INVENTORY MANAGEMENT

Chapter 12

FUNCTIONS OF INVENTORY
1. To “decouple” or separate various parts of the production process.
2. To decouple the firm from fluctuations in demand and provide a stock of goods that will provide a selection for
customers.
3. To take advantage of quantity discounts.
4. To hedge against inflation
Types of Inventory
 Raw material inventory – materials that are usually purchased but have yet to enter the manufacturing process.
 Work-in-process inventory (WIP) – products or components that are no longer raw material but have yet to become
finished products.
 Maintenance/repair/operating supply inventory (MRO) – inventories devoted to maintenance, repair, operating
supplies necessary to keep machineries and processes productive.
 Finished-goods inventory – an end time ready to be sold, but still an asset on the company’s books.
A completed product awaiting shipment.

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

ABC analysis – a method for dividing on-hand inventory into three classifications based on annual dollar volume.
 Pareto principle – it states that there are a “critical few and trivial (insignificant) many.”

Example 1: ABC analysis

Silicon Chips, Inc., maker of superfast DRAM chips, has organized its 10 inventory items on an annual dollar-
volume basis. Shown below are the items (identified by stock number), their annual demand, unit cost, annual dollar
volume, and the percentage of the total represented by each item. In the following table, we show these items grouped
into ABC classifications.

ABC Calculation
Percent of Percent of
Item Number Annual Annual Annual
Stock of Items Volume x Unit = Dollar Dollar
Number Stocked (units) Cost Volume Volume Class
#10286 1,000 $ 90.00 $ 90,000 38.8% A
#11526 20% 500 154.00 77,000 33.2% 72% A

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B
#10500 1,000 12.50 12,500 5.4% B

#12572 600 $ 14.00 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C
#01036 50% 100 8.50 850 .4% 5% C
#01307 1,200 .42 504 .2% C
#10572 250 .60 150 .1% C
8,550 $ 232,057 100%
Graphic Representation
of ABC analysis A items
80
Percent of 70 _
annual dollar 60 _
usage 50 _
40 _
30 _
20 _ B items
10 _ C items
0 l l l l l l l l l l
. 10 20 30 40 50 60 70 80 90 100
Percent of inventory items

Policies that may be based on ABC analysis

1. Purchasing resources expended on supplier development should be much for individual A items than for C items.
2. A items, as opposed to B and C items, should have tighter physical inventory control; perhaps they belong in a more
secure area, and perhaps the accuracy of inventory records for A items should be verified more frequently.
3. Forecasting A items may warrant more care than forecasting other items.

Record Accuracy
Good inventory policies are meaningless if management does not know what inventory is on hand. Accuracy of
records is a critical ingredient in production and inventory systems. Only when an organization can determine
accurately what is on hand can it make it precise decisions about ordering, scheduling, and shipping.

Cycle Counting – a continuing reconciliation of inventory with inventory records.

With cycle counting procedures, items are counted, records are verified, and inaccuracies are periodically
documented. A items will be counted frequently, perhaps once a month; B items will be counted less frequently,
perhaps once a quarter; and C items will be counted perhaps once every 6 months.

Example 2: Cycle counting

Cole’s Trucks, Inc., a builder f high quality refuse trucks, has about 5,000 items in its inventory. After hiring Matt
Clark, a bright young OM student, for the summer, the firm determined that it has 500 A items, 1,750 B items, and 2,750
C items. Company policy is to count all A items every month (every 20 working days), all B items every quarter (every 60
working days), and all C items every 6 months (every 120 working days). How many items should be counted each day?

Items Class Quantity Cycle Counting Policy Number of Items Counted per Day
A 500 Each month (20 working days) 500/20 = 25/day
B 1,750 Each quarter (60 working days) 1,750/60 = 29/day
C 2,750 Every 6 months (120 working days) 2,750/120 = 23/day
77/day

Advantages of Cycle Counting

1. Eliminates the shutdown and interruption of production necessary for annual physical inventories.
2. Eliminates annual inventory adjustments.
3. Trained personnel audit the accuracy of inventory.
4. Allows the cause of the errors to be identified and remedial action to be taken.
5. Maintains accurate inventory records.

Control of Service Inventories

 Shrinkage – retail inventory that is unaccounted for between receipt and sale.
It occurs from damage and theft as well as from sloppy (careless/poor) paperwork.
 Pilferage – a small amount of theft.
 Ways to Control Losses
 Good personnel selection, training, and discipline.
These are never easy but very necessary in food-service, wholesale, and retail operations, where employees
have access to directly consumable items.
 Tight control of incoming shipments.
This task is being addressed by many firms through the use of bar-code and radio frequency ID systems that
read every incoming shipment and automatically check tallies against purchase orders.
 Effective control of all goods leaving the facility.
This job is accomplished with bar codes on items being shipped, magnetic strips on merchandise, or via direct
observation.

