Inventory Management

 Inventory meaning
 Independent demand VS Dependent demand
 Types of inventory
 Functions of inventory
 Objectives of inventory
 Requirements for effective inventory
management.
 Inventory model
 Basic EOQ model
 EPQ model
 Fixed Time period model
 Re-order model
 Single period model
Inventory
 Is the stock of any item or resources used in
an organization
 An inventory system is the set of policies and
controls that monitor levels of inventory and
determine
 what level should be maintained,
 when stock should be replenished and
 how large order should be.
 In mfg inventory refers to items that contribute
to or become part of a firm’s product output
 In service inventory refers to the tangible
goods to be sold and the supplies necessary to
administer the service
Inventory
Independent Demand
 a stock or store of goods

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
Independent vs dependent
 Independent demand – finished
goods, items that are ready to be
sold
 E.g. a computer
 Dependent demand – components
of finished products
 E.g. parts that make up the computer
Types of Inventories
 Raw materials & purchased parts
 Partially completed goods called
work in progress
 Finished-goods inventories
 (manufacturing firms)
or merchandise
(retail stores)
Types of Inventories
 Replacement parts, tools, &
supplies
 Goods-in-transit to warehouses or
customers
Functions of Inventory
 To meet anticipated demand
 To smooth production
requirements
 To decouple operations
 To protect against stock-outs
Functions of Inventory
(Cont’d)
 To take advantage of order cycles
 To hedge against price increases
 To permit operations
 To take advantage of quantity
discounts
Objective of Inventory
Control
 To achieve satisfactory levels of
customer service while keeping
inventory costs within reasonable
bounds
 Level of customer service
Costs of ordering and carrying inventory


Inventory turnover is the ratio of average

cost of goods sold to average inventory
investment.
Effective Inventory Management
 A system to keep track of inventory
 A reliable forecast of demand
 Knowledge of lead times
 Reasonable estimates of
 Holding costs
 Ordering costs
 Shortage costs
 A classification system
Inventory Counting
Systems
 Periodic System
Physical count of items made at
periodic intervals
 Perpetual Inventory System
System that keeps track
of removals from inventory
continuously, thus monitoring
current levels of each item
Inventory Counting
Systems
 Two-Bin System - Two containers
of inventory; reorder when the first
is empty
 Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached 0

214800 232087768
Key Inventory Terms
 Lead time: time interval between ordering
and receiving the order
 Holding (carrying) costs: cost to carry an
item in inventory for a length of time, usually a
year
 Ordering costs: costs of ordering and
receiving inventory
 Shortage costs: costs when demand
exceeds supply
ABC Classification System
Classifying inventory according to some measure
of importance and allocating control efforts
accordingly.
A - very important
B - mod. Important
C - least important High
A
Annual
$ value B
of items

Low C
Low High
Percentage of Items
Economic Order Quantity Models

 Economic order quantity (EOQ)

model
 The order size that minimizes total
annual cost
 Economic production model
 Quantity discount model
Assumptions of EOQ Model
 Only one product is involved
 Annual demand requirements known
 Demand is even throughout the year
 Lead time does not vary
 Each order is received in a single
delivery
 There are no quantity discounts
 The Inventory Cycle
Profile of Inventory Level Over Time
Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
 Total Cost

Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q
et differentiate TC with respect to Q. Setting the result =0, & solving Q
TC/dQ= d QH/2 +d DS/Q = H/2- DS/Q2
H/2- DS/Q2 = 0 or DS/Q2 = H/2 or Q2 H= 2DS or Q= √2DS/H
Note the second derivative is positive which indicates a minimum has been obtai
 Cost Minimization Goal

The Total-Cost Curve is U-Shaped

Q D
TC = H + S
Annual Cost

2 Q

Ordering Costs

QO (optimal order quantity)

 Deriving the EOQ
Using calculus, we take the derivative of
the total cost function and set the
derivative (slope) equal to zero and
solve for Q.

2DS 2(Annual Demand)(Order or Setup Cost)

Q OPT = =
H Annual Holding Cost
Minimum Total Cost
The total cost curve reaches its
minimum where the carrying and
ordering costs are equal.

Q = DS
H
2 Q
Economic Production
Quantity (EPQ)
 Production done in batches or lots
 Capacity to produce a part
exceeds the part’s usage or
demand rate
 Assumptions of EPQ are similar to
EOQ except orders are received
incrementally during production
Economic Run Size

2DS p
Q0 =
H p− u
Derivation of EPQ
 Annual carrying cost = I max* H/2 ,
 Imax= Q/P ( p - u) where p = production and u= usage
rate and
 Q/P is the run time or no of days.
 Annual carrying cost= QH(p-u)/2p
 Set up cost = DS/Q
 As we know the optimum size Q or EPQ occurs in the
trade off between carrying cost and order cost. In
other words when
 Carrying cost = Order cost.

