 0 . . The total
when a spec1al order IS purchased at umt price =
The inventory sitution is graphical.
during the period Q/R, ' PQ - dQ dF(2RQ f
_ PFQ*Q CQ
Q +

total cost = purchase cost + holding cost + order cost,

+
is as follows:
where
d
(P - d)Q 2 (P - d) FQR + c p
= unit price decrease,
TCS = +
= unit purchase cost before the
discount,

(P - d)Q (P -2Rd)FQ2 C. +
C order cost per order,

= annual holding cost fraction,

=

= +
F
R = annual demand in units,

Q = economic order quantity in units,

Q = special order size in units.

/ Special Order
costs
i n d t h e ot al one-time pecial order size (Q*),
the difference in total
u t be maximized, so the ftrst derivative is set equal to zero:7

g = TCn - TCs = special order cost saving

= ( Q*) (P -2R
d + Q- d)FQ2
-d
2R - C,
Q - dF(Q*)2
= d + (P -Rd)FQ - _ 0,
dQ Q* _

Q (P dRd)F + p

PQ* = optimum special order size.
d
= _
_

No e tha t w hen t h e unit price discount is zero (d = 0), the formula for the

zer (g = 0). B
OptJmu m special order size reduces to the EOQ formula and the cost saving is
y replacing Q with Q in the cost saving
OptJm um cost saving
* formula for the g,
is obtained:

g C(P
=
p
- d)( - lr
For a more detailed analysis see R. J. Thrsine and A.B. Schwarzkopf,
Journal Q/ Buslf!es:s
"Optimal Srock

shment Strategies in Response to Thmporary Price Reductions,"

l.o::;
tcs, Vol. 10,
No. 2, 1989.
 Deterministic Models Chap, 3
em and Systems:
Independent D Fixed Orde r Size Systems
116
1 17

tim e of zero ; if the lead time is not eq a1

ble to place a s?ecial ord er When

:Yero,thetheleadstock
pos1. ove, I. t is always desira

a unit pri c e disc

.
Since g is always a regular replemshment .
ount t
.
s enco u ntered during the special order is placed must be red ce positio n q at the time
tim e demand (the reo rder
poin t).

Examp le
. Example I is offering a speciaprice
Known Price Increases

The suppl6ier m
l discou nt d u ring regular replen .
:
aril educed the unit
from $ 1 0.00 to $ 9.00. What A supp lier may anno unce that a price increase . .
ishment and has tempor Y
o take advantage of the
disco unt? some future date. As with special sale p .

for an Item
. Will take place on

.
hase d
::
amount shoul d be pure he logtcal response is o order

Q -
ad ditional units to take advantage of the
d
(P - d)F!_ + P
.
resent) pnce.
is placed before the higher price becomes effiect tve,
' I f a spectal order
- _!!! - management's responsibil
ity
__!!_ is to determine the size of the order.
+ I 0(400) sed bY an am ount k o some
Assu e the price of an item will be increa
date t I . U mt purchas es before t I still cost P. but
_ = 3407 units.

p
- (10 - 1)0.3 10 - I
+ k . Thus, purchase quantities prior to he anno m th ose ade aft r t will cost
,

0.426). Thereafter the order q u an ti ty should the EOQ of

. mcrease
u nced pnce
A special order for 3407 units should be purchased. The amount willbelast for 0.426 are

400 units. The resultant cost saving would be

. fiCR
pji =
=
years (3407/8000
Q. - - 'V
1 2
EOQ before price increase.

g C(P - (
d) _ 1)2 ( )
p
30( 1 0 - 1 ) 3407 _
=
Q
=
10 400
Sin e all sub sequ:nt purchases will be made at the new price
.
opttmal lot s1ze wdl become
(P + k), the
= $1525.85.

Qa = 'V

{.P'+k)F = Q* 'V/P"
. !2CR P+k = EOQ after price increase.

that t e temporary unit price discount was available at the regular time f01
The previous optimizing formulation for the special order size assumed
Assuming a replenishment lead time of zero, the known price situation is

the regular time f01

rple shment (when the stock position reached the reorder point). In some depicted in Figure 3- 1 1 . The price increase occurs before the stock position is
sltuatt ? ns , the temporary price discount expires before exhausted, and there is no opportunity for a regular replenishment. As shown
replemshment, and management must decide Q
by the solid lines, a special order of is purchased at 1 1 , when the stock position
if a special order should be placed
q
+ q)/R (after the special order and the stock position have been exhausted).
on the expirati n date. If the special is units. The next purchase will occur at time t3 after an elapsed time of
order must be placed before the regulru
(Q .
the!
. hment
replems lime and the toc k POSitiOn
.
q
:
.
IS uruts on the expiration date,

elap sed time of q!R (after the stock position has been depleted). To obtain the
opti mizing formulations ar If no special order is placed, the next purchase will occur at time 12, after an

d
Q
p _ d - q,
--.!!! !__
(P - )F +
opti mal special order size, it is necessary to maximize the cost difference from
...! !.T_
=

(Q+ q)IR
q)/R, when a spectal order ts
' to 13 or during with and witout a special order. . .
(Q +
purchased at unit price P, is as follows:
The total cost during the period

: : : [ ( } ]
1 = + + order cost,
Q total cost purchas e cost holding cost

I o t ru. ,;'",.;on, it . ,
ways advantag
ous to place the special d The
TCs - PQ. + Q.PF Rg_ + g_2 PF Rg_ + lJ.2 PF Rg_ +
-
C
cost sav mg
d)

ts only posit ive
. wh en t he sp
P! (P - PFqQ PFQ2 PFq2 .
fo r Q nly when Q > = PQ + + 2R + 2R + C
ectal order size exceeds ....;
Q
lime
ordet
the economic order q

.

s - d)
q)/R, the total cost when all
decision ie is o
!:'l place the special
ectal sale and plac
1 ; Q PI(P
igo Q*, 3:
11 (Q +
If

;
e the order l f no spe orders
i ionally, the abo r q t th cial order is placed durin g
regular replenish ment
ve formul ati
on for

Q
Is den ved for a replenis h ment 1
are PU rc
hased at unit price P+
k is as follows:
 d Systems: Deterministic Models C hap, 3
Independent Oemen Fixed Order Size Systems

119
118

R = annu a l dem and

in un its,

.
q stoc k p ositio n

-
=
in units w
hen spec1. al
order is placed
Q _
eco n o mic order ,
quantity be
fore the price
increase
Q: = econo mic order
q uantity afte
r the price inc
rease
Q s p ecial order

=
size in units

t2 to r3
Q
QIQ: = n u m ber of orders
of size
a durmg
.

(Q.

To fmd t h e o tt al one-time

first denvatJve IS
special order size .
*) the difference .
costs m u s t be m axtm1zed , so the

g = TCn - TC.
. . m total
set equal to zero:

(
= special

+
order cost saving

+ (P )
R Q
k)FQ: PFq PFQ2
k
R 2R - C,
= _ _

Q, t, +
!!g_ + (P k)FQ: PFq PFQ
k
R
_

R - R = O,
=
1 \ dQ
+
I \

= +
I
'E!_
\

p
I \ Q* (P k)Q: _

I \ PF q.
\ I \ I

savmg IS
\ I \ I By repl aing Q with
\I .
Q i n the cost savings formula for g,
the optimum cost
\I
. obtain ed:

TIME

A. spec ial _? rder of Q* results in a cost saving only if g* > 0, and this only
FIGURE 3- 1 1 Known price increase

? ccurs if Q *IQ* i s greater than 1 . Thus, a special order should be placed only
+ + +
g; (P k)F Q. + Q
TCn
(P k) Q
+
f the special order size is greater than
g_ PF g_ CQ (the EOQ at unit price P).
=

2 R 2 The above formulation for the special order size is derived for a

+
R Q:
+ +
re ple nish

+
m e n t lead time of zero. If the lead time is not equal to zero, the stock
(P
2R
=
(P k) Q k)FQ:Q PFq2 CQ ositio n q at the time the special order is placed must be reduced by the lead
21? + Q: lim e dem a
n d (the reorder point).

+ + +
+
(P k)Q (P k)FQ:Q PFq2
Exam ple 7
=

R 2R '
Th e supp lier in Example 1 will increase his unit price from $ 1 0 to $ 1 1 o I
where

k kno wn pric

p = unit purch
=
e inc rease Janu ary. What amount should be purchased on 31 December before the pnce
'
increase is
effective i f the stock position is 346 units? Whal will be the cosl savmg

C-
ase cost b
efo re the of th e special purcha
pri ce i ncrease,

2(30)SOOO
- order cos se?

F = ann ual hol

t per ord

(P+k)F =
er'

= v{2CR (10 + 1)0.3

ding cost
= 381 units.
fractio n, Q:
 Indepe ndent Dem
and Syst ems:
Deterministic Mod els
Chap, 3
120 Batch-Type Production Systems

k)Q: (q 121
kR -
Q p
+

= Pi +
_ (P _ B)

: ::
may require coordi nating pro du cti on ru
deter mining th or er of producti on an hr gh batch sche uling-that
- - er o: each rtem to prod is,
it may not seek optim um produ cti on leve next P 1 uct m the sequence. Thus,
1 (8000) 308) before productiOn s cha nged over to the e
=
+ (346
10 uce
acity to

g' : :[(f.)' ]
ls
item s in relation to their dem ands pro ' bt a loc ate productron. cap
duct ton rates, and
JO[(':J' - 1 ]
levels. existing inventory
1 =

=
Economic Pro duct ion Qu
antity (EPO)- Si
$ 1 7 1 1 .93. ngle Ite ms

On 31 December, 3048 units should be u r has pc

ed . The am unt will last for 0.38 1
years (3048/8000 = 0 . 381). The cost saving o the specrai order rs $ 1 7 1 1 .93.
The EOQ for m u ation assu mes that the
mventory at a gtven ttm . entire order
e. Tills assum ption appliesfor an item is received into
chased externally or produced in-house. whether the item is ur
Thereafier, the order quantity should be 381 uruts at the unrt pnce of $ 1 1 .00.
a consta t
If a firm produces
roduct is entered into inve a product tha has t
' . .
the p orde r uant1ty shou ld be
deter
ntory instantaneously,
The previous optimizing formulation for special o d er size assu med the
. case, purch ase cost wiiJ be replaced by produ mined by the EOQ-model. In this
price increase occurs when there is a positive stoc k positiOn a n d there is no ction cost and order cost replaced
. by setup cost. 8
opportunity for a regular replenishment. If the spec1aJ order can be placed dur. The assum ption that the entire order
ing regular replenishment (when the stock position reaches the reorder point), is received into inventory at one time
(instantane ously) is often not true. Freque

P
the optimizing formulations are ntly, items are produced and added
( +
to invent ory gradua lly rather than all at once. Thus,
Q- = Pi: - -,
the EOQ model must be
P does so. Whereas the EOQ assume s d
kR + - - k)Q: revised to accom modate tills change . The econom
ic production quantit y (EPQ)
ns to stock

c[Q - 1]2.
(infinjte repJenjs hment rate), the EPQ assumes
continuo
to stock (finite replenish ment rate) over the productio us gradual additions
g =
n period. With a finite
repleni shment rate, the inventory level will never be as
large as the
producti o n a n d consumpti on simultaneo usly occur during lot size, since
desirable to place a specia l order when
Since g is always positive, it is always the period of
a price increase is encountered during produc tion.
a regul ar repJe njshm ent. Units may be t a ken to the storeroom and added to inventory as they are
. Speci al sale prices and know n
tncrease the order size ubstantial price increases may i n dicat e the need to pro duced or as they are received from an external source. Whether the
item is
shelf lrfe, posJble engmeerin ly. Storage const raj nts, capit a] constraints, obt ained through purchasing (including intrafirm transfer) or production, the
shoul be consrdered when
g changes, and potenti a chan
ges in deman unit cost is usually the most jmportant single cost. I f the item is purchased,
:: :S :::/
l
size is contemplated. Somt
a large increase in order
an established time s upply for an
.o price determination is usually the responsibility of the purchasing department.
olici s of never exceedi ng If the item is manufactured, the unit production cost will consist of direct labor,
ordenng more than
.
an d control excess rnven a year's supp ly) to limit holding casu direct materi a l s , ! and factory burden. Direct labor consists of th?se labor
maten r s the cost
tory.
of the s ubstance rom which the item is made. Factory den mcld all
ch arges convenieqtJ y identified with a specified item. Drrect _
BATC H-TYP E P ma nufacturin g costs other than direct material and cLifbor, such as mdirect
ROD U CT I ON SYST
EM S l abo r, indirect material, depreciation, taxes, insurance, power, mamtenance, _
In batch-type productio supervisi on, and so forth.
(batches). In most n systems ' prod ucts are often made
SJZ
.
m J
. .
eq urpent; these procases, mulr i le pro ducts to stock in lot ln finite replenishment rate. sJtuatr ns, the a or decision involves the
du cts are produ ced on the saJil determin ation of the size of the productron run (order). The P roduction run

capacity as t ndivid ual sh are n d even c ompet
ba ch product ron mayitems and/or a s mebe e for comm o pro ducU n
P nn l i .
sta tiO "The setupjobcostandis essentially the cost of the time eu d t e
to dismantle it after the JOb ;. : 1!',:7pt c:u::,:;;
units to .tncl ude in e involve the d termm s of a produc t family. la f
n n to m m1?n of the o ptim um nu mber so affectnedtobydothethenumber
ach Productio atJ o
mize tot a l annual costs . It aJ
IS lOIS .

and length of setups.

 Introduct ion Chap. 1
Types of Inventory

The wealth of a natton tS_. rneasu d in a given time peno d. Good s are ta gi -
. red by its gross natio nal rodu ct, whic h is t e 90% of total product cost, but they typically are large enough
for serious
attent ion.
outpUI of goods and se!WtCe roduce can see, touch, or feel; services are less s_kta_ngible Materials managem ent has a tremendo us influence on the ultimate c ost of
ble, phy ical roducts that Yorman of an act based on knowl edge, l ll , or a product, because it handles the total flow of materials in an organization. The
product that m volve the_ per . ace( ns always transform raw matenals mto
final products, while service organrza : I ns
ilities . Manu factu n g organ r tota l flow can extend from suppliers to production and subsequentl y through
capab only use materials as an adjunct to dis tribution centers to customers. Encompassed in the management of the ma
their final products. terial flow is the responsibility for the planning, acquisition, storage, move
It is vir ua! ly tmposst'bl e to fnd an organizationorthat does not either use, ment, and control of materials and final products. The emphasis is primarily
transform, dtstnbut.e, or seli trials of one kind another. In the United on planning and controlling the flow.
Staes, the bu sme.ss m entor estment is from 1 5 to 200J o of the annual gross
natiOnal product. Th ts tr anl tes into approxim ately one trillion dollars, or
.Is spread
$4000 for every person. Business inventory _
pro_f usely throug ut INVENTORY
the economy, predominately in manufactunng, wholesaling, and retruling
organizations. The control and maintenance of inventory is a problem common to all
The effective management of materials is crucial to the performance organizations in any sector of the economy. The problems of inventory do not
of many organizations. It can have serious implications for the finance, pro confine themselves to profit-making institutions but likewise are encountered by
duction, and marketing functions of any organization. Finance is influenced social and nonprofit institutions. Inventories are common to farms, manufac
through liquidity and return on investment, production through efficiency and turers, wholesalers, retailers, hospitals, churches, prisons, zoos, universities,
cost of operations, and marketing through sales and customer relations.
Designing, financing, manufacturing, and marketing a product have and national, state, and local governments. Indeed, inventories re a!so relevant
historically been the major organizational functions. Traditionally manage to the family unit in relation to food, clothing, medicines, toiietnes, and so
ment devoted more time to the expenditure of moneys for personnel , plant, and forth. -
equipment than for materials. Materials were thought of as cheap, readily The term inventory can be used to mean several different th 'mgs, sueh as,

1. the stock on hand of materials at a given time (a tangible

avable, :md_infinitely plentiful. The realities of the marketp
this YOIc VIew and have added materials management lace have changed asset which can
orgaruzat10nal functions. to the list of major be seen, measured, and counted);
When organizations purchase the same raw mater 2 . an itemized list of all physical assets;
3 . (as a verb) to determin e the quantity
. _
things are Stmple. Basic ra aterials have ials over and over again of items on hand;
many uses, and any excesses wilj
4 . (for financia l and account ing recor.ds) the_
eve tu ally be depleted. Wtth
mcreased value of the stock of goods
u ts. Not only does the numbe
rnae , ess and buy more of their inp speci alizati on, organizations tend to
multiply, but so does owned by an organiz ation at a particu lar time.
now inclu de complicattheir com Iexit . Along With . basi_ .r of nputs
complexity of inputs ed com nen/ and assembhes. . c raw matenals, . mputs .
In thts. text,_ mve
. I unless otherwise specified. A more
as and hen any ex ess tr refers to I m
compreh ensive defimti_on would re rer to invento
: hen the_ quantity and ry as mari held in an
needed, difficulties canincreoccu Inputs might never be
required. r and more matenals -transfu
incomplete stae .a!!__ tng future e, use,-r - rmatio
-- n.-
manageme nt skills are _!
Wit h m ore variegated and
d_.Itures on materia ls increases. Forspeci aliz d m. uts, the proportion expen
m ;ctnng of
ends over h a!f of its sales re exe d iture . Theanizati
als costs usu ally are the largest singleanu org ons today, mate TY PES OF INVENTO RY
mr;/?nal, a?d ven aver age manufacturing . raw materials, in-process goodsfunct , d m-
saler n b utoserrsvices . An even lar erue n urch ased parts, components, raw Inventory may con tst of_s lies , items
ished goods. Supplies arc:._!.!!_ - tory
orung
final product . l)rpical supplie:'nare
consumed in the normal
distb u: nd re, ad retailers is lkeJt ion of th sales dollar of whole
if b uildi ng: a d facters wn little mbe aten ls of an organii? n th_at e tk PiHI b itthe
httes aremayleasoed. orernthan I nvecosts. Wholesalers,
M aterials costs range ntory, p articularl y pencils, paper, hght bulbs , s e called s,MRO
u i
c tt ng to ols, and fac i lity
, for maint enanc e, reprur,
ru te
and
widel y, from 15 to nance items. (Facto ry supp lies a
 Probems
Introduction Chap. 1
Organizational Categories and Inventory

supp lies ) Raw morerio/s are

items purche d from s_uppliers to be
d tion process. They will be m
operau .
used a mpu
o cti fied or trans
.
1. 0 the

0 T ic al raw materials for a furniture m a n u factu rer
O RGA NIZAT I O N A L CATEGORIES AND INVE TORY

PROBLEMS
formed mto s d goo
_
and so fort h . In-process
are
paint,
have different inventory r '!(!
:r-:n..s. B
lumber, s 0 ue, vs varnish nails Diffret types ?f rga.niz.a tions

are

all com eted' final prducts' that are still in tbe prod uctio n classtfymg orgaruz.a nons as retail, wholes
proces-s. Tbpam Y nt both the accumulation of partially
goods _ ale/distribution, and manc;.!acLrm;g
completed work an d
fhr processmg. Ftmshed goods are t h e fin al nl! fr -:>m
ey represe the extent of mvento ry problem s can be
generally delineated . In tra'>e:s
await
. l.!le
.
the queue of material
. .
retai l syste to wholesa le/distri bution systems
to manufacturing
de and complexity. Table 1 - l iLdlcates
product, available for sale , dismbuuon , or storage. .
The assignment of inventory to any of tbese categones lS dependent on the
. problems of mventory increase in magnitu

inventory encountered in ea:l:..

t h e orga.niz.ation al category and the types of

the ultimate co!lS'.IID.er : o

enriry under srudy. This is because the finished product of one emiry may be Retail systems are orga.niz.at ions that provide

a salable form and mao'e

the raw material of another. For e.'>ll.lll p le, a refrigerator manufacturer con goods and services. Inventory is purchased in
siders copper tubing as a raw material, but the ftrrn that produces t h e tubing without further processing or conversion. The
systems that provide phjsi::aJ
considers rt as a ftnisbed good. The customer for finished goods inventory
mav be the ultimate consumer, a retail organization, a wholesale distribut or,
products obtain them from wholesalers or directly from
factories-for ple.
prod
indicates the rypes o f inventory.
stores which sell groceries, clOthing, hardware, and varieties of
consumer
uctS in departmentalized facilities. They have inventory problems associated
with
or other manufacturer. Figure 11
supplies and finished goods. Retail systems that provide services to consumers
experience only a supplies inventory problem. Typical organizations in this care
;\e:u Function
gory are h o s pitals, fmancial institutions, universities, and penal institutions.
Wholesale/ctistribution systems comprise organizations that purchase
large quantities of manufacrured goods for distribution to retail systems. These
organizations do not usually provide goods to rbe ultimate consumers, bm
Sale
dispense their bulk purchases to retailers !!!. smaller quantities . Therefo
wholesale/distribution systems have invemory problems confmed to supplies
and fi.Ili.shed goods.
Manufacruri.ng systems comprise organizations that purchase mare-
Supplies rials and change their form to create a finished product. The systems -e the
raw

most ctifflcult and complex inventory problems. Manufacrunn sysrems can be

ldk

subcti\'ided into special project, intenninent process, and conunuous proces,s.

TABLE 1 - 1

Transfonn.atioo
Type of ln\'elltory

Raw ln-ProcesS FrnlsheC

Type o f organization Supplies Materials Goods Goods

A . Retail systems:
I . Sale of goods
2. Sale of sel"\ices
B. Wholesale distribution systems
C. l an u facruring S)'Steros:

1. Special project
2. lntermirtent process

a . Process industnes
3. Continuous Prooe:s
--
b . Repetit.i\-e ro fg . .--------------
 Introduct ion Chap. 1 Functions of Inventory

. ' t;d-life one-time events have

jects a l::
such as bridges, space rofita.bility can be enhanced by a reputation of having p roduct avatlab . le
.special proports u pecia'l projects usually expli it. statements Immediately or within a reasonable time.
nd
mven tory I S m m
es,
atelht : numbers of end items. Since only spec1f1ed .num er he
disco.tinuity factor allows the treatme nt of various dependent
of the roject s go duced no additional finish ed g.oods per ttons .(reta!lmg
mg) , distribu ting, warehousing, manufacturing, and purchas
o end I tems :: :Umber of, end the precise reqUirement fo: raw matenals m an mdepen dent and conomical manner.
m t items essary to gear product . on d1rectly to consumptionInventor ies mar..e it unnec
I

t is com pleted the projec orgamzat10n IS e1ther

ru ; and the production capability is establisedt accor d.mg .to on ract
to adapt to th necss1.t1es . of production. Inventorieors tofreeforce consumption
one stage in the
secificati;ns. When thetoprojec er special proje

ct. .
supply-productJOn-d1s nbut10n process from the next, permitting
disbanded or assigned anoth low-volume, batch, .o r custom.1ed
. operate ore econm1cally. Raw material inventory isolates the supplier each to
Intermittent processes are used fors must share the capaCit y of a fac1hty . the user, m-process mventory isolates production departments from each oth from
production where many differen t product
Machines and equipment of the same general category are grouped together a d fin.ish d goods inventory isolates the customer from the producer. T
into separate work stations or departme nts.forControl of the flow of work is d1scontmUJty factor permits the firm to schedule many operations at a more
managed through individual work orders each batch. Generalvariety purpose desirable performance level than if they were integrated dependently.
equipment is used, and skilled labor is required to perform theprocesses of The uncertainty factor concerns unforeseen events that modify the orig
operations required on numerous different products. Intermittent are inal plans of the organization. It includes errors in demand estimates, variable
flexible, but the jumbled pattern of work flow requires an elaborate planning production yields, equipment breakdowns, strikes, acts of God, shipping de
and control system. lays, and unusual weather conditions. When inventory is available, the organ
Continuous processes are used for high volume production of a limited ization has some protection from unanticipated or unplanned occurrences.
number of products, typified by mass production assembly lines. The facility The economy factor permits the organization to take advantage of cost
is designed and dedicated exclusively to its products. Each work station is reducing alternatives. It enables the organization to purchase or produce items
located in the sequence needed to make the product. The two types of con in economic quantities. Bulk purchases with quantity discounts can reduce cost
tinuous processes are process industries and repetitive manufacture. Process significantly. Per unit costs can be excessive if items are ordered separately
industries deal with fluids, gases, powders, and processes involving either the without regard to transportation and lot size economies. Price hedging against
chem.ical reactivity or blending of ingredients. Typical process industry prod impending material cost increases may also favor large quantity purchases.
ucts elude 01!, ?eer, detergents, sulfuric acid, and paper. Repetitive'm anu I nventories an be used to smooth production and stabilize manpower levels in
fact nng deals with discrete units of output such as automobiles, televisions, undulating and seasonal businesses.
refngerators, and ovens . Another way to explain the purposes inventory serves is by introducing
functional classifications of inventory. Based on its utility, all inventory can be
placed in one or more of the following categories:
working stock, r :1. rJ' Jl e. .,1/-p- "
FUNCT IONS OF
1.
INVEN TORY

J (fl ' II' I ' t; CJ. ' '

2. safety stock, - IQ.V( H 1 11 )-.(
Inventory exists because supply and deman d are . .

