Unit 2

Management of Conversion System

Chapter 10: Inventory Management
Lesson 29 - Inventory Management – Basic EOQ model

Learning Objectives
After reading this lesson you would be able to understand
Importance of inventory management
Different types of inventory
Classifying different types of inventory
Optimal ordering quantity

Good Morning students, today we are going to introduce the

concept of what is known as Inventory Management. We will
explore various approaches to Inventory Management and
focuses on its importance as an indispensable tool in
Production and operations management.

Well dear students, all of us, I guess has a fair bit of an idea about
what inventory is all about. I don’t know about your answer, but as
far as I am concerned, this class has an abundant inventory of,
what you call the skill set and talent i.e. the human capital.
Please allow me to focus on the job at hand in a better and
organized manner.
Inventory management
Inventory management is an important concern for all managers.
Inventory is created when the receipt of materials, parts, or
finished goods exceeds their disbursement. It is depleted when
their disbursement exceeds their receipt. Inventory can serve
important functions that add flexibility to the operations of a firm.
Well, what about the uses of inventory?
Any answers around here?
Inventory-uses
Six uses of inventory are:
1. To provide a stock of goods to meet anticipated demand by
customers.
2. To decouple production from distribution. For example, if
product demand is high only during the summer, a firm may
build up stock during the winter and thus avoid the costs of
shortages and stockouts in the summer. Similarly, if a firm’s
supplies fluctuate, extra raw materials of inventory may be
needed to “decouple” production processes.
3. To take advantage of quantity discounts, since purchases in
larger quantities can substantially reduce the cost of goods.
4. To hedge against inflation and price changes.
 5. To protect against shortages that can occur due to weather,
supplier shortages, quality problems, or improper deliveries.
“Safety stocks”, namely, extra goods on hand, can reduce the
risk of stockouts.
6. To permit operations to continue smoothly with the use of
“work-in-process” inventory. This is because it takes time to
make goods and because a pipeline of inventories are stocked
throughout the process.

Let us now try to find dome basis for proper categorization of

inventory.

Types of inventory
There are four types of inventories generally a firm maintains.
These are:-
(1) raw material inventory,
(2) work-in-process inventory,
(3) maintenance/repair/operating supply (MRO) inventory, and
(4) finished goods inventory.

Raw material inventory has been purchased, but not

processed. The items can be used to separate suppliers from the
production process. Work-in-process (WIP) inventory has
undergone some change but is not completed. WIP exists because
of the time it takes for a product to be made (called cycle time).
Reducing the cycle time reduces inventory. MROs are inventories
devoted to maintenance/repair/operating supplies. They exist
because the need and timing for maintenance and repair of some
equipment are unknown. Finished goods inventory is completed
and awaiting shipment. Finished goods may be inventoried
because customer demands for a given time period may be
unknown.
We are now going to look at Inventory management again with a
much broader perspective.

Inventory management-
Operations managers establish systems for managing inventory.
First step is to classify inventory items.
Thousands of items are held in inventory by a typical organization,
but only a small percentage of need management’s closest
attention and tightest control. ABC analysis is the process of
dividing items into three classes according to their value (rupee
usage) so that managers can focus on items that have the highest
value. This method is the equivalent of creating a Pareto chart
except that it is applied to inventory rather than quality. The Pareto
principle states that there are a “critical few and trivial many”. The
idea is to focus resources on the few critical inventory parts and
not the many trivial ones. Figure 10.1 shows, class A items
typically represent only about 20 percent of the items but account
for 80 percent of the rupee usage. Class B items account for
another 30 percent of the items but only 15 percent of the rupee
usage. Finally, 50 percent of the items fall in class C, representing
a mere 5 percent of the rupee usage.

Fig Graphic representation of ABC analysis

The goal of ABC analysis is :-

to identify the inventory levels of class A items and enable
management to control them tightly by using the levels as
discussed. To determine annual rupee volume for ABC analysis,
we measure the annual demand of each inventory item times the
cost per unit.
Dear friends, let us examine our conceptual understanding
now.
With the help of an example, let us understand how the ABC
analysis is done.

Example 10.1
The maintenance department for a small manufacturing firm has
responsibility for maintaining an inventory of spare parts for the
machinery it services. The parts inventory, unit cost, and annual
usage are as follows.
Part Unit Cost Annual
(Rs) Usage
1 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
 10 20 120

The department manager wants to classify the inventory parts

according to the ABC system in order to determine which stocks of
parts should most closely be monitored
The first step is to rank the items according to their total value and
also compute each item’s percentage value and quantity.

