Om3 C12

MANAGING INVENTORIES
CHAPTER 12
DAVID A. COLLIER AND JAMES R. EVANS
OM3 Chapter 12 Managing Inventories

2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
CHAPTER 12
LO1 Explain the importance of inventory, types of

inventories, and key decisions and costs.
LO2 Describe the major characteristics that

impact inventory decisions.
LO3 Describe how to conduct an ABC inventory

analysis.
LO4 Explain how a fixed order quantity inventory

system operates, and how to use the EOQ and
safety stock models.
LO5 Explain how a fixed period inventory system

operates.
LO6 Describe how to apply the single period

inventory model.
CHAPTER 12
anana Republic is a unit of San Franciscos Gap,
Inc. and accounts for about 13 percent of Gaps

sales. As Gap shifted its product line to basics such
as cropped pants, jeans, and khakis, Banana
Republic had to move away from such staples and
toward trends, trying to build a name for itself in
fashion circles. But fashion items, which have a
much shorter product life cycle and are riskier
because their demand is more variable and
uncertain, bring up a host of operations
management issues. In one recent holiday season,
the company had bet that blue would be the top- 3

CHAPTER 12
What do you think?

Can you cite any
experiences in
which the lack of
appropriate
inventory at a retail
store has caused
you as the
customer to be
dissatisfied?
CHAPTER 12
Inventory is any asset held for future use or

sale.
Objectives:
Maintain sufficient inventory
Incur lowest possible cost
Inventory Management involves planning,
coordinating, and controlling the acquisition,
storage, handling, movement, distribution,
and possible sale of raw materials,
component parts and subassemblies,
supplies and tools, replacement parts, and
other assets that are needed to meet
customer wants and needs.

CHAPTER 12
Understanding Inventory
Raw materials, component parts,
subassemblies, and supplies are inputs to
manufacturing and service-delivery
processes.
Work-in-process (WIP) inventory consists
of partially finished products in various
stages of completion that are awaiting
further processing.
Finished goods inventory is completed
products ready for distribution or sale to
customers.
Safety stock inventory is an additional
amount of inventory that is kept over and

CHAPTER 12
Exhibit 12.1 Role of Inventory in the Value Chain

CHAPTER 12
Inventory Management Decisions and Costs

Inventory managers deal with two
fundamental decisions:
1. When to order items from a supplier or
when to initiate production runs if the firm
makes its own items.
2. How much to order or produce each time
a supplier or production order is placed.

CHAPTER 12
Inventory Management Decisions and Costs

Four categories of inventory costs:
1. Ordering or setup costs
2. Inventory-holding costs
3. Shortage costs
4. Unit cost of the stock-keeping units (SKUs)

CHAPTER 12
Inventory Management Decisions & Costs

Ordering costs or setup costs are
incurred as a result of the work involved
in placing purchase orders with suppliers
or configuring tools, equipment, and
machines within a factory to produce an
item.
Inventory-holding costs or inventorycarrying costs are the expenses
associated with carrying inventory.
10
CHAPTER 12
Inventory Management Decisions & Costs

Shortage costs or stockout costs are
the costs associated with a SKU being
unavailable when needed to meet
demand.
Unit cost is the price paid for purchased
goods or the internal cost of producing
them.

11
CHAPTER 12
Inventory Characteristics
Number of items: each item is identified
by a unique identifier, called a stockkeeping unit (SKU).
A stock-keeping unit (SKU) is a
single item or asset stored at a
particular location.

12
CHAPTER 12
Nature of Demand:
Independent demand is demand for an

SKU that is unrelated to the demand for other
SKUs and needs to be forecast.
Dependent demand is demand directly
related to the demand for other SKUs and can
be calculated without needing to be forecast.
Demand can either be constant
(deterministic) or uncertain (stochastic).
Static demand is stable demand.
Dynamic demand varies over time.
13
CHAPTER 12
Number and Duration of Time Periods:
Single period
Multiple time periods
Lead Time:
The lead time is the time between
placement of an order and its receipt.

