Tata McGraw

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Inventory Control
Chapter 17
Inventory System Defined
Inventory Costs
Independent vs. Dependent Demand
Single-Period Inventory Model
Multi-Period Inventory Models: Basic
Fixed-Order Quantity Models
Multi-Period Inventory Models: Basic
Fixed-Time Period Model
Miscellaneous Systems and Issues
OBJECTIVES
17-3
Inventory System
Inventory is the stock of any item or
resource used in an organization and
can include: raw materials, finished
products, component parts, supplies,
and work-in-process
An inventory system is the set of
policies and controls that monitor levels
of inventory and determines what levels
should be maintained, when stock
should be replenished, and how large
orders should be
17-4
Purposes of Inventory
1. To maintain independence of
operations
2. To meet variation in product demand
3. To allow flexibility in production
scheduling
4. To provide a safeguard for variation in
raw material delivery time
5. To take advantage of economic
purchase-order size
17-5
Inventory Costs
Holding (or carrying) costs
Costs for storage, handling,
insurance, etc
Setup (or production change) costs
Costs for arranging specific
equipment setups, etc
Ordering costs
Costs of someone placing an order,
etc
Shortage costs
Costs of canceling an order, etc
17-6
E(1
)
Independent vs. Dependent Demand
Independent Demand (Demand for the final end-
product or demand not related to other items)
Dependent
Demand
(Derived demand
items for
component
parts,
subassemblies,
raw materials,
etc)
Finished
product
Component parts
17-7
Inventory Systems
Single-Period Inventory Model
One time purchasing decision (Example:
vendor selling t-shirts at a football game)
Seeks to balance the costs of inventory
overstock and under stock
Multi-Period Inventory Models
Fixed-Order Quantity Models
Event triggered (Example: running out of
stock)
Fixed-Time Period Models
Time triggered (Example: Monthly sales
call by sales representative)
17-8
Single-Period Inventory Model
u o
u
C C
C
P

sold be unit will y that the Probabilit

estimated under demand of unit per Cost C
estimated over demand of unit per Cost C
: Where
u
o

P
This model states that we
should continue to increase
the size of the inventory so
long as the probability of
selling the last unit added is
equal to or greater than the
ratio of: Cu/Co+Cu
17-9
Single Period Model Example
Our college basketball team is playing in a
tournament game this weekend. Based
on our past experience we sell on average
2,400 shirts with a standard deviation of
350. We make $10 on every shirt we sell
at the game, but lose $5 on every shirt not
sold. How many shirts should we make
for the game?
C
u
=$10 and C
o
= $5; P $10 / ($10 + $5) = .667

Z
.667
= .432 (use NORMSDIST(.667) or Appendix E)
therefore we need 2,400 + .432(350) = 2,551 shirts

17-10
Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 1)
Demand for the product is constant
and uniform throughout the period
Lead time (time from ordering to
receipt) is constant
Price per unit of product is constant
17-11
Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 2)
Inventory holding cost is based
on average inventory
Ordering or setup costs are
constant
All demands for the product will
be satisfied (No back orders are
allowed)
17-12
Basic Fixed-Order Quantity Model and Reorder Point Behavior
R = Reorder point
Q = Economic order quantity
L = Lead time
L
L
Q Q Q
R
Time
Number
of units
on hand
1. You receive an order quantity Q.
2. Your start using
them up over time.
3. When you reach down to
a level of inventory of R,
you place your next Q
sized order.
4. The cycle then repeats.
17-13
Cost Minimization Goal
Ordering Costs
Holding
Costs
Order Quantity (Q)
C
O
S
T
Annual Cost of
Items (DC)
Total Cost
Q
OPT
By adding the item, holding, and ordering costs
together, we determine the total cost curve, which in
turn is used to find the Q
opt
inventory order point that
minimizes total costs
17-14
Basic Fixed-Order Quantity (EOQ) Model Formula
H
2
Q
+ S
Q
D
+ DC = TC
Total
Annual =
Cost
Annual
Purchase
Cost
Annual
Ordering
Cost
Annual
Holding
Cost
+ +
TC=Total annual
cost
D =Demand
C =Cost per unit
Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
L =Lead time
H=Annual holding
and storage cost
per unit of inventory
17-15
Deriving the EOQ
Using calculus, we take the first derivative of
the total cost function with respect to Q, and
set the derivative (slope) equal to zero,
solving for the optimized (cost minimized)
value of Q
opt