Part Total % Value % Quantity %

Value Cumulative
(Rs)
9 30,600 35.9 6.0 6.0
8 16,000 18.7 5.0 11.0
2 14,000 16.4 4.0 15.0
1 5,400 6.3 9.0 24.0
4 4,800 5.6 6.0 30.0
3 3,900 4.6 10.0 40.0
6 3,600 4.2 18.0 58.0
5 3,000 3.5 13.0 71.0
10 2,400 2.8 12.0 83.0
7 1,700 2.0 17.0 100.0
85,400
Making an intuitive judgment, it appeared that the first three items
form a group with the highest value, the next three items form a
second group, and the last four items constitute a group. Thus, the
ABC classification for these items is as follows.

Class Items % Value %

Quantity
A 9, 8, 2 71.0 15.0
B 1, 4, 3 16.5 25.0
C 6, 5, 10, 7 12.5 60.0

Criteria other than annual dollar volume can determine item

classification. For instance, anticipated engineering changes,
delivery problems, quality problems, or high unit cost may dictate
upgrading items to a higher classification. The advantage of
dividing inventory items into classes allows policies and controls
to be established for each class.
Can anyone tell the class what factors influence the choice of
this form of analysis?
O.K.Let me help you with this one.

Policies that may be based on ABC analysis include the following:

 1. The purchasing resources expended on supplier development
should be much higher for individual A items than for C
items.
2. A items, as opposed to B and C items, should have tighter
physical inventory control.
3. Forecasting A items may warrant more care than forecasting
other items.

Dear friends, at this juncture, let me tell you that the

management of service inventories needs some special
considerations. Although we tend to think of services as not
having inventory, that is not the case. For instance, extensive
inventory is held in wholesale and retail businesses, making
inventory management crucial. In the food service business, for
example, control of inventory can make the difference between
success and failure. Moreover, inventory that is in transit or idle in
a warehouse is lost value.
Similarly, inventory which is damaged or stolen prior to sale is a
loss. The impact on profitability is substantial, consequently
inventory accuracy and control is critical.

The applicable techniques include:

 1. 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 merchandise.

2. Tight control of incoming shipments. This is being addressed

by many firms through the use of bar-code systems that read
every incoming shipment and automatically check the tallies
against the purchase order. When properly designed, these
systems are very hard to defeat.

3. Effective control of all goods leaving the facility. This is

done with bar codes or items being shipped, personnel
stationed at the exits and in potentially high-loss areas.

We will now examine a variety of inventory models and the

costs associated with them.
Let us begin.
Inventory models

Inventory control models assume that demand for an item is

independent of, or dependent on, the demand for other items. 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 production requirements of toaster
ovens.
Here we will concentrate on managing independent demand items.

Holding, ordering, and setup costs

Holding costs are the costs associated with holding or carrying
inventory over time. Therefore, holding costs also include costs
related to storage, such as insurance, extra staffing, and interest
payments. Table 10.1 shows the kinds of costs that need to be
evaluated to determine holding costs.

Table 10.1 Determining inventory holding costs

Category Cost as a percent of inventory
value
Housing costs, such as building 6%
rent, depreciation, operating (3 – 10%)
cost, taxes, insurance
Material handling costs, 3%
including equipment, lease or (1 – 3.5%)
depreciation, power, operating
cost
Labour cost from extra 3%
handling (3 – 5%)
Investment costs, such as 11%
borrowing costs, taxes, and (6 – 24%)
insurance on inventory
Scrap and obsolescence 3%
(2 – 5%)
Overall carrying cost 26%

Ordering cost
Ordering cost includes costs of supplies, forms, order processing,
clerical support, and so forth. When orders are being
manufactured, ordering costs also exist, but they are known as
setup costs.
Setup cost is the cost to prepare a machine or process for
manufacturing an order. In many environments setup cost is highly
correlated with setup time. Setup usually requires a substantial
amount of work prior to an operation actually being accomplished
at the work center.
Inventory models for independent demand
Here we will introduce three inventory models that address two
important questions: when to order and
How much to order.
These independent demand models are:
1. Basic economic order quantity (EOQ) model
2. Production order quantity model
3. Quantity discount model

