Operations Management

Inventory Management
Importance of Inventory Management
Importance of Inventory

• One of the most expensive assets of many companies

representing as much as 50% of total invested capital
• Less inventory lowers costs but increases chances of running out
• More inventory raises costs but always keeps customers happy

3
Objective of Inventory Management

• The objective of inventory management is to strike a balance

between inventory investment and customer service
• All organizations have some type of inventory planning and
control system.
• An inventory management plan addresses two issues: how much
to order and when to order

4
Functions of Inventory

1. To provide a selection of goods for anticipated demand and to

separate the firm from fluctuations in demand
2. To decouple or separate various parts of the production process
3. To take advantage of quantity discounts
4. To hedge against inflation

5
• Raw material
• Purchased but not processed
• Work-in-process (WIP)
• Undergone some change but not completed
• A function of cycle time for a product
• Maintenance/repair/operating (MRO)
• Necessary to keep machinery and processes productive
• Finished goods
• Completed product awaiting shipment
6
The Material Flow Cycle

7
Managing Inventory
Managing Inventory

1) How inventory items can be classified (ABC

analysis)
2) How accurate inventory records can be
maintained

9
ABC Analysis

• Divides inventory into three classes based on annual dollar

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

10
ABC Analysis

11
ABC Analysis Example

• Silicon Chips, Inc., maker of superfast DRAM chips, wants to

categorize its 10 major inventory items using ABC analysis.
• ABC analysis organizes the items on an annual dollar-volume
basis. Shown below (in columns 1–4) are the 10 items (identified
by stock numbers), their annual demands, and unit costs.
• Annual dollar volume is computed in column 5, along with the
percentage of the total represented by each item in column 6.
Column 7 groups the 10 items into A, B, and C categories.

12
ABC Analysis Example

13
Record Accuracy

• Accurate records are a critical ingredient in production and

inventory systems
• Periodic systems require regular checks of inventory
• Two-bin system
• Perpetual inventory tracks receipts and subtractions on a
continuing basis
• May be semi-automated

14
Cycle Counting

• Items are counted and records updated on a periodic basis

• Often used with ABC analysis
• Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and corrected
5. Maintains accurate inventory records

15
Cycle Counting Example

5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C

items

Policy is to count A items every month (20 working days), B items

every quarter (60 days), and C items every six months (120 days)

16
Inventory Models
Inventory Models

• Independent demand - the demand for item is independent of

the demand for any other item in inventory
• Dependent demand - the demand for item is dependent upon
the demand for some other item in the inventory

18
Inventory Models

• Independent demand - the demand for item is independent of

the demand for any other item in inventory
• Dependent demand - the demand for item is dependent upon
the demand for some other item in the inventory

19
Inventory Models

• Holding costs - the costs of holding or “carrying” inventory over

time
• Ordering cost - the costs of placing an order and receiving
goods
• Setup cost - cost to prepare a machine or process for
manufacturing an order
• May be highly correlated with setup time

20
Holding Costs

21
Holding Cost

• The holding cost is computed as a function of the amount of

inventory on hand.
• It is calculated per unit held in inventory per unit time

22
Ordering/ Setup Cost

The order/setup cost has 2 components: a fixed cost K incurred

independent of the size of the order and a variable cost incurred on
a per unit basis
0 if 𝑥 = 0
𝑂𝐶(𝑥) = ൝
𝐾 + 𝑐𝑥 if 𝑥 > 0

• As mentioned previously Costs included in K typically include

book-keeping costs associated with processing an order, fixed
transportation costs, and order handling costs.

23
Inventory Models for Independent Demand

• Need to determine when and how much to order

1. Basic economic order quantity (EOQ) model
2. Production order quantity model
3. Quantity discount model

24
The Economic Order Quantity model
Basic EOQ Model

Model assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
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

26
Basic EOQ Model

• Let Q be the order size

• Whenever the inventory level reaches zero, order Q.
• Now we can determine the optimal value of Q that
minimizes cost per unit time.