HAc.,,,
dlfftcult to .synchro nize per- 1 f I

3 . anticip ation stock,-

fectly an d it takes time to erform atenal-r
!..r
v

reasos, su pply and de m an : fre uen . elated operatiOns t

specuvely provide and require st;ck . TY differ m the rates at which .[,
. . For several
4. pipeline stock, - . <I

they re
Y 5. decoup ling stock ,
' 1

four function al factors of inve ntor hese reason s c n .best be explai ned by
6. psychic stock .
_ ti m e , d1scontmu1ty, uncerta inty, and
. The time
econ omy.
req uired beforefactor invol ves the Iong process of produ .
1 ctiOn and distribution or lot size stoc) is inventod ryneacquir ed
Working stock (also known as cycle
goods rea
rodu .ction sched ule , cutchrathw emf'1;: ra nsu m er. :n me is requ ired to develop the on a lot
is
so that ordenng can be order
(transi im e) , i nspect raw m U Sll O ship raw materials from advance of requirementsbasis.
t ee huct to tht.e wholesal
pp ers re I i ns, d h ld in Lo sizing .done to
:ie r:ther than on an as needed . nts, or m

b l i wai t for such er or xco nsu rn:

t
e s, pro? uce the p roduct, and ship e quanu ty discou
a;s!l ti.me ). Few cons.umers wou ld minim ize ordering and holding costs, achiev
i nventor ables an orgamanzatei tende d pe decoupling function of in' nrory.
o n to redur-eiotheofleadti mtime
on . all their purchases. ' Some authors cal l the discon tinuity factor the
m meeti ng demand.
 Int roduction Chap. 1 Inventory Problem Classifications

rable fretgtst 7rote Inlotgesizes stategy IS to attempt to reduce inventor ry. A wise
. neral , th e averag e amount of in- to elimi ate problems than to cover them up :-v. th e cess mvento .
constitutes an organization 's b: m JZ. mg:o
qual ify for favo
ventorY on han. d th at resu at l Onal encumberan ces w
hich dictate its xi te or eliminating oper-
working stock or fl uctuation sup stock) is inventory held in
Safety stock (o
ften called bu ffer e u ncer tai nties of ply and demand. Safety
ms
. t th
reserve to protectoutagato t he arnount of stock held durin g a reple nishment I N VENTO RY PROBL EM CLASSIFICATIONS
rages
stock ave ection against stockouts.
l_!g
according to the repetitiveness of the ine:tany
cycle as a prot stabilization _ stock) s inven ventory problems can be classified i was: They can be organized
Anticipa tion stock
(also known as seasonalnordem tiC requ rmets
seaso and, erra he knowledg e of demand, the knowledge ryf the declston,
_the source of supply,
mventory system. Figure 1 -2 displays t h e mventory
cope with peak
tory built up toprograms, strikes, or vacation shutd?wns) , or def1c1en1es lead time, and the type of
(promotional suppl ied or pro ? uced m adva nce of require _ problem classificat ions with
in production capacity. Itgispeak demand penods to keep produ ctiOn _ rates the following subdivisions:
1. Repetitiveness
ments and depletedthedurin
level and stabilize work force. transit stock or work-in- process) is
Pipeline stock (often referre
d to as to receive materi al at a. Single order
for the time it takes
lly, pipeline stock is invento ry on trucks,d, , 2. a.Supply
to allow
inventory put in transit l through the production process, and deliver b. Repeat order
the input end, send materia source
goods at the output end. Externapipeline. Outside supply
ships, and railcars or in a literal moved.Internally, it is being processe
3. Knowledge of demand
b. Inside supply
waiting to be processed, or being
Decoupling stock is inventory accumulated between dependent
activities or a. ( 1 ) Constant demand
(2) Variable demand
stages to reduce the requirement for completely synchronized operations.
It isolates one pan of the system from the next to allow each to operate b. ( 1 ) Independent demand
(2) Dependent demand
more independently. Thus, it acts as a lubrication for the supply
4. Knowledge of lead time
production-distribution system that protects it against excessive friction.
Psychic stock is retail display inventory carried to stimulate demand and act
a a silent salesperson. It increases the chance an item is seen and con a. Constant lead time
stdered for purchase. Full shelves increase sales by exposing customers to b. Variable lead time
h
:ok 5l.s as well as stockouts can lead to lost sales and lost cus-
a spossible and creating greater product visibility. Under- 5. Inventory system
a. Perpetual
:r :::e resk categories supp rt low cost operations, psychic
ng category. It ts o.ncrnd with revenue gen
b. Periodic
c. Material requirements planning
eration via deman cre:on versus cost mmtmtzatlOn which is supply
oriented . \
d. Distribution requirements planning
e. Single order quantiti]
Inventories usually not held f r thetr. own sake but as m ans to an end.
The ends are the objectiare Repetitiveness of the inventory decision refers to
the frequency of orders.
extstence. Clearly there arevesvariou establishd by the orgaruzatlOn-tts
_ _ reasons for A single order is placed once and is notofrepeated, at any rate regularly. Examples
s season, and catered food
_ of purposes. They cannos ty s of _mvent? ry that are intended to serve ap of single orders are the acquisitions materials for the construction of an

a vanety t :. man ed m exactly the same way, b ut artment building, cut trees stocked for the Christma
must be overseen in keeping
Inven tory is a necessarywith t spectftc function . is placed again and again
served at a business or social affair. A repeat order thai are repetiti\"
an: uncl!onal classific part _mg ? usmess. '_V . functional facto rs as determined by outine guidelines. Stock or units ely con
ma ations expl ain t extstence of mventory, this does ot sumed are replenished or restocked on a recurring basis. repeat
htle Most of the items in
attempts at its reductio
operat\tal problems or make probln shou d not be pursued. Inventory can htde sup ermarkets and department stores are restocked through orders (though
ems easte r to live with. It is more desira ble high fashion items in a department store frequently are single order
items).
 11
Introductio n Chap. 1 Inventory Problem Classifications

source i s llmfold outstde supply

10
The classific ation by the supply
. an d
i n s tde s u p p l y. When an item is inside
supplied , the company pmduces
the nem.
In essence one part o f the compan y
orders from another part of the
.-.:ompany,
and work orders are utilized to obtain
items in this manner. The tssuance
of
internal work orders compou nds the
inventor y problem with producti
on sched
u l i n g problem s. When the supply

are sent (commun icated) to eY.temaJ

source is outside, items are obtained
from
approved suppliers . Purchase orders
sources for items manufact ured outside
the organizat ion.
Another inventory classificat ion pertains
to the kno wledge of demand.
The most common assumptio n about
the demand distributio n is that the
demand is constant over time. The demand
can also follow some empirical
distributio n over time that is not of a standard
type, or some specified distri
b u t i o n such as the normal, Poisson, or exponential.
An additional subdivision of knowledge of demand
includes independem
and dependent demand. Independence means no relationship
exists between the
demand for an item and for any other item. In contrast, dependence
means the
demand for an item is directly related to or the result of demand for a "higher
level" i t e m . End items and products are characteristically independent, while
raw materials, components, and subassemblies are essentially dependent. Since
t h e demand for dependent items originates elsewhere, it can simply be derived

h will
or calculated from the demand for the item of which it becomes a part. Once
an organization determines how many independent demand products
make, it can calculate fairly accurately the number of dependent items it needs
(though allowances must usually be made for scrap and other losses). The
demand for independent items is less deterministic and generally must be
obtained by forecasting.
Inventory problems can also be subdivided according to knowledge

able. If
of lead time. Lead time is usually considered either cons ant or v M_I
t h e lead time is variable, its distribution may be deterrruned empmcally or

specif
lly, inventory problems can be classified according to the type
of

inventory system. There are many varieties of systems; some

f the o t c m
planrung, distnbunon
mon are the perpetual, periodic, material requirements
requirements planning, and single order quantity inventory
syste - The per-

etual inventory system orders stock every t_ime

the mv ntory posmon ches
reorder oint , so records must be maintamed _
of all mventory transcnns.
?
s ar us and sr ncal
per t:ormance IS what gives the system its name.
mvento
The p erp e ual updating of the records to reveal
.
_
The penodic tnventof) )stem
.

1-2
of the system is examined only at diScrete
ord rs s tock n a ttm cy cle The state
_
: ;;% a d decisions on stock replenishment are only
made

DD
FIGURE (penodtc) pomt m

lD
Inventory problem classific

CD
ations (MRP) system orders

VD
at these mterva s. aterial requiremen ts planning

P
dependen t demand, ts. Its mechani ms plan
:
production requiremen

(DRP) sysrem
independ ent demand , lanned

P2
constant de: s tock only to meet p P

P,

mand, variable demand , Ol.JT in a
uiremen ts for end item production schedules
'fl
constan t lead ti me, VLT variable

lead ltme, perpetual inventory
system ,
matenal requuements
plannin g system,
p
ependent demand
e distribution requiremen ts planning
periodic inventory system,
t1me- phased forma t.

;
ments planntng system = distribution requi re
, P, = sin gle o
rder quantit system.
 Intr duc i
13
o t on Chap. 1 Inventory Costs

12

. center re uirements in multiech

elon netwo rks.
Replen shments can b e categorized
according t o size, pattern, and
_

tock to meet distrib
utiOn or short-hved tme . Replemshment tze refers to the quant lead
.
took to meet unique ity or size of the order to be receiv
:
r syste
i gle order qua ntity sy t
m o r
xamined in sub sequent chapters. nto
.
mventory. T he stze may be c?nstant or variab ed
requirements. A ll of these ; e e
bdividing the invent ory
problem, but the
le, depen
mventory system. When a replemshment order is receive ding on the type of
d, it usually goes into
There are other way . ate the maj or dimensions of t e problems that
storage and becomes part of the organization's invent
ory. It is carried on the
ove mdt
classificati ons given ab lp s th problems of inve
ntory , It IS necessar to balane seet as an asse until it is sold to a customer
or consumed by the
: :; :
can be encounter_ed. To hb nv ntory situation. Since
it is neve: po s ble orgamzatton. Tihe replentshment pattern refers to how
the units are added to
build models whtch desc ximations an smJDhflca inventory. Replemshme
_
nt pttens are usually instantaneous,
i h total accuracy, appro uniform, or
to represent the real worl _ mdtcates that

actical reasons that ( I ) it IS lm ossl? to
ss. These dvlat!On s from batch . Instantaneous recetpt the entire lot is received into stock
e odel-building proce . le1
tions must be made dun g : _ at ,he same time. Replenishment lead time is the length of
(2)
necessary fo t time between the
reality are close approximatiOn of decisio n to replenish an item and its actual addition to stock
intractable, and (3) extremely acc rate model
rid is really like, a very and can be
determme what the real
:
reality would be athem t cally
constant o r variable. Probability distributions are used in describing
lead time, much the same as they are in describing variable demand.
variable
so expenstve that heir final benefit does not justify their cost. The
can be
\
relevance of a model to a_ ven. situation
must be based on the reasona bleness
chapters will utilize mathem at
Constraints are limitations placed on the inventory sy stem
. Space con
straints may limit the amount of inventory held; capital constraints the amount
of its assumptions and hmttauons. Subsequent of money invested in inventories; and facility, equipment, or personnel con
s.
ical models for the solution of inventory problem straints the supply capability and operating level of an organization . Man
agement policies (such as never being out of stock on certain items) and
administrative decisions (such as reciprocal purchasing agreements) can confine
an inventory sy stem in innumerable ways.
PROPERTIES OF INVENTORY

Several properties of inventory are universal. Demands, replenihments, con

inventory ; replenishments are units put into inventory ; costs are what IS sac
straints, and costs are the most commonly cited. Demands are umts take from INVENTORY COSTS

rificed in keeping or not keeping inventory ; and constraints are limitations The objective of inventory management is to have the appropriate amounts of
imposed on demands, replenishments, and costs by management or physical materials in the right place, at the right time, and at low cost . Inventory csts
environmental conditions. Demands, replenishments, and constraints are dis are associated with the operation of an inventory sy stem and result from actlon
cussed next; costs are described in the following section.
or lack of action on the part of management ip establishing the system. They
Demands can be categorized according to their size, rate, and pattern.
Demand size refers to the magnitude of demand and has the dimension o quan
are the basic economic parameters to any inventory decision model, and the
f more relevant ones to most sy stems are itemized as follows:
i t is variable . When the demand size is known, the system is referred to as deter
tity. When the size is the same from period to period, it is constant; otherwise,
ministic. When the demand size is not known, it is possible some cases to 1.
2.
purchase cost,
asertam_ its probability distribution, so that in
3.
order/setup cost,
the system is probabilistic. Prob

abtbty dtstnbu . _
'-"" 4 .
t10ns can be discrete or continuous. Discret holding cost,

take on certain alues, whereas continuous distrib e distributions can

fracti s
:
e :h ang umts_ such as
autom obiles,
utions can take on any
it is impossible to obtin
stockout cost.

: :
i h e s the purchase of _ Note that for a particular inventory item, only those _ cost elements that are
is not limited to ime !:
: :
ttems by volume such as gaso hn(
the normal, Poisso
lues ). tandard t ncremental (out of pocket) are prtinnt n th ana price if it is obtained
n, nd e ponenttl are frequeprobability distributions such a!
r
demand rate is simp!
the
to how units are wihd de and s ze per unit of time. Demand patterns re fer
ntly assumed for demand. The

T he purchase cost (P) of an 1tem
from an external source, or the umt_ pro c i c if it is produced internallin
y.
aw
begi nning of the perio; atn t:e Iom nve ntory . Units may be withdrawn at the
period , or in some othe app end of the period, uniformly throughout the mventory. For purchased ttes, 11 ts . ;:
:' he unit cost should alwys be . tk as th
e u rc
t of the item as it is placed
price plus any freight cost. For
are nt pattern (e.g.,
seasonally ) .
t
manufactured items, the umt cost me udes direct labor, direct
material, and
 Chap. 1
15
Introduction
14
Cost Accumulation Profile

purch se
.
s odified for differ
ent quantity levels a com pany would expedi te a n eergency backorder for the item
and assume any
factory overhead. The
qua nllt i n extra costs charged for the spec 1al service (e g d'l t
: :
s l

IS
and freq.uently premium shipping and pac ki .
( } origin ats from
when a sup plier offers the expens of issuing a os
lost. 11 e actual cost is less identifia ble in this case
o
The order/setup cst
lier or from internal productiOn
setup costs.
with the numb er of or ers or setups
the sale
but ranges frorr:

se order to an outsl d u the pparent prof1t loss on the sale to loss of goodwil l, which can
purcha v directly be hard to
ed
This cost 1s usually assum order cost mcludes such specl fy. It can b seen that the stockout cost can vary considerably from
the siz of the order. The to 1te m , ? ep ndmg n cus tomer response or internal practice. It can be
. item
laced and
uems as makmg
not at all
req io ns, analyzi ng vendors,
writing purchase rders,
following up orders, and d o n g the tremely h1gh 1 f the m1ssmg . 1. em forces a production ex
a customer to g elsewhere m the future. The quantificat ion of these costs has
line to shut down or causes
. . matenals, m sPectin materi als,
receJvmg
: e t the transa ction. The setup cos compnses the
long een a d!fflc lt and u n atis actorily resolved issue. For this reason, man
.
:
processmg necessa ry to c mp
d item. It
e p ro d ction process to produce the ordere .
costs . of chan gmg over
.
t
order schedu ling the work ' prepro duction orgauzat10ns avOid the estlmatmg problem by specifying customer servicey
usually mcludes prepanng t h e shop lvels
setup, expedi ting, and quality accept
ance. .
g cost, sub u m s the costs o ?jetive of inventory management (though not the sole objective) is
The holding cost (H), synonymous with carrym ning the phys1ca l mvestm ent the mJmmJzatJon of costs. Only those costs which change as the level of
associated with investing in inventory and maintai e, han inventory changes should be considered in any analysis. For example, amounts
in storage. It incorporates such items as capital costs, taxes, msuranc cost reflects expended on heating, lighting, and security services for a warehouse should be
dling, storage, shrinkage, obsolescence, and deteriorati on. Capital
invested elsewhere, a disregarded if they do not change as stock levels vary.
lost earning power or opportunity cost. If the funds were
return on the investment would be expected. Capital cost is a charge that
accounts for this unreceived return. Many states treat inventories as taxable
property; so the more you have, the higher the taxes. Insurance coverage re COST ACCUMULATION PROFILE
quirements are dependent on the amount to be replaced if property is destroyed.
Insurance premiums vary w ith the size of the inventory investment. Obsoles Organizations that manufacture products accumulate costs as manufacturing
cence is the risk that an item will lose value because of shifts in styles or takes place. Until raw materials are released, no labor or labor-related costs are
consumer preference. Shrinkage is the decrea.se in inventory quantities over time incurred . But once manufacturing begins, those materials acquire more and
from loss or theft . Deterioration means a change in properties due to age or more value (cost) as labor and factory overhead are added. Ultimately, com
environmental degradation. Many items are age-controlled and must be sold or pleted items reach peak value as they go into finished goods inventory and await
used before .an expiration date (e.g., food items, photographic materials, and shipment to the customer.
pharmaceuucals). Th usllal simplifying assumption made in inventory m an Assume a n intermittent manufacturin g process where material is routed
agement IS. that hold1ng costs are proportion al to the size of the invento ry through a series of steps (stages). Value is added at each step, and time is
:e: : : u basi, they mos consumed between steps (in queue, transfer, or storage). Assume the product is
e e i th thiS assumptiO con IS monly range from 20 to 40 0Jo of
manu factured i n discrete, equal-sized batches. The inventory cost accumula
i'
hold'l cost of invento ry items as a percent
the practice of establishing the
tion profile is illustrated in Figure 1 - 3 . At the beginning of the process, the
co t
x ;:]h s:c age of their dollar value
is that of the raw materials ; each step (incline) adds additiona l cost : T
e hon
e tern r i :ns (depletio
\ :
n cost) is the econom ic conseq ue ce o f a
n
zontal line segments indicate that materials do not change value wh1le
1n a raw
order is not filled; an n xternal:
shortage occurs when a custom er's
m aterial , storage, or finished goods state. The slope of th Line .
at each ste.p
department within the organization i genotoccurs when an order of a group or represents the rate at which labor cost is being added. The fmal vert1cal . IS
ns
backord.er costs, present profit loss filled. External shortages can. mcu r manufa ctunng
(goodw1ll erosion). Internal shorta (potenu al sale), and future profit J oss the addition of factory overhead to the batch to obtain the total
reso urces) and a delay in a com pleti e can result ln lost production (1d_ le cost .
_
the reaction of the customer to the o at e . The extent ? f the cost depends on The cost accum ulation profile shows the
pattern by which cos s are
investi ent . pomt of
or an ttem out of stoc k, the econ out of-stock cond1t1on . 1 f demand occu rs i nc urred (added ) for a manufactured produc t. From an
total tm_1e 1nvenro ry
aco rde red, satis fied by substit omic loss depen.ds on whether the sh ortage view, it is desira ble to shorte n the throughput time-:-.t e
JI!On unll. l fmal produ.;.t
atton , the sale is not lost but ution of another 1tem, or canceled . l n t he one mu st spend in an organi zati on from materi als acqms
on\y delayed a few days in shipmen t . Typic allY shipm ent .
 17
Introduction

16
Chap. 1
Conflicting Goals

TABLE 1 -2 Departmental orientations toward inventory

c ---- I nvento ry Goal Inclination

storage
Functional Inventory
Functional Area Responsibility

High
High
Marketing Sell the product Good customer service

High
Production Make the product Efficient lot sizes
Purchasing Buy required materials Low cost per unit
Finance Provide working capital Efficient use of capital Low
Engineering Design the product Avoiding obsolescence Low

Balance is a paramount consideration when goals and objectives are

under consideration. Concentration may be on one objective at certain times

and o n another objective at other times , and tradeoffs must be considered.
Finished
Goods
Concentration on inventory turnover can result in higher unit cost because of
Work-in-Process
smaller, more frequent purchases. Concentration on low unit cost results in

---
Manufacturing
large quantity purchases which reduce inventory turnover. A purchasing agent
-----1
CycleTime
Throughput Time may give undue emphasis to low unit cost while ignoring continuity of supply,
quality, and inventory investment. A production manager may overemphasize

ventories are a source of conflict among different managers in an

conti.puity of supply to the detriment of low unit cost or inventory investment.
Materials Product

Acquisition Shipmen!
Un
Inventory cost accumulation profile
TIME
organization. The conflict arises because different managers have different

OA ; material cost, A B ; labor cost, BC ; factory overhead , OC = tot al p rodu ct cost .

FIGURE 1-3

roles to play which involve the use of inventory. Suboptimization is the term
used to describe subsystem optimization at the expense of system_goals. Sub
optimization results from the conflicting roles that managers play Thbles
1-2

and ).:3depict departmental concerns about inventory.

at least differ
e above mentioned situations can result in conflict or
l:r.h
CONFLICTING GOALS
that managers play. Many
ences in opinion and stem from the different roles
The goals associated with matena 1s management a re not monolithic or even systems have been wrecked or subverted by inter
. promising materials control
The conflicting roles of managers
:7
easily delineated .rTh!e al of maten_ al s _ m anagem ent are to minimize departmen tal rivalries and cross-purposes.
inventory investmnt policies
cost ) plant operation : Some of the m
e u tomer servt ce, and assure e ficient (l w
?
must not be allowed to impair the organization as
a whole. Materials

mveto ? turnover, consisten. cy of q a l mo n subgoal s are lw umt ost, htgh

conttn utty of su11_g1ly It is pia t
in direct connic t .
Durin g a war or a period of
tty, favorable suppher relatiOns, and
m 0 see that these goals can be inconsi stent or even
:
me scarc t. ty t h_e simple act of locating
must be establishe d that result in the lowest
l:lu
ventory management is everybody's
overall costs.)
concern, but it is not uncommon to
biiit Responsibility for inventory
find everybody's concern nobody's responsi
Y]
ns
TABLE 1-3 Conflicting departmental orientatio

J,
sources of supply may become
the m t ort t
f ma!_ or supplier is closed becaus 1
b)ec_t tve. This may also be true Area TYpical Response

e of r dt fftculttes . Wtth _ _
u gm dem and, consi derable
{n a young c? mpany tha
pressure fo su ?pl y so u
unpredtcted up
rc s can be experienced .
Marketing/sales 1 can't sell from an empty wagon.
I can't keep our customers if we continue

not sufficient product variety.
t is gro win ra ptdly to stockout and there is
su in short
Si /: e nal l ocks are borrowings a rem vested t n plant and equipment.
function
os_
t
M ear mngs and , cas_h t s perpetually can produce larger lot sizes,
I can reduce per unit cost and

:
Production If 1
efficiently.
esse ntial, there is p
passin u
make c h avatl ble ressu re _to keep stock levels low to 1 can reduce our per unit cost
if I buy large quantities in bulk.
_for other
;
Purchasing

;t t ty dtscou nts. Npurp oses inventory? The levels

get the funds to pay for the
umerou s o ers tn s all_ quantities mea ns
buy Where am 1 going to
operat o
Finance
and-to- mouth" basi d dehvenes are necessary to should be lower.
.
turnover, which can s. Th fit anything else in the building
produce deleteri ese con t tto ns resul t i n_ hifh inventorY Warehousing 1 am out of space. I can't
ous operati Onal
side effec
 Introduction Ch ap. 1
The Inventory Flow Cycle
18 19

must be regulated with

ments with parti cular interests. Purcha_sing may tory reservoir called finished goods. This third reservoir
. ften dividofedraw among dpartand p urchased item s, while manufactunng l oks
relation to external demand. The cycle can continue into
e charg mate nals _
on centers. A typical
e contr ols finishe d goods . The allocat wns an additional reservo1r
r in-process
IS
goods, and cal, t is unlikely that the talent nd expertis_ e
ark if the organization maintains warehouses or distributi
ar logt manufacturing inventory flow cycle is illustrated in

u n er a
of responsibility appe contro_l are available in all the departentslocatwn . It c ommo nly Figure l -4 .
areas that regulate the flow into and out of the different
It
indicates the
required for proper mventory res onsibilitysubinopatismgle inventory categories.
e desirable to putDepallartmen
SUPPLY
r. tal con ri- t and
:;erials managemventones_ are under a :erials manager.
m i zat i on are less hkely

ma?agemnt :::s01 account

to o when
;aterial

Improve coor-
consolid ate aottvtttes,

and sprVId e a s ability for all mater ial -re lated

actvtes. It can mcrease

din_at_,n, ciency by providing shorter links between rel ted

activtties. When these relatedfl"ctsactivities are dispersed throughout an orgamza-

tion, they can produce con t andt bespark debilitating power struggl_@
I t i s i nextricably
. The inventory problem canno handled inareisolation. sm
. .
g, prod uctwn, a-
o . h h roblems of distribution, w h ouWhen
: =dlg, rhasing, marketing, and finance. depen dent
_
activ
ities are managed independent activities, there are usually confliCts am ng
as

activities which result in reduced aggregate per formnce . Supply, prductwn,

and distribution are not independent and should be mteated. The mventory
system is part of a larger operating system and should facthtate t h goal of the
organization. The management of inventory requires a broa vtepmt and
should not be treated a series of independent decisions on mdtvtdual
as
_ Items.
Inventories are not an island unto themselves, but are there to serve the pur
poses of the organization outlined in policy statements.
as

Inventory must be managed, not delegated to routine. To over

come its stormy past, inventory management has been clerical broadened into materials
management. Materials management is composed of all material-related func
tions, such purchasing, transporta logistics, production control, inven
tory, and sometimes even quality. Thetion,
as

and production managers. It

materials manager is made independent
and on the same level the finance, market
izational goals and not to
is the materials mnager's job to strive for ing,
as

become the stepchild of any other functionalorgan area .

THE INVENTORY
FLOW CYC LE

l nventory manageme
in v s
' Is sche l. or
nt vol e co
a reabty it a du ingthe rates into
ntrolling
of flow of materi al
f
an d out o f syste _
m . In
phase, materials
li timing problem . In the 1. U
. a]

poPofn:t red from

roc
In
s ir 0
and su

ry vestm

en t at must be ma aged.
ite s forms the fi suppli ers. This re ervo
The
rst
v anety and quan
purch: be tlimed
he
tity of i tems
ed ho ld ?
so they wtll m et t
demand for their

s these items are r leased 1os DEMAND

manufact rin g,
utilization by ! A_
the amza 1on.

facil y. As
they join an
goods . This sec other
s rvou
e
po
of mventory called m- r

Manufacturing Inventory How cycle

ond reservoir

: b c ting ryl , ti to the capacity f th

it ces

they enter anoth er 10 ven FIGURE 1 -4

managed
items leave th
e in re a on
es goo ds
ae o
 Chap. 1
20 21
Introductio n
Financial Considerations

whether it i cash,
requires a synch roniz ation
Each
. ories or reservoirs rm s
o flow
Ther is an opti m level of investment in any asset,
much can impajr income just ;u
of the tnventory categ .
of th<.> rate f intoothand fr: th: /:
can b e control led
N articul ar category

plan t , eqwp ent, o mvent ry Having too

ed, an organi zatio n c n

:
without the ow is regulat muc as havmg too httl. W1th mvent ries,

unc i n sales or disrupted production. An
respect 10 ers. _ too much can result in unnecessary
in any particu lar category, It w1U
?
f t o efficiently. ;::;::::
hen problems . d velop holdt g c sts, and too httle can result m lost

affect th: th
o e and m u e tional effective ness. It is important that


orgamzatwn must be care u l not to overinves
t in inventory that ties up capital
the mulnstage ?
cycle.
d in any inventory flo an d becomes obsolete, yet It must take care not to

Different_ aruz: m ia
tnflue c b underestimate needs and run
. to control , but
have fewer or more categones

flow
org t ns out of materials (thus idling people and equipmen
t) or finished products (thus
the cycle_ts remar a Y r For example retailers and distributors will
;
losing sales and customers) .

not have pro ess go

m w hic h th ey are purchas d . However, there
the same
o t gory since bey resell items in I n regard to inventory as an organizational
asset, it should be further
configuration - are still multistage

Therefore, it is to be
understood that inventory is an idle or incomplete resource
and its costs are only
influences that must be controlled . j ustified by the efficiency of operations it makes possible.
The driving force behind the inventory flow cycle IS t ?e demand for
.
held only when the other alternatives are either more costly
finished goods. From it, there is a derived demand for all those 1tems that com
or less profitable.
The scoreboard for profit making orgartizations is the income
pose it. Whether forecasted or derived from customers' _orders, _ demand starts
statement
and the balance sheet. The income statement shows the performance
the panicular operational processes necessary to fulfill 1t. The mventory flow
of the

cycle is a vital pan of the operational processes that satisfy customer demand .
" FINANCIAL CONSIDERATIONS
Organizations ar b e ecoming increasin gly aware that the overall efficiency and
effectiveness of operations are directly related to materials management. The
organization in profit or loss terms for a given period of time. The balance sheet
reveals the general financial condition of an orgarlization at a given point in
time . Inventory appears as a current asset on the balance sheet . Its balance sheet
entry is usually the accumulated monetary value at cost of all categories of
inventory (supplies, raw materials, in-process goods, and finished goods). The
importance of inventory for the income statement is that the cost of resources
consumed (cost of goods sold) by the orgarlization during a given time period

aim of inventory control is to maintain inventories at such a level that

must b e allocated before income can be determined. Abbreviated samples of a

d objectives of the organizatio n are achieved. t h e goals balance sheet and income statement are illustrated in Tables 1 -4 and 1 - 5 .

directly and revenue only indirectly. Inventory doesInventory policies affect cost Liquidity indicates an organization's ability t o pay its bills (meet its

do that), although it makes revenue generation possible. not generate revenue (sal es maturing short-term obligations). Assets are listed in order of decreasing

The relative significan_ce of inventory management to an organization liquidity on the balance sheet. Current assets are expected to be converted into

a bo ve rnvestment in inv ntory and t ?e magnit of th cash within one year, while current liabilities are expected to be pajd within one

=tJ. :ts :;: P

:: . . te oducts. The overall mvestment inventoude e year. Net working capital is defined as current assets minus current ab es.
Liquidity problems are likely if current assets barely cover current liabilities.

e :;;i :c balance sheet of the organization. If the

m ry can be
i nvest
emphasis should be plac :tage of current assets or tot asets, maj_or TABLE 1-4 Sample balance sheet
costs are a large percen tage 0 f totalentprodu
$ 80,000
Curren! Liabilities
40,000
.

