Operations

Management

Chapter 12 –
Inventory Management
 Inventory

• One of the most expensive assets of many

companies representing as much as 50% of
total invested capital

• Operations managers must balance

inventory investment and customer
service
 Functions of Inventory

1. To decouple or separate various parts of the production

process in case of fluctuations in supplies (e.g. keep extra
inventory to dis-associate production from suppliers)

2. To decouple the firm from fluctuations in demand and

provide a stock of goods that will provide a selection for
customers

3. To take advantage of quantity discounts

4. To hedge against inflation

 Types of Inventory
• Raw material
• Purchased but not processed

• Work-in-process (WIP)
• Undergone some change but not completed
• A function of cycle time for a product

• Maintenance/repair/operating (MRO)
• Necessary to keep machinery and processes productive

• Finished goods
• Completed product awaiting shipment
 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
 Inventory Management

• How inventory items can be classified

(ABC Analysis)

• How accurate inventory records can

be maintained

• Plan about when and how much to

order/keep inventory
 ABC Analysis
• 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

• Used to establish policies that focus on the few critical parts

and not many insignificant ones

• Works according to Pareto Principle (80/20 rule) i.e. “Critical

Few and trivial Many”

• Annual dollar volume = annual demand x cost

 ABC Analysis

Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class

#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A

72%
#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

23%
#10867 30% 350 42.86 15,001 6.4% B

#10500 1,000 12.50 12,500 5.4% B

 ABC Analysis

Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class

#12572 600 $ 14.17 $ 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

5%
#01036 50% 100 8.50 850 .4% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

 ABC Analysis

A Items
80 –
Percent of annual dollar usage
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percent of inventory items
 ABC Analysis

• Other criteria than annual dollar

volume may be used
• Anticipated engineering / processing
changes
• Delivery problems
• Quality problems
• High unit cost
 ABC Analysis

• Policies employed for A-Class Inventory may

include
• More emphasis on supplier development
• Tighter physical inventory control
• More accuracy in forecasting items
• Determining order frequency
• Seeking low cost sources (suppliers)
• Monitoring/tracking order status (avoid uncertainty)
• Monitoring shelf life
• Schedule (divided deliveries)
• Stock count
 Record Accuracy
• Accurate records are critical ingredient in
production and inventory systems (maintained by
periodic or perpetual systems)

• Allows organization to focus on what is needed

• Necessary to make precise decisions about

ordering, scheduling, and shipping

• Incoming and outgoing record keeping must be

accurate

• Ensure security of Stockrooms

 Cycle Counting

• Items are counted and records updated on a

continuing (perpetual) or periodic basis

• Often used with ABC analysis

to determine cycle
• Has several advantages
• Eliminates shutdowns and interruptions
• Eliminates annual inventory adjustment
• Trained personnel audit inventory accuracy
• Allows causes of errors to be identified and corrected
• Maintains accurate inventory records
 Cycle Counting Example

• 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)

Item Number of Items

Class Quantity Cycle Counting Policy Counted per Day
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
77/day
 Control of Service Inventories

• Can be a critical component

of profitability
• Losses may come from
shrinkage or pilferage
• Applicable techniques include
1. Good personnel selection, training, and
discipline
2. Tight control on incoming shipments
3. Effective control on all goods leaving facility
 Independent V/s
Dependent Demand

• Independent demand - the demand for item

is independent of the demand for any other
item in inventory
• For example, the demand for refrigerators is independent
of the demand for toaster ovens.
• Dependent demand - the demand for item
is dependent upon the demand for some
other item in the inventory.
• However, the demand for toaster oven components is
dependent on the requirements of toaster ovens.
 Holding, Ordering, and Setup Costs

• Holding costs - the costs of holding or “carrying”

inventory over time

• Ordering costs - the costs of placing an order and

receiving goods (costs of supplies, forms, order processing,
purchasing, clerical support, and so forth)

• Setup costs - cost to prepare a machine or

process for manufacturing an order (includes time and
labour to clean and change tools or holders)
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value
Housing costs (building rent or 6% (3 - 10%)
depreciation, operating costs, taxes,
insurance)
Material handling costs (equipment lease or 3% (1 -
depreciation, power, operating cost) 3.5%)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, 11% (6 -
and insurance on inventory) 24%)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
Inventory Models for Independent
Demand

Need to determine when and how much

to order

• Basic economic order quantity

• Production order quantity
• Quantity discount model
 Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stock-outs can be completely avoided if order
is placed at right time
 Inventory Usage Over Time

Usage rate Average

Order quantity
= Q (maximum inventory on
Inventory level

inventory hand
level) Q
2

Minimum
inventory

0
Time

Saw-tooth Shape
 Minimizing Costs
Objective is to minimize total costs
Curve for total
cost of holding
and setup

Minimum
total cost
Annual cost

Holding cost
curve

Setup (or order)

cost curve
Optimal order Order quantity
quantity (Q*)
 Equations Developed to Solve for Q*

