Operations Management: Sustainability

and Supply Chain Management Outline (1 of 2)

Thirteenth Edition, Global Edition
• Global Company Profile: Amazon.com
• The Importance of Inventory

Chapter 12 • Managing Inventory

Inventory Management • Inventory Models
• Inventory Models for Independent Demand

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Inventory Management at
Outline (2 of 2) Amazon.com (1 of 3)
• Probabilistic Models and Safety Stock • Amazon.com started as a “virtual” retailer – no inventory,
no warehouses, no overhead – just computers taking
• Single-Period Model
orders to be filled by others
• Fixed-Period (P) Systems
• Growth has forced Amazon.com to become a world leader
in warehousing and inventory management

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Inventory Management at Inventory Management at
Amazon.com (2 of 3) Amazon.com (3 of 3)
1. Each order is assigned by computer to one of the 5. Crates arrive at central point where items are boxed and
distribution centers labeled with new bar code
2. A “flow meister” at each distribution center assigns work 6. Order arrives at customer within 1 - 2 days
crews
Amazon expects the customer experience to yield the lowest
3. Robots and technology help workers move merchandise price, fastest delivery, and error-free order fulfillment
and pick the correct items
4. Items are placed into crates on a conveyor, bar code
scanners scan each item 15 times to virtually eliminate
errors

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Learning Objectives (1 of 2) Learning Objectives (2 of 2)

When you complete this chapter you should be able to: When you complete this chapter you should be able to:
12.1 Conduct an ABC analysis 12.5 Apply the production order quantity model
12.2 Explain and use cycle counting 12.6 Explain and use the quantity discount model
12.3 Explain and use the EOQ model for independent 12.7 Understand service levels and probabilistic inventory
inventory demand models
12.4 Compute a reorder point and explain safety stock

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Inventory Management Importance of Inventory
The objective of inventory management is to strike a • One of the most expensive assets of many companies
balance between inventory investment and customer representing as much as 50% of total invested capital
service
• Less inventory lowers costs but increases chances of
shortages, which might stop processes or result in
dissatisfied customers
• More inventory raises costs but improves the likelihood of
meeting process and customer demands

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Functions of Inventory Types of Inventory

1. To provide a selection of goods for anticipated demand • Raw material
and to separate the firm from fluctuations in demand – Purchased but not processed
2. To decouple or separate various parts of the production • Work-in-process (W IP)
process – Undergone some change but not completed
3. To take advantage of quantity discounts – A function of flow time for a product
4. To hedge against inflation • Maintenance/repair/operating (MRO)
– Necessary to keep machinery and processes
productive
• Finished goods
– Completed product awaiting shipment
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The Material Flow Cycle Managing Inventory
Figure 12.1 1. How inventory items can be classified (ABC analysis)
2. How accurate inventory records can be maintained

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ABC Analysis (1 of 5) ABC Analysis (2 of 5)

• Divides inventory into three classes based on annual dollar Figure 12.2
volume
– Class A - high annual dollar volume
– Class B - medium annual dollar volume
– Class C - low annual dollar volume
• Used to establish policies that focus on the few critical
parts and not the many trivial ones

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ABC Analysis (3 of 5) ABC Analysis (4 of 5)
ABC Calculation • Other criteria than annual dollar volume may be used
– High shortage or holding cost
– Anticipated engineering changes
– Delivery problems
– Quality problems

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Record Accuracy (1 of 2)
ABC Analysis (5 of 5) • Accurate records are a critical ingredient in production and inventory
systems
• Policies employed may include – Periodic systems require regular checks of inventory
1. More emphasis on supplier development for A items ▪ Two-bin system
– Perpetual inventory tracks receipts and subtractions on a
2. Tighter physical inventory control for A items continuing basis
3. More care in forecasting A items ▪ May be semi-automated

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Record Accuracy (2 of 2) Cycle Counting
• Incoming and outgoing • Items are counted and records updated on a periodic basis
record keeping must be
• Often used with ABC analysis
accurate
• Has several advantages
• Stockrooms should be
secure 1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
• Necessary to make precise
decisions about ordering, 3. Trained personnel audit inventory accuracy
scheduling, and shipping 4. Allows causes of errors to be identified and corrected
5. Maintains accurate inventory records