27
Basic EOQ Model

• T = Q/D.
• The cost per ordering cycle is the sum of holding and ordering cost.
• Let I(t) be the inventory level at time t. The holding cost per cycle is
𝑇
ℎ𝑄2
න ℎ𝐼(𝑡)𝑑𝑡 = ℎ × area under inventory level = .
2𝐷
0
The ordering cost per cycle is K + cQ.
• Then, the cost per ordering cycle is 𝐶𝑇 (𝑄) = 𝐾 + 𝑐𝑄 + ℎ𝑄2 /(2𝐷)
• The cost per unit time is
𝐶𝑇 (𝑄) 𝐾 + 𝑐𝑄 + ℎ𝑄2 /(2𝐷) 𝐷 𝑄
𝐶𝑈 (𝑄) = = = 𝐾 + 𝑐𝐷 + ℎ .
𝑇 𝑄/𝐷 𝑄 2

28
Basic EOQ Model

• The cost per unit time is

𝐶𝑇 (𝑄) 𝐾+𝑐𝑄+ℎ𝑄 2 /(2𝐷) 𝐷 𝑄
• 𝐶𝑈 (𝑄) = = = 𝐾 + 𝑐𝐷 + ℎ .
𝑇 𝑄/𝐷 𝑄 2
• Differentiating implies that
𝜕𝐶𝑈 (𝑄) 𝐾𝐷 ℎ 𝜕2 𝐶𝑈 (𝑄) 2𝐾𝐷
• 𝜕𝑄
= − 𝑄2 + 2 , 𝜕𝑄2
= 𝑄3
>0
• Therefore, CU(Q) is convex, and the optimal order quantity that
minimizes CU(Q), Q*, is found by setting the first derivative
2𝐾𝐷
equal to zero as 𝑄∗ = ℎ

29
An EOQ Example

Sharp, Inc., a company that markets painless hypodermic needles to hospitals,

would like to reduce its inventory cost by determining the optimal number of
hypodermic needles to obtain per order
The annual demand is 1,000 units; the setup or ordering cost is $10 per order; and
the holding cost per unit per year is $.50
Determine optimal number of needles to order
D = 1,000 units/year
K = $10 per order
h = $.50 per unit per year
2𝐾𝐷 2×1000×10
𝑄∗ = = = 40,000 = 200 units
ℎ 0.5

30
An EOQ Example

• Sharp, Inc. has a 250-day working year and wants to find the
number of orders (N) and the expected time between orders (T).
𝐷 1000
• Expected Number of orders=𝑁 = 𝑄∗ = = 5 𝑜𝑟𝑑𝑒𝑟𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
200
1 250
• Cycle Length = T = 5 𝑦𝑒𝑎𝑟𝑠 = = 50 𝑑𝑎𝑦𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑜𝑟𝑑𝑒𝑟𝑠
5

31
An EOQ Example

• The cost per unit time is

𝐷 𝑄
𝑇𝐶 = 𝐾 + 𝑐𝐷 + ℎ
𝑄 2
• Since the term 𝑐𝐷 is constant, it is often omitted when
calculating the total cost per year
𝐷 𝑄 1000 200
• In this example 𝑇𝐶 = 𝐾 𝑄 + ℎ 2 = 10 × + .5 × =
200 2
100$\year

32
An EOQ Example

• When including actual cost of material c

• Total annual cost = Setup cost + Holding cost + Product cost
𝐷 𝑄
• 𝑇𝐶 = 𝐾 𝑄 + ℎ 2 + 𝑐𝐷
• Because material cost does not depend on the particular order
policy, we still incur an annual material cost of 𝑐𝐷
• Since 𝑐 = $10, an additional 𝑐𝐷=$10,000 is incurred.

33
Robustness of EOQ

• 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 EOQ

34
Example

• Management in the Sharp, Inc., examples underestimates total

annual demand by 50% (say demand is actually 1,500 needles
rather than 1,000 needles) while using the same Q. How will the
annual inventory cost be impacted?

35
Example

𝐷𝑛𝑒𝑤 = 1,500 units, K = $10 per order, h = $.50 per unit per year
• If Demand is actually 1,500 needles rather than 1,000, but
management uses an order quantity of Q=200(when it should be
Q=244.9 based on D=1,500)
𝐾𝐷 ℎ𝑄 1500 200
• 𝑇𝐶 = + = 10 × + .5 × = 125
𝑄 2 200 2
• If the correct Q=244.9 was placed:
𝐾𝐷 ℎ𝑄 1500 244.9
• 𝑇𝐶 = + = 10 × 244.9 + .5 × = 122.47
𝑄 2 2
• Only 2% less than the total cost of $125 when the order quantity
was 200
36
Reorder Points

