LECTURE 6

INVENTORY MANAGEMENT
F Roberts Jacob and Richard B Chace. Operations Management and Supply Chain
Management: Chapter 11
Operations Management - 7th Edition - Roberta Russell & Bernard W. Taylor, III Chapter
13
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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

Nov 20, 2017 Lecture 6 Inventory Management 2

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

Nov 20, 2017 Lecture 6 Inventory Management 3

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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

Nov 20, 2017 Lecture 6 Inventory Management 4

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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

Nov 20, 2017 Lecture 6 Inventory Management 5

I N D E P E N D E NT V E R SU S D E P E N
D E N T DEMAND
Independent demand: The demands for various items are unrelated to each other.
To determine the quantities of independent items that must be produced, firms usually turn
to their sales and market research departments. They use a variety of techniques, including
customer surveys, forecasting techniques, and economic and sociological trends on
forecasting. Because independent demand is uncertain, extra units must be carried in
inventory.
Dependent demand: The need for any one item is a direct result of the need for
some other item, usually an item of which it is a part.
Dependent demand is a relatively straightforward computational problem. Needed
quantities of a dependent-demand item are simply computed, based on the number needed
in each higher-level item in which it is used.

Nov 20, 2017 Lecture 6 Inventory Management 6

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Independent Vs Dependent Inventory

Independent Demand (Demand for the final end-product
or demand not related to other items)

Finished
product
Dependent
Demand
(Derived demand
items for
E(1) component parts,
subassemblies,
raw materials, etc)
Component parts
Nov 20, 2017 Lecture 6 Inventory Management 7
 17-8

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)

Nov 20, 2017 Lecture 6 Inventory Management 8

Single-Period Inventory Model
A single period inventory model is a business scenario faced by companies that
order seasonal or one-time items. There is only one chance to get the quantity
right when ordering, as the product has no value after the time it is needed. There
are costs to both ordering too much or too little, and the company's managers
must try to get the order right the first time to minimize the chance of loss.

Nov 20, 2017 Lecture 6 Inventory Management 9

Single-Period Inventory Example
Example to think about is the classic single-period newsperson problem.
Consider the problem that the newsperson has in deciding how many newspapers
to put in the sales stand outside a hotel lobby each morning.
If the person does not put enough papers in the stand, some customers will not be able
to purchase a paper and the newsperson will lose the profit associated with these sales.
On the other hand, if too many papers are placed in the stand, the newsperson will have
paid for papers that were not sold during the day, lowering profit for the day.

Nov 20, 2017 Lecture 6 Inventory Management 10

Decision Situations
You face a "quantity" decision: For example, how many tickets to sell for a flight, how many minutes to
allow for a trip, how many product catalogs to print for this year, or how many dollars to put in an ATM
machine.
You are facing an uncertain (i.e., random) demand: Continuing the examples, the number of seats on the
airplane plus the number of no-shows, the time the trip will actually take, the number of catalog requests
that will come in over the year, or the amount of money that patrons will (attempt to) withdraw from the
machine before it is restocked.
You must live with the consequences of your decision: You can't sell extra tickets in the final minutes before
departure, you can't stop the clock or go back in time, the setup cost of a second press-run is prohibitive, or
you can't justify the cost of an "emergency.
The cost of being "under"( i.e., of setting your quantity below demand, rather than precisely at the
demanded level) varies linearly with the amount by which you are under (i.e., is a fixed per-unit-under cost).
The cost of being "over" (i.e., of setting your quantity above the demanded level) also varies linearly with
the amount by which you are over.

Nov 20, 2017 Lecture 6 Inventory Management 11

Trade-offs in a Single-Period Models
Loss resulting from the items unsold
ML= Purchase price - Salvage value
Profit resulting from the items sold
MP= Selling price - Purchase price
Trade-off
Given costs of overestimating/underestimating demand and the probabilities of various
demand sizes how many units will be ordered?