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Cycle Counting Example Control of Service Inventories

5,000 items in inventory, 500 A items, 1,750 B items, 2,750 • Can be a critical component of profitability
C items
• Losses may come from shrinkage or pilferage
Policy is to count A items every month (20 working days), B
• Applicable techniques include
items every quarter (60 days), and C items every six months
(120 days) 1. Good personnel selection, training, and discipline
2. Tight control of incoming shipments
CYCLE COUNTING NUMBER OF ITEMS
ITEM CLASS QUANTITY
POLICY COUNTED PER DAY 3. Effective control of all goods leaving facility
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day
C 2,750 Every 6 months 2,750/120 = 23/day
blank blank blank 77/day

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Inventory Models (1 of 2) Inventory Models (2 of 2)
• Independent demand - the demand for item is • Holding costs - the costs of holding or “carrying” inventory
independent of the demand for any other item in inventory over time
• Dependent demand - the demand for item is dependent • Ordering cost - the costs of placing an order and receiving
upon the demand for some other item in the inventory goods
• Setup cost - cost to prepare a machine or process for
manufacturing an order
– May be highly correlated with setup time

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Holding Costs (1 of 2) Holding Costs (2 of 2)

Table 12.1 Determining Inventory Holding Costs
Table 12.1 Determining Inventory Holding Costs COST (AND RANGE)
CATEGORY AS A PERCENTAGE OF
INVENTORY VALUE
COST (AND RANGE)
CATEGORY AS A PERCENTAGE OF Housing costs (building rent or depreciation, 6% (3 - 10%)
INVENTORY VALUE operating costs, taxes, insurance)
Housing costs (building rent or depreciation, 6% (3 - 10%) Material handling costs (equipment lease or 3% (1 - 3.5%)
operating costs, taxes, insurance) depreciation, power, operating cost)
Material handling costs (equipment lease or 3% (1 - 3.5%) Labor cost (receiving, warehousing, security) 3% (3 - 5%)
depreciation, power, operating cost)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
insurance on inventory)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%) Pilferage, space, and obsolescence (much higher 3% (2 - 5%)
insurance on inventory) in industries undergoing rapid change like tablets
Pilferage, space, and obsolescence (much higher 3% (2 - 5%) and smart phones)
in industries undergoing rapid change like tablets Overall carrying cost 26%
and smart phones)
Overall carrying cost 26% Holding costs vary considerably depending on the business, location, and
interest rates. Generally greater than 15%, some high tech and fashion
items have holding costs greater than 40%.
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Inventory Models for Independent
Demand Basic EOQ Model
Need to determine when and how much to order Important assumptions
1. Basic economic order quantity (EOQ) model 1. Demand is known, constant, and independent
2. Production order quantity model 2. Lead time is known and constant
3. Quantity discount model 3. Receipt of inventory is instantaneous and complete
4. Quantity discounts are not possible
5. Only variable costs are setup (or ordering) and holding
6. Stockouts can be completely avoided

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Minimizing Costs (1 of 7)
Inventory Usage Over Time Objective is to minimize total costs

Figure 12.3 Figure 12.4c

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Minimizing Costs (2 of 7) Minimizing Costs (3 of 7)
• By minimizing the sum of setup (or ordering) and holding The necessary steps are:
costs, total costs are minimized
1. Develop an expression for setup or ordering cost
• Optimal order size Q* will minimize total cost
2. Develop an expression for holding cost
• A reduction in either cost reduces the total cost
3. Set setup (order) cost equal to holding cost
• Optimal order quantity occurs when holding cost and setup
4. Solve the equation for the optimal order quantity.
cost are equal

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Minimizing Costs (5 of 7)
Minimizing Costs (4 of 7) Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)

Q = Number of units per order
D = Annual demand in units for the inventory
Q* = Optimal number of units per order (EOQ)
item
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
H = Holding or carrying cost per unit per year

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Minimizing Costs (6 of 7) Minimizing Costs (7 of 7)
Q = Number of pieces per order Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ) Q* = Optimal number of pieces per order (EOQ)

