Inventory Management

Inventory Management

• Inventory refers to stocks of goods and

materials that are maintained for many
purposes, the most common being to satisfy
normal demand patterns.
BASIC INVENTORY The reasons for holding inventory and
CONCEPTS the various types of inventory
Enables the firms to achieve
economics of scale

5 reasons for holding

Balance supply and demand
Understanding
the role of inventory Enables specialization in
inventory in manufacturing dcchuyen
tinh the thuc
mon hoa

manufacturing Provides protection from

and marketing uncertainties in demand and order
cycles

Acts as a buffer between critical

interfaces within the supply chain
 Transportation costs
ECONOMICS OF In purchasing , transportation Transportation economies
SCALE and manufacturing
Manufacturing economies

BALANCE
S&D Seasonal supply and demand

SPECIALIZATION Specialization in the products

that it manufactures
 Price increase
Protection from Raw materials Strike
uncertainties inventory Seasonal availability
Earthquake

Supplier – procurement (purchasing)

Purchasing-production
A buffer Production- marketing
throughout the
Marketing- distribution
supply chain
Distribution –intermediary
Intermediary- consumer/user
INVENTORY CLASSIFICATION phan chia du tru

1. Cycle 2. In transit
stock inventory

6 TYPES OF 3. Safety or
4.
Speculative
INVENTORY buffer stock
stock
du tru dau co tich tru

5. Seasonal 6. Dead
stock Stock
 1. CYCLES INVENTORY: result from the replenishment
process in order to meet the demand under conditions of
certainty ( when the firm can predict demand and
replenishment times ) perfectly.

Order arrival
Inventory Order placed
Average cycle
inventory

Order quantity of 400 units

2. IN TRANSIT INVENTORY : du tru chu ki

• The items that are on route from one location to

another.
• They are considered part of cycle stock even
through they are not available for sale/use until
after they arrive at destination.

Note: for calculation of inventory carrying costs, in-transit

inventories should be considered as inventory at place of
shipment origin since the items are not available for use, sale
or subsequent reshipment
 3. SAFETY OR BUFFER STOCK: is held in excess of cycle
stock because of uncertainty in demand or lead time. du tru an toan

A. With variable demand

Inventory

Average cycle
inventory

Average
inventory
(150)
8 10 20 30 40

days
SAFETY STOCK = ?
 SAFETY OR BUFFER STOCK: is held in excess of cycle
stock because of uncertainty in demand or lead time. du tru dau co ( mn muon loai bo )

B. With variable lead-time

inventory

Average cycle
inventory

Average
inventory
(140) 12

Safety stock = ?
 SAFETY OR BUFFER STOCK: is held in excess of cycle
stock because of uncertainty in demand or lead time.

C. With variable lead time and demand

inventory
Average cycle
inventory

Average
inventory
200 8 days
12

Safety stock = ?
 du tru dau co ( nen kinh te thi truong muon loai bo )

4. SPECULATIVE STOCK is inventory held for

reason other than satisfying current demand

Forecasted
Protect
price
against the Seasonal Seasonal
increase or
possibility of consumption demand
materials
a strike
shortage
5. SEASONAL STOCK is a form of speculative stock
that involves the accumulation of inventory before a
season begins in order to maintain a stable labor force
and stable production runs

Agricultural products
(growing season)
DEAD STOCK is a set of of items for which no demand has
been registered for some specified period of time.
 Inventory Costs
• Inventory costs in the twenty-first century
represent approximately one-third of total
logistics costs.

• Inventory cost should factor into an organization’s

inventory management policy.

• Inventory costs include:

– Carrying cost cc ( holding cost )

– Ordering cost setup cost ( Co)

– Stockout cost chi phi thieu hut hoac du thua, chi phi mat mat do thieu hut hang hoa
 Inventory Costs

• Inventory carrying (holding) costs

– the costs associated with holding inventory.
– In general expressed in percentage terms and
this percentage is multiplied by the inventory’s
value
– Resulting number represents dollar value
associated with holding the particularl inventory.
Inventory Costs
Inventory Costs

lai
 Why Carrying Costs Increase

• More units must be stored if more are ordered

Purchase Order Purchase Order

Description Qty. Description Qty.
Microwave 1 Microwave 1000
Order quantity Order quantity
Annual cost (dollars)