1. Develop an expression for setup or ordering cost.

2. Develop an expression for holding cost.

3. Set setup (order) cost equal to holding cost.

4. Solve the equation for the optimal order quantity (Q*).

 The EOQ Model
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item D
S = Setup or ordering cost for each order Annual setup cost = S
Q
H = Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order

= D (S)
Q
 The EOQ Model
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order D
Annual setup cost = S
H = Holding or carrying cost per unit per year Q
Q
Annual holding cost = H
2
Annual holding cost = (Average inventory level)
x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2

= Q (H)
2
 The EOQ Model
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D
D = Annual demand in units for the inventory item Annual setup cost = S
Q
S = Setup or ordering cost for each order Q
H = Holding or carrying cost per unit per year Annual holding cost = H
2

Optimal order quantity is found when annual setup cost

equals annual holding cost

D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
 An EOQ Example
Determine expected number of orders.
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected number Demand D

of orders =N= =
Order quantity Q*

1,000
N= 200 = 5 orders per year
 An EOQ Example
Determine expected time between orders.
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year Production days/year = 250

Number of working
Expected time days per year
between orders =T= N

250
T= 5 = 50 days between orders
 An EOQ Example
Determine total annual cost.
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days
Total annual cost = Setup cost + Holding cost

TC = (D/Q)S + (Q/2)H

TC = (1,000/200)10 + (200/2)0.50

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

 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
 Reorder Points

• EOQ answers the “how much” question

• The reorder point (ROP) tells when to
order
Demand Lead time for a new
ROP = per day order in days

=dxL
D
d= Number of working days in a year
 Reorder Point Curve

Q*

Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
 Reorder Point Example

Demand = 8,000 iPods per year

250 working day year
Lead time for orders is 3 working days
D
d= 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

Production Order Quantity Model

• Used when inventory builds up over

a period of time after an order is
placed

• Used when units are produced and

sold simultaneously
 Production Order Quantity Model

Part of inventory cycle during

which production (and usage) is
taking place
Inventory level

Demand part of cycle with

no production
Maximum
inventory

t Time
 Production Order Quantity Model

Q = Number of pieces per order p = Daily production rate

H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Annual inventory Holding cost

= (Average inventory level) x
holding cost per unit per year

Annual inventory
level = (Maximum inventory level)/2

Maximum Total produced during the Total used during the

= –
inventory level production run production run
= pt – dt
 Production Order Quantity Model

Q = Number of pieces per order p = Daily production rate

H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Maximum Total produced during the Total used during the

= –
inventory level production run production run
= pt – dt
However, Q = total produced = pt ; thus t = Q/p

Maximum Q Q d
inventory level =p –d =Q 1–
p p p

Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p
 Production Order Quantity Model

Q = Number of pieces per order p = Daily production rate

H = Holding cost per unit per year d = Daily demand/usage rate
D = Annual demand

Setup cost = (D/Q)S

1
Holding cost = 2 HQ[1 - (d/p)]
(D/Q)S = 1
HQ[1 - (d/p)]
2
2DS
Q =
2
H[1 - (d/p)]

2DS
Q* = H[1 - (d/p)]
p
Production Order Quantity Example

D = 1,000 units p = 8 units per day

S = $10 d = 4 units per day
H = $0.50 per unit per year

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

2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]

= 282.8 or 283 hubcaps

 Production Order Quantity Model

Note:

D 1,000
d=4= =
Number of days the plant is in operation 250

When annual data are used the equation becomes

2DS
Q* =
annual demand rate
H 1– annual production rate
 Quantity Discount Models

• Reduced prices are often available when larger

quantities are purchased

• Trade-off is between reduced product cost and

increased holding cost

Total cost = Setup cost + Holding cost + Product cost

TC = D S + Q H + PD
Q 2
 Quantity Discount Models

A typical quantity discount schedule

Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80

3 2,000 and over 5 $4.75

 Quantity Discount Models

Steps in analyzing a quantity discount

1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify, choose
the smallest possible order size to get the
discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total
cost
 Quantity Discount Models

Total cost curve for discount 2

Total cost
curve for
discount 1
Total cost $

Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a and must
be adjusted upward to 1,000 units at point b

1st price 2nd price

break break

0 1,000 2,000
Order quantity
 Quantity Discount Example

Calculate Q* for every discount

2DS
2(5,000)(49) Q* =
IP
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49) Q = Quantity ordered

Q2* = = 714 cars/order D = Annual demand in units
(.2)(4.80) S = Setup or ordering cost per order
P = Price per unit
2(5,000)(49) I = Holding cost per unit per year
Q3* = = 718 cars/order expressed as a percent of price P
(.2)(4.75)
 Quantity Discount Example

Calculate Q* for every discount

2(5,000)(49)
Q1* = = 700 cars/order 2DS
(.2)(5.00) Q* =
IP
2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75) 2,000 — adjusted
 Quantity Discount Example

Annual Annual Annual

Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 $24,000 $245 $480 $24,725

1,000
3 $4.75 2,000 $23,750 $122.50 $950 $24,822.50

Choose the price and quantity that gives the lowest total cost
Buy 1,000 units at $4.80 per unit