Q =
2DS
H
=
2(Annual Demand)(Order or Setup Cost)
Annual Holding Cost
OPT
Reorder point, R = d L
_
d = average daily demand (constant)
L = Lead time (constant)
_
We also need a
reorder point to
tell us when to
place an order
17-16
EOQ Example (1) Problem Data
Annual Demand = 1,000 units
Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
Given the information below, what are the EOQ and
reorder point?
17-17
EOQ Example (1) Solution
Q =
2DS
H
=
2(1,000 )(10)
2.50
= 89.443 units or
OPT
90 units
d =
1,000 units / year
365 days / year
= 2.74 units / day
Reorder point, R = d L = 2.74units / day (7days) = 19.18 or
_
20 units
In summary, you place an optimal order of 90 units. In
the course of using the units to meet demand, when
you only have 20 units left, place the next order of 90
units.
17-18
EOQ Example (2) Problem Data
Annual Demand = 10,000 units
Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost
per unit
Lead time = 10 days
Cost per unit = $15
Determine the economic order quantity
and the reorder point given the following
17-19
EOQ Example (2) Solution
Q =
2DS
H
=
2(10,000 )(10)
1.50
= 365.148 units, or
OPT
366 units
d =
10,000 units / year
365 days / year
= 27.397 units / day
R = d L = 27.397 units / day (10 days) = 273.97 or
_
274 units
Place an order for 366 units. When in the course of
using the inventory you are left with only 274 units,
place the next order of 366 units.
17-20
Fixed-Time Period Model with Safety Stock Formula
order) on items (includes level inventory current = I
time lead and review over the demand of deviation standard =
y probabilit service specified a for deviations standard of number the = z
demand daily average forecast = d
days in time lead = L
reviews between days of number the = T
ordered be to quantitiy = q
: Where
I - Z + L) + (T d = q
L + T
L + T

q = Average demand + Safety stock Inventory currently on hand

17-21
Multi-Period Models: Fixed-Time Period Model:
Determining the Value of s
T+L

T+L d
i 1
T+L
d
T+L d
2
=
Since each day is independent and is constant,
= (T+ L)
i
2

The standard deviation of a

sequence of random events
equals the square root of the
sum of the variances
17-22
Example of the Fixed-Time Period Model
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.
Given the information below, how many units
should be ordered?
17-23
Example of the Fixed-Time Period Model: Solution (Part 1)

T+ L d
2
2
= (T + L) = 30 + 10 4 = 25.298
The value for z is found by using the Excel
NORMSINV function, or as we will do here, using
Appendix D. By adding 0.5 to all the values in
Appendix D and finding the value in the table that
comes closest to the service probability, the z
value can be read by adding the column heading
label to the row label.
So, by adding 0.5 to the value from Appendix D of 0.4599,
we have a probability of 0.9599, which is given by a z = 1.75
17-24
Example of the Fixed-Time Period Model: Solution (Part 2)
or 644.272, = 200 - 44.272 800 = q
200 - 298) (1.75)(25. + 10) + 20(30 = q
I - Z + L) + (T d = q
L + T
units 645