Carrying cost

Lot Size (Q)

san luong dat trong 1 don hang
 Carrying Cost

Carrying Cost = average inventory x carrying cost per unit

AnnualcarryingCost = AveInventory )( carrying cos t / unit / year )

tinh chi phi phai tinh 1 nam muc du tru trung binh 1 nam

dau ki Q cuoi ki 0

æQö
AnnualcarryingCost = ç ÷ H
è2ø
 Holding cost

3000 —
Annual cost (dollars)

2000 —
Q
Carrying cost = (H)
2

1000 —

0— | | | | | | | |
50 100 150 200 250 300 350 400

Lot Size (Q)

 Inventory Costs

• Ordering costs refer to those costs associated

with ordering inventory, such as order costs
and setup costs.
 Inventory Costs
• Examples of order costs include:
– Costs of receiving an order (wages)
– Conducting a credit check
– Verifying inventory availability
– Entering orders into the system
– Preparing invoices
– Receiving payment
 Why Order Costs Decrease
• If we order more when we place an order,
Order cost $10
then we order fewer times over the year.
Purchase Order
• Example: You expect to order 10 microwave Description Qty.
ovens over a year for a retail store like Sears. It Microwave 1
cost $10 to place an order.
n If you order 1 microwave, how many
orders will you place over the year?
what is the ordering cost? What is the Order Cost $10
ordering cost per microwave? Purchase Order
Description Qty.
n If you order 10 microwaves, how many
Microwave 10
orders will you place over the year? What
is the ordering cost? What is the ordering
cost per microwave?
Annual cost (dollars)

Carrying cost

Ordering cost

Lot Size (Q)

 Ordering cost

Ordering Cost = # of orders per year x ordering cost per order

AnnualDemand
AnnualOrderCost = (OrderCost )
OrderQuantity

D
AnnualOrderCost = S
Q
Carrying & Ordering Cost

3000 —
Annual cost (dollars)

2000 —
Q
Carrying cost = (H)
2

1000 —
D
Ordering cost = (S)
Q

0— | | | | | | | |
50 100 150 200 250 300 350 400

Lot Size (Q)

 Inventory Costs
• Trade-Off between Carrying and Ordering Costs
– Costs respond in opposite ways to the number of
orders or size of orders
– An increase in the number of orders leads to higher
order costs but lower carrying costs
 Inventory Costs
• Stockout costs
– an estimated cost or penalty for a stockout
– involve an understanding of a customer’s reaction to a
company being out of stock when a customer wants to
buy an item
Inventory Costs
 Inventory Costs
• General Rules Regarding Stockout Costs

– The higher the average cost of a stockout, the better it

is for the company to hold some amount of inventory
(safety stock) to protect against stockouts.

– The higher the probability of a delayed sale, the lower

the average stockout costs and the lower the inventory
that needs to be held by a company.
 Inventory Costs
• Trade-Off between Carrying and Stockout
Costs
– Costs move in opposite directions
– Higher inventory levels (higher carrying costs)
result in lower chances of a stockout (lower
stockout costs)
Inventory Costs
 When to Order
• Key issue involves when product should be
ordered
– Can order a fixed amount of inventory (fixed order
quantity system)
– Or orders can be placed at fixed time intervals
(fixed order interval system)
 When to Order
• Reorder (trigger) point (ROP)
– Level of inventory at which a replenishment order
is placed
– Necessary for efficient fixed order quantity system
 When to Order
• Reorder Point (ROP) calculations:

ROP = DD x RC under certainty

ROP = (DD x RC) + SS under uncertainty
Where DD = daily demand
RC = length of replenishment cycle (Lead-time)
SS = safety stock
 How Much to Order
Economic order quantity (EOQ)
Basic EOQ model
– Known and constant demand
– Known and constant lead time
– Instantaneous receipt of material
– No quantity discounts
– Only order (setup) cost and holding cost
– No stockouts
 How Much to Order
Economic order quantity (EOQ)

– Deals with calculating the proper order size with

respect to two costs
§ Costs of carrying the inventory
§ Costs of ordering the inventory
─ Determines the point at which the sum of carrying
costs and ordering costs is minimized, or the point
at which carrying costs equal ordering costs

Copyright © 2015 Pearson Education, Inc.