$
Current Assets
ory manage ment.
L1kew1se, 1f matenal
ct costs, inventory management
20,000
critical. Accounts payable
100,000
Cash and securities
10,000
is
. Inventories tie up money For Notes payable
300,000
Accounts receivable
Curren! long term debt 50,000
rnvemories represents a sizable many_ organtza Accrued expenses
10,000
. . .
Inventory
300,000
heets reveals t hat many busines: revtew of Am rican industry b alane Prepaid expenses
t10ns, the investment tD

I:.ong Term Debt

550,000
rnventory. Poor control of invemo a 20-4007o of thetr total assets tied u p 10 Fixed Assets
amunts of capital, limit the ex can ;eate a negative cash Net plant & equipment
Preferred stock 140,000
:tal , and reduce the return on inp io f an orgation flow, tie u p large Owners' Equity
ressure for capital and the vestmen by roaenmg the investment Common stock 300.000
.
throug h lack of

deciJon makers more awar of th effec ti _ 100,000

. . ve Utilizatton of resources has made
base .
Retained earnings
::ries_could e used soe mew ec ce of in ories. Cash invested in lbtal Liabilities
d diStn bution. or Profit vent
makin g, debt servicin g, or Total Assets $ 1 ,000, 000 & Owners' Equity S I ,OOO . OOO
 I ntroduction Ohap. 1 Fi nancial Considerations
23
22

TABLE 1-5
very useful for d scoverin g slow-mo ving items, spotting cost problems
. , and
mak mg compara tive analyses between inventory types and between preent
$400 ,000
$ 1 ,000 , 000 and

200, 000
past performance.

with na f o f oher organizat ions in the same industry. I t can be plotted over
Sales
I nventory turnover also is used to compare an organizat
Direct material ion's performance
Direct labor 100,000
a
Factory overhead 700,000 - 700,000 n umber of years and used as a basis for intelligent questionin g in identifying or
Cost of Goods Sold 300,000 confirming problems. Caution is advised in making comparison s with other
Gross Profit 50,000 orga nizations, since the turnover performanc e is a function of many unisolated
Selling expenses 100,000 factors, such as:
Thtal Selling/ Administrative Expens
Administrative expense - 1 50,000
e 150,000
1 50,000

2. degree of vertical integration,

Operating Income 1 . organizational strategies,
- 50,000

3 . nature and type o f distribution network,

Interest Expense
$ 1 00 ,000

4. accounting convention (LIFO vs . FIFO),

Net Income Before Thxes

5 . capital intensity (throughput time)-:1

A current ratio (current assets divided by current liabilities)
of 2.0 or greater
indicates a healthy working capital, e.g.,

= 2S l .
. _ current assets $450,000 (_xcept for broad comparison purposes, inventory turnover by itself is not
current rauo - =
an adequate measure of inventory management efficiency or effectiveness. By
cunent liabilities $ 1 60,000
; focusing o n the financial aspects o f inventory, it neglects important operational
Another liquidity ratio (from the balance sheet) which excludes inventory is the features (such as material availability, quantity discounts, and efficient plant
quick ratio (also called the acid test). It recognizes the importance of the ability operations) and customer service considerations (such as stockouts and cus
to pay current obligations without relying on the sale of inventory: tomer dissatisfaction). As the turnover is increased, it drives the inventory level
quick ratio
current assets - inventory
= $450,000 - $300 , 000
down; at some point the reduct'on of inventory will interfere with operating
efficiency and customer service.
=
c,urrent liabilities = 0 _ 94 .
$ 1 60,000
An approximation of the throughput time (see Figure J -3) for an organ
A quick ratio of 1 .0 or greater is generally considered healthy. ization can be obtained by dividing the inventory turnover into the number of
. ln entory is frequently evaluated by turnover, a measure o f the velocity operating days in a year. The resulting throughput time is the average amount
wuh which materials move through the organiz
ation. Thrnov er is the ratio of o f time the inventory is in the organization, e.g.,
the annal cost o goods sold (from the
income statem ent) to the average or
current mvetory mvestment (from . operating days per year
.
number of limes the mventory has
the balance sheet). This ratio computes the
turned over during the year, e . ,
(0roughput time =
inventory turnover
.g
inventory turnover = cost of goods sold 360
= J 5 4 . 5 days.
= i300:ooo
$700, 000

Generally it is assu med

=
inventory = 2. 33 . 2.33

that a hi h . entor I f t he turnover is calculated for each type of inventory, t h e averae cyc.le .times
A pote ntial distort ion :: l
prob m th this
.y tu o:er is desirable.
ratio I that t he numerat r (cost for raw materials, in-process goods, and finished goods can be obtate sunilarly.
P01 t 1.n hme. 1b overc
of .goo.ds sold) is for an 1
. entire year, wh . t _ G n inventory manager is interested in the economy, efficiency, d
e
begm mg an ending :
ome point dis denom mator (mventor y) ts for a
inventory investm tOn , freq uently an average o f . the
effecti veness of the inventory system. Economy refers to the J w cost operatLOn
system
ulty With this aggregated ratio nts IS used. Anoth er potential d1ffl of the inventory system; efficiency refers to how well the mventory .
: ry
vento . T s pro is its .
blem can be overco dlsregar of the compositio n of t he
pe rfor ms in relation to some standard (such as turnover); and effec lve
es

raw material .
on.
re fers to how well the inve ntory system serves the goals of the orgamzat
as well as
ch type of t nventory: me by hav mg specific turnover
ratios for
aggregate inventor srr oces inventory, and Thus, overall erforma nce might be mea red in

terms of cost of operatio n,

r ratios can be
finished goods , _.
y. This
Y o r Inventory turnove historical perf rmance s tanda rds, and abllty to meet cuswme r demand
 24
Introduction Chap. 1
Just-In-Time
25

S
NING STRATEGIE
PRO DUCT POSITIO
-+----- Engineer-to-Order
n selects will determine
gies that an organizatio
The product positioning strate For each product, a strat.e y ust be de.
to be held.
the types of inventory uct os1 1nmg str tegy
target market. . The prod
veloped for satisfying its ts wtlh ng to watt for
time and the time a cstom er
------ Make-to-Order -----
depen ds on the produ ct cycle product posi
rements are denvd fom t ?e
product delivery. Inventory requi
tioning strategy. An organization
may produce/prtde ttems 10 three ays: (I)
(2) after receiV Ing an order, or (3) 10 some
'- in anticipation of receiving an order,
.
- c-;mbination of the previous two ility is a realization of the
The recognition of the need for product availab
::., the price is too high or the
importance of time. A customer may not buy if
is simply not available
quality is poor, but a customer cannot buy if the product
is the total
within the demanded lead time. The cycle time (throughput time)
elapsed time required to produce/provide a product. Generally, the only way a
customer can obtain delivery of a product in less than the cycle time is through
the availability of inventory.
General product positioning strategies may be one or more of the
following:
[1 Makto-Stock (/.fTS): When an order is received, the product is im
mediate! available from mventory and is an off-the-shelf standard item The LEAD TIME
: ts completely produced and placed in inventory in anticipatin of
FIGURE 1-5 Product positioning strategies
.
2. Make-to-Order (MTO)'pro du tlon to-order and engineer-to-order, the customer must wait the entire cycle time; in
order is received. The customer ust walt dos not start until a customer assemble-to-order, the customer wait time is less than the cycle time. It is com
the entire cycle time for the product.
3. Assemble-to-Order (ATO) Wh
The
on for organizations to have different strategies for different products.
i s dtfferent product positioning strategies
n an orer IS . are illustrated in Figure J - 5 .
received, the product
sembled from a group of stand d :: :

cu . e produc has umerous optiO

mbhes already in inventory. Fin
:;
Jshed goods are not usually availa e, . l
na JU T-IN-T
features and. each customer may desire
: es not wa1t the entire cycle time
a que configuratiOn. The customer S IME
for the p o uct, but only the time required f:j, h . .
\!:. e JUSt-m-time (JIT) concept, developed by the Japanese, challenges the
usuall ul te sho.rt for most pr I ari'ous optJo ns. The. asembly lead time is foundations of classical inventory theory in reference to the production of
assembl.e the product from 'ts v
th.. """"sary units in the nec-

ucts t a are firushed or pack
oducts. A similar catego
at n to prod goods. It requires the production of precisely
aged to order rather thannz JO applies
.
4 one extra piece is just as
assembled essary quantities at the necessary time with the objective of plus or minus zero
a.n order is received, it is necessary to p erform ance to schedule . This means producing
a bad as being one piece short. Anything over the minimum amount required
Engm eer-to-

::;;
Order (ETO)
the Poduct to custo
as to produce it. Th iS
P
.

t gy app11es to spec1 a1 mer t1 0 ns as well

is viewed as waste, because effort and material expended for something not
uiremen ts. The ' needed now cannot be utilized now (later requirements are handled later). The
P

customer is usual! w. . ty roducts for uni que cu stomer req

Y illing to tolerate a 1ong lead
:j
s i nce accepted performance had been to meet or exceed the scheduled require
tim uring philosophy,
With a make-to-sto JIT concept is counter to the historical American manufact
and the customer wait . ck s.t rategy, fi nished ods . nven
order, and engineer-to t ; me IS very
short . W i mak t tory is maintai ned
e-t?-order, assemb le-to me nts "just in case" somethi ng went wrong}he absolute minimum rt'OUn=e5 of

so the customer must-oP strategies, no finished
e an order and go ds m ventory is avai lable, ,Waste, in this view, is anything beyonaT
Wait for ?I ts co m plet m ater ial, machine s, and labor required to add value to the producl. Value is
ion. In make
 27
Introduction C h ap. 1 Business Cycle Influence
26

activi ties such as

Inve? tory accumulaton can accelerate business activities
r ;
al ork fo med on a product.
Mach ining, assem.
dramaticall .
added only by the actu \:
and pa ;;kagt : v ue to a product. Other
eduling add cost to a product but
When busmess taper off, mventon. es continue to rise for some time and
levels become excesstve. Organizations not only stop buying in excess of de

bli , pai nti g,
mg, ston ng, cou :
ntt
t ng, nd sch s a d cost but not value, ma d , but they buy sbstantially less than current consumption. The under
editers, and safety stock
mov
not value. Fork truks, P A ything which does not direct ly add value to the
ast d buymg auses productin to dFop precipitously, which helps to accelerate an
Cost without valu e
b minimized if not elim
inated.
is viewed i a negat ve fashion, not
economtc downturn. Fmally, an equilibrium point is reached and recovery
comme ces. Th recovery catches organizations unprepared, so sales exceed
produ s
: :::Sn :
d t h v l e of inventory. It
deterrent to product quality that
hides (covers p) productio? and mentory lvels d op. When production levels eventually exceed
as an asset. It is considered a re sales and mvenones srt mcreasmg, the cycle begins all over again. The cycle
ms. Witho ut invento ry, problems are exposed, o they ca_n be medted _ olve a time honzon of several years,
proble
that unnecessanly occupies space c n may m _ and it is most relevant to durable
before they cause trouble. Anything goods mdustnes that have long production lead times. Economists refer to the
occupies space. T reduce the resultmg
sumes a valuable resource. Inventory above phenomenon as the accelerator effeGt.,-J
and matenal flows.
With JIT, the ideal lot size is one. The manufactunng
waste, it is necessary to plan efficient layouts _ process can be Organizations that are more "distant from the marketplace" are apt to be
wherein the perfect arrangement would be more vulnerable to swings in the business cycle. A relatively small change in
viewed as a network of work centers
demand at the consumer level can generate several times the amount of demand
to have each worker complete his or her task on an item and pass it directly to
change at the producer level in multistage systems. Demand changes at the
the next worker just as that person is ready for it. The idea is to drive all queues
toward zero in order to: consumer level get amplified through numerous stages of a logistical network.
11his amplification occurs because each stage tends to respond to demand
1. 1 fluctuations by modifying its replenishment lot sizes and safety stocks (in
2. w
minimize inventory investment,
creased demand results in increased lot sizes and safety stocks, and decreased
3. react faster to demand changes,
shorten production lead times,
demand in decreased sizes and stocks). Thus, the initial change at the consumer
4. uncover any q uality problem$J
) level is greatly multiplied at the highest level in the network (the factory).
Of course, time lags in multistage systems further compound the amplifica
Sce it is impssible to have all the workers in a network adjacent to one
tion problem.
_ A long distribution chain or network is likely to set up internal oscillations
other and tt must mclude outside suppliers, the system must allow for transit in demand. A small variation in retail sales can cause giant fluctuations in the

tlme tween wor centers. However, transfer quantities are
kept as small as stock levels of the manufacturer and disrupt the flow of production. This
posst e, and lt SIZes are a fraction of a day's producti
on. There are no allow- whipsaw effect creates natural and artificial cyclical processes in inventories and
ances for contmgenCJes_ Every 't
m IS
expected tO be COrrect when received; production levels which can combine, cancel, or dampen themselves. Many
delivery commitment is p ct to

every machine is expectedeto be ailable
when needed to produce the item ; ever'} manufacturers try to obtain information on demand at the retail level, so
some
uled. Consequently ther : be honoed at the precise time it is sched guidance in relation to real or artificial undulations is obtained. Ignorance
demands being made
of
on
the consumer 's real behavior can result in very erratic
nance, and mutual tst bet ee : ::J emp? asts n quality, preventive main
parttctpants m the manufacturing network
the manufacturer. The ideal system is one where the manufact urer knows what
s
is actually happeni"fig in the marketplace. Management can dampen oscillation
by ( 1) using a forecasting model that disregards short-term demand
changes,
(2) adopting a single stage (centrali
BUSINE SS CYCLE INF

1-
LUEN CE
sta es
be under the control of a single group, and (3) mstttutmg duect
zed) syste .so th t tw or more
. commumcauon
as successive periods m:;on 1 the national economy. They are
Business cycles are a perstst
::IZable
. ent pheno .
that are based on real deand
ry tht reeat themselv of pansJOn, cont with the ultimate consumer level to obtain real demand dati)
raction, recession , and
es in the same o The solution is to focus on rates of flow
produce or order oy to real
the s e lime mterval, der, and sometimes over roughlY e consumer restdes.
econ : .s overall mveme
as in . the Past hile ot all industries follow the at the downstream stages of the network where the ultimat
mulatio nt, few are im

W _ If all the stages of the logistical networ k were to
largely disappear.
undulatio: n the nat_n have long bee0n re og I
ne t ts mfluence. Inventory acc
depletto dem and at the consumer level, the oscillation problem would that have passed
ton mzed as contributing factors to real deman d and not on orders
_ ute al economy be on
of inventory cont nb
to the cyclic :: ggregate basis, the flow patterns
b Vtor
T he emp hasis should
through several stages of the distribution system.
of business activity.
 Introduction Ch ap. 1

28
Case 1 : Rough Seas
29

Questions
CO NCLU SIO N
:
va d organiz
ation al sta ture of materials mao t'IOnaJ
1 . Why has materia s m anagement gained more prominence as a func
The signifca ce, rele. : forces are dictating changes in .
2.
f re. Num erous area of an orgamzat1on?
e
ag.emnt wtll m creas ard increasing the number of highly
;
thts dtrectwn. One fo
e is the trend tow What types f i ven_rory and what assodated problems are encountered by

specialize an m 1
roducts As a result
of this devel opment, more
buy more of their materi al
wholesale/di stnbutiOn systems and continuous process manufact unng .
r will m ke fewer and
3.
e systems?
;
orgaruz attons represent an incre asin g percen
q ently materials will
4.
What functions does inventory serve?
requtr me n s. contro l will be even more impo rtant than
costs .:nd their
5.
t t o Bas d on utility, what are the broad categories of inventory?
; /: sing trend towa rd aut.o.mation.
od econd majr force is the increa
of mater ials is required for an autom atd facility. Fail J?efme replenishment lead time and specify its major components in the'u
An uninte rrupte d flow
6.
time sequence.
close it down. A third maJOr force is the
ure of supply on a single item can
7.
ing world popula tion with an almost What costs are subsumed under the term "holding cost"?
burgeoning cost of materials. An expand
shortag es in supply which What constitu es the purchase (unit production) cost for an internally
insatiable demand for goods and services is creating
abundan t raw materials manufactured Item?
8.
are causing costs to increase. The days of cheap and
appear to be past. These forces and many others indicate that the manage
9.
I n what type of situation can a stockout cost be extremely high?
ment of materials is no longer a trivial matter to be delegated to lower man Briefly discuss what positions various managers would most likely take in
agerial levels.
10.
regard to (i) inventory levels, (ii) stockouts.
Inventories can be economically puzzling to the casual observer, since they Why is it desirable to shorten the throughput time?
11.
are subject to varied influences. Stock levels may soar if managers expect rising
In what ways are inventories important for both major types of financial
atte or decline when organizations cannot get all the items they desire, or
sales or if sals do not measure up to earlier expectations. Inventories may
statements (balance sheet and income statement)?
tf dectst? n makers are bearish on future activities. Organizations may hoard 12. What is inventory turnover? State a few of the potential problems of
;:: :: : h expect sharpy rising prices or materials shortages. ln- inventory turnover analysis.
13.
r
r ve .e n expand rapidly when shortages of key basic materials What part does inventory play in the traditional business cycle?
:: r 14.
.
s lt n ouctto n bottlenecks. It is possible for the same level of inventory
e b essmg an d a curse at different p010.
Give several of the goals of "just-in-time" (JIT).
. ts 10 time. Furthermore, the com 15. List some examples of materials management problems you personally
position of inventories is frequentlY JUSt as Important as the overall mventor _ y
level. have experienced.
.
CASE 1 : ROUGH SEAS
Yressures of the marketplace fore . .
orgamzatlOns I to roader prod uct
coverage and greater delivery capabilitie
:
the probms of materials managemen GAs product vanety_ mceases, so do

t reater product vanety mcreases the parts
complextlles of forecasting future . Bay Cove Marine distribute s several lines o f boating equipmen t, including
demad which escalates the inventory invet
ment neeed to maintain custo s in lower
;e estahshed by means f branc
mpJ ty and mvestmenL !?_ h wa

mer servi ce' evels. xp
re ouses,
E nded delivery capabil itieS
whtch also escalate inven torY
for new and older models of pleasure boats, to coastal companie
Virginia and upper North Carolina . The items Bay Cove distribute s to dealers
' service depart
are for direct sale to customers or for installati on by dealers
s, inboards,
ts . orgaizations have difficu
lt .
managmg their inventory . The us ual m ents . The pleasure boats the local dealers service include outboard
reas

inve s
t.h ?ability to forecast

ad u ely. outriggers, and small sailing vessels. Bay Cove has always carried complete lines
nevY:
or n nticipation of deman f theW hen materials are added o
enahs, the result dem
t
ted of boating equipme nt and marine paraphe rnalia. Its
reputation has been
parts and the widest
is excess:v stock and is later than expec
mai ntained by a policy of stocking complete lines of
been fairly level over the previous three
stronger tha anttctp . If the r o
;:
ated, the res ult is i demand is soo ne r selection of equipm ent within the area.
reduce inve
synchronize e
more accurate fore : ; u e stoc k . Fa tors that tend to
c s s orter lead Annua l sales for B'ay Cove have season. Current
sta
works, and nd o. ns : technology upgrades, ' . times, integrated/ years , with the usual peaks prior to and during the summer ions indicate a
ardtzatton . Imp roved commu nicatio n net sales are exhibit ing a gradual downward trend, and
project
 13 Inven tory is ubiquit us in today 's organi at .
and nature

in so me
o f matnals held. Inven
form of raw matenals waiting to ente th e
intermediate form o f tran s or
Plete ly transformed by the productI' On syste
Jon s bu t varies
torY In a ma

P od
nu facturi ng
uctio
matio n, fin
n P rocess
n/
wi de! in the

r
: In
num ber
a_Y ta ke the
- pro
ished go ds at cess
5 35

m ' or su pp lies ready com

proc ess. It also may be fou nd as retail an d wh use d to support th e
AGG REGATE ole ale
distinct parts of a distribution system or a serv finished goods located t
plies. Thus inventory p erforms m any 'functio ice ind ustry materi
als or su ;
INVE NTORY CON TRO L
ns throughout
The management of inventory is a :
may have over 1 0 ooo item s
any organization
m nagement of
diversity. A typical
in
organization
. ' m Inventory The .
Items may differ
cost, weight, shape, volume, and co lor. They rna be pack
Y aged separately or to-
gether and .stored in boxes, crates , pallets , b
TYPES OF CONTROL SYSTEMS
. . arre1s, bottles bags or b'
ms. Th
storage facilities may require strict environmen ta1 control ' e
(over dust tern er-
at ure, h umi' d Ity,
' etc. ) , onl coered protection from P
Perpetual Inventory System _ the elements, o no ar-
Tho-Bin Inventory System ticular s helter. Transp ortatio n mto, within, and from the organiza
_ .
via vanous types of conveyanc s (e. g . , train, boat, truck, aircraft, pipeline,
tion rna be
Periodic Inventory System _ . con
Optional Replenishment Inventory System veyor, etc. ) and nvolve qwantitles of thousands, dozens, or single units
Aggregate mventory should be viewed from its strategic contribution .
Distribution Requirements Planning Inventory System to
Single Order Quantity Inventory System th e goals of the organization. Its legitimacy is derived from how effectively it
Material Requirements Planning Inventory System se rves the purposes of the organization in support of higher level organizational
Just-in-Time Inventory System strategies. In this context, inventory is the servant to other functional (finance,
Theory of Constraints Inventory System marketing, and production) requirements. This must be true for two reasons.
SELECTIVE INVENTORY CONTROL
Inventory is a current asset, and short term assets should not dictate the long
INVEN10RY SYSTEM DEVELOPMENT
category, and manageme nt must integrate all assets (resources) in the pursuit of
term direction of an organization. Additionally, inventory is only a single asset

INVEN10RY SYSTEM IMPROVEMENT as shown in Figure 13- 1 , inventory acts as a servant, not
AGGREGATE INVENTORY MEASUREMENT
its objectives . Thus,
the master.
AGGREGATE INVENTORY REDUCTIO N
.
ures reg d ng th e
Inventory result s from management policies and proced i
der Ived from
Raw Materials, Supplies, and Finished Goods operati ons of an organ izatio n. These policies and procedures are _
s) and matenal supp ly
In-Process Inventory external expectatio ns about prod u ct demand (customer . .
LEAD TIME REDUCTION
tatiOns) sueh as avail a ble
. . ces. The I'wk s In
.
. . .
. t .
raw ts (limi
{suppliers) as well as from mterna l cons
es, cap cihes, an fI anca1 resour
l
. the logistica chain
CONCWSION
capabiliti ges in one
independent, so chan
{supply, productiO , and distn JO . but ) are not

can cause changes m the others . . ffic i .

may
local optimi_zation
Questions
Cases
n ies based on
hat are not glob
al ly efficient for the
res lt in isolated "island s o f efficiency neces sar y tra ns
ncies does not
enti re logi stical chain. The sum of local efficie _
ine optimization
only
late into aggregate efficiency for the
total_ sys te
hGenu
f e en tire log
istical chain .
i miztwn es that they be
occurs when it resu lts in globa l o pt f nvento ry requir
The large num ber of phy sical eI h m og eneous categories man -
o
for con
un ts
er of rlat i Y in ventory are made more
tro J PU
cl as si fied
into a smaller nu mb of f
. d dJVersi tY 't bly rhe type o
rposes . The com plexit Y an to eac h ca
gea ble by applyin g sim ilar proced u s have an im pact on a mo
tegory. ! nev i , t all ot her
In ven tory control systems selected ill :
organizational activi ties .
 13
536
Aggregate Inventory Control Chap. rype s of Control System s

537
1. ensure that sufficient goods an
2.
d m aterials are ava..L
identify excess and fast- and sl
Organizational
3.
. ow
prov de accurate , concise, and tim
-movt. ng items , able,
4.
objectives
1 ely rep
expend the least am ount of resour . orts to management,
ces tn accomplishing the abov
Without minimizing th e imp orta nce
e.
of ntitative t ch lqu
be un de.rstood that a comprehensive inventoryqua . es, I. t should
system invol: rluch
refin ed mven ry models. AI aspects of the system
mu st be c DSidered,more
than
Organizational
Just th e specific model(s ). SlX areas are vital in the d
eveI opment an not
nance of the system , and a breakdown in any one can un d . and ma.J.nte -
strategies of the entire system : ernune the effic1en
. cy
1. the development of demand forecasts and the treatment
2.
of forecast errors,
t he selection of inventory models (EOQ, EOI, EPQ, DRP, and MRP),
3. the measurement of inventory costs (order, holding, stockout),
4. the methods used to record and account for items,
s. the methods for receipt, handling, storage, and issue of items,
Production Finance

6.
Marketing
strategies s!Tategies strategies
the information procedures used to report exceptions.

TYPES OF CONTROL SYSTEMS

There are various types of inventory control systems, and there are spe: ial
hybrids of the common ones. It is difficult to classify them in an order! fshio
and still demarcate their definin c aracer t i ;:g:t :jr
lnvemory

the system s used most frequently IS given .10 g . - Included in the diagram
s!Tategies

systems by demand situatio n and operatl.n g d1oct nlen ne :

d optJO na rep tshment and in addi. .t.l. On
are te perpetual, to-bm, distribuu on
FIGURE 1 3-1 Derived inventory strategies
. peno 1 end item s,
reqUirements planmng systems, wh Jch usua lly appl y to ramts
to the material requi rements P.lannm. g, ust-in-ti me, and theoryducof cons

nents used to pro end .Items.
.zed ' but rem ains
The starting point in developing a control system is an analysis of the . c m o
The sin le order quant ity system also IS categon
systems which apply to maten als an P uruque m that
objectives of the intended system. This procedure discloses the critical activities
it lac ks a reorder dimen sion.
. terns are referred to .as fixed or /:
in the operation where control can be most effective. It is imperative that ,the .
d). Th i r tion re
control mechanism satisfy the service and operating objectives of the institu tio n
at the lowest possible cost . For this reason it is the responsibility of top man
The perpetual and two- bm an d opt ion al repl erushm : :
systems (quantity based). The peri c
agement to select the control system (or systems) and to establish aggreg te referred to as fixed order intervJ s yshase terns (time base ple sh ents of items
inventory levels. However, an inventory control system, with guidelines o m quirements planning system is tJm.e-p
d sys tem f reial meq ements plan
or
1 a distribution network (d IS const rai n ts systems are deQuand otityrd-bas
. tnb utiO n based) . Th e mate r nve ! Uir er q uantity
sy -
ventory policies, often is converted to rules for specific items by the operatiO ns

personnel who implement and monitor the system. of

By definition the operating system should indicate how routine an d nmg, just-in-time and theory
s(pr od uc tion based).dete ine if an order
systems for prod ction en viro nm and ) to only made on
nonroutine situations are to be treated via predetermined rules and procedures . it each dem
ed sy terns d at that ume. A di t
A good control system provides for self-control and only requires attentio n to
tern s are
should bechecked contin uall Y (w
b as
a count of st.oc s ribution
placed. With tim e- plce
exceptions . Adjustments are made as the system operates to desig nated review dates , and ord ers :re
 System s
13
538
rype s of Control

539
Aggregate Inventory Control C hq p.

based sys tem p ed i c t s d i s tri b ution req uirem ents

them . Pro d uct iOn-based system s orde r stoc k oannlyd schedu les orders to meet
re qu irem ents. to meet m anu fact uring
Perpetual Invento ry System

A per petu al s.yste.m . keep s a runn ing record of the

a
. nt in stock. Each ttme
wa1 1
.
u ni t (o r umts) ts 1ssued from stock the withdraamou
Positi on is compared with the reord er point If the stoc kIS ogd and the stock
,
less than the e ? rd r pomt , an orde r is prepared for a fixed numbe1sr of
.
pos1t1on equal to or
the stock pos1t1on s more than the reorder point, no action is taken. units. If
This s ystem IS based on the econom ic order quantit
y {EOQ) and the
reord er point . T h e e petual system is completely defined by knowing the order
size (Q) and the mm1mal stock level that signals the placing of an order (B ) .
U nd er this system the reorder point and order quantity are fixed, the review
period and demand rate are var i ab le , and the lead time can be fixed or variable.
F ig ure 1 3-3 describes the behavior of the perpetual inventory system for a single
item.
The major disadvantage of the perpetual system is that it requires
perpetual auditing of the inventory in stock to know as quickly as possible when
the reorder point is reached. The review may consist of analyzing perpetual
reco rd s (manual or computerized) as they are posted. Since an order can .occur
at an y time, this prevents the economies th a t result from the amalgamatiOn of
severa l items from one supplier into one o rder.

