Chapter 10

Inventory
Management
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 Inventory
 Stock of items held to meet
future demand
 Inventory management answers
two questions
 How much to order
 When to order

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 Types of Inventory
 Raw materials
 Purchased parts and supplies
 Labor
 In-process (partially completed) products
 Component parts
 Working capital
 Tools, machinery, and equipment

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 Reasons to Hold
Inventory
 Meet unexpected demand
 Smooth seasonal or cyclical demand
 Meet variations in customer demand
 Take advantage of
price discounts
 Hedge against price
increases
 Quantity discounts
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Two Forms of Demand
 Dependent
 Items used to produce final products

 Independent
 Items demanded by external customers

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 Inventory Costs
 Carrying Cost
 Cost of holding an item in inventory
 Ordering Cost
 Cost of replenishing inventory
 Shortage Cost
 Temporary or permanent loss of
sales when demand cannot be met

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 Inventory Control
Systems
 Continuous system (fixed-order-
quantity)
 Constant amount ordered when
inventory declines to predetermined
level
 Periodic system (fixed-time-period)
 Order placed for variable amount
after fixed passage of time
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 ABC Classification
System
 Demand volume and value of items vary
 Classify inventory into 3 categories,
typically on the basis of the dollar value
to the firm
PERCENTAGE PERCENTAGE
CLASS OF UNITS OF DOLLARS
A 5 - 15 70 - 80
B 30 15
C 50 - 60 5 - 10

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 ABC Classification
PART UNIT COST ANNUAL USAGE
1 $ 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120
Example 10.1

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 ABC Classification
TOTAL % OF TOTAL % OF TOTAL
PART PART
VALUE UNIT
VALUECOSTQUANTITY
ANNUAL USAGE
% CUMMULATIVE
9 1
$30,600 $ 60
35.9 6.0 90 6.0
8 16,000
2 18.7
350 5.0 40 11.0
2 14,000 16.4 4.0 15.0
3 30 130
1 5,400 6.3 9.0 24.0
4 4
4,800 5.680 6.0 60 30.0
3 5
3,900 4.630 10.0 100 40.0
6 6
3,600 4.220 18.0 180 58.0
5 3,000
7 3.510 13.0 170 71.0
10 2,400 2.8 12.0 83.0
8 320 50
7 1,700 2.0 17.0 100.0
9 510 60
$85,400
10 20 120
Example 10.1

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 ABC Classification
TOTAL % OF TOTAL % OF TOTAL
PART PART
VALUE UNIT
VALUECOSTQUANTITY
ANNUAL USAGE
% CUMMULATIVE
9 1
$30,600 $ 60
35.9 6.0 90 6.0
8 16,000
2 18.7
350 5.0 A
40 11.0
2 14,000 16.4 4.0 15.0
3 30 130
1 5,400 6.3 9.0 24.0
4 4
4,800 5.680 6.0 60 30.0
B
3 5
3,900 4.630 10.0 100 40.0
6 6
3,600 4.220 18.0 180 58.0
5 3,000
7 3.510 13.0 170 71.0
10 2,400
8 2.8
320 12.0 C
50 83.0
7 1,700 2.0 17.0 100.0
9 510 60
$85,400
10 20 120
Example 10.1

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 ABC Classification
TOTAL % OF TOTAL % OF TOTAL
PART PART
VALUE UNIT
VALUECOSTQUANTITY
ANNUAL USAGE
% CUMMULATIVE
1
9 $30,600 $ 60
35.9 6.0 90 6.0
8 16,000
2 18.7
350 5.0 A
40 11.0
2 14,000 16.4 % OF TOTAL4.0 15.0
% OF TOTAL
3 30 130
1 CLASS
5,400 ITEMS6.3 VALUE9.0 24.0
QUANTITY
4 4
4,800 5.680 6.0 60
A3,900 9, 8, 2 4.630 71.010.0
B 15.030.0
3 5 100 40.0
6 B3,600
6 1, 4, 3 4.220 16.518.0 180 25.058.0
5 C3,000 6, 5, 10,
3.5710 12.513.0 60.071.0
7 170
10 2,400
8 2.8
320 12.0 C
50 83.0
7 1,700 2.0 17.0 100.0
9 510 60
$85,400
10 20 120
Example 10.1

