Inventory

Management
 Learning Objectives

§ Conduct an ABC analysis

§ Explain and use cycle counting
§ Explain and use the EOQ model for
independent inventory demand
§ Compute a reorder point and explain safety
stock
§ Apply the production order quantity model
§ Explain and use the quantity discount model
Importance of Inventory
The objective of
inventory management
is to strike a balance
between inventory
investment and
customer service
 Importance of Inventory

As much as 50%
Arguably the most
of total invested
important OM decision
capital

Less inventory More inventory

• Reduce cost • Raises cost
• Increase chances • Customers always
of running out happy
Provide selection for
anticipated demand

Separate firm from

fluctuations in demand Functions
Decouple various parts of
production process of
Take advantage of
quantity discounts
Inventory

Hedge against inflation

Generate holding costs
Difficult to control, store and maintain
Handling inventory a non-value added activity
Reduces cash availability
Risk of product obsolescence
Delays responsiveness to new products
“Bandage” around a problem – miss out the root problem
Types of Inventory

§ Raw material

§ Work-in-process (WIP)

§ Maintenance / repair /
operating (MRO)

§ Finished goods
 Types of Inventory

Raw Material Inventory

§ Purchased but not processed

§ Can be used to decouple (i.e. separate)

suppliers from production process

§ Aim: Eliminate supplier variability

 Types of Inventory

Work-in-Progress Material

§ Undergone some changes but

not completed
§ A function of cycle time for a
product
§ Reduction in cycle time reduces
inventory
 The Material Flow Cycle

Cycle time
95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time

“Most of the time that work is in process (95% of the cycle

time) is NOT productive time”
 Types of Inventory

Maintenance/Repair/Operating (MRO)

§ Necessary to keep machinery

and processes productive

§ Often a function of
maintenance schedules
 Types of Inventory
Finished Goods Inventory

§ Completed product
awaiting shipment

§ Cater for future customer

demands
Managing Inventory
Managing Inventory

1) How inventory items can be

classified (ABC analysis)

2) How accurate inventory

records can be maintained
 ABC Analysis

§ Used to establish policies that focus on the few critical

parts and not the many trivial ones

§ 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
 ABC Analysis

Percentage of annual dollar usage

A Items
80 –
70 – 15% inventory, 70-80% dollar usage
60 –
50 –
40 –
30 – 30% inventory, 15-25% dollar usage
20 – B Items
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
55% inventory, 5% dollar usage

Percentage of inventory items

Example: ABC Analysis – ABC Calculation
 ABC Analysis

Other criteria than annual dollar volume may be used

§ High shortage or holding cost
§ Anticipated engineering changes
§ Delivery problems
§ Quality problems

Advantage of dividing inventory into classes

allows policies and controls to be established
 ABC Analysis

Policies may include

1. More emphasis on supplier

development for A items
2. Tighter physical inventory control for
A items à security, accuracy of
records
3. More care in forecasting A items
 Record Accuracy

§ Pre-requisite to inventory
management, scheduling and sales
§ Incoming and outgoing record
must be accurate
§ Stockrooms should be secure and
have good housekeeping
§ Necessary to make precise
decisions about ordering,
scheduling, and shipping
 Record Accuracy
§ Periodic systems
§ Regular checks to determine quantity on hand
§ Small retailers, vendor-managed
§ Lack of control
§ Variation: Two-bin system – places order when the first
container is empty

§ Perpetual systems
§ Tracks both receipt (receiving dept) and subtractions (leave
stockroom, POS) on a continuing basis
 Cycle Counting

§ Records must be verified through continuing audit

§ Items are counted and records updated on a periodic basis

§ Often used with ABC analysis

§ Items counted à records verified à inaccuracies

periodically documented
§ Inaccuracies then traced and appropriate remedial action
taken to ensure integrity
 Advantages of Cycle Counting

§ Eliminates shutdowns and interruptions

§ Eliminates annual inventory adjustments

§ Trained personnel audit inventory accuracy

§ Allows causes of errors to be identified and corrected

§ Maintains accurate inventory records

 Example: Cycle Counting
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)
CYCLE
ITEM COUNTING NUMBER OF ITEMS
CLASS QUANTITY COUNTED PER DAY
POLICY
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
 Control of Service Inventories
§ Can be a critical component of profitability