2. Fixed reorder point 8

3. Fixed reorder quantity AC
I. Variable demand (slope)

4. Fixed lead time DE = FG = If/

5. Variable time between orders OF # Flf
c
i
>

D
TIM E -I
system
Inventory
1 33 Perpet ual
FIG UR E
 13
540 541
Systems
Type s of Control
Aggregate Inventory Control Chap.

Periodic Invento ry System

e
perpetual system may becom evident if:
Further weaknesses o f the
In a p erio ic inventory system the number of ite ms in

storage IS
. revtewed at a
1. Reorder points, order quantit fixed time mterval T A count mus t be take n f 1 he o
ies, and safety stocks are not restudied or .

1
f
ds on hand at the des
2. Delays are encountered in posting
changed for years. igna ted inventory review date. The size of e rep e shment
transactions.
order depends

3. Errors or mistakes are made

upon the number of units in stock at that time There,ore
Y
in posting transactions.
. , the order quantit
varies from p e n od to pe n od , and the decision

4. Numero us indepen dent orders result

in high freight costs.
s. Supplier discounts based on the dollar
volume o f orders are forfeited.
. maker changes the quantuy .
ordered to reflect changes m the deman d rate.
igure 1 3-4 de scribes the behavio r of the periodic inventory
. system for a
single Item . A wnmum nvent ry level E is established for each item The
.

with perpetul records is order qua ? tlty IS the Il_l aJnmum mventory level minus the inventory position
.

control. It IS extremely
.

on the revtew date (revtew dates are at points F, H, and J in the illustration).
On the positive side, the fixed order size system
excellent for independent demand items needing close
useful in these situations as well as others, because: Under this system, the review period is fixed; the order quantity, demand rate,

1. An efficient, meaningful order size is used.

and reorder point are variable; and the lead time can be ftxed or variable.

2. Safety stock is needed only for the lead time period.

The presumption in the periodic system is that some sort of physical count

3. The system is relatively insensitive to forecast and parameter changes.

is made at the time of review. In many instances records of transactions (sales
slips) are available, but the accuracy of the information system may require an
4. Inventory checks are related to usage; slow-moving items receive less
action records). Automatic data processing equipment can provide perpetual
actual count for verification (lost or stolen items are not apparent from trans
attention.
b is
inventory records with order decisions still being made on a prescribed
ac ommodaon
Two-Bin Inventory System without t h e need for an actual physical count of items. Some
items, errors m transaction
As indicated before, the two-bin system is a version of the fixed order size
must b e made i n these systems for the return of sale
accounting , lost items, and stock shrinkage.
system which operates without perpetual record keeping. Inventory usually is

2. Fixed review period FH = HJ

stored in two bins; upon order receipt, an amount equal to the reorder point is I . Variable demand(slope )

11: E- B >' E - D
put into one bin, and the remainder of the order is placed in another bin. Stock 1
FG >' HI >' JK
!: ::: :; :
5.
Safely stock = 08
is taken first from the bin which contains the difference between the order

6. .
quantity and the reorder point. When stock in this bin is depleted, an order is Variable lead lime

-
____
released. Demands then are filled from the second bin, containing the expected invenrory position al
revie w nmel
_ _
_
(Reorder quanli ly =
lead time quantity plus any safety stock (reorder point quantity). Due to this _

procedure, records need not be maintained of each withdrawal, and the signal
for a replenishment order comes about by visual observation.
The system actually can be used with only one bin. An order can be
.
tngered when the inventory level reaches some attention-gettin device. The
g
device may be a physical mark, such as a line painted at
the reorder volu me level
on a tank of gasoline or other liquid, or it may
be a partition placed in front
of or on top of the reorder point quantity when stock
. is stored in a bin or
ontainer. Any similar markings or apparatus can be used to signal w hen sto ck
Is drawn down to the reorder point quantity.
Since the two-bin system does not provide open
order informatio n, it can
only be used when no more than one
replenishment order is outstanding.
Therefore, the order quantity must always

tem
nventory sys
be greater than the reorde r poi nt.

periodiC i
The two-bin systm is suited best for
items of low value o f fairly consistent use

FIGURE 13-4
and short lead hmes, such as office supplies,
nuts, bolts, and so forth.
542
Aggregate Inventory Control Chap. ,3 Types of Control Systems

543
I.
2.
Variable demand (slo
1M : MN
FIXed review period ;;}_
:5 ::=rB or lowrG/ : IJ :
. Fixed lead ti me :qtyJE- C ' E D
- K:
JL :

6. Safety stock :
OA
-
NP

r------

1. A reduction in ordering cost may be possible because items are processed

under a single order.
2. Suppliers may offer discounts for purchases exceeding a given dollar
volume. The lumping of several items into a single order can make the
discount more attainable.
3. Shipping costs may be significantly decreased if an order is of a con
venient size such as a boxcar. This can often be accomplished by the
B
simultaneous ordering of several items.
c
The manner (or timing) in which the perpetual and periodic systems

D
customarily initiate replenishment orders not only affects their ability to engage
in consolidated ordering but also holds implications for their safety stock re
quirements. In the perpetual system, safety stock represents protection against
SAFETY STOCK
demand fluctuations during the lead time period.1 With a fixed order period,
the periodic system requires safety stock for protection against demand fluctu
F G H J K M N p
ations during both the review period and the lead time. This means that
TIME
the
periodic system will require a larger safety stock for a given item
than the
perpetual system. However, some or all of the additional safety
stock expense
may be justified by the economies achieved from joint
orders. FIGURE 13-5 Optional replenishment inventory system

A m axim um inventory level is established for the item. If the inventory positi n
i s above the reorder point on the review date (e.g., at points F, I, L , and M m
Option al Replen ishmen t Invento
ry System
the illu stra tion) no order is placed. If the inventory position is at or elow the
reorder point o the review date (e.g., at points G, 1, andN), n order IS plcd.
Th otional replenishment inventory system
is a hybrid of the perpetu al and
penod1c syste s. Stock levels are reviewe
.
no placed until the mvento
d at regular interva ls, but orders are The order qu antity is the maximum inventory level minus the mventory posi tion
ry position has fallen to a predetermined reorder
pomt . Whe? pl cing an order is expens at the review date .
ive, it may be advantageous not to order ic systems are defined
at ery evJew m . Figure 1 3-5 typifies Reme mber that both the perpetual and the P eriod

a smgle Item w1th 1ts three defining
the optional replenishment system for
parameters: by only two parameters, in contrast to t.hree 0 the optional replenishment

defining parameter per
system . The instateme nt of the reorder po a h1 d
1.
ITiits ord ers to be placed in efficient quantrtJes , r uces arameter periodic
the costs which may

orders ID h tw
the length of the review perio
d T,
,
o-p
resu lt fro m
frequent placements of small
3.
t h e maximum inventory level
s indistinguisha ble from
2.
the reorder point B. sys tem . However the optional replenishme? t syste J so long that an order
he the pen od is
Perio dic inve tory system when revieW
cont r l
1 It can be shown that the average
I S tr

. the best valu set ID

iggered at almost every review. es of the three
rather t han only at set times.
1 valu
.
mventory wtU be lower if orders are placed when needed The computational effort t0 ob taJD es are usu ally a rat her ar b t-
Param eters
is prohibitiv e. Th us , c?ntro
trary fa
shi on in practical applicauons.
 Types of Control Syste ms

545
Aggregate Inventory Control Chap. 13
544

ex hib it a c o tin ous and in dependent dem

Distribut ion Requirem ents Planning Inventory
System
a n d distnbuto :
and Item s sold
sa lers,
man ufact rers .
rs us ually meet the
qu
se re Jrem ent
by retailers, whole
s, as do product s
sold by
method of handling stock re
Distributio n requirements planning (DRP) is a For I t m s t hat exhib it a discrete
nt. I t applies time-pha sed and dependent
plenishmen t in a multiechelo n distribution environme . .
are less d e Irable. These item s are more appr
dr,m and, classi cal

m a manufactun ng
logic to produ.cts in a distributio n network in a manner simii ar to the way M p oPri ately system s

applies it to the subassemblie s and components of products

.
terial reqUirements plan ning (MRP) syst m .
inve ntory items available at all times It P ns .
. cont rolle d under a
This syste m does
n<J< try to make
rna

si es s
z
from the mas
bill of materials network. While MRP is an "explosion" process 1 nve tory lot
they are time
ph ased to w h e n they are needed I vent
ter production schedule to the detailed scheduling of component requirements, 1 v an be lower, nd holdin
DRP is an "implosion" process from the lowest levels o f a network to the cen
costs reduced substantially, i f inv ntory is t g

P
; unng time peno ds
tral distribution center.
demand. In order to achieve these economies s v RP t de
of zero
an elaborate

He
schedulin g system that indicates when each d pende
DRP, like MRP, distinguishes between independent and dependent de e a .
Items suitable for MRP are components of prod cts I s eeded.
mand. All demands in a distribution network are dependent except at the level
:
e
where products leave the network. DRP relies on forecasts at the lowest level in product 's bill of material s; they usually constitute the major ty
it he i
the network to derive inventory demand at all higher levels . Although gross inventory by a manufacturing organization .
requirements must be forecasted at the local distribution level, they can be .
Time p h asing is the ess ntial ingredient of an MRP
system.Time phasing
calculated at all the other levels. reqmres known future requtrements and sufficient time to react (lead time).
Gross requirements for items are developed from forecasts at all local dis M R P i s i mpossible without these conditions, but even these conditions are not
tribution centers in a time-phased order point (TPOP) format . The planned sufficient t o ensure its success .
order releases for a given item in each time period at the local centers are ac Known future requirements are ascertained from forecasts and customer
cumulated and become gross requirements at the parent center. Thus, parent orders t h a t are translated into a capacity-feasible master production schedule
centers no longer have to forecast lumpy requirements, but can accumulate them (MPS). The master schedule indicates those products that should be produced
from their demand sources. Based on the future visibility of requirements, DRP re in future periods. It applies predominately to the end items that the organiza
plenishes what has been consu.med in succeeding levels of a distribution network. tion produces for its customers. It does not include all the components that are
necessary to make the end item. Once the MPS is established, the exact quan
the
Single Order Quantity Inventory System tities o f these dependen t or derived demand components needed to make
end item s can b e calculat ed from the bills of materials for end Items. Thus, all
The single order quantity system is not really an inventory system but a general
of thes e compon ents will have known future requirements . .
category for handling the variety of items that are ordered infrequently o r only companson with t.he numbe r of
is desirable, smce ;ore.ca; ts
in
The n u m b er of end items will be small
once. They tend to be unique and require special attention. Items fall i n this
components but oncanly .orcalcu
components i n a manu facturer's inventory. This m e-
category when (I) demand is nonrepetitive and occurs at infrequent intervals
need not be developed for depen dent d eman d
or (2) an uncertain demand exists for a short-lived item. The first de:: are derived and be-
nts that make up an end item
situation is penden t demand item . All dependent nds
tpified by promotional, fad, or seasonal items ordered by have
retail outlets; occa late d from parent reqUirements . All com po
Sionally eeded spare parts for maintenance ; and materials
required in the dep enden ema d .
vital ingred ient for anMR P in ven ory
onstructiOn of special projects. The second situation is typified by highly per
al order, fabnau on,to
.
every materiexist
her .
S u ffiCient time to react IS ant
Ishable items (fresh fish, flowers) or short-lived ,
obsolescen t items (Christmas syste m . Lead times must be estab hs
d for
horizon s,y what it poss i ble
is
trees, ne spapers, periodicals). Lot sizes for
single order items are determined sub assembly, and assem bly. I f a su fic:;;;urch
.
ase exactl needed ,
is.
by margmal analysis, cost analysis,
end precise reqUJ:ement s
and assemblealltheitem
calculation from specific project requ ire Ite
start wit hout any invento ry for
ments, or manage ment judgme nt.
ed,
of s and thw Inter
The Je e1t mes
fabricate just those comp onents need
d
sing. .
Material Requ irements Planning Inventory
System
With no surpluse s or shor tages .
of m phatha t slarts with . hed
the fiIS
schedi !wstem
relatio nships are vital to the success
st classi al inventory systems assume that inventory items should be avail M R P is a back ward th rough .IaS l: \:eb
aterials , ory
10 invent so 1
al s
:eo;d: P r. aThlime Its I is plan
ey r: plenish inventory with a lot size that is triggered by a Prod uct . It then ork s bac k to
. . n. go
asse mbly and fabnca tw
Interval . These systems are appropriat e for items that
need ed (not before a n d not after).
 13
546 547
e Inventory Control
Sel ectiv
Aggregate Inventory Control Chap.

cont rol ho ld be exercised over the m . It is fr

inven ton es m to three classes accordi ng to dolla ol ume (the a erJU! to di-1-:lt
(
tly arlvant g
Just-I n-Tim e Invent ory System
and t h e unit purchase cost or P d .
q uantity -ctJon
cost). This approach is t;ll)l<;d
prod uct of ann!!al

The ju t-tn-tim e (liT) invento ry system,

developed b y t h e Japane se, is used in
A BC analysis. The A class is high val
U:S who se dolar olume typi
accou nts for 75-80% of the value of the to l :: ry, whi i: represe

raw materia ls and in-proc ess inventory
repetitiv e manufa cturing . It control s v t;ll]J y

whose do
_
lly lmks work centers so there is nting only
levels for dependent demand items. It logistica J 5 -20 0Jo o f the inventory items. The B class
an even now of material s similar to that found
in an assembl y line. It attempts
volum e account for 1 0- 1 5 % of the value of the i nv 1
ue
e: l_lar
20- 25 0Jo of t h e mventory items. The c class is 1
an ideal lot size of one unit. while representmg
to drive all queues toward zero and achieve ue/ whose volume
; .:n :
plant loading (usu
1
For JIT to be feasible, the precondit ions are uniform
Figure 3-6 s hows a typical ABC inventory classi cati
acco unts for 5 - l OOJo of the inventory value but
1re:m

e ry
at the source (zero ve
ally for one month), group technology, quality control
e
: =
kanban type produc mto
defects), minimized setup times Oess than ten minutes), a A, B, and C items is arbitrary, and further divisions rna be es lis
T h e m vento value for each item is obtained by multiplying the annual
of pro
tion control system, and local (nearby) suppliers. JIT is a philosophy .

sea
duction where inventory is considered undesirable .
dema n d by t h e urut cost. Annual demand is used to avoid distortions from
sonal changes . The entire inventory is listed in descendin g order of value. The
Theory of Constraints Inventory System
items are then classified as described above.

The theory of constraints (TOC), also known as synchronous m a n u facturing,
is a continual improvement philosophy that focuses o n operational constraints.
It postulates that there are identifiable constraints associated with the operation
of any organization and that management should exercise control by identifying
C
The same degree of control is not justified for all items. The class A items
low inventory in
require t h e greatest attention, and the class C items the least attention. Class
items need no special calculation s, since they represent a
supply with a periodic review
vestment . The order quantity might be a one-year
d with a semiannual review
once a year. Class B items could have EOQs develope

. The major concern of an ABC classi

and effectively managing them. A constraint is defined as anything that pre
developed with a review of the
vents a system from achieving a higher performance relative to its goals. TOC of the variab les. Class A items could have EOQs
finite-schedules all activities (resources) to the requirements of the most binding variables each time an order is placed he largest
inventory items that represent t
constints. Nonconstraint resources are subjugated to constraint req uirements ficatio n is to direct atten tion to those
to attam optimal utilization of the constraint. Time bu ffers of inventory are

I
located at constraints to ensure l OO"lo utilization. Transfer Jot sizes that are fre

I
I
quenty smaller than process lot sizes are used to overlap operations and syn 1 00%
:J
...l I
hroruze the product flow rate. The improvement strategy is to continually
0 I
mcrease thoughput (output the organization can sell) while reducing inventory
I
I

I
and operatmg expense.

I
80

I
:J
0

I

60 I
I
SELECTIVE INVENTOR Y CONTROL

j I
0 I
0::

0 I
Mterials management involves thousands or even millions of individual trans
--I
I
tlons h year. To do their job effectively, materials managers m ust avoid the
4{)
f I
IStracuon of urumportant details and concentrate on significant matters.
b
u.. I
I

0 I
I n e tory contrl procedures should isolate those items

t: rom t er 1 tat can be controlled
.
req uiring precise con

to co t 0 can mdcate where the manager should concentrate efforts.

with less precision . Selective in -
20
lS us 1 uneconomical to apply
I

all iterns earn .m an inventory. Frequently, 60

40
J detailed inventory control analysis to

2ERCENT Of roTAL ITEMS

a small percentage of invento ry

analySS
items :nts or most of the total invntory
value. I t is usually eco nomical
C Inventory
o
them. Conv sely, mall quantities nl cal AB
rv,,.
t pur rg supply of lw cost Item ad maintain little contro l over
; : _ of expens1ve Items are purchased , and tigh t 13-6
FIG UR E
548
Inventory Control
Selective
Aggregate Inventory Control Ohap. 1 3

TA BL E 13-2
549

TABLE 1 3 1 Comparison of A, 8, and C Classes

Degree o f 'JYpe of Freq uen cy Size o f

A nn ual
Usage Ann ual Dollar
o f Review Safety Stocks Item Cost
Lot Sizes

0- 1
Cia s Contro l Records Usage

A $ 2,8 00
Ranl--
40,000 $.07
Low Conti n u o u s Small

I
Tight Accurate and
G-2 1 95 ,000 5

8 400
complete
.II
2 1 ,450
0- 3 4,000
c
Moderate Good Medium Occasional M o d era te .10
Loose Simple Large q
I n fre ue n t Large M-1 1 00,000 .05 9

M- 3
5 ,000 3
M-2 2,000 .14 280 10
240,000 .07 16,800 2
M- 4 16,000 .08 1 ,280 6
annual expenditures. If inventory levels can b reduced for class A items, it will P-1 80,000 .06 4,800 4

The purpose of classifying items into groups IS thus to establish appro

result in a significant reduction in inventory mvest ent. P-2 10,000 .07 700
. 7
P-3 5,000 .09
8
C:
priate levels of control over each item. The A B aalysis s useful for any type $53,960

TABLE 13-3
of independent demand system (perpetual, penodtc, opttonal replemshment, _
and so forth). With the periodic system, the ABC analysis can be s u bdivided
so high volume items receive a short review and low volume items receive a much
longer review. On a periodic basis, class A items might be ordered weekly, B Annual Dollar Cumulative Dollar Cumulative
Item Usage Usage Percentage Class
items might be ordered biweekly, and C items might be ordered quarterly or

0 -2
semiannually. Note that the unit cost of an item is not the sole determin 39.8 A
ant of $21 ,450 $21 ,450
the classification . A n A item may have a high dollar volume M- 3 1 6,800 38,250 70.9 A
through a combi
nation of either low cost and high quantity or high 43,250 80.2 B

8
cost and low quantity. M- 1 5 ,000
89.0 B
Likewise, C items may have a low dollar volume because 48,050

c
o f low demand or low P-1 4,800
94.2

c
cost . G-1 2,800 50,850
96.6

c
M-4 1 ,280 52, 1 30
If items are on a fixed order size system 97.9
with an EOQ, the EOQ auto

c
P-2 700 52,830
maticall y adjusts the lot sizes to an ABC 98.7

0-3 c
configu ration. A low annual demand P-3 450 53,280
results in a smaller lot size, while a low 53,68 0 99.5
unit cost results in a larger lot size. When 400
an item is a C because of low unit 100.0
cost , it is automati cally ordered M-2 280 53,960
lot size . When an item is a C because in a larger

TABL E 1 3-4
of a high unit cost and a low unit demand,
it may be advisable to order it
on a one-fo r-on e basis or to
order
Item IS reord ered when
only when a
no n demand occurs. Perhaps only one
unit m ay be kept in stock , and the
the existin g unit is remove d Dollars per
from stock . Gro up
. '!h A , B, and C classes are arti ficial Class
tailor I ts t v n tory system strata . Each organization should
to its own peculia rities.
group then I nvent ory Organi zations may choose to A G- 2 , M-3
into more than three classif =

B
C
t h e same: high value icatio ns ' but the principle i s M- 1 , P- 1 , G-1
o f the A, B, and C classes
items receive the most
o r
=

.
least A comp arison attentio n and l o w v a l u e i t e m s the = al l th e s
is contained in Thble 1 3- 1 .

ones mus be
th an ftn ancial
t
si fi
1 e an it em s das
'
s might be :
ctors other
ssT1ed fa
! ;!
Examp le

; Before items can be c

io s ca n d ras ical Jy ch wr
.20& 0 A e
t c
cahon as well as 1ts control P oced
s an nst e tan
;
1 vent ries only ten eval u ated . Additi nal co tm por
and 50% C items . The e),____
items, but decides ? ure. Some
tic
st to set u p an A BC invento y .

p rov e
ms, 300Jo B items,
e m .orm ahon sh
r
com pany records
erra
ti
e ad_
l_ m
_

1.
_ _
own i n 'Thble 1 3-2 g
n __and
. (lo
pro b Jem
__
Thbles 1 3-3 an d 1 _ _ __

t;_k.t;a. .... ... d .:. t h df t.______

3-4 stratify t h i tems cure m e n t
- b
e i nto the A BC classi fic a difficult pro
ation .
-- -- -- -- -- --
 ggr gnt lnv ntol)l Control Chap. 1 3 lnva nlol)l System Oovelopmom

INVENTORY SYSTEM DEVELO P M E N T

Tht> d i i o n t o implement and, u b e-queml_, to rede ign an imentory system

resr wirh rop management . Howeyer, rhe u l t imate fare of a n inventory c o n trol
"),rem u ually l i in the hand o f lower level opera t i o n p e r o n n e l . Th nvoid
resi ranee to change and implementation difficulrie , the affected

y t e rn . Their i n c l u i o n u s u
depart m e n r
,hould be included in the de ign o f the inventory
ally r e ult, in a better ) tern wi t h fewer behavioral
problem w h e n i t i s i n -
tallt>d. Departmen t t h a t h e l p reate t h e inventory
) tern t e n d t o n u r t u re it
during the implemen tation pha e and correct INVENT OR'\'
unanri ipated de i g n flaws. \V i t h
o u t e-mployee support. a n y im emory
) t e rn is ubject t o d e m i s e o r at l e a s t a

on<'
s
lnven tol)l contro l system
There are many approache to inten I. EOQ
turbulent future.

EOI . i:'Conomk on:ier

FIGU RE 1 37
:
t r I'
3-7. Since mar erial man agement is not an qu3nUt .
de igni ng a n inve n t ory ) t e m . A general
e

J i ngle order
frame\\ ork i di played i n Figure ORP distribution requiremem plonnm,
.
n-time. M P
nomk du :!;t, nJnITning. just-i
= = rna
=

duction ,chcdule. MRP moteno _n:timphn ed order point.

i lan d unto it el f, the y tern order quantity, EPQ = ec

theory of con tmmt . TPOP -

OQ =

TOC
m u t erve the goals o f the organiza
t i o n a well as .=

l m e mory Y tern requ

the eni ce objective o r
other depart ment . =

ire forecast or e..x pecred

. req uire men t for a l l e n d rroc t for the
Item produ ced or u . which tllen con
ed b y the organ.i z.at ion g d Pnrtm ent,

o t nm -.
are t ra n s m i t t e d t o the p u rchasm
forecas ting m del
. Item foreca t a r e devel
oped from
:e .
'tion are tran m
i t ted t t h prv

an A BC analy i o f r Jes
uch a were covered in

are uaht a..-

? , pro uctlO _
a previous cha pter. item . For i nterna l s u pplier the produ 'tion
? r Y te rn would be prefera ble . I f
cast s are obt ru.ned , After item fore
tment , whic the
. Ill\ "'" th
the inve ntory w i l l i n d
du t i o n c o n t ro l depar
bin i nvento ry y tem i
icat e , hat ysrem the sup plie . they
a perpet ual or t wo- receiVed from

y,tem, m b ,t
When ordered item are
Indi cated , the
EOQ and E PQ model can
be e mploye d . I f congl
omera t e order ce ted a n d p u t i n t o
invent o r . N ee l ,to a

' a l l of the tran acti on,
v or
ntrol . I n e nt y
es ary l he EO I model
:
Y tern . If item fal l
can be u t i lized for
o
';;, :; ;
' d
1:'": ";:\
cn t ttl-7 ow
rnent mve nr ry t h e periodic o r o p t i o nal re g e em t i o n o r p o p r ' " " i n t hat rnn i ndica

- m, n>
,

' ' . ''t

? i n to t h e i n g le order
category , t h e a cent ro co
model c<ll_l b e mai ntai ned from
.
d Ucllon operation
Incorporate d . I f ite
m s are needed to support
c h e d u l ed pro - i t e m . These records
beco me t c data
ba e for fore
orl.. . '"' nk r. .
;
: the MR p mo del can be applie the lifc ratio n o f pop erw

enr ry. de l lon

s pro
From t he ' ano d. t h e q u a n t i' t ), of item
and
1 .

rule can be e um, 1h

u mod .
. an d an unde t l_lol. tO\ nt r'
con trol
f o r com put er

ny im n t r ,-
organization i v r an d mg o f t he pec uliarit ies of t h e nat ural con d'd 1 ate .. end . 'll t u rnit
ry ) ,, tem den

i m ento rv de is

:
d cate _ll em
tab
hou ld be ordeed , requi ar n -
li hed for a l l i t e m . W h e n The u l t i mate uc e of an in ento
etaile pro c d ur e . , t m

t heory into ' orka ble

mined t t he ap irions
r at
PPher. For exter nal u
pphers, pu rch a e req U I t t w n
 552 P.q.J rf:9ale lntentor; Con1Iol
C hap. 1 3

3. Reduce cycle times .

an d !.r/ r.
procedures can be as important as precise quantitative accura.:r.
collection a n d processing o f ast quantities of data. The design o f forms an d Contin uo :ts
put .
senes of errttc sta
red uce throu
D__:
and sto ps res
rr1er.e fl-..
.
. time whic .
h r ults .e es

; tory'
The foundations of any inveJJtory control system are m p u t data i
::r:."JW-o;
t:--..a,
an d

on the accu racy of records of i nflows and outflows. Poor records and data
<;:..f-:r....
control records, hich must be current and accurate. I nventory control is base a large port ton of ults ir i

4 . Use fewer suppliers.

tts thro ugh p

With fewer sup

d ut tim e.

