CHAPTER

12

Inventory
Management

MSc/Chapter 12/CMJ
 What is Inventory?
• Is any ……………………………………………... that
used to satisfy a current or future need.
• Example of inventory:
• Replacement parts, tools, & supplies
• Goods-in-transit to warehouses or customers
 Types of Inventories
• Raw materials & purchased parts
• Partially completed goods called
………………………………………………..
• Finished-goods inventories
• (manufacturing firms)
or merchandise
(retail stores)
 Inventory as an Important Asset
 Inventory can be the most expensive and the most
important asset for an organization

Inventor
y
40%

Other Assets
60%
Inventory as a percentage of total assets
 Inventory Planning and Control - Fig. 8.1

Planning on
what Forecasting Controlling
Inventory to Parts/Product Inventory
Stock and Demand Levels
How to
Acquire It

Feedback
Measurements to
Revise Plans and
Forecasts
 ABC Classification System
Figure 8.1

Classifying inventory according to some

measure of importance and allocating
control efforts accordingly.
High
A - very important A
Annual
B - mod. important$ value
of items
B
C - least important
C
Low

Few Many
Number of Items
 Functions of Inventory
• ………………………………………..
• ………………………………………..
• Adapting to irregular ………………… and
……………………………………
• Enabling the company to take
advantage of …………………………
• To protect against ……………………
Inventory Management Questions
• What should be the ……………………… (Q) ?
 Economic ……………………………….. model
 Economic ………………………….. model
 ………………………………………. model
• When should an order be placed, called a
………………………………………… (ROP) ?
• How much safety stock (SS) should be
maintained?

Overall goal is to minimize total inventory

cost
Key Inventory Terms & Inventory Costs

• …………………………………….: time interval

between ordering and receiving the order
• ………………………………. : Purchase/material
cost
• …………………………………..: cost to carry an
item in inventory for a length of time, usually a
year
• …………………………………………..: costs of
ordering and receiving inventory
• Shortage costs/cost of stockouts: costs when
demand exceeds supply
 Determine How Much To Order?
Economic Order Quantity Models

Assumptions of EOQ Model

• Only ……………………………… is involved

• Annual …………… requirements ………………
• Demand is …………….. throughout the year
• Lead time does not vary
• Each order is received in a …………………………
• There are ……………………………………………..
 The Inventory Cycle
Inventory Usage Over Time
Figure 8.2
Q = maximum Inventory Level

Q Usage
Quantity rate
on hand Constant
Drop

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
 Inventory Costs in EOQ Model Formula

1. Average inventory level = Q/2 –OR- Q ÷ 2

2. Annual holding cost =(Q/2)Ch

3. Number of order per year = D/Q –OR-

D÷Q

4. Annual holding cost = (D/Q)Co

 6. EOQ MODEL Formula
Per Unit Carrying Cost:

2DC o
Q* =
C
h
Denominato
Percentage Carrying r Change
Cost:
2DC o
Q* =
IC
 Inventory Costs in EOQ Model
Formula
6. Total inventory cost:

D Q
Ct = Co + Ch
Q 2
Where:
Q = number of pieces to order
EOQ = Q* = Optimal number of pieces to
order
D = Demand in units for inventory item
Co = Ordering cost each order
Ch = Holding or carrying cost per unit per
 Example 1
Kmart sells postpaid phone cards to UMS
students. The annual demand is 1000 units, the
ordering cost is RM10 per order, and the average
carrying cost per unit per year is RM0.50. If the
EOQ assumptions are met, find the:
a) Optimal number of units to order
b) Average inventory level
c) Annual holding cost
d) Annual ordering cost
e) Total inventory cost
f) Average Ringgit value of the inventory, if the per
unit cost of the card is RM30.
 Solutions: EOQ Decision Model Example

D = 1000, Co = RM10, Ch = RM0.50, C =

RM30

a) EOQ =

40,000 =
 Solutions: EOQ Decision Model Example
D = 1000, Co = RM10, Ch = RM0.50, C =
RM30
b) Average inventory level = Q/2 =

c) Average holding cost =

d) annual ordering cost =

e) Total inventory costs = D/Q (Co) + Q/2 (Ch)

=
f) Average Ringgit value of inventory = Q/2 ( C)
=
 Determine How Much To Order
Production Run Model (PRM)

• Used when inventory continuously flows

over a period of time
• Production done in batches or lots
• Used daily demand rate
• Ordering cost change to ……………………….
• Assumptions of PRM are similar to EOQ
except orders are received incrementally
during production
 Production Quantity EOQ Formula
• Annual Carrying Cost:
Q d
(1 − ) Ch
2 p
• Annual Setup or Ordering Cost:
D
• Setup Cost: Cs
Q

• Ordering Costs: D
Q Co
• Length of production cycle t = Q/p
formula:
 Formula for Optimal Production
Quantity

2DCs
Q *
=
 _ d
p
C h  1 p
 
If production is not the cause of delayed
receipts, use the same model but replace Cs
with Co
Where:
D = Annual demand , Cs = Setup cost, Ch =
Carrying cost
p = Daily production rate, d = Daily demand rate
 Example 2
Brown Manufacturing produces scientific
calculators in batches. The firm’s demand for
the year is 10,000 units. It costs about $100 to
setup the manufacturing process, and the
carrying cost is about 50 cents per set up, 80
calculators can be manufactured daily. The
traditionally been 60 units each day. Brown
operates its calculators production area 167
days per year. How many calculators should
the factory produce in each batch? How long
should the production part of the inventory
cycle last?
Solution:
 Brown Manufacturing Example continued

