Student Course Experience Surveys – Winter 2025

It’s time to share your feedback on your learning experience.

DSB MBA Program

Open: March 28, 2025 8:00 a.m.
Close: April 11, 2025 11:59 p.m.

Students will receive an email from McMaster Central BLUE

Course Experience Surveys. Kindly use the link in the email
provided to the SCES for your courses.
Student Course Experience Surveys can also be accessed at:
https://mcmaster.bluera.com/mcmaster/
 Lecture 9: Inventory Management I

Instructor: Nooshin Salari

Office: RJC 225
Email: Salarin@mcmaster.ca

1
Inventory Management Stockout: Best buy

• In December 2011, Best Buy faced a major inventory management failure that led
to mass order cancellations during the peak holiday shopping season. The
company issued a statement apologizing for the inconvenience, but the damage
had already been done.

• Instead of delivering orders late, Best Buy canceled them outright, suggesting that
the company had oversold products it didn’t actually have in stock. This resulted
in frustrated customers, negative press, and a loss of consumer trust, with articles
titled “How Best Buy Stole Christmas” circulating widely.

2
Inventory Management Stockout: Best buy

• The Consequences of Poor Inventory Management:

• 91% of unhappy customers never return to a company after a bad experience.
• Best Buy’s failure gave competitors like Amazon an opportunity to attract
dissatisfied customers, as switching to another online retailer required just a few
clicks.
• Rather than delaying shipments, they canceled orders, showing a lack of flexibility
in their supply chain.
• The failure to deliver during the busiest shopping season hurt their long-term
brand image.

3
What Went Wrong?

4
Introduction to Inventory Management

• Inventory is one of the most valuable assets for many businesses, often accounting
for up to 50% of total invested capital.
• Too much inventory → Leads to high holding costs and capital being tied up.
• Too little inventory → Can result in stockouts, lost sales, and dissatisfied
customers.
• Companies cannot achieve a low-cost strategy without an effective inventory
system.

5
Introduction to Inventory Management

• Every organization requires an inventory management system, regardless of

industry:
✓Banks → Manage cash reserves to meet customer withdrawals.
✓Hospitals → Control blood supplies and pharmaceuticals to prevent shortages.
✓Retail & E-commerce → Ensure products are in stock to meet demand.
✓Manufacturers → Track raw materials, work-in-progress, and finished goods.

6
 Types of Inventory

• Inventory: A resource that a firm holds in stock with the intent of

selling it or transforming it into a more valuable state.

• Types of Inventory:
1) raw material inventory: has been purchased but not processed, e.g. steel
for car manufacturing, flour for a bakery, etc.
2) work-in-process inventory: Refers to partially completed products still in
production, e.g. an unfinished cake in a bakery.
3) maintenance/repair/operating supply (MRO) inventory: Includes items
needed for equipment maintenance and daily operations, e.g. tools, office
supplies, machine spare parts.
4) finished goods inventory: Final products ready for sale or distribution,
e.g. A fully assembled car, packaged cereal boxes

7
Inventory accuracy

• To ensure inventory accuracy and optimization, firms implement systems that

focus on:
✓Inventory classification (ABC Analysis)
✓Accurate recordkeeping

8
Inventory Classification: ABC Analysis

• All items in a company’s inventory are not equal and do not need the same level of
control.
• We can apply Pareto’s law to determine the level of control needed for individual
items.
• Pareto’s law implies that roughly 10 to 20 percent of a company’s inventory items
account for approximately 60 to 80 percent of its inventory costs.
• The goal is to prioritize inventory management efforts by focusing on high-value
items.

9
Inventory Classification: ABC Analysis

• Class A: High-value, low-quantity items (e.g., expensive machinery parts).

• Class B: Mid-value, mid-quantity items (e.g., office supplies).
• Class C: Low-value, high-quantity items (e.g., nuts and bolts).

10
Graphic Representation of ABC Analysis

11
Example

• Silicon Chips, Inc.,

wants to categorize
its 10 major
inventory items
using ABC analysis.

12
Inventory Policies Based on ABC Classification

• A items require more supplier

development efforts to ensure
reliability.
• More frequent inventory audits should
be conducted for A items compared to
B and C items.
• A items require detailed forecasting, as
stockouts could have major financial
impacts.
• C items have less purchasing
supervision and can be ordered in bulk
since they are low-cost and low-risk.

13
ABC Analysis: Other Classification Criteria

• While ABC analysis is typically based on annual dollar volume, other factors may
influence an item’s classification, such as:
• Delivery Problems – Items with long or unreliable lead times may need a higher
classification to ensure availability.
• Quality Issues – Items prone to defects or strict quality control may need extra
oversight.
• High Unit Cost – Expensive items, even if low in demand, may require stricter
control.

