Supply Chain Management: Inventory

Management

Donglei Du

Faculty of Business Administration, University of New Brunswick, NB Canada Fredericton

E3B 9Y2 (ddu@umbc.edu)

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Table ofcontentsI
1 Introduction
2 Inventory Management
3 Inventory models
4 Economic Order Quantity (EOQ)
EOQ model
When-to-order?
5 Economic Production Quantity (EPQ): model description
EPQ model
6 The Newsboy Problem-Unknown demand (probabilistic model)
The newsvendormodel
7 Multiple-period stochastic model: model description
8 Managing inventory in the supply chain
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 Section 1

Introduction

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OutlineI
Introduce some basic concepts in inventory management
Inventory level (IL)
Reorder point (ROP)
Lead time
Safety stock
Continuous review and periodic review systems
Service level
Introduce some basic inventory models, both deterministic and
probabilistic.
deterministic models
EOQ model
EPQ model
probabilistic models
Single-period model: Newsboy model
Multiple-period model
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 Section 2

Inventory Management

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What is Inventory?I
Inventory is a stock or store of goods or services, kept for use or
sale in the future. There are four types of inventory
Raw materials & purchased parts
Partially completed goods called work in progress (WIP)
Finished-goods inventories
Goods-in-transit to warehouses or customers (GIT)
The motive for inventory: there are three motives for holding
inventory, similar to cash.
Transaction motive: Economies of scale is achieved when the
number of set-ups are reduced or the number of transactions
are minimized.
Precautionary motive: hedge against uncertainty, including
demand uncertainty, supply uncertainty
Speculative motive: hedge against price increases in materials or
labor
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What is inventory management?

The objective of inventory is to achieve satisfactory levels of

customer service while keeping inventory costs within reasonable
bounds.
Level of customer service: (1) in-stock (fill) rate (2) number of
back orders (3) inventory turnover rate: the ratio of average cost
of goods sold to average inventoryinvestment
Inventory cost: cost of ordering and carrying trade-off

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An ExampleI

Let us look at a typical supply chain consists of suppliers and

manufacturers, who convert raw materials into finished materials,
and distribution centers and warehouses, form which finished
products are distributed to customers. This implies that inventory
appears in the supply chain in several forms:
Raw materials Finished product
Work-in-process Goods-in-transit
(WIP) (GIP)

suppliers Transportation distributors Transportation Transportation

cost retailers customers
plants warehouses cost cost

Production/ Inventory & Inventory &

purchase warehousing warehousing
costs costs costs

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 Section 3

Inventory models

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Inventory ModelsI

Inventory models come in all shapes. We will focus on models

for only a single product at a single location. Essentially each
inventory model is determined by three key variables:
demand:
deterministic, that is, known exactly and in advance.
random. Forecasting technique may be used in the latter case
when historical data are available to estimate the average and
standard deviation of the demand (will introduce forecasting
techniques later).
costs:
order cost: the cost of product and the transportation cost
inventory holding cost: taxes and insurances, maintenance,etc.
physical aspects of the system: the physical structure of the
inventory system, such as single or multiple-warehouse.
Usually, there aretwo basic decisions in all inventory models:
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Inventory ModelsII

How much to order?

When to order?

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 Section 4

Economic Order Quantity (EOQ)

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 Subsection 1

EOQ model

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Economic Order Quantity (EOQ): Model
descriptionI

The EOQ model is a simple deterministic model that illustrates

the trade-offs between ordering and inventory costs.
Consider a single warehouse facing constant demand for a single
item. The warehouse orders from the supplier, who is assumed to
have an unlimited quantity of the product.
The EOQ model assume the following scenario:
Annual demand D is deterministic and occurs at a constant
rate—constant demand rate: i.e., the same number of units is
taken from inventory each period of time, such as 5 units per
day, 25 units per week, 100 units per month and so on.
Order quantity are fixed at Q units per order.