14
CHAPTER 12
Stockouts:
A stockout is the inability to satisfy
demand for an item.
A backorder occurs when a customer is
willing to wait for an item.
A lost sale occurs when the customer is
unwilling to wait and purchases the item
elsewhere.

15
CHAPTER 12

16
CHAPTER 12
ABC Inventory Analysis

ABC inventory analysis categorizes SKUs into
three groups according to their total annual
dollar usage.
1. A items account for a large dollar value
but a relatively small percentage of total
items.
2. C items account for a small dollar value
but a large percentage of total items.
3. B items are between A and C.
17
CHAPTER 12
ABC Inventory (Pareto) Analysis

A items account for a large dollar value but
relatively small percentage of total items
(e.g., 10% to 30 % of items, yet 60% to 80%
of total dollar value).
C items account for a small dollar value but
a large percentage of total items (e.g., 50%
to 60% of items, yet about 5% to 15% of total
dollar value). These can be managed using
automated computer systems.
B items are between A and C.

18
CHAPTER 12
Solved Problem
The data shows projected
annual dollar usage for 20
items. Exhibit 12.3 shows
the data sorted, and
indicates that about 70% of
total dollar usage is
accounted for by the first 5
items.
Exhibit 12.2
Usage-Cost Data for
20 Inventoried Items

19
CHAPTER 12
Exhibit 12.3 ABC Analysis Calculations

20
CHAPTER 12
Exhibit 12.4 ABC Histogram for the Results from Exhibit 12.3

21
CHAPTER 12
Managing Fixed Quantity Inventory Systems

In a fixed quantity system (FQS), the
order quantity or lot size is fixed; the
same amount, Q, is ordered every time.
The fixed order (lot) size, Q, can be a
box, pallet, container, or truck load.
Q does not have to be economically
determined, as we will do for the EOQ
model later.

22
CHAPTER 12

The process of triggering an order is based
on the inventory position.
Inventory position (IP) is the on-hand
quantity (OH) plus any orders placed but
which have not arrived (scheduled
receipts, or SR), minus any backorders
(BO).
IP = OH + SR BO
[12.1]

23
CHAPTER 12

When inventory falls at or below a certain
value, r, called the reorder point, a new
order is placed.
The reorder point is the value of the
inventory position that triggers a new
order.

24
CHAPTER 12
Exhibit 12.5 Summary of Fixed Quantity System (FQS)

25
CHAPTER 12
Exhibit 12.6 Fixed Quantity System (FQS) under Stable Demand

26
CHAPTER 12
Exhibit 12.7 Fixed Quantity System (FQS) with Highly Variable Demand

27
CHAPTER 12
The EOQ Model

The Economic Order Quantity (EOQ)
model is a classic economic model
developed in the early 1900s that
minimizes total cost, which is the sum of
the inventory-holding cost and the
ordering cost.

28
CHAPTER 12
The EOQ Model

Assumptions:
Only a single item (SKU) is considered.
The entire order quantity (Q) arrives in the
inventory at one time.
Only two types of costs are relevant
order/setup and inventory holding costs.
No stockouts are allowed.
The demand for the item is deterministic
and continuous over time.
Lead time is constant.
29
CHAPTER 12
The EOQ Model

Cycle inventory (also called order or
lot size inventory) is inventory that
results from purchasing or producing in
larger lots than are needed for
immediate consumption or sale.
Average cycle inventory = (Maximum
inventory +
Minimum
inventory)/2
= Q/2
[12.2

30
CHAPTER 12
Exhibit 12.8 Cycle Inventory Pattern for the EOQ Model

31
CHAPTER 12
The EOQ Model

Inventory Holding Cost
The cost of storing one unit in inventory for
the year, Ch, is:
Ch = (I)(C)
[12.3]
Where:
I = Annual inventory-holding charge
expressed as a percent of unit cost.
C = Unit cost of the inventory item or SKU.

