Principles of Supply Chain Management (5e)

Chapter
INVENTORY
MANAGEMENT

Prepared by Cynthia Wisner, MBA

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 Principles of Supply Chain Management (5e)

LEARNING OBJECTIVES
You should be able to:

• Distinguish dependent from independent demand

inventories
• Describe the four basic types of inventories & their
functions
• Describe the costs of inventory & inventory turnovers
• Describe ABC classification, ABC inventory matrix &
cycle counting

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 Principles of Supply Chain Management (5e)

LEARNING OBJECTIVES (Continued)

You should be able to:

• Describe RFID & how it can be used in inventory
management
• Describe the EOQ model & its underlying assumptions
• Describe the Quantity Discounts & the EMQ Models &
their relationships with the basic EOQ model
• Describe the various statistical ROP models
• Describe the continuous review & periodic review
systems

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3
 Principles of Supply Chain Management (5e)

CHAPTER OUTLINE

• Introduction
• Dependent and Independent Demand
• Concepts and Tools of Inventory
Management
• Inventory Models

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otherwise on a password-protected website or school-approved learning management system for classroom use.
 Principles of Supply Chain Management (5e)

Introduction
▪ Inventory can be one of the most expensive assets of an
organization
▪ Management must reduce inventory levels yet avoid
stockouts
▪ Managing perishable inventory presents a unique
challenge
▪ Excessive inventory is a sign of poor inventory
management
▪ Excessive inventory adversely affects financial
performance

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 Principles of Supply Chain Management (5e)

Dependent & Independent Demand

Inventory management models –
Generally classified as dependent demand and
independent demand models

▪ Dependent Demand – internal demand for parts

based on demand of the final product in which parts are used
▪ Examples include; Subassemblies, components, & raw
materials
▪ Independent Demand – demand for end products &
has demand pattern affected by trends, seasonal patterns, &
general market conditions

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otherwise on a password-protected website or school-approved learning management system for classroom use.
 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management
▪ Primary functions of inventory are to –
• Buffer from uncertainty in the marketplace
• Decouple dependencies in the supply chain (e.g., safety
stock)

▪ Four broad categories of inventories

• Raw materials- unprocessed purchase inputs
• Work-in-process (WIP)- partially processed materials not
yet ready for sales
• Finished goods- completed products ready for shipment
• Maintenance, repair & operating (MRO)- materials &
supplies used in producing products (e.g., cleaners &
brooms)

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otherwise on a password-protected website or school-approved learning management system for classroom use.
 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management (Continued)

Inventory Costs
• Direct costs- directly traceable to unit produced (e.g.,
labor)
• Indirect costs- cannot be traced directly to the unit
produced (e.g., overhead)
• Fixed costs- independent of the output quantity (e.g,
buildings, equipment)
• Variable costs- vary with output level (e.g., materials)
• Order costs- direct variable costs for placing an order
• Holding or carrying costs- incurred for holding inventory
in storage
• In mfg, setup costs are related to machine setups

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 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management (Continued)

Inventory Investment measurements include:

▪ Absolute value of inventory (on balance sheet)
▪ Cycle counting, or physically counting inventory
on a periodic basis
▪ Inventory turnover or turnover ratio - how many
times inventory “turns” in an accounting period.
Higher number is better

Cost of Revenue
Inventory Turnover Ratio =
Average Inventory

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otherwise on a password-protected website or school-approved learning management system for classroom use.
 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management (Continued)

ABC Inventory Control System

Determines which inventories should be counted &
managed more closely than others

▪ Groups inventory as A, B, & C Items

• A items are given the highest priority with larger safety stocks.
A items account for approximately 20% of the total items &
about 80% of the total inventory cost
• B items account for the other about 40% of total items & 15%
of total inventory cost.
• C items have the lowest value and hence lowest priority. They
account for the remaining 40% of total items & 5% of total
inventory cost.

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 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management (Continued)

The ABC Inventory Matrix

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 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management (Continued)

Radio Frequency Identification (RFID) - tracks individual

unit of goods. Does not require direct line of sight to read a
tag and information on the tag is updatable.

