KC42202: PLANT DESIGN: OPERATION &

MAINTENANCE

Lecture 4: Inventory Management in Plant

Operation
Program: Bachelors of Chemical Engineering (Hons)
Year: 4
Faculty of Engineering, Universiti Malaysia Sabah
Topic/Lecture Overview
• Describe the different types and use of inventory
• Describe the objectives of inventory management
• Calculate inventory performance measures
• Understand relevant costs associated with inventory
• Calculate order quantities
Learning Objectives - Continued
• Understand how to justify smaller order sizes
• Calculate appropriate safety stock inventory policies
• Calculate order quantities for single-period inventory
• Perform ABC inventory control and analysis
• Understand the role of cycle counting in inventory
record accuracy
Types of Inventory
• Inventory comes in many shapes and sizes such as
• Raw materials – purchased items or extracted materials
transformed into components or products
• Components – parts or subassemblies used in final
product
• Work-in-process – items in process throughout the plant
• Finished goods – products sold to customers
• Distribution inventory – finished goods in the distribution
system
Types of Inventory
Uses of Inventory
• Anticipation or seasonal inventory
• Fluctuation Inventory or Safety stock: buffer demand
fluctuations
• Lot-size or cycle stock: take advantage of quantity discounts or
purchasing efficiencies
• Transportation or Pipeline inventory
• Speculative or hedge inventory protects against some future
event, e.g. labor strike
• Maintenance, repair, and operating (MRO) inventories
Objectives of Inventory Management
• Provide desired customer service level
• Customer service is the ability to satisfy customer
requirements
• Percentage of orders shipped on schedule
• Percentage of line items shipped on schedule
• Percentage of dollar volume shipped on schedule
• Idle time due to material and component shortages
Inventory Management Objectives
Provide for cost-efficient operations:
• Buffer stock for smooth production flow
• Maintain a level work force
• Allowing longer production runs & quantity discounts

• Minimum inventory investments:

• Inventory turnover
• Weeks, days, or hours of supply
Customer Service Level Examples
• Percentage of Orders Shipped on Schedule
• Good measure if orders have similar value. Does not capture value.
• If one company represents 50% of your business but only 5% of your orders,
95% on schedule could represent only 50% of value
• Percentage of Line Items Shipped on Schedule
• Recognizes that not all orders are equal, but does not capture
$ value of orders. More expensive to measure. Ok for finished goods.
• A 90% service level might mean shipping 225 items out of the total 250 line
items totaled from 20 orders scheduled
• Percentage Of Dollar Volume Shipped on Schedule
• Recognizes the differences in orders in terms of both line items and
$ value
Inventory Investment Measures Example: The Coach Motor Home Company has annual cost of
goods sold of $10,000,000. The average inventory value at any point in time is $384,615. Calculate
inventory turnover and weeks/days of supply.

• Inventory Turnover:
annual cost of goods sold $10,000,000
Turnover    26 inventory turns
average inventory value $384,615

• Weeks/Days of Supply:
average inventory on hand in dollars $384,615
Weeks of Supply    2weeks
average weekly usage in dollars $10,000,000/52

$384,615
Days of Supply   10 days
$10,000,000/260
Relevant Inventory Costs
Item Cost Includes price paid for the item plus
other direct costs associated with the
purchase
Holding Include the variable expenses incurred
Costs by the plant related to the volume of
inventory held
e.g. 15-25%
Capital The higher of the cost of capital or the
Costs opportunity cost for the company
Relevant Inventory Costs

Ordering Fixed, constant dollar amount incurred

Cost for each order placed
Shortage Loss of customer goodwill, back order
Costs handling, and lost sales
Risk costs Obsolescence, damage, deterioration,
theft, insurance and taxes
Storage Included the variable expenses for
costs space, workers, and equipment related
to the volume of inventory held
Determining Order Quantities
Lot-for-lot Order exactly what is needed

Fixed-order Specifies the number of units to order

quantity whenever an order is placed
Min-max Places a replenishment order when
system the on-hand inventory falls below the
predetermined minimum level.
Order n Order quantity is determined by total
periods demand for the item for the next n
periods
Three Mathematical Models for Determining
Order Quantity
• Economic Order Quantity (EOQ or Q System)
• An optimizing method used for determining order quantity
and reorder points
• Part of continuous review system which tracks on-hand
inventory each time a withdrawal is made
• Economic Production Quantity (EPQ)
• A model that allows for incremental product delivery
• Quantity Discount Model
• Modifies the EOQ process to consider cases where quantity
discounts are available
Economic Order Quantity