D = Annual demand in units for the inventory item D = Annual demand in units for the inventory
item
S = Setup or ordering cost for each order
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
H = Holding or carrying cost per unit per year
Optimal order quantity is found when annual setup cost
equals annual holding cost
Solving for Q*

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An EOQ Example (1 of 6) An EOQ Example (2 of 6)

Determine optimal number of needles to order Determine expected number of orders
D = 1,000 units D = 1,000 units Q* = 200 units
S = $10 per order S = $10 per order
H = $.50 per unit per year H = $.50 per unit per year

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 An EOQ Example (4 of 6)
An EOQ Example (3 of 6) Determine the total annual cost

Determine optimal time between orders D = 1,000 units Q* = 200 units

D = 1,000 units Q* = 200 units S = $10 per order N = 5 orders/year

S = $10 per order N = 5 orders/year H = $.50 per unit per year T = 50 days

H = $.50 per unit per year

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The EOQ Model Robust Model

When including actual cost of material P • The EOQ model is robust
• It works even if all parameters and assumptions are not met
• The total cost curve is relatively flat in the area of the E OQ

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An EOQ Example (5 of 6) An EOQ Example (6 of 6)
Only 2% less than
the total cost of
$125 when the
order quantity was
200

Ordering old Q* Ordering new Q*

Ordering old Q* Ordering new Q*

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Reorder Points Reorder Point Curve

• EOQ answers the “how much” question Figure 12.5
• The reorder point (ROP) tells “when” to order
• Lead time (L) is the time between placing and receiving an
order

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 Production Order Quantity Model
Reorder Point Example (1 of 5)

Demand = 8,000 iPhones per year 1. Used when inventory builds up over a period of time after
an order is placed
250 working day year
2. Used when units are produced and sold simultaneously
Lead time for orders is 3 working days, may take 4
Figure 12.6

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Production Order Quantity Model Production Order Quantity Model

(2 of 5) (3 of 5)
Q = Number of units per order p = Daily production rate
Q = Number of units per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand (usage) rate
H = Holding cost per unit per year d = Daily demand (usage) rate
t = Length of the production run in days
t = Length of the production run in days

However, Q = total produced = pt ; thus t = Q/p

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Production Order Quantity Model
(4 of 5) Production Order Quantity Example
Q = Number of units per order p = Daily production rate
D = 1,000 units p = 8 units per day
H = Holding cost per unit per year d = Daily demand (usage) rate
S = $10 d = 4 units per day
t = Length of the production run in days
H = $0.50 per unit per year

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Production Order Quantity Model Quantity Discount Models (1 of 5)

(5 of 5) • Reduced prices are often available when larger quantities
are purchased
Note:
• Trade-off is between reduced product cost and increased
holding cost

Table 12.2 A Quantity Discount Schedule

When annual data are used the equation becomes:

PRICE RANGE QUANTITY ORDERED PRICE PER UNIT P
Initial price 0 to 119 $ 100

Discount price 1 120 to 1,499 $ 98

Discount price 2 1,500 and over $ 96

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Quantity Discount Models (2 of 5)
Quantity Discount Models (3 of 5)
Steps in analyzing a quantity discount
1. Starting with the lowest possible purchase price,
calculate Q* until the first feasible EOQ is found. This is
where Q = Quantity ordered P = Price per unit a possible best order quantity, along with all price-break
D = Annual demand in units I = Holding cost per unit per year quantities for all lower prices.
S = Ordering or setup cost per order expressed as a percent of price P 2. Calculate the total annual cost for each possible order
quantity determined in Step 1. Select the quantity that
gives the lowest total cost.

