Operations Management: Sustainability

and Supply Chain Management

Twelfth Edition

Chapter 12
Inventory Management

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Outline (1 of 2)
• Global Company Profile: Amazon.com
• The Importance of Inventory
• Managing Inventory
• Inventory Models
• Inventory Models for Independent Demand

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Outline (2 of 2)
• Probabilistic Models and Safety Stock
• Single-Period Model
• Fixed-Period (P) Systems

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Inventory Management at Amazon.Com (1 of 3)
• Amazon.com started as a “virtual” retailer – no inventory,
no warehouses, no overhead – just computers taking
orders to be filled by others
• Growth has forced Amazon.com to become a world
leader in warehousing and inventory management

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Inventory Management at Amazon.Com (2 of 3)
1. Each order is assigned by computer to the closest
distribution center that has the product(s)
2. A “flow meister” at each distribution center assigns work
crews
3. Technology helps workers pick the correct items from
the shelves with almost no errors
4. Items are placed in crates on a conveyor, bar code
scanners scan each item 15 times to virtually eliminate
errors

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Inventory Management at Amazon.Com (3 of 3)
5. Crates arrive at central point where items are boxed and
labeled with new bar code
6. Gift wrapping is done by hand at 30 packages per hour
7. Completed boxes are packed, taped, weighed and
labeled before leaving warehouse in a truck
8. Order arrives at customer within 1 - 2 days

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Learning Objectives (1 of 2)
12.1 Conduct an ABC analysis
12.2 Explain and use cycle counting
12.3 Explain and use the EOQ model for
independent inventory demand
12.4 Compute a reorder point and explain safety
stock

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Learning Objectives (2 of 2)
12.5 Apply the production order quantity model
12.6 Explain and use the quantity discount model
12.7 Understand service levels and probabilistic
inventory models

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Inventory Management
The objective of inventory management is to
strike a balance between inventory
investment and customer service

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Importance of Inventory
• One of the most expensive assets of many companies
representing as much as 50% of total invested capital
• Less inventory lowers costs but increases chances of
running out
• More inventory raises costs but always keeps customers
happy

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Functions of Inventory
1. To provide a selection of goods for anticipated demand
and to separate the firm from fluctuations in demand
2. To decouple or separate various parts of the production
process
3. To take advantage of quantity discounts
4. To hedge against inflation

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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

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Figure 12.1 The Material Flow Cycle

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Managing Inventory
1. How inventory items can be classified (ABC analysis)
2. How accurate inventory records can be maintained

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ABC Analysis (1 of 5)
• 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 the many trivial ones

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ABC Analysis (2 of 5)
Figure 12.2 Graphic Representation of ABC Analysis

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ABC Analysis (3 of 5)
ABC Calculation

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ABC Analysis (4 of 5)
• Other criteria than annual dollar volume may be used
– High shortage or holding cost
– Anticipated engineering changes
– Delivery problems
– Quality problems

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ABC Analysis (5 of 5)
• Policies employed may include

1. More emphasis on supplier development for A

items
2. Tighter physical inventory control for A items
3. More care in forecasting A items

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Record Accuracy (1 of 2)
• Accurate records are a
critical ingredient in
production and inventory
systems
– Periodic systems
require regular checks
of inventory
 Two-bin system
– Perpetual inventory
tracks receipts and
subtractions on a
continuing basis
 May be semi-
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Record Accuracy (2 of 2)
• Incoming and outgoing record keeping must be accurate
• Stockrooms should be secure
• Necessary to make precise decisions about ordering,
scheduling, and shipping

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Cycle Counting
• Items are counted and records updated on a periodic
basis
• Often used with ABC analysis
• Has several advantages

1. Eliminates shutdowns and interruptions

2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and corrected
5. Maintains accurate inventory records

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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)

Cycle Counting Number Of Items Counted

Item Class Quantity Policy Per Day
A 500 Each month 500 twentieths = 25 a day
500 20  25 day
B 1,750 Each quarter 1,750
1,750sixtieths
60  29= day
29 a day.