§ Losses may come from shrinkage (inventory unaccounted for,

damage, theft, sloppy paperwork) or pilferage (inventory theft)

§ Applicable techniques include

1. Good personnel selection, training, and discipline
2. Tight control of incoming shipments
3. Effective control of all goods leaving facility
Inventory Models
 Independent demand
Demand for
The demand for item is refrigerator &
independent of the demand for
demand for any other toaster oven
item in inventory
Inventory
Models
Dependent demand Demand for
The demand for item is toaster oven
dependent upon the components &
demand for some other demand for
item in the inventory toaster oven
 Inventory Models
Three important COSTS to take into consideration

Holding cost Ordering cost Setup cost

• Costs of • Costs of placing an • Costs to prepare
holding/carrying order, and receiving process for
inventory goods producing order
• Include • Include cost of • Include time and
obsolescence and suppliers, forms, labor to clean,
storage (insurance, order processing, change
staff, interest) purchasing, clerical tooling/holders
• Often understated support • Highly correlated
with setup time
 Holding Costs
COST (AND RANGE) AS A
CATEGORY PERCENTAGE OF INVENTORY
VALUE
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance on inventory)
Pilferage, space, and obsolescence (much higher in 3% (2 - 5%)
industries undergoing rapid change like tablets and
smart phones)
Overall carrying cost 26%
 Holding Costs
COST (AND RANGE) AS A
CATEGORY PERCENTAGE OF INVENTORY
VALUE
d ep e n d in g on
Housing costs (building rents or r y c o n sid
depreciation, e r ably 6% (3 - 10%)
cos t v a st rat es .
oldinginsurance)
operating costs,Htaxes, a tion , a n d in te re
c h
bu s in e s s , lo c m e h igh te
the costs th a n 1 5 % ,orso r - 3.5%)
Material handling
n er a ll y (equipment
g re at e r lease
g co s ts g re3%ate(1
Ge operating cost)
depreciation, power, e m s h av e h oldin
it
and fashion
Labor cost (receiving, %.
than 40warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance on inventory)
Pilferage, space, and obsolescence (much higher in 3% (2 - 5%)
industries undergoing rapid change like tablets and
smart phones)
Overall carrying cost 26%
Inventory Models of
Independent Demand
Inventory Models for Independent
Demand
Used to determine
(1) when to order
(2) how much to order

1. Basic economic order quantity (EOQ) model

(most commonly used)
2. Production order quantity model
3. Quantity discount model
1
Basic
Economic
Order
Quantity
(EOQ) Model
 Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time (time between placement and receipt of order) 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
 Basic EOQ Model
Inventory Usage Over Time

Total order received

Order quantity = Q
(maximum Usage rate
Inventory level

inventory level) Average inventory

on hand
Q
2

Minimum
inventory 0
Time
 Minimizing Cost

§ Objective of most inventory

models is to minimize cost

§ Significant costs are setup (or

ordering) cost and holding (or
carrying cost)
§ All other cost are constant

Minimize (setup + holding cost)

è Minimize total cost
 Minimizing Costs

§ Optimal order size Q* will minimize total cost

§ Intersection between setup (order) cost and holding cost
§ Total setup cost = Total holding cost

§ A reduction in either cost reduces the total cost

§ Smaller lot sizes have a positive impact on quality and

production flexibility
 Minimizing Costs

With EOQ model, the optimal order quantity will occur

at a point where the total setup cost is equal to the
total holding cost

Necessary steps:
1. Develop an expression for setup/ordering cost
2. Develop an expression for holding cost
3. Set: Setup (order) cost = Holding cost
4. Solve the equation for the optimal order quantity
 Minimizing Costs
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

STEP 1:
Annual = (Number of orders placed per year)
setup cost x (Setup or order cost per order)
Annual demand Setup/order
= cost per order
# units in each order
Annual ! D$
= # &S
setup cost " Q %
 Minimizing Costs
D
Annual setup cost = S
Q = Number of units per order
Q
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

STEP 1:
Annual = (Number of orders placed per year)
setup cost x (Setup or order cost per order)
Annual demand Setup or order
= cost per order
# units in each order
! D$
= # &S
"Q%
 Minimizing Costs
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

