CHAPTER 5 – INVENTORY MANAGEMENT

Dung H. Nguyen
Faculty of International Economic Relations
University of Economics and Law

‹#› Het begint met een idee

CONTENTS

 Definition, Types, Purposes

 Inventory costs
 Inventory models
 Inventory issues

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DEFINITION AND TYPES OF INVENTORY

 Inventory is supplies of goods and materials (incl. raw materials, work

in progress, and finished goods) that are held by an organization.
 Types of inventory
o Cycle stock
o Safety stock
o In-transit stock
o Speculative stock

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PURPOSES OF INVENTORY

 Be a buffer between different parts of the supply chain

 Allow for demands that are larger than expected or unexpected
 Allow for deliveries that are delayed
 Take advantage of price discounts on large orders
 Allow the purchase of items when the price is low
 Allow the purchase of scarce items
 Allow for seasonal operations
 Make full loads and reduce transport costs
 Cover for emergencies
 Be profitable when inflation is high
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INVENTORY COSTS

 Carrying (holding) costs

o Obsolescence costs
o Inventory shrinkage
o Storage costs
o Handling costs
o Insurance, tax, interest
 Ordering costs
 Stock-out (shortage) costs

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INVENTORY MODELS

 Single-period models: based on one-time purchasing decision

 Fixed-order quantity models (continuous system): inventory is
continuously tracked and an order is placed when the inventory
declines to a reorder point
 Fixed-time period models (periodic system): inventory is checked at
regular periodic intervals and an order is placed to raise the
inventory level to a specified threshold

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FIXED-ORDER QUANTITY MODEL – EOQ MODEL

Assumptions
 A continuous, constant, and known rate of demand
 A constant and known lead time
 A constant purchase price, independent of the order quantity
 All demand is satisfied
 Inventory holding cost is based on average inventory
 A constant ordering cost

 Determine order quantity that the total cost (incl. purchase cost,
ordering cost, holding cost) is minimized
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FIXED-ORDER QUANTITY MODEL – EOQ MODEL

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EOQ MODEL - EXAMPLE

Demand for a smartphone at a store is 75 units per month. The store

incurs a fixed order cost of $700 each time an order is placed. Each
smartphone costs the store $800 and the store has an annual holding
cost of 20 percent per unit. What is the optimal order size in each
replenishment?

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LOT SIZING WITH MULTIPLE PRODUCTS/CUSTOMERS

1. Lots are ordered and delivered independently for each product

2. Lots are ordered and delivered jointly for all k models
3. Lots are ordered and delivered jointly for a selected subset of the
products

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LOTS ARE ORDERED AND DELIVERED INDEPENDENTLY

Annual demands for the three products are DL = 12,000 units, DM =

1,200 units, and DH = 120 units. Each model costs $500. A fixed
transportation cost of $4,000 is incurred each time an order is
delivered. For each model ordered and delivered on the same truck, an
additional fixed cost of $1,000 per model is incurred for receiving and
storage. Holding cost: 20 percent. Calculate the annual cost.

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LOTS ARE ORDERED AND DELIVERED INDEPENDENTLY

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LOTS ARE ORDERED AND DELIVERED INDEPENDENTLY

Litepro Medpro Heavypro

Demand per year 12,000 1,200 120
Fixed cost/order $5,000 $5,000 $5,000
Optimal order size 1,095 346 110
Cycle inventory 548 173 55
Annual holding cost $54,772 $17,321 $5,477
Order frequency 11.0/year 3.5/year 1.1/year
Annual ordering cost $54,772 $17,321 $5,477
Average flow time 2.4 weeks 7.5 weeks 23.7 weeks
Annual cost $109,544 $34,642 $10,954

Total cost: $155,140

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LOTS ARE ORDERED AND DELIVERED JOINTLY

A decision to aggregate and order all three models each time an order
is placed. Calculate the optimal lot size for each model and the annual
cost.

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LOTS ARE ORDERED AND DELIVERED JOINTLY

∗
∗

∗ ∗

∗ ∗ ∗

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LOTS ARE ORDERED AND DELIVERED JOINTLY

Litepro Medpro Heavypro

Demand per year (D) 12,000 1,200 120
Order frequency (n ) 9.75/year 9.75/year 9.75/year
Optimal order size (D/n ) 1,230 123 12.3
Cycle inventory 615 61.5 6.15
Annual holding cost $61,512 $6,151 $615
Average flow time 2.67 weeks 2.67 weeks 2.67 weeks

Total cost: $136,558

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LOTS ARE ORDERED AND DELIVERED JOINTLY FOR A SELECTED SUBSET OF THE PRODUCTS

A decision to order jointly, but to be selective about which models they

include in each order. Evaluate the ordering policy and costs.

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LOTS ARE ORDERED AND DELIVERED JOINTLY FOR A SELECTED SUBSET OF THE PRODUCTS

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LOTS ARE ORDERED AND DELIVERED JOINTLY FOR A SELECTED SUBSET OF THE PRODUCTS

Litepro Medpro Heavypro

Demand per year (D) 12,000 1,200 120
Order frequency (n ) 11.47/year 5.74/year 2.29/year
Optimal order size (D/n ) 1,046 209 52
Cycle inventory 523 104.5 26
Annual holding cost $52,307 $10,461 $2,615
Average flow time 2.27 weeks 4.53 weeks 11.35 weeks

Total cost: $130,767

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EPQ MODEL

Assumptions
 Only one product involved
 Annual demand is known
 The usage rate is constant
 Usage occurs continually
 Production occurs periodically
 The production rate is constant
 Lead time is known and constant
 There are no quality discounts

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EPQ MODEL

Slope =
Slope =
Production rate p Slope= - usage rate u
Production rate p
– usage rate u

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EPQ MODEL

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EPQ MODEL - EXAMPLE

A toy manufacturer uses 48,000 rubber wheels per year for its
popular toy car series. The firm makes its own wheels, which it can
produce at a rate 800 wheels per day. The toy cars are assembled
uniformly over entire year. Holding cost is $1 per wheel a year. Setup
costs for a production run of wheels is $45. The firm operates 240
days per year.
What is the optimal run size?