INVENTORY MODELS
Independent versus Dependent Demand
For example, the demand for refrigerators is independent of the demand for toaster ovens. However, the
demand for toaster oven components is dependent on the requirements of toaster ovens.

 Holding cost – the cost to keep or carry inventory in stock.

It also includes obsolescence and costs related to storage, such as insurance, extra staffing, and
interest payments.
 Ordering cost – the cost of the ordering process.
Includes cost of supplies, forms, order processing, clerical support, and so forth.
 Setup cost – the cost to prepare a machine or process for production.
Includes time and labor to clean and change tools or holders.
 Setup time – the time required to prepare a machine or process for production.

INVENTORY MODELS FOR INDEPENDENT DEMAND

3 Independent Demand Models
1. Basic economic order quantity (EOQ) model – an inventory-control technique that minimizes the total ordering and
holding costs.
2. Production order quantity model
3. Quantity discount model

Determining Inventory Holding Cost

Cost (and Range) as a
Category Percent of Inventory Value
Housing costs (building rent or depreciation, operating cost, taxes, insurance) 6% (3-10%)
Material handling costs (equipment lease or depreciation, power, operating cost) 3% (1-3.5%)
Labor cost 3% (3-5%)
Investment costs (borrowing costs, taxes, and insurance on inventory) 11% (6-24%)
Pilferage, scrap, and obsolescence 3% (2-5%)
Overall carrying cost 26%

Note: All numbers are approximate, as they vary substantially depending on the nature of the business location,
and current interest rates. Any inventory holding cost of less than 15% is suspect, but annual inventory holding costs
often approach 40% of the value of inventory.

The Basic EOQ Model

Assumptions
1. Demand is known, constant, and independent.
2. Lead time – that is, the time between placement and receipt of order – is known and constant.
3. Receipt of inventory is instantaneous and complete.
In other words, the inventory from an order arrives in one batch at one time.
4. Quantity discounts are not possible.
5. The only variable costs are the cost of setting up or placing an order (setup cost) and the cost of holding or storing
inventory over time (holding or carrying cost).
6. Stockouts (shortages) can be completely avoided if orders are placed at the right time.

Inventory Usage over Time

Usage rate
Order quantity = Q Average inventory
(maximum inventory level) on hand
Q
2
Inventory level

Minimum
Inventory

0
Time
Minimizing Costs
The objective of most inventory models is to minimize costs. With the assumptions just given, significant costs
are setup (or ordering) cost and holding (or carrying) cost. All other costs, such as the cost of the inventory itself, are
constant. Thus if we minimize the sum of setup and holding costs, we will also be minimizing total costs.

Total Cost as a Function or Order Quantity

Curve for total cost of holding and setup

Minimum
total cost
Holding (or carrying) cost curve
Annual cost

Setup (or order) cost curve

Optimal order quantity Order quantity

Note: The optimal order quantity occurs at the point where the ordering-cost curve and the carrying-cost curve
intersect. This was not by chance. With the EOQ model, the optimal order quantity will occur at a point where
the total setup cost is equal to the total holding cost.

Necessary Steps to Develop Equations that Solve Directly for Q*

1. Develop an expression for setup or ordering cost.
2. Develop an expression for holding cost.
3. Set setup cost equal to holding cost.
4. Solve the equation for the optimal order quantity.

Q = number of pieces per order S = setup or ordering cost for each order
Q* = optimum number of pieces per order (EOQ) H = holding or carrying cost per unit per year
D = annual demand in units for the inventory item
a) Annual setup cost = (number of orders placed per year) x (setup or order cost per order)
Annual demand
= Setup or order cost per order
Number of units in each order
D D
= (S) = S
Q Q

b) Annual holding cost = (average inventory level) x (holding cost per unit per year)

Order quantity
= Holding cost per unit per year
2
Q Q
= (H) = H
2 2

c) Optimal order quantity is found when annual setup cost equals annual holding cost,
D Q
S = H
Q 2

d) To solve for Q*, simply cross multiply terms and isolate Q on the left of the equal sign:
2DS = Q²H
2DS
Q² =
H
2DS
Q* =
H

Example 3: Finding the optimal order size

Sharp, Inc., a company that makes painless hypodermic needles to hospitals, would like to reduce its inventory
cost by determining the optimal number of hypodermic needles to obtain per order. The annual demand is 1,000 units;
the setup or ordering cost is $10 per order; and the holding cost per unit per year is $50. Using these figures, we can
calculate the optimal number of units per order:

2DS
Q* =
H
2 (1,000)(10)
Q* = 0.50 = 40,000 = 200 units

To determine the expected number of orders placed during the year (N) and the expected time between orders
(T) are as follows:
Demand D
Expected number of orders = N = =
Order quantity Q*