STEP 2:
Annual Average Holding cost per
= x
holding cost inventory level unit per year

Order quantity Holding cost per

= unit per year
2
æQ ö
= ç ÷H
è2ø
 Minimizing Costs
D
Q = Number of units per order Annual setup cost = S
Q
Q* = Optimal number of units per order (EOQ)
D = Annual demand in units forAnnual
the inventory item Q
holding cost = H
S = Setup or ordering cost for each order 2
H = Holding or carrying cost per unit per year

STEP 2:
Annual Average Holding cost per
= x
holding cost inventory level unit per year

Order quantity Holding cost per

= unit per year
2
æQ ö
= ç ÷H
è2ø
 Minimizing Costs
D
Q = Number of units per order Annual setup cost = S
Q
Q* = Optimal number of units per order (EOQ)
D = Annual demand in units forAnnual
the inventory item Q
holding cost = H
S = Setup or ordering cost for each order 2
H = Holding or carrying cost per unit per year

STEP 3:

Annual setup cost = Annual holding cost

! D$ !Q $
# &S = # & H
"Q% "2%
 Minimizing Costs
D
Q = Number of units per order Annual setup cost = S
Q
Q* = Optimal number of units per order (EOQ)
D = Annual demand in units forAnnual
the inventory item Q
holding cost = H
S = Setup or ordering cost for each order 2
H = Holding or carrying cost per unit per year

STEP 4:
Optimal order quantity, Q*:
2DS = Q 2 H
2 2DS
Q =
H
2DS
Q* =
H
 Example 1: EOQ
Determine optimal number of needles to order
Annual demand, D = 1,000 units
Setup cost, S = $10 per order
Holding cost, H = $0.50 per unit per year

* 2DS
Q =
H

2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
 Minimizing Costs
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

Expected number Demand

= N = D
of orders =
Order quantity Q*

Expected time # working days per year

between orders = T = N
 Minimizing Costs
D
Q = Number of units per order Expected no. of orders = *
Q
Q* = Optimal number of units per order (EOQ)
D = Annual demand in units for the inventory
Expected time #item
working days/year
=
S = Setup or ordering cost for each order
between orders N
H = Holding or carrying cost per unit per year

Expected number Demand

= N = D
of orders =
Order quantity Q*

Expected time # working days per year

between orders = T = N
 Example 2: EOQ
Determine expected number of orders
Annual demand, D = 1,000 units
Setup cost, S = $10 per order
Holding cost, H = $0.50 per unit per year
Order quantity, Q*= 200 units

Expected Demand D
number of = N = Order quantity = *
orders Q
1,000
N= = 5 orders per year
200
 Example 3: EOQ
Determine optimal time between orders
Annual demand, D = 1,000 units
Setup cost, S = $10 per order
Holding cost, H = $0.50 per unit per year
Order quantity, Q*= 200 units
Expected number of orders, N = 5 orders/year

Expected time = T = # working days per year

between orders Expected number of orders
250
T= = 50 days between orders
5
 Minimizing Costs
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

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
 Minimizing Costs
D Q
Q = Number of units per orderTotal annual cost = S+ H
Q 2
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

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
 Example 4: EOQ
Determine the total annual cost
Annual demand, D = 1,000 units
Setup cost, S = $10 per order
Holding cost, H = $0.50 per unit per year
Order quantity, Q* = 200 units
Expected number of orders, N = 5 orders/year
Expected time between orders, T = 50 days

D Q
Total annual cost = S + H
Q 2
1, 000 200
= ($10) + ($0.50)
200 2
= $50 + $50 = $100
 EOQ Model

When including actual cost of material purchased, P:

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

D Q
TC = S + H + PD
Q 2
 Robust Model

§ 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
 Example: EOQ
Determine optimal number of needles to order
D = 1,000 units 1,500 units Q*1,000 = 200 units
S = $10 per order T = 50 days
H = $.50 per unit per year Q*1,500 = 244.9 units
N= 5 orders/year

