Inventory Management

2
Why do we have inventories?
Inventory is one of the most expensive assets of
many companies.
It represents as much as 40% of total invested
capital.
Inventory is any stored resource that is used to
satisfy a current or future need.
Raw materials, work-in-process, and finished goods
are examples of inventory.
Two basic questions in inventory management are
(1) how much to order (or produce), and (2) when to
order (or produce).
3
Basic Functions of Inventory
Basic Functions of Inventory are:
1. If product demand is high in summer, a firm
might produce during winter (Decoupling).
2. Inventory can be a hedge against price
changes and inflation.
3. Another use of inventory is to take advantage
of quantity discounts (when buying).
(Many suppliers offer discounts for large orders)
4
ABC Analysis
ABC analysis divides on-hand inventory into
three classifications on the basis of dollar
(TL) volume.
It is also known as Pareto analysis. (which is
named after principles dictated by Pareto).
The idea is to focus resources on the critical
few and not on the trivial many.
(Annual Dollar Volume of an Item) = (Its
Annual Demand) x (Its Cost per unit)
5
ABC Analysis
Class A items are those on which the annual dollar
volume is high.
They represent 70-80% of total inventory costs, but
they account for only 15% of total inventory items.
Class B items are those on which annual dollar
volume is medium.
They represent 15-25% of total dollar value, and they
account for 30% of total inventory items on the
average.
Class C items are low dollar volume items.
They represent only the 5% of total dollar volume, but
they include as many as 50-60% of total inventory
items.
6
ABC Analysis
Percent
of
Annual
Dollar
Volume
Percent of
Inventory
Items
80
Class
A
Items
20
20
50 100
Class
C Items
7
ABC Analysis
Some of the Inventory Management Policies
that may be based on ABC analysis include:

a) Class A items should have tighter inventory
control.
b) Class A items may be stored in a more
secure area.
c) Forecasting Class A items may warrant more
care.
8
Cycle Counting of Inventory
Inventory records must be verified through a
continuing audit.
Such audits are known as (periodical) cycle
counting.. (e.g., counting items at supermarket).
Cycle counting uses inventory classifications
developed by ABC analysis.
That is:
Class A items are counted frequently, perhaps once a
month.
Class B items are counted less frequently, perhaps
once a quarter.
Class C items are counted perhaps once every six
months.
9
Just-in-Time Inventory
Just in Time Inventory is the minimum inventory that
is necessary to keep a system perfectly running.
With just in time (JIT) inventory, The exact amount of
items arrive at the moment they are needed, Not a
minute before OR not a minute after.
To achieve JIT inventory, Managers should Reduce
the Variability Caused by some Internal and
External Factors.
(Goldratts boys scout example Apply the pace of the
slowest boy).
Existence of Inventory hides the variability.
What causes variability?
10
What causes variability?
Most variability is caused by tolerating waste
(inventory).
(1) For example, employees or machines
produce units that do not conform to
standards. These are waste. And they cause
variability.
(2) Or, engineering drawings are inaccurate,
Again resulting in loss of production And
consecutively resulting in Variability.
11
What causes variability?...
These are the internal (controllable) factors that
cause Variability.
However, Some of the variability is caused by some
external factors.
For example, customer demands may change due to
some external factors (such as competitors actions
or promotions)
In summary, To achieve JIT inventory, Managers
must begin with Reducing Inventory.
Reducing Inventory uncovers the Rocks located
along the way on a river, And the water stream
becomes more clear.
12
Rocks located along the way
Others
Waiting
Time
Move
Time
Queue
Time
Set-up
Time
Run
Time
Input Output
Lead Time
Cycle Time
The section called Others are the Rocks on the river.