C 2,750 Every 6 months 2,750 one hundred and

120  23= day
2,750twentieths 23 a day.

Blank Blank Blank 77 Total is 77

day aday.

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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 of incoming shipments
3. Effective control of all goods leaving facility

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Inventory Models (1 of 2)
• Independent demand - the demand for item is
independent of the demand for any other item in
inventory
• Dependent demand - the demand for item is
dependent upon the demand for some other item
in the inventory

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Inventory Models (2 of 2)
• Holding costs - the costs of holding or “carrying”
inventory over time
• Ordering cost - the costs of placing an order and
receiving goods
• Setup cost - cost to prepare a machine or process for
manufacturing an order
– May be highly correlated with setup time

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Holding Costs (1 of 2)
Table 12.1 Determining Inventory Holding Costs

Cost (And Range) As A

Percent Of Inventory
Category Value
Housing costs (building rent or depreciation, operating 6% (3 - 10%)
costs, taxes, insurance)
Material handling costs (equipment lease or depreciation, 3% (1 - 3.5%)
power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and insurance 11% (6 - 24%)
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%

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Holding Costs (2 of 2)
Holding costs vary considerably depending on the
business, location, and interest rates. Generally greater
than 15%, some high tech and fashion items have holding
costs greater than 40%.

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Inventory Models for Independent Demand
Need to determine when and how much to
order
1. Basic economic order quantity (EOQ) model
2. Production order quantity model
3. Quantity discount model

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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 (or ordering) and
holding
6. Stockouts can be completely avoided
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Figure 12.3 Inventory Usage over Time

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Minimizing Costs (1 of 6)
Objective is to minimize total costs

Figure 12.4 Costs as a Function of Order Quantity: Total costs

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Minimizing Costs (2 of 6)
• By minimizing the sum of setup (or ordering) and
holding costs, total costs are minimized
• Optimal order size Q* will minimize total cost
• A reduction in either cost reduces the total cost
• Optimal order quantity occurs when holding cost
and setup cost are equal

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Minimizing Costs (3 of 6)
Q = Number of units per order
Q* = Optimal number of units per order (E OQ)
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

Annual setup cost = (Number of orders placed per

year) × (Setup or order cost
per order)
 Annual demand   Setup or order 
   
 Number of units in each order   cost per order 
D
  S
Q
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Minimizing Costs (4 of 6)
Q = Number of pieces per order
Q* = Optimal number of pieces per order (E OQ)
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

Annual setup cost = (Number of orders placed per

year) × (Setup or order cost
per order)  
 Annual demand  Setup or order
=   
 Number of units in each order   cost per order 
D
Annual setup cost   S
Q
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Minimizing Costs (5 of 6)
Annual holding cost = (Average inventory
level) × (Holding cost per
unit per year)
 Order quantity 
  (Holding cost per unit per year)
 2 
Q
Annual holding cost   H
2

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Minimizing Costs (6 of 6)
Optimal order quantity is found when annual setup
cost equals annual holding cost

Solving for Q* 2DS Q 2H

2 2DS
Q 
H
D Q 2DS
  S  H Q* 
Q 2 H

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An EOQ Example (1 of 6)
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2 DS
Q* 
H

2(1,000)(10)
Q*   40,000  200 units
0.50

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An EOQ Example (2 of 6)
Determine expected number of orders
D = 1,000 units
S = $10 per order
I = $.50 per unit per year
Q* =200 units

Demand D
Expected number of N  
Order quantity Q 
orders
1,000
N 5 orders per year
200

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An EOQ Example (3 of 6)
Determine optimal time between orders
D = 1,000 units
S = $10 per order
I = $.50 per unit per year
Q* =200 units
N = 5 orders/year
Number of working days per year
Expected time between orders T 
Expected number of orders

