Inventory Management [EOQ & EBQ]

Part 1
RSB
 Inventory Management
 Types of Inventory
 Relevant Inventory Costs
 Some Concepts and Terminologies in Inventory Management
 EOQ Model
 INVENTORY AND INVENTORY MANAGEMENT

 Concept of Inventory
 A stock of materials used to satisfy customer demand or to support the
production of services or goods

 Inventory Management
 The planning and controlling of inventories in order to meet the
competitive priorities of the organization
 INVENTORY AND INVENTORY MANAGEMENT

 Purpose of Inventories
 To protect against uncertainties: In inventory systems, there are
uncertainties in supply, demand, and lead time.
 Safety stocks are maintained in inventory to protect against those
uncertainties.
 To allow economic production and purchase: It is often economical to
produce or procure materials in lots
 INVENTORY AND INVENTORY MANAGEMENT

 Purpose of Inventories

 To cover anticipated changes in demand or supply: Examples include

cases where the price or availability of raw materials is expected to
change.

 Companies often stockpile steel based on the rolling plans of steel mills.
 INVENTORY AND INVENTORY MANAGEMENT

 Purpose of Inventories

 Another source of anticipation is a planned market promotion where a

large amount of finished goods may be stocked prior to a sale.

 Companies in seasonal businesses (e.g., air conditioners and

refrigerators) often hold inventories to smooth production
 INVENTORY AND INVENTORY MANAGEMENT

 Purpose of Inventories
 To provide for transit: Transit inventories consist of materials that are
on their way from one point to another in the supply chain.
 These inventories are affected by plant location decisions and by the
choice of carrier.
 Sometimes the inventory in transit is called pipeline inventory because
it is in the “distribution pipeline.”
 TYPES OF INVENTORY

Inventory exists in three aggregate categories that are useful for

accounting purposes :

Raw Materials (RM)

Inventories needed for the production of services or goods
 TYPES OF INVENTORY

Work-in-process (WIP)
Consists of items such as, components or assemblies needed to
produce a final product in manufacturing

Finished goods (FG)

The items in manufacturing plants, warehouses, and retail outlets
that are sold to the firm’s customers
 TYPES OF INVENTORY

Another perspective of inventory classification is “how it is created”

In this context, inventories are categorised into four forms, namely:
(1) cycle inventory , (2) safety stock, (3) anticipation inventory, and (4)
pipeline inventory

Cycle Inventory
The portion of total inventory that varies directly with lot size
 TYPES OF INVENTORY

Safety Stock Inventory

Surplus inventory that a company holds to protect against
uncertainties in demand, lead time, and supply changes

Anticipation Inventory
Inventory used to absorb uneven rates of demand or supply

Pipeline Inventory
Inventory that is created when an order for an item is issued
but not yet received
 RELEVANT INVENTORY COSTS

Holding or Carrying Costs

Ordering Costs

Receiving and Inspections Costs

Shortage Costs

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 RELEVANT INVENTORY COSTS

Holding or Carrying Costs

The sum of the cost of capital and the variable costs of keeping items on
hand for a period of time, such as storage and handling, taxes,
insurance, and shrinkage
The holding cost is typically charged as a percentage of rupee value per
unit of time.
In practice, holding costs typically range from 15 to 30 per cent per year
Usually consists of three components

18-13
 RELEVANT INVENTORY COSTS

Cost of capital:
When items are carried in inventory, the capital invested is not available
for other purposes.
This represents a cost of foregone opportunities for other investments,
which is assigned to inventory as an opportunity cost.

18-14
 RELEVANT INVENTORY COSTS

Cost of storage:
This cost includes variable space cost, insurance, and taxes.
 In some cases, a part of the storage cost is fixed, for example, when a
warehouse is owned and cannot be used for other purposes. Such fixed
costs should not be included in the cost of inventory storage.
Likewise, taxes, and insurance should be included only if they vary with the
inventory level.

18-15
 RELEVANT INVENTORY COSTS

Costs of obsolescence, deterioration, and loss:

Obsolescence costs should be assigned to items that have a high risk of
becoming obsolete; the higher the risk, the higher the costs.
Perishable products should be charged with deterioration costs when the
item deteriorates over time, for example, food and blood.
Pharmaceutical products have an expiration date printed on them and
become obsolete at that time.
The cost of loss include pilferage and breakage costs associated with
holding items in inventory.

18-16
 RELEVANT INVENTORY COSTS

Ordering (or Setup) Costs

The cost of preparing a purchase order for a supplier or a production order for
manufacturing.
Ordering cost does not depend on the number of items ordered; it is assigned
to the entire batch.
This cost includes the cost of preparing the purchase order, expediting the
order, transportation costs, receiving costs, and so on.