Total Cost = Holding Cost + Order Cost
 Total Cost

3000 —
Q D
Annual cost (dollars)

Total cost = (H) + (S)

2 Q

2000 —
Q
Holding cost = (H)
2

1000 —
D
Ordering cost = (S)
Q

0— | | | | | | | |
50 100 150 200 250 300 350 400

Lot Size (Q)

 Total cost:

TotalCost = TotalOrderCost + TotalHoldingCost

D Q
TC = S + H
Q 2
What is the annual cost of the current
policy?
D – Total demand

D Q
Q – Order quantity TC = S + H
Q 2
S – Setup/order cost

H – Holding cost
 Gift Shop
• A museum of natural history is having problems
managing their inventories. Low inventory turnover
is squeezing profit margins and causing cash-flow
problems.
• A Class A item, a birdfeeder is also a top-selling
item.
– Sales: 18 units/week
– Purchase cost: $60/unit
– Order cost: $ 45/order
– Annual holding cost/unit: 25% of purchase cost
– 52-week year
• Management has been ordering in lots of 390 units.
What is the annual cost of the current
policy?
• Q – order quantity
Q

• TC – Total cost
– Annual
Time
– Monthly
– ??
What is the annual cost of the current policy?

D – Total demand D Q
936/year TC = S + H
Q 2
Q – Order quantity
390/order 936 390
TC = 45 + 15
390 2
S – Setup/order cost
$45/order TC = 108 + 2925
H – Holding cost TC = 3033
= 0.25*60
= $15/unit/year
Can the gift shop do better?

Current
cost
3000 —
Q D
Annual cost (dollars)

Total cost = (H) + (S)

2 Q

2000 —
Q
Carrying cost = (H)
2

1000 —
D
Ordering cost = (S)
Q

0— | | | | | | | |
50 100 150 200 250 300 350 400
Current
Lot Size (Q)
Q
Economic Order Quantity – Q*

3000 —
Annual cost (dollars)

2000 —

1000 —
Order cost = Holding Cost
0— | | | | | | | |
50 100 150 200 250 300 350 400

Q* Lot Size (Q)

Economic Order Quantity (EOQ) – Q*

2 DS
Q* =
H

2(936)(45)
Q* = = 74.94 » 75units / order
15
Total Cost of Economic Order Quantity (EOQ) – Q*

D Q*
TC = S+ H
Q* 2
936 75
TC = 45 + 15
75 2
When Q = 390
TC = 1124.10 TC = 3033
 When to order?

• Reorder point (ROP)

– Lead time – amount of time from order placement
to receipt of goods

– Lead time demand – the demand the occurs

during the lead time
 Reorder point

Order
received
On-hand inventory

OH

R
Order
placed

L
TBO
 Gift shop reorder point

• Demand: 18 birdfeeders/week

• Lead time: 2 weeks

• Lead time demand: 36 birdfeeders

• ROP: 36 birdfeeders
 Gift shop order policy

• Place order when the on-hand inventory is 36

birdfeeders.
• Order 75 birdfeeders
• Order received in 2 weeks
• Place next order when the on-hand inventory
is 36 birdfeeders
An automobile manufacturer uses about 60,000 pairs of
bumpers (front bumper and rear bumper) per year, which it
orders from a supplier. The bumpers are used at a
reasonably steady rate during the 240 working days per
year. It costs $3.00 to keep one pair of bumpers in
inventory for one month, and it costs $25.00 to place an
order. A pair of bumpers costs $150.00.
a. Write the annual carrying cost function.
b. Write the annual ordering cost function.
c. Write the annual total cost function.
d. What is the EOQ?
e. What is the total annual expense of ordering the EOQ every
time?
f. How many orders will be placed per year?
g. What is the total annual expense of ordering 600 pairs of
bumpers every time? How much is saved per year by ordering
the EOQ?
a. The annual carrying cost
Cc = HQ/2 = 3(12)Q/2 = 18Q.
b. The annual ordering cost
Co = DS/Q = 60000(25)/Q = 1500000/Q
c. The annual total cost TC = 18Q + 1500000/Q.
d.