14
Record Accuracy in Inventory Management

• Errors in inventory records can lead to stockouts, overstocking, and poor decision-
making.
• Companies maintain accuracy using two main systems:
✓Periodic Inventory System
✓Perpetual Inventory System

15
1) Periodic Inventory System

• Inventory is physically counted at regular intervals (e.g., weekly, monthly, or annually).

• Used by small retailers and businesses.
Downside:
• Lack of real-time tracking.
• Risk of errors and stock shortages between counts.

• Example: A small bookstore reviews its inventory once a month. At the end of each
month, the manager checks how many copies of each book remain and places an order to
restock based on sales and anticipated demand.
• The store starts with 200 copies of a popular novel.
• After a month, only 60 copies remain.
• The manager decides to order 140 more copies to bring inventory back to 200.

16
2) Perpetual Inventory System

• Inventory is tracked in real time as items are received and sold.

• Uses barcode scanners, RFID technology, and POS (Point-of-Sale) systems.
• More accurate than periodic inventory systems.

Example: Retail Stores & Warehouses

➢When a product is sold at checkout, the inventory database is updated instantly.
➢Helps prevent stockouts and ensures timely reordering.

17
Cycle Counting in Inventory Management

• Cycle counting is an ongoing

inventory auditing process where a
portion of inventory is regularly
counted and verified to maintain
accuracy.
• Unlike annual physical inventories,
which require facility shutdowns,
cycle counting allows continuous
verification without disrupting
operations.
• Helps identify and correct
discrepancies in inventory records.
18
How Cycle Counting Works

• Inventory is classified using ABC

Analysis, and counting frequency is
based on an item’s value and
importance.
• A items (high-value, low-quantity) →
Counted monthly.
• B items (medium-value) → Counted
quarterly.
• C items (low-value, high-quantity) →
Counted every six months.

19
Steps in Cycle Counting

• Select inventory items to be counted (using ABC classification).

• Count items without prior knowledge of recorded quantities (to ensure unbiased
results).
• Compare actual counts with system records.
• Investigate discrepancies and take corrective action.
• Update inventory records and continue regular cycle counts.

20
Discussion

• SKU Management & Reduction

• Large retailers often stock too many SKUs, making inventory management more
difficult.
• Can you think of a store where you’ve seen too many similar products? Did it
make shopping easier or harder?

21
Independent vs Independent Demand

• Inventory control models differentiate between independent and dependent

demand.
Can you think of a product whose demand is completely independent and one that
depends on another product?
➢Independent Demand: The demand for an item is not influenced by other products.
✓The demand for refrigerators is independent of toaster ovens.

➢Dependent Demand: The demand for an item relies on another product’s

demand.

22
Inventory Costs- Ordering and/or setup costs

• Ordering and/or setup costs: the expenses a company incurs each time it places an order for
inventory. These costs apply to both retail and manufacturing businesses.
➢Administrative Costs – Processing purchase orders, documentation, and approval workflows.
➢Shipping & Handling Fees – Costs associated with receiving inventory.
➢ Inspection Costs – Checking incoming goods for quality and accuracy.
• Setup Costs: In manufacturing, setup cost is the cost incurred each time production is started or
switched to a different product or batch. This directly impacts inventory decisions, especially how
much and how often to produce.
➢Machine Adjustments – Cleaning, reconfiguring, and calibrating equipment.
➢Tool Changes – Switching out parts or materials for a different product.
➢Downtime Costs – The lost production time while setup is being performed.
➢Labor Costs – Workers involved in the setup process.
A car factory switches from producing SUVs to sedans. This requires adjusting machinery, changing
tools, and recalibrating production lines, all of which take time and resources.

23
Inventory Holding Cost

• Inventory holding cost, also known as carrying cost, refers to the total expenses a business incurs
to store and maintain its inventory over a certain period.
• Why do you think companies don’t just stockpile large amounts of inventory to avoid stockouts?
Components of Inventory Holding Cost
➢Storage Costs: Includes rent, utilities, warehouse maintenance, and security.
➢Capital Costs: taxes, and insurance on inventory
➢Depreciation: Items may lose value over time, especially in industries like electronics and fashion.
➢Shrinkage & Damage Loss of inventory due to theft, fraud, or misplacement. Products can spoil,
break, or degrade while in storage.
➢Labour cost (receiving, warehousing, security)
The average carrying cost of inventory across all manufacturing in North America is 30-35% of its
value.

24
Purchase and shortage costs

Unit purchase cost of the stock keeping-unit: The price paid for the purchased
good or the internal cost of producing them.

Shortage costs or stockout costs: Costs associated with a SKU being unavailable
when needed to meet demand. This includes lost sales, lost goodwill, shortage
penalty, backorder cost, lawsuits etc.

