INVENTORY MANAGEMENT

Rajiv Misra
 INVENTORY MANAGEMENT

•Independent Demand

•Deterministic
•Stochastic (Newsvendor)

•Dependent Demand

Rajiv Misra
INDEPENDENT VS DEPENDENT DEMAND

Independent Demand (Demand not related to other

items or the final end-product)

Dependent
Demand
(Derived demand
items for
component
parts,
E(1) subassemblies,
raw materials,
etc.)

Rajiv Misra
 INVENTORY MANAGEMENT

•Periodic Review

•Continuous Review

Rajiv Misra
 EOQ MODEL: ASSUMPTIONS

1. Production is instantaneous – there is no capacity constraint and the

entire lot is produced simultaneously.
2. Delivery is immediate – there is no time lag between production and
availability to satisfy demand.
3. Demand is deterministic – there is no uncertainty about the quantity or
timing of demand.
4. Demand is constant over time – in fact, it can be represented as a straight
line, so that if annual demand is 365 units this translates into a daily
demand of one unit.
5. A production run incurs a fixed setup cost – regardless of the size of the
lot or the status of the factory, the setup cost is constant.
6. Products can be analyzed singly – either there is only a single product or
conditions exist that ensure separability of products.

Rajiv Misra
 EOQ MODEL: MECHANISM
Basic Fixed-Order Quantity Model and Reorder Point Behavior

1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
L L
2. Your start using
them up over time. 3. When you reach down to
Time a level of inventory of R,
R = Reorder point
Q = Economic order quantity you place your next Q
L = Lead time sized order.
Rajiv Misra
 EOQ MODEL: NOTATION

D demand rate (units per year)

c unit production cost, not counting setup or inventory costs

A fixed or setup cost to place an order

h holding cost (Rs per year); if the holding cost is consists entirely of
interest on money tied up in inventory, then h = ic where i is an annual
interest rate.

Q the unknown size of the order or lot size decision variable

Rajiv Misra
 EOQ MODEL: COSTS

Annual Holding Cost

Annual Setup Costs:

Annual Purchase Cost:

Rajiv Misra
EOQ MODEL: AVERAGE INVENTORY

Rajiv Misra
 EOQ MODEL: TOTAL COST

Annual Holding Cost: Q

average inventory =
2
hQ
annual holding cost =
2

AD
Annual Setup Costs: setup cost = ( D / Q = No of setups/yr)
Q

Annual Purchase Cost: cD per year

hQ DA
Cost Function: Y (Q) = + + cD
2 Q

Holding Setup Production Rajiv Misra

 EOQ MODEL: TOTAL COST

The total cost curve reaches its minimum where the carrying
and ordering costs are equal.
Annual Cost

Q D
T C = H + S
2 Q

Ordering Costs

Order Quantity (Q)

(optimal order quantity)
QO
Rajiv Misra
 EOQ

hQ DA
Y (Q) = + + cD
2 Q

dY (Q) h DA
= − 2 =0
dQ 2 Q

2 AD EOQ Square Root Formula

Q =
*

Rajiv Misra
 EOQ EXAMPLE

A grocery store pays Rs 100 for each delivery of milk

from the dairy. They sell 200 liters per week. Each liter
costs the store Rs2, and they sell it for Rs3. They earn a
15% return on cash that is invested in milk. They have a
large refrigerator that holds up to 2,000 liter. It costs them
Rs10,000 per year to maintain.

Rajiv Misra
 EOQ EXAMPLE: SOLUTION

A grocery store pays Rs 100 for each delivery of milk

from the dairy. They sell 200 liters per week. Each liter
costs the store Rs2, and they sell it for Rs3. They earn a
15% return on cash that is invested in milk. They have a
large refrigerator that holds up to 2,000 liter. It costs them
Rs10,000 per year to maintain.

D ~ 200(52) = 10,400 liter per year.

h ~ 15%(Rs 2) = $.30 per liter per year
A ~ Rs 100

Q* = 2,633 Î Roughly one replenishment every 9 weeks?!?!

Rajiv Misra
 EOQ EXAMPLE: STORAGE CAPACITY

Suppose that the refrigerator held only 100 liter. How

much would it be worth to expand capacity to 200 liter?

Rajiv Misra
EOQ EXAMPLE: STORAGE CAPACITY

Suppose that the refrigerator held only 100 liter. How

much would it be worth to expand capacity to 200 liter?