Figure 29.1 Inventory usage over time

The basic economic order quantity model

The economic order quantity (EOQ) is one of the oldest and most
commonly known inventory control techniques. This technique is
relatively easy to use but is based on several assumptions:
1. Demand is known and constant
2. Lead time, that is, the time between the placement of the order
and the receipt of the order, is known and constant
3. Receipt of inventory is instantaneous. 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

Figure 29.1 shows the inventory usage over time under these
assumptions. Q represents the amount that is ordered. If this
amount is 500 dresses, all 500 dresses arrive at one time (when an
order is received). Thus, the inventory level jumps from 0 to 500
dresses. In general, an inventory level increases from 0 to Q units
when an order arrives.

Because demand is constant over time, inventory drops at a

uniform rate over time. When the inventory level reaches 0 the
new order is placed and received, and the inventory level again
jumps to Q units. This process continues indefinitely over time.
The objective of most inventory models is to minimize the total
costs. Under the assumptions considered, the significant costs are
the setup (or ordering) cost and the holding (or carrying) cost. All
other costs, such as the cost of the inventory itself, are constant.
Thus, if we minimize the sum of the setup and holding costs, we
will also be minimizing the total costs. Figure 10.2 illustrates total
cost as a function of order quantity, Q. The optimal order size, Q*,
will be the quantity that minimizes the total costs. As the quantity
ordered increases, the total number of orders placed per year will
decrease. Thus, as the quantity ordered increases, the annual setup
or ordering cost will decrease. But as the order quantity increases,
the holding cost will increase due to larger average inventories that
are maintained.
The optimal order quantity occurred at the point where the
ordering cost curve and the carrying cost curve intersected. 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.
The necessary steps in developing the model are:
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 best order quantity
Using the following variables we can determine setup and
holding costs and solve for Q*:
Q = Number of pieces per order
Q* = Optimum number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

1. Annual setup cost = Number of orders placed per year x

Setup or order cost per order
= (Annual demand / Number of units in
each order) x Setup or
order cost per order
= (D / Q) S
2. Annual holding cost = Average inventory level x Holding
cost per unit per year
= (Order quantity / 2) Holding cost per
unit per year
= (Q / 2) H

3. Optimal order quantity is found when annual setup cost

equals annual holding cost, namely,
 (D/Q) S = (Q/2) H

4. To solve for Q*, simply cross-multiply terms and isolate Q

on the left of the equal sign.
2DS = Q2H

Q2 = (2DS/H)
Q* = √(2DS)/H

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

Total annual cost = setup cost + Holding cost

In terms of variables the total cost TC can be expressed as:

TC = (D/Q) S + (Q/2) H
Wee friends, this calls for an example.

Example 10.2
Electronic Village stocks and sells a particular brand of personal
computer. It costs the store Rs450 each time it places an order
with the manufacturer for the personal computers. The annual
cost of carrying the PCs in inventory is Rs170. The store
manager estimates that annual demand for the PCs will be 1200
units. Determine the optimal order quantity and the total
minimum inventory cost.

Solution:
D = 1200 personal computer
H = Rs170
S = Rs450
Q* = √(2DS)/H
= √(2 (450)(1200) / 170)
= 79.7 personal computers

TC = (D/Q) S + (Q/2) H
= 450 (1200/79.7) + 170 (79.7/2)
= Rs13,549.91

Moving over to Reorder points then.

Reorder points
Once we have decided how much to order, now we will look at
the second inventory question, when to order. The time
between the placement and receipt of an order, called the lead
time or delivery time, can be as short as a few hours to as long
as months. Thus, when-to-order decision is usually expressed in
terms of a reorder point, the inventory level at which an order
should be placed.
The reorder point (ROP) is given as:

ROP = (Demand per day) x (Lead time for a new order in

days)
=dxL

This equation for ROP assumes that demand is uniform and

constant. When this is not the case, extra stock, often called
safety stock, should be added.
The demand per day, d, is found by dividing the annual
demand, D, by the number of working days in a year:

d = D / (Number of working days in a year)

We will take an example to demonstrate how to calculate

reorder point.