So, to satisfy 96 percent of the demand,

you should place an order of 645 units at
this review period
17-25
Price-Break Model Formula
Cost Holding Annual
Cost) Setup or der Demand)(Or 2(Annual
=
iC
2DS
= Q
OPT
Based on the same assumptions as the EOQ model,
the price-break model has a similar Q
opt
formula:
i = percentage of unit cost attributed to carrying inventory
C = cost per unit
Since C changes for each price-break, the formula
above will have to be used with each price-break cost
value
17-26
Price-Break Example Problem Data
(Part 1)
A company has a chance to reduce their inventory
ordering costs by placing larger quantity orders using
the price-break order quantity schedule below. What
should their optimal order quantity be if this company
purchases this single inventory item with an e-mail
ordering cost of $4, a carrying cost rate of 2% of the
inventory cost of the item, and an annual demand of
10,000 units?
Order Quantity(units) Price/unit($)
0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
17-27
Price-Break Example Solution (Part 2)
units 1,826 =
0.02(1.20)
4) 2(10,000)(
=
iC
2DS
= Q
OPT
Annual Demand (D)= 10,000 units
Cost to place an order (S)= $4
First, plug data into formula for each price-break value of C
units 2,000 =
0.02(1.00)
4) 2(10,000)(
=
iC
2DS
= Q
OPT
units 2,020 =
0.02(0.98)
4) 2(10,000)(
=
iC
2DS
= Q
OPT
Carrying cost % of total cost (i)= 2%
Cost per unit (C) = $1.20, $1.00, $0.98
Interval from 0 to 2499, the
Q
opt
value is feasible
Interval from 2500-3999, the
Q
opt
value is not feasible
Interval from 4000 & more, the
Q
opt
value is not feasible
Next, determine if the computed Q
opt
values are feasible or not
17-28
Price-Break Example Solution (Part 3)
Since the feasible solution occurred in the first price-
break, it means that all the other true Q
opt
values occur
at the beginnings of each price-break interval. Why?
0 1826 2500 4000 Order Quantity
Total
annual
costs
So the candidates
for the price-
breaks are 1826,
2500, and 4000
units
Because the total annual cost function is
a u shaped function
17-29
Price-Break Example Solution (Part 4)
iC
2
Q
+ S
Q
D
+ DC = TC
Next, we plug the true Q
opt
values into the total cost
annual cost function to determine the total cost under
each price-break
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
= $12,043.82
TC(2500-3999)= $10,041
TC(4000&more)= $9,949.20
Finally, we select the least costly Q
opt
, which is this
problem occurs in the 4000 & more interval. In summary,
our optimal order quantity is 4000 units
17-30
Maximum Inventory Level, M
Miscellaneous Systems:
Optional Replenishment System
M
Actual Inventory Level, I
q = M - I
I
Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.
17-31
Miscellaneous Systems:
Bin Systems
Two-Bin System
Full Empty
Order One Bin of
Inventory
One-Bin System
Periodic Check
Order Enough to
Refill Bin
17-32
ABC Classification System
Items kept in inventory are not of equal
importance in terms of:
dollars invested
profit potential
sales or usage volume
stock-out penalties
0
30
60
30
60
A
B
C
% of
$ Value
% of
Use
So, identify inventory items based on percentage of total
dollar value, where A items are roughly top 15 %, B
items as next 35 %, and the lower 65% are the C items
17-33
Inventory Accuracy and Cycle Counting
Inventory accuracy refers to
how well the inventory
records agree with physical
count
Cycle Counting is a physical
inventory-taking technique in
which inventory is counted on
a frequent basis rather than
once or twice a year
17-34
Question Bowl
Which of the following is a reason why
firms keep a supply of inventory?
a. To maintain independence of
operations
b. To meet variation in product demand
c. To allow flexibility in production
scheduling
d. To take advantage of economic
purchase order size
e. All of the above
Answer: e. All of the above (Also can include to provide
a safeguard for variation in raw material delivery
time.)
17-35
Question Bowl
An Inventory System should
include policies that are related
to which of the following?
a. How large inventory purchase
orders should be
b. Monitoring levels of inventory
c. Stating when stock should be
replenished
d. All of the above
e. None of the above
Answer: d. All of the above
17-36
Question Bowl
Which of the following is an
Inventory Cost item that is
related to the managerial and
clerical costs to prepare a
purchase or production
order?
a. Holding costs
b. Setup costs
c. Carrying costs
d. Shortage costs
e. None of the above
Answer: e. None of the
above (Correct answer
is Ordering Costs.)
17-37
Question Bowl
Which of the following is
considered a Independent
Demand inventory item?
a. Bolts to a automobile
manufacturer
b. Timber to a home builder
c. Windows to a home builder
d. Containers of milk to a grocery
store
e. None of the above
Answer: d. Containers of milk to a grocery store
17-38
Question Bowl
If you are marketing a more
expensive independent demand
inventory item, which inventory
model should you use?
a. Fixed-time period model
b. Fixed-order quantity model
c. Periodic system
d. Periodic review system
e. P-model
Answer: b. Fixed-order quantity model
17-39
Question Bowl
If the annual demand for an
inventory item is 5,000 units,
the ordering costs are $100 per
order, and the cost of holding a
unit is stock for a year is $10,
which of the following is
approximately the Q
opt
?
a. 5,000 units
b. $5,000
c. 500 units
d. 316 units
e. None of the above
Answer: d. 316
units
(Sqrt[(2x1000x10
0)/10=316.2277)
17-40
Question Bowl
The basic logic behind the ABC
Classification system for inventory
management is which of the
following?
a. Two-bin logic
b. One-bin logic
c. Pareto principle
d. All of the above
e. None of the above
Answer: c. Pareto principle
17-41
Question Bowl
A physical inventory-taking
technique in which inventory is
counted frequently rather than
once or twice a year is which of
the following?
a. Cycle counting
b. Mathematical programming
c. Pareto principle
d. ABC classification
e. Stockkeeping unit (SKU)
Answer: a. Cycle counting
17-42

End of Chapter 17

17-43