Those rocks include Quality Variability, In-transit Delays, Machine
Breakdowns, Large Lot-sizes, Inaccurate drawings, Employee
attendance variability.
13
Just-In-Time Production
JIT production means
(1) Elimination of Waste,
(2) Synchronized Manufacturing, and
(3) Little Inventory.
Reducing the order batch size can be a major help in
reducing inventory.
Average Inventory = (Maximum Inventory +
Minimum Inventory) / 2
Average Inventory drops as the inventory re-order
quantity drops because the maximum inventory level
drops.
14
Kanban System
Moreover, the smaller the lot size, the fewer the
problems are hidden.
One way to achieve small lot sizes is to Move
Inventory through the shop Only as needed.
This is called a pull system. In this system, Ideal
Lot size is 1.
Japanese call this system as Kanban system.
Kanban is a Japanese word for Card.
A card is used to signal the need for material in a
work center.
15
Kanban System
Sending a card authorizes the previous work
center to send its finished batch to the
subsequent work center.
Batches are typically very small. Such a
system requires tight schedules and frequent
set-ups for machines.
On the other hand, Small batches allow a
very limited amount of faulty material, less
damages, less space occupation, less
material handling, less accidents, etc.
16
Inventory Related Costs:
Holding, Ordering and Set-up Costs
Holding Costs are the costs associated with holding
or carrying inventory over time.
It includes costs related to storage; such as
insurance, extra staffing, interest, and so on.
Some example holding costs are:
building rent or depreciation,
building operating cost,
taxes on building, insurance on building,
material handling equipment leasing or depreciation,
equipment operating cost, handling manpower cost,
taxes on inventory, insurance, etc.
17
Inventory Related Costs:
Ordering and Set-up Costs
Ordering Costs include, cost of supplies, order
processing, clerical cost, etc.
The ordering cost is valid if the products are purchased
NOT produced internally.
Set-up cost is the cost to prepare a machine for
manufacturing an order.
Set-up cost is highly correlated with set-up time.
Machines that traditionally have taken long hours to set
up Are Now being set up in less than a minute by
employing FMSs or CIM systems.
Reducing set up times is an excellent way to Reduce
Inventory.
18
Inventory Models
Demand for an item is either dependent on the
demand for other items or it is independent.
For example, demand for refrigerator is independent
of the demand for cars.
But, demand for auto tires is certainly dependent on
the demand of cars.
We will deal with the Independent Demand
Situation.
In the dependent demand situation we use Material
Requirement Planning (MRP) systems.
19
What to answer?
In the independent demand situation, we
should be interested in answering:

a) When to place an order for an item, and
b) How much of an item to order.
20
Independent Demand Inventory Models
There are Four Basic Independent Demand
Inventory Models:
1) Economic Order Quantity (EOP) Model (the
most known model).
2) Production Order Quantity Model.
3) Back order inventory model.
4) Quantity discount model.
21
Economic Order Quantity (EOQ)
Model
EOQ model makes a number of assumptions:
1-) Demand is known and constant.
2-) Lead time (the time between placement of order and
receipt of the order) is constant and known.
3-) Orders arrive in one batch at a time, and they arrive in
one point in time.
4-) Quantity discounts are not possible.
5-) The costs include only setup cost (or ordering cost
when buying) and holding cost.
6-) Orders are always placed at the right times.
Therefore, stock outs (or shortages) can be completely
avoided.
22
With these assumptions in EOQ Model, the graphic
of inventory usage over time is as follows:
Inventory
Level
Time
Q
Average
Inventory
Level
Usage
Rate
0
Q = order quantity
(That is also equal to the
Maximum Inventory)

Minimum Inventory = 0
When inventory level reaches 0, a new
order is placed and received.
23
Objective: Minimize total cost
The objective of inventory models is to
minimize total cost.

If we minimize the setup and holding costs,
we will be able to minimize total cost.

As the quantity ordered (Q) increases,
holding cost increases, and setup cost
decreases.
24
Where the total cost is minimum?
Annual
Cost
Order
Quantity (Q)
Annual
Holding
Cost
Setup
Cost
(Ordering
Cost)
Total
Cost
Minimum
Total
Cost
Optimal Order
Quantity (Q*)
Optimal order quantity (Q*) occurs at a point where setup cost
is equal to the total (annual) holding cost.
25
Finding the optimum
Optimal order quantity (Q*) occurs at a point where
setup cost is equal to the total (annual) holding cost.

By using this fact, we can write an equation for Q* as
follows:

D: Annual Demand in units for the inventory item.

S: Setup cost (or the ordering cost) for each order.
Notice: (Setup cost for production, order cost for buying).

H: Annual Holding cost of inventory per unit.
26
Finding the optimum
There will be (D/Q) times of ordering in a whole
year.