= 289 pairs of bumpers.

e. The annual total expense

TC = (Q/2)H + (D/Q)S = (289/2)36 + (60,000/289)25 = $10,392.00 per year.
f. The number of orders = D/Q = 60000/289 = 208 per year.
g. The annual total expense
TC(600) = 18(600) + 1500000/600 = $13,300.
The annual savings are $13,300 - $10,392 = $2,908.00.
 POQ model

• Assumptions
– Known and constant demand
– Known and constant lead time
– Partial receipt of material
– No quantity discounts
– Only order (setup) cost and holding cost
– No stockouts
 POQ model

• Producing and shipping product

simultaneously until production quantity is
reached.
• Ship the inventory at a constant rate (no
production)
• Reorder same amount
• Begin production and shipping product
simultaneously
Production Order Quantity
On-hand inventory

Time
Production Order Quantity

Production quantity
Q
On-hand inventory

Time
Production Order Quantity

Production quantity
Q
On-hand inventory

Demand during
production interval

p–d

Time
Production Order Quantity

Production quantity
Q
On-hand inventory

Demand during
production interval

p–d

Time
Production Order Quantity

Production quantity
Q
On-hand inventory

Demand during
production interval

p–d

Time
Production Demand
and demand only
TBO
Production Order Quantity
Production quantity
Q
On-hand inventory

Demand during
production interval

p–d

Time
Production Demand
and demand only
TBO
 Production Order Quantity (POQ Model)

Production quantity
Q
On-hand inventory

Demand during
production interval

Maximum inventory

p–d

Time
Production Demand
and demand only
 POQ Model

D – annual demand
S – Setup cost
2 DS
Q =
*
p
H – Holding cost
H (1 - d / p )
d – daily demand rate
p – daily production rate
 Chemical Plant
A plant manager of a chemical plant must
determine the lot size for a particular chemical
that has a steady demand of 30 barrels/day. The
production rate is 190 barrels/day, annual
demand is 10,500 barrels, setup cost is $200,
annual holding cost is $0.21/barrel, and the plant
operates 350 days/year.
Determine the production order quantity?
What is the maximum inventory quantity and the
total cost ?
 Chemical Plant

Demand: d = 30 barrels/day
D = 10,500 barrels/year

Setup cost: $200/setup

Holding cost: $0.21/barrel/year

Production: 190 barrels/day

 Chemical Plant

2 DS
Q =
*
p
H (1 - d / p )

2(10500)(200)
Q =
*
p
0.21(1 - 30 / 190)

Q = 4,873.4 » 4,873barrels
*
p

Qmax = 4873(1 - 30 / 190) = 4,104

Ex2.
Assume that our firm produces type C fire
extinguishers. We make 30,000 of these fire
extinguishers per year. Each extinguisher requires one
handle (assume a 300 day work year for daily usage
rate purposes). Assume an annual carrying cost of
$1.50 per handle; production setup cost of $150, and a
daily production rate of 300. What is the optimal
production order quantity?
What is the maximum inventory quantity and the total
cost ?
 Quantity Discount Model

• Answers how much to order & when to order

• Allows quantity discounts
– Reduced price when item is purchased in larger
quantities
– Other EOQ assumptions apply
• Trade-off is between lower price & increased
holding cost
• Compute EOQ for each quantity discount
price
• Is computed EOQ in discount range?
• If not, use the lowest cost quantity in discount
range
• Compute total cost for EOQ or lowest cost
quantity in discount range
• Select quantity with lowest total cost
See example below:
Discount Number Discount Quantity Discount Discount Cost
1 0 to 999 0% $5.00
2 1,000 to 1,999 4% $4.80
3 2,000 and over 5% $4.75

The normal cost for the item in this example is $5. When 1,000 to
1,999 units are ordered at one time, the cost per unit drops to $4.8,
and when quantity ordered at one time is 2,000 unit or more, the
cost is $4.75 per unit.
Furthermore, the ordering cost is $49 per order, the annual
demand is 5,000 race cars, and the inventory carrying charge as a
percentage of cost is 20%, or 0.2. What order quantity will minimize
the total cost ?
C
Calculate Q* for every discount

