CHAPTER 12: INVENTORY MANAGEMENT o An end item ready to be sold, but still an asset on the company’s books

IMPORTANCE

- Operation managers around the world recognized that inventory management is crucial.
- Objective: to strike a balance between inventory investment and customer service
- Low-cost strategy can never be achieved without good inventory management
- Addresses two basic inventory issues:
o How much to order
o When to order

FUNCTIONS
MANAGING INVENTORY
- To provide a selection of goods for anticipated customer demand and to separate the
firm from fluctuations in that demand. Such inventories are typical in retail Two ingredients:
establishments
- How inventory items can be classified
- To decouple various parts of the production process. For example, if a firm’s supplies
- How accurate inventory records can be maintained
fluctuate, extra inventory may be necessary to decouple the production process from
suppliers ABC Analysis
- To take advantage of quantity discounts, because in larger quantities may reduce the
- Method for dividing on-hand inventory into three classifications based on annual dollar
cost of goods or their delivery
volume
- To hedge against inflation and upward price changes
- Inventory application of what is known as Pareto Principle which states that “there are
TYPES a few and trivial many.”
- To establish inventory policies that focus resources on the few critical inventory parts
- Raw materials inventory
and not the many trivial ones
o materials that are usually purchased but have yet to enter the manufacturing
- Annual Dollar Volume
process.
o Annual demand of each inventory item x cost per unit
o Purchased but not processed
▪ Class A – low inventory items but high annual dollar volume
- Work-in-Process inventory
▪ Class B – medium inventory items, medium annual dollar volume
o Products/components that are no longer raw materials but have yet to become
▪ Class C – high inventory items but low annual dollar volume
finished products
- The advantage of dividing inventory items into classes allows policies and controls to
o Components/raw materials undergone some change but are not completed
be established for each class
o Exists because of the time it takes for a product to be made called (cycle time)
- Policies
- Maintenance/repair/operating (MRO) supply inventory
o Purchasing resources expended on supplier development should be much
o Inventories devoted to maintenance, repair and operating supplies necessary to
higher for individual A items than for C items
keep machinery and processes productive.
o A items should have tighter physical inventory control; they belong in a more
o Exist because the need and timing for maintenance and repair of some
secure area and accuracy of inventory records for A items should be verified
equipment are unknown
more frequently
- Finished goods inventory
 o Forecasting A items may warrant more care than forecasting other items o Class B will be counted less frequently; quarterly
o Class C will be counted once every 6 months; semi-annually
- Advantages:
Record Accuracy o Eliminates the shutdown and interruption of production necessary for annual
physical inventories
- Prerequisite to inventory management, production selling, and sales o Eliminates annual inventory adjustments
- Can be maintained either periodic or perpetual system o Trained personnel audit the accuracy of inventory
- Requires good incoming and outgoing record keeping as well as good security. o Allows the cause of the errors to be identified and remedial action to be taken
Periodic System o Maintenance accuracy inventory records

- Require regular (periodic) checks of inventory to determine quantity on hand

- Used by some small retailers and facilities with vendor-managed inventory Control of Service Inventories
- Downside: lack of control between reviews and necessity of carrying extra inventory to
protect against shortages - Extensive inventory is held in wholesale and retail businesses, making inventory
- Variation: two-bin system management important
o Used for materials that are considered inexpensive and/or nonessential. - Inventory accuracy and control is critical because the impact on profitability is
o Materials are divided into two separate bins substantial
o Ex: manager sets up two containers/bins and places an order when the first bin - Shrinkage
is empty o Retail inventory that is unaccounted for between receipt and sale
o Occurs from damage and theft, and from sloppy paperwork
Perpetual Inventory - Pilferage
- Tracks both receipts and subtractions from inventory on a continuing basis. o A small amount of theft
- Receipts are usually noted in the receiving department in some semiautomated way, o Also known as inventory theft
such as bar-code reader - Applicable techniques
- Disbursements are noted as items leave the stockroom or, in retailing establishments, o Good personnel selection, training and discipline
at the point-of-sale cash register ▪ Very necessary in food-service, wholesale and retail operations where
employees have access to directly consumable merchandise
o Tight control of incoming shipments
Cycle Counting ▪ Use of Universal Product Code (UPC) or bar code and Radio Frequency
Identification (RFID) systems that read every incoming shipment and
- Continuing reconciliation of inventory with inventory records automatically check tallies against purchase orders
- Uses inventory classifications developed through ABC Analysis ▪ If properly designed, it can be very hard to defeat
- With cycle counting procedures, items are counted, records are verified and inaccuracies o Effective control of all goods leaving the facility
are periodically documented ▪ Accomplished with bar codes, RFID tags, magnetic strips on merchandise
- Cause of inaccuracies are then traced and appropriate remedial action are taken to and via direct observation
ensure integrity of inventory system - A handheld scanner can scan RFID tags, aiding control of both incoming and outgoing
o Class A will be counted frequently; once per month shipments
INVENTORY MODELS INVENTORY MODELS FOR INDEPENDENT DEMAND