Therefore, Annual Setup Cost = (D/Q) . S

Average Annual Holding Cost = (Average Inventory) . H
= (Q/2) . H
27
Finding the optimum
We get optimum point by setting:

Annual Setup Cost = Annual Holding Cost
(D/Q) . S = (Q/2) . H

Therefore,
Q
2
= 2DS / H
Q* = [2DS / H]
1/2

Q* value is also called as the EOQ.
28
Example
An Inventory model has the following
characteristics:

Annual Demand (D) = 1000 units
Ordering (Setup) cost (S)= $10 per order;
Holding cost per unit per year (H) = $.50

Assume that there are 270 working days in a
year (excluding holidays and weekends).
29
Example
Questions:
a) Find the Economic Order Quantity (Q*) for
this inventory model.
b) How many orders should be placed during
one year?
c) What is the expected time between two
consecutive orders?
d) What is the total annual cost of this inventory
model?
30
Example
Answers:
a) EOQ= Q* = [2(1000)10 / .50]
1/2
= 200 units
b) Expected number of orders placed during the year
(N) = D / Q* = 1000 / 200 = 5 times.
c) Expected time between orders (T) = (Working days in
a year) / N = 270 / 5 = 54 days.
d) Total Annual Cost = Annual Setup Cost + Annual Holding Cost
= DS / Q* + (Q*) H / 2
= 1000 (10) / 200 + (200) (.50) / 2
= $100
31
Proof of Optimality by Using
Derivation
If we take the derivative of Total Cost (TC)
function, based on the order quantity (Q), we
get the following:

TC = DS / Q + (Q)H / 2

dTC/dQ = (- DS / Q
2
) + (H / 2)
32
Proof of Optimality by Using
Derivation
As a mathematic rule, if we set this derived
equation equal to zero, we get the optimal
(minimum) point of the total cost function:
Therefore,
dTC/dQ = (- DS / Q
2
) + (H / 2) = 0

From here,
(- DS / Q
2
) = - H / 2
Q
2
= 2DS / H
Q* = [2DS / H]
1/2
33
Proof of Optimality by Using
Derivation
One more check is needed for the optimality
of Q.
That is we take the second derivative of the
total cost function based on Q.
If the second derivative is positive, the Q*
value is a real optimum. (Rule)
In fact, second derivative is equal to 2DS / Q
3

which is a positive value (It is a real optimum)
34
Considering the Reorder Point
So far, we only decided how much to order
(That is Q*).
Now, we should find what time to order.
We assumed that firm will wait until its
inventory reaches to zero before placing an
order.
And, we also assumed that the Orders will
receive immediately.
However, there is a time between placement
and receipt of an order.
35
Considering the Reorder Point
This is called LEAD TIME or delivery time.
Here, we will use the term Reorder Point
(ROP) for when to order.
ROP (in units) = (Demand Per Day) x (Lead
time for a new order in days)

ROP = d x L
36
Reorder Point
Inventory
Time
(Days)
Q* Slope = d
(units/day)
ROP
(units)
L = Lead Time
ROP = d . L
When the inventory level reaches the ROP, a new order is
required.

It will take a time that is equal to the Lead Time (L) to receive
the new order.
37
Reorder Point
Here, Demand per day (d) is found by the
following equation:
d = D / Number of working days in a year

This ROP equation assumes that demand is
uniform and constant.

If this is not the case, an extra (safety) stock
is added (because of uncertainty).
38
Example
Annual demand for an item is D = 8000/year.

This year there will be 200 working days in a
year.

Delivery of an order for this item takes 3
working days (L = 3 days).
39
Example
Questions:

a) Find the demand per day for this item.

b) What is the ROP for this item?
40
Example
Answers:
a) Demand per day for this item (d) = 8000 / 200
= 40 units / day.

b) ROP = d . L = 40 . 3 = 120 units.
When inventory level becomes 120 units, an
Order should be placed.
41
Production Order Quantity Model
In EOQ Model, We assumed that the entire
order was received at one time.
However, Some Business Firms may receive
their orders over a period of time.
Such cases require a different inventory
model.
Here, we take into account the daily
production rate and daily demand rate.
42
Production Order Quantity Model..
Inventory
Time
Maximum
Inventory
t
Production
occurs at a
rate of p
Demand
occurs
at a rate
of d
43
Production Order Quantity Model..
Since this model is especially suitable for
production environments, It is called
Production Order Quantity Model.
Here, we use the same approach as we used in
EOQ model.
Lets define the following:
p: Daily Production rate (units / day)
d: Daily demand rate (units / day)
t: Length of the production in days.
H: Annual holding cost per unit
44
Production Order Quantity Model..
Average Holding Cost = (Average Inventory) . H
= (Max. Inventory / 2) . H

In the period of production:
Max. Inventory = (Total Produced) (Total Used)
= p x t d x t

Here, Q is the total units that are produced.
Therefore,
Q = p x t and t = Q / p
45
Production Order Quantity Model..
If we replace the values of t in the Max.
Inventory formula:
Max. Inventory = p (Q/p) - d (Q/p)
= Q - dQ/p
= Q (1 d/p)
Annual Holding Cost = (Max. Inventory / 2) . H
= Q/2 (1 d/p) . H
Annual Setup Cost = (D/Q) . S
46
Production Order Quantity Model..
Now we will set:
Annual Holding Cost = Annual Setup Cost
Q/2 (1 d/p) . H = (D/Q) . S
(

=
p
d
H
DS
Q
1
2
2
(

=
p
d
H
DS
Q
1
2
*
This formula gives us the optimum production quantity for the
Production Order Quantity Model.