Number of working days per year

Expected time between orders = T =
N
Example 4: Computing number of orders and time between orders
Using the data from Sharp, Inc., in example 3, and assuming a 250-day working year, we find the number of
orders (N) and the expected time between orders (T) as:
Demand D
N = =
Order quantity Q*
1,000
= = 5 orders per year
200

Number of working days per year

T =
Expected number of orders (N)
250
= = 50 days between orders
5

The total annual variable inventory cost is the sum of setup and holding costs:

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2

Example 5: Computing total cost

Again using Sharp, Inc., data from examples 3 and 4, we determine that the total annual inventory costs are:

D Q 1,000 200
TC = S + H = ($10) + ($.50) = (5)($10) + (100)($.50) = $50 + $50 = $100
Q 2 200 2

The total inventory cost expression may also be written to include the annual cost of the material purchased. If
we assume that the annual demand and the price per hypodermic needle are known values (for example, 1,000
hypodermic needles per year at P = $10) and total annual cost should include purchase cost, then Equation becomes:

D Q
TC = S + H + PD
Q 2

Robust Model – a model that gives satisfactory answers even with substantial variation in its parameters.

Example 6: EOQ is a robust model

If management in the Sharp, Inc., examples underestimates total annual demand by 50% (say demand is actually
1,500 needles rather than 1,000 needles) while using the same Q, the annual inventory cost increases only $25 ($100
versus $125), or 25%. Here is why.
If demand in example 5 is actually 1,500 needles rather than 1,000, but management uses an order quantity of
Q = 200 (when it should be Q = 244.9 based on D = 1,500), the sum of holding and ordering cost increases 25%.

D Q 1,500 200
Annual cost = S + H = ($10) + ($.50) = (7.5)($10) + (100)($.50) = $75 + $50 = $125
Q 2 200 2
 However, had we known that the demand was for 1,500 with an EOQ of 244.9 units, we would have spent
$122.48, as shown:

1,500 244.9
Annual cost = ($10) + ($.50) = (6.125)($10) + (122.45)($.50) = $61.24 + $61.24 = $122.48
244.9 2

Note: The expenditure of $125.00, made with an estimate of demand that was substantially wrong, is only 2%
($2.52/122.48) higher than we would have paid had we known the actual demand and ordered accordingly.

Reorder Points (ROP) – the inventory level (point) at which action is taken to replenish the stocked item.
 Lead time – in purchasing systems, the time between placing an order and receiving it.
– in production systems, it is the wait, move, queue, setup, and run times for each component produced.

The Reorder Point Curve

Q* is the optimum order quantity and lead time represents the time between placing and receiving an order.

Q*

Slope = units/day = d
Inventory
level (units)
ROP
(units)

Time (days)
Lead time = L

This equation for ROP assumes that demand during lead time and lead times itself is constant.

ROP = (demand per day)(lead time for a new order in days)

= dxL

When this is not the case, extra stock, often called safety stock, should be added.
 Safety stock – extra stock to allow for uneven demand; or buffer.
D
d=
number of working days in a year

Example 7: Computing reorder points (ROP)

An Apple distributor has a demand for 8,000 iPods per year. The firm operates a 250-day working year. On
average, delivery of an order takes 3 working days. We calculate the reorder point as:
D 8,000
d= = = 32 units
number of working days in a year 250

ROP = d x L = 32 units per day x 3 days = 96 units

Thus, when inventory stocks drop to 96, an order should be placed. The order will arrive 3 days later, just as the firm’s
stock is depleted.
Production Order Quantity Model
There are times when the firm may receive its inventory over a period of time. Such cases require a different model,
one that does not require the instantaneous-receipt assumption. This model is applicable under two situations:
1. When inventory continuously flows or builds up over a period of time after an order has been placed, or
2. When units are produced and sold simultaneously
Under these circumstances, we take into account daily production (or inventory-flow) rate and daily demand rate.

Change in Inventory Levels over Time for the Production Model

Part of inventory cycle during which

production (and usage) takes place

Inventory Demand part of cycle with no production

level (only usage takes place)
Maximum -
inventory

I t I
Time

2DS
Qρ* =
H [ 1 – (d/p) ]

Example 8: A production order quantity model

Nathan Manufacturing, Inc., makes and sells specially hubcaps for the retail automobile aftermarket. Nathan’s
forecast for its wire-wheel hubcap is 1,000 units per year, with an average daily demand of 4 units. However, the
production process is most efficient at 8 units per day. So the company produces 8 per day but uses only 4 per day.
Given the following values, solve for the optimum number of units per order.

(Note: This plant schedules production of this hubcap only as needed, during the 250 days per year the shop operates.)

