Dr.

Karim Kobeissi

Chapter 8: Inventory
Management

Inventory - Definition
Any stored resource used to
satisfy a current or future need
(raw materials, work-in-process,
finished goods, etc.).

What Type of Businesses Need to Manage Inventory ?

Maintaining inventories is necessary for any

company

dealing

with

including

manufacturers,

physical

products,

wholesalers,

and

retailers.
Inventories of Raw
Materials

- Manufacturers

Inventories of Finished Products Awaiting

Shipment

Inventories of Goods
- Wholesalers and Retailers
Customers

Available for Purchase by

Why Do We Need to Manage Inventory?

Sales Growth: right inventory at the right place at

the right time Avoiding Stockouts - No Lost Deal :
Sorry we are out of that item.
Cost Reduction: less money tied up in inventory
(represents as much as 50% of invested capitol at
some

companies),

inventory

obsolescence.

Higher Profit

management,

T : Trillion

Benefits of Inventory
Hedge against uncertain demand
Hedge against uncertain supply
Economize on ordering costs
Smoothing

We build and keep inventory in order to

match supply and demand in the most
cost effective way.

Inventory Planning and Control

For maintaining the right balance between
high and low inventory to minimize cost

Inventory Control Decisions

Objective: Minimize Total Inventory
Cost
Decisions:
How much to order?
When to order?
How much stock to keep?

Basic Economic Order Quantity (EOQ):

Determining How Much to Order

One of the oldest and most well known

inventory control techniques
Easy to use
Based on a number of assumptions

Assumptions of the EOQ Model

1.

A known and constant demand rate - the number of units

being withdrawn from inventory is known and constant
over time- for example: 300 units / day ; 5000 units /
month.

2.

The lead time (the delay between the initiation of an order

and the completion of its fulfilment) is known and
constant.

3.

The order quantity to replenish inventory arrives all at

once just when desired.

4.

Purchase cost per unit is constant (no quantity discount).

5.

Planned shortages (inventory = 0) are not allowed.

Economic Order Quantity

Formula

EOQ = (daily demand) X (lead time) = Reorder Point

Applied Example on EOQ

Let Atlantic Cost Tire - ACT be a firm that sell tires with:
Yearly demand = 6000 units
Lead time = 9 days
The number of working days per year for ACT= 250 days
-Compute the EOQ for ACT
Daily Demand = yearly demand /number of working days per
year
= 6000/250 = 24 tires sold per day
EOQ = (daily demand) X (lead time) = 24 X 9 = 216 tires
Each time the inventory level drops down to having 216

tires remaining, ACT faxes an order to its supplier.

21
6

Inventory Manager Software

The Optimal Inventory Policy For the Basic EOQ

To find an optimal inventory policy,

managers focus on Minimizing the
Total

Variable Inventory

Cost per

Year Finding the Optimal Order

Finding the Optimal Order Quantity (Q*)

Parameters:
Q* = Optimal order quantity (the
EOQ)
D = Annual demand
Co = Ordering cost per order
Ch = Holding (or carrying ) cost per unit
per year
P = Purchase cost per unit

C o m p o n e n t s o f t h e To t a l Va r i a b l e
Inventory Cost
Annual setup cost = (Number of orders per year) x (Ordering cost per order)
= (D/Q) x Co

Annual holding cost = (Average inventory) x (Holding cost per unit per year)
= (Q/2) x Ch

= To t a l Va r i a b l e I n v e n t o r y C o s t p e r Ye a r
Note:

(Q/2) is the average inventory level

Purchase cost does not depend on Q

Two Methods for Carrying Cost

Carry cost (Ch) can be expressed either:
1. As a fixed cost, such as
Ch = $0.50 per unit per year
2. As a percentage of the items purchase
cost (P)
Ch = I x P

EOQ Model Total Cost

At optimal order quantity (Q*):

Carrying cost = Ordering cost

Finding the Optimal Order Quantity

(con)
There is a simple square root formula that
gives the optimal order quantity (Q*) that
minimizes the total variable inventory
cost per year for any application of the
basic EOQ model.