Ordering using old Q* Ordering using new Q*

D Q
TC = S + H 1,500 244.9
Q 2 = ($10) + ($.50)
244.9 2
1,500 200 = 6.125($10) +122.45($.50)
= ($10) + ($.50)
200 2
= $61.25 + $61.22 = $122.47
= $75 + $50 = $125
 Example: EOQ
Determine optimal number of needles to order
D = 1,000 units 1,500 units Q*1,000 = 200 units
Only 2% less than the
S = $10 per order T = 50 days
total cost of $125
H = $.50 per unit per year Q*1,500 = 244.9 units
when the order
N= 5 orders/year quantity was 200
Ordering using old Q* Ordering using new Q*
D Q
TC = S + H 1,500 244.9
Q 2 = ($10) + ($.50)
244.9 2
1,500 200 = 6.125($10) +122.45($.50)
= ($10) + ($.50)
200 2
= $61.25 + $61.22 = $122.47
= $75 + $50 = $125
 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
order
Demand Lead time for a new
ROP = per day order in days

ROP = d x L

Demand per = Annual demand, D

day, d Number of working days in a year
 Reorder Point Curve
Inventory level (units) Q*
Stock is replenished as order arrives

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
 Reorder Points
§ 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 =
Expected demand + Safety
during lead time stock
 Example: Reorder Point
Demand = 8,000 iPhones per year
Firm operates on 250 working day year
Lead time for orders is 3 working days, may take 4

Demand D
,d=
per day Number of working days in a year
= 8,000/250 = 32 units

ROP = d x L
= 32 units per day x 3 days = 96 units
= 32 units per day x 4 days = 128 units
2
Production
Order
Quantity
Model
 Production Order Quantity Model
Used when
1. inventory builds up over a period of time
after an order is placed
2. units are produced and sold simultaneously
 Production Order Quantity Model

§ Useful when inventory continuously builds up over time

§ This model is derived by setting ordering or setup costs equal
to holding costs, and solving for optimal order size, Q*.

Q= Number of units per order

H= Holding cost per unit per year
t= Length of the production run in days
D= Annual demand in units
p= Daily production rate
d= Daily demand/usage rate
 Production Order Quantity Model
D
Annual setup cost = S
Q
§ Useful when inventory continuously builds up over time
§ This model is derived by setting ordering or setup costs equal
to holding costs, and solving for optimal order size, Q*.

Q= Number of units per order

H= Holding cost per unit per year
t= Length of the production run in days
D= Annual demand in units
p= Daily production rate
d= Daily demand/usage rate
Production Order Quantity Model
Q= Number of units per order
H= Holding cost per unit per year
t= Length of the production run in days
p= Daily production rate
d= Daily demand/usage rate

æ Annual inventory ö æ Average inventory ö æHolding cost per ö

ç ÷=ç ÷xç ÷
è holding cost ø è level ø è unit per year ø

æ Average inventory ö æMaximum inventory ö

ç ÷=ç ÷ /2
è level ø è level ø
 Production Order Quantity Model
Q= Number of units per order
H= Holding cost per unit per year
t= Length of the production run in days
p= Daily production rate
d= Daily demand/usage rate

æMax inventoryö æTotal production duringö æ Total used during ö

ç ÷=ç ÷-ç ÷
è level ø è the production run ø è the production run ø
= pt - dt
However, Q = Total produced = pt
\t = Q p
æMax inventory ö æQ ö æQ ö æ dö
ç ÷= pç ÷ - d ç ÷ = Qç1 - ÷
è level ø è pø è pø è pø
Production Order Quantity Model
Q= Number of units per order
H= Holding cost per unit per year
t= Length of the production run in days
p= Daily production rate
d= Daily demand/usage rate

æ Average inventory ö æHolding cost per ö

( )
Holding cost = ç
è level
÷xç
ø è unit per year ø
÷

æ Maximum inventory level ö

=ç
è 2
()
÷H
ø
Q é æ d öù
= ê1 - ç ÷úH
2 ë è p øû
Production Order Quantity Model
D
Annual setup cost = S
Q= Number of units per order Q
H= Holding cost per unit per year ! '
Annual holding cost = 𝐻𝑄 1 − (
t= Length of the production run in days "
p= Daily production rate
d= Daily demand/usage rate