Because unit price varies, holding cost is expressed as a

percentage (I) of unit price (P)
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Quantity Discount Models (5 of 5)

Quantity Discount Models (4 of 5) Calculate Q* for every discount
starting with the lowest price
Figure 12.7

Infeasible – calculate Q*
for next-higher price

Feasible
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Quantity Discount Example Quantity Discount Variations
Table 12.3 Total Cost Computations for Chris Beehner • All-units discount is the most popular form
Electronics
• Incremental quantity discounts apply only to those units
purchased beyond the price break quantity
• Fixed fees may encourage larger purchases
• Aggregation over items or time
• Truckload discounts, buy-one-get-one-free offers,
one-time-only sales

Choose the price and quantity that gives the lowest total cost
Buy 275 drones at $98 per unit

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Probabilistic Models and Safety

Stock Safety Stock Example (1 of 2)
• Used when demand is not constant or certain ROP = 50 units Stockout cost = $40 per frame
• Use safety stock to achieve a desired service level and Orders per year = 6 Carrying cost = $5 per frame per year
avoid stockouts
NUMBER OF UNITS PROBABILITY

30 .2
40 .2
Annual stockout costs = The sum of the units short for
ROP 🡪 50 .3
each demand level × The probability of that demand
level × The stockout cost/unit × The number of 60 .2
orders per year 70 .1
blank 1.0
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Safety Stock Example (2 of 2)
ROP = 50 units Stockout cost = $40 per frame
Probabilistic Demand (1 of 3)
Orders per year = 6 Carrying cost = $5 per frame per year Figure 12.8

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
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Probabilistic Demand (2 of 3) Probabilistic Demand (3 of 3)

Use prescribed service levels to set safety stock when the
cost of stockouts cannot be determined

where

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Probabilistic Example (1 of 3)
μ= Average demand = 350 kits
Other Probabilistic Models (1 of 4)
σdLT = Standard deviation of demand during lead time = • When data on demand during lead time are not available,
10 kits there are other models available
Stockout policy = 5% (service level = 95%) 1. When demand is variable and lead time is constant
2. When lead time is variable and demand is constant
Using Appendix I, for an area under the curve of 95%, the Z 3. When both demand and lead time are variable
= 1.645

Safety stock = ZσdLT = 1.645(10) = 16.5 kits

Reorder point = Expected demand during lead time + Safety stock

= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits
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Probabilistic Example (2 of 3)
Other Probabilistic Models (2 of 4) Average daily demand (normally distributed) = 15

Demand is variable and lead time is constant Lead time in days (constant) = 2
Standard deviation of daily demand = 5
Service level = 90%
Z for 90% = 1.28
From Appendix I
where

Safety stock is about 9 computers

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Other Probabilistic Models (3 of 4) Probabilistic Example (3 of 3)
Lead time is variable and demand is constant Daily demand (constant) = 10
Average lead time = 6 days
Standard deviation of lead time = σLT = 1
Service level = 98%, so Z (from Appendix I) = 2.055
where

Reorder point is about 81 cameras

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Probabilistic Example
Other Probabilistic Models (4 of 4) Average daily demand (normally distributed) = 150

Both demand and lead time are variable Standard deviation = σd = 16

Average lead time 5 days (normally distributed)
Standard deviation = σLT = 1 day
Service level = 95%, so Z = 1.645 (from Appendix I)
where

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 Single-Period Example (1 of 2)
Single-Period Model Average demand = μ = 120 papers/day

• Only one order is placed for a product Standard deviation = σ = 15 papers

• Units have little or no value at the end of the sales period Cs = cost of shortage = $1.25 − $.70 = $.55

Co = cost of overage = $.70 − $.30 = $.40

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Single-Period Example (2 of 2)
From Appendix I, for the area .579, Z ≅ .199 Fixed-Period (P) Systems (1 of 3)
The optimal stocking level • Fixed-quantity models require continuous monitoring
using perpetual inventory systems
= 120 copies + (.199)(σ)
• In fixed-period systems orders placed at the end of a
= 120 + (.199)(15) = 120 + 3 = 123 papers fixed period
• Periodic review, P system
The stockout risk = 1 − Service level

= 1 − .579 = .421 = 42.1%

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Fixed-Period (P) Systems (2 of 3) Fixed-Period (P) Systems (3 of 3)
• Inventory counted only at end of period Figure 12.9
• Order brings inventory up to target level
– Only relevant costs are ordering and holding
– Lead times are known and constant
– Items are independent of one another

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Fixed-Period Systems Copyright

• Inventory is only counted at each review period
This work is protected by United States copyright laws and is
• May be scheduled at convenient times provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
• Appropriate in routine situations any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
• May result in stockouts between periods and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
• May require increased safety stock restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

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