Finding the Optimal Order Quantity (Q*)

Recall that at the optimal order quantity (Q*):

Carrying cost = Ordering cost (D/Q*) x Co = (Q*/2)

x Ch
Rearranging to solve for Q*:

( 2 DCo / Ch )

Q*

Where,
D = Annual demand
Co = Ordering cost per order
Ch = Holding cost per unit per year

Example: Sumco Pump Co.

Sumco Pump Co. buys pump housing from a manufacturer and
sells to retailers
D = Annual demand = 1000 pumps annually
Co = Ordering cost per order = $10 per order
Ch = Carrying cost per unit per year = $0.50 per pump per year
P = $5
- Compute the Optimal Order Quantity and the number of orders
per year

Q* =
200 units.
( 2 DCo / Ch )
- In order to minimize

(2x 1000x10) / 0.5 =

the total cost of its inventory, Sumco

Pump Co. will fax an order (Q* ) = 200 units each time it needs
to replenish its inventory.

- Number of orders per year = D / Q* = 1000 / 200 =5 ORDERS

EOQ With Planned Shortages

One of the banes of any inventory manager is the
occurrence of an inventory shortage. This causes
a variety of headaches, including dealing with
unhappy customers and having extra record
keeping to arrange for filling the demand later
(backorders)

when

the

inventory

can

be

replenished. By assuming that planned shortages

are not allowed, the basic EOQ model satisfies the
common desire of managers to avoid shortages
as much as possible.

EOQ With Planned Shortages

However, there are situations where permitting
limited planned shortages makes sense from a
managerial

perspective.

The

most

important

requirement is that the customers generally are

able and willing to accept a reasonable delay in
filling their orders if need be. If the cost of holding
inventory is high relative to these shortage costs,
then lowering the average inventory level by
permitting occasional brief shortages may be a
sound business decision.

EOQ with Planned Shortages

Assumptions

Demand occurs at a constant rate of D items/year.

Ordering cost: $k per order.
Holding cost: $h per item in inventory per year.
Backorder cost:
$p unit shortage cost
(backordered) per year.
Purchase cost per unit is constant (no quantity
discount).
Set-up time (lead time) is constant.
Planned shortages are permitted (backordered
demand units are withdrawn from a replenishment
order when it is delivered).

Under

these

assumptions,

the

Inventorylevel

pattern of inventory levels over

time
shown

has

the

beside.

QS

appearance
Now

the

inventory levels extend down

to negative values that reflect
the number of units of the
product that are backordered.
Letting the inventory level is

QS
Q

allowed to go down to (-S), at

which point an order quantity
(Q) is placed. (S) units out of

the (Q) are used to fill the

backorders, so the maximum
inventory level is (Q-S).

S
S

Time

The Objective of the Model

This model has two decision variables the

order quantity (Q) and the maximum shortage
(S). The objective in choosing (Q) and (S) is to:
Minimize TVC = total variable inventory cost
per year
This TVC needs to include the same kinds of costs
as for the basic EOQ model plus the cost of
incurring the shortages. Thus,

TVC= Annual setup cost + Annual holding cost + Annual

shortage cost

EOQ with Planned Shortages

Formulas
Optimal order quantity:
Q*=
2KD/h
(h+ p )/p
Maximum number of backorders:
S * = Q *[h /(h +p)]
- Maximum inventory level = Q* - S*
- Reorder Point = - S* + (daily demand) (lead time)
Number of orders per year: D/Q *
Time between orders (cycle time): Q */D years
Total annual cost:
[h (Q *-S *)2/2Q *] + [Dk /Q *] + [S *2p/2Q *]

(holding + ordering + backordering)

Application to the ACT Case Study

D = $115,
h = $4.20, p = $7.50.
Plugging these costs into the two formulas then gives the following results:

Q* = 716 tires(order quantity)

S* = 257 tires(maximum shortage)
Q* - S* = 459 tires(maximum inventory level)

The resulting total variable inventory cost per year is

TVC = $1,928.

The value of S* also leads to identifying the reorder point for this inventory policy.

Reorder point = - S* + (daily demand) (lead time)

= - 257 tires + (24 tires/day) (9 days)
= - 41 tires.
Thus, according to this (unusual) policy, the order for purchasing another (Q*) =716
tires from the supplier should be placed when the number of tires backordered
reaches 41. The delivery then should arrive 9 working days later when the
number of tires backordered reaches approximately 257.