250
T 50 days between orders
5
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An EOQ Example (4 of 6)
Determine the total annual
cost
Q* = 200 units
D = 1,000 units
N = 5 orders/year
S = $10 per order
T = 50 days
H = $.50 per unit per year
Total annual cost = Setup cost + Holding
cost
D Q
TC  S  H
Q 2
1,000 200
 $20   $.50 
200 2
(5)($10)  (100)($.50)
$50  $50 $100
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The EOQ Model
When including actual cost of material P
Total annual cost = Setup cost + Holding cost + Product
cost

D Q
TC  S  H  PD
Q 2

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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
EO Q

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An EOQ Example (5 of 6)
Determine optimal number of needles to order
D  1,000 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 old Q* Ordering new Q*

D Q
TC  S  H 1,500 244.9
Q 2  ($10)  ($.50)
244.9 2
1,500 200
 ($10)  ($.50) 6.125($10)  122.45($.50)
200 2
$75 + $50 $125 $61.25  $61.22 $122.47
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An EOQ Example (6 of 6)
Only 2% less than the total cost of $125 when the order
quantity was 200

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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
an order
 Demand   Lead time for a new 
ROP   
 per day  order in days 

ROP = d x
L
D
d
Number of working days in a year
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Reorder Point Curve
Figure 12.5 The Reorder Point (ROP)

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Reorder Point Example
Demand = 8,000 iPhones per year
250 working day year
Lead time for orders is 3 working days, may take 4

D
d
Number of working days in a year
8,000 / 250 32 units
RO P = d x L
= 32 units per day × 3 days = 96
units
= 32 units per day × 4 days = 128
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Production Order Quantity Model (1 of 5)
1. Used when inventory builds up over a period of time
after an order is placed
2. Used when units are produced and sold simultaneously

Figure 12.6 Change in Inventory Levels over Time for the

Production Model

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Production Order Quantity Model (2 of 5)
Q= Number of units per order p = Daily production
H= Holding cost per unit per d = Daily demand/usage rate
year
t = Length of the production run in
days
 holding cost 
Annual inventory  Average inventory level 
  Holding cost
per unit per year  
 level 
Annual inventory = Maximum inventory level  / 2

 Maximum
inventory level
 
 Total produced during
the production run
   Total used during
the production run

pt  dt
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Production Order Quantity Model (3 of 5)

 Maximum
inventory level
 Total produced during
the production run
   Total used during
the production run

pt  dt
However, Q = total produced = pt ; thus t = Q/p

 Maximum  Q Q  d

 inventory level   p  p  d  p Q  1 p 
       

Maximum inventory level  d 

Q
Holding cost  (H )  1  H
2
  p  
2 

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Production Order Quantity Model (4 of 5)

Setup cost = ( D / Q )S

2 
1
Holding cost = HQ  1   
d
p

D 1   d 
S = HQ 1   
Q 2
  p  

2 2 DS 2 DS
Q = Q *p =
  d    d 
H 1   H 1  
  p     p  
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Production Order Quantity Example
D = 1,000 units
S = $10
H = $0.50 per unit per year * 2 DS
Q 
p = 8 units per day
p H  1 d p  
d = 4 units per day *
Qp
2(1,000)(10)

0.50 1 ( 4 8) 
20,000
  80,000
0.50(1 2)

 282.8 hubcaps, or 283 hubcaps

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Production Order Quantity Model (5 of 5)
Note:
D 1,000
d 4  
Number of days the plant is in operation 250

When annual data are used the equation

becomes:
* 2 DS
Qp 
 Annual demand rate 
H 1 
 Annual production rate 

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Quantity Discount Models (1 of 4)
• Reduced prices are often available when larger
quantities are purchased
• Trade-off is between reduced product cost and
increased holding cost

Table 12.2 A Quantity Discount Schedule

Price Range Quantity Ordered Price Per Unit P

Initial price 0 to 119 $ 100
Discount price 1 200 to 1,499 $ 98
Discount price 2 1,500 and over $ 96

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Quantity Discount Models (2 of 4)
Total annual cost = Setup cost + Holding cost + Product cost

D Q
TC  S IP  PD
Q 2

where Q = Quantity ordered P = Price per unit

D = Annual demand in I = Holding cost per unit
units per year expressed as
S = Ordering or setup cost a percent of price P
per order 2DS
Q* 
IP
Because unit price varies, holding cost is expressed as a
percent (I) of unit price (P)
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Quantity Discount Models (3 of 4)
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.