RFID Tags (Transponders) Readers Information Infrastructure (Local/ERP Servers)

Item

Hand Held Readers

Shelf Readers
Box Fixed Portal Readers Database
RFID Middleware
Local / ERP Server
Pallet
Crate

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 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management (Continued)

Near Field Communication (NFC) - secure form of data

exchange between an NFC tag & Android-powered devices
Two major RFID standards:
1. Electronic product code (EPC) standard, managed by the
EPCglobal, Inc.
• Classes 0, 1 and 2 are passive RFID tags - do not store power on
the tags
• Classes 3 and 4 are active RFID tags contain a power source to
boost their range
• Class 5 tags communicate with other class 5 tags and devices
2. 18000 standard of the International Standards Organization
(ISO)

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 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management (Continued)

Components of Radio Frequency Identification System

▪ Tag - computer chip and an antenna for wireless

communication
▪ Reader - handheld or fixed-position RFID device that
reads the tags
▪ Communication network - connects the readers to
transmit inventory information to the enterprise
information system
▪ RFID software - manages the collection, synchronization,
and communication of the data with systems, and stores
the information in a database
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 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management (Continued)

How RFID Automates the supply chain:

▪ Materials Management – goods automatically counted &
logged as they enter supply warehouse
▪ Manufacturing – customer configurations encoded on tag
can be incorporated automatically during the production
process
▪ Distribution Center – shipment leaving DC automatically
updates ERP to trigger replenishment order & notify
customer for delivery
▪ Retail Store – reader placed on store shelf to trigger
automatic replenishments when item reaches its reorder
point
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otherwise on a password-protected website or school-approved learning management system for classroom use.
 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management (Continued)

Global RFID Implementation and Challenges

▪ Tagging strategies differ considerably by region

▪ China is skeptical about sharing potentially confidential
information with foreign businesses
▪ Consumer-privacy issues and high implementation costs
for hardware and tags
▪ Differences between radio frequencies in different parts
of the world
▪ UHF signals are reflected by metal and absorbed by
water
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otherwise on a password-protected website or school-approved learning management system for classroom use.
 Principles of Supply Chain Management (5e)

Concepts and Tools of Inventory

Management (Continued)

Big Data Decision-Making

▪ Big data broadly refers to collections of data

sets too large & complex to be processed by
traditional database management tools

▪ Big data technology helps process data in real

time to take advantage of information captured
by RFID

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 Principles of Supply Chain Management (5e)

Inventory Models
Fixed Order Quantity Models

• Economic Order Quantity Model

• Quantity Discount Model
• Economic Manufacturing Quantity Model

These models use fixed parameters to derive the

optimum order quantity to minimize total inventory cost

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

Economic Order Quantity (EOQ) Model –

quantitative decision model based on the trade-off between
annual inventory holding costs & annual order costs

• Seeks to determine optimal order quantity

• Order Cost is direct variable cost associated with
placing an order. (Sometimes called setup cost)
• Holding Cost is cost incurred for holding inventory in
storage. (Sometimes called carrying cost)

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

▪ Assumptions of the EOQ Model

1. Demand must be known & constant
2. Order lead time is known & constant
3. Replenishment is instantaneous
4. Price is constant
5. Holding cost is known & constant
6. Ordering cost is known & constant
7. Stock-outs are not allowed

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

Total Annual Inventory Cost (TAIC) formula

• TAIC = Annual purchase cost + Annual holding cost +
Annual order cost
• TAIC = APC + AHC + AOC = (R x C) + (Q/2 x (k x C)) +
(R/Q x S)
Where
TAIC = total annual inventory cost C = purchase cost per unit
APC = annual purchase cost S = cost of placing one order
AHC = annual holding cost R = annual demand
AOC = annual order cost Q = order quantity
k = holding rate, where annual holding cost per unit = k x C

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otherwise on a password-protected website or school-approved learning management system for classroom use.
 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

• Economic Order Quantity formula

2𝑅𝑆
EOQ =
𝑘𝐶

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

EOQ Model

If order size is smaller

than EOQ of 600 units
• annual holding cost
is slightly lower
• annual order cost is
slightly higher

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

Physical Inventory with the EOQ Model

Inventory on hand & relationships to – EOQ, average
inventory, lead time, reorder point, & order cycle

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

▪ The Quantity Discount Model or price-break model

• Relaxes the constant price assumption by allowing
purchase quantity discounts

• Considers trade-off between purchasing in larger

quantities to take advantage of the price discount & the
higher costs of holding inventory