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 ABC Classification
100 – C
B
80 –
% of Value

60 –
A
40 –

20 –

0 |– | | | | |
0 20 40 60 80 100
% of Quantity
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 Assumptions of Basic
EOQ Model
 Demand is known with certainty
and is constant over time
 No shortages are allowed
 Lead time for the receipt of orders
is constant
 The order quantity is received all
at once

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 The Inventory Order Cycle
Order quantity, Q
Inventory Level

Reorder point, R

0 Time

Figure 10.1
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 The Inventory Order Cycle
Order quantity, Q
Demand
rate
Inventory Level

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
placed receipt placed receipt
Figure 10.1
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 EOQ Cost Model
Co - cost of placing order D - annual demand
Cc - annual per-unit carrying cost Q - order quantity

Co D
Annual ordering cost =
Q
CcQ
Annual carrying cost =
2
CoD CcQ
Total cost = +
Q 2

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 EOQ Cost Model
CDeriving
o - cost ofQplacing order D - annual
Proving demand
equality of
opt
Cc - annual per-unit carrying cost costs at optimal
Q - order point
quantity
CoD CcQ
TC = +
Q 2 CoD CcQ
Annual ordering cost = =
TC C o D C c
Q 2
= +
Q Q2 2 CcQ 2CoD
Annual carrying cost = Q2 =
C0D Cc 2 Cc
0= +
Q2 2 CoD CcQ
Total cost = + 2CoD
2CoD Q 2Q =
opt Cc
Qopt =
Cc

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 EOQ Cost Model
Annual
cost ($)

Order Quantity, Q

Figure 10.2
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 EOQ Cost Model
Annual
cost ($)

CoD
Ordering Cost = Q

Order Quantity, Q

Figure 10.2
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 EOQ Cost Model
Annual
cost ($)

CcQ
Carrying Cost =
2

CoD
Ordering Cost = Q

Order Quantity, Q

Figure 10.2
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 EOQ Cost Model
Annual
cost ($) Total Cost
Slope = 0
CcQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost = Q

Optimal order Order Quantity, Q

Qopt
Figure 10.2
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 EOQ Example
Cc = $0.75 per yard Co = $150 D = 10,000 yards

2CoD CoD CcQ

Qopt = TCmin = +
Cc Q 2
2(150)(10,000) (150)(10,000) (0.75)(2,000)
Qopt = (0.75) TCmin = 2,000 + 2

Qopt = 2,000 yards TCmin = $750 + $750 = $1,500

Orders per year = D/Qopt Order cycle time = 311 days/(D/Qopt)

= 10,000/2,000 = 311/5
= 5 orders/year = 62.2 store days
Example 10.2
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 EOQ with
Noninstantaneous Receipt
Inventory
level

Maximum
Q(1-d/p) inventory
level

Average
Q inventory
(1-d/p)
2 level

0
Time

Figure 10.3

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 EOQ with
Noninstantaneous Receipt
Inventory
level

Maximum
Q(1-d/p) inventory
level

Average
Q inventory
(1-d/p)
2 level

0
Begin End Time
order order
Order
receipt receipt
receipt period
Figure 10.3

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 EOQ with
Noninstantaneous Receipt
p = production rate d = demand rate

Maximum inventory level = Q - Q d

p

=Q1- d 2CoD
p
Qopt = d
Q d Cc 1 -
Average inventory level = 1- p
2 p

CoD CcQ d
TC = Q + 2 1 - p

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 Production Quantity
Cc = $0.75 per yard Co = $150 D = 10,000 yards
d = 10,000/311 = 32.2 yards per day p = 150 yards per day

2CoD 2(150)(10,000)
Qopt = = = 2,256.8 yards
Cc 1 - d 0.75 1 -
32.2
p 150

CoD CcQ d
TC = Q + 2 1 - p = $1,329

Q 2,256.8
Production run = = = 15.05 days per order
p 150
Example 10.3
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 Production Quantity
Cc = $0.75 per yard Co = $150 D = 10,000 yards
d = 10,000/311 = 32.2 yards per day p = 150 yards per day