æ Average inventory ö æHolding cost per ö

( )
Holding cost = ç
è level
÷xç
ø è unit per year ø
÷

æ Maximum inventory level ö

=ç
è 2
()
÷H
ø
Q é æ d öù
= ê1 - ç ÷úH
2 ë è p øû
Production Order Quantity Model
Q= Number of units per order D
Annual setup cost = S
H= Holding cost per unit per year Q
t= Length of the production run in days ! '
p= Daily production rate holding cost = " 𝐻𝑄 1 − (
Annual
d= Daily demand/usage rate

Optimal order quantity, Q*:

Annual setup cost = Annual holding cost
2DS
D
[ ( )]
2
Q =
Q
S = 1 HQ 1 - d p
2 H 1- d p [ ( )]
2DS
Q p* =
[ ( )]
H 1- d p
 Example: Production Order Quantity
D = 1,000 units
S = $10 * 2DS
H = $0.50 per unit per year Q =
p
H "#1− d p $%
( )
p = 8 units per day
d = 4 units per day
Operates 250 days per year * 2(1,000)(10)
Q =
p
0.50"#1− (4 8)$%

20,000
= = 80,000
0.50(1 2)
= 282.8 hubcaps, or 283 hubcaps
Production Order Quantity Model
Note:
D
d=4=
Number of days the plant is in operation
1,000
=
250

When annual data are used the equation

becomes:
* 2DS
Q = p " Annual demand rate %
H $1− '
# Annual production rate &
3 Quantity
Discount
Model
 Quantity Discount Models

§ Reduced prices are often available when larger quantities

are purchased

§ Objective is still to minimize cost

§ Placing an order for the greatest discount price may not

minimize total inventory cost

§ Trade-off is between reduced product cost and

increased holding cost
 Quantity Discount Models
A Quantity Discount Schedule

QUANTITY PRICE PER

PRICE RANGE ORDERED UNIT P
Initial price 0 to 119 $100
Discount price 1 120 to 1,499 $ 98
Discount price 2 1,500 and over $ 96

The 120 quantity and 1,500 quantity are called price-break

quantities
Quantity Discount Models

Total annual Setup + Holding + Product

cost
= cost cost cost

D Q Cannot assume
TC = S + IP + PD constant H when
Q 2
price per unit
where changes for each
Q = Quantity ordered quantity discount
D = Annual demand in units
S = Ordering or setup cost per order
P = Price per unit
I = Holding cost per unit per year expressed
as a percent of price P
 Quantity Discount Models

* 2DS
Q =
IP

EOQ formula is modified for the quantity discount model

because as unit price varies, holding cost is expressed as
a percent (I) of unit price (P)
 Quantity Discount Models

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.
Quantity Discount Models
 Example: Quantity Discount
QUANTITY PRICE PER
PRICE RANGE ORDERED UNIT P
Initial price 0 to 119 $100
Discount price 1 120 to 1,499 $ 98
Discount price 2 1,500 and over $ 96

Setup cost is $200 per order, annual demand

is 5,200 units, and annual inventory carrying
charge as a percent of cost, I, is 28%. *2DS
Q =
Calculate Q* for every discount starting with IP
the lowest price
 2DS
QExample:
*
= Quantity Discount
IP

2(5,200)($200)
Q$96* = = 278 drones/order
(.28)($96)
Infeasible (278<1500)
– calculate Q* for
next-higher price

2(5,200)($200)
Q$98* = = 275 drones/order
(.28)($98)
Feasible (between
120-1499)
 Example: Quantity Discount

Choose the price and quantity that gives the lowest total
cost
Buy 275 drones at $98 per unit
 Variations of Quantity Discount
§ All-units discount is the most popular form
§ Incremental quantity discounts apply only to those units
purchased beyond the price break quantity
§ Fixed fees (shipping, processing) may encourage larger
purchases
§ Aggregation over items or time
§ Truckload discounts, buy-one-get-one-free offers, one-
time-only sales
 Learning Objectives

1. Conduct an ABC analysis

2. Explain and use cycle counting

3. Explain and use the EOQ model for independent inventory demand

4. Compute a reorder point and explain safety stock

5. Apply the production order quantity model

6. Explain and use the quantity discount model