Inventory Management

Learning Objectives
When you complete this chapter you
should be able to:
1. Conduct an ABC analysis

2. Explain and use cycle counting

3. Explain and use the EOQ model for
independent inventory demand

4. Compute a reorder point and safety stock

5. Apply the production order quantity model

Inventory Management
The objective of inventory
management is to strike a balance
between inventory investment and
customer service

Importance of Inventory
One of the most expensive assets of
many companies representing as
much as 50% of total invested capital
Operations managers must balance
inventory investment and customer
service

Functions of Inventory
1. To provide a selection of goods for
anticipated demand and to separate
the firm from fluctuations in demand
2. To decouple or separate various
parts of the production process

3. To take advantage of quantity

discounts
4. To hedge against inflation

Types of Inventory
Raw material
Purchased but not processed

Work-in-process (WIP)
Undergone some change but not completed

A function of cycle time for a product

Maintenance/repair/operating (MRO)
Necessary to keep machinery and processes
productive

Finished goods
Completed product awaiting shipment

The Material Flow Cycle

Cycle time
95%
Input

Wait for
inspection

Figure 12.1

Wait to
be moved

Move Wait in queue Setup

time
for operator
time

5%
Run
time

Output

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

ABC Analysis
Divides inventory into three classes based
on annual dollar volume
Class A - high annual dollar volume
Class B - medium annual dollar volume
Class C - low annual dollar volume

Used to establish policies that focus on the

few critical parts and not the many trivial
ones

ABC Analysis
ABC Calculation
(1)

(2)

(3)

ITEM
STOCK
NUMBER

PERCENT
OF
NUMBER
OF ITEMS
STOCKED

ANNUAL
VOLUME
(UNITS)

#10286

(5)

(6)

(7)

UNIT
COST

ANNUAL
DOLLAR
VOLUME

PERCENT
OF ANNUAL
DOLLAR
VOLUME

CLASS

1,000

$ 90.00

$ 90,000

38.8%

#11526

500

154.00

77,000

33.2%

#12760

1,550

17.00

26,350

11.3%

350

42.86

15,001

6.4%

#10500

1,000

12.50

12,500

5.4%

#12572

600

$ 14.17

$ 8,502

3.7%

#14075

2,000

.60

1,200

.5%

100

8.50

850

.4%

#01307

1,200

.42

504

.2%

#10572

250

.60

150

.1%

$232,057

100.0%

#10867

#01036

20%

(4)

30%

50%

8,550

A
72%

A
B

23%

5%

Percentage of annual dollar usage

ABC Analysis
80
70
60
50
40
30
20
10
0

A Items

B Items

|
|
|
|

10 20 30 40

Figure 12.2

C Items
|

50

60

70

80

Percentage of inventory items

90 100

ABC Analysis
Other criteria than annual dollar volume
may be used
High shortage or holding cost
Anticipated engineering changes
Delivery problems
Quality problems

ABC Analysis
Policies employed may include
1. More emphasis on supplier development for
A items
2. Tighter physical inventory control for A items
3. More care in forecasting A items

Exercise
Perform an ABC analysis on the following set of products.

Item

Annual Demand

Unit Cost

A211
B390
C003
D100
E707
F660
G473
H921

1200
100
4500
400
35
250
1000
100

$9
$90
$6
$150
$2000
$120
$90
$75

Answer
Item
G473
E707
D100
F660
C003
A211
B390
H921

Annual
Unit
Demand Cost
1000
$90
35
$2,000
400
$150
250
$120
4500
$6
1200
$9
100
$90
100
$75

Volume
$90,000
$70,000
$60,000
$30,000
$27,000
$10,800
$9,000
$7,500
$304,300

Cumulative
volume
$90,000
$160,000
$220,000
$250,000
$277,000
$287,800
$296,800
$304,300

Cumulative
percent
29.6%
52.6%
72.3%
82.2%
91.0%
94.6%
97.5%
100.0%

The table below details the contribution of each of the eight products. Item G473 is
clearly an A item, and items A211, B390, and H921 are all C items. Other classifications
are somewhat subjective, but one choice is to label E707 and D100 as A items, and F660

and C003 as B items.

Record Accuracy

Accurate records are a critical

ingredient in production and
inventory systems

Periodic systems require regular

checks of inventory

Two-bin system

Perpetual inventory tracks receipts

and subtractions on a continuing basis

May be semi-automated

Record Accuracy

Incoming and outgoing

record keeping must be
accurate

Stockrooms should be secure

Necessary to make precise decisions

about ordering, scheduling, and
shipping

Cycle Counting
Items are counted and records updated on
a periodic basis
Often used with ABC analysis
Has several advantages
1.
2.
3.
4.

