Chapter 6:

Inventory Management

© Wiley 2007
 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
Types of Inventory
 Uses of Inventory
• Anticipation or seasonal inventory
• Fluctuation Inventory or Safety stock: buffer
demand fluctuations
• Lot-size or cycle stock: take advantage of
quantity discounts or purchasing efficiencies
• Transportation or Pipeline inventory
• Speculative or hedge inventory protects
against some future event, e.g. labor strike
• Maintenance, repair, and operating (MRO)
inventories
Objectives of Inventory Management
• Provide desired customer service level
• Customer service is the ability to satisfy
customer requirements
– Percentage of orders shipped on schedule
– Percentage of line items shipped on schedule
– Percentage of dollar volume shipped on
schedule
– Idle time due to material and component
shortages
 Inventory Management
Objectives
Provide for cost-efficient operations:
– Buffer stock for smooth production flow
– Maintain a level work force
– Allowing longer production runs & quantity
discounts
• Minimum inventory investments:
– Inventory turnover
– Weeks, days, or hours of supply
 Customer Service Level Examples
• Percentage of Orders Shipped on Schedule
– Good measure if orders have similar value. Does not capture
value.
– If one company represents 50% of your business but only 5%
of your orders, 95% on schedule could represent only 50% of
value
• Percentage of Line Items Shipped on Schedule
– Recognizes that not all orders are equal, but does not capture
$ value of orders. More expensive to measure. Ok for finished
goods.
– A 90% service level might mean shipping 225 items out of the
total 250 line items totaled from 20 orders scheduled
• Percentage Of Dollar Volume Shipped on Schedule
– Recognizes the differences in orders in terms of both line
items and $ value
Inventory Investment Measures Example: The Coach
Motor Home Company has annual cost of goods sold of
$10,000,000. The average inventory value at any point in
time is $384,615. Calculate inventory turnover and
weeks/days of supply.
• Inventory Turnover:
annual cost of goods sold $10,000,000
Turnover    26 inventory turns
average inventory value $384,615

• Weeks/Days of Supply:
average inventory on hand in dollars $384,615
Weeks of Supply    2weeks
average weekly usage in dollars $10,000,000/52

$384,615
Days of Supply   10 days
$10,000,000/260
 Relevant Inventory Costs

Item Cost Includes price paid for the item plus

other direct costs associated with the
purchase
Holding Include the variable expenses incurred
Costs by the plant related to the volume of
inventory held
e.g. 15-25%
Capital The higher of the cost of capital or the
Costs opportunity cost for the company
 Relevant Inventory Costs
Ordering Fixed, constant dollar amount incurred
Cost for each order placed
Shortage Loss of customer goodwill, back order
Costs handling, and lost sales

Risk costs Obsolescence, damage, deterioration,

theft, insurance and taxes
Storage Included the variable expenses for
costs space, workers, and equipment related
to the volume of inventory held
 Determining Order Quantities
Lot-for-lot Order exactly what is needed

Fixed-order Specifies the number of units to order

quantity whenever an order is placed

Min-max Places a replenishment order when

system the on-hand inventory falls below the
predetermined minimum level.
Order n Order quantity is determined by total
periods demand for the item for the next n
periods
 Examples of Ordering Approaches
Lot for Lot Example
1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 0 0 0 0 0 0 0
Order Placement 40 70 65 60 55 85 75 85

Fixed Order Quantity Example with Order Quantity of 200

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 160 90 25 165 110 25 150 65
Order Placement 200 200 200

Min-Max Example with min.= 50 and max.= 250 units

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 180 110 185 125 70 165 90 165
Order Placement 220 140 180 160