11 ...
, the ca:::.. o-; gr..;.
;,r-:wisb -
can

material co!
ro . Smailer order
destroy a perfectly designed control system. Inadequate records result
i n oper

":.anm i-;s - :.
for quality, price , and
ating personnel finding informal methods (usually to the s u bversi

with "favored
on of the .
more fr e q u ent d el i venes

5. Inform supp/zers L .
formal procedures) for sat isfying inventory needs (hoarding, stockpil are more likely
i n g , over
.
lUl/ demand. If 5
p;;lieo -= a ll;
ordering, early ordering, and so forth). Accurate and up-to-dat .
of expected ann

prod
e records permit

i to r!A-:e Sl!ffi':it
Modern analytical techniq ues have taken m u c h
an inYentory system to function efficiently and effectively. of annual eeds, t hey can
their
the ex pected eman
plan
uct on b
d . This action can
e and Permit the sup re.:
ventory available to meet

plier to better plan

, but not all, o f the guess d

sched ule
work out o f inventory management. Stock lead t
;
levels n o longer need to be deter
mined solely by habit, h u nch, or acciden operatw ns.
and proc

6. Contract with suppliers for minim

t. formula s are availabl e to establis
h
um annual purchases. Contraa
order quantiti es and order interval
s, while statistic al probab ility theory

chase a fixed annual quantit

can be
y from suppliers whb paymen1 w
coin':ide
applied to safety stock determi

ed, but has been supple mente

nation. Intellig ent and i n formed
manag ement
to %
y discounts can be
judgm ent has not been replac
d. Both q ualitat ive with t h e receipt of materials. Quantit
manner while materials are or ered and
and quanti tative evalua tions, in rlrisobtained
invoh ing consid erable s t u d
y and collab oratio n ,

tems implem ented.

d
price increases .
are usuall y required before received in quantities.economic
intelli gent decisi ons c a n be
made and effective sys This approach can also be a hedge against future
.The design of inventory 7. Buy on consignment. Arrange with suppliers to pay for their items as th
are s o l d or used. This action will transfer large
system s m ust includ e suffic
ient flexib ility to
mJt grovth , expan sion, and intern
tional sysm. The syste
al chang e witho ut upset
ting the opera
a portion of the holding
m must be able to cope costs to the supplier.

8. Consider transportation costs. Failing to

event. Th rnven tory syste with the excep tiona l item
m shou ld be capa ble of or

portatiOn can rncrease unn._ c:,

. being integrated i n to the other coider tportarion
organJzattonal syste ms
with little diffi culty .
and t h e most economical mode of trans

v b g r l t n 10 needs results in
9. Order economical quantities. O er u yin in e a io
conside rably.

INV ENTORY SYST E M

1 0. Control access to storage areas. prote t against losses from

theft, spou-il
I M P ROVE M E NT excessive holding costs.

Eac p u rcha e or production situation m ust be c

::ss. The n u mber p reced ed by a decision

making
age, u nauthorize d withdrawals by emp oyees, and
the ravages of the
1

forecasts can su bnan-

f items in volved can range

ma k i g proces . and
1 1 . Obtain better forecasts. More reliable
m ber of tram actJ from scores to eleme n t s .
ons is far in er.cess millions and .

0
items. The d ecl sion prectse
o f the n u m ber of

ke . , hst
a Y or d et
may be Sim ple
tend to imprm-e forecast
tory ma nag er I be rate . There are
or com I ex , programm
mtu tive or mat
hem atical ed or nonprogr
amm e d , Shorter
tiall y reduce safety stocks. arn e h rizons
provem cnt<; an d i ncrease per form ance.many ways an inven

1 2. Dispose of excess stock. Al stock sh ould be revi

c a n m- accuracy.
wo uld e t

ent meth ods
S ome appar- ewed egularly to ieruify
J. Stan dardize
slo w-m owg tte!D5. Dtsposal
I v:n:orJe<,
us,
. a n
surp
. J and
obs olete s u bstandard qualit y, age, and reduced-
St(Jck tle r, , rework, sah
1 eductJ On J.ben therednuced al tern ati es inclu de re tu rn to
scrap
eac h ite: r
ql.l antiti e> f by a red uction in the vendo
et m ent
\tead of fi ve J 3 , Imp
h o f the ruff.
Inve ntory i nv u m ber o f d i fferent items
.
pr ice sale.
ccurate wve . ntor)'oug record resultriehtin numero w
2 Rer.1uce lead
d sragtng, and nefftin - -
t at a re used for
o ered by car

pro blems (too much ? f t h e hedul

low
the s a m e p u r p o se.
rove record accuracy. Ina
rying

ltmes. Loc al
differe nt i:::, , one stand ard item in-
, n ot n
supp rJer can
uff
u r n over rate, exessJ ve :X Peditveingrecanord acc u:aC). d u ce th need for

.
e<;se ntJaJiy w ro n g st
.3 nwr)' counts.
Wx; k req u,remen red u ce res ponse
t\ . ti me and lower
t n g) . C ycle count mg ca n ro
dis rupti ve shutdo wns of P
rations for phY teal m
 13
554
Aggre gate Inventory Measur em ent

'i55
Aggregate Inventory Control Chap.

1 4 , Improve capacity planning. Overloa

ding a faility results in backlogs and
n schedul e should not be
poor customer service. The master p ductw
eck work centers).
loaded beyond the capacity of the fac1hty (bottlen
AGGR EGATE INVE NTORY MEA SU REM
E NT
the tec hniques for its measurement 1 sence . t rall level of inventory and
Aggregate inventory measurement relates to
the ove

15.
:
each tree. " Four common ways to e s e aggreI gate" lo ks at the forest and not
duction facilitY is limited by setup times. When a work center IS bemg set
Minimize setup times. The unencumbered flow
of work thro gh .a pro
mventory are as follows:
1. aggregate inventory value,
2. ratio of aggreg ate invent ory value to
up, no output is being produced and other arriving jobs must wait in a
queue. With shorter setup times, smaller lot sizes are possible.
3. days of supply,
annual sales,
16.
4. inventory turnover.
Simplify product structures. Excessive bill of materials levels can increase
cycle times, materials handling, and record keeping.
17. Consider multishift operations. The cycle time for completing sequential An organization may use one or more of the above for aggregate inventory
operations can be reduced substantially, which improves customer service. measurement.
18. Focus on continuous improvement. Place emphasis on standardization, Aggregate inventory value is simply the total value of inventory at cost.
simplification, integration, synchronization, and constraint elimination. Many organizations set dollar limits or budgets on the amount which can be
invested in each general class of materials. They are usually applied to broad
Frequently the quickest, most effective way to reduce inventory is better classes and not to individual items. The dollar limits indicate the upper invest
priority planning and control of operations. A poorly devised operating system ment limit w hich the aggregate inventory value should not exceed . Aggregate
may appear efficient in the presence of excessive inventory. Improved planning inventory value is very simple and easy to use, but it neglects the dynamic nature
and scheduling of operations can reduce the investment in inventory. of inventory and its other financial interactions.
Organizationally, the inventory control function is usually assigned to the The inventory to sales ratio is the aggregate inventory at cost divided by
purchasing or the production control department. Purchasing feeds the inven annual sales. This ratio recognizes the dynamic relation between inventory and
tory reservoir, while production control draws from it. Because department man sales , but it can vary substantially due to cost and/or selling price canges. If
agers ten to neglect the significance of costs outside their own departments, profit margins change, the ratio can become distorted and less mearungful for
the matenals magment concept has developed. The materials manager con
: . comparison purposes. . .
ory) IS the .total vale
yn
lidates purchasmg, mventory control and production control into a single oper-
mg t. The mate. als management concept grew out of the frustration of many
. . The numb er of days of supply (time supply of mven easure IS
of inventory at cost divide d by the sales per day at cost This m .
sales IS not mamtame
:
comparues at not bemg able to control inventory effectively. It is not uncommon
in nature, but it can become confounded if the cost of
departments to ntually fmd fault with each other, when the true culprit is
adequate orgaruzat10nal structure. Decisions to add new products, purchase
. and controlled . . It
Inventory turnover refers to the cyc
le of using and rep lacing materials
IS the ratio of the annual cost of goods so
foretgn <:<>mponents, and add distribution points can have . ld (annual sales at cost) to
the average
a dramatic effect on in
, f the investment in invent
ory
;: :
vetory mvestment. Likewise, uncontrolled product prolifera
tion errors in trans inventry. It indicats the number of "tur ha
action documentation, and outdated bills of materials
create seri r anization has sales such t t
,
its cost of goods sold is $ 600 000 a
e numbe of items in inv ntory has been growing ous
problems. for a given t i. me penod (usually a year) .
because of the year :O
d h an average inventory valued at
generate the
$ J S0 ,000 , it wou l d have
incre gly techmcal nature of the Items, a demand th rganizatio n could four tum
:
same sales with an average m ventory rth entory investment and 31so saves
tomers, ad requements for better service. for greater variety by cus $3 00,000 , it has two turnov.ers per ye
:: :;:
. The number of dollars invested in
overs per year. High turnover reduces the the low in ventories cuse frequen
1 wmg at a faster rate than the number of items.
hold ing costs But it can be harmfuI l'f cost of customer service and manu
. Computerization inv
the sol tlo

materials mana of t.hese problems. The comput er aspect of
has been mte uonally :J
!
to divert the re der om the downpla yed in this book so as not stoc kouts. A high inventory turnover at t h entory turnover recog nizes. the
e
t
t
really I mportant ubject matter. The computer's l
facturing expense is of dubious . value . become s ort :
: m':t:
contribution lies in its power to tios it can easily re uce
. execute a multitu de of straightforward proce- mo
dures in a ve sh namic nature of inventory, but h ke niq ues usually
::
management s n e
The computer, bile an esential tool of mate ials
;ial to unertandmg':" Aggregate inventoY mas %::re
t tech
s of dollars . The tecof P
hn ::a
and analytical techni ques the subJect. Computer rouunes
do not ehmmate the need for good management .
.
results m absolute terms or ti

Items t the comm on fmancl os. The desirable range
nce i
 f ' '"' II ,, 1., '' I ',.,. ,,,, (,t ! 1';

AGGREGATE I NVEt4TORY AEOUCTiml

In nc:crf:;ln ti...I!JIIIfflit,. l!f!l)fiiiJffiC/Jt ' i t ffl/ nt,t

b v.. jt,Jc u, .L.. h i re Ot"JretJ
tf'IWih ri>ll;' 111 fifltfit1)Ji l j llffiJ rl!tiHfJ l1ft 11 .,
Jfflfllj t',j J {Jf,..ftifJ t ,&ft

\o't,lr.Hn":', r .AirW! JICHII:t, m:w:,ro 111 rn:,; t;e f(JtC/",.,11

t.l1 )t,t,y ftlf llftj+, tiJ JJfl (lf(,f
f (tit 111M1U m t h i n the llfgf1(fiYt)llfl, I JlU<I I f j th tt.tJrtJIIfJ (,f tfl(l f(lfl2t 1f./:J{I
j ftXIJWl ltfl (;!!lh f)t, II IHJI1 Jt;tlll/1 f>JJ t<t . , fll 'll;{ltill j re(Jf(;V;Ilt+, >: t,JJb,UI.fl J f
/;JJt

a f r o mlftl f i l m +. , antJ lfJhllj t i m t h t Jtl!hl If i l l b t tf 1 fW WX llllt:JJthr j i r1 l,f{ji;J

et.
tt1 Jrl!fifllt r;r ft,r manu,:,
) V.:IVttt iwr1r1J,, 1 i, Clmtin !lfll1t1; (;J,II)n ltitf, !;aCf, teee:f r,t, trn .
tJ 11 Ialul; dt(tCrr rJ+,
'f .ale, 11 tHit . t1tt.r firot, m ll'hen 1t ,, rfJt;a
"('''''
be th'm,, ,,r : a '''"'fl t,,}t t;, Y'rr t a (/1i11t J(J t i mtt. J. lU.rtin-"
thn,

;, n anal; 1 r,f thc et,rrJ>I)'\HJ'Jfl ljf the l n icfl t.IJfj,

Llrtll, II rna'J
,---J --'-
''
A uf'''H" if, l'Jjlre 0 . a n aett JTI' ItntiJ J'f f;r,, fJI!.;. u i l l rtet the firorrd:JI
f;<,int /1,1 i n rell t hr'f rl w1'''fl

(..(, mrr.,itit,,, tq t;r"e ,,f JTJ tent.<,r'f. Y.etJ w:..t J 'II trte0 hr,uJtJ ben 11ith t.lrc
iiJV(IIft,r; t:rr t h t rer,rtv;nt rhc: IJH llo'lt+,tm;r,t ,,, 1r;,<.;tJt,{J ()( i n lf:fttiJ f j
lrove,!rnent an1J t h tr fiX.. JI ,,n the r,ther t;J1 H <.lc'tCe'n'lmt r,rdt:r.
l'rett 1 1re ft;t i w renthrJ rJ,Jt;..1J'HI, frt<!HI;n t J / m:;,n::te frt1ffl trJ(; rn;;rae
men t t(,)lt, milK rtii'''l r,1 :tt ,f.av.r; !ICJf(,, muct, <,m thert h {J(j prf-1
"'' FIGURE 1 3-- 8 J.qJ -' l';fi'-'I
rer
'1' '
It 1 tr,, tr '!ft(Jt6'/ 1<:
1ttm ltf!flft,pwtt.e tJ, H +,)tu.IJ'Ifl+,1 t:em{hll rJ 1 ,tr, rtjr,fl re W',h'.i
''' be '/ Jrl;l..;tJ;Jl ''hi!IJI,uhl ! f fJft.er' H u t;r,nd Jti'm r r;.. JJt ir1 an tJkt tt, mtt;r)M i>atrJG.ll '}h- :.vnP &-
HIent<, r y C(,r, t rt,J

>tt. hi:-re a 11nte r aJ!/e$Ch1.t iC""reJ a ltJJ r1t,i n t ,,., time '''
''' a h i htr
t u ,.mc.t raW ft,r 11 iren 1J!;rit,,j r,f timt, AIH1t1JJ.h
mnar ,

a.grtg:;,U; fiMHJ(..J I d.:,ta dt,

!
g;,wJ f,,, '11M! "' a n a l pntt llt'ft.nt.IHJ un
rfi''Priat.eJ:r ntlk:tt.e 1Jtft11 tli/MJt,n:,l JA;rff}IJfiM':t. t the tkt..a
m 1Jt t;,e di .aggre
b;;.lnr:.e$ :;,t th-e ''JJeratJrJSt l'=v'tJ .
..... ...... _ _ _ ,... _ ,..... _ _ _ _ _
- - - -- - - - -- -

---- ----
 13 Aggregate Inventory Reduction
560
561
Aggregate Inventory Control Chap.

manage ment policy variab le

The holding cost fraction F can b e used a s a
y more expens i_ ve, so t he re
10 control tock levels. A high fraction makes inventor
expensiv e, so there will be
will be le of it . A low fraction makes inventory less
be changed in large in
more of it. For this fraction to have an impact, it must
there is a limit
crements. A change of 1 or 20Jo will not usually be noticed. Also,
to how low you can drive inventory by increasing
the holding cost fraction.
Since service levels may take account of the number of replenishm ents , a high
Fcan result in more orders being placed, which increases the exposure to stock Orders in transit
outs. Thus, a high F will decrease the working stock inventory.

t
It takes some time before the inventory investment will respond to a
change in F. Its effect is fast for active items that are replenished frequently. For Orders i n temporary storage
In-process
inventory
slower-moving items it will have no effect until the items are ordered. Thus, the
reaction to a change in F can be varied and sluggish .
There is a tendency for product lines and models to proliferate over time.
0rders wai ti n g to be work ed
Simplification and standardization can reduce the number of end items. Prod Noo "

ucts with only slight product differentiation targeted for small market segments
might be eliminated in favor of more popular models. In the case o f obvious
substitutability, products with the smallest profit margins might be discontin Orders being inspected
ued . For modular products with numerous optional features, manufacturers
L--
.-- ---------__----1
might shift from a make-to-stock to a make-to-order to an assemble-to-order
Productive
situation and only carry the more popular configurations. In general, product
_ should be periodically revised
hnes and updated in a manner that does not en
courage proliferation and continuation of poor performers. Unique items can
_
be prov1ded on a special order basis .

In-Process Invento ry
Finished goods

The level of work-in-process (WIP) inventor y is determin In-process inventory profile

ed by the amount of FIGURE 1 3- 1 1
work released to the shop and the ou t put rate rom .
. f lt. The in-proces s inventory
profile is illustrated in Ftgure 1 3- l l . To reduce W I P, reduce the number of ity
orders released t? the sh?? decreas Growing WIP and excessive lead times are symptoms of poor capac
:
c e t he capacty of cntJ al (overlo

e the through put time (lead time) or in
aded or bottlen eck) work center. 'JYpi- plan ning . Since the output of a fa1hty 1s
. . . d'eta " td by its bottleneck work ceo
c y, mput _ ns mclude
cons1derat10 ter, they should be loaded to cap acity wi_ th httlf
.
:r::!nned idle time (except
bottleneck centers to
1.
mamte nane). There shod ways be a q
keeping backlogs off th e s hop n ensu re the1r complete utilzatJ on. onbo :
eck work centers should
not be
oor (do not overload the shop beyond bottlenec k
. _ _ _ . tJOn rat: should be dicta by the ount bene
2.
bottleneck capacitY lmJta ted

.
loaded to capacity, but their utJhza
releasing an order at th e I
, ttOns );
is of param
centers. Capacity utilization at bottle nec k work centers ers builds unneeded
uling period ' the I ower t he W possible momen t (the shorte r the sched-
atest
:it, wh ile capacity utilization at nonbottleneckd -:nsk cent
l P' becau se o f t h e decrease in handling,
at critical centers can
be

r I J\ ions and
congestion, and confl ict). I nvento ry and is of no benefit. Overloaded c n overti me. Addi
resolved through alternate rou tings, sch ed u e
d times .
tion ally, reduced setup times will res ult in re pred icated on a decrease
::
The majority of WIP is of It sizes and lea

tJme . If queu es can be shor a ou t to 80-900Jo_ of t h e manuf actunng cycle

sent in such q ueues usually re reted by work waiting in queues; _the t ime
er b
s t Y
. A reduction in in-po cess inve nto t sh ould nev
tened ' WI p and lead times : 0 of a produc moot hl and p
redu ced . can be corresp ondi ngly I n man ufacturing cycle ume. Id al l y,
of p ro duc tion as s y ra
topped . It should pass th roug h JtS sta hould
be elim ina ted, as
td)y a s to t fl ow sho uld
s possib le. Al l e nc u mbrance
 13
562
conclu sion

563
Aggregate Inventory Control C hap.

ts o f s :tup rime, move multi plier f hion . l ?w chartin g pro

all redundant acthit ies. lanufacturing .cyd time consis . cess steps
reve
timt- tornge !.ime. queue time,
e-con summg act JVI Ues. aJs non -value-added
inspectwn ume, and proc s
ume. Except for tim Time i s usu all
:
ed beca use o

pro , rime. these all represe

nt non-value-added oprauons that s?ould be
.
in ependent acivities, nons ync hroniza tio
uling) , r ducuon of Parts that are reje
0 : :
ende ac . v t
: erializ.ation of
m u l l es (poor sched
e
minimized. Improv me nr strategi
es include shonem ng, st.ra.lgh te mng, and
or inefficient work flows (poor layou ts
cted/ re or ked
).
(unaccepta ble qual
ity),
ly ch ain of I . .
"mu thing material flows. Product flows through t he supp
.
f lio\: a convoluted and circuitous net work
o O st l!cal
t hat Ielu des mbo
a.c v t ..
es
ll l l customarily
tion, mterplant transfer, inventory repos't' . und transpona

::
ng wareho ues. and
cus
1. aged by senuau tono
flsO:!
LEAD TIME REDUC TION mer deliveries. Traditio nally
to , produ ct
dep art ments (purcha sing, transponation distn'b
Time-based competition is an evolving
mous
business strategy that defi_nes the u Ion warehousing, manu
c-
sitm.ificance of organizational activities. Its emphasis n among t b em . Information
fa
is on a flexible mternal turin g, and customer service) with little coordinatio
. ' .
' dwell time in the system . about th e turung and quant.Jty of product flows

ironm ent thar increases throughput by eliminating
e m is defined as the entire logistical
The syst chain from creation (conception)
to ultimate consumption. Any activity that consumes time but does not add
\'alue ro the product is an initial r.arger for reduction or elimination as waste.
\\aste is anything thar does not add value or consumes more time than is nec
essary. The enemies are downtime, nonsynchronized activities, queues, nonin
tegrated local optimizations, and adversarial functional interactions. Lead time
reduction '\\ithin th e supply-production-distribution chain is the mechanism for
\Vh.ile everybody agrees that wasted time is undesirable, consensus on
time-based competition.
is managed through the use
. of
acuo n systms that are seldom completely integra
ted, which renders them
er:tly e ct1ve and s ow to respond. Improvement strategies usually involve
stmplificatlOn, automation, and integration.
The ultimate goal of a comprehensive lead time reduction strategy is
not
merely to cut the amount of total lead time but to increase the speed of through
put. This is congruent with the philosophy underlying the theory of constraints,
which increases throughput by ftrst identifying the most critical bottlenecks
in the system . Bottlenecks are then systematically and sequentially optimized
to maximize system throughput. Ideally, a system relieved of bottlenecks will

what constitutes wasted time is far from unanimous. High speed is not always
synonymous with better use of time, but attacking and eliminating delays invar
iably improves throughput and customer services. Measures for reductions-in
design times, cycle times, setup times, throughput times, and delivery times are
appearing with greater regularity on performance reports. Eliminating delays
and improving product flows requires creativity, specialized skills, capital invest
ments, and behavioral changes that challenge the status quo. Frequently, signif
icant improvements can be attained with little, i f any, additional investment.
Time-based competition or speed refers to the ability to deliver products
increase throughput and lead the ftrm to seek new markets (by pursuing new
market segments or new uses for the product), which increases demand. The
increased demand placed on the system will ultimately locate nw bottlenec,
whi ch leads to new opportunity for system optimization, w hi c leads
to
n strategies
creased throughput, and the process continues. Lead time reducti O
fit within the general "continuous im provement fratnewor "
k.
CONCW SION

unearths numerous causes of inefficiency, and their elimination results in

or services faster than competitors. Looking for ways to speed up procedures
but not any
earn its keep.
a long time ago,
fold benefits. This includes the time to bring new products to market, the
Inventory was considered a measure 0 wealth f
that h 0uld more than
nme to manufacture an existing product, and the time to deliver product to
more . Today, i t i s viewed as a curren set
IS
liability.
asset or operatio nal
/
organiza i o
a l f it in curs m o re costs than benefits, 11 a nega Jve t nal f objectives.
rmance of all the
a customer. Concurrent engineering focuses of
on time reduction in the entire Its app ropriate role is derived and insuppo unc

ted as a u tion .
.
fl u.e ce t e erfo
"concept to customer'' process. Instead of performing
activities i n a series , it n n
tiona) areas . As show n in Figure 1 3-.12 , tt
Altho ug h a sing le asset, it is able to t
can f nc
d the vari a bili y
combmes t b e ep c
a simultaneous or parallel manner, usually with the assistan ce t of require-
i
. sCJpline project
of a mullldi team. environmets :ver ally s
Management of time, specifically ead time, can The dive rsity of operating su perio r. Nu merou
be a competitive ad tem s
00 )
l
ments mean that no single
s
inven tory ss Th tradition al myopic fallacy of
vantage. To gain control over lead time,
s .
s u c h as
the flrst step is an analysis of the statu s sstb le e
Op tio ns and hybrid systems are po d

that are
orient to t e
n
quo. The flow of material and informatio efficiencies an tiliza
n must be identified and the lead time r ; ( on r::
u

. cal .
e fo nn
nt in a l gJs
?Ptimizing local measures of p
IS being supplan ted with global op .
arated into its various elements or components. Managing time the mirror
unage 0! managing Quality, cost,
is
innovation, and productivity. Reducing
ti s
t manage me
o tt
wasted tune automatically improves the other measures logist ical chain of activities . Consrra;; mance.
of performance in a pe or
aggregate
Paramo unt for effic ien t
564
Aggregate Inventory Control C hap. 1 3 Qu estions

obj ect ve o f profi t-m aking firms. Inv
entory redu

CONSTRAINTS
direct r m pact on net cash fl o w. U nle .
lOn has_ an .tmmediate ar,tj
v payment for it5
OUTPUTS ss an organi
ers or is ex e
_
pro ducts before It m ust pay its sup pli za 1?0 r

I. Perpetual
REPEAT ORDER SYSTEM S nen ng h1gh (doub
in ven tory turnover, it h an untap ped
The problem s o f Inventory
opp ortu le digit)
Improve perfo r:na
ce .
11
2. Two-bin and mate rials
account a 0 : e v
_ a ag ent re ubiq
3 . Perindic and complex . No Simple form ula takes into Uitous
4 . Opti o nal replenishme n t
5. MRP
6. Just-in-time
tered in real situati ons. The value of
practical and under standa ble solution to
good a : ;
_ nables un

at ons n permJ tttng a
a pr ten a eater than
anaI ysts ts not a pre-
Forecast>
Demand rates
Production rates
7 . DRP
8. TOC
any J oss caused by a lack of precision. Aggre
cise science.
gate inven

Lead times
Stock-on-band SINGLE ORDER SYSTEMS
Questions
Backorder;
DECISION RULES
Product strucrures
I . What to order?
1. What should an effective inventory control
2. When to order?
3. How much?
system accomplish? What
4. From whom? vital areas should be considered in developing a
comprehensive control

2. Identify the most frequently used inventory systems, and indicate the
system?
FIGURE 13-12 T he inventory function

3. What is the major disadvantage of the perpetual inventory system? What

basis on which each operates.
The design of aggregate materials management systems can be p
proached from different angles. It is common for emphasis to be put on specific

4. How does the two-bin inventory system differ from the perpetual system?
other problems may occur with the use of this system?

gram should include at least the following elements:

control models rather than the relevant systems. A broad-based aggregate pro

5. Compare the potential ordering practices and saf

1. determination or delineation of organizational goals,
stoc requirements of
the periodic inventory system with those assoCiated with the perpetual
2. assessment of the significance of materials management to organizational
t Parameter in
6 . What is the benefit denved
syste m

. bmen t
l repIerus
a reorder ?om
3 . determination of aggregate materials needs,
goals, . .
from usmg
conj unction with the two other parameters of the opuona
4 . design of appropriate material control models,
5. design of forecasting models, 7. Discuss indepen dent and dependent demand
system?
as they occur in a distribu-

6. measurement and collection of model parameter

(D)
. e requuements at tbe
system .
8. How does DRP d ete
tion requirements planning
7. model testing and implemen tation,
inputs, central distribution level?

8. variable reportin g and model redesign 9.
system.
VJtal mgre d ients for an MRP inventory

9. operationalization of the materials 1 0.

Name some of the
, (JIT) apply?
JU I"tern's classification
envir onm ent does . st-in -time

11.
To w hat manu factu ring
manage ment system. as well
affect an
W hat conside rations can d rastically
as its contro
_ an ABC inventory analysis?
basics must be operating in order for
Most systems fail because the fundame In
1 2.
ntals or basks are forgotten . The l proced ure .
success of an mventory
does the ultimate
the sophisticated tools to be successful With what organizational group
Just like football, the game is won or .

whi ch rru"gh
lost on the line. With so much e m ph asis ting an inve nt o ry
13 .
system lie? Why?

.
on computers, we often are tempted . t be useful in initia
to believe they are the solution to all of the
problems. Computerized techniques Give two or three hints
can very quickly and efficiently turn a little duce mvent ory
bit of nonsense into a whole lot contr ol system . wer suppliers re
14.
.
of nonsense. and using fe
Inventory reduction has a tremendous Ho w can redu cing lead umes
potential for product ivity improve

IS. . g Point for

ment. Many organizations believe costs? redu ction ?
that maximizing net cash flow is the premi er inve nt ory
W here is a good startin
 C hap_
10

11
4 78
Distri bution Invento ry Syste ms

. as the mean s to reduce inven tory investrn t

. provm g forecasts.
ph asized Jm en
. a . n bet ween staff spec ialists and lme man agers Was f
invent ory turn . .
and increase
3. Com m u m
.