10,400 100
TC (100) = Rs100 + Rs 0.3 = Rs10,415
100 2
10,400 200
TC (200) = Rs100 + Rs 0.3 = Rs5,230
200 2

ÎRs 5,185 per year in operational savings from doubling

freezer size.

Rajiv Misra
 EOQ EXAMPLE: ATM

A bank has determined that it costs Rs30 to replenish the

cash in one of its suburban ATMs. Customers take cash
out of the ATM at a rate of Rs 2000 per day (365 days per
year). The bank earns a 10% return on cash that is not
sitting in an ATM. Let us define Rs1000 to be a basic unit
of cash.

Rajiv Misra
 EOQ EXAMPLE: ATM

A bank has determined that it costs Rs30 to replenish the

cash in one of its suburban ATMs. Customers take cash
out of the ATM at a rate of Rs 2000 per day (365 days per
year). The bank earns a 10% return on cash that is not
sitting in an ATM. Let us define Rs1000 to be a basic unit
of cash.

D ~ Rs 2K(365) = $730K per year.

h ~ 10%($1K) = Rs100 per K per year
S ~ Rs30

Q* = Rs 20.9K Î Roughly one replenishment every 10 days.

Rajiv Misra
 EOQ MODEL: MANAGING UNCERTAINTY
Inventory level

Reorder
point, R

Safety stock
0
LT LT
Time
Rajiv Misra
 EOQ MODEL: MANAGING UNCERTAINTY
Quantity

Maximum probable
demand during lead
time
Expected demand
during lead time
Reorder point R

Safety stock
LT

Rajiv Misra
EOQ MODEL: MANAGING UNCERTAINTY

Service level =
Risk of a stock-out
probability of no stock-out

Expected Quantity
Safety-stock
demand
0 z z-scale
Q R

The value for “z” is found by using the Excel

NORMSINV (Service Level) function. Rajiv Misra
EOQ MODEL: MANAGING UNCERTAINTY

0 1 2 3 4 5 6 7 8

Average Demand each week = 100

Standard Deviation =4
Lead Time =2
Service Level = 95%

Find out the Safety Stock?

Rajiv Misra
EOQ MODEL: MANAGING UNCERTAINTY

0 1 2 3 4 5 6 7 8

Average Demand during two weeks = 200

Rajiv Misra
EOQ MODEL: MANAGING UNCERTAINTY

Service level =
Risk of a stock-out
probability of no stock-out

Expected Quantity
Safety-stock
demand
0 z z-scale
Q R
200 ?

The value for “z” is found by using the Excel

NORMSINV (Service Level) function. Rajiv Misra
EOQ MODEL: MANAGING UNCERTAINTY

0 1 2 3 4 5 6 7 8

Average Demand Lead Time = 200

Standard Deviation =

Rajiv Misra
EOQ MODEL: MANAGING UNCERTAINTY

0 1 2 3 4 5 6 7 8

SD 4 4

Average Demand Lead Time = 200

Standard Deviation = (2)(4)
2
=

Rajiv Misra
EOQ MODEL: MANAGING UNCERTAINTY

σL = (2 )(4 )
2
= 5.656854

Safety Stock = z σ L
The value for “z” is found by using the Excel
NORMSINV function.

So, if we want to be 95 percent sure of not

stocking out, z = 1.64, we need to carry 10
units of safety stock (1.64 x 5.6569 = 9.3).
Rajiv Misra
 SAFETY STOCK CALCULATION

L
σL = ∑ (σ )
2
w
i =1

Since each week is independent and σ w is constant,

σ L = (L)σ w 2

The standard deviation of a sequence of random events equals the

square root of the sum of the variances.

Rajiv Misra
DEVELOPING INVENTORY INTUITION

Rajiv Misra
 DEVELOPING INVENTORY INTUITION

Consider a situation with an item that we wish to stock on an

ongoing basis. The demand for the item averages 100 units
per week with a standard deviation of 30 units. Lead time is
3 weeks and the EOQ is 400 units. Probability of not
stocking out is 97%.

What is the reorder point?

Rajiv Misra
 DEVELOPING INVENTORY INTUITION

Reorder Point = Expected Demand During Lead Time + Safety Stock

= 300 + 98 = 398

Expected Demand During Lead Time = 100 x 3 = 300 units

Safety Stock
• Standard Deviation of demand during lead time = sqrt( 3 x 302) = 51.96
• NORMSINV(.97) = 1.88
• Safety Stock = 1.88 x 51.96 = 97.688 (98 units)

Rajiv Misra
 DEVELOPING INVENTORY INTUITION

How often do you expect the item to be ordered?