Nov 20, 2017 Lecture 6 Inventory Management 12

 Model

Nov 20, 2017 Lecture 6 Inventory Management 13

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Single Inventory Model

This
Thismodel
modelstates
statesthat
thatwe
we

Cu should
shouldcontinue
continueto toincrease
increasethethe

P
size
sizeof
ofthe
theinventory
inventoryso solong
longasas
the
theprobability
probabilityofofselling
sellingthe
the
Co Cu last
lastunit
unitadded
greater
addedisisequal
greaterthan
thanthe
equalto
theratio
ratioof:
toor
of:
or

Cu/Co+Cu
Cu/Co+Cu
Where:
Co Cost per unit of demandover estimated
Cu Cost per unit of demandunder estimated
P Probability that theunit willbe sold
Nov 20, 2017 Lecture 6 Inventory Management 14
 SINGLE-
PERIOD
INVENTORY
MODEL

Nov 20, 2017 Lecture 6 Inventory Management 15

Order/Inventory Size

Nov 20, 2017 Lecture 6 Inventory Management 16

Problem
Lets consider that the newsperson selling papers in the sales
stand had collected data over a few months and had found that
on average each Monday 90 papers were sold with a standard
deviation of 10 papers. Lets say that our newspaper person pays
$0.20 for each paper and sells the papers for $0.50. In this case
the marginal cost associated with underestimating demand is
$0.30, the lost profit. Similarly, the marginal cost of
overestimating demand is $0.20, the cost of buying too many
papers.

Nov 20, 2017 Lecture 6 Inventory Management 17

Solution

Nov 20, 2017 Lecture 6 Inventory Management 18

Nov 20, 2017 Lecture 6 Inventory Management 19
 20
Nov 20, 2017 Lecture 6 Inventory Management
 17-21

Problem
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?
Cu = $10 and Co = $5; P $10 / ($10 + $5) = .667

Z.667 = .432 (use NORMSDIST(.667) )

therefore we need 2,400 + .432(350) = 2,551 shirts

Nov 20, 2017 Lecture 6 Inventory Management 21

Example: Hotel Reservations
A hotel near the university always fills up on the evening before football games.
History has shown that when the hotel is fully booked, the number of last-minute
cancellations has a mean of 5 and standard deviation of 3. The average room rate
is $80. When the hotel is overbooked, the policy is to find a room in a nearby hotel
and to pay for the room for the customer. This usually costs the hotel
approximately $200 since rooms booked on such late notice are expensive. How
many rooms should the hotel overbook?

Nov 20, 2017 Lecture 6 Inventory Management 22

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?

Nov 20, 2017 Lecture 6 Inventory Management 23

 17-24

Multi-Period Models:
Fixed-Order Quantity Model - Assumptions
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
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)

Nov 20, 2017 Lecture 6 Inventory Management 24

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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.
Nov 20, 2017 Lecture 6 Inventory Management 25
Multiperiod Inventory Systems
Multiperiod inventory systems are designed to ensure that an item will be
available on an ongoing basis throughout the year. Usually the item will be
ordered multiple times throughout the year where the logic in the system dictates
the actual quantity ordered and the timing of the order.
There are two general types of multiperiod inventory systems:
1. Fixedorder quantity models (also called the economic order quantity , EOQ, and Q-
model ). the fixedorder quantity model is a perpetual system, which requires that
every time a withdrawal from inventory or an addition to inventory is made, records
must be updated to reflect whether the reorder point has been reached.
2. Fixedtime period models (also referred to variously as the periodic system, periodic
review system, fixedorder interval system, and P-model ).

Nov 20, 2017 Lecture 6 Inventory Management 26

Difference between two models
The basic distinction is that fixedorder quantity models are event triggered and fixedtime period
models are time triggered. That is, a fixedorder quantity model initiates an order when the event
of reaching a specified reorder level occurs. This event may take place at any time, depending on the
demand for the items considered. In contrast, the fixedtime period model is limited to placing
orders at the end of a predetermined time period; only the passage of time triggers the model.
The fixedtime period model has a larger average inventory because it must also protect against
stock out during the review period, T ; the fixedorder quantity model has no review period.
The fixedorder quantity model favors more expensive items because average inventory is lower.
The fixedorder quantity model is more appropriate for important items such as critical repair parts
because there is closer monitoring and therefore quicker response to potential stock out.
The fixedorder quantity model requires more time to maintain because every addition or
withdrawal is logged.

