12

Inventory
Management

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives
 Define the term inventory and list the major
reasons for holding inventories; and list the main
requirements for effective inventory management.
 Discuss the nature and importance of service
inventories
 Discuss periodic and perpetual review systems.
 Discuss the objectives of inventory management.
 Describe the A-B-C approach and explain how it
is useful.

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 Learning Objectives
 Describe the basic EOQ model and its
assumptions and solve typical problems.
 Describe the economic production quantity
model and solve typical problems.
 Describe the quantity discount model and
solve typical problems.
 Describe reorder point models and solve
typical problems.
 Describe situations in which the single-
period model would be appropriate, and
solve typical problems.
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 Inventory
Inventory: a stock or store of goods Independent Demand

A Dependent Demand

B(4) C(2)

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

Independent demand is uncertain.

Dependent demand is certain.
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 Inventory Models
 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

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 Types of Inventories
 Raw materials & purchased parts
 Partially completed goods called
work in progress
 Finished-goods inventories
 (manufacturing firms)
or merchandise
(retail stores)

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Types of Inventories (Cont’d)
 Replacement parts, tools, & supplies
 Goods-in-transit to warehouses or
customers

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 Functions of Inventory

 To meet anticipated demand

 To smooth production requirements
 To decouple operations
 To protect against stock-outs

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 Functions of Inventory (Cont’d)

 To take advantage of order cycles

 To help hedge against price increases
 To permit operations
 To take advantage of quantity
discounts

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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.
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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
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 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

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 Inventory Counting Systems
(Cont’d)
 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

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 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

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 ABC Classification System
Figure 12.1

Classifying inventory according to some

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

Low C
Low High
Percentage of Items
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 Cycle Counting

 A physical count of items in inventory

 Cycle counting management
 How much accuracy is needed?
 When should cycle counting be performed?
 Who should do it?

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Economic Order Quantity Models

 Economic order quantity (EOQ) model

 The order size that minimizes total annual
cost

 Economic production model

 Quantity discount model

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 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
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 The Inventory Cycle
Figure 12.2

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

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 Total Cost

Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q

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 Cost Minimization Goal
Figure 12.4C

The Total-Cost Curve is U-Shaped

QD


T
C
HS
Annual Cost

2Q

Ordering Costs

Order Quantity
QO (optimal order quantity)
(Q)

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 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.
2
DS 2
(Annual
)
(
Order
De
)
Q=
OPT =
H Annual H

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 Minimum Total Cost

The total cost curve reaches its

minimum where the carrying and
ordering costs are equal.

Q = DS
H
2 Q

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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

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 Economic Production Quantity
Assumptions
 Only one item is involved
 Annual demand is known
 Usage rate is constant
 Usage occurs continually
 Production rate is constant
 Lead time does not vary
 No quantity discounts

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 Economic Run Size

2DS p
Q0 
H p u

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Total Costs with Purchasing Cost

Annual Annual Purchasing

+
TC = carrying + ordering cost
cost cost

Q + DS + PD
TC = H
2 Q

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 Total Costs with PD
Figure 12.7
Cost

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without PD

PD

0 EOQ Quantity

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 Total Cost with Constant Carrying
Figure 12.9 Costs

TCa
Total Cost

TCb
Decreasing
TCc Price

CC a,b,c

OC

EOQ Quantity

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 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.

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 Determinants of the Reorder
Point
 The rate of demand
 The lead time
 Demand and/or lead time variability
 Stockout risk (safety stock)

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 Safety Stock
Figure 12.12
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

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 Reorder Point
Figure 12.13

The ROP based on a normal

Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale

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 Fixed-Order-Interval Model

 Orders are placed at fixed time intervals

 Order quantity for next interval?
 Suppliers might encourage fixed
intervals
 May require only periodic checks of
inventory levels
 Risk of stockout
 Fill rate – the percentage of demand
filled by the stock on hand
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 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

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 Fixed-Interval Disadvantages

 Requires a larger safety stock

 Increases carrying cost
 Costs of periodic reviews

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 Single Period Model

 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

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 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
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 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

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 Example 15
 Ce = $0.20 per unit
 Cs = $0.60 per unit
 Service level = Cs/(Cs+Ce) = .6/(.6+.2)
 Service level = .75
Ce Cs

Service Level = 75%

Quantity

Stockout risk = 1.00 – 0.75 = 0.25

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 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

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