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LITTLE’S LAW

The average amount of inventory in a system is proportional to the

time it takes for inventory to flow through the system

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 REORDER POINT

1. Receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
2. Start using them L L
up over time. 3. When inventory reaches
Time down to a level of R, place
the next Q sized order.

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SAFETY STOCK

The amount of inventory carried in addition to the expected demand

to reduce risk of stock-out during lead time
Quantity

Expected demand
during lead time

ROP

Safety stock

LT Time
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SERVICE LEVEL

The probability of not having a stock-out in a replenishment cycle

Service level
Risk of
Probability of a stock-out
no stockout

Expected ROP Quantity

demand Safety
stock
0 z z-scale

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SAFETY STOCK

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STANDARD NORMAL DISTRIBUTION

Z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767

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EXERCISE

Weekly demand for coke at a supermarket is normally distributed,

with a mean of 1,500 bottles and a standard deviation of 300. The
replenishment lead time is two weeks. Assuming that a continuous
review policy is used, please calculate the safety stock that the
supermarket should carry to achieve a service level of 90 percent.
What is the reorder point?

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EXERCISE

Daily demand for computers at a shop is normally distributed, with a

mean of 500 and a standard deviation of 30. The computer supplier
takes an average of seven days to replenish inventory at the shop.
The shop’s manager wants a cycle service level of 90 percent.
Determine the safety inventory of computers if the standard
deviation of the lead time is two days.

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FIXED-TIME PERIOD MODEL

Weekly demand for coke at a supermarket is normally distributed, with a mean

of 1,500 bottles and a standard deviation of 300. The replenishment lead time
is two weeks. Assuming that an inventory review of every three weeks is
conducted, please calculate the safety stock that the supermarket should carry
to achieve a service level of 90 percent. What is the order-up-to level?
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SINGLE-PERIOD MODEL

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EXERCISE

A school organize a tournament game this month. Based on the past

experience the tournament organizer sells on average 1,500 T-shirts
with a standard deviation of 200. We make $10 on every shirt we sell
at the game, but lose $5 on every shirt not sold. How many shirts
should we make for the game?

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ABC ANALYSIS OF INVENTORY

ABC inventory classification is to classify items into groups to

establish the appropriate control over each item.
 A items: 20% of items (making up 80% of annual dollar usage)
 B items: 40% of items (making up 15% of annual dollar usage)
 C items: 40% of items (making up 5% of annual dollar usage)

High

A
Annual
$ value
of items
B

Low C
Low High
Percentage of Items
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ABC INVENTORY CLASSIFICATION

Annual Unit Cost Annual $ Usage

Part Number Annual $ Usage
Unit Usage ($) (%)
1 1,100 2 2,200 6%
2 600 40 24,000 63%
3 100 4 400 1%
4 1,300 1 1,300 3%
5 100 60 6,000 16%
6 10 25 250 1%
7 100 2 200 1%
8 1,500 2 3,000 8%
9 200 2 400 1%
10 500 1 500 1%
38,250

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ABC INVENTORY CLASSIFICATION

Part Annual $ Cummulative $ Cummulative % Cummulative %

Annual $ Usage
Number Usage (%) Usage $ Usage of Items
2 24,000 63% 24,000 63% 10%
5 6,000 16% 30,000 78% 20%
8 3,000 8% 33,000 86% 30%
1 2,200 6% 35,200 92% 40%
4 1,300 3% 36,500 95% 50%
10 500 1% 37,000 97% 60%
3 400 1% 37,400 98% 70%
9 400 1% 37,800 99% 80%
6 250 1% 38,050 99% 90%
7 200 1% 38,250 100% 100%

Percentage Percentage of Value per

Classification
of Items $ Usage Class
A 20% 78% 30,000
B 40% 18% 7,000
C 40% 3% 1,250
Total 100% 100%
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INVENTORY TURNOVER

The number of times that inventory is sold in a one-year period

The higher ratio  the better performance!

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SAFETY STOCK IN CENTRALIZED VS DECENTRALIZED SYSTEMS

DECENTRALIZED OPTION

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SAFETY STOCK IN CENTRALIZED VS DECENTRALIZED SYSTEMS

CENTRALIZED OPTION

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SAFETY STOCK IN CENTRALIZED VS DECENTRALIZED SYSTEMS

CENTRALIZED OPTION (a special case)

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EXERCISE

A car dealership has four outlets serving the entire and large province.
Weekly demand at each outlet is normally distributed, with a mean of 25
cars and a standard deviation of 5. The lead time for replenishment from
the manufacturer is 2 weeks. Each outlet covers a separate geographic area,
and the demand across any pair of areas is independent. The dealership is
considering the possibility of replacing the four outlets with a single large
outlet. Assume that the demand in the central outlet is the sum of the
demand across all four areas. The dealership is targeting a service level of
0.90. Compare the level of safety inventory needed in the two options.

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RISK POOLING

Centralized option (aggregation) reduces the required safety

inventory — as long as the demand being aggregated is not perfectly
positively correlated (ρ=1).

Risk pooling: Demand variability is reduced if demand is aggregated

across locations  safety stock is reduced.

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 CHAPTER 5 – INVENTORY MANAGEMENT

THANK YOU!

‹#› Het begint met een idee