• Due to step-wise shape of total inventory cost curve,

optimal order quantity lies on either one of the feasible
EOQs or at the price break point

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

Quantity Discount Model

Total Costs ($) EOQC=$5.00 = 483 (Infeasible EOQ)
EOQC=$4.50 = 509 (Infeasible EOQ)
EOQC=$4.00 = 540 (Feasible EOQ)

Total Annual Inventory Cost

Optimal Order Quantity

First price break

Second price break

0 201 501 Order Size (Q)

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

▪ Economic Manufacturing Quantity Model or

Production Order Quantity Model

• Relaxes the instantaneous replenishment assumption

by allowing usage during production or partial delivery

• EMQ model is especially appropriate for a

manufacturing environment with simultaneous
manufacture and consumption

• Inventory builds up gradually during the production

period rather than at once as in the EOQ model

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

The EMQ Model

Inventory On-hand

Qm

- D)
Inv
P
at ( ent
ory
up
dep
lete
ilds

sa
tD
bu
y
tor
en
Inv

Production
Demand Only
& Demand

TP TC Time

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

▪ Economic Manufacturing Quantity Model

• Production rate, P, - production lot size divided by the
time required to produce the lot
𝑄
P=
𝑇𝑝
• Maximum inventory, QM, - multiply inventory build-up
rate with production period

QM = (P – D) × TP

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

▪ The Statistical Reorder Point (ROP)

• Lowest inventory level when a new order must

be placed to avoid a stockout
• Demand and delivery lead time are never
certain and require safety stock
• In-stock probability is commonly referred to as
the service level

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

Statistical ROP with Probabilistic Demand and Constant

Lead Time - assumes lead time is constant while demand during
delivery lead time is unknown but can be specified using normal
distribution
Relationship between safety stock and probability of a stockout
when average demand during the lead time is represented by μ,
and ROP is represented by x, then the safety stock is (x – μ)
𝑥−µ
which is derived from standard deviation formula 𝑍=
𝜎
Calculated as the average demand
during the order’s delivery lead time
plus the desired safety stock, or:

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

Statistical ROP with Constant Demand and Probabilistic

Lead Time - demand is constant and lead time is unknown
but can be specified by means of a normal distribution
Safety stock is: (daily demand × 𝑍𝜎𝐿𝑇 )

Reorder point is: ROP = (daily demand × average lead time

in days) + (daily demand × 𝑍𝜎𝐿𝑇 )
Where
𝜎𝐿𝑇 = the standard deviation of lead time in days

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

Statistical ROP with Demand and Lead Time are both

Probabilistic - both demand and lead time are unknown
but can be specified by means of a normal distribution
Safety stock must be held to cover the variations in both
demand and lead time.
Computed as follows:
Where
𝜎𝑑𝐿𝑇 = Standard deviation of demand during the lead time

𝜎𝑑 = Standard deviation of daily demand

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

Continuous Review System

• Reality shows that stock records and actual quantity
are different & requires continuous review of inventory
to determine when to reorder
• Can be difficult to achieve and expensive to implement
• Costly to conduct but requires less safety stock

Periodic Review Inventory System

• Reviews physical inventory at specific points in time
and requires higher level of safety stock

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

The Continuous Review System

• (s, Q) continuous review policy: orders the
same quantity, Q, when physical inventory
reaches the reorder point, s
• (s, S) continuous review policy: When current
inventory reaches or falls below the reorder
point, s, sufficient units are ordered to bring
the inventory up to a pre-determined level, S.

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 Principles of Supply Chain Management (5e)

Inventory Models (Continued)

The Periodic Review System

• (nQ, s, R) periodic review policy: If at the time of inventory
review, the physical inventory is equal to or less than the
reorder point, s, the quantity, nQ, is ordered to bring the
inventory up to the level between s and (s + Q).
• (S, R) periodic review policy: At each review time, a
sufficient quantity is ordered to bring the inventory up to a
pre-determined maximum inventory level, S.
• (s, S, R) policy: If at the time of inventory review, the
physical inventory is equal to or less than the reorder point,
s, a sufficient quantity is ordered to bring the inventory
level up to the maximum inventory level, S.

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 Principles of Supply Chain Management (5e)

End of Chapter 7

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otherwise on a password-protected website or school-approved learning management system for classroom use.
37