18-17
 RELEVANT INVENTORY COSTS
Ordering (or Setup) Costs
When the item is produced within the firm, there are also costs associated
with placing an order that are independent of the number of items produced.
These so-called setup costs include paperwork costs plus the costs required to
set up the production equipment for a run.

18-18
 RELEVANT INVENTORY COSTS

Receiving and Inspections Costs

The cost associated with receiving the items and checking the lots

Shortage Costs
If an organization runs out of stock for an item and there is demand from a
customer, then there is a shortage that has an associated cost

18-19
SOME CONCEPTS AND TERMINOLOGIES IN INVENTORY MANAGEMENT

Stock-out
An order that cannot be satisfied, resulting in a loss of the sale

Backorder
A customer order that cannot be filled when promised or demanded but is filled
later

Quantity Discount
A drop in the price per unit when an order is sufficiently large
 SOME CONCEPTS AND TERMINOLOGIES IN INVENTORY MANAGEMENT

Lot Sizing
The determination of how frequently and in what quantity to order inventory

Safety Stock
Safety stocks are desirable when suppliers fail to deliver either the desired
quantity on the specified date or items of acceptable quality, or when
manufactured items require significant amounts of scrap or rework
Safety stock inventory ensures that operations are not disrupted when such
problems occur, allowing subsequent operations to continue
 INVENTORY MANAGEMENT QUESTIONS

What should be the order quantity (Q)?

When should an order be placed (ROP)?

How much safety stock (SS) should be maintained?

 DIFFERENT INVENTORY MODELS

Economic Order Quantity (EOQ)

Finite Replenishment Rate – Simultaneous Occurrence of Production and

Consumption
Demand Uncertainty - Safety Stocks
Inventory Control Systems
Continuous-Review (Q model)
Periodic-Review (P or Order-up-to Model)
 INVENTORY LEVELS FOR EOQ MODEL

 The lot size that minimizes total annual inventory holding and ordering costs
 ASSUMPTIONS FOR EOQ MODEL

 The demand rate for the item is constant (for example, always 10 units per
day) and known with certainty

 No constraints are placed (such as truck capacity or materials handling

limitations) on the size of each lot

 The only two relevant costs are the inventory holding cost and the fixed
cost per lot for ordering or setup
 ASSUMPTIONS FOR EOQ MODEL

 Decisions for one item can be made independent of decisions for other items
 In other words, no advantage is gained in combining several orders going to
the same supplier

 The lead time is constant (e.g., always 14 days) and known with certainty (The
amount received is exactly what was ordered and it arrives all at once rather
than in a piecemeal manner)
 ASSUMPTIONS FOR EOQ MODEL

 No stock-outs are allowed. Since demand and lead time are constant, one
can determine exactly when to order material to avoid stock-outs.

 The unit item cost is constant.

 The carrying cost depends linearly on the average inventory level.

 The ordering cost for each lot is independent of the number of items in the
lot.
ANNUAL COSTS FOR EOQ MODEL
 EOQ FORMULA
Notations:
D = demand in units per year
H= holding cost in dollars/unit/year
S = cost of placing an order in dollars
Q = order quantity in units

Total Annual Cost for Purchase Lots = TC = S*(D/Q) + H*(Q/2)

𝒅(𝑻𝑪) 𝑫 𝟏
=> =− *S + *H
𝒅𝑸 𝑸𝟐 𝟐
𝑫 𝟏
=> 0 = − *S + *H
𝑸𝟐 𝟐
(For minimization, first order derivate is 0)
Rearranging we get,
𝟐∗𝑫∗𝑺
EOQ (Q) =
𝑯
 PROBLEM ON INVENTORY MANAGEMENT ‒ EOQ

A museum of natural history opened a gift shop two years ago where
managing inventories has become a problem
Low inventory turnover is squeezing profit margins and causing cash-flow
problems
One of the top-selling stock-keeping units (SKUs) in the container group at
the museum’s gift shop is a bird feeder
Sales are 18 units per week, and the supplier charges $60 per unit
The cost of placing an order with the supplier is $45
 PROBLEM ON INVENTORY MANAGEMENT ‒ EOQ
Annual holding cost is 25 percent of a feeder’s value, and the museum
operates 52 weeks per year
Management chose a 390-unit lot size so that new orders could be placed
less frequently
Questions to be answered:
What is the annual cycle-inventory cost of the current policy of using a 390-
unit lot size?
Would a lot size of 468 be better?
Calculate the EOQ and its total annual cycle-inventory cost
 PROBLEM ON INVENTORY MANAGEMENT ‒ EOQ