25
Inventory Models for Independent Demand

• We wish to minimize inventory costs but also reduce stockouts!

• How can OM tools help us on that end?’

• we introduce an inventory model that address two important questions: when to

order and how much to order.

26
Basic EOQ Assumptions

• Assumptions:
• Known annual demand, constant (deterministic) demand rate.
• Time to order and receive it is negligible. The entire order quantity
(Q) is received at once.
• Ordering cost per order and holding (carrying) cost per unit per
year are constant.
• Only one item (SKU) is involved.

27
Question

• Imagine you own a clothing store. You sell 500 dresses per month, and each order
costs $50 to place. Storing inventory costs $2 per dress per month.

• How would you decide how many dresses to order at a time to minimize costs?

28
Inventory Level
Assume that we place an order of size Q at time 0. After the lead time is 0, the order arrives
immediately and the inventory level is Q
Since the total demand D will be consumed in one year, we would like to know how long it
would take to consume Q units.

Inventory The inventory An order of size Q is placed again and arrives

level will decline instantaneously, raising the inventory level back to Q.
Q along a straight
line of slope
minus D.

0 Q/D
It would take Q/D
Inventory Cycle time units for the
inventory to reach 0.
29
Inventory Cycle

Inventory Cycle
Inventory Average
Sales or Q
Demand Quantity Inventory
Rate on hand On-hand

Time

Inventory Cycle Receive Receive Receive

Order Order Order

30
 Average Inventory levels and numb ers of orders
• Should you order larger amounts of inventory less frequently?
Fig. a Fig. b
Inventory Q1=Q Inventory
Q2=Q/2

Average Small
order size Average
Inventory
Q/2 Inventory

Few orders produce a high average inventory Time Many orders produce a low average inventory Time

• In Fig. b, we cut our inventory by placing more orders

• This results in a lower average inventory because we are buying smaller quantities
• It is great to order many orders of a smaller quantity, and that will bring your holding costs
down, but your ordering costs will go up.
31
 Note

• Placing few orders of larger amounts results in:

➢Low ordering costs (why?)
➢High holding costs (why?)
• Placing many orders of smaller amounts results in:
➢High ordering costs
➢Low holding costs

➢ EOQ inventory models balances the inventory holding costs and inventory
ordering costs via economies of scale.
➢ Goal: find he optimal order quantity Q

32
EOQ decision

• How much product should we order so that our costs (i.e., the cost function) is
minimized?

Decision:
• Q, quantity to be ordered
• Objective Function:
• To minimize total costs
• Significant costs are setup (or ordering) cost and holding (or carrying) cost. All
other costs, such as the unit purchase cost are constant

33
Expressions for different type of Costs

1. Develop an Expression for Setup or Ordering Cost:

Let D be the annual demand.

If we order Q units each time, then we place orders per year.
If S is the fixed cost of placing one order (order’s setup cost), then:

Annual
ordering cost
=
( number of
orders per year)( cost
per order ) ()
= D
Q
S

34
Annual ordering cost

𝐷
𝑆
𝑄

35
Expressions for different type of Costs
2. Develop an Expression for Holding Cost:

Let H be the annual holding cost per inventory unit

• That is, how much it costs to have one unit in inventory during a whole year
• A unit of inventory does not stay in the system during all the year (because of demand),
so we will only be interested on the average total holding cost.

holding cost (
Annual inventory = average
inventory )( annual holding
cost per unit )= 𝑄
2
𝐻
Average Inventory Level = average of the maximum and minimum inventory levels
Q+0 𝑄
= =
2 2

36
Annual holding cost

𝑄
𝐻
2

37
Total annual cost (TC)

• Total annual cost (TC):

Non linear function of Q, as Q is in the denominator

𝐷 𝑄
𝑇𝐶 = × 𝑆 + × 𝐻
𝑄 2
where
• Q: decision variable representing order quantity
• D: Annual Demand
• S: Cost for placing an order
• H: Annual holding cost

38
Minimizing total annual cost

39
Minimizing total annual cost

• Note at the optimal order quantity

(EOQ), the annual holding cost
equals the annual ordering cost.
This is a fundamental property of
the EOQ model.
• At EOQ:
Annual Holding Cost = Annual
Ordering Cost
This balance minimizes total
inventory cost.