Annual demand = D = 1,000 units

Setup costs = S = $10
Holding cost = H = $0.50 per unit per year
Daily production rate = p = 8 units daily
Daily demand rate = d = 4 units daily

2DS
Qρ* =
H [ 1 – (d/p) ]

2(1,000)(10)
=
0.50 [1 – (4/8)]

20,000
= = 80,000
0.50(1/2)
 = 282.8 (or 283) hubcaps
Quantity Discount Models – a reduced price for items purchased in large quantities.
Total cost = Setup cost + Holding cost + Product cost
or where: Q = quantity ordered
D QH D = annual demand in units
TC = S + + PD S = ordering or setup cost per order or per setup
Q 2 P = price per unit
H = holding cost per unit per year

Table 12.2 A Quantity Discount Schedule

Discount Number Discount Quantity Discount (%) Discount Price
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75

4 Steps in Discount Process

Step 1: For each discount, calculate a value for optimal order size Q*, using the following equation:
2DS
Q* =
IP
Note: The holding cost is IP instead of H. Because the price of the item is a factor in annual holding cost, we
cannot assume the holding cost is constant when the price per unit changes for each quantity discount.
Thus, it is common to express the holding cost (I) as a percent of unit price (P) instead of as a constant cost
per unit per year.
Step 2: For any discount, if the order quantity is too low to qualify for the discount, adjust the order quantity upward to
the lowest quantity that will qualify for the discount.
Step 3: Using the preceding total cost equation compute a total cost for every Q* determined in steps 1 and 2.
Step 4: Select the Q* that has the lowest total cost, as computed in step 3. It will be the quantity that will minimize the
total inventory cost.

Example 9: Quantity discount model

Wahl’s Discount Store stocks toy race cars. Recently the store has been given a quantity discount schedule for
these cars. This quantity schedule was shown in Table 12.2. Thus, the normal cost for the toy race cars is $5.00. For
orders between 1,000 and 1,999 units, the unit cost drops to $4.80; for orders of 2,000 or more units, the unit cost is only
$4.75. Furthermore, ordering cost is $49.00 per order, annual demand is 5,000 race cars, and inventory carrying charge,
as a percent of cost, I, is 20%, or .2. What order quantity will minimize the total inventory cost?
The first step is to compute Q* for every discount in Table 12.2:
2(5,000)(49)
Q₁* = = 700 cars order
(.2)(5.00)

2(5,000)(49)
Q₂* = = 714 cars order
(.2)(4.80)

2(5,000)(49)
Q₃* = = 718 cars order
(.2)(4.75)

The second step is to adjust upward values of Q* that are below the allowable discount range.
Q₁* = 700
Q₂* = 1,000 – adjusted
Q₃* = 2,000 – adjusted
The third step is to use total cost equation and compute a total cost for each order quantity. This step is taken with the
aid of Table 12.3, which presents the computations for each level of discount introduced in Table 12.2.

Table 12.3 Total Cost Computations for Wahl’s Discount Store

Annual Annual Annual
Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700
2 $4.80 1,000 $24,000 $245 $480 $24,725
3 $4.75 2,000 $23,750 $122.50 $950 $24,822.50

The fourth step is to select that order quantity with the lowest total cost. Looking at Table 12.3, you can see that an
order quantity of 1,000 toy race cars will minimize total cost. You should see however, that the total cost for ordering
2,000 is only slightly greater than the total cost of ordering 1,000 cars. Thus, if the third discount cost is lowered to
$4.65, for example, then this quantity might be the one that minimizes total inventory cost.

PROBABILISTIC MODELS AND SAFETY STOCK

Probabilistic Model – a statistical model applicable when product demand or any other variable is not known but can be
specified by means of probability distribution.
 Service level – the complement of the probability of a stockout.

FIXED-PERIOD (P) SYSTEMS

 Fixed-quantity (Q) system – an EOQ ordering system, with the same order amount each time.
 Perpetual inventory system – a system that keeps track of each withdrawal or addition to inventory continuously, so
records are always current.
 Fixed-period (P) system – a system in which inventory orders are made at regular time intervals.
Models for Independent Demand Summarized
Q = number of pieces per order P = price
EOQ = optimum order quantity (Q*) I = annual inventory carrying cost as a percent of price
D = annual demand in units μ = mean demand
S = setup or ordering cost for each order σdLT = standard deviation of demand during lead time
H = holding or carrying cost per unit per σLT = standard deviation of lead time
year in dollars Z = standardized value under normal curve
p = daily production rate
d = daily demand rate

EOQ 2DS
Q* =
H
EOQ production order quantity model
2DS
Qρ* =
H [ 1 – (d/p) ]
Total cost for the EOQ and quantity discount EOQ models
TC = total cost
= Setup cost + Holding cost + Product cost
D Q
= S + H + PD
Q 2
Quantity discount EOQ model
2DS
Q* =
IP