• EOQ answers the “how much” question

• The reorder point (ROP) tells “when” to order
• Lead time (L) is the time between placing and receiving an order
• 𝑅𝑂𝑃 = 𝐷 × 𝐿

37
Reorder Point

38
Reorder Point Example

• An Apple store has a demand (D) for 8,000 iPods per year. The
firm operates a 250-day working year. On average, delivery of an
order takes 3 working days. The store wants to find the optimal
ordering policy (how much to order and the reorder point).
3
• 𝑅𝑂𝑃 = 𝐷 × 𝐿 = 8000 × 250 =96

39
Reorder Point Example

• The equation for ROP assumes that demand during lead time
and lead time itself are constant. When this is not the case, extra
stock, often called safety stock (ss), should be added.
• 𝑅𝑂𝑃 = 𝐷 × 𝐿 + 𝑠𝑠
• Referring to the previous example, suppose that the delivery of
an order takes 3 working days, but has been known to take as
long as 4 days.
3 1
• 𝑅𝑂𝑃 = 𝐷 × 𝐿 = 8000 × 250 + 8000 × 250 =128

40
Production Order Quantity Model
Production Order Quantity Model

• Used when inventory builds up over a period of time after an

order is placed
• Used when units are produced and sold simultaneously

42
Production Order Quantity Model

Q(1-D/P)
P-D D
1 1

Q/P Time
T=Q/D

𝐷
𝐾+𝑐𝑄 ℎ𝑄 1−𝑃 𝑇 𝐾𝐷
The cost per unit time is 𝐶𝑈 𝑄 = + = + 𝑐𝐷 +
𝑇 2𝑇 𝑄
ℎ𝑄 𝐷 𝐾𝐷 ℎ′ 𝑄 𝐷
1−𝑃 = + where ℎ′ = ℎ(1 − 𝑃)
2 𝑄 2

43
Production Order Quantity Model

𝐷
𝐾+𝑐𝑄 ℎ𝑄 1− 𝑇 𝐾𝐷
The cost per unit time is 𝐶𝑈 𝑄 = + 𝑃
= +
𝑇 2𝑇 𝑄
ℎ𝑄 𝐷 𝐾𝐷 ℎ′ 𝑄 𝐷
1− = + where ℎ′ = ℎ(1 − 𝑃 )
2 𝑃 𝑄 2

2𝐾𝐷
𝑄 ∗=
ℎ(1 − 𝐷/𝑃)

44
Production Order Quantity Example

Nathan Manufacturing, Inc., makes and sells specialty hubcaps for

the retail automobile aftermarket. Nathan’s forecast for its wire-
wheel hubcap is 1,000 units next year, with an average daily
demand of 4 units. However, the production process is most
efficient at 8 units per day. So the company produces 8 per day but
uses only 4 per day. The company wants to solve for the optimum
number of units per order. (Note: This plant schedules production of
this hubcap only as needed, during the 250 days per year the shop
operates.)

45
Production Order Quantity Example

D = 1,000 units/year
P =8 units per day= 2000 units/year
K= $10
h = $0.50 per unit per year

2𝐾𝐷 2 × 10 × 1000
𝑄 ∗= = = 282.8 ≈ 283
𝐷 1000
ℎ 1−𝑃 0.5 1 − 2000

46
Quantity Discount Models
Quantity Discount Models

• Reduced prices are often available when larger quantities are

purchased
• Trade-off is between reduced product cost and increased
holding cost

48
Quantity Discount Models

• Total annual cost = Setup cost + Holding cost + Product cost

𝐾𝐷 ℎ 𝑄 𝑄
• 𝑇𝐶 = + + 𝑐𝐷, 𝑤ℎ𝑒𝑟𝑒 ℎ 𝑄 = 𝐼𝑃(Because unit price
𝑄 2
varies, holding cost is expressed as a percent (I) of unit price (P) )
• where Q= Quantity ordered, P= Price per unit
• D= Annual demand in units,I = Holding cost per unit per year
expressed as a percent of price P
• K= Ordering or setup cost per order

49
 𝐾𝐷 𝐼𝑃𝑄
𝑇𝐶 = + + 𝑐𝐷
𝑄 2
2𝐾𝐷
• 𝑄∗ = 𝐼𝑃

• Note that cD is no longer constant since this term depends on

the quantity purchased

50
1. For each discount, calculate a value for optimal order size Q*,
2𝐾𝐷
using the following equation: 𝑄∗ =
𝐼𝑃