Q* value for discount 2 and 3 are too low to be eligible for the discounted
prices. They are therefore, adjusted upward to 1000 and 2,000, respedtively.
Ex.2. An automobile manufacturer uses about 60,000 pairs of bumpers (front bumper
and rear bumper) per year, which it orders from a supplier. The bumpers are used at a
reasonably steady rate during the 240 working days per year. It costs $3.00 to keep one
pair of bumpers in inventory for one month, and it costs $25.00 to place an order. A pair
of bumpers costs $150.00. The supplier offers a system of quantity
discounts, as follows:
Order Quantity Cost per Pair Discount
1 to 299 pairs $150.00 0%
300 to 499 pairs $150.00 4%
500 or more pairs $150.00 10%
a. Write the annual total cost function for orders for less than 300
pairs.
b. Write the annual total cost function for orders for 300 to 499 pairs.
c. Write the total cost function for orders for at least 500 pairs.
d. What is the EOQ?
e. What is the total annual expense, including the purchasing cost of
ordering the EOQ?
a. The annual total cost = 18Q + 1500000/Q + 150D.
b. The net price = 150(1 – dis.) = 150(1 - 0.04) = $144.00.
The annual total cost = 18Q + 1500000/Q + 144D.
c. The net price = 150(1 – dis.) = 150(1 - 0.10) $135.00.
The annual total cost = 18Q + 1500000/Q + 135D.
d.
= 289 pairs of bumpers

Adjusted: Q*1 = 289

Q*2 = 300
Q*3 = 500
TC1 = 18(289) + 1.500.000/289 + 150(60.000) = 9,010,392
TC2 = 18(300) + 1.500.000/300 + 144(60.000) = 8,650,400
TC3 = 18(500) + 1.500.000/500 + 135(60.000) = 8,112,000
ÞEOQ = 500
ÞTC = 8,112,000
 How Much to Order
Economic order quantity (EOQ)
• Economic order quantity (EOQ) in dollars

Where:
EOQ = the most economic order size, in
dollars
A = annual usage, in dollars
B = administrative costs per order of
placing the order
C = carrying costs of the inventory (%)

Copyright © 2015 Pearson Education, Inc.

 How Much to Order
• Economic order quantity (EOQ) in units

Where:
EOQ = the most economic order size, in units
A = annual demand, in units
B = administrative costs per order of placing the
order
C = carrying costs of the inventory (%)
I = dollar value of the inventory, per unit
How Much to Order
How Much to Order
Inventory Flows
 Inventory Flows
• Safety stock can prevent against two problem
areas
– Increased rate of demand
– Longer-than-normal replenishment
• When fixed order quantity system like EOQ is
used, time between orders may vary
• When reorder point is reached, fixed order
quantity is ordered
 Inventory Management: Special
Concerns
• ABC Analysis of Inventory
– recognizes that inventories are not of equal value to a firm
– as such all inventory should not be managed in the same
way

• Dead inventory (dead stock)

– is a fourth category, D, to ABC analysis where D stands for
either “dogs” or dead inventory (dead stock)
– refers to product for which there is no sales during a 12
month period.
 Inventory Management: Special
Concerns
• Inventory Turnover
– number of times that inventory is sold in a one-year
period. (Compare with competitors or benchmarked
companies
Inventory turnover = cost of goods sold
average inventory
• Complementary Products
– inventories that can be used or distributed together, i.e.
razor blades and razors.

• Substitute Products
– products that can fill the same need or want as another
product.
 Contemporary Approaches to
Managing Inventory
• Lean Manufacturing
– Focuses on the elimination of waste and the
increase of speed and flow
– Identifies seven major sources of waste
including inventory
– Just-in-time (JIT) is one of the best known lean
inventory practices
 Contemporary Approaches to
Managing Inventory
• Lean Manufacturing
– Just-in-time (JIT)
§ Seeks to minimize inventory by reducing (or
eliminating) safety stock while having the required
amount of materials arrive at the production
location at the exact time they are needed
 Contemporary Approaches to
Managing Inventory
• Service Parts Logistics
– Involves designing a network of facilities to
stock service parts:
§ Deciding upon inventory ordering policies
§ Stocking the required parts
§ Transporting parts from stocking facilities to
customers

Source: Mehmet Ferhat Candas and Erhat Kutanoglu, “Benefits of Considering Inventory in Service Parts
Logistics Network
 Contemporary Approaches to
Managing Inventory
• Vendor-Managed Inventory (VMI)
– Size and timing of replenishment orders are
the responsibility of the manufacturer
– Allows manufacturers to have access to a
distributor’s or retailer’s sales and inventory
data
– Benefits include reduced inventories, fewer
stockouts and improved customer retention
Contemporary Approaches to
Managing Inventory
FIGURE 8.4 Advertisement
from a Parts Bank Service
Source: Courtesy of Associated
Distribution Logistics (ADL)