Eliminates shutdowns and interruptions

Eliminates annual inventory adjustment
Trained personnel audit inventory accuracy
Allows causes of errors to be identified and
corrected
5. Maintains accurate inventory records

Cycle Counting Example

5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C
items
Policy is to count A items every month (20 working days), B items
every quarter (60 days), and C items every six months (120 days)
CYCLE
COUNTING
POLICY

ITEM
CLASS

QUANTITY

500

Each month

1,750

Each quarter

2,750

Every 6 months

NUMBER OF ITEMS
COUNTED PER DAY
500/20 =

25/day

1,750/60 =

29/day

2,750/120 =

23/day
77/day

Control of Service Inventories

Can be a critical component
of profitability
Losses may come from
shrinkage or pilferage
Applicable techniques include
1. Good personnel selection, training, and
discipline
2. Tight control of incoming shipments
3. Effective control of all goods leaving facility

Inventory Models
Independent demand - the demand for
item is independent of the demand for any
other item in inventory
Dependent demand - the demand for
item is dependent upon the demand for
some other item in the inventory

Inventory Models
Holding costs - the costs of holding or
carrying inventory over time
Ordering costs - the costs of placing an
order and receiving goods
Setup costs - cost to prepare a machine
or process for manufacturing an order
May be highly correlated with setup time

Holding Costs
TABLE 12.1

Determining Inventory Holding Costs

COST (AND RANGE)
AS A PERCENT OF
CATEGORY
INVENTORY VALUE
Housing costs (building rent or depreciation,
6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or
3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security)
3% (3 - 5%)
Investment costs (borrowing costs, taxes, and
insurance on inventory)
Pilferage, space, and obsolescence (much
higher in industries undergoing rapid change like
PCs and cell phones)
Overall carrying cost

11% (6 - 24%)
3% (2 - 5%)

26%

Holding Costs
TABLE 12.1

Determining Inventory Holding Costs

COST (AND RANGE)
AS A PERCENT OF
CATEGORY
INVENTORY VALUE
Housing costs (building rent or depreciation,
6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or
3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security)
3% (3 - 5%)
Investment costs (borrowing costs, taxes, and
insurance on inventory)
Pilferage, space, and obsolescence (much
higher in industries undergoing rapid change like
PCs and cell phones)
Overall carrying cost

11% (6 - 24%)
3% (2 - 5%)

26%

Inventory Models for

Independent Demand
Need to determine when and
how much to order
1. Basic economic order quantity
(EOQ) model

2. Production order quantity model

3. Quantity discount model

Basic EOQ Model

Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant

3. Receipt of inventory is instantaneous and

complete
4. Quantity discounts are not possible

5. Only variable costs are setup (or ordering)

and holding
6. Stockouts can be completely avoided

Inventory Usage Over Time

Figure 12.3

Inventory level

Total order received

Order
quantity = Q
(maximum
inventory
level)

Usage rate

Minimum
inventory 0
Time

Average
inventory
on hand
Q
2

Minimizing Costs
Objective is to minimize total costs
Table 12.4(c)

Total cost of
holding and
setup (order)

Annual cost

Minimum
total cost
Holding cost

Setup (order) cost

Optimal order
quantity (Q*)

Order quantity

Minimizing Costs
By minimizing the sum of setup (or
ordering) and holding costs, total costs are
minimized
Optimal order size Q* will minimize total
cost
A reduction in either cost reduces the total
cost
Optimal order quantity occurs when
holding cost and setup cost are equal

D
Minimizing Costs
Annual setup cost = S
Q

Q
Q*
D
S
H

= Number of pieces per order

= Optimal number of pieces per order (EOQ)
= Annual demand in units for the inventory item
= Setup or ordering cost for each order
= Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)
x (Setup or order cost per order)
=

Annual demand
Number of units in each order

D
= S
Q

Setup or order
cost per order

D
Minimizing Costs
Annual setup cost = S

Q
Q*
D
S
H

Q
Q
Annual holding cost = H
2

= Number of pieces per order

= Optimal number of pieces per order (EOQ)
= Annual demand in units for the inventory item
= Setup or ordering cost for each order
= Holding or carrying cost per unit per year
Annual holding cost = (Average inventory level)
x (Holding cost per unit per year)
=

Order quantity
2

Q
= H
2

(Holding cost per unit per year)

D
Minimizing Costs
Annual setup cost = S

Q
Q*
D
S
H

Q
Q
Annual holding cost = H
2

= Number of pieces per order

= Optimal number of pieces per order (EOQ)
= Annual demand in units for the inventory item
= Setup or ordering cost for each order
= Holding or carrying cost per unit per year

Optimal order quantity is found when annual setup

cost equals annual holding cost
Q
D
S = H
Q
2

Solving for Q*

2DS = Q 2 H
Q2 =
Q* =

2DS
H
2DS
H

An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

Q* =

2DS
H

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

An EOQ Example
Determine expected number of orders
D = 1,000 units
Q* = 200 units
S = $10 per order
H = $.50 per unit per year
Expected
Demand
number of = N =
Order quantity
orders

D
=
Q*

1,000
N=
= 5 orders per year
200

An EOQ Example
Determine optimal time between orders
D = 1,000 units
Q* = 200 units
S = $10 per order
N = 5 orders/year
H = $.50 per unit per year
Expected
Number of working days per year
time between = T =
Expected number of orders
orders
T=

250
5

= 50 days between orders

An EOQ Example
Determine the total annual cost
D = 1,000 units
Q* = 200 units
S = $10 per order
N = 5 orders/year
H = $.50 per unit per year
T = 50 days
Total annual cost = Setup cost + Holding cost