:r to em hasize the importan e ten

personnel were prone_ struct o s


one- vay. lthough m l ? for system conve or
r ect deadlines . A were not ora med and never d evelrsi n
::r ;
m d d by the staff, they
o
ures. Cons uent y, apph catJO n of procedu res p
o
I NVENTORY VALUATION
fo
into rm al proced ame in dividu alized '
):>y in
ventory m anagers bec .
analysiS and data accuracy
. AND MEASUR EME NT
4 . The DRP project
team emphasized ata (Item)
imp lemen t uon. Howe ver, the data base integri
at the beginning of the ty
were '?tegrat ed. Some of the maj or data
depreciated as more items noted mclude:
S
FLOW OF COST
that were
analysis problems
a. invalid purchase
FIFO
orders,
b. inaccurate lead tim
LI FO
es, .
s past due scheduled rece 1pts, .
d. inaccurate forecasts,
c . numerou
espec ially for new 1tem s, Average Cos t
e. inaccurate balances of on-ha
nd and on-or der for new items, Specific Cost
f. incorrect package/contain
WWER OF COST OR MARKET
er sizes, Sum mary
g. incorrect analyses of transf
er vs. purchase o f items.
s.
selective . The DRP system was used pri INV ENTORY RECORDS
DRP outputs, such as
The use of DRP outputs was

messages to expedite or deexpedite orders, were often deemphasized or

marily to generate planned order releases. Other Periodic Count Method
Cycle Count Method
INVENTORY SECURITY
was
ignored.
6. Several performance measures were monitored. Customer service Questio ns
measured by the number of orders filled on time, and rewards were tied Problems
to improvements in customer service. Inventory turn was measured but Cases

of backorders (initially backorders were excessive). As conversion pro

not tied to any reward system. Productivity was measured by the number

gressed, It became more and more difficult to balance company objec

tives. To some extent inventory turn was sacrificed for increased customer
service.

So far the project team considers the DRP implementation reasonably

successful, given the obstacles of a major system conversion . M ore products
have been added, and customer service remains high. Since not all the expected
results fr m a DRP system were realized, the project team decided to o utline the

ares whlc should have been carefully addressed arid to identi fy steps and
actiOns wh1ch would have made conversion even more succes sful.

l. Wh at steps should the project team .have followed in system conversion?

What areas and issues should have been addressed within these steps?
2. What s?ecific recom mendatio ns in these areas might have m ade the
converswn more successful?
 480
ation and Measure me nt
Inventory Valu Costs
floW of

. ncial characteris tics. The physical ch aracteri . 481

l n\'ento? has phystcal ru1d fina que ntly purchas ed or manu fact red
(flow of goods) are factual .
and objective , whereas financia l ch aracte/IShcs hcs ' .
at dif
sold) , and unsold items must be va lued r the income statmenLt (poses
(e rn . since the items sold must b :cos
( flo w of costs) are o:e su bJeC
ferent unit

Usu.
co sts Th . s
(ve The physical and financial att rib utes
for the b aI .
ted fo a prob-

ally are se arate dlstmct h :;: d

\n e
:
enden t problem areas for an or a

cost of
ance sheet (i goods

tion. In ths sectiOn, emp will e placed on the financial cha ract fl?la- Sttcs
nventory).

associated with the flow of costs. .

ry s at l. b uta bl. to the nee
The financial significance of invent?
FLOW O F COSTS
d to
e fl nancta1 positiO n , as well as
measure and analyze an organiza tion's relativ . . the
or mcome over a p artic 'J1he invento ry flow method refers to th
need for measuring operating performa nce . . ul ar ti .
(month, quarter, or year). Inv ntory, m an accou n tm g sense , repres me
inventory. The .assum ed flow for acco n i te:;s are added to and taken from
period ents
value assigned to goods either acqwred o produc ubseq uent sale or
d or th e a ctual phys 1cal flow of goods. The selec rposes may not be the same as
i
consumption. Inventory accounts at a artlcul r pomt m t ime .are a snapshot method by mana geme nt will determine th n of the assumed mventory flow
view of the total asset value of inventory Items either ? n h a? d or m process. 'Phe
e fl
inventory flow assum ptions in practice today w of costs. There are 1arious
valuation of these accounts is used to assess present fmanclal co ndition and an.
o
than 900Jo of curre nt usage. Listed in ord , f of which account fer more
re r
ticipate future financial condition. As a cor?Ji ary, t e amounts dedu cted from accounting purposes) begin ning with the :ot fre quency of use (for internal
uent , they

1.
q are:
inventory accounts during any particular time penod are the basic data for
FIFO ( first i n , first out),
2.
determining the cost of goods sold during the period, which is a basic de
terminant of income. Obviously, consistent ? olicies a n method.s of inventory LIFO (last in, first out),
valuation are imperative for the undistorted mterpretatwn of a firm's financial 3. average cost,
position at any given time and for the meaningful measurement o f performance 4. specific cost.
between time periods.
Inventory costs and expenses will depend on the accounting procedures The above inventory flow methods are primarily concerned with the flow
adopted. Accounting procedures determine when a n d h o w a change in assets of costs rather than the flow of ph;sical goods . The selection of a flow method
owned should be recognized, and when and how assets are transfor med into will depend upon several factors, including the type of organization, the pro
costs and expenses. Facts are not altered, but accounting procedures govern the jected economy, industry practices. tax implications, and other regulations.
recognition of events which affect periodic income dete r m i n ation and financial It is important to note that whil" n nrganization may choose one method for
ratio analysis.
Inventory accounting is generally on a basis o f cost. The cost for inven
external reporting, it may choose a di ffere nt method for internal reporting.
Once a flow method is adopted, it is not easy to change to another method
tory purposes may be determined under any one of several assumptions as to because of tax requirements and accountants' concerns fo consistency in r
the flow of costs. N o single prescribed method exists for determinin inventory
of standard pro
g reporting. . .
costs for accounting purposes. However, there are a number Inventory recm Is are usually kept on a perpetual or a periodic baSIS. 1th
The major objective in se
ced res with combinati ons and variations of each.
are recorded for each T ransaouon as or lmme eli ately after 1t occurs. The
perpetual records , all changes to stock (addition s, subtactw ns, or deletw.ns)
performa nce. To determine the
lectmg a method is to clearly re flect periodic phys1cal
ollar amount of inventor y at any given point in time, t h e quantity of inventory quanti ty a n d value of goods 1_ 0 mvent
.

. ory. are vailable at any time (real time)

Items on hand must be known and a .
from the accounting records. With pen odic r c rds ' the
invento ry is counted or
obtaine d by countin g or measuring. The value
value must be assigne d to those quantities.
.

The quantit y o : i tems on hand is f an accounting period) to

measu red at fixed time intervals (usually at t e d o
.
asslgne to mdlvld
.
ual items is based on one of severa
l accoun t i ng methods . The deter mine stock status, and records are kept ; he cos s
t associ ated with each

import ant, since it c a n signi ficantly affect the

accoun tmg method used is very
in flow of goods. A running count of 1 nvento Y p urcha sed , sold, or in
stock is
total dolla amou nt of inven
not maintained with each transacu ond
for accoun tability c a n be s u bdiv ided into t he
tory and the relate d cost of goods sold . to carry cost from
The mventory metho ds s are si mply sche mes
t All of the inventorY flow metho
m h d of val ation and the sta e ent as expenses. The cost
allocated do

':.:
ro e I unit costs were
tl n I S based on the
inventory flow meth od. I n most cases, the met hod
no
th e balance sheet to the inco me
not have to mat h the actu al

flow of goo ds.
Goo d can be old by

fre ;;
origin al cost of the item. There wo uld be

irst , yet assi gnin g cost according to the
consta nt, but durin g a period physically removmg the oldest 1 :
o f t i me , items are
 482 Chap_ 1 1
Inventory Valuation a n d Measu reme nt
costs
FlOW of

483
last unit produced. The llow of goods does not have to be related in any Way A per i odi c cou nt reveals that the
to the llow of costs. endi ng .
Inventory
is 300 u nits.

FIFO
Units Sold

200

The most widely used inventory llow method fo intern ! accounting pu 300

are Issue from the rolposdeests

$2()()

is FIFO. Under FIFO, it is assumed that matenals

200
330

supply in stock, and units issued are valued at he olde t cost listed on the stoc
700 232

ledger sheets, with materials on hand at all times bemg the most recent Pur.k $762

chases. Under FIFO, the inventory cost is computed on the assumption that Ending Inventory U n i ts
goods sold or consumed are those which have been on hand lonest and tha t
F b. r Unit Price
Total Cost
e Pu ch as es
those remaining in stock represent the latest purchas_e or produ ction . M ar. Purchases 200
!.QQ
$ l . l6

FIFO tends to coincide with the actual phystcal movement of goods

$232

1 .26
Total 300
through many organizations. It is scrupulously fol owd for g oods that are $358

subject to deterioration and obsolescence. The endmg mventory from FIFO

closely approximates the actual current value, as the costs assigned to the goo
The cost of goods sold with FIFO i s $762,

on hand are the most recent. While this technique tends to produce inventoryds
and the value of ending invento
$ 1 1 20 - $762 = $358 for 300 units. ry is

assets at current costs during inflationary periods, it understates the value of Example 2
cost of goods sold on the income statement. When the price of materials and
other costs are subject to change, FIFO is not likely to result in matching costs Table 1 1 -2 shows the same inventory as in Example I , but records it in a perpetual
inventory record. What are the values of ending inventory and the cost of goods
against revenues on a current basis. Thus, cost changes can create income state sold?
ment distortions.
FIFO is fairly simple and compatible with the operations of many organ TABLE 1 1 -2 Perpetual Inventory Record (FIFO)

izations. It is adaptable to either perpetual or periodic systems. The use of

FIFO simplifies record-keeping requirements, as the actual physical flow usu Received Issued Balance

ally coincides with record-keeping activities. A few simple examples can best U ni ts
Unit Total Unit Total Unit Total

illustrate the FIFO method. Date Cost Cost Units Cost Cost Units Cost Cost

I Jan. 200 $ 1 .00 $200

1
Exam ple
31 Jan. 300 $ 1 . 10 $330 200
300
1 . 00
1 . 10
200
330
-

Table is availab
I April reveals an ending inventleoryonofan300item.
The periodic inventory record 1 00 1 . 10 1 10
shown in 200 $ 1 .00 $200
I 1-1 3 Feb'.
.
: ;
physic ! count of the items A
on 200 1 10 220

400
-
units.
t J the value of the ending
i d
inventory? What is the cost
of goods sold for the 28 Feb. 1.16 464
1 00
400
1.10
1.16
110
464

TABLE 1 1 -1 Periodic Inventory

Record (FIFO) 1 Mar.
-
] . 16 232
10 200 1.16 232

200
Date
'JYpe of 'Transaction Units 1.16 232
Unit P rice
- 200
Total Cost Mar. 1100 1 . 26 1 26 1 00 1 . 26 126

L----'-
31
I Jan. Beginning inventor

28 Feb .
y

e to ry IS $35 8 $232
200

:: g v n
31 Jan . $ 1 .00 $ 200

400
Purchase system is $762
300 1.10 3 30 der the perpetual .

($200 + $220 + $ 1 1 0 +
Purchase (
old for th
3 1 Mar.
Purch ase 1 . 16 464 The cost of goods s f endi n i n

Total _!QQ 1 .26

$23 2), an

1 000 $ l l 20 + $ 1 26) for 300 units.

 Ch ap. 1 flow
1
of c osts
tion and Measurement
Inventory Valua

with LIF
O is $8 1 0 nd
484 4&5
st of go ds sold
1' he co :
d a n e d ing
ory re ord , it is esse.ntial to car ry umt s .

10 300 Note t h a t this same the value of
$3 1 0 for
When prepar ing a perpet ual invent
t;
ite ending inven
:
.
oo sold of $7 62 n
tely the ba la nce a
e
each individ ual transactio separa ds n in Example 1
of g
inform ation concer ning
invento had
ry record ts m ore complex and ti -
column . Note how the perpetu al invento record. However, FIFO is rea rne
consum ing than the periodi c invento ry
dily
mple 4
adaptab le to either method . Table 1 1 -4 shows the sa me i nve n to ry as in Example 3 b .
What are the values of e ' ut records tt
. m

LIFO
inventorY record.
a perpetual
nding i nventory
and the cost
s o ld ?
of goods

should b e c harged to t he cost Perpetual Inventory

LIFO assumes that the most current cost of goods
1 1 -4 Record (LIFO)
TABL E
g in inventory represents
of goods sold. Under LIFO, the cost of units remainin Issued
are valued at t h e latest costs
the oldest costs available, while the units issued
Balance
of LIFO is to match current revenues agai nst Unit Total
available. The underlyin g purpose Unit Total Unit Total
a m o unts ap proxi D ate Units Cost Cost Units Cost
current costs, so the method charges current revenues with Cost Units Cost

200
Cost
mating replacement costs. 1 Jan . $ 1 . 00 $200
Like FIFO, LIFO can be used with either perpetual or periodic inventory
300 $ 1 . 1 0 $330 200 1 . 00
systems. The following examples are illustrations of the LIFO method . 3 1 Jan. 200
300 1 . 10 330

Example 3 3 Feb. 300

1 00
$1.10
1 .00
$330
100
100 1 .00 100

The periodic inventory record shown in Table 1 1 - 3 is available on an item. A

400 464
1.16 464 100 1.00 100
physical count of the item on I April reveals an ending inventory of 300 units. 28 Feb. 400
1.16
What is the value of the ending inventory? What is the cost of goods sold for the

I
period? 300 1.16 348 100 1 . 00 1 00
Mar. 1 00 1.16 116

TABLE 1 1 -3 Periodic Inventory Record (LIFO)

100 1 . 00 100
3 1 Mar. 100 1 .26 126 1.16 116
100
Date Type of Trans action Units Unit Price Total Cost 100 1 .26 126

I Jan. Beginning inventory 200 $ 1 .00 $ 200

quarter under the per
et :: : !
s s

31 Jan. Purchase 300 1.10 330 h
($330 + $ 1 00 + $348) , and he
The cost of goods sold for t e . 2

::::: :l
28 Feb. 400 ent
Purchase 1.16 464 t value of en_dmg m

+ $ 1 26) for 300

n Emple 2 had
a
31 Mar. Purchase _!QQ 1 . 26 s am
units.
N ote that thi 5 I
ue o f $3 8 . t sh
ould also

cost of goods sold of $72 and an

Total 1000 $ l l20 n dmg y

t e n e :c t
o n d ending inventor
f goods s ld a
s 10 th os o system
be noted that generally ff re c _ etual inventory
Units Sold Unit Price Total Cost will arise between apenodtc :: m en stem and a perp
ra t
wi th using the FIFO
meth
od.

100 $1 .26 when using the LIFO method, m

$ 1 26
400 the incom statem
:ts fwitrahpidrevepricnuee chforge (inflao !:in
1.16 464 .
1 . 10
The importance of matchm
IS
700 . generally acknow leged. In e o tab
$810
he upward cycle is attnbu : be inn ing of

En ing Inven to ry
of the increase in earnmgs dunng t. d the goods on hartdteat t ed !t the time
prices. Durig an inflationary p:;:higher price thart co :e come for the
d 10
d Units Unit Price Total Cost
_ wlll generally be sold s will be reflecte e qt'tYi levels the
of purchase. This increase in rven;nt ai ned at the sam
J a n. Inventory the penod
a
I 200 $ 1 .00 $200
Jan. Purchases
.!QQ t a l ext:nt in
period; however, if invntorY - :ave been expended t
1 . 10 _!!Q
rece1ved WI
o su
Total 300 $310
add itional revenues
 11
487
of costs
ion and Measurement Chap. flO>'
Invento ry Valuat

ror pe r io d ic i n ventory system s, since

486

the increa se in i nc om e, fre. cos ts are

tory n ts . Thus ,
not allocat
pun.:h a,ing the replac emen t inve
p
ed u nll l the end
eriod.
Ql ntly termed " invent ory prof1t
protects agai nst .,. of t he
s," J S 1lluso ry. L I FO the average cost metho d, t h
ihe per od a re average d to obtain t h e end ng r
ith
ventor y profir ," because its use
(as compa re d to t

mg
h use o f t her val uati
pnces ?Y a ss 1g ni ng a h ig he
: .

e os s o
all li ke ite ms
Inventor y valu
available u n ng
g period s of n
metho ds) decreases incom e duri . r n g or decreasmg costs, e . Durin e od

n am pen the
eX t remes : I t responds more grad u a 'y t an the oth er
asJ the
ioo re
zat1o n s with a hi g . average cos t p n s or
s less beneft t to orgam \1 metho d tend
cost to goods sold. L I FO prov1de
h s to
y are closely match ed to revenue
invent ory ( U rnover, since their costs alread
Wh ile h
e average cost me hod is si e to a
P
inven tory w
t
t hods .
of a n average
to its favora i
period s of rising prices d u e ly it
pp , refl ects a ll
L I FO often is preferred during e figure . The unit cos e
" ll o ns
effecl on incom e !axes and cash
on hand. It does not ignore t h need o f n
e

Y
s
n ot be equat
not reveal price changes e
ed to any tan gi % ;,
tgure ,
eth o d is s h o w n in the two exa mpcl.es whtch follo
a n d does n ot create e it doe arly as may be desired.
ry at higher prices nn d
organi zarion to repleni sh invento
The average
income caused by goods costed m uch lo w er cost m w.
"balloo ning" effect on appare nt
its desirab ility w i t h respect to t h e i n co e
than actual replace ment costs. Despite
its unrealis tic valuati on of i n vent ory
Example S
staleme nt , some crit icize L I FO for r

1'he per iodic inventory record shown in Table I I S . s a atlable
t h e valuatio n of i n ve n t o ry u n i ts at t e
balance sheet purpose s. It is felt that
ratio and t h e other c u r rent asset e
.
current
the
;
on an item. A
available distorts
cost phy sical count of the item on 1 1\ pril reveals an e
:
oldest
l pos i t i o n . I n a d d i t i on , except

tnventory of 300 units
lario ships in assessing the near-term financia W h a t are the values or the ending inventory and th : o
.

b u l k ttems (coal, sand, etc.) L I FO does not

usually coincide w i t h t he p hysic .
(a) stm ple average , (b) weighted average, and (c) moving a a !;
sold usmg the

flow of goods.

I .OO + 1 . 1 0 + 1.16 + 1 .26 .

simple average = = $ 1 . 1 3 umt cost,
Average Cost 4

e ndin g inventory value (ending inventory)(unit cost) = 300( 1 . 1 3)

perfect c o m b i n a t i o n of a real i s t i c ending
$339,
! n an attempt to provide the elusive
=
=

mventory and cost of goods ol , t h e average cost method was developed . This cost of goods sold = (units issued)(unit cost) = 700(
1 . 1 3) = $79 1 .

method does not attempt to md1cate what unit went out first o r last, but rather
b:
to determme the average cost for each item during a t i m e period. There are three
types of averages t h a t can be used:
weighted average t, P_
1Q1
1 . simple average, N
=

) + 1 . 1 6(400) + 1 .
26 ( 1 00)
_
, __

2. weighted average, 1 .00(200) + 1 . 1 0(300

3 . moving average.
1000

. . . . = $ 1 . 1 2 unit cost,
.
All t h ree averages can be u s d Wit h a penodJc Inventory system, but only the
. (en ding invento
ry) (unit cost) = 300 ( I . I 2
) = $336 '

" d mg t h e s u m of producti ? n or
moving average is well su t e to the perpetual mventory syste m .
The S i m pIe average IS deter m i n ed bY d lVI
. ending invent ory value = 1 . 1 2) = $78 4.
. . it cost) = 700(
(uni ts issued)(un
purchase unit costs by the n u m ber of productiO . cost of goods sold =
average neglects the size o f t he I 01 (number o f u m. t s) and gives the u n i t produc
n r u n s or orders. The simple

tion or purchase cost of ac h I ot equal weigh l . The weighted average corrects

ory Record
TABLE 1 1 -5 Periodic Invent

'JYpe of 1Ja nsa oti o n

the distortion of t h e sim

ave age by considering q u a n t i t y as well as u n i t cost. Date

The weighted average d i 1 s e co t of goods ava i l a b l e for s a l e or use by Lh e
t I Jan.
inven tory
total n u m ber o f u n i t s av I a b Be gi nni ng
e dunng t h e period . The m o v i n g average com

putes an average u n i t cos a ft r each
purchase o r a d d i t i o n t o stock m a k i ng it
3 1 Jan. Purc a se
h
Purch ase
better s u i ted for compute ze m
and the weighted average 1 not e
:
. .

entory operations . S i n c e t h e s i m le ave rag e
28 Feb .
31 Mar. Purcha se
calcula ted u n t i l the period is over they a re lbtal
not well suited to perpetu a Invent
ory system s . A l l of t h e averages a r suitabl e
 488
Invento ry Va luati
on and Measurem ent
I flOW
of Costs

489
valu es
(C O GS a n d e n d i ng inven tor .
A al ;
) de
TABLE 1 1 -6
wil l f l
between t h e extrem e value f nved under. the avera
Moving
J
$ 1 . 00----
TotaJ Cost st meth ods
Da te
n un
Units Unit Price Averag c ost .m e t ho d s are obj ect v i der FIFO and
I
$1.00 $200
e m am pu l a I O n as are FIFO and
mp\e to appl
i :. y, and not as sub
200 330 inc o m
hys i cal flow o f I t e m s t hat are ho
L F hey al so ten


Jan.
300 1.10
464
1 . 06
p mogene
d to approxim
t
400
31 J a n . 1 . 10
28 Feb.
100
1.16
1 . 26 1 26 1 . 12 Specif ic Cost
31 Mar.

c:
average for each additio
n to stock is obta ined b Of a ll th i ventory . flow assum ptions , the

. .

s e lflc
See Table 1 1 -6 . The moving m b r of units . The mavin reahstc valuatiOn of ending inventory n cost method prov
ides the
and di :iding by the nu rno st
summing the totaJ cost column .
T h us $ 1 . 1 2. cedure consists ? f taging or numbering each ite :: t 0 f goods sold. The
pro

ending invento ry vaJue = (ending

is the last movmg average , wh1ch I S .
average for the period ost It IS placed 1nto mventory
invento ry)(uni t cost)
c
so i ts exact. .
IS read1ly discernab le . Since
an item is both vaued and
p hY sical ow are Identic
expensed
sp ec1ftc cost, h
= 300(1 . 12) at its
t e cost flow and the

:t
al with this
rnet hod . The cost of m aintaining records d th method can mount very
= $336, ,
qu ic kly so it is most appropriate for good .
Slgru .
lcant value which are few
(units issued)( unit cost)
cost of goods sold in number.
=

$700(1 . 1 2) The specific cost m :tod has the added flexibility of being suitable for
=
=
. c mventor
$784. eit h er perpe
tual or enodt .
y
y systems. It is employed frequently in job
sho ps for the valuatiOn of mvntor 1tems used in custom-made products. If the
.
are true averages th at
Note how the weighted average and the moving average of custom orders
nu m ber bemg processed is large, its implementation can be
results in a slight
result in the same costs. On the other hand, the simple average
extremely expensive and difficult. Thus, its use is more commonly confined to
distortion of costs.
small operations .
Example 6
Summ ary
From the perpetuaJ inventory record in Table 1 1-7, what are the ending inventory
value and the cost of goods sold for the item?
We have seen that there are several methods of inventory costing o r vaJuation
TABLE 1 1 -7 Perpet ual Inventory Record (Moving Average) that may be used by organizations.
Since there is no standard recommended
upon the nature and
practice for inventor y costing, the best method depends practicaJ, reliable,
chosen should be
Received Issued Balance
objectives of the organization. The method the same, all the
remain
and as easy to apply as possible. As long as
unit costs
Unit Total Unit Total Unit Total .

::::; : :
er IS very
ever the inventory turnov
Date Units Cost Cost Units Cost Cost Units Cost Cost methods are essen tially equivalent. When e u

he ized. w
high, the d ifferences am?ng t. metho ds are minim
200 $ 1 .00 $200 change dramatic ally, maJOr ?lfferences
o s

3 : :: 300 $1.10 $330 500 1 .06 530

among the method
the fou cost flow
assu rnp
3 Feb. 400 $1 .06 $424 100 1 .06 106 such differences , the follow mg examp le comp ares

28 Feb. 400 1 . 1 6 464 500 1 . 14 570 lions when costs are rising.
1 Mar
31 Mar.. 1 00 1 .26 126 300 1 . 1 4 342 ; :::: ;;:
7
::; lne uni cost is the moving average which is obtained by dividing the number of . gI e Product has
Example and sales
the produ ction
a sm
A n organization t hat produ ces e rel evant :
a ance I nto t he balance total cost.
1 1-8.
The fo\ lowmg
data also ar

sum of the tot I costs for issues , or $766

record given in Thble

($424 + $342). The value of endmg

The cost of goods sold t h e

!0Joft: S
IS
a
. ses
Ope rating expen 2.00/un it
.
mventory obtamed from the fina l am ou nt t
$354 for 300 units.
IS
in the balance tota 1 cost colum n:
Opening in ven
tory
50
.
Thx rate
d perio di c . N . 1ber
The average cost method s match
the average costs of the period agamst
revenue and assign average costs
to ending inventory. Characteristically, the
 Chap. 1 1 LOwer
of Cost or M a rket

491
and Measurement
Inventory Valuation

1 r f r lower. profit and taxes tha n the F I FO m

the opposite holds true . ethod. lt i important to n
the e o
e

specifi c cost m e ho s .
FIFO, L I FO, avera ge
the organi zation under the cost however,
that JUSt
Determ ine the net income for
t d . .
did not resu lt in': sP.enod o falling pri .
dtfference between the
tn thts
(simpl e and weight ed), and am ou nts used examp le

to note the dif-

The results are shown in Thble
I J -9.
s i
m p le and wmghtedaverage comp utatio
t he method of calc ulatio n
ns, but irnpntonant
fe re nce m .
-
x imethods
No two methods resul tin exactly the same en . Inven
the doll ar dif;ce. thattorycould
TABLE 11 8
Sales th e e a m ple
were mu l t p l ie
d by 1000, dollar value. I f
Production .
t he use o f t h e vanous might be appreciable F uctua ons re<;ult from
M on th Quantity
Unit
Cost
Total
Cost Quantity
Unit
Pri ce RTo tal
even ue
- t
o r signi icant nuct ons a tn place
are gen rally upw rd ; should any the f u
be changed signi fica:yt . Thus
h e pen od , the d t ffe.ren ces could
the example
t ke during
the
600 $2.04 $ 1 ,224.00 500 $3 .00 $ 1 ,500 n eeds to know what mventor y flow method is in use and w hat tts :Impacmanager t on per-
Jan. o m an ce measures will be .
2.05 1 , 1 68.50 610 3 . 00 1 ,830 fr
Ma .r
Feb. 570
550
610
2.10
2.08
1 , 155.00
1 ,268.80
650
590
3 .00
3 . 00
1 ,950
1 ,770
Apr.
May 580 2.15 1 ,247.00 600 3 . 20 1 ,920 '
June 490 2.17 I ,063 .30 400 3 . 20 1 ,280 LOW E R OF COST OR MARKET
July 450 2.25 1 ,0 1 2.50 470 3 . 20 1 ,504

I
480 2.30 1 , 104.00 540 3 . 20 1 ,728
Aug.
1 ,350.00 570 3.50 1 ,995
As
p rev.iously discussed, inventory. valuation is normally based on original cost
Sept. 540 2.50
Oct. 610 2.57 1 , 567.70 650 3.50 2,275 for an Item . However, there are Circumstances where this principle is not ap
Nov. 600 2.59 1 ,554.00 670 3.50 I 2,345 plied. The most common dep arture from the cost basis occurs when the value
Dec . __bQ 1 ,508.00 600 3.50 2 , 1 00 o f an item falls below its original cost. When this happens, the difference
6660 $27.40 $ 1 5,222.80 6850 $22 , 1 97 I should be recognized as a loss in the current period, and remaining inventory
should be carried in the accounting records at the current "market" vue. T
Total

1 1 -9 is commonly called the LCM (lower of cost or market) rule.