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Quantity Discount Models (4 of 4)
Figure 12.7 EOQs and Possible Best Order Quantities for the Quantity
Discount Problem with Three Prices in Table 12.2 (see slide 55)

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Quantity Discount Example (1 of 2)
Calculate Q* for every *2DS
discount starting with the Q 
lowest price
IP
2(5,200)($200)
Q$96 *   278 drones / order
(.28)($96)

Infeasible – calculate Q* for next-higher price

2(5,200)($200)
Q$98 *  275 drones / order
(.28)($98)
Feasible

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Quantity Discount Example (2 of 2)
Table 12.3 Total Cost Computations for Chris Beehner Electronics

Annual Annual Annual

Order Unit Ordering Holding Product Total Annual
Quantity Price Cost Cost Cost Cost

275 $98 $3,782 $3,773 $509,600 $517,155

1,500 $96 $693 $20,160 $499,200 $520,053

Choose the price and quantity that gives the lowest total cost
Buy 275 drones at $98 per unit

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Quantity Discount Variations
• All-units discount is the most popular form
• Incremental quantity discounts apply only to
those units purchased beyond the price break
quantity
• Fixed fees may encourage larger purchases
• Aggregation over items or time
• Truckload discounts, buy-one-get-one-free
offers, one-time-only sales

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Probabilistic Models and Safety Stock
• Used when demand is not constant or certain
• Use safety stock to achieve a desired service
level and avoid stockouts

ROP = d × L + ss

Annual stockout costs = The sum of the units short for each
demand level × The probability of that demand level × The
stockout cost/unit × The number of orders per year

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Safety Stock Example (1 of 2)
ROP = 50 units
Orders per year = 6
Stockout cost = $40 per frame
Carrying cost = $5 per frame per year
Number Of Units Probability
30 .2
40 .2
ROP  50 .3
60 .2
70 .1
Blank 1.0

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Safety Stock Example (2 of 2)

Safety Additional Total

Stock Holding Cost Stockout Cost Cost
20 times $5 = $100
(20)($5) = $100 $0
20 $100
10 times $5 = $50.
(10)($5) = $ 50 (10)(.1)
10 = ($40)(6)
times 0.1 $240
times $40 times 6 = $240.
10 $290
10(10)(.2)($40)(6)
times 0.2 times $40 times 6 + 20 times
 (20)(.1)($40)(6) 0.1
$960
$0
0 times $40 times 6 = $960. $960

A safety stock of 20 frames gives the lowest total

cost
ROP = 50 + 20 = 70 frames

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Probabilistic Demand (1 of 3)
Figure 12.8 Probabilistic Demand for a Hospital Item

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Probabilistic Demand (2 of 3)
Use prescribed service levels to set safety stock
when the cost of stockouts cannot be determined

ROP demand during lead time + Z dLT

Where Z = Number of standard deviations

 dLT = Standard deviation of demand during
lead time

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Probabilistic Demand (3 of 3)

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Probabilistic Example (1 of 4)
 = Average demand = 350 kits

 dLT = Standard deviation of demand during lead time =

10 kits

Stockout policy = 5% (service level = 95%)

Using Appendix I, for an area under the curve of 95%, the Z =

1.645
Safety stock Z dLT = 1.645(10) = 16.5
= kits
Reorder point = Expected demand during lead time +
Safety stock
= 350 kits + 16.5 kits of safety stock
= 366.5 or 367
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Other Probabilistic Models (1 of 4)
• When data on demand during lead time is not
available, there are other models available