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

The EOQ Model

When including actual cost of material P
Total annual cost = Setup cost + Holding cost + Product cost

TC =

D
Q
S + H + PD
Q
2

Robust Model
The EOQ model is robust
It works even if all parameters and
assumptions are not met
The total cost curve is relatively flat in
the area of the EOQ

An EOQ Example
Determine optimal number of needles
Only to
2%order
less than
D = 1,000 units 1,500 units Q* =the
200total
units
cost of
S = $10 per order
N =$125
5 orders/year
when the
H = $.50 per unit per year
T order
= 50 days
quantity was
200

D
Q
S+ H
Q
2
1,500
200
=
($10) +
($.50)
200
2
= $75 + $50 = $125

TC =

1,500
244.9
=
($10) +
($.50)
244.9
2
= 6.125($10) +122.45($.50)
= $61.25 + $61.22 = $122.47

Reorder Points
EOQ answers the how much question
The reorder point (ROP) tells when to order
Lead time (L) is the time between placing and
receiving an order
ROP =

Demand
per day

Lead time for a new

order in days

=dxL
d=

D
Number of working days in a year

Reorder Point Curve

Figure 12.5

Inventory level (units)

Q*
Resupply takes place as order arrives

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L

Reorder Point Example

Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days, may take 4
d=

D
Number of working days in a year

= 8,000/250 = 32 units
ROP = d x L
= 32 units per day x 3 days = 96 units

= 32 units per day x 4 days = 128 units

Exercise
The soft goods department of a large department
store sells 175 units per month of a certain large
bath towel. The unit cost of a towel to the store is
$2.50 and the cost of placing an order has been
estimated to be $12.00. The store uses an inventory
carrying charge of 27% per year. Determine the
optimal order quantity, order frequency, and the
annual cost of inventory management. If, through
automation of the purchasing process, the ordering
cost can be cut to $4.00, what will be the new
economic order quantity, order frequency, and
annual inventory management cost? Explain these
results.

Exercise
A firm that makes electronic circuits has
been ordering a certain raw material 250
ounces at a time. The firm estimates that
carrying cost is 30% per year, and that
ordering cost is about $20 per order. The
current price of the ingredient is $200 per
ounce. The assumptions of the basic EOQ
model are thought to apply. For what value of
annual demand is their action optimal?

Exercise
The Rushton Trash Company stocks, among many other
products, a certain container, each of which occupies four
square feet of warehouse space. The warehouse space
currently available for storing this product is limited to 600
square feet. Demand for the product is 15,000 units per year.
Holding costs are $4 per container per year; Ordering costs are
$5 per order.
a. What is the cost-minimizing order quantity decision for
Rushton?
b. What is the total inventory-related cost of this decision?

c. What is the total inventory-related cost of managing the

inventory of this product, when the limited amount of
warehouse space is taken into account?
d. What would the firm be willing to pay for additional
warehouse space?

Production Order Quantity Model

Inventory level

1. Used when inventory builds up over a

period of time after an order is placed
2. Used when units are produced and
sold simultaneously
Figure 12.6
Part of inventory cycle during which
production (and usage) is taking place
Demand part of cycle with
no production (only usage)

Maximum
inventory

Time

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
t = Length of the production run in days
Annual inventory = (Average inventory level) x
Holding cost
holding cost
per unit per year
Annual inventory = (Maximum inventory level)/2
level
Maximum
= Total produced during Total used during
inventory level
the production run
the production run

= pt dt

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
t = Length of the production run in days
Maximum
= Total produced during Total used during
inventory level
the production run
the production run
= pt dt
However, Q = total produced = pt ; thus t = Q/p
Maximum
inventory level

=p

Q
p d

Q
p =Q 1

d
p

Maximum inventory level

Holding cost =
(H) =
2

Q
1
2

d
H
p

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
t = Length of the production run in days

Setup cost = (D / Q)S

Holding cost = 21 HQ 1- d p

D
S = 21 HQ 1- d p
Q

Q2 =
Q *p =

2DS

H 1- d p
2DS

H 1- d p

Production Order Quantity

Example
D = 1,000 units
S = $10
H = $0.50 per unit per year
Q *p =
Q *p =
=

2DS

p = 8 units per day

d = 4 units per day

H 1- d p
2(1,000)(10)
0.501- (4 8)
20,000
= 80,000
0.50(1 2)

= 282.8 hubcaps, or 283 hubcaps

Production Order Quantity Model

Note:
D
d=4=
=
Number of days the plant is in operation

1,000
250

When annual data are used the equation becomes

2DS
Q =

Annual demand rate

H 1
Annual
production
rate

*
p

Exercise
Consider a product with a daily demand of 400 units, a
setup cost per production run of $100, a monthly holding
cost per unit of $2.00, and an annual production rate of
292,000 units. The firm operates and experiences
demand 365 days per year. Suppose that management
mistakenly used the basic EOQ model to calculate the
batch size instead of using the POQ model. How much
money per year has that mistake cost the company?