Dependent Demand - Addresses two important questions:

o When to order
- Refers to the demand for raw materials, components or parts that are used to produce
o How much to order
a finished product
- Directly linked to the demand for the final product (the number of raw materials to
purchase depends on the number of finished goods to be produced)
Basic Economic Order Quantity (EOQ) Model
- it is what production needs/purchases
- ex: tires, flour, plywood - Most commonly used inventory-control techniques as it is easy to use
- Based on several assumptions:
Independent Demand
o Demand for an item is known, reasonably constant, and independent for other
- refers to the demand for finished goods/end products that are sold to customers items
- customer purchases o Lead time – time between placement and receipt of the order – is known and
- Not directly tied to the production of another item (demand for this is dependent on consistent
customer preferences, market trends and economic conditions) o Receipt of inventory is instantaneous and complete (the inventory from an order
- Ex: cars, cake, cabinet arrives in one batch at one time)
o Quantity discounts are not possible
Inventory Costs
o The only variable costs are:
Holding Costs ▪ Setup/ordering cost – cost of setting up or placing an order
▪ Holding/carrying cost – cost of holding/storing inventory over time
- Refers to the cost to keep or carry inventory in stock o Stockouts (shortages) can be completely avoided if orders are placed at the right
- Includes obsolescence (outdated/no longer used) and costs related to storage such as time
insurance, staffing

Ordering Costs

- Refers to the cost of the ordering process

- Includes cost of supplies, forms, order processing, purchasing, clerical support

Setup Costs

- Refers to the cost to prepare a machine or process for manufacturing an order

- Includes time and labor to clean and change tools or holders
- Reducing set up costs can lower ordering cost (by using such efficient procedures as
electronic ordering and payment) o
Setup time o The necessary steps to solve EOQ or Q*
▪ Develop an expression for setup/order cost
- Refers to the time to prepare a machine/process of production ▪ Develop an expression for holding cost
▪ Set order cost to equal holding cost
 ▪ Solve the optimal order quantity equation - reduction in either holding/setup cost
o Variables: will reduce the total cost curve
▪ Q – no. of units per order
▪ Q* - optimum number of units per order - reducing setup cost curve also reduces
▪ D – Annual demand in units for inventory item optimal order optimal order quantity
▪ S – Setup/Order cost for each order (lot size)
▪ H – holding/carrying cost per unit per year - small lot size have positive impact on
o Annual Setup Cost = (D/Q) S quality and production flexibility
o Annual holding cost = (Q/2) H
o Optimal order quantity is found when annual order cost equals annual holding - - optimal order quantity occurs where
cost: (D/Q) S = (Q/2) H order cost and holding cost intersect
2𝐷𝑆 2𝐷𝑆
o 𝐸𝑂𝑄: 2𝐷𝑆 = 𝑄2 𝐻 = 𝑄2 = = 𝑄∗ = √
𝐻 𝐻

Reorder Points

Minimizing Costs - Refers to the inventory level at which action is taken to replenish the stock item
- When to order – Reorder point (ROP)
- Objective of most inventory models is to minimize total costs by minimizing the sum of
- Simple inventory models assume that receipt of an order is instantaneous (firm places
ordering/setup costs and carrying/holding costs
an order when items reach zero & ordered item will be received immediately) but time
- How much to order
between placement and receipt of order (lead time) can be as short as hours or long as
- Optimal order size will be the quantity that months
minimizes the total costs - Eqtn: Reorder Point (ROP) = Demand per day (d) x Lead time for a new order in days (L)
o Assumes that demand during lead time and lead time itself are constant
- as quantity order increases, the total no. of o If not constant, safety stock (ss) should be added
orders placed per year will decrease ▪ Equation: ROP = expected demand during lead time + safety stock
- quantity ordered increases, annual
ordering cost will decrease