2CoD 2(150)(10,000)
Qopt = = D 10,000 = 2,256.8 yards
Number of
Cc 1 - d
production runs = = 32.2 = 4.43 runs/year
0.75Q1 - 2,256.8
p 150

d 32.2
Maximum inventory
CoD CcQ level = Q 1 - = 2,256.8 1 -
d p 150
TC = Q + 2 1 - p = $1,329
= 1,772 yards

Q 2,256.8
Production run = = = 15.05 days per order
p 150
Example 10.3
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Quantity Discounts
 Price per unit decreases as order
quantity increases
CoD CcQ
TC = + + PD
Q 2

where

P = per unit price of the item

D = annual demand

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Quantity Discounts
 Price per unit decreases as order
quantity increases
CoD CcQ
TC = + + PD
Q 2

where
ORDER SIZE PRICE
P = per unit price
0 - of
99the item $10
D = annual
100demand
- 199 8 (d1)
200+ 6 (d2)

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Quantity Discount Model
Inventory cost ($)

Figure 10.4
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Quantity Discount Model
TC = ($10 )

TC (d1 = $8 )

TC (d2 = $6 )
Inventory cost ($)

Carrying cost

Ordering cost

Q(d1 ) = 100 Qopt Q(d2 ) = 200

Figure 10.4
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Quantity Discount Model
TC = ($10 )

TC (d1 = $8 )

TC (d2 = $6 )
Inventory cost ($)

Carrying cost

Ordering cost

Q(d1 ) = 100 Qopt Q(d2 ) = 200

Figure 10.4
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 Quantity Discount
QUANTITY PRICE
Co = $2,500
1 - 49 $1,400 Cc = $190 per computer
50 - 89 1,100 D = 200
90+ 900

2CoD 2(2500)(200)
Qopt = = = 72.5 PCs
Cc 190

For Q = 72.5 Co D CcQopt

TC = + 2 + PD = $233,784
Qopt

For Q = 90 C oD CcQ
TC = + 2 + PD = $194,105
Q
Example 10.4
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 When to Order
Reorder Point is the level of inventory
at which a new order is placed

R = dL
where
d = demand rate per period
L = lead time

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 Reorder Point Example
Demand = 10,000 yards/year
Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154 yards/day
Lead time = L = 10 days

R = dL = (32.154)(10) = 321.54 yards

Example 10.5

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 Safety Stocks
 Safety stock
 buffer added to on hand inventory during
lead time
 Stockout
 an inventory shortage
 Service level
 probability that the inventory available
during lead time will meet demand

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 Variable Demand with
a Reorder Point

Q
Inventory level

Reorder
point, R

Figure 10.5 Time

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 Variable Demand with
a Reorder Point

Q
Inventory level

Reorder
point, R

0
LT LT
Figure 10.5 Time
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 Reorder Point with
a Safety Stock
Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Figure 10.6 Time
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 Reorder Point With
Variable Demand
R = dL + zd L
where
d = average daily demand
L = lead time
d = the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
probability
zd L = safety stock

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 Reorder Point for
a Service Level
Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
zd L

dL R
Figure 10.7 Demand
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 Reorder Point for
Variable Demand
The carpet store wants a reorder point with a
95% service level and a 5% stockout probability
d = 30 yards per day
L = 10 days
d = 5 yards per day

For a 95% service level, z = 1.65

R = dL + z d L Safety stock = z d L
= 30(10) + (1.65)(5)( 10) = (1.65)(5)( 10)
= 326.1 yards = 26.1 yards

Example 10.6
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 Order Quantity for a
Periodic Inventory System
Q = d(tb + L) + zd tb + L - I

where
d = average demand rate
tb = the fixed time between orders
L = lead time
d = standard deviation of demand
zd tb + L = safety stock
I = inventory level

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Fixed-Period Model with
Variable Demand
d = 6 bottles per day
d = 1.2 bottles
tb = 60 days
L = 5 days
I = 8 bottles
z = 1.65 (for a 95% service level)

Q = d(tb + L) + zd tb + L - I
= (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8
= 397.96 bottles

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