• EOQ Assumptions:
• Demand is known & constant - no
safety stock is required
• Lead time is known & constant
• No quantity discounts are
available
• Ordering (or setup) costs are
constant
• All demand is satisfied (no
shortages)
• The order quantity arrives in a
single shipment
Economic Order Quantity
Total Annual Inventory Cost with EOQ
Model
• Total annual cost= annual ordering cost + annual
holding costs
 D Q 2DS
TCQ   S   H; and Q 
Q  2  H

© Wiley 2007
Continuous (Q) Review System Example: A computer company has annual demand of 10,000.
They want to determine EOQ for circuit boards which have an annual holding cost (H) of $6 per
unit, and an ordering cost (S) of $75. They want to calculate TC and the reorder point (R) if the
purchasing lead time is 5 days.

• EOQ (Q)
2DS 2 * 10,000 * $75
Q   500 units
H $6
• Reorder Point (R)
10,000
R  Daily Demand x Lead Time  * 5 days  200 units
250 days

• Total Inventory Cost (TC)

 10,000   500 
TC    $75   $6  $1500  $1500  $3000
 500   2 
Economic Production Quantity (EPQ)

• Same assumptions as the EOQ except: inventory arrives in

increments & is drawn down as it arrives

© Wiley 2007
EPQ Equations

• Total cost:
 D   I MAX 
TC EPQ   S   H
Q   2 

• Maximum inventory:
 d
• d=avg. daily demand rate I MAX  Q 1  
• p=daily production rate  p

• Calculating EPQ 2DS

EPQ 
 d
H
 1  
 p

EPQ Problem: HP Ltd. Produces its premium plant food in 50# bags. Demand is 100,000 lbs. per week and they operate 50
wks. each year and HP can produce 250,000 lbs. per week. The setup cost is $200 and the annual holding cost rate is $.55 per
bag. Calculate the EPQ. Determine the maximum inventory level. Calculate the total cost of using the EPQ policy.

2DS
EPQ 
 d 
H
 1  

 p 

 d
I MAX  Q
1  p 

 

 D   I MAX 
TC EPQ   S   H
Q   2 
EPQ Problem: HP Ltd. Produces its premium plant food in 50# bags. Demand is 100,000 lbs. per week and they operate 50
wks. each year and HP can produce 250,000 lbs. per week. The setup cost is $200 and the annual holding cost rate is $.55 per
bag. Calculate the EPQ. Determine the maximum inventory level. Calculate the total cost of using the EPQ policy.

2DS 2(50)(100,000)( 200)

EPQ  EPQ   77,850 Bags
 d   100,000 
H
1  p 
 .551  
   250000 

 
I MAX

 Q
d
1  p 
 I  1 0 0, 0 0 0 
MAX  7 7, 8 5 0 1   4 6, 7 1 0b a g s
 2 5 0, 0 0 0 
 

 5,000,000   46,710 
D  I 
TC EPQ   S    MAX H  TC   200    .55  $25,690
Q   2   77,850   2 
Quantity Discount Model
• Same as the EOQ model, except:
• Unit price depends upon the quantity ordered

• The total cost equation becomes:

TCQD
 D  Q 
  S   H
Q   2 
 CD
Quantity Discount Procedure
• Calculate the EOQ at the lowest price
• Determine whether the EOQ is feasible at that price
• Will the vendor sell that quantity at that price?
• If yes, stop – if no, continue
• Check the feasibility of EOQ at the next higher price

• Continue to the next slide ...

QD Procedure (continued)
• Continue until you identify a feasible EOQ
• Calculate the total costs (including total item cost) for the feasible
EOQ model
• Calculate the total costs of buying at the minimum quantity required
for each of the cheaper unit prices
• Compare the total cost of each option & choose the lowest cost
alternative
• Any other issues to consider?
Quantity Discount Example: Collin’s Sport store is considering going to a different hat supplier. The present
supplier charges $10 each and requires maximum quantities of 490 hats (holding cost of $2). The annual
demand is 12,000 hats, the ordering cost is $20, and the inventory carrying cost is 20% of the hat cost, a new
supplier is offering hats at $9 in lots of 4000 (holding cost of $1.80). Who should he buy from?

• EOQ at lowest price $9. Is it feasible?