Nov 20, 2017 Lecture 6 Inventory Management 27

FixedOrder Quantity and FixedTime
Period Differences

Nov 20, 2017 Lecture 6 Inventory Management 28

 17-29

Cost Minimization Goal

By
Byadding
addingthetheitem,
item,holding,
holding,and
andordering
orderingcosts
coststogether,
together,wewedetermine
determinethe
the
total
totalcost
costcurve,
curve,which
whichininturn
turnisisused
usedto
tofind
findthe
theQQopt inventory order point
opt inventory order point
that
thatminimizes
minimizestotal
totalcosts
costs

Total Cost
C
O
S Holding
T
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Nov 20, 2017 Order
Lecture Quantity
6 Inventory (Q)
Management 29
 17-30

Basic Fixed-Order Quantity (EOQ) Model

Formula TC=Total
TC=Total
cost
cost
annual
annual

Total Annual Annual Annual DD=Demand

=Demand
Annual = Purchase + Ordering + Holding CC=Cost
=Costperperunit
unit
Cost Cost Cost Cost QQ=Order
=Orderquantity
quantity
SS=Cost
=Costofofplacing
placing
an
anorder
orderororsetup
setup
cost
cost
RR=Reorder
=Reorderpoint
point
LL=Lead
=Leadtime
time
D Q H=Annual
H=Annualholding
holding
TC = DC + S + H and
andstorage
storagecost
cost
Q 2 per
perunit
unitof
ofinventory
inventory

Nov 20, 2017 Lecture 6 Inventory Management 30

Basic Fixed-Order Quantity (EOQ) Model
Formula

Nov 20, 2017 Lecture 6 Inventory Management 31

 17-32

Deriving 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 Qopt

2DS 2(Annual Demand)(Order or Setup Cost)

QOPT = =
H Annual Holding Cost

We also need a _

reorder point to tell R

e
or
de
rp
oi
nt
,R=
dL
_
us when to place an
d=a
v
er
ag
eda
i
lyd
e
man
d(c
o
ns
ta
nt
)
order
L=L
ea
dt
ime
(c
on
s
ta
nt
)
Nov 20, 2017 Lecture 6 Inventory Management 32
 17-33

Example
Given the information below, what are the EOQ and reorder point?

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

Nov 20, 2017 Lecture 6 Inventory Management 33

 17-34

2DS 2(1,000 )(10)

Q OPT = = = 89.443 units or 90 units
H 2.50

1,000 units / year

d = = 2.74 units / day
365 days / year

_
Reorder point, R = d L = 2.74units / day (7days) = 19.18 or 20 units

In
Insummary,
summary,you
youplace
placean
anoptimal
optimalorder
orderof
of90
90units.
units. In
Inthe
the
course
courseof
ofusing
usingthe
theunits
unitsto
tomeet
meetdemand,
demand,when
whenyou
youonly
only
have
have20
20units
unitsleft,
left,place
placethe
thenext
nextorder
orderof
of90
90units.
units.

Nov 20, 2017 Lecture 6 Inventory Management 34

 17-35

Determine the economic order quantity

and the reorder point given the following

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
Nov 20, 2017 Lecture 6 Inventory Management 35
 17-36

2D S 2(10,000 )(10)
Q O PT = = = 365.148 units, or 366 u n its
H 1.50

10,000 units / year

d= = 27.397 units / day
365 days / year

_
R = d L = 27.397 units / day (10 days) = 273.97 or 274 u nits

Place
Placean
anorder
orderfor
for366
366units.
units. When
Whenininthe
thecourse
courseof
ofusing
using
the
theinventory
inventoryyou
youare
areleft
leftwith
withonly
only274
274units,
units,place
placethe
the
next
nextorder
orderof
of366
366units.
units.
Nov 20, 2017 Lecture 6 Inventory Management 36
Safety Stock
Safety stock is the amount of inventory carried in addition to the expected
demand.
In the majority of cases, though, demand is not constant but varies from day to
day. Safety stock must therefore be maintained to provide some level of
protection against stock outs. Safety stock can be defined as the amount of
inventory carried in addition to the expected demand.
Safety Stock Calculation: The reorder point is set to cover the expected demand
during the lead time plus a safety stock determined by the desired service level.
Thus, the key difference between a fixedorder quantity model where demand is
known and one where demand is uncertain is in computing the reorder point. The
order quantity is the same in both cases.