Order n Periods with n = 3 periods

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 135 65 0 140 85 0 85 0
Order Placement 175 200 160
 Mathematical Models for Determining
Order Quantity
• Economic Order Quantity (EOQ or Q System)
– An optimizing method used for determining order
quantity and reorder points
– Part of continuous review system which tracks on-
hand inventory each time a withdrawal is made.
• Economic Production Quantity (EPQ)
– A model that allows for incremental product delivery
• Quantity Discount Model
– Modifies the EOQ process to consider cases where
quantity discounts are available.
 Economic Order Quantity
• EOQ Assumptions:
– Demand is known &
constant - no safety stock is
required
– Lead time is known &
constant
– No quantity discounts are
available
– Ordering (or setup) costs are
constant
– All demand is satisfied (no
shortages)
– The order quantity arrives in
a single shipment
 Total Annual Inventory Cost with EOQ Model
• Total annual cost= annual ordering cost + annual
holding costs
 D Q 2DS
TCQ   S   H; and Q 
Q  2  H
Continuous (Q) Review System Example: A computer company has
annual demand of 10,000. They want to determine EOQ for circuit
boards which have an annual holding cost (H) of $6 per unit, and an
ordering cost (S) of $75. They want to calculate TC and the reorder
point (R) if the purchasing lead time is 5 days.
• EOQ (Q)
2DS 2 * 10,000 * $75
Q   500 units
H $6
• Reorder Point (R)
10,000
R  Daily Demand x Lead Time  * 5 days  200 units
250 days

• Total Inventory Cost (TC)

 10,000   500 
TC    $75   $6  $1500  $1500  $3000
 500   2 
 Economic Production Quantity (EPQ)
• Same assumptions as the EOQ except: inventory arrives in
increments & is drawn down as it arrives
 EPQ Equations
• Total cost:  D   I MAX 
TC EPQ   S   H
Q   2 

• Maximum inventory:  d
– d=avg. daily demand rate I MAX  Q 1  
 p
– p=daily production rate

2DS
• Calculating EPQ EPQ 
 d
H
 1  
 p

EPQ Problem: HP Ltd. Produces its premium plant food in 50# bags.
Demand is 100,000 lbs. per week and they operate 50 wks. each
year and HP can produce 250,000 lbs. per week. The setup cost is
$200 and the annual holding cost rate is $.55 per bag. Calculate the
EPQ. Determine the maximum inventory level. Calculate the total
cost of using the EPQ policy.

2DS
EPQ 
 d
H 1  
 p

 d
I MAX  Q 1  
 p

 D   I MAX 
TC EPQ   S   H
Q   2 
 2DS 2(50)(100,000)(200)
EPQ  EPQ   77,850 Bags
 d  100,000 
H 1   .551  
 p
 250000 

 
I MAX
 d
 Q 1  
p
I  100 , 000 
MAX  77 , 850  1   46 , 710 bags
 250 , 000 


 5,000,000   46,710 
D  I 
TC EPQ   S    MAX H  TC   200    .55  $25,690
Q   2   77,850   2 
 Quantity Discount Model
• Same as the EOQ model, except:
– Unit price depends upon the quantity ordered

• The total cost equation becomes:

TC QD
 D  Q 
  S   H
Q   2 
 CD
 Quantity Discount Procedure
• Calculate the EOQ at the lowest price
• Determine whether the EOQ is feasible at that price
– Will the vendor sell that quantity at that price?
• If yes, stop – if no, continue
• Check the feasibility of EOQ at the next higher price
• Continue until you identify a feasible EOQ
• Calculate the total costs (including total item cost) for the
feasible EOQ model
• Calculate the total costs of buying at the minimum
quantity required for each of the cheaper unit prices
• Compare the total cost of each option & choose the
lowest cost alternative
• Any other issues to consider?
Quantity Discount Example: Collin’s Sport store is considering going
to a different hat supplier. The present supplier charges $10 each
and requires minimum quantities of 490 hats. The annual demand is
12,000 hats, the ordering cost is $20, and the inventory carrying
cost is 20% of the hat cost, a new supplier is offering hats at $9 in
lots of 4000. Who should he buy from?
• EOQ at lowest price $9. Is it feasible?
2(12,000)(20)
EOQ$9   516 hats
$1.80