40
Supplementary material (not part of the exam)

Optimal order quantity is found when annual setup (order) cost equals annual holding cost,
namely:
𝐷 𝑄
𝑆= 𝐻
𝑄 2
To solve for Q*, simply cross-multiply terms and isolate Q on the left of the equal sign:

2𝐷𝑆 = 𝑄 2 𝐻
2𝐷𝑆
𝑄=
𝐻

41
Minimizing total annual cost

• Optimal Order Quantity (Q*): Order quantity that minimizes the total cost (TC)
• Q* is also known as the Economic Order Quantity or EOQ

∗
2𝐷𝑆
𝑄 =
𝐻

where
Q: decision variable representing order quantity
D: Annual Demand
S: Cost for placing an order
H: Annual holding cost

42
Example
• Suppose the annual demand for tires at Costco is 9600 units, the annual holding
cost is $16 per tire, and the ordering cost is $75 per order. Find the optimal
quantity to order.

Ordering decisions

43
Example (Cont.)

• How many orders will be placed every year?

• Number of orders per year

• Number of orders per year=

Ordering decisions

44
Example (Cont.)
• The distributer operates 288 days a year. What is the time interval between orders?

• Expected time interval between orders=

• Expected Number of orders per year=

• Expected time interval between orders=

Ordering decisions
45
Total annual cost (TC)

• Inventory costs may also be expressed to include the actual cost of the material
purchased.
• If we assume that the annual demand and the price per item are known values then the
Total annual cost (TC) would be equal to
Does not depend on Q
𝐷 𝑄
𝑇𝐶 = × 𝑆 + × 𝐻 + 𝑃 × 𝐷
𝑄 2
where
• Q: decision variable representing order quantity
• D: Annual Demand
• S: Cost for placing an order
• H: Annual holding cost
Example (Cont.)

• If the purchase price of a tire is $100 what is the total annual cost of tires for
Costco?

Ordering decisions

47
Example (Cont.)

• Let’s choose a different Q, for instance Q=250 tires instead, then the total cost of
ordering and holding is equal to:

48
EOQ is robust!

EOQ is robust – it provides reliable results even when input values vary significantly.
• Why Robustness Matters
➢Ordering and holding costs are often difficult to estimate accurately.
➢A robust model is less sensitive to parameter changes → more practical in real-world
settings.
• The total cost curve is shallow near the EOQ, therefore small changes in:
➢Setup costs
➢Holding costs
➢Demand
➢EOQ value
→ lead to only modest changes in total cost.

49
Example

• Sharp, Inc., a company that markets painless hypodermic needles to hospitals,

would like to reduce its inventory cost by determining the optimal number of
hypodermic needles to obtain per order.
• The annual demand is 1,000 units; the setup or ordering cost is $10 per order; and
the holding cost per unit per year is $0.50.
a) Calculate the optimal number of units per order
b) Sharp, Inc. has a 250-day working year and wants to find the number of orders
(N) and the expected time between orders (T).
c) Determine the combined annual ordering and holding costs.

50
Example

• Management in the Sharp, Inc., examples underestimates total annual demand by

50% (say demand is actually 1,500 needles rather than 1,000 needles) while using
the same Q. How will the annual inventory cost be affected?

• We will solve for annual costs twice. First, we will apply the wrong EOQ and
calculate Total cost; then we will recompute costs with the correct EOQ.

51
Question

• Demand at Sharp remains at 1,000, H is still $0.50, and we order 200 needles at a
time . But if the true order cost=S=$15 (rather than $10), what is the annual cost?

• what is the annual cost for the optimal Q?

52
Note!

• We may conclude that the EOQ is indeed robust and that significant errors do not
cost us very much. This attribute of the EOQ model is most convenient because
our ability to accurately determine demand, holding cost, and ordering cost is
limited.

53
Example

• ABC Ltd. uses EOQ logic to determine the order quantity for its various
components and is planning its orders. The Annual consumption is 80,000 units,
Cost to place one order is $1,200, Cost per unit is $50 and carrying cost is 6% of
Unit cost. Find EOQ, No. of order per year, ordering cost, holding cost and Total
Cost of Inventory

54
Question

• Midwest Precision Control Corp. needs to choose between two ordering strategies for managing
inventory of a specific item. The company anticipates an annual demand of 1,000 units.
Details of the two strategies are as follows:
Option A:
➢Ordering method: Manual via teletype
➢Ordering cost: $40 per order
➢Annual holding cost: $100 per unit
Option B:
➢ Ordering method: Online system
➢ Ordering cost: $30 per order
➢ Holding cost: 20% of the unit price
➢ Unit price: $480
Which option should the company choose based on total cost minimization?

55
When to order?

Let’s assume that lead time is zero: the time between placing and receiving an order=0
When should we place an order?

Inventory Lead time=0

Q* Q*
Inventory
On-hand

Time

Receive Receive Receive

Order Order Order
56
When to order?

The time between placement and

receipt of an order, called lead
time, or delivery time, can be as Lead time= L days
short as a few hours or as long as
months.

• We need to order a bit in advance to account for this extra time

• Inventory level for which we must order is the Reorder Point (ROP)

57