Nov 20, 2017 Lecture 6 Inventory Management 37

Fixed Order Quantity Model with Safety
Stock

Nov 20, 2017 Lecture 6 Inventory Management 38

Nov 20, 2017 Lecture 6 Inventory Management 39
Fixed Order Quantity Model with Safety
Stock

Nov 20, 2017 Lecture 6 Inventory Management 40

 Example
Consider an economic order
quantity case where annual
demand D = 1,000 units,
economic order quantity Q =
200 units, the desired
probability of not stocking out
P = .95, the standard deviation
of demand during lead time L
= 25 units, and lead time L = 15
days. Determine the reorder
point. Assume that demand is
over a 250-workday year.

Nov 20, 2017 Lecture 6 Inventory Management 41

 Example
Daily demand for a certain product is
normally distributed with a mean of
60 and standard deviation of 7. The
source of supply is reliable and
maintains a constant lead time of six
days. The cost of placing the order is
$10 and annual holding costs are $0.50
per unit. There are no stock-out costs,
and unfilled orders are filled as soon as
the order arrives. Assume sales occur
over the entire 365 days of the year.
Find the order quantity and reorder
point to satisfy a 95 percent
probability of not stocking out during
the lead time.
Nov 20, 2017 Lecture 6 Inventory Management 42
Production Order Quantity Model
Used when inventory builds up over a period of time after
an order is placed
Used when units are produced and sold simultaneously

Part of inventory cycle during

which production (and usage) is
taking place
Inventory level

Demand part of cycle with

no production
Maximum
inventory

t Time
Nov 20, 2017 Lecture 6 Inventory Management 43
Production Order Quantity Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
D = Annual demand

Setup cost = (D/Q)S

Holding cost = 1/2 HQ[1 - (d/p)]

(D/Q)S = 1/2 HQ[1 - (d/p)]

2DS
Q =
2
H[1 - (d/p)]

2DS
Q* = H[1 - (d/p)]
Nov 20, 2017 Lecture 6 Inventory Management 44
Example

Nov 20, 2017 Lecture 6 Inventory Management 45

Example

Nov 20, 2017 Lecture 6 Inventory Management 46

FIXED TIME PERIOD MODELS
Fixedtime period models generate order quantities that vary from period to
period, depending on the usage rates. These generally require a higher level of
safety stock than a fixedorder quantity system.

Nov 20, 2017 Lecture 6 Inventory Management 47

Fixed Time Period Model with Safety
Stock

Nov 20, 2017 Lecture 6 Inventory Management 48

 17-49

Fixed-Time Period Model with Safety Stock Formula

q = Average demand + Safety stock Inventory currently on hand

q = d (T + L) + Z 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
T + L = standard deviation of demand over the review and lead time
I = current inventory level (includes items on order)

Nov 20, 2017 Lecture 6 Inventory Management 49

 Example
Daily demand for a product
is 10 units with a standard
deviation of 3 units. The
review period is 30 days,
and lead time is 14 days.
Management has set a
policy of satisfying 98
percent of demand from
items in stock. At the
beginning of this review
period, there are 150 units
in inventory. How many
units should be ordered?

Nov 20, 2017 Lecture 6 Inventory Management 50

Example
The KVS Pharmacy stocks a popular brand of over-the-counter
flu and cold medicine. The average demand for the medicine is 6
packages per day, with a standard deviation of 1.2 packages. A
vendor for the pharmaceutical company checks KVSs stock
every 60 days. During one visit the store had 8 packages in stock.
The lead time to receive an order is 5 days. Determine the order
size for this order period that will enable KVS to maintain a 95%
service level.