What is the expected average inventory for the item.

Rajiv Misra
 DEVELOPING INVENTORY INTUITION

Expect to order every 4 weeks (400/100 = 4).

Average Inventory = Q/2 + Safety Stock = 298

Rajiv Misra
DEVELOPING INVENTORY INTUITION

In general, what percentage of the yearly demand do you

expect to meet? Would it equal 97%? Be greater than
97%? Or less than 97%? Why?

Rajiv Misra
DEVELOPING INVENTORY INTUITION

More that 97%.

Why?? Only taking the risk over the lead time.

Rajiv Misra
 DEVELOPING INVENTORY INTUITION

Currently there are 278 units on hand. The firm has just
placed an order for the item. What it the probability they
will stock out before the order arrives?

Rajiv Misra
 DEVELOPING INVENTORY INTUITION

Expected demand over the 3 weeks is 300 units. Therefore,

there are -22 units of safety stock. The z-score associated
with
-22 units = -22/51.96 = -.4234. This corresponds to a
probability of not stocking out of .336 (NORMSDIST(-
.4234)). Probability of stocking out .664 (66 percent).

Rajiv Misra
 SUMMARY

Dependent vs Independent Demand

Fixed Order Quantity Model
• Reorder Point, Order Quantity
Safety Stock – Demand Uncertainty

Rajiv Misra
FIXED TIME PERIOD REVIEW
 FIXED TIME PERIOD REVIEW

Periodic Review System T – Time between orders

This is fixed.
Max Level – At the beginning of each order cycle order up to
Inventory Level

this level.

Q If the lead time (L) were zero,

what should the max level be?

Max = DemandT + SST

Q = Max – Current Inv. Position

T T
Time
Rajiv Misra
 FIXED TIME PERIOD REVIEW

Periodic Review System T – Time between orders

This is fixed.

Max Level – At the beginning of each order cycle order up to

Inventory Level

this level.

Q What if the lead time (L) were

not zero, what should the
max level be?
Max = DemandT+L + SST+L
Q = Max – Current Inv. Position
L L

T T
Time
Rajiv Misra
FIXED TIME PERIOD REVIEW
 FIXED TIME PERIOD REVIEW

qq==Average
Averagedemand
demand++Safety
Safetystock
stock––Inventory
Inventorycurrently
currentlyon
onhand
hand

q = d (T + L) + Z σ T + L - I

Where :
q = quantitiy to be ordered
T = the number of days between reviews
L = lead time in days
d = forecast average daily demand
z = the number of standard deviations for a specified service probabilit y
σ T + L = standard deviation of demand over the review and lead time
I = current inventory level (includes items on order)
 FIXED TIME PERIOD REVIEW

Multi-Period Models: Fixed-Time Period Model:

Determining the Value of σT+L

∑((σσ ))
T+
T+LL 22
σσT+T+LL == ∑
i =i =11
ddi
i

Since
Sinceeach
eachday
dayisisindependent andσσdd isisconstant,
independentand constant,
σσT+T+LL == (T + L)σ 22
(T + L)σdd

The standard deviation of a sequence of random events equals the square

root of the sum of the variances
 FIXED TIME PERIOD REVIEW

Given
Given the
the information
information below,
below, how
how many
many units
units
should
should be
be ordered?
ordered?

Average daily demand for a product is 20

units. The review period is 30 days, and lead
time is 10 days. Management has set a policy
of satisfying 96 percent of demand from items
in stock. At the beginning of the review
period there are 200 units in inventory. The
daily demand standard deviation is 4 units.
 FIXED TIME PERIOD REVIEW

σ T+ L = (T + L)σ d =
2
( 30 + 10)( 4) = 25.298
2

The
The value
value for
for “z”
“z” isis found
found by
by using
using the
the Excel
Excel
NORMSINV
NORMSINV function,
function,

zz==1.75
1.75
 FIXED TIME PERIOD REVIEW

q = d(T + L) + Z σ T + L - I

q = 20(30 + 10) + (1.75)(25.298) - 200

q = 800 + 44.272 - 200 = 644.272, or 645 units

So,
So, to
to satisfy
satisfy 96
96 percent
percent of
of the
the demand,
demand,
you
you should
should place
place an
an order
order of
of 645
645 units
units at
at
this
this review
review period
period