It is used when inventory is consumed as it is produced.
47
Backorder Inventory Model
In this model, we assume that stock outs (and
backordering) are allowed.
In addition to previous assumptions, we assume that
sales will not be lost due to a stock out.
Because, we will back order any demand that can not
be fulfilled.
B: Backordering cost per unit per year
b: The amount backordered at the time the next order
arrives
Q b: Remaining units after the backorder is satisfied
48
Backorder Inventory Model
Inventory
Time
(Q - b)
b
T1 T2
b
Q
0
49
Backorder Inventory Model
Total Annual Cost = Annual Setup Cost + Annual
Holding Cost + Annual Backordering Cost

Annual Setup (Ordering) Cost = (D/Q) . S

Annual Holding Cost = (Average Inventory Level) . H

Average Average inventory Proportion of time
Inventory = level during there is inventory
Level in stock period in stock

= (Q b) / 2 . T1 / T
50
Backorder Inventory Model
By using the graphical ratios, we know that:
T1 / T = (Q b) / Q
Therefore, if we replace T1/T in the above
equation we get
Average Inventory Level = (Q b)
2
/ 2Q

(Q b)
2
Annual Holding Cost = ---------- . H
2Q
51
Backorder Inventory Model
Annual Backordering Cost = (Average Backordering) . B

Average Backordering = (Average number of stock outs during out
of stock period) x (Proportion of time inventory is on backorder)

Average Backordering = b / 2 . T2 / T

By using the graphical ratios, we know that:
T2 / T = b / Q Therefore, if we replace T2/T in the above equation
we get:
Average Backordering = b
2
/ 2Q and

b
2
Annual Backordering Cost = ---------- . B
2Q
52
Backorder Inventory Model
DS (Q b)
2
b
2

Total Cost (TC) = ------- + ---------- . H + --------- . B
Q 2Q 2Q
We find optimum order quantity (Q*) and optimum
backordering quantity (b*) by taking the derivatives of
dTC/dQ = 0 and dTC / db = 0 and then putting the
values in their places.
We find that:
|
.
|

\
|
+
|
.
|

\
|
=
B
B H
H
DS
Q
2
*
H B
H Q
b
+
=
*
*
53
Quantity Discount Model
A quantity discount is simply a reduced price (P) for an
item when it is purchased in LARGER quantities.

A typical quantity discount schedule is as follows:

Alternative Quantity Discount (%) Discount (unit) Price
1 0-999 0 $5.00
2 1000-1999 4 $4.80
3 2000- 5 $4.75
54
Quantity Discount Model
Since the unit cost for the Third discount is
the lowest, We might be tempted to order
2000 or more units.
However, this quantity might not be the one
that minimizes the Total Cost.
Remember that, As the quantity goes up, the
holding cost increases.
Here, there is a trade off between reduced
product price (P) and increased holding cost
(H).
55
Quantity Discount Model
Total Cost = Setup Cost + Holding Cost + Product
Price (Cost)
Total Cost = DS / Q + QH / 2 + PD
where P is the price per unit
To determine the minimum Total Cost, we perform the
following process which includes 4 steps:
Step 1: Assume that
I: is a percentage value, and
I . P represents the holding cost as a percentage of
price per unit (P).
56
Quantity Discount Model
For each discount alternative, calculate a
value of Q* = [2DS / IP]
1/2
Here, instead of using a value of H, the
holding cost is equal to I . P
That is, If the item is expensive (such as a
Class A Item), Its holding cost will be higher.
Since the price of item (P) is a factor in
Annual Holding Cost, we can no longer
assume that the holding cost is constant
(such as H) when price changes.
57
Quantity Discount Model
Step 2: For any discount alternative,
If the calculated optimum order quantity (Q*) is too
low to qualify for the discount range,
Then, Adjust the order quantity upward to the lowest
quantity that will qualify for the particular discount
alternative.
Step 3: Using the total cost (TC) equation above,
compute a total cost for every order quantity (Q).
Use the adjusted Q values.
Step 4: Select the discount alternative which has the
minimum Total Cost (TC).
58
Example
Consider the quantity discount schedule
given in the beginning (above).
Assume that the Ordering (Setup