32
CHAPTER 12
The EOQ Model

Annual inventory-holding cost is computed
as:
)(
average annual holding

annual inventory
holding cost = inventory cost per unit
1
QCh
2

[12.4]
33
CHAPTER 12
The EOQ Model

Ordering Cost
If D = Annual demand and we order Q units
each time, then we place D/Q orders/year.
Annual ordering cost is computed as:
)(
) ()
cost
number of
annual
=
orders per year per order
ordering cost
D
Q
Co
[12.5]
Where C0 is the cost of placing one order.

34
CHAPTER 12
The EOQ Model

Total Annual Cost
Total annual cost is the sum of the inventory
holding cost plus the order or setup cost:
1
D
Co
TC = QCh +
Q
2
[12.6]

35
CHAPTER 12
The EOQ Model

Economic Order Quantity
The EOQ is the order quantity that
minimizes the total annual cost:
Q* =
2DCo
Ch
[12.7]

36
CHAPTER 12
The EOQ Model

Calculating the Reorder Point
The reorder point, r, depends on the lead
time and demand rate.
Multiply the fixed demand rate d by the
length of the lead time L (making sure they
are expressed in the same units, e.g., days
or months):
r = Lead time demand
= (demand rate)(lead time)
= (d)(L)
[12.8]

37
CHAPTER 12
Solved Problem
D = 24,000 cases per
year.
Co = $38.00 per order.
I = 18 percent.
C = $12.00 per case.
Ch = IC = $2.16.
24,000
1
TC = Q ($2.16) +
($38.00)
Q
2
EOQ =
2(24,000)(38) = 919 cases rounded

2.16
to a whole number.

38
CHAPTER 12
Exhibit 12.9 Chart of Holding, Ordering, and Total Costs

39
CHAPTER 12
Safety Stock and Uncertain Demand in a Fixed

Order Quantity System
When demand is uncertain, using EOQ
based on the average demand will result in
a high probability of a stockout.
Safety stock is additional planned onhand inventory that acts as a buffer to
reduce the risk of a stockout.
A service level is the desired probability
of not having a stockout during a lead-time
period.
40
CHAPTER 12

41
CHAPTER 12

When a normal probability distribution provides a
good approximation of lead time demand, the general
expression for reorder point is:
r = L + zL
[12.9]
Where:
L = Average demand during the lead time.
L = Standard deviation of demand during the lead
time.
z = The number of standard deviations necessary to
achieve the acceptable service level.
zL represents the amount of safety stock.
42
CHAPTER 12

We may not know the mean and standard deviation
of demand during the lead time, but only for some
other length of time, t, such as a month or year.
Suppose that t and t are the mean and standard
deviation of demand for some time interval t. If the
distributions of demand for all time intervals are
identical to and independent of each other, then:
L = tL
[12.10]
L = t L
[12.11]

43
CHAPTER 12
Solved Problem
Southern Office Supplies, Inc. distributes laser
printer paper.
Ordering costs are $45.00 per order.

One ream of paper costs $3.80.
Annual inventory-holding cost rate is 20%.
The average annual demand is 15,000 reams, or
about 15,000/52 = 288.5 per week.
The standard deviation of weekly demand is
about 71.
The lead time from the manufacturer is two
Inventory-holding
cost is Ch = IC = 0.20($3.80)
weeks.
= $0.76 per ream per year.

44
CHAPTER 12
Solved Problem
The average demand during the lead
time is (288.5)(2) = 577 reams.
The standard deviation of demand
during the lead time is approximately
712 = 100 reams.
The EOQ model results in an order
quantity of 1333, reorder point of 577,
and total annual cost of $1,012.92.