2. For any discount, if the order quantity is too low to qualify for the
discount, adjust the order quantity upward to the lowest quantity
that will qualify for the discount.
3. Using the preceding total cost equation, compute a total cost for
every Q* determined in Steps 1 and 2.
4. Select the Q* that has the lowest total cost, as computed in Step
3. It will be the quantity that will minimize the total inventory
cost.
51
Quantity Discount Example

Wohl’s Discount Store stocks toy race cars. Recently, the store has been given a
quantity discount schedule for these cars. This quantity schedule was shown in Table
12.2. Thus, the normal cost for the toy race cars is $5.00. For orders between 1,000
and 1,999 units, the unit cost drops to $4.80; for orders of 2,000 or more units, the
unit cost is only $4.75. Furthermore, ordering cost is $49.00 per order, annual demand
is 5,000 race cars, and inventory carrying charge, as a percent of cost, I, is 20%, or .2.
What order quantity will minimize the total inventory cost?
The quantity discount schema is summarized in the following table:

𝑄 < 1000
1000 ≤ 𝑄 < 1999
𝑄 ≥ 2000
52
Quantity Discount Example

Calculate Q* for every discount starting with the lowest price

∗ 2×49×5000
𝑄5$ = = 700,feasible
.2×5

∗ 2×49×5000
𝑄4.8$ = = 714, which is infeasible since in that price
.2×4.8
range we should order is between 1000 and 1999- needs to be
adjusted
∗ 2×49×5000
𝑄4.75$ = = 718, which is infeasible since in that price
.2×4.75
range we should order at least 2000- needs to be adjusted
53
Quantity Discount Example

∗ 2×49×5000
𝑄5$ = = 700,
.2×5

∗ 2×49×5000
𝑄4.8$ = = 1000 − adjusted
.2×4.8

∗ 2×49×5000
𝑄4.75$ = = 2000-adjusted
.2×4.75

54
Quantity Discount Example

𝐾𝐷 𝐼𝑃𝑄
𝑇𝐶 = + + 𝑐𝐷
𝑄 2

55
Quantity Discount Variations

• All-units discount is the most popular form

• Incremental quantity discounts apply only to those units
purchased beyond the price break quantity

56
Probabilistic Models and Safety Stock
Probabilistic Models and Safety Stock

• Used when demand is not constant or certain

• Use safety stock to achieve a desired service level and avoid
stockouts: ROP = d x L + ss
• Annual stockout costs = The sum of the units short for each
demand level × The probability of that demand level × The
stockout cost/unit × The number of orders per year

58
Safety Stock Example

David Rivera Optical has determined that its reorder point for eyeglass frames is
50 (d x L) units. Its carrying cost per frame per year is $5, and stockout (or lost
sale) cost is $40 per frame. The store has experienced the following probability
distribution for inventory demand during the lead time (reorder period). The
optimum number of orders per year is six. How much safety stock should David
Rivera keep on hand?

59
Safety Stock Example

ROP = 50 units Stockout cost = $40 per frame

Orders per year = 6 Carrying cost = $5 per frame per year

A safety stock of 20 frames gives the lowest total cost:

ROP = 50 + 20 = 70 frames

60
Probabilistic Demand

61
Probabilistic Demand

• Use prescribed service levels to set safety stock when the cost of
stockouts cannot be determined
• ROP = demand during lead time + ZsdLT
where Z = Number of standard deviations
sdLT = Standard deviation of demand during lead
time
ZsdLT is the safety stock calculated based on the service level
required.

62
Example

Memphis Regional Hospital stocks a “code blue” resuscitation kit

that has a normally distributed demand during the reorder period.
The mean (average) demand during the reorder period is 350 kits,
and the standard deviation is 10 kits. The hospital administrator
wants to follow a policy that results in stockouts only 5% of the
time.
(a) What is the appropriate value of Z?
(b) How much safety stock should the hospital maintain?
(c) What reorder point should be used?