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Economic Order Quantity (EOQ): Model
descriptionII

A fixed ordering cost co per order, not depending on the

quantity ordered.
A holding cost ch per unit per year, depending on the size of the
inventory. Sometimes holding cost can usually be calculated as
follows:

ch = annual holding cost rate×annual cost of holding one unit in

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Shortages (such as stock-outs and backorder) are not permitted.
There is no lead time or the lead time isconstant.
The planning horizon is long
The objective is to decide the order quantity Q per order so as to
minimize the total annual cost, including holding and setting-up
costs.

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Economic Order Quantity (EOQ): Analysis

The following graph illustrates the inventory level as a function

of time—a saw-toothed inventorypattern.
Quality on hand

place receive place receive time

order order order order

lead
time

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Inventory level (IL) is the quantity on hand, which is different
from inventory position (IP), which is equal to inventory
on-hand plus quantity on order minus backorder (if any).
The maximum I L is Q, the minimum is 0, therefore the average
I L is Q2.
Since
Annual holdingcost = Average inventory × Annual holding cost
Q
= c
2 h
Annual ordering cost = Number of orders per year× cost perord
Dc
= o
Q
So
Total annual cost = annual holding cost + annual setup cost
Q D
= ch + co
2 Q
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The trade-off of holding and ordering costs is illustrated in the
following figure.
The Total-Cost Curve is U-Shaped
Q D
Annual Cost TC  H S
2 Q

Ordering Costs

Order Quantity
Q O(optimal order quantity)
(Q)

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Therefore, the optimal order quantity is achieved at the point
where the two costs meet.
The economic order quantityis
.
2D co
Q= ∗
ch

The cycle time (the time between two consecutive orders) is

Q∗
Cycle Time= D

Number of orders peryear

1 D
Number of orders per year= = ∗
cycle time Q

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An ExampleI

A local distributor for a national tire company expects to sell

approximately 9600 steel-belted radical tires of a certain size and
tread design next year. Annual carrying cost is $16 per tire, and
ordering cost is $75 per order. The distributor operates 288 days a
year.
What is the EOQ?
√ √
Q∗ = 2Dc o /c h = 2(9600)75/16 = 300

How many times per year would the store reorder if the ECQ is
ordered?
D/Q ∗ = 9600/300 = 32

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An ExampleII

What is the length of an order cycle if the EOQ isordered?

Q ∗ /D = 300/9600 = 1/32 year

or
1/32 × 288 = 9 working days
What is the total cost.

T C = (Q∗/2)ch+(D/Q∗)co = (300/2)16+(9600/300)75 = 4800

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Sensitivity analysis

Estimating ordering and inventory costs is not an easy job, let

alone accurate. Now let us see whether the EOQ model is robust
to the costs, i.e., whether the order quantity is stable or not
when the costsvary.
Our claim is EOQ model is insensitive to small variations or
errors in the cost estimates.

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 Subsection 2

When-to-order?

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When-to-order: some concepts

The reorder point (ROP) is defined to be the inventory level at

which a new order should be placed.
The when-to-order decision is usually expressed in terms of a
reorder point.
We will consider deterministic and stochastic modelsseparately.

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When-to-order: deterministic demand and
deterministic leadtime

Here we consider a simple deterministic demand and

deterministic lead time model.
Assume constant demand per period is d.
Lead times is Afor a new order in terms of periods.
Then
ROP = Ad
Note that in our previous EOQ model, we assume A= 0 so the
reorder point is ROP = 0.

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 Inventory level

ROP

ld

d d Time
l  lead time l  lead time

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An ExampleI
Mr. X takes two special tablets per day, which are delivered to
his home seven days after an order is called in. At what point
should Mr. X reorder?
Solution:In this case, the daily demand and lead time are
both constants (special random variable), and
d = 2
A = 7

Therefore
ROP = Ad = 2 × 7 = 14
i.e., Mr. X should reorder when there are 14 tablets
left.
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