Term II: Supply Chain Management (SCM)

Session 9-10: Inventory Management

Rohit Gupta
Operations Management Area
IIM Ranchi
Email: rohit.gupta@iimranchi.ac.in
Motivation
The culprit is “phantom inventory”—goods
that show up in management systems as
available but in fact are hidden from view
because they’ve been misplaced, often tucked
away in a backroom and forgotten.

“As it relates to the inventory, we do

believe that we have an ongoing
opportunity to...reduce our inventory
levels”

Factories in the U.S. are churning through

their inventories, as logistical problems
keep some manufacturers from restocking
rapidly enough to keep up with rising
demand.
 “Get comfortable with days of inventory, not
weeks,” Tom Shortt, Home Depot’s senior vice
president of supply chain, says is the message
going out to stores.

Target believes the key to success for

online sales is managing inventory in its
physical stores.

It is a shift happening across the retail sector as

companies try to figure out ways to profitably serve
the growing needs of online shoppers while making
their network of stores less of a financial burden.
Chains must predict whether demand will come from
the internet or a store visit, and whether they’ll ship
online orders from a distribution center or a store.
Every move of inventory is an added cost that eats
away at already thin margins.
What are Inventories ?

 Finished product held for sale

 Goods in warehouses
 Work in process
 Raw material
 Maintenance/repair/operations (MRO)
 Goods in transit
 Staff hired to meet service needs
 Any owned or financially controlled raw material, work in process, and/or
finished good or service held in anticipation of a sale but not yet sold.
 Reasons for Inventories

 Improve customer service

 Provides immediacy in product availability

 Encourage production, purchase, and transportation economies

 Allows for long production runs
 Takes advantage of price-quantity discounts
 Allows for transport economies from larger shipment sizes

 Act as a hedge against price changes

 Allows purchasing to take place under most favourable price terms

 Protect against uncertainties in demand and lead times

 Provides a measure of safety to keep operations running when
demand levels and lead times cannot be known for sure

 Act as a hedge against contingencies

 Buffers against events like strikes, fires, and disruptions in supply
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

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
 Three Levels of Inventory Decisions
Strategic Level Decisions

Supply chain Decisions

• What are the potential alternatives to inventory?
• How should the product be designed?

Tactical Level Decisions

Deployment Decisions
• What items should be carried as inventory?
• In what form should they be maintained?
• How much of each should be held and where?

Operational Level Decisions

Replenishment Decisions
• How often should inventory status be determined?
• When should a replenishment decision be made?
• How large should the replenishment be?
 Methods of Inventory Control

 Inventory in a company consists of thousands of different items in stock.

 Control of all these items creates a serious problem to the management, if same
amount of control is exercised on each of these items.
 To exercise proper control, it is necessary to take selective approach and find
the attention required for each item according to its importance.
 Essential for achieving maximum benefits with minimum efforts and cost.
 Depending upon advantages and purposes, different analyses have been
developed to help in bringing practical solution of the problem of inventory
control.
 Commonly Used Methods

Commonly used systems can be classified as,

i. ABC analysis – Always Better Control analysis
ii. VED analysis – Vital, Essential, and Desirable analysis
iii. SDE analysis – Scarce, Difficult, and Easily Available analysis
iv. HML analysis – High, Medium, and Low Cost analysis
v. FSN analysis – Fast moving, Slow moving, and Non-moving items analysis
 ABC Analysis
 Annual consumption analysis of any organization would indicate that a handful of top
high value items – less than 15-20% of total number will account for a substantial portion
of about 70-80% of total consumption value, and these items are called ‘A’ items which
needs careful attention of the materials manager.
 A large number of ‘bottom’ items – over 50-55% of total number of items – account only
for about 5-10% of consumption value and are known as the ‘C’ items.
 Items that lie between top and bottom are called the ‘B’ category items.
 Concentrating on ‘A’ class items, material manager is able to control inventories and
show ‘visible’ results in a short span of time.
 ‘A’ items require a tightly controlled inventory system with constant attention to the
purchase and stores management.
 A large effort per item on only a few items can cost only moderately, but the effort can
result in large savings.
 ‘B’ items require a formalized inventory system with periodic attention by the purchase
and stores management.
 ‘C’ items use a simpler system designed to cause the least trouble for the purchase and
stores department.
Classification Table

% of Total Number of
Item % of Consumption Value
Items

A 15-20% 70-80%

B 25-30% 10-15%

C 50-55% 5-10%
 Numerical Example
Store of an oil engine repair shop has 10 items whose details are shown in the following table.
Apply ABC analysis to classify the items kept in the store, so that appropriate inventory
control policy can be designed.