- order quantity increases, the holding cost

will increase due to larger average
inventories that are maintained

-
-
Production Order Quantity Model ▪ annual inventory holding cost = annual inventory level x holding cost
per unit per year
- Refers to an economic order quantity technique applied to production orders
▪ annual inventory holding cost:
- Applicable under 2 situations: 𝑚𝑎𝑥𝑖𝑚𝑢𝑚 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 𝑄 𝑑
o When inventory continuously flows/builds up over a period of time after an (𝐻) = 2 [1 − (𝑝)]𝐻
2
order has been placed
o When units are produced and sold simultaneously
▪
o Under these circumstances, we consider daily production rate and daily demand
rate
- Useful when inventory continuously builds up over time and traditional economic order
quantity assumptions are valid
- Derive to this model by setting up order/setup cost (S) equal to holding cost (H) and solve
for optimal order size (Q*)

Quantity Discount Models

Quantity Discounts

- Refers to a reduced price for items purchased in large quantities

- - Researchers have found that most companies either offer/receive quantity discounts for
- To determine the expression for annual inventory holding cost: at least some of the products that they sell/purchase
o Q – number of units per order - Placing an order for large quantity, even with the greatest discount price, may not
o H – holding cost per unit per year minimize total inventory cost because holding cost increases
o p – daily production rate - The major trade off when considering quantity discounts is between reduced product
o d – daily demand rate/usage rate cost and increased holding cost
o t – length of the production run in days - Variable:
▪ maximum inventory level = total production during the period run – o Q – quantity ordered
total used during the production run (pt – dt) o D – annual demand in units
o S – setup/ordering cost per order
o P – price per unit
o I – holding cost per unit per year as a percent of price (P)
- Formula:
o Total Annual Cost = Annual setup/ordering cost + Annual holding cost + annual
𝑫 𝑸
product cost (𝑻𝑪 = 𝑸 𝑺 + 𝟐 𝑰𝑷 + 𝑷𝑫)
▪ average inventory level = max inventory level / 2
 o Holding cost as IP instead of H: because the price of an item is a factor in annual Other Probabilistic Models
holding cost, holding cost is not constant when price changes per unit changes
• Single-Period Models
each quantity discount
- Refers to the system of ordering items that have a little or no value at the end
of the sales period (perishables)
- Describes a situation in which one order is placed for a product
- At the end of sales period, any remaining products has little or no value
- Typical problem for seasonal goods, bakery goods, newspapers and magazines
(this issue often called newsstand problem)
Probabilistic Models and Safety Stock

• Probabilistic Model
- Refers to a statistical model applicable when product demand or any other
variable is not known but can be specified by means of a probability distribution -
- Applied when product demand is not known but can be specified by means of • Fixed-quantity (Q) System
probability distribution - Refers to an ordering system with the same order amount each time
- Real-world adjustment because demand and lead time won’t always be known - Same fixed amount is added to the inventory every time an order for an item is
and constant placed
▪ Demand depends on seasonal trends, economic conditions, market - To use this model, inventory must be continuously monitored (requires
fluctuations and supplier delays perpetual system inventory)
- An important concern of management is maintaining an adequate service level - Every item that is either added/withdrawn from inventory, records must be
in the face of uncertain demand updated to determine whether the reorder point has been reached
• Service Level • Fixed-period (P) System
- Refers to the probability that demand will not be greater than supply during lead - Refers to a system in which inventory orders are made at regular time intervals
time (chance of not having shortage) - Also called as periodic review or P system
- Complement of the probability of a stockout - Inventory is ordered at the end of the given period
• Stockout - Uses periodic system inventory
- Rises from uncertain demand (increase demand cause stockouts (out of stock - Have several of the same assumptions as basic EOQ fixed-quantity system:
items) ▪ Only relevant costs: ordering and holding cost
- To reduce stockouts is to hold extra units in inventory which is referred as safety ▪ Lead time are known and constant
stock ▪ Items are independent of one another
• Safety Stock -
- Involves adding a number of units as a buffer to the reorder point
- The amount of safety stock maintained depends on the cost of incurring a
stockout and the cost of holding the extra inventory