• Since the EOQ of 516 is not feasible, calculate the total cost
(C) for each price to make the decision
12,000 490
C$10   
$20  $2  $1012,000  $120,980
490 2
12,000 4000
C$9  $20  $1.80  $912,000  $101,660
4000 2
• 4000 hats at $9 each saves $19,320 annually. Space?
 Safety Stock and Service Levels
• If demand or lead time is
uncertain, safety stock can be
added to improve order-cycle
service levels
– R = dL +SS
– Where SS =zσdL, and Z is the
number of standard deviations and
σdL is standard deviation of the
demand during lead time
• Order-cycle service level
– The probability that demand
during lead time will not
exceed on-hand inventory
– A 95% service level (stockout
risk of 5%) has a Z=1.645
 Periodic Review Systems
• Orders are placed at specified, fixed-time intervals (e.g.
every Friday), for a order size (Q) to bring on-hand
inventory (OH) up to the target inventory (TI), similar to
the min-max system.
• Advantages are:
– No need for a system to continuously monitor item
– Items ordered from the same supplier can be reviewed on the
same day saving purchase order costs
• Disadvantages:
– Replenishment quantities (Q) vary
– Order quantities may not quality for quantity discounts
– On the average, inventory levels will be higher than Q systems-
more stockroom space needed
 Periodic Review Systems: Calculations for
TI
• Targeted Inventory level:
TI = d(RP + L) + SS
d = average period demand
RP = review period (days, wks)
L = lead time (days, wks)
SS = zσRP+L
• Replenishment Quantity (Q)=TI-OH
P System: an auto parts store calculated the EOQ for Drive Belts at 236 units and
wants to compare the Total Inventory Costs for a Q vs. a P Review System.
Annual demand (D) is 2704, avg. weekly demand is 52, weekly σ is 1.77 belts, and
lead time is 3 weeks. The annual TC for the Q system is $229; H=$97, S=$10.

Q 236
• Review Period RP  x 52weeks  x52  5wks
D 2704
• Target Inventory for 95% Service Level
TI  d(RP  L)  SS  d(RP  L)  zσRP  L
 
TI  52 units 5  3   1.645  1.77 5  3  416  8  424 belts

• Average On-Hand
OHavg= TI-dL=424-(52belts)(3wks) = 268 belts
• Annual Total Cost (P System)
52 268
TCp  $10  $.97   115  130  $245
5 2
Annual Cost Difference  $245  $229  $16
 ABC Inventory Classification
• ABC classification is a method for determining level of
control and frequency of review of inventory items
• A Pareto analysis can be done to segment items into
value categories depending on annual dollar volume
• A Items – typically 20% of the items accounting for 80%
of the inventory value-use Q system
• B Items – typically an additional 30% of the items
accounting for 15% of the inventory value-use Q or P
• C Items – Typically the remaining 50% of the items
accounting for only 5% of the inventory value-use P
The AAU Corp. is considering doing an ABC analysis on its
entire inventory but has decided to test the technique on
a small sample of 15 of its SKU’s. The annual usage and
unit cost of each item is shown below
(A) First calculate the annual dollar volume for
each item
B) List the items in descending order based on annual dollar volume.
(C) Calculate the cumulative annual dollar volume as a percentage of
total dollars. (D) Classify the items into groups
 Graphical solution For Example 12.15 showing the ABC
classification of materials
• The A items (106 and 110) account for 60.5% of the value and 13.3% of the items
• The B items (115,105,111,and 104) account for 25% of the value and 26.7% of the
items
• The C items make up the last 14.5% of the value and 60% of the items
• How might you control each item classification? Different ordering rules for each?
 Justifying Smaller Order Quantities
• JIT or “Lean Systems” would recommend reducing
order quantities to the lowest practical levels
• Benefits from reducing Q’s:
– Improved customer responsiveness (inventory = Lead time)
– Reduced Cycle Inventory
– Reduced raw materials and purchased components
• Justifying smaller EOQ’s:
2DS
Q
H

• Reduce Q’s by reducing setup time (S). “Setup

reduction” is a well documented, structured approach
to reducing S
 Inventory Record Accuracy

• Inaccurate inventory records can cause:

– Lost sales
– Disrupted operations
– Poor customer service
– Lower productivity
– Planning errors and expediting
 Inventory Record Accuracy
• Two methods are available for checking record
accuracy
– Periodic counting - physical inventory is taken
periodically, usually annually
– Cycle counting-daily counting of prespecified items
provides the following advantages:
• Timely detection and correction of inaccurate records
• Elimination of lost production time due to unexpected
stock outs
• Structured approach using employees trained in cycle
counting.
 Inventory Management Across the
Organization
• Inventory management policies affect
functional areas throughout
– Accounting is concerned of the cost
implications of inventory
– Marketing is concerned as stocking decision
affect the level of customer service
– Information Systems is involved to tack and
control inventory records
 Chapter 6 Highlights
• Raw materials, purchased components, work-in-
process, finished goods, distribution inventory
and maintenance, repair and operating supplies
are all types of inventory.
• Inventories have several uses: anticipation
inventory is built before it is needed; fluctuation
stock provides a cushion; cycle stock is a result of
the company’s ordering quantity; transportation
inventory includes items in transit; speculative
inventory is a buildup to protect against some
future event and MRO inventory supports daily
operations
 Chapter 6 Highlights
• The objectives of inventory management are to provide
the desired level of customer service, to allow cost-
efficient operations, and to minimize inventory
investment.
• Customer service can be measured in several ways,
including as a percentage of orders shipped on schedule,
a percentage of line items shipped on schedule, a
percentage of dollar volume shipped on schedule, or idle
time due to material and component shortages.
• Cots-efficient operations are achieved by using inventory
as buffer stocks allowing a stable year-round workforce,
and spreading the setup cost over a larger number of
Inventory performance is measured by turns/supply.
• Inventory costs include item cost, holding cost, ordering
cost, and shortage cost.
 Chapter 6 Highlights (continued)
• Inventory investment is measured in inventory turnover
and/or level of supply. Inventory performance is
calculated as inventory turnover or weeks, days, or
hours of supply.
• Relevant inventory costs include items costs, holding
costs, and shortage costs.
• Holding costs include capital costs, storage costs, and
risk costs. Ordering costs are fixed costs for placing an
order or performing a setup.
• Shortage costs included costs related to additional
paperwork, additional shipping expense, and the
intangible cost of lost customer goodwill.
 Chapter 6 Highlights (continued)
• Lot-for-lot, fixed-order quantity, min-max
systems, order n periods, periodic review
systems, EOQ models, quantity discount models,
and single-period models can be used to
determine order quantities.
• Ordering decisions can be improved by analyzing
total costs of an inventory policy.
• Total costs include ordering cost, holding cost,
and material cost
 Chapter 6 Highlights (continued)
• Practical considerations can cause a company to
not use the optimal order quantity, that is,
minimum order requirements
• Smaller lot sizes give a company flexibility and
shorter response times.
• The key to reducing order quantities is to reduce
ordering or setup costs.
• Calculating the appropriate safety stock policy
enables companies to satisfy their customer
service objective at minimum costs.
• The desired customer service level determines
the appropriate z value.
 Chapter 6 Highlights (continued)
• Inventory decisions about perishable products
can be made using the single-period inventory
model.
• The expected payoff is calculated to assist the
quantity decision
• The ABC classification system allows a company
to assign the appropriate level of control and
frequency of review of an item based on its
annual dollar volume
• Cycle counting is a method for maintaining
accurate inventory records.
• Determining what and when to count are the
major decisions
 Chapter 6 Highlights (continued)
• Order Q’s can be determined by using L4L, fixed order
Q’s, min-max, order n periods, quantity discounts, and
single period systems.
• Ordering decisions can be improved by analyzing TC
• Smaller lot sizes increase flexibility and reduce response
time.
• Safety stock can be added to reorder point calculations
to meet desired service level z value.
• Inventory decisions about perishable products can be
made by using the single-period inventory model.
• ABC analysis can be used to assign the appropriate level
of control and review frequency based on the annual
dollar volume of each item.
• Cycle counting of pre-specified items is an accepted
method for maintaining inventory records
THE END