 QH (p-u)/2p = DS/Q

 Q = √ 2DSp/H(p-u)
When to Reorder with EOQ
Ordering
 Reorder Point - When the quantity
on hand of an item drops to this
amount, the item is reordered
 Safety Stock - Stock that is held in
excess of expected demand due to
variable demand rate and/or lead
time.
 Service Level - Probability that
demand will not exceed supply
during lead time.
Determinants of the Reorder Point

 The rate of demand

 The lead time
 Demand and/or lead time
variability
 Stock out risk (safety stock)
 Safety Stock
Quantity

Maximum probable demand

during lead time

Expected demand
during lead time

ROP

Safety stock reduces risk of Safety stock

stockout during lead time LT Time
Reorder Point

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale
ROP
 For constant Demand & Lead Time
 ROP= d L
 d= Average daily demand
 L = Lead Time
ROP with safety stock
 When demand is uncertain ? Of saftey
stock comes
 Reorder point is ROP= d L+zσL
 d= Average daily demand
 L= Lead time
 Z= number of std deviation
 σL = Std deviation of usage during lead time
 zσL = amount of safety stock
 ROP with safety stock
 d = ∑d /n
i

 Standard deviation of daily demand is

 σd = √ ∑(di-d) 2/n

 σd refers to one day if lead time extends over

several days we can use statistical premises that the
std deviation of a series of independent occurrences
is equal to the square root of the sum of the
variances.ie
 σL = √ σ21+ σ22+ σ23+….+ σ2L
 To find out Z use formula NORMSINV() or see
Example
 Daily demand for a certain product is normally
distributed with a mean of 60 and standard
deviation of 7.The source of supply is reliable
and maintains a constant lead time of six
days.The cost of placing the order is $10 and
annual holding cost are $.50 per unit.There are
no stock out cost and unfilled orders are filled
as soon as order arrives.Assume sales occur
over the the entire 365 days of a year.Find the
order quantity and rop to satisfy a 95%
probability of not stocking out during lead
time.
Solution
 d=60
 S= $10
 H= $.50
 L=6
 D= 60*365
 σd = 7
 EOQ = √2DS/H = √2*60*365*10/.5= √876000= 936 units
 ROP= d L+zσL = 60*6 +1.64*17.15=388 units

 σL = √ σ21+ σ22+ σ23+….+ σ2L

 σL = √ 6*72 =17.15
Fixed-Order-Interval Model
 Orders are placed at fixed time intervals
 Fixed time period model generates order
quantities that vary from period to period,
depending on usage rate
 This generally requires higher safety stock
 FOIMQ = Average demand over the vulnerable
period+Safety Stock- Inventory currently on hand
 Q= d(T+L) + zσT+L -I
 T= Number of days b2n reviews, σT+L = std deviations of
demand over the review and lead time
FOIM
 Daily demand for a product is 10 units with a standard
deviation of 3 units.The review period is 30 days and lead time
is 14 days.Mgt has set a policy of satisfying 98 % demand
from items in stock.At the beginning of this review period
there are 150 units in inventory.How many units should be
ordered?

 Q= d(T+L) + zσT+L -I
 = 10(30+14) +2.05 √(T+L) σ2d –150
 =10*44+2.05 √(30+14)(3)2-150
 440+2.05*19.9-150=331 units
Fixed-Interval Benefits
 Tight control of inventory items
 Items from same supplier may
yield savings in:
 Ordering
 Packing
 Shipping costs
 May be practical when inventories
cannot be closely monitored
Fixed-Interval
Disadvantages
 Requires a larger safety stock
 Increases carrying cost
 Costs of periodic reviews
Single Period Model
 model for ordering of perishables
and other items with limited useful
lives
 Shortage cost: generally the
unrealized profits per unit
 Excess cost: difference between
purchase cost and salvage value of
items left over at the end of a
period
Single Period Model
 Continuous stocking levels
 Identifies optimal stocking levels
 Optimal stocking level balances unit
shortage and excess cost
 Discrete stocking levels
 Service levels are discrete rather than
continuous
 Desired service level is equaled or exceeded
Optimal Stocking Level
Cs Cs = Shortage cost per unit
Service level =
Cs + Ce Ce = Excess cost per unit
Ce Cs

Service Level

Quantity

So
Balance point
Example
 Ce = $0.20 per unit
 Cs = $0.60 per unit

 Service level = Cs/(Cs+Ce) =

Ce Cs
.6/(.6+.2)
 Service level = .75
Service Level = 75%

Quantity

Stockout risk = 1.00 – 0.75 = 0.25

Operations Strategy
 Too much inventory
 Tends to hide problems
 Easier to live with problems than to
eliminate them
 Costly to maintain
 Wise strategy
 Reduce lot sizes
 Reduce safety stock