Chapter 12

Inventory Management

Inventory Management – is a core operations management activity. Good inventory

management is important for the successful operations of most business and their supply
chains.

Inventory – a stock or store of goods. Inventories are a vital part of business. Not only are they
necessary for operations, but they also contribute to customers satisfaction.

Independent-demand – items that are ready to be sold or used.

Dependent-demand – components of finished products, rather than the finished products

themselves.

Functions of Inventory

1. To meet anticipated customer demand

2. To smooth production requirements
3. To decouple operations
4. To protect against stockout
5. To take advantage of order cycle
6. To hedge against price increases
7. To permit operations
8. To take advantage of quantity discounts

Little’s Law – the average amount of inventory in a system is equal to the product of the average
demanad rate and the average time a unit is in the system.

Objectives of Inventory Control

Inventory management has two main concerns. One is the level of the customer service,
that is, to have the right goods, in sufficient quantities, in the right place, at the right time. The
other is the costs of ordering and carrying inventories.

Inventory turnover – ratio of average cost of goods sold to average inventory investment
Requirements for Effective Inventory Management

1. A system to keep track of the inventory on hand and on order.

2. A reliable forecast of demand that includes an indication of possible forecast error.
3. Knowledge of lead times and lead time variablility.
4. Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
5. A classification system for inventory items.

Periodic system – physical count of items in inventory made at periodic intervals (weekly,
monthly).

Perpetual Inventory System – system that keeps track of removals from inventory
continuously, thus monitoring current levels of each items.

Two-bin System – two containers of inventory; reorder when the first is empty

Universal Product Code (UPC) – bar code printed on a label that has information about the
item to which it is attached.

Demand Forecasts and Lead-Time Information

Inventories are used to satisfy demand requirements, so it is essential to have reliable

estimates of the amount and timing of demand.

Lead time – time interval between ordering and receiving the order

Point-of-scale (POS) system – record items at time of sale

Inventory Costs

Three basic cost associated with inventories

1. Holding (carrying) – cost to carry an item in inventory for a length of time, usually a
year.
2. Ordering costs – costs of ordering and receiving an inventory
3. Shortage costs – costs resulting when demand exceeds the supply of inventory; often
unrealized profit per unit
Classification System

A-B-C Approach – classifying inventory according to some measure of importance, and

allocating control efforts accordingly

Cycle counting – a physical count of items in inventory. The purpose of cycle counting is to
reduce discrepancies between the amounts indicated by inventory records and the actual
quantities of inventory on hand.

The key questions concerning cycle counting for management are:

1. How much accuracy is needed?

2. When should cycle counting be performed?
3. Who should do it?

Economic Order Quantity (EOQ) – the order size that minimizes total annual cost

Three order size models

1. The basic economic order quantity model

2. The economic production quantity model
3. The quantity discount model

Basic Economic Order Quantity (EOQ) Model – is the simplest of the three models. It is used
to identify fixed order size that will minimize the sum of the annual cost of holding inventory
and orrdering inventory.

Assumptions of Basic Economic Order Quantity (EOQ) Model

1. Only one product is involved

2. Annual demand requirements are known
3. Demand is spread evenly throughout the year so that the demand rate is reasonably
constant
4. Lead time does not envy
 5. Each order is received in a single delivery
6. There are no quantity discounts

Annual carrying cost – is computed by multiplying the average amount of inventory on hand by
the cost to carry one unit for one year, even though any given unit would not necessarily be held
for a year.

Q H
Annual carrying cost = 2

Where Q – order quantity in units

H – Holding (carrying) cost per unit

Annual ordering cost – is a function of the number of orders per year and the ordering cost per
order

D S
Annual ordering cost = Q

Where D – demand, usually in units per year

S – ordering cost

Total Annual Cost (TC) associated with carrying and ordering inventory when Q units are
ordered each time

TC = Annual carrying cost + Annual ordering cost

Economic Production Quantity (EPQ)

The batch mode of production is widely used in production. Even in assembling

operations, portions of the work are done in batches. The reason for this is that in certain
instances, the capacity to produce a part exceeds the part’s usage or demand rate.

Assumptions of Economic Production Quantity (EPQ)

1. Only one product is involved

2. Annual demand is known
3. The usage rate is constant
4. Usage occurs continually, but production occurs periodically
5. The production rate is constant
6. Lead time does not vary
7. There are no quantity discounts

Quantity Discounts – are price reductions for large orders offered to customers to induce them
to buy in large quantities.

Reorder Point (ROP) – when the quantity on hand of an item drops to this amount, the item is
reordered.

Four Determinants of the Reorder Point Quantity

1. The rate of demand (usually based on a forecast).

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

Safety Stock – stock that is held in excess of expected demand due to variable demand and/or
lead time.

Service Level – probability that demand will not exceed supply during lead time.
The Amount of Safety Stocks Factors

1. The average demand rate and average lead time

2. Demand and lead time variability
3. The desired service level

Fill rate – the percentage of demand filled by the stock on hand

Fixed-order-interval (FOI) Model – orders are placed at fixed time intervals (weekly, twice a
month, etc,)

Single-period Model – model for ordering of perishables and other items with limited useful
lives.

Shortage cost – is simply the unrealized profit per unit

Excess cost – difference between purchase cost and salvage claue of items left over at the end of
a period.

Uniform – the concept of identifying an optimal stocking level is perhaps easier to visualizes in
demand