45
CHAPTER 12
Solved Problem
Desired service level of 95%, which results in a
stockout of roughly once every 2 years. For a
normal distribution, this corresponds to a
standard normal
z-value
r = of+1.645.
z = 577 = 1.645(100) = 742 reams
L
This policy increases the reorder point by 742

577 = 165 reams, which represents the safety
stock.
The cost of the additional safety stock is Ch times
the amount of safety stock, or ($0.76/ream)(165
reams) = $125.40.
46
CHAPTER 12
EOQ and Sustainability Practices

Commonly hidden in inventory management
decisions are the costs to dispose of obsolete,
hazardous materials.
Environmental considerations, material losses, and
waste disposal can be included in the EOQ model to
improve inventory decisions.
If a company examines its hazardous waste
disposals and observed that some percentage of its
material is eventually disposed of instead of used,
then the company should incorporate this into their
inventory decisions.
Example: Annual demand for paint is 4000 lbs., item
cost is $3/lb., order cost is $50, inventory-holding
cost rate is 10%, 5% of paint is not sold and

47
CHAPTER 12
EOQ and Sustainability Practices

Disposal costs, on a per unit basis, can be
comparable to the initial item costs.
For example, knowing that 5% of the paint is
disposed of, then the inventory-holding
should be calculated as:
Ch = [(10%)($3/lb. item cost)]
+ [(5% of paint disposed of)($1/lb. disposal
cost)]
= $0.35/lb./year
48
CHAPTER 12
Managing Fixed Period Inventory Systems

An alternative to a fixed order quantity system
is a fixed period system (FPS)sometimes
called a periodic review systemin which the
inventory position is checked only at fixed
intervals of time, T, rather than on a
continuous basis.
Two principal decisions in a FPS:
1. The time interval between reviews (T),
and
2. The replenishment level (M)

49
CHAPTER 12

Economic time interval:
T = Q*/D
[12.12]
Optimal replenishment level without safety

stock:
M = d (T + L)
[12.13]
Where:
d = Average demand per time period.
L = Lead time in the same time units.
M = Demand during the lead time plus review
period.
50
CHAPTER 12
Exhibit 12.10 Summary of Fixed Period Inventory Systems

51
CHAPTER 12
Exhibit 12.11 Operation of a Fixed Period Systems (FPS)

52
CHAPTER 12

Uncertain Demand
Compute safety stock over the period T +
L.
The replenishment level is computed as:
M = T+L + zT+L
[12.14]
T+L = t (T + L)
[12.15]
[12.16]
T+L = t T + L
53
CHAPTER 12
Single-Period Inventory Model

Applies to inventory situations in which
one order is placed for a good in
anticipation of a future selling season
where demand is uncertain.
At the end of the period, the product has
either sold out or there is a surplus of
unsold items to sell for a salvage value.
Sometimes called a newsvendor problem,
because newspaper sales are a typical
example.
54
CHAPTER 12
Single-Period Inventory Model

Solve using marginal economic analysis.
cs = The cost per item of overestimating
demand (salvage cost); this cost represents the
loss of ordering one additional item and finding
that it cannot be sold.
cu = The cost per item of underestimating
demand (shortage cost); this cost represents
the opportunity loss of not ordering one
additional item and finding that it could have
Thebeen
optimal
sold.order quantity Q* must satisfy:
cu
[12.17]
P (demand Q*) =
cu + cs
55
CHAPTER 12
Solved Problem
A buyer orders fashion swimwear about six
months before the summer season.
Each piece costs $40 and sells for $60.
At the sale price of $30, it is expected that any
remaining stock can be sold during the August
sale.
The cost per item of overestimating demand is
equal to the purchase cost per item minus the
August sale price per item: cs = $40 $30 =
$10.
The per-item cost of underestimating demand is
the difference between the regular selling price
per item and the purchase cost per item; that is,
cu = $60 $40 = $20.

56
CHAPTER 12
Solved Problem
Assume that a uniform probability distribution
ranging
from 350 to 650 items describes the demand.
Exhibit 12.12 Probability Distribution for Single Period Model

57
CHAPTER 12
Solved Problem
The optimal order size Q must satisfy:

P (demand Q*) = cu /(cu + cs)
= 20/(20+10) = 2/3
Because the demand distribution is uniform,
the value of Q* is two-thirds of the way from
350 to 650. This results in Q* = 550.