Component Code Description Price/unit (Rs.) Consumption/year (units)

C01 Packing thread 100 100
C02 Tower bolt 200 300
C03 Hexagonal Nut 50 700
C04 Bush 300 400
C05 Coupling 500 1000
C06 Bearing (Big) 3000 30
C07 Bearing (Small) 1000 100
C08 Fuel Pump 7000 500
C09 Fixture 5000 105
C10 Drill Bit 60 1000
Solution

Component Consumption/year Total Consumption

Description Price/unit (Rs.)
Code (units) Value (Rs.)
C01 Packing thread 100 100 10000
C02 Tower bolt 200 300 60000
C03 Hexagonal Nut 50 700 35000
C04 Bush 300 400 120000
C05 Coupling 500 1000 500000
C06 Bearing (Big) 3000 30 90000
C07 Bearing (Small) 1000 100 100000
C08 Fuel Pump 7000 500 3500000
C09 Fixture 5000 105 525000
C10 Drill Bit 60 1000 60000
5000000
Solution

Total Cumulative
Component Class of
Description Consumption Consumption
Code Item
Value (Rs.) Value (Rs.)
C08 Fuel Pump 3500000 3500000 A
C09 Fixture 525000 4025000 A
C05 Coupling 500000 4525000 B
C04 Bush 120000 4645000 B
Bearing
C07 100000 4745000 B
(Small)
C06 Bearing (Big) 90000 4835000 C
C02 Tower bolt 60000 4895000 C
C10 Drill Bit 60000 4955000 C
Hexagonal
C03 35000 4990000 C
Nut
Packing
C01 10000 5000000 C
thread
 VED Analysis

 This analysis specially pertains to classification of maintenance spare parts.

 Spares are split into three categories of importance from the viewpoint of functional
utility.

 ‘V’ sands for vital items, without which production would come to a halt. These items
would render the equipment or whole line operation in the process totally and immediately
inoperative and unsafe. If these items go out of stock or are not readily available there will
be loss of production.

 ‘E” stands for essential items, without which the performance or efficiency of the
equipment will be reduced. Non-availability of these items may result in temporary loss of
productivity.

 “D” stands for desirable items, the remaining items which do not cause any immediate
loss in production fall under this category.
 SDE Analysis

 This analysis is based on availability position of each item. In this analysis,

 ‘S’ refers to the scarce items, which are short in supply and their availability is scarce.
This includes imported items.

 ‘D’ refers to difficult to get items, which cannot be procured easily. These items may not
be available in local market and have to be procured from far off cities or these are items
for which there are a limited number of suppliers or items for which quality suppliers are
difficult to get.

 ‘E’ refers to easily available items.

 SDE analysis proves to be very useful in industrial situations where certain materials are
scarce in supply and gives proper guidelines for deciding inventory policies.
 HML Analysis

 ABC analysis total annual usage of materials is considered.

 We may come across quite a few items which fall in ‘B’ category although their unit cost
is quiet high.

 In HML analysis unit cost of items are considered for determining the importance of
items.

 Limits of unit costs are fixed for High Cost items (H), Medium Cost items (M), and Low
Cost items (L)

 All the items are segregated into H, M, L, categories depending upon their unit cost.

 This analysis is quiet useful in deciding the safety stock in relation to the availability of
the material (SDE analysis).
 FSN Analysis

 FSN analysis divides the items of stores into three categories in the descending order of
importance of their usage rate

 ‘F’ stands for fast moving items that are consumed in a very short span of time.

 'S' indicates slow moving items which are not issued at frequent intervals & are expected
to be exhausted over a period, say one year.

 'N' stands for non-moving items which are not consumed during last one year.
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

Relevant Costs

▶ 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
Inventory Models for Independent Demand

Need to determine
How much to order
When to order

1. Basic economic order quantity (EOQ) model

2. Production order quantity model
3. Quantity discount model
Basic EOQ Model

Important assumptions

1. Demand is known (deterministic), 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
 Inventory Usage Over Time

Total order received

Average
Order quantity Usage rate inventory on
= Q (maximum hand
Inventory level

inventory
Q
level)
2

Minimum
inventory 0
Time
What is Optimal Order Quantity?
Objective is to minimize total costs

TC= Purchase + Order + Holding

TRC = Order + Holding

Total cost of
holding and setup
(order)

Minimum
total cost
Annual cost

Holding cost

Setup (order) cost

Optimal order Order quantity

quantity (Q*)
Minimizing Costs

▶ By minimizing the sum of setup (or ordering) and holding costs, total costs are minimized
▶ Optimal order size Q* will minimize total cost
▶ A reduction in either cost reduces the total cost
▶ Optimal order quantity occurs when holding cost and setup cost are equal

Q = Number of units per order

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

Annual demand Setup or order

=
Number of units in each order cost per order

𝐷
= S
𝑄

Annual holding cost = (Average inventory level) x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2

𝑄
= 𝐻
2
Optimal order quantity is found when annual setup cost equals annual holding cost

𝐷 𝑄
S= 𝐻
𝑄 2

Solving for Q*
2 DS  Q 2 H
2 DS
Q 
2

H
2 DS
Q* 
H
 Numerical Example
Sharp Inc, a company that markets painless hypodermic needles to hospitals, would like to
reduce inventory cost by determining the optimal number of hypodermic needles to obtain
per order. Calculate the optimal number of needles to order. The annual demand is 1000
units; ordering cost is $10 per order and the holding cost per unit per year is $0.50.