63
Example

• The hospital determines how much inventory is needed to meet the demand
95% of the time. The data are as follows:
m = Average demand = 350 kits
sdLT = Standard deviation of demand during lead time = 10 kits
Stockout policy =5% (service level = 95%)
Using the normal pdf table (attached), for an area under the curve of 95%,
the Z = 1.645
Safety stock = ZsdLT = 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
64
Other Probabilistic Models
Probabilistic Demand

• When data on demand during lead time is not available, there

are other models available
1. When demand is variable and lead time is constant
2. When lead time is variable and demand is constant
3. When both demand and lead time are variable

66
Demand is variable and lead time is constant

ROP = (Average daily demand x Lead time in days) + ZsdLT

where sdLT = sd Lead time
sd = Standard deviation of demand per day

67
Example

The average daily demand for Lenovo laptop computers at a Circuit

Town store is 15, with a standard deviation of 5 units. The lead time
is constant at 2 days. Find the reorder point if management wants a
90% service level (i.e., risk stockouts only 10% of the time). How
much of this is safety stock

68
Example

Average daily demand (normally distributed) = 15

Lead time in days (constant) = 2
Standard deviation of daily demand = 5
Service level = 90%
Z for 90% = 1.28 (from normal pdf table)
ROP = (15 units x 2 days) + ZsdLT
= 30 + 1.28(5)( 2)= 30 + 9.02 = 39.02

Safety stock is about 9 computers

69
Lead time is variable, and demand is constant

• ROP = (Daily demand x Average lead time in days) + Z x (Daily

demand) x sLT
• where sLT = Standard deviation of lead time in days

70
Example

A store sells about 10 digital cameras a day (almost a constant

quantity). Lead time for camera delivery is normally distributed with
a mean time of 6 days and a standard deviation of 1 day. A 98%
service level is set. Find the ROP.

71
Example

Daily demand (constant) = 10

Average lead time = 6 days
Standard deviation of lead time = sLT = 1
Service level = 98%, so Z = 2.055
ROP= (10 units x 6 days) + 2.055(10 units)(1)
= 60 + 20.55 = 80.55
Reorder point is about 81 cameras

72
Both demand and lead time are variable

ROP = (Average daily demand x Average lead time) + ZsdLT

where sd = Standard deviation of demand per day

sLT = Standard deviation of lead time in days

sdLT= Average lead time x sd2 + (Average daily demand) 2 s2LT

73
Example

The Circuit Town store’s most popular item is six-packs of 9-volt

batteries. About 150 packs are sold per day, following a normal
distribution with a standard deviation of 16 packs. Batteries are
ordered from an out-of-state distributor; lead time is normally
distributed with an average of 5 days and a standard deviation of 1
day. To maintain a 95% service level, what ROP is appropriate?

74
Example

Average daily demand (normally distributed) = 150

Standard deviation = sd = 16
Average lead time 5 days (normally distributed)
Standard deviation = sLT = 1 day
Service level = 95%, so Z = 1.645
sdLT= 5 daysx 162 + 150212=154
𝑅𝑂𝑃 = 150 × 5 + 1.645 × 154 = 1003 𝑝𝑎𝑐𝑘𝑠

75
Single-Period Model
Single-Period Model

• Only one order is placed for a product

• Units have little or no value at the end of the sales period
• This is a typical problem for Christmas trees, seasonal goods,
bakery goods, newspapers, and magazines.
Cs = Cost of shortage = Sales price/unit – Cost/unit
Co = Cost of overage = Cost/unit – Salvage value
𝐶𝑠
• Optimal service level=𝐶
𝑠 +𝐶𝑜

77
Single-Period Example

Chris Ellis’s newsstand, just outside the Smithsonian subway station

in Washington, DC, usually sells 120 copies of the Washington Post
each day. Chris believes the sale of the Post is normally distributed,
with a standard deviation of 15 papers. He pays 70 cents for each
paper, which sells for $1.25. The Post gives him a 30-cent credit for
each unsold paper. He wants to determine how many papers he
should order each day and the stockout risk for that quantity

78
Single-Period Example

Average demand = m = 120 papers/day

Standard deviation = s = 15 papers
Cs = cost of shortage = $1.25 – $.70 = $.55
Co = cost of overage = $.70 – $.30 = $.40
𝐶𝑠 .55 .55
Optimal service level= = = = .579 ⇒ 𝑍 = 0.2
𝐶𝑠 +𝐶𝑜 .55+.4 .95

The optimal stocking level= 120 copies + (.20)(s) = 120 + (.20)(15) = 120
+ 3 = 123 papers

The stockout risk = 1 – Service level= 1 – .579 = .422 = 42.2%

79