1. When demand is variable and lead time is

constant
2. When lead time is variable and demand is
constant
3. When both demand and lead time are variable

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Other Probabilistic Models (2 of 4)
Demand is variable and lead time is constant

ROP = (Average daily demand ×

Z dLT+
Lead time in days)

where  dLT  d Lead time

 d = Standard deviation of demand per day

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Probabilistic Example (2 of 4)
Average daily demand (normally distributed) = 15
Lead time in days (constant) = 2
Standard deviation of daily demand = 5
Service level = 90%
Z for 90% = 1.28 From Appendix I

ROP 15 units  2 days   Z dLT

 30  1.28 5   2
 30  9.02  39.02  39

Safety stock is about 9 computers

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Other Probabilistic Models (3 of 4)
Lead time is variable and demand is constant

ROP = (Daily demand × Average

lead time  LT
in days) + Z × (Daily demand) ×
where  LT = Standard deviation of lead time in
days

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Probabilistic Example (3 of 4)
Daily demand (constant) = 10
Average lead time = 6 days
Standard deviation of lead time LT
= 1

Service level = 98%, so Z (from Appendix I) = 2.055

ROP = (10 units × 6 days) + 2.055(10 units)(1)
= 60 + 20.55 = 80.55
Reorder point is about 81 cameras

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Other Probabilistic Models (4 of 4)
Both demand and lead time are variable
ROP = (Average daily demand
Z dLT
× Average lead time) +

where  d  Standard deviation of demand per day

 LT  Standard deviation of lead time in days
( Average lead time   d 2 )
 dLT =
 Average daily demand) 2 2LT

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Probabilistic Example (4 of 4)
Average daily demand (normally distributed) = 150
Standard deviation=d 16

Average lead time 5 days (normally distributed)

Standard deviation=LT 1 day

Service level = 95%, so Z = 1.645 (from Appendix I)

ROP (150 packs 5 days)  1.645 dLT

 dLT  5 days 162   150 2 12   5 256   22,500 1

 1,280   22,500   23,780 154
ROP (150 5)  1.645(154) 750  253 1,003 packs
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Single-Period Model
• Only one order is placed for a product
• Units have little or no value at the end of the sales
period
Cs = Cost of shortage = Sales price/unit – Cost/unit
Co = Cost of overage = Cost/unit – Salvage value

Cs
Service level =
Cs  Co

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Single-Period Example (1 of 2)
Average demand =  120 papers / day

Standard  15 papers

deviation =
Cs = cost of shortage = $1.25 – $.70 =
$.55
Co = cost of overage = $.70 – $.30 =
$.40 Cs
Service level =
Cs  Co
.55
=
.55  .40
.55
= =.579
.95

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Single-Period Example (2 of 2)
From Appendix I, for the Z .20
area .579,
The optimal stocking level

= 120 copies +  
(.20)
= 120 + (.20)(15) = 120 + 3 = 123 papers

The stockout risk = 1 − Service level

= 1 − .579 = .422 = 42.2%

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Fixed-Period (P) Systems (1 of 3)
• Fixed-quantity models require continuous
monitoring using perpetual inventory systems
• In fixed-period systems orders placed at the
end of a fixed period
• Periodic review, P system

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Fixed-Period (P) Systems (2 of 3)
• Inventory counted only at end of period
• Order brings inventory up to target level
– Only relevant costs are ordering and holding
– Lead times are known and constant
– Items are independent of one another

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Fixed-Period (P) Systems (3 of 3)
Figure 12.9 Inventory Level in a Fixed-Period (P) System

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Fixed-Period Systems
• Inventory is only counted at each review period
• May be scheduled at convenient times
• Appropriate in routine situations
• May result in stockouts between periods
• May require increased safety stock

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Copyright

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