Nov 20, 2017 Lecture 6 Inventory Management 51

 Fixed-Period Model with
Variable Demand
d = 6 bottles per day
d = 1.2 bottles
tb = 60 days
L = 5 days
I = 8 bottles
z = 1.65 (for a 95% service level)

Q = d(tb + L) + zd tb + L - I
= (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8
= 397.96 bottles
Nov 20, 2017 Lecture 6 Inventory Management 52
 17-53

Given the information below, how many

units should be 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.

Nov 20, 2017 Lecture 6 Inventory Management 53

 17-54

Example
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

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

Nov 20, 2017 Lecture 6 Inventory Management 54

 17-55

q = d(T + L) + Z T + L - I

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

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

So, to satisfy 96 percent of the demand, you should

place an order of 645 units at this review period
Nov 20, 2017 Lecture 6 Inventory Management 55
ABC Inventory Management
Based on Pareto concept (80/20 rule) and total usage in dollars of each item.
Classification of items as A, B, or C based on usage.
Purpose is to set priorities on effort used to manage different SKUs, i.e. to allocate
scarce management resources.
SKU: Stock Keeping Unit

Nov 20, 2017 Lecture 6 Inventory Management 56

ABC Inventory Management
A items: 20% of SKUs, 80% of money
B items: 30 % of SKUs, 15% of money
C items: 50 % of SKUs, 5% of money
Three classes is arbitrary; could be any number.
Percent are approximate.
Danger: money use may not reflect importance of any given SKU!

Nov 20, 2017 Lecture 6 Inventory Management 57

Example of SKU list for 10 items
Percentage of
Annual Usage Total Dollar
Item in Units Unit Cost Dollar Usage Usage

1 5,000 $ 1.50 $ 7,500 2.9%

2 1,500 8.00 12,000 4.7%

3 10,000 10.50 105,000 41.2%

4 6,000 2.00 12,000 4.7%

5 7,500 0.50 3,750 1.5%

6 6,000 13.60 81,600 32.0%

Nov 20, 2017 Lecture 6 Inventory Management 58

7 5,000 0.75 3,750 1.5%

ABC Chart for SKU List
45.0% 120.0%

40.0% A B C
100.0%

Cumulative % Usage
Percent Usage 35.0%
30.0% 80.0%

25.0%
60.0%
20.0%

15.0% 40.0%
10.0%
20.0%
5.0%

0.0% 0.0%
3 6 9 2 4 1 10 8 5 7

Item No.

Percentage of Total Dollar Usage Cumulative Percentage

Nov 20, 2017 Lecture 6 Inventory Management 59

Example
Foster Drugs, Inc., handles a variety of health and beauty products. A particular hair conditioner product
costs Foster Drugs $2.95 per unit. The annual holding cost rate is 20%. A fixed-quantity model
recommends an order quantity of 300 units per order.
a. Lead time is one week and the lead-time demand is normally distributed with a mean of 150 units and a standard
deviation of 40 units. What is the reorder point if the firm is willing to tolerate a 1% chance of stockout on any one
cycle?
b. What safety stock and annual safety stock cost are associated with your recommendation in part (a)?
c. The fixed-quantity model requires a continuous-review system. Management is considering making a transition to a
fixed-period system in an attempt to coordinate ordering for many of its products. The demand during the proposed
two-week review period and the one-week lead-time period is normally distributed with a mean of 450 units and a
standard deviation of 70 units. What is the recommended replenishment level for this periodic-review system if the
firm is willing to tolerate the same 1% chance of stockout associated with any replenishment decision?
d. What safety stock and annual safety stock cost are associated with your recommendation in part ( c )?
e. Compare your answers to parts (b) and (d). The company is seriously considering the fixed-period system. Would
you support the decision? Explain.
f. Would you tend to favor the continuous-review system for more expensive items? For example, assume that the
product in the above example sold for $295 per unit. Explain.

Nov 20, 2017 Lecture 6 Inventory Management 60