1. What is Qp*? 2DCs

Q
*
=
p
 _ d
Ch  1 
p
 

Q*
=
p  _ 
 1 
*
Q p =
 Brown Manufacturing Example continued

2. How long should the production cycle

last ? What is t (Q/p)?
Q p= 4,000 units
*

p = 80 units per day

t = Q/p =
 How Much To Order?
Quantity Discount Models
 Objective is to Minimize total inventory costs;
includes material costs
 Material costs relevant in total cost:
• TC = DC + D/Q(Co) + Q/2(Ch)

where
 D = unit annual demand

 C = unit cost

 Co = each order cost

 Ch = carrying cost per unit per year

IC must be used in place of Ch in decision-
making
 Steps for Solving Quantity
Discount
1. Compute EOQ for each discount price:

2DCo
Q* =
IC

2. If EOQ < discount minimum level,

make Q = minimum.
3. For each EOQ, compute total cost:
TC = DC + D/Q(Co) + Q/2(Ch)
1. Choose the lowest cost quantity from
all levels.
 Quantity Discount Models Example
Text example: You are given Quantity Discount
Schedule

Table
Material cost:
12.1
•Total material cost is affected by the
……………. (%)
•Unit cost if first $5.00, then $4.80, and finally
$4.75
•The ordering cost is $49 per order, the
demand is 5000 toy cars and the inventory
carrying cost is 20% of the unit price. What is
 Quantity Discount Steps – A Review

1.Calculate Q for each discount.

2.Adjust Q upward if quantity is too low for discount.

3.Compute total cost for each discount.

4.Select Q with the the lowest total cost.

 Quantity Discount Steps – A Review
1. Calculate Q for each discount.

Q*1 =

Q*2 =

Q*3 =
 Quantity Discount Steps – A Review

2.Adjust Q upward if quantity is too low for discount.

Find optimal Q* for each discount levels

Q*1 = 700

Q*2 < 1000, the minimum quantity for discount

Q*2 = 1000 is an adjusted quantity

Q* 3 < 2000, the minimum quantity for discount

Q*3 = 2000 is an adjusted quantity

 Quantity Discount Steps – A Review
3.Compute total cost for each discount.
Q + D Co + DC
TC = Ch
2 Q
TC 1 = …………………………………………………………..
.::. ______________________________________________
TC 2 = ……………………………………………………………..
.::. ______________________________________________
TC 3 = ………………………………………………………………
.::. ______________________________________________
4.Select Q with lowest cost. In conclusion, the optimal order quantity that will minimize the
cost is 1000 units
 Determine When To Order?
Reorder Point

The reorder point is the inventory level at

which a new order is placed.
Order must be made while there is enough
stock in place to cover demand during lead
time.
Formulation:
R = dL
where d = demand rate per time period
L = lead time
Lead time is time between placing and
receipt of an order.
 Reorder Point

Figure 8.3
Reorder Point and Lead Time
 Reorder Point Example

Kmart’s demand for A$ papers is 3600 reams per

year. Suppose Kmart operates 200 days per year,
and delivery of an order take 4 working days, find
the reorder point.
Solution:

This mean when inventory stock drops to 72

reams, an order must be placed.
 Determinants of the
Reorder Point
• The rate of demand
• The lead time

• Demand and/or lead time

variability
• Stockout risk (safety stock)
 Safety Stock
Stockouts occur when there are uncertainties
with:
•Demand
•Lead time
Safety stock is extra stock on hand to avoid
stockouts

ROP is adjusted to implement safety stock

policy:
ROP = d*L + SS
d = average daily demand
L = average lead time, time for an order to
be delivered
 Safety Stock Example

afety stock is inventory held at all times regardless of th

quantity of inventory ordered using the EOQ model.

Example:
ideo’s expected demand is 247 packages per week.
Management feels that a maximum demand of
350 packages per week may occur.
How much safety stock should be carried if
the lead time is 2 weeks?
 Safety Stock Example

Maximum demand – Expected demand

= Excess demand per week
 Probabilistic Models and Safety
Stock
 Used when demand is not ………. or
………...
 Use safety stock to achieve a desired
service level and avoid stockouts
Reorder point & Safety
Stock
Reorder point = ROP = d x L + ss
d= average daily (weekly) demand
L=lead time in days (weeks)
ss= safety stock
How much safety stock should you carry?
 Probability Safety Stock
Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

Number of Units Probability

30 .2
40 .2
ROP  50 .3
60 .2
70 .1
1.0
 Probability Safety Stock
Example
• If we have 20 units of Number of Units Probability
SS (70 units ROP) then
the highest demand we
expect is 70 and we will 30 .2
have not stock-out 40 .2
costs. (But we’ll have
extra holding cost) ROP  50 .3
• If we have 10 units of
SS (60 ROP) then we 60 .2
could have demand of
70 .1
70 and run out.
1.0
 Expected units short
d max
Expected units short = ∑ P( d )( d − R )
d =R +1
• In this case (R=60) and R+1 is next level or 70
• Expected units short = P(70)(70-60) =.1(10)=.1

Annual Stock-out Costs

Annual stock-out costs = Expected units short

x the stock-out cost/unit
x the number of orders per year

Example SS=10
Annual Stock-out costs = 10 (.10)($40)(6) = $240
Extra holding costs with 10 SS= 10*$5/yr = $50