2(12,000)( 20)
EOQ$9   516 hats
$1.80
• Since the EOQ of 516 is not feasible, calculate the total cost (C) for each
price to make the decision
12,000
C$10  $20  490 $2  $1012,000  $120,980
490 2
12,000
C$9  $20  4000 $1.80  $912,000  $101,660
4000 2

• 4000 hats at $9 each saves $19,320 annually. Space?

Safety Stock and Service Levels

• If demand or lead time is uncertain,

safety stock can be added to improve
order-cycle service levels
• R = dL +SS
• Where SS =zσdL, and Z is the number
of standard deviations and σdL is
standard deviation of the demand
during lead time

• Order-cycle service level

• The probability that demand during
lead time will not exceed on-hand
inventory
• A 95% service level (stockout risk of
5%) has a Z=1.645
Periodic Review Systems
• Orders are placed at specified, fixed-time intervals (e.g.
every Friday), for a order size (Q) to bring on-hand
inventory (OH) up to the target inventory (TI), similar to the
min-max system.
• Advantages are:
• No need for a system to continuously monitor item
• Items ordered from the same supplier can be reviewed on the
same day saving purchase order costs
• Disadvantages:
• Replenishment quantities (Q) vary
• Order quantities may not quality for quantity discounts
• On the average, inventory levels will be higher than Q systems-
more stockroom space needed
Periodic Review Systems: Calculations for TI
• Targeted Inventory level:
TI = d(RP + L) + SS
d = average period demand
RP = review period (days, weeks)
L = lead time (days, weeks)
SS = zσRP+L
• Replenishment Quantity (Q)=TI-OH

© Wiley 2007
P System: an auto parts store calculated the EOQ for Drive Belts at 236 units and wants to compare
the Total Inventory Costs for a Q vs. a P Review System. Annual demand (D) is 2704, avg.
weekly demand is 52, weekly σ is 1.77 belts, and lead time is 3 weeks. The annual TC for the Q
system is $229; H=$0.97, S=$10.

• Review Period Q 236

RP  x 52weeks  x52  5wks
D 2704
• Target Inventory for 95% Service Level
TI  d(RP  L)  SS  d(RP  L)  zσRP  L
 
TI  52 units 5  3  1.645 1.77 5  3  416  8  424 belts
• Average On-Hand
OHavg= TI-dL=424-(52belts)(3wks) = 268 belts
• Annual Total Cost (P System)
52 268
TCp  $10  $.97   115  130  $245
5 2
Annual Cost Difference  $245  $229  $16
Single Period Inventory Model
• The SPI model is designed for products that share the following characteristics:
• Sold at their regular price only during a single-time period
• Demand is highly variable but follows a known probability distribution
• Salvage value is less than its original cost so money is lost when these products are sold for
their salvage value
• Objective is to balance the gross profit of the sale of a unit with the cost
incurred when a unit is sold after its primary selling period
SPI Model Example: Tee shirts are purchase in multiples of 10 for a charity event for $8 each.
When sold during the event the selling price is $20. After the event their salvage value is just $2.
From past events the organizers know the probability of selling different quantities of tee shirts
within a range from 80 to 120

Payoff Table
Prob. Of Occurrence .20 .25 .30 .15 .10
Customer Demand 80 90 100 110 120
# of Shirts Ordered Profit
80 $960 $960 $960 $960 $960 $960
90 $900 $1080 $1080 $1080 $1080 $1040
Buy 100 $840 $1020 $1200 $1200 $1200 $1083
110 $780 $ 960 $1140 $1320 $1320 $1068
120 $720 $ 900 $1080 $1260 $1440 $1026

Sample calculations:
Payoff (Buy 110)= sell 100($20-$8) –((110-100) x ($8-$2))= $1140
Expected Profit (Buy 100)= ($840 X .20)+($1020 x .25)+($1200 x .30) +
($1200 x .15)+($1200 x .10) = $1083
ABC Inventory Classification
• ABC classification is a method for determining level of control and frequency of
review of inventory items
• A Pareto analysis can be done to segment items into value categories depending
on annual dollar volume
• A Items – typically 20% of the items accounting for 80% of the inventory value-
use Q system
• B Items – typically an additional 30% of the items accounting for 15% of the
inventory value-use Q or P
• C Items – Typically the remaining 50% of the items accounting for only 5% of the
inventory value-use P
Justifying Smaller Order Quantities