TABLE
I usually means the replacement cost of an item, whether through
The term market
purchase or

I
Average Cost valued at cost or
Specific productio n . Simplified, the rule means that inventory is to be than cost for
Method: FIFO L I FO Simple Weighted Cost at les s
cost to replace, which ever is lower. Inventory may be valued . pnce .
levels, and
s 10
Sales $22 , 1 97 $22 , 1 97 $22 , 1 97 $22 , 1 97 $22 , 1 97 several reasons, includ ing physical deterioration, change
Beginning inventory 800 800 800 800 800 obsolescence.
c
Pro du t io n 1 5 ,223 1 5 ,223 1 5 ,223 1 5 ,223
8
1 5 ,223
Goods available for sale
b c d
16,023 16,023 1 6,023 1 6,023 1 6,023
.
uters . s.ix
$ 1 800
Example

uters cost of periodperDal s

Less: ending inventory
for v:. o;s brands ofat apers onal comp
u ru .
Cost of goods s ol d
Gross income
1 5 ,477
6,720
1 5 ,603 1 5 ,544
6,594
1 5 ,543 1 5 ,479
6,71 8
Daly' s P C Emporium is a ret ru le.r
months ago, Daly's received a h m p
J n o y at the end ofowethed a price. declin_)r
n omp
catalog from ; distribtbeutorcomputers sbould Daly's ? p
6,653 6,654 e t r
Ten o f these comput ers remam Ill !

u
L e s s : operating expenses 5,000 5,000 5 ,000 5 ,000 5,000 which sh
t : be reported for the period
he re o
Income before taxes rece ntly receive d a new
1 ,720 1 ,594 1 ,653 1 ,654 1,718
fro m $ 1 ,800 to $ ! ,500 a unit. Wh
_]JJ_
L e s s : income taxes ld
as ending invent ory? Wh a loss t , tf y, h
Net income $ 860 $ 797 $ 826 $ 827 $ 859 Replacement
: (Number of units)(last- in cost) ( 2 I 0)($2.60) $S46. Cost
(Number of t s )( first- in cost) Units i n
= =

(Number of u ru ts ) (co st )
c
= ( 2 1 0){$2.00 ) $420.
= Inventory

( 2 I O)(S27. 401 1 2 )

00)
- JO( t 5
=
(Numb er of units)( cost) = ( 2 I O)(S
$479.
=
10
nv t rY

$3. 000 ===

I 5 ,223)/6 660 $ l S . OOO
(Numbe r of units)(Nov. cost) =
_:::)___.,
$480

500
t v
en o
= =

t O( t SOO -
=
_

= =
( 2 I O)(S2.5 9) $544_ din g i

r'ISi ng . As was prev . 0usly

Value of en
=

As can be seen, costs were . e

=
of rising costs ' the LIFO 1 stated , d u n ng a pe n o
d loss for t h pe
r iod =

met hod will result

in a higher cost of goods sold an d
 In entory Valuati on and Measurement ory Records
492 10_.e nt

493
Chap,
11

of nve n t o ry rec? rd a curacy.

I N V E N TORY RECORDS record acc u racy 1 c nt tcal to ope
i Whet h er
or omputerut:d,
. the YMem

curnr e . ,II. de n requ tre

efficien t l y u n le s rec.ord nre 8
1 manu al

til mem lor acc

ra tio n .

0 inventory ) tem work ura1

Three c eruu

11 t he 111 : n t o r
ry records are:
. ven to
t . a g o od s y s t e m for
cis ion
b a l a nc e ol t ndi v

item . If t h e invent ry balance i overstated

on wh n or how much to order are bn ed . id u at

1 2. a go o d y s t e m for audit i ng record ac

of t c kml t . rec ordi ng
, t h e re I a n k
. If th.e
all receipt
a nd d s
.
i like\ be e.x ce s Ill e n t o ry. l b ur ements .

curate iventorv
inventory balance i understate d. t h e re I nac cu racy t hat
record can t rigger
t i v i t y. late d e l i ery. exce si e e.xp ed
n c h a i n react i o n
of proble m s : to t
Sal e
ca u s e of error s .

J, t r u s t w o r t hy. respo nsible personne l .

di cover and
h
correc t t e

ing, p;;,mium freight o t . and o on.

hortnues. mi d schedules. tow produc
orgrulizati on frequently order more
Th overcome m e of t h s e pro ble ms
it:
,
t h n n needed. crentmg xcess mvent ory an
The cond i t i n o f invent ory
rec ord
d i s in l1uenced

rd - ke e pm g ac uracy re-
by the personnel

l'otve are t h p e o p l e who physically receive, issue

t h e physt a\ contro l, and
high obsole ce nc e . involve d , the veri
fication system . The
.
peonntl n
a thei r ft rst h n e supe r tsors. T he stock room weU
ppropriate control of inventory item and re o
.
q u i re a verifi arion of items and record . In e m o r y ttem hould be cla ssi fi
ed supe
n
;v : r
tore maten al as

su p o r l , t h e lf u bo rdm a t es c annot be e.x.pected to trive

and proper\ identi fied 0 t hey can be located for eri fica t i o n . This means th at
proper c o n t ro l over inventory must a l s o include t h e methods of s t o rage and
sibilit y for a d t a ke p nde in maintai ni ng record accuracy
: t ::t:

1 n
teg ty. Opera tives must ? . fully for re ord in-

1 p ro ce d ures so t h ey recogmz e the importance of accuracy. It is desirable

handling. Control i nece sary to ensure against errors in item s t a t us , such as e mstructed and trained

to et
in stockroom operating
inaccurate and item lo s t to embezzlemen t , d a m a g e . p o i \ a g e , a n d ob
ount
ac

t h a t provide i n fo r m at ion on u s a g e , b a l a n c e s , and recei pts . It

sotescence. Control usually is accomplished through a series of inve n t ory rec curacy goals , m e a s u re accuracy, and post records of performa
I n e in com

A n i m portant aspect o f physical con1rol is to limit and c.ontrol acces

ords and report parison w i t h goals.

' ith no interest o f its own i n the operat i o n s .

is de.sirable for record erifications and physical counts t o be conduc ted by an
to
independent agency the store ro o m . Each t i m e a part is added t.o the stockroom or withdrawn from

and undocumented t ra nsac t i o ns must be stopped, or control is virtually impo

Some o f t h e basic data r e q u i r e d t o k e e p meaningful a n d u s e f u l inventory " it. the t ransaction should be logged i n the appropriate record. Unauthorized
record as follow :

1 . item identification and/or clas ificat ion,

are

ible. An enclosed and locked storeroom accessible only to authorized per

sonnel can do m u c h to control undocumented transactions. It is desirable for

3 . unit co t a n d net prices, room. A clean and well-oTdered storage area will reduce lost and misplaced items.
2 . item location( ) , all parts to be identified by part number and geographical location in the tore

4. interchangeable and/or substitute items, e space in the stockroom is to use a locator s

5 . shelf l i fe , te m . The stockroo m is divided into sections and subsecti

An efficient way to utili z
ns wit an appp :;
6. end item ( w h a t i t is used on or w i t h ) ,
locat ton ? r 10 an availa
ate n u m bering scheme. Parts are stored in the same

7. d at e s item entered inventory,
along wtth the p ru:t nu
sect ion ' w i t h t h e locatio n noted o n the receipt record
ber. As part issues are reqmred, h e 'vareh ou
de lgnat

8. dates of withdrawal,
. seperson proceeds to the

locatio n of t h e part. A we\l-dev1sed

locator system can co
tribute much to data

10. unit b a lan ce .
9. supply sources, int eg rit .
?' . n can be u to
. S , and zoned locatio

store i :e n t r y items . _ W it h fi-.-.:ed loc t

F t xed locati OnS, random loca tiO anently asstgned
::i h item is perm

a s pec t ft c , smgle locatiOn ( sp ace): alion.s. 1tem do not

fi ng ite m but

Wit h random toc

nd
s proble ms in
.
Accurate inventor y records are an importa
nt aspect of financial acco unt
?
Tt n

ng as well as a corners tone of invento ry contro l.

The fou n d atio n of any can lead t o inefficient space ut t h z t t n - d to het easie st ope the
n spa . a sam;
::
n ol syste
is the informat ion containe d i n records u pon wh ich ave a speci fic loca tion but are asslgll! ts u uhzed

tme
i r
.
ade. W i t h o u t record
. d for maJo r probl ems
.
accuracy, the best-des igned system IS des- Item m ay be stored in more th n
on locatio
n . While space
be updated
with eacrraat:
if not failur e. effici e n t l y, t h e locatio n of an t te u s t
mre :
k Loca tio n . Zoned
. s meth od of location h_v brid

tg
W hi e every invent ory
(receipt or w i t h d rawal) . N at u ly, hi
: /
t
.
uncom mo n for
system must be concer ned w
i t h i n ve ntory reco rd
Ords and careful repo rnns of sto
. ral
c
/('QtiOr:s gned to a

or fixed and random l oc at OnS . A

more attentio n to be give n to t he more i n ilar ttem 1
. ng of sim
r g ec me aspects of a system
while overlo oking t h e ted ious aspec ts i g ro upi
 ry Records

495
n and Measurement nto
Invento ry Valuatio Chap. t Inve
494 1

On the day f the count, operati .

. A holdm g ae a should be ons the storage areas sh
e in the space available wit hin the
designated zone. An item is located anywher
given zone. Space is used more efficiently,
and each Item has a gencral but not terin ated
actua l c untmg period designa:d to retatn all material r
ould be
. . durtn g the so it is e ded eceiv
a specific location. . y the mtegnty
nd ccuracy
t yet sh from the
sold , b ut n mternal i pped, should be segrega:! d not cou count. AJI ite
A physical count of items is necessary to verif nted on th e loa
of inventory records. Di fferences between book
(record) and physical mven to. d ock . All movem ents and shipments hould be ding
dura wn except for emegencies. I f the physical count sspended for the
.
s) must be adju sted and
ries must be ascertained. Any difference s (variance
for. A periodic physical customers should be adv1sed of the shutdown d s .
requ1res several days,
the amount of overage or underage properly accounted count The tag metho d of recording inventory 1::: .
or a cycle progra m can be 0 Is ts frequ
ently
inventory tea s take the count; one member fills t the tags and used. The
count of inventory can be made for all items,
closing the facility for
instituted. A physical count of all items usually involves places them
and the records are on the matenals, and the other re-counts and chec he
a time while the quantities of all items are substantiate d accuracy
(amount as well as part number). The tags are us: f r both of the tags
updated. The cycle count method involves the continuous counting of inve ntory manua l
computer systems. When an area has been completed b n n emory team,an?
t :hecked for ac-It
throughout the year.
Inventory accuracy is a fundamental requirement of any inventory system . should be checked to ensure that all items are tagged\s . .
True record integrity requires a management policy intolerant of errors. Man curacy), and then the tags are collected. Items in th h P no
agement must establish a climate of accuracy and the necessary tools for its as well as those in the export holding area, retu;:eP::a :i1:g
achievement. displays , ad so forth, should also be included in the count. '
Periodic Count Method
I The mventory records and the physical inventory should be reconciled
with the mventory
.
tags. The inventory data from the tags are transferred to
inventory summary sheets. An auditing team should check any significant vari
The periodic count method refers to the periodic auditing o f the inventory ations and reconcile discrepancies before materials start to move again. Appro
balances on hand to verify and maintain accurate inventory records. The in priate adjustments should be made to inventory records and to general ledgers
ventory record may be manually posted, machine posted, or maintained on a so that the record balance agrees with the quantity actually on hand.
computer. The periodic count method requires a complete count of all cat Inventory systems tend to accumulate errors over time. An annual physi
egories of inventory over a short time period. For some organizations, an cal inventory does not support day-to-day inventory accuracy. The primary
annual or se annual verification may be adequate. If only one physical inven purpose of periodic count methods is to validate aggregate inventory values
t? ry IS
. take m
a year, it usually is at the end of the fiscal year and is frequently compiled for financial statements.
limed to omc t. de with the yearly low point in production and inventory levels .
Takmg a annual physical inventory is like selecting a marriage partner: Cycle Count Method
.
the tune spent m preparation can pay off handsomely in the final results. A writ
ten standard proce? ure that can also serve as a training document should be Cycle counting is a physical inventory-taking techniq
ue perf?rm ed continu
ousy rather than periodically. t is. a basict step toard cont rolhn.g he : r:
of mventory records and mam tamm I cycle c i ive:iuuaJ a preduction
prepared. PreparatiOn for the physical inventory should involve the following:
h gh
1. Housekee in .
at a
rovements can be achieve by obsolescence,
m. poduction disruption s, 1m roed custo ;
effective
P_ The arrangement of material in its proper location so it
me ;:e educe: ory shrink
2 Identifica tion.
can be eastly mventoried.
eh mmation of the annual phystcal mventory, a
reduc;ion in invent
the disruptive
The proper identification of all items with part number
meth od is less expe nstv e than
age. Frequently, the cycle
3 Instruction . A review of
and nomencl ature. count
inventory-taking forms and procedures with
periodic count method. . are to (I} identify the cau of erros,ses
. The goals of cycle countng o (3) maintain
a high levelHistor
of tn
4 Training. An instruction
personnel pnor to taking inventory.
(2) cor rect uhe conditi ons causin g t
: : rrect statement of count) to
ss ts.
;::o::;:
.
f personnel in the use of scales , and (4) pro d
h ysical inve ntorY (pen odtc
S. Teams. The establ ishme
counters, and measureme t ento ry record accur acy,
tcall y, organizatio ns cond ucted an an nu al the balance sheet.
nt 0 f 1. n ntory teams o f two or more members
e
an asset onaudit
ntry asessio
attest to uhe dollar accu racy of vhe mve . n i n its of te anual
and the assignment of respon . :
his ws usually required by th e a;o::gg:urrofposes. Tlte pri mary obJecuve of
fma nctal statements for external P
. .
ing the inventory levels.
stbth ty for countmg, checkmg, and record
 Chap.
n and Measurement Reco rds

497
Inventory Valu atio entorv
11 ln
496

5. coun tin g of iterns afte

al p u r poses o f operat Transacion system. The
ory records for intern in g
cycle count ing is accurate invent cy . tran s acti Ons have trans pire d . r a specific number of
the organi zation. The primar y
empha sis is not dollar accura b u t Piec e co u nt
accur
countin g of stock t h rough ou t th e Year. u rse , vari ous combi nations of t he abo
O f co11h
ve s ; erns can also be used
balance system have ."trig-
is method involve s a continu ous .
tem, an d z
interval. reorder system, receiver sys
every day, or .at some othe ttme
ger ru les

A limited numbe r of items are checked : to count when an order is plac
count on a full-ttm e or part-tm e basi s. The ed o
Personnel can be assigned to cycle
s ed, or count when the ite m bal anc wen a eplen ish ment order
stock items to be checked may be
selected at random r accord mg . to a Pre l ih accuracy of the coun t sho
rece i v
s :he Item balance ,
determin ed plan. The cycle count method
does ot requ 1 re a d 1 s rupt 1ve termi le uld be high . If
the c 1 5 taken when anis itemlow
nation of operati ons as is require d
.
with the penod.tc count method . stocks out , t h e accuracy should be greatest however,unWtth .
a high safety stock

I
The cycle count method is becoming ?
m re Widely used . Many orga niza
. (ser vic e level ) , the count may not b e t aken ' ft n g Includ ing the count
tions have switched to cycle counting because
1t stresses correctmg the caus es of in eit her he requisitionin g or receivi ng proes: =n e average
simply adjusting the records. I n a d d i t i o n , it permits th e use cou nts wil l eq u a l the average inventory turn over.
number of
errors as opposed to
of specialists or regularly assigned store
personnel to conduct the physical
count. When regu larly assigned personnel are used,
they can perfor m the
count during lulls in their assigned duties; when specialists are used, they
cycl e
are
I i t h cycl e c.ount i g only a s mall portion of the total
investig ated at a g1ven t1me. Th1s reduces the magnitude r h
.
s tant ial l . Each day 's co nt can be reconciled
stock is being
bl s
without dely. :cf:o:s :
full-time personnel who continually count i n ventory items. In large organi za be estabh s h.ed s o that all. mvent?ry itms ar counted at least once during a year,
or ?n a s t_atlstlc_a l sampling b s1s. W1th statistical procedures, a random sample
_

of ttems m a g1 ven category IS counted, and the results are generalized to the
tions specialists are desirable, since they become fam i l i a r w i t h items , t he lo cator
system, the storage system, and "peculiar" t h i ngs that can occur.
The cycle count tests the condition o f inventory records a n d provides a populatio n of items.
measure of record accuracy. Record accuracy can be measured by t h e percentage The procedu re for determining the average number of items to count per
of items i n error and the relative magnitude of the errors. The s i g n i fica nce of day with an ABC analysis is relatively simple. A cycle is the time required to
count all items in inventory at least once, and it is often a year. The count
pensive item is signi ficant, while an error of plus or m i n u s 2 % might be accept
the error relates to the relative value o f the item. An error of one unit for an ex
freq ency is the n umber of times an item is counted in each cycle. For example,
A items m i g h t be counted monthly, B items quarterly, and C items annually. We
u

able for low cost items.

Cycle counting can prioritize concentration o n the integrity o f inventory have
items with high annual dollar usage ( A B C principle). The " A " items (highest
. E(number of items in a class)(count frequency)
Items c o u n ted/day
annual usage items) should be counted most freq uently, " C" items least =
number of days per cycle
frequently. " A " items might be counted every one or two m o n t h s , "B" items
every three or four months, and "C" items every year. Since " C" items may
Example
I 000 are class B, and
represent the bulk of the inventory, but a small percentage of i n vestm ent, less
A
A
9
effort is expended on them. Each organization m u s t establish a cycle count
supplier has 5000 items in stock, of tc
3500 are class C. There are 300
w h. h 500 are class
based on its own peculiarities . d
the respective count

year,
operat ing days per
Several procedures have been developed to vary t h e cycle count freq uency.
ld
freq uencies for the classes are 5 , 2 , and 1 times per year. ow many items shou

tota1 n u m_
Some of the more prevalent systems are as
follows: be cycle counted each day? annual counts:
The following tab l e
ber of _
deter mine s the
_

1 ABC system. The stratification of it

highest frequency on " A " items and
items based o n t h e A BC princip le w h __
the_
t h e lowest on "C" items .
2" Reorder system. The countin Olass
3 Reciver system. The counting
g of items at the t i m e of reorder.
of i tems when a repleni s h me nt order is A
recetved.
4 Zero balance ystem. The
B

zero r countin g of items when the balance on

o negat1ve (backo rder).
ha nd is c
 l)llestlons
Invento ry Valuation and Measurement Chap. 1
1

3-
498
499
Requi re authonzed orders and requtslltons f
4.
total annu al coun ts
sw re valu able ttems tn l ocked ca bmets o t
or all transact ions
=
5-
Items counte d/day numbe r of days/year
:safes t f necessary.
per iod ically spot-check stock on hand P du n ng work mg hours
f(eep storerooms locked an d encl osed ex
6_
8000 e
agatnst tnventory record
7.
= = 26.67, or 27.
Investigate unusual cons umption ror proper
/
300

8.
s .
use.
PeFiodically check the au t hent ici t Y 0 stgnatures
the number of B it.ems counted per day
is 27(2500/ 8000 ) = 8 .4375, or 9 i te ms
The number of A items counted per day
is 27(2000/ 8000) = 6.75, or 7 item s; and an d authorizat
the number of C items counted per day is
Prov1de secunty bonds for storeroom p ersonnel to
.
ions.

Thus, because of rounding, 28 (9 + 7 + 12

9,
27(3500/8 000) = 1 1 . 8 1 25 , or 1 2 ite ms.
= 28) items should be counted each
through negligence or theft. protect against losses
is apt to increase the origi nally stipu
day. The rounding of fractions to integers
. ntory
The effort , tim , an money spent on the securit of tnve
lated count frequencie s.
located among the ttem_s m proporti on to their relativ i : should be
c - At no time
ac !hould the cost of secunty exceed the benefits that acc -
i
The cycle count method is an excellent method for maintaining the
curacy of records. Some of the more apparent advantages are as follows:

1.
Questions
Operations do not have to be terminated during the cycle count, and the
annual physical inventory is eliminated. t. What i s the financial significance of inventory valuation? .
2. Errors are discovered quickly, inventory records are adjusted throughout 2. U pon w hat factors does the selection of an inventory flow method
the year, and causes of error are eliminated.
3. 3.
depend?
Record accuracy improves, and a more correct statement of assets results. Which valuation method is most suitable for goods that are subject to
Inventory counts are not performed under pressure, so measurements are
Give the primary disadvantage of the FIFO inventory flow method .
deterioration and obsolescence? Why?
4.
more accurate. Year-end inventory writeoffs can be eliminated, and a cor

4. 5.
rect statement of assets can be obtained throughout the year.
Specialists bco e efficient in obtaining good counts, reconciling differ How does the LIFO inventory flow method protect against "inventory

6. Accordin g to some critics, what is recognized as a weakne.ss

of the LIFO
profits"?
5.
ences, and ftndmg solutions to systematic errors.
Efforts are concentrated in problem areas.

7. Name t h ree types of averages that can be used

method?
in the average cost in
ventory flow meth od. To which types of invento
ry systems does each
8. State the limitat ions of the average cost inven
INVENTORY SECURITY apply?
tory flow method. tftc ..
applicat ion of the spec
.
ion for the
1 ' t't s va1 ue, SIZe, we1ght, application, utility, and
Security requirements vary widely among organizations and are depende nt 9. escribe the most a ppro priate s ituat
D
resalability 0 n a11 , h e m re valuable
upon the nature of the mate na .
: : cost inventory flow meth od.
r flow methods esse
ntially
IO. U nder wha t cond ition
the greater the need for se .
?
curity. Hoev r m e pe st e lte _ n item, s are the four mvento Y
s . reqUJre relatively little protection because valuing
: :
of their size wi ht n m ted ullhty equ ivalent?
ll. When is it appro priat e to dev1ate from
the cost principle of
(large ca_s tings, special molds) . .
Materis c b a arded by estabhshmg _ and enforcing storroom
i can reveal existm g or ccurate inventory
records .
1 2. L 1st
regulations. Periodic auditi of store oom I
_
operations in ventory? .
_ three require ments for m amtat'ning a
eye
potential security problems he followmg
measures should apply to storeroom le count meth
ods of
1 3 D ifferentiate between the peri
nt an d
operations: odic cou
taking a physical inventory coun t vary the
1. ve been developed to
1 4 Describe som e of the proced
ures h ic h ha
2.
Limit access to storage areas to authoriz
ed personn el .
Count, weigh ' or measure all mater
ials on receipt. cycle count freque ncy.
 Simulation ation Categori es
Si fll ul

509
508

Jn e al. li fe ,

f w s for eval u at in g r such transi en t

Typical approaches may range

hes involve a variety . phen o men
JU
alter.
fanagem ent decision approac ] ucal m e.th ods are us
a are co
mm onp
from p re t tw uo n and
t
d e nt to aJl a y ually based lace occu
natives .
systems . Include d m
this range ar exp e nen ce
and need no
t b e !muted by such
assu m
. on ste ady state enc
con d tton
es .. Whereas

:
experim entation with existing s , Sim ulation

fo r
analogy with similar situation s,
analysis with the d f anai J cal mo del s,
an d
The use of s
u l at ion tec
hn iq
a system. Sirnulat IOn I S associated wi t h th e
last co mp uters . Whtle th e de si gn
of
uld not
?
e very f
easibl e if it w
experim entation with a model of
:
. m an stm ere not
ul att on m
pJic ate d
and does not mvolv e a
employe d when complex tty precludes t h e us e of an a. large am odels is not

:::
approac h and is usually u of adv ve
u::
m
numb e r
of variable s and equat i an ced math
lytical e ons is co ematics a
:
Thou san ds
uJ atio ns .an d
manipula ting a m o d e l of a syste com putatio ns are of sim ple mani
s study usually involves m . usually re
e design fea t u r o r d c i Sl on r ules . Th
arit h et lc
operation s are usually each sim ulation, and
for the purpose of evaluating alternativ e too nu erou the
can be ascerta.Jn e d WJt hout tam pe rin g of t h e ompu ter, SIIDulatio . hand com putatio n .
effects of numerou s alternativ e policies the rud n h as become With
with the actual system. This form of system ex n
p
.
e m entau o n can reduce t he risk ager b ecaus 1 t allows t h e m an p ul ation i of m an
an
p n ant tool
to the man
changes that would not be bene fi c ial . as s ociate d h a prob l e in an artificial
m Y anables and param
eters
of upsetting the existing structure with enviro t.
ty t o test and evaluate pro pos als To facilitate c om pute r programm
Simulation gives the manager an opportuni ing, sim n models are frequ
without running the r i s k of actually installing new approaches and abso rbing formu lated d converted into a flow chan format ently
The model can

g g (GPSS(FORT
p rogr me d mto a eneral purpose langu age
With simulation , "trial and erro r" then be
A:ASCAL)
, SIMS:;;;
the costs associated wi t h expensive errors.

stMAN . or GASP) . Th e re : SL 11,
a sp ec al purpose stmulation lan ua e
i or
need not become "trial and catast rop he . "
reveal i n advanc e the
Simulation c a n answer "what i f" questions which adv
are distinct e ffic iencies and
amages m usmg a

ary, starting with a simple

options that are desirable. It is able to indicate possible
solutions based on t h e sim ulatio n language.
input of alternatives; h owever, it does not indicate the alternatives
to evaluate. The rocess of simulat ion is often e oluti n
v o
e
The m an a g r selects the alternatives to evaluate, but is not sure the best alter represe ntallo n of a problem d th e n gradually adding more complexities and
.

problem , recognizing the input vari ables and their st atistical variations, exer
native has been included. Hence, a simulation model does cot promise an op embellishme nts. The process IS based upon building a logical representation of
timum solution. This is an important distinction between simulation and a

cising the model to make it behave like the situation it represents, and observing
al in :
analytical models.
Simulation has additional characteristics which differentiate it from other the consequences. Typical process ste ps usu ly clude

1. problem formulation,
techniques. Most analytical models tend to represent reality, while simulation

2. conceptual model construction,

models imitate it. An analytical model cannot b e extricated from its premises
and assumptions, while simulation can investigate the effect of a relaxation of
assumptions. When problems involve risk or uncertainty, an analytical sol ut io n 3. data acquisition,
4. programm ing language model translatio n ,
may be difficult or impossible to obtain. Simulation is also useful when ana

5. model verificati on and validation,

lytical solutions are not appropriate because the models are either too complex

6. iterative experimentation,
or too costly. Analytical models can become extremely c o m p lex, with numerous

7. statistic al analysis of results.

interacting variables. Since simulation is adept at handling dependent variable
interactions, it is a powerful tool for systems analysis. Its time compression cap
abilities can provide insight into the long term effects of various strategies.