2 DS 2(1,000)(10)
Q 
*
Q 
*
 40,000  200 units
H 0.50

Now determine expected number of orders in a year

Expected Demand D
number of =N= =
orders Order quantity Q*

1,000
N= = 5 orders per year
200
Determine optimal time between orders

Expected time Number of working days per year

between orders = T = Expected number of orders

250
T= = 50 days between orders
5

Determine total annual cost if purchase price is $10 per unit.

Total annual cost = Setup cost + Holding cost + Purchase cost

D Q
TC  S  H  PD
Q 2
1,000 200
 ($10)  ($.50)  (1000)($10)
200 2
 (5)($10)  (100)($.50)  ($10000)
 $10100
 Numerical

A local artisan uses supplies purchased from an overseas supplier. The owner believes the
assumptions of the EOQ model are met reasonably well. Minimization of inventory costs is her
objective. Relevant data, from the files of the craft firm, are annual demand (D) =150 units, ordering
cost (S) = $42 per order, and holding cost (H) = $4 per unit per year

a. How many should she order at one time?

b. How many times per year will she replenish her inventory of this material?
c. What will be the total annual inventory (holding and ordering) costs associated with this material
(rounded to the nearest dollar)?
d. If she discovered that the carrying cost had been overstated, and was in reality only $1 per unit per
year, what is the corrected value of EOQ?

Solution

a. Q* = 56.12. She should order 57 units at a time.

b. N = 2.67 She should place about 3 orders per year.
c. Setup costs = 2.67($42) = $112. Holding costs = (56.12/2)($4) = $112.
Total costs = $112 + $112 = $224.
d. At the lower value for H, the EOQ will be doubled to 112.25.
Reorder Point
 Represents quantity required to ensure against exhaustion of supply during interval
between placement of an order and delivery.
 When stock falls to this level, it is an indication that a new purchase order must be placed.

 EOQ answers the “how much” question

 The reorder point (ROP) tells “when” to order

Reorder Point Calculation

ROP = 𝐷𝑒𝑚𝑎𝑛𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦 × 𝐿𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑑𝑎𝑦𝑠 = 𝑑 × 𝐿

𝐷
𝑑=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
Graphical Representation

Q*

Inventory level (units)

Stock is replenished as order arrives

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
Numerical Example

An Apple store has a demand for 8000 iPhones per year. The firm operates a 250 day
working year. On average, delivery of an order takes 3 working days. Calculate the
reorder point for the store.

Solution

𝐷 8000
𝑑= = = 32 𝑢𝑛𝑖𝑡𝑠/𝑑𝑎𝑦
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟 250

ROP = 𝐷𝑒𝑚𝑎𝑛𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦 × 𝐿𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑑𝑎𝑦𝑠 = 𝑑 × 𝐿 = 32 × 3 = 96 𝑢𝑛𝑖𝑡𝑠

 Production Order Quantity Model

1. Used when inventory continuously flows or builds up over a period of time after an
order has been placed. Or
2. Used when units are produced and sold simultaneously

Part of inventory cycle during which

Inventory level

production (and usage) is taking place

Demand part of cycle with no
production (only usage takes place)
Maximum
inventory

t Time
 Production Order Quantity Model

Q = Number of units per order p = Daily production rate

H = Holding cost per unit per year d = Daily demand/usage rate
t =Length of the production run in days

Assumption: 𝑝 > 𝑑

𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 × 𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 = 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 /2

𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑑 𝑑𝑢𝑟𝑖𝑛𝑔

𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 = −
𝑡ℎ𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑟𝑢𝑛 𝑡ℎ𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑟𝑢𝑛

𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 = 𝑝𝑡 − 𝑑𝑡

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

𝑄 𝑄 𝑑
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 = 𝑝 −𝑑 =𝑄 1−
𝑝 𝑝 𝑝

𝑄 𝑑
𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = 1− 𝐻
2 𝑝

𝐷
𝑆𝑒𝑡𝑢𝑝 𝐶𝑜𝑠𝑡 = 𝑆
𝑄

S  HQ1  d p 
D 1
Q 2
2 DS
Q2 
H 1  d p 
2 DS
Q*p 
H 1  d p 
 Numerical Example
Nathan Manufacturing, Inc. makes and sells speciality hubcaps for the retail automobile aftermarket. Nathan
forecast for its wire-wheel hubcap is 1000 units next year, with an average daily demand of 4 units.
However, the production process is most efficient to produce 8 units per day but company uses only 4 per
day. The company wants to solve for the optimum number of units per order. The cost data is given below