58
CHAPTER 12
Theres More to Inventory Modeling

Quantitative models have been developed for other
practical situations:
Backorder Models: It may be desirable from an

economic point of view to plan for and allow
shortages, such as when the value per unit of the
inventory is very high, and hence the inventoryholding cost is high (a new-car dealers inventory).
Most customers do not find the specific car they want
in stock, but are willing to backorder it.
Quantity Discount Models: Suppliers often offer
discounts for purchasing larger quantities of goods.
This often occurs because of economies of scale
associated with larger quantities or simply as an
incentive to increase total revenue.

59
CHAPTER 12
Hardy Hospital Case Study

1. What are good estimates of order cost and
inventory holding cost? (State all
assumptions and show all computations.)
2. What is the EOQ and reorder point for Strike
Disinfectant given your answer to Question 1?
3. Compute the total order and inventory
holding costs for a Fixed Quantity System
(FQS) and compare to their current order Q's.
Can you save money by adopting a FQS?
4. What are your final recommendations?
Clearly explain your reasoning.
60

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MANAGING INVENTORIES

DAVID A. COLLIER AND JAMES R. EVANS

OM3 Chapter 12 Managing Inventories

LO1 Explain the importance of inventory, types of

LO2 Describe the major characteristics that

LO3 Describe how to conduct an ABC inventory

LO4 Explain how a fixed order quantity inventory

LO5 Explain how a fixed period inventory system

LO6 Describe how to apply the single period

anana Republic is a unit of San Franciscos Gap,

Inc. and accounts for about 13 percent of Gaps

OM3 Chapter 12 Managing Inventories

What do you think?

Inventory is any asset held for future use or

OM3 Chapter 12 Managing Inventories

OM3 Chapter 12 Managing Inventories

Exhibit 12.1 Role of Inventory in the Value Chain

OM3 Chapter 12 Managing Inventories

Inventory Management Decisions and Costs

OM3 Chapter 12 Managing Inventories

Inventory Management Decisions and Costs

OM3 Chapter 12 Managing Inventories

Inventory Management Decisions & Costs

Inventory Management Decisions & Costs

OM3 Chapter 12 Managing Inventories

OM3 Chapter 12 Managing Inventories

Independent demand is demand for an

OM3 Chapter 12 Managing Inventories

OM3 Chapter 12 Managing Inventories

OM3 Chapter 12 Managing Inventories

ABC Inventory Analysis

ABC Inventory (Pareto) Analysis

OM3 Chapter 12 Managing Inventories

OM3 Chapter 12 Managing Inventories

Exhibit 12.3 ABC Analysis Calculations

OM3 Chapter 12 Managing Inventories

OM3 Chapter 12 Managing Inventories

Managing Fixed Quantity Inventory Systems

OM3 Chapter 12 Managing Inventories

Managing Fixed Quantity Inventory Systems

OM3 Chapter 12 Managing Inventories

Managing Fixed Quantity Inventory Systems

OM3 Chapter 12 Managing Inventories

Exhibit 12.5 Summary of Fixed Quantity System (FQS)

OM3 Chapter 12 Managing Inventories

Exhibit 12.6 Fixed Quantity System (FQS) under Stable Demand

OM3 Chapter 12 Managing Inventories

OM3 Chapter 12 Managing Inventories

The EOQ Model

OM3 Chapter 12 Managing Inventories

The EOQ Model

The EOQ Model

OM3 Chapter 12 Managing Inventories

Exhibit 12.8 Cycle Inventory Pattern for the EOQ Model

OM3 Chapter 12 Managing Inventories

The EOQ Model

OM3 Chapter 12 Managing Inventories

The EOQ Model

average annual holding

OM3 Chapter 12 Managing Inventories

The EOQ Model

Where C0 is the cost of placing one order.

The EOQ Model