1 SIMULAT ION CATEGO RIES

Simulation is used to reproduce a typical series o f events (usual ly in math
ematical form) which could have occurred in practice . The process often con
sists of repeating an experiment many times to obtain an estimate o f the overall
. . d 1nto two bas c
types-determin
i isti c
.

t
d

1 probabilistic. Determ
effect of certain actions. If enough experiments (events) are simulated and mean Sim ulation mode ls can be classtfle be stated explicJ ly
values determined, it can be assumed that they represent w h at would have inis tic m d els ha
o ;::: \
rfes that can
T al ap
p ach

v:
class
el n puts he
. .
.
a e itY di stn
happened in practice. Statistical methods are commonly used to draw inferences and use the expected alues of inclu de robabil
or to test hypotheses about the results obtained from simulatio n experi ments . I to dynamic systems IS det e r
st it does not
mm
u us and
, the relatio n shiPS among ;
or the

IS
Initial transient phenomena such as oscillations, rapid growt h , and su lions, its variables m st b co ntm o ebn . fram ewo r

1
ns are the m g
e . Eq uatio bY Proba
den decay are n t unusual in simulation ables must be stable over u m . tables defined
. (or i n reality). If system stab ility o d e s have key var
ab ilisuc m
demed, a sufficient startup period should
b e allowed for stabilit y to develop. I c lassical appr oach . Prob
 Simulation Ohap. ante ca rlo Simulation
510 12
51 1
hilit dstribut1o. ns and of e t eand values . In these models, variab ies need
s P c vary wi t h timemst1c,
be contmuo us, an re latt ?nf hile it. is not uncomrn
n

for manag me n t su:n u lat t on gamliStic. n

: . u
s to. be determi busmes s Sit ati o ns i
the reaJ world usually are probabi
&umplc 1
A supply attendant at a too1 c 1. b d. tributes hand tools to mechanics. It takes him
e.xactly 3 minu tes. to s:a;:1anic;rSimulate 1 5 minutes ( 1 0:00 to 1 0: 1 5 ) o r
oo e ics a ive at 10:00, 1 0 :0 1 , 1 0:04, 10: 1 0, and
:: z :;::t:me, indicate the idle time of the attendant, the waiting tirne
of .th mechanic, and the number of mechanics . theThequeue.
Thble 1 2 - 1 develops the relevant informatwn. attendant IS Idle ;-; , or
m
. . J

200Jo, of the time.

TABLE 1 2- 1

A rri val Service Service Idle Time Waiting No. of

Time of Begins Ends or Time of Mec hanics
Mechanics at at At.tendant Mechanics in Queue
1 0:00 10:00 1 0:03
10:01 10:03 1 0:06
10:04 10:06 1 0:09
10: 1 0 10:10 10: 1 3
1 0: 1 5 1 0: 1 5 1 0: 1 8

DECISION
MONTE CARLO SIMU LATION

Monte Carlo simulation

1.
Monte Carlo simulation is a probabilistic type of simulation that approximates FIGURE 1 2_ 1

the solution to a problem by sampling from a random process. It involves

tion are as follows:
determining the probability distributions of the variables u nder study and t hen The major steps in Monte Carlo simula

i
randomly sampling from the distr butions to obtain
data. A series of rando m
? certain key variables .
They
numbers is used to describe the movement of each
random variable over t i me
Def i ne the known pro abt..hty
. bu tions of
. dtstn
sue the Pois son, normaJ, or pon.en-
and allows an artificial but realistic sequence
of events to occur. Monte Carlo
may be stand ard distnbuoons
p
as
n o
.
cal dt s t bu . o ns
obtai ned from htstoncaJ
simulation permits the manager to determine tial ' or they may be em iri
how varied policies or organiza
. probability di tribu-a
2. Convert the frequency dts n. b
tional condition s will be affected by records.
the behavior of random or t ra nsient inO
15 .
:
t i on s to
cu mul auve
be assoctate
given in Figure 1 2- 1 .
ences. A general approach to
solving problems by Monte Carlo simulation
tions. This s at Y o e var
iable value will
. d with

probabilit y dJstn. buuy. otn atomple

assure th on
.

. u Jation. A wa o
give n rando m number
de-

3. Sample at random .f ro m
Monte Carlo simulatio n establishe
s a stochasti c model o f a real sit uatio n e
.

the cu mu Jativ
and then performs sampling
t h e sJm
ermi n e specific vana b l: :ble of rand? n rne; onh tora obtai n ,P i fks
erates a vast amount of data
experiments on the model. This techni que gen
e
lu s to
use in T ndom num ber
IS t o use n u bers fro :
that might otherw ise take a very long ti me to
obtain . Followi ng the generat
ve p roba
are insert ed m the
bthiY dist nb i
e
ion of data, analytic al computatio n s can be made
and then a problem soluti
on derive d. c u u l a ti
 Inventory Simulatio n Probl
Simulation Cha p. perpetu al em
12
512

1 23
seque nce o f assi gned ra n dom TA BL E
observation . The
ariabl e values for each
ion expec ted to be enco un tered
patter n of variat

4.
n u m bers will imitat e the
analysis for a large

um er of observati ons
: Time Freque ncy C umul ati 'e

Simula te t h e operat ion under

F requen
cy
determ med m the sa e manner --
of replica tions is _-

The approp riate nu mber . 5 20
a t al expenment In the r 20
of a sample m ea] 6
as the appropriate size 30 0 1 - 20
tests of s1gmf1 cance can be used . With 7 50
cal 20
world. The ordinary statisti
2 1 - 50
70

90
simula tion the size of the sample can be very large, and it 8 10 5 1 -70

__!Q
computerized 9
80
samples with very small sam pling erro rs. 10 7 1 -80
is often econom ical to run large 10 8 1 -90
10C
91 -oo
1 00
the choice of frequency distribution s . Unless
Everything that depends on
well chosen, the entire simulat i o n can be of
there is some assurance they are
be obtained from historica l records or ex
questiona ble value. Distribut ions can TABLE 12-4
priori on a quasisub jective basis .
perimen tation, or establish ed a
long-run frequency. They have a
Random numbers are numbers of equal Simulated Assembly
and each number has an equal op Replication
complete lack of sequential predictabili ty, Time (minutes)
tabulated numbers can be vali
portunity to be selected. The randomness of
can be obtained fro m 5
dated by a chi-square test. The stream of random numbers
10
case, the compu ted
a published table or created by the computer. In the latter 6
numbers are termed "pseudorandom numbers . " Table 1 2- 1 6
at t h e end of this
6
chapter is a typical random number table. 6
7
Monte Carlo simulation has many practical uses, such as waiting line
7 5
problems where standard distributions for arrival rates a n d service rates are
8 10

..2
inadequate, layout problems of multiphase assembly lines, inventory problems 10
9
determining reorder points and order quantities, equipment replacement 10
problems, and so forth. 70

Example 2
number s in
frequency disuibution. Random
The probability distribution o f pogo stick assembly times is given i n Table 1 2-2. random numbe r to the cumulative
5 1 -70 give 7.' 7 1 -80
time of 5, 2 1 -50 give 6,

:liwns w1th the following random numbers: 04, 95, 45, 2 1 , 44 , 5 7 , 03 , 98 , 98 ,

Detr e th average assembly time by simulating the performance time for ten the range 0 1 -20 give a performance
es. The sn ulated umes are gven m Table
10 minut
give 8 , 8 1 -90 give 9, 9 1 -00 give
s.
70/10 = 7 mmute
1 2-4 . The average assembly time is
v;;hfrequency distribution t a cumulative frequency distribuJion ,
d

as i n T he Simulated assembly time can be obtained by referring each

PR OBLE M
TABLE 12-2 PERPETUAL INVEN TORY SIM UL ATION
ory policy for
an
. . mnrn cost invent
Time (minutes) Frequency estabhsh a mini dem and (in units
per
The assignme nt at hand IS to
i tem w h i c h histori cally h s bee n su bJ
_
t

b ot h variab le
rd r
f m o e to
d i
eli very). H st
g
ri cal d e
5 20
week) and variab le lead ttm
_
e (In we f
oll owm mfo
rma
6 30
a e c on r atn ed i n Tab le 1 2-5 . The
ilable: t e h
order
7 20 mand and lead time data \
or activity
is also ava

:;
w ith mvent "tocko t cost
8 tio n on t h e costs asso ciated is $5, and

::: P i
per week

nut). and reo

10

_!Q
9 ng c o bjec tive
oldi
10 placement cost is $ 1 0, u ost i nve ntor
10
!
per w eek o f occurre nce $20
.
order q ua
bin atio n of
1 00 co
dete r m inati on of a spec1 f1c
 Simulation Problem

51 5
Simulation u al Inventory
perpet
514

I
c
rASLE 1 2-7

Lend
Qu.uu i r y Dctnnndcd Frequency
BLE 12-5 -

(no. or
Time Qua n t i t y

(un i r s "'<'<'" )
Rela t i ve
Pf't>QllC ilC)'
(weeks) De ma nded

0
week s)

30 Ot -()4
60
I

20 --.J.
9 2 05-12

t OO
I -I

s
3 13-40
4 4 1 -80
8 1 -96

_!_ 99 00
5
97-98

50
6

Lead Relative Cumulative Random

Tim Frequency Frequency Numbers

i m u l a t i o n . U ing reorder p o i n t s 30
60

t h rough 8, fifty- ix possibl

60

0 t h rough 6 and rder q u a n t i t i e I

0 1 -60
Thi a n be handled easily by
problem 90 6 1 -90
e i m u la tions 9 99 9 1 -99
1 2-6 would cont ain
cell in t h e matrix of Th b l
1 00 00
(com bination ) can be run. Each
w i t h t he smallest ost would i n d icat e the
t ile r ult of a i m u l n t i o n . The cell

a ingle cell, C38 are s h o w n . These com

cost which would be placed in cell CJs in t he matrix
t i t y o m b i n a t i o n o f t hose e.xami ned . For
be t reorder point nnd order q u a n

considered suitable. 1b determine the most desimble cell

The s i m u l a t i o n gives the
implicity, onl ' the amputati on for
if 2 5 repl i c a t i o n s were
o r the i m u l a t i o n of 2 5 weeks o f data .
putm ions are ba ed on 25 replicatio ns
c u m u l a t i v e frequency distribu in the m a t r i x , all cells must be simulated in a like manner. The simulation

tions. Thble 1 2 - 7 i
Con erting the frequency distributio n t o
example has b u i l t into i t the following assumptions:
obtained .

1.
of order q u a n t i t y 8 and reorder

point 3 are run. From the e data.

In Thble 1 2 - 8 , twenty-five replicat i o n
d e m a n d occurs at the beginning of the week.
2.
All
replen ishme nt orders arrive
at the beginning of the week.

3. H o l d i n g costs are deter

All
d by the number of units
in stock at the end
mine

mer W Iu
average co t
of each wee k .

+ 60 4. I f t h e dem and for t h

e item exceeds the balance on hand, the custo
545 + 70
s avail able . . . lost and
acce pt all the item week , It IS
5. If t h e d e m and
25
for an item is not satisfied in the given
average co t $27.00/wee k .
n o t reco vera ble
in the following week. of units
dless o f the nu mber
=

6 . The s t o c ko u t
20 p er week regar
cost is a fixed $

of d e m a n d that
are u nfilled. . order (but not rec
eivro)
p l us the numderberpomf tu:tt;nis.hment order i placed
TABLE 1 2-6

i nt Q u an t i t y : is equal to or less
7. If the u n i t b alance
Po or
Reorder Order re
tha n t he

Co 3 Co.,
uni ts. .
for a d d it i o nal umt . The
c, 6 c"
c, j exarnPIe
balance of 8
demand valu e
Cos
.111\. tl. lll u nit
.
C C C Co. Co
o, m
an r and
o3 ,
gn mb
Cz 3 c26
C, N
be i s with a mng do m nu

rval
c" n

r
C cl c,
found by ust
Cn
u
The s i m u l a tiOn
CH CJ6
for : n an
) .

" ek is
::;
c Cs
Cn

c.8 fl'T w k 1). Th

C c
it s cor
C
,
ea

c.,
n

c.. J referring to t he rando 0

lJ

c.6
z

c.j
CJ s
simulated d e ma n d
t e va l 0 1 nu m ber int
1 r i
cJ C C C

cj ,
,

cj ,
H
to th!
c16
u

cj. cj
J4
m refe rn n _

(e. g . , using t h e
c. c..
and
9
t runed
random nd ingerdemand
, c44
1 IS
c62 c6,
ob
c66
nu b
eM co,
l
C C
C,s
of 2 u r u ts
n H
c
6, c6J
Cos
i n Thble 1 2- 7 , a co
rres po
 12
517
tual Inventory Simul ation Proble m
Simulation Ch ap. perpe
516

ulated demand v a l u e is subtracted f r

51:
.
week , .w hi_ch results in an end - of- : tu:al.ttance.
00
balance fro m the

'"" '""
per previ-
(replic at i on) , the stock p ositi on At the end of each
:ek wi t h t e reorder point . I f the
0
(sto ck
w mpared
han plus stock

alue is foun d using a randot

on order) is
reo er
\c eeded, a lead ttme t has been reach
heran do numbe r m terval and its correspon
b
:< or
ding l: ;:; ::
r g

As each week (re p cat on) epires , I is added

r po mt has not ben
reorde
eached, no t
h t
order is placed.

I
, to the number of weeks
from all outsta ndmg lead
is sub t racted
week , any
and
time values. With the stan
of a new
orders schedu led for delivery are added
to the unit balance from the
. The process c ontinue s for the
previous. week . specified number of replications
Appropnate mvento costs are
(25 in this case). entered at the end of each simu
. The avera g co st for the stmulated cell is obtained by
lated week . . adding all the
costs a d dt.vtdmg. by the number of simulated weeks
inventory
S
or replications.
iO
.
The precedmg imulat n of a smgle cell in the matrix indicated the vast

num ber
m n
of simple. co puta io s asoci ted with a simulation. While the
. .
com putations are stmple, theu quantity dtctates the u se f a computer lt ts an .
easy matter for a computer to ru thousands o.f rephcattons on each cell m a
desuab\e alternative.
mat rix and indicate the most

3
.
of cell C,s,
$20 per unit er week in the inventory evaluatton
Example
s
I f stockou t co ts are
what is t h e average cost per wee

k or the 25 replications? (All other aspects
of the

proble m are unchan ged.) only difference will be

; :
are unc h n d nd the
The order and holding costs
weeks 1 8 , 2 1 ' an en stockouts occurred (Table
in the stocko ut costs for

+
holding cost + order
12-9). Thus

N
cost stockout cost

average cost
=

= 545 + 70 + 1 80 = $3 1 .80/week .
25

TABI!.E 12-9

---r-+------+-----r---
 518 pe ri odic
12
Simul ation Inventory S1mula t1on
C hap Problem
.

u
PERIODIC INVENTORY SIMULATION PROBLEM
0

The task of establishing a minimum cost inven tory P ? licy for t h e item i den ti fie ;:l
I
j
. d

or
in the previous section (perpetual inventory s ulau o problem ) n o m us t
be
restructured for a periodic inventory system. Tills re uues t h e d eter mm ati on

u 0
.

-o u
a specit1c combination of the reorder cycle an d maximum I n ve n to r: leve l . D
a:
ue 0
.
to space limitations on the system, the m u n u m b e r uruts t h at
can
.,
be stored at any given time is set at 50. Restnctmg the ma>um um m .

E
ve ntory

Cii
;;

level to the range 20-50 uruts i n steps of 5, and the reorder cycle to the ra
nge
1 - 5 weeks in steps of 1 , t h e matrix of possible c o m b i n a t i o ns is s how
n in

u
Ta ble 1 2 - 1 0 .
0
To determine t h e best policy, each cell would be s i m ulated . T h e cell

:0
with

0
Oil
the lowest cost would be selected as the best strategy. As an example , using c:

::z:
the
distributions and cost data from the previous sect i o n , t h e c o m p u tatio
ns for a

ventory of 30 uruts, wruch correspond to cell C53 0 The s i m u l a t i o n

single cell will be displayed: a reorder cycle of 5 weeks and a maxim
um in

co
will start at "'
;::
time 0 with 25 units on h a n d . At each review peri o d , an order w i l l be

:J
placed for

replications of cell C53 0 From these data,

30 uruts less the num ber of uruts in stock and on order. Table 1 2-
1 1 conta ins 25

-o

N
holding cost + order cost + stockout cost

0

average cost ==

+ 50 + 0 ;;:
2250
;>,

f=
==
$92/we e k .
e
==
25
-o
To actually determin e t h e best periodic
i n ventory p o l i cy, i t i s necessar y to .,
]
Cii
evaluate each cell in the matrix.
The 25 replicat ions given w o u

l d n o t be suf
ficient. Several h u n dred replicat

Cii
ions of each cell i n the matrix
w o u l d ensure a
reliable estimat e. With the use
of a compu ter, i t is a s i m p l e
m a t ter to determ ine
a desirab le period ic invent
ory policy by such a s i m .,
ulation.
Throu ghout the use o f
for est blishin g a perpet

M o n t e C a r l o s i m u lation ,
ual and period ic invent ory
t h e s o l u t i o n proced ures
system have been o u t l ined
for a smgle produ ct. The -o
techn ique was i l l ustrat c:
ed for a very s i m p l e problem .
El
TABLE 1 2 - 1 0
;>,

z
.
Reorder Cycle Maxi m u m

E
;g
(weeks ) I n ve ntory ( u n i ts):
50 45 40 35 20
30 25

.g -o
E

C ISO c ,. s c , .o C I JS c, 2o
C I JO c , 2s
C2SO c24 .s c24o c2J s C2Jo c22s C22o
CJ SO
C4SO
cJs cJo CJJS CJJO Cns C32o
c.. s c440 c.J s c.Jo c2s c. 2o
Csso cs s Cso Cn o
-o
.,
CSJ c5J o cs2s
5 .B
Cii
E
 Joint Probabilit y Distribu
Simul ation ation of

'521
tions
C ha p,
12 stro ul
520

,
Althoug h no t illustra ted, many o t h e r fctors could have b n i n tro du ce
d an d
varied , such as quant ity discounts , pnce changes . exped t t t n g cos ts,
st r i kes
ackorden ng. Ad d t t t o n al
materia l shortages, p i l ferage, and p rtlal b. fa ctors
include a s t m u l a w n , alLhough are
compara tively easy to m t h ey are fo rbi ddin
gly
complex in analytical form.

SIMU LATION OF JOINT PROBA

BILITY DISTR IBUTI ONS -
Lead T i m e
L Probab ility Random
demand and lead t i m e .c a n b a p p roxi m a ted for in
The interd ependence of

0.25
de

01 -25
Number,
Monte Carlo s t J a t w n . W h en d em an d
pendent distribut ions by using

0.75
and

26-75
0.25

1 .00
inventory problem, I t IS necessa r y to devel op th
lead time are variables in an

7&-00
eir 0.50
i t ie and reorder p o i n t s c a n be set .
combined probability so order q u a n t Th e 0.25
.
e d e m a n d d u r i ng t
resultan t joint probability distribution will defme t h he l ead

The M nte Carlo process consists of selecting a

time period.

le ad orne p en o d : Addtt1on al random numbers will be used to generate

Although demand and l e ad ti e varia les can b e c o b i n e d n u mer ically,
.
random number for each
.
i t involves the algebra of multmomtal equatwns for s u m m m g all the possi ble demand
combinations o f variables. With M o n t e Carlo, t h e j o i n t behavi o r o f the dis du r ing the lead t t m e . The lead time demand will consist of the
summation of the

m od i fi ed to accept random numbers in the manner shown in Table 12- 1 3 .

tribution is simulated by random n u m bers. The n u merical m e t h o d i s exact, but individ ual demands during the lead time. The independent distributions are
the Monte Carlo method i s quicker a n d s u fficiently accurate for practical

probability d i s t ri bu t i o n i n Table 12-14 is obtained.

purposes. Thble 1 2- 1 5 contains t h e 20-replication simulation. From i t , the joint

The Monte Carlo method consists of selecting v a l u e s of lead time and

demand on a random basis. Although t h e procedure req u i res a large n u m ber of
replications to establish the j o i n t d i s t r i b u t i o n , it can be extremely useful when TABLE 1 2 - 1 4
standard distributions d o not apply. A s i m p l e exam p l e can b e s t i l l u strate the
Lead Time Probability
procedure. P(Mj

0.10
Demand M Frequency

Example 4
0.20
M o n te Carlo simulation, establish the joint probability of lead time 0.30
0.25
demand for 20 rep l ic a ti on s using random numbers from Table 1 2 - 1 6 a t the end of
0.10
Using

0.05
0.00
the chapter (start with the last two digits from column 1 in Thble 1 2- 1 6 ) . The

0 0.00
I

0
Independent demand and lead time distributions are shown in Table 1 2- 1 2 .

0.00
0

_Q 1 . 00
TABLE 1 2 - 1 2

D a i l y Deman d
Probab ility Lead Time Probabi lity
D ( units)
P(D) L (days) P(L)

e ns . '::;ti:
2 0 r plicatio
0.40 0.25
0.30 0.50
0 . 20 0.25 a s for only
Q.:.!Q 1 .00
T h e prece d i n g exa ple

rib utio n of
es tab lish a j o i n t proba t hty dt s
lead time
rel iab le es
t im
dem and
ate .
1 .00
several h u n d re d repl icat iOn s 10
ass ure a
 o f Simula tion Run
80gth

523
Simulatio n

ENGTH O F SIMULATION RU N
522 Ch ap
. 12

TABLE 1 2 - 1 5

A si
Random Numbers Simulated Activity m ulat i on r u_n i s the same as a s . .

ahstical sam
T im e
ai b emg
Le ad
ad_Ti_m_e__o_em_an_d+_:.:..=_::__:..:.=..--=D_:::
a p roces s
m::_al:d_LeDademTandime
simu lated . The nfo ple of a process
__
or
m ation g under stud
depen ent on the length of the si ulat ained from a

---:--t-Le ; ton run, i ust as that simulation
sarn ph ng depend s on th e size of th sa from
63 58
maung the
needed length p
of a simula IOn
le taken. The u metho_ statistical
al
66
per fo rm
a few short t ri al runs us ing
run (nu mb er
d t fferem random
d for esti-
rep ications)
l is t
35 09
111ea n and
standard d ev iation of h u bers to obtain theo
72
no rmal :
:ariable being measr
92 70 m
the easu
red va riable is
buted , the l t f : surnl_ng that

cy _
eng
14 can be deter mined fo r a gi ven a cu n and a stat h s mulauon run
_ istical co f"de
44
27 formula can be
[ollowmg used to d eterm me the desired lengt f ;hce eve! . The
77 run: e stmulallon

N
80
z2 2
s
21 = /('2 = desired length of st. muIation
. run,
23 58
6 56
s2 E(X - = EX2 - (EX )2/n
n - 1
X )2
28 13 =
91 n- I
30 94

44
7 where

K = pX =
37
desired acc u racy of simulated variable,
P = accuracy fraction,
20
lO
s = standard deviation of n
42 42
sample runs of simulated variable X'
99
II 16
12 93
X = simulated variable,

X =
13 51 30
arithmetic mean o f sample runs of simulated variable X,
Z = standar d normal
34
14 28 56 deviate for a specified confidence level

for 6 8 . 3 0Jo confid ence level; Z = 2.0 for

85
95.50Jo confidence level ;
I (Z =
15 96 14

3 . 0 for 99.70Jo confidence level).

l.O
92
Z = is a function of three
d variable, (2) the desired accuraccuracy
57
) of a simulation run

The desired length s am ple size(

a 50Jo
16 acy, and
things: ( 1 ) the variability of the sim ul ate
9 81
17 45 950Jo confide nce level
and
be
fractio n indicate the analyst wan t s the simulated out of 100 umes .
85
(3) the specified confidenc e level. A
I variable averge to within
(plus or minus) 50Jo of the popu l at
18 68 78
32 ion average 95

e
Example 5
ns of tensyystemears' dure ation ato da;:t2h:n: :f
A series of simulation ru
inventmrys . g : :
:l h minimum 120 umt l e ngt
inventory for a perpetua l
h a e i nve ntory leve l of h s
licati s) to dspa cot Yn fidence level of 95o/o?
a standard deviation of 40
_
u t
ecf aver g
of 5 umts an
St ulation runs rep ( o
Wtth an accuracy
 Simulation Ch ap p roblems
524

S25
. 12

z = 1 . 96 10 . Wh at two purp oses are serve

n. What capa tl i tt e s are re
for t he 9 5070 confi dence level,
d by S .
b
(S )2
t.rnu lat ton?
Z 2s 2 ( 1 . 96) 2(40) 2 qutred for
N=y -
- = 246 years. model? the dev
elop ment of a
sim ulation

A t least 246 replications would be required. Problems

1 . A s mall cons truct ion comp

fi ittonal bak $50.00 a day

any ow
whether they are used or n . E ns two b'ackhoes that cost

can be
CONCLUSION ot ach add
ented for $50.00
r_ _ _ per
_ d_
ay. Actual boe required
_ _ use tgures

_ _ _
are listed below:
Simulation is t h e process o f designing a model t o repr ent a cision s_ituation No. o f Backhoes
__
and experimenting with the model to evaluate al ternauve dectstons. It 1s a syn. Used
_ No. of Days
thetic method of dynamic trial and error analysts o f phenomenon over tt rne.

22
It is especially useful when the complexity of a situation prevent an analytical 13
treatment or when the exact sequence of events cannot be _predicted .
16
. 38
Simulation serves the dual purposes of system analysts and the Improve
_.!..!.
ment of system design. Simulation serves system analysis by generating infor
mation on how a system operates and the significance of particular variables 100
and their interrelationships in a system. For system design, it provides insights
U s i ng the random numbers below, simulat
into potential improvement areas. Simulation can indicate w hich variables are e IS days of construction to
determine the average daily backhoe cost.
more important in generating a desirable output .
Simulation can be used to help solve simple, narrowly defined problems

2. A manager of a new warehouse operation must determine the number of

56, 1 0 , 40, 65, 45, 0 1 , 69, 16, 1 3 , 12, 78, 88, 62, 43, 67.
or complex multi variable problems. In almost all cases a computer is desirable.

workers to hire. The daily workload varies from 40 to 70 labor-hours as

The essence o f simulation does not lie in its structure, for i t lacks structure. The
structure for a simulation problem must be defined by its user. For this reason,
indicated in the table. Pertinent data are as follows:
the development of a simulation model requires a basic understanding of the
system under study and a degree o f conceptual creativity. Cumulative
Hours Probability Probability

Questions 40 0.05 0.05.

0.13 0.18
45
0.3"

2. What characteristi cs differentiate simulation from other

50 0.21

60
1 . What is simulation? What are its advantages? 0.27
0.66

0. 1 1
55 0.83
techniques avail- 0.17
0.94

3. Differentia te between determinis tic and probabilis

able to managem ent? 65 1 . 00
Q.:Q
4. What is involve d in Monte Carlo
70
tic simulation model s.

5 . What are the major steps in Monte

simulat ion?

6. How are frequency distributio n

Carlo simulat ion? $4.00/hour
Regular pay

7. What are some practical uses

S6.00/hour
s selected for use in Monte Carlo simula tion? Overtime pay 4 hours ptr ptrs
on

8. Using Monte Carlo simulati

for Monte Carlo simulation? Max . allowed overttme $40.00/day ptr perso
n

Thmporary help rary

on, how can lead time demand be approxi 1wo tempo
.
y v
er I 9 hours ,

9. On what does the accuracy

mated when lead time and demand the da IS o
are indepe ndent variables?
of i n formatio n gained from a sim ulation
I f the backlog at the end of l t
worker are hired by th :
da un ti he b ac klog goes b :
k bel ow 20 hours .
a vertime, test
teer r ll o
: ployees vo lun
depend? t re ul ar em
Assummg that all o f h