D = 1,000 units p = 8 units per day

S = $10 d = 4 units per day
H = $0.50 per unit per year

2 DS
Q*p 
H 1  d p 
2(1,000)(10)
Q*p 
0.501  (4 8)
20,000
  80,000
0.50(1 2)
 282.8 hubcaps, or 283 hubcaps
Numerical Example
The manager of a bottle-filling plant which bottles soft drink needs to decide the optimal number
of soft drink bottles to produce. Demand for drink is reasonably constant at 80,000 bottles per
month (a month has 160 production hours). The bottling lines fill at a rate of 3000 bottles per hour,
but take an hour to clean and reset between different drinks. The cost (of labour and lost
production capacity) of each of these changeovers has been calculated at $100 per hour. Stock-
holding costs are counted at $ 0.1 per bottle per month.

Solution

𝐷 = 80000 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ = 500 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟 2𝐷𝑆 2 × 80000 × 100

𝑄𝑃∗ = = = 13856
𝑑 500
𝐻 1−𝑝 0.1 1 − 3000

The staff who operate the lines have devised a method of reducing the changeover time from 1
hour to 30 minutes. How would that change the optimal quantity?

2 × 80000 × 50
= 9798
500
0.1 1 − 3000
Economic Order Quantity with Quantity Discounts

 Basic EOQ model is based on the assumption that price per unit of the item is fixed
irrespective of the order quantity.
 Sometimes suppliers offer discount if large quantities are purchased.
 Quantity discount reduces material and procurement costs but increases inventory
carrying cost.
 Decision has to be made whether the purchaser should stick to EOQ or raise order
quantity to take advantage of price discount.
 Total annual cost = Setup cost + Holding cost + Product cost

D Q
TC  S  IP  PD
Q 2

Price of item is a factor in annual holding cost, Holding cost is not constant when the
price per unit changes for each quantity discount.

where Q = Quantity ordered P = Price per unit

D = Annual demand in units I = Percentage
S= Ordering or setup cost per order

2 DS
Q* 
IP

Because unit price varies, holding cost is expressed as a percent (I) of unit price (P)
 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 a possible best order quantity, along with all price-break
quantities for all lower prices.
2. Calculate the total annual cost for each possible order quantity determined in Step 1.
Select the quantity that gives the lowest total cost.
Numerical Example

Chris Beehner Electronics stocks toy remote control flying drones. Recently, the store has
been offered a quantity discount schedule for the drones. This quantity schedule is shown
below in table. Furthermore, setup cost is $ 200 per order, annual demand is 5200 units, and
annual inventory carrying charge as a percent of unit price is 28%. What order quantity will
minimize the total inventory cost?

A Quantity Discount Schedule

PRICE RANGE QUANTITY ORDERED PRICE PER UNIT P

Initial price 0 to 199 $100
Discount price 1 200 to 1,499 $ 98
Discount price 2 1,500 and over $ 96
 Solution
Calculate Q* for every discount starting with the lowest price

∗ 2 5200 $200
𝑄$96 = = 278 𝑑𝑟𝑜𝑛𝑒𝑠/𝑜𝑟𝑑𝑒𝑟 Infeasible
0.28 $96

∗ 2 5200 $200
𝑄$98 = = 275 𝑑𝑟𝑜𝑛𝑒𝑠/𝑜𝑟𝑑𝑒𝑟 Feasible
0.28 $98

Total Cost Computations for Chris Beehner Electronics

Order Unit Annual Annual Holding Annual Product

Total Annual Cost
Quantity Price Ordering Cost Cost Cost

275 $98 $3,782 $3,773 $509,600 $517,155

1,500 $96 $693 $20,160 $499,200 $520,053
 Numerical Example

The annual demand for an item is 10,000 units. The cost to process an order is $75 and the
annual inventory holding cost is 20% of item cost.
(a) What is the optimal order quantity, given the following price breaks for purchasing the
item?
(b) What price should the firm pay per unit?
(c) What is the total annual cost at the optimal behaviour?

Quantity Price
1-9 $2.95 per unit
10 - 999 $2.50 per unit
1,000 - 4,999 $2.30 per unit
5,000 or more $1.85 per unit
 Solution

STEP 1: EOQ at $1.85 = 2013.47 → infeasible

EOQ at $2.30 = 1805.79 → feasible
So the possible best answers are 1806 and 5000

STEP 2: TC for 1806 units = $23,830.66

TC for 5000 units = $19,575.00

(a) Order 5000 units at a time.

(b) The price is $1.85 per unit.
(c) Total annual purchasing, holding, and setup costs = $19,575.00.