• JIT or “Lean Systems” would recommend reducing order quantities to

the lowest practical levels
• Benefits from reducing Q’s:
• Improved customer responsiveness (inventory = Lead time)
• Reduced Cycle Inventory
• Reduced raw materials and purchased components
• Justifying smaller EOQ’s:
2DS
Q
H

• Reduce Q’s by reducing setup time (S). “Setup reduction” is a well

documented, structured approach to reducing S
Inventory Record Accuracy

• Inaccurate inventory records can cause:

• Lost sales
• Disrupted operations
• Poor customer service
• Lower productivity
• Planning errors and expediting
Inventory Record Accuracy

• Two methods are available for checking record accuracy

• Periodic counting - physical inventory is taken periodically, usually
annually
• Cycle counting-daily counting of prespecified items provides the
following advantages:
• Timely detection and correction of inaccurate records
• Elimination of lost production time due to unexpected stock outs
• Structured approach using employees trained in cycle counting
Inventory Management Across the
Organization
• Inventory management policies affect functional areas throughout
• Accounting is concerned of the cost implications of inventory
• Marketing is concerned as stocking decision affect the level of customer
service
• Information Systems is involved to tack and control inventory records
Chapter 12 Highlights
• Raw materials, purchased components, work-in-
process, finished goods, distribution inventory and
maintenance, repair and operating supplies are all
types of inventory. Inventories have several uses:
anticipation inventory is built before it is needed;
fluctuation stock provides a cushion; cycle stock is
a result of the company’s ordering quantity;
transportation inventory includes items in transit;
speculative inventory is a buildup to protect
against some future event and MRO inventory
supports daily operations
Chapter 12 Highlights
• The objectives of inventory management are to provide the
desired level of customer service, to allow cost-efficient
operations, and to minimize inventory investment.
Customer service can be measured in several ways,
including as a percentage of orders shipped on schedule, a
percentage of line items shipped on schedule, a percentage
of dollar volume shipped on schedule, or idle time due to
material and component shortages. Cots-efficient
operations are achieved by using inventory as buffer stocks
allowing a stable year-round workforce, and spreading the
setup cost over a larger number of Inventory performance
is measured by turns/supply.
• Inventory costs include item cost, holding cost, ordering
cost, and shortage cost.
Chapter 12 Highlights (continued)
• Inventory investment is measured in inventory turnover
and/or level of supply. Inventory performance is calculated
as inventory turnover or weeks, days, or hours of supply.
• Relevant inventory costs include items costs, holding costs,
and shortage costs. Holding costs include capital costs,
storage costs, and risk costs. Ordering costs are fixed costs
for placing an order or performing a setup. Shortage costs
included costs related to additional paperwork, additional
shipping expense, and the intangible cost of lost customer
goodwill.
Chapter 12 Highlights (continued)

• Lot-for-lot, fixed-order quantity, min-max systems,

order n periods, periodic review systems, EOQ
models, quantity discount models, and single-
period models can be used to determine order
quantities.
• Ordering decisions can be improved by analyzing
total costs of an inventory policy. Total costs
include ordering cost, holding cost, and material
cost
Chapter 12 Highlights (continued)
• Practical considerations can cause a company to
not use the optimal order quantity, that is,
minimum order requirements
• Smaller lot sizes give a company flexibility and
shorter response times. The key to reducing order
quantities is to reduce ordering or setup costs.
• Calculating the appropriate safety stock policy
enables companies to satisfy their customer
service objective at minimum costs. The desired
customer service level determines the appropriate
z value.
Chapter 12 Highlights (continued)
• Inventory decisions about perishable products can
be made using the single-period inventory model.
The expected payoff is calculated to assist the
quantity decision
• The ABC classification system allows a company to
assign the appropriate level of control and
frequency of review of an item based on its annual
dollar volume
• Cycle counting is a method for maintaining
accurate inventory records. Determining what and
when to count are the major decisions
Chapter 12 Highlights (continued)
• Order Q’s can be determined by using L4L, fixed order Q’s, min-max,
order n periods, quantity discounts, and single period systems.
• Ordering decisions can be improved by analyzing TC
• Smaller lot sizes increase flexibility and reduce response time.
• Safety stock can be added to reorder point calculations to meet desired
service level z value.
• Inventory decisions about perishable products can be made by using
the single-period inventory model.
• ABC analysis can be used to assign the appropriate level of control and
review frequency based on the annual dollar volume of each item.
• Cycle counting of pre-specified items is an accepted method for
maintaining inventory records
 The End
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