Example 10.3
The I-75 Discount Carpet Store is open 311 days per year. If
annual demand is 10,000 yards of Super Shag Carpet and the
lead time to receive an order is 10 days, determine the reorder
point for carpet.
Solution:
r = dL
= (10,000/ 311) 10
= 321.54
Thus, when the inventory level falls to approximately 321 yards
of carpet, a new order is placed. Notice that the reorder point is
not related to the optimal order quantity or any of the inventory
costs.
Friends, the next model lined up for today’s discussion is:-

Production order quantity model

In the EOQ inventory model, we assumed that the entire
inventory order was received at one time. There are times,
however, 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 when inventory continuously flows or builds up over
a period of time after an order has been placed or when units are
produced and sold simultaneously. Under these circumstances,
we take into account the daily production (or inventory flow)
 rate and the daily demand rate. Figure 29.2 shows inventory
levels as a function of time.

Figure 29.2 Inventory levels over time for the production model

Because this model is especially suitable for the production

environment, it is commonly called the production order
quantity model. It is useful when inventory continuously builds
up over time and the traditional economic order quantity
assumptions are valid. We derive this model by setting ordering or
setup costs equal to holding costs and solving for Q*. Using the
following symbols, we can determine the expression for annual
inventory holding cost for the production run model:

Q = Number of pieces per order

H = Holding cost per unit per year
 p = Daily production rate
d = Daily demand rate, or usage rate
t = Length of the production run in days

1. Annual inventory holding cost = (Average inventory level) x

(Holding cost per unit per year)
= (Average inventory level) x H
2. Average inventory level = (Maximum inventory level) /2

3. Maximum inventory level = (Total produced during the

production run) – (Total used during
the production run)
= pt – dt

But Q = total produced = pt, and thus t = Q/p. Therefore,

Maximum inventory level = p(Q/p) – d(Q/p)

= Q – (d / p) Q
= Q (1 – d / p)

4. Annual inventory holding cost (or simply holding cost) =

(Maximum inventory level / 2) H = (Q / 2) ( 1 – (d / p) ) H
 Using the expression for holding cost above and the
expression for setup cost developed in the basic EOQ model, we
solve for the optimal number of pieces per order by equating setup
cost and holding cost:

Setup cost = (D / Q) S
Holding cost = (1/2) HQ (1 – (d / p) )

Set ordering cost equal to holding cost to obtain Q*p:

(D / Q) S = (1/2) HQ(1 – (d / p))

Q2 = 2DS / (H (1 – (d / p))

Q*p = √ 2DS / (H (1 – (d / p))

We can use the above equation, Q*p, to solve for the

optimum order or production quantity when inventory is consumed
as it is produced.
We will take an example to see how to use it.
Example 10.4
We now assume that I-75 Outlet Store has its own manufacturing
facility in which it produces Super Shag carpet. We further assume
that the ordering cost is the cost of setting up the production
process to make Super Shag carpet. Estimated annual demand is
10,000 meters of carpet, and annual carrying cost is Rs0.75 per
meter. The manufacturing facility operates the same days the store
is open (i.e., 311 days) and produces 150 meters of the carpet per
day. Determine the optimal order size, total inventory cost, the
length of time to receive an order, the number of orders per year,
and the maximum inventory level.

Solution:
S = Rs150
H = Rs0.75
D = 10,000 meters
d = 10,000 / 311 = 32.2 meters per day
p = 150 meters per day

The optimal order size is determined as follows:

Q* = √ 2DS / (H (1 – (d / p))
= √(2 (150) (10,000) / (0.75 (1 – (32.2 / 150) ) ) )
= 2,256.8 meters
This value is substituted into the following formula to determine
total minimum annual inventory cost:
TC min = (D / Q) S + (D / 2) H ( 1 – d / p)
= ( (150)(10,000) / 2,256.8) + (0.75 (2,256.8) / 2) (1 –
32.2/150) )
= Rs1,329
The length of time to receive an order for this type of
manufacturing operation is commonly called the length of the
production run. It is computed as follows:

Production run length = Q/p

= 2,256.8 / 150 = 15.05 days per order
The number of orders per year is actually the number of production
runs that will be made:

Number of production runs (from orders) = D/Q

= 10,000 / 2,256.8
= 4.43 runs per year

Finally, the maximum inventory level is

Maximum inventory level = Q (1 – d / p)

 = 2,256.8 (1 – 32.2 / 150)
= 1,772 meters.

With that, we have come to the end of today’s discussions. I

hope it has been an enriching and satisfying experience.

Points to ponder