Solution:
D =(18 units/week) (52 weeks/year) = 936 units/year
H = 0.25($60/unit)= $15/unit/year
The total annual cycle-inventory cost for the current policy is
𝑸 𝑫 𝟑𝟗𝟎 𝟗𝟑𝟔
C= (H)+ (S) = (15)+ (45) = 3033
𝟐 𝑸 𝟐 𝟑𝟗𝟎
The total annual cycle-inventory cost for the alternative lot size is
𝑸 𝑫 𝟒𝟔𝟖 𝟗𝟑𝟔
C= (H)+ (S) = (15)+ (45) = 3600
𝟐 𝑸 𝟐 𝟒𝟔𝟖
 PROBLEM ON INVENTORY MANAGEMENT ‒ EOQ

Solution:
Decision Point
The lot size of 468 units, which is a half-year supply, would be a more expensive
option than the current policy
The savings in ordering costs are more than offset by the increase in holding
costs. Management should use the total annual cycle-inventory cost function to
explore other lot-size alternatives

𝟐𝑫𝑺 𝟐∗𝟗𝟑𝟔∗𝟒𝟓
 EOQ = = = 74.94 Units =75 Units
𝑯 𝟏𝟓
 GUIDELINES ON WHEN TO USE OR MODIFY THE EOQ

 Do not use the EOQ

 If you use “make-to-order” strategy and your customer specifies that the
entire order should be delivered in one shipment

 If the order size is constrained by capacity limitations (e.g., number of

delivery trucks and so on.)
 GUIDELINES ON WHEN TO USE OR MODIFY THE EOQ

 Modify the EOQ

 If significant quantity discounts are given for ordering larger lots

 If replenishment of the inventory is not instantaneous, which can happen if

the items must be used or sold as soon as they are finished without waiting
until the entire lot has been completed
 GUIDELINES ON WHEN TO USE OR MODIFY THE EOQ

 Use the EOQ

 If you follow a “make-to-stock” strategy and the item has

relatively stable demand

 If your carrying costs per unit and setup (or ordering) costs are
known and relatively stable
 EOQ Without The Instantaneous Receipt Assumption
• When inventory accumulates over time, the instantaneous receipt
assumption does not apply
• Daily demand rate must be taken into account
• The revised model is often called the production run model

Inventory Part of Inventory Cycle There is No Production

Level During Which Production is During This Part of the
Taking Place Inventory Cycle
Maximum
Inventory

t Time
 Annual Carrying Cost for Production Run Model
• In production runs, setup cost replaces ordering cost
• The model uses the following variables

Q  number of pieces per order, or

production run
Cs  setup cost
Ch  holding or carrying cost per unit per
year
p  daily production rate
d  daily demand rate
t  length of production run in days
D = Annual demand
 Annual Carrying Cost for Production Run Model
Maximum inventory level
 (Total produced during the production run) – (Total used during the production run)

 (Daily production rate) x (Number of days of production) – (Daily demand) x

(Number of days of production)
 (pt) – (dt)
since Total produced  Q  pt
Q
we know t
p
Maximum Q Q  d
inventory  pt  dt  p  d  Q 1 
level p p  p
Annual Carrying Cost for Production Run Model

• Since the average inventory is one-half the maximum

Q d 
Average inventory   1 
2 p

and

Q d 
Annual holding cost   1 C h
2 p
 Annual Setup Cost for Production Run Model

• Setup cost replaces ordering cost when a product is produced over time

D
Annual setup cost  C s
Q

and
D
Annual ordering cost  C o
Q
 Determining the Optimal Production Quantity

• By setting setup costs equal to holding costs, we can solve for the optimal order quantity

Annual holding cost  Annual setup cost

Q d  D
 1 C h  C s
2 p Q

 Solving for Q, we get

2 DC s
Q* 
 d
C h  1 
 p
 Production Run Model

 Summary of equations

Q d 
Annual holding cost   1 C h
2 p

D
Annual setup cost  C s
Q

2 DC s
Optimal production quantity Q * 
 d
C h  1 
 p
 Brown Manufacturing Example

• Brown Manufacturing produces commercial refrigeration units in batches

Annual demand  D  10,000 units

Setup cost  Cs  $100
Carrying cost  Ch  $0.50 per unit per year
Daily production rate  p  80 units daily
Daily demand rate  d  60 units daily
 Brown Manufacturing Example

2 DC s Q
1. Q 
*
Production cycle 
 d p
C h  1 
 p 4,000
  50 days
80
2  10,000  100
2. Q 
*

 60 
0.5 1  
 80 
2,000,000
  16,000,000
 
0.5 1
4
 4,000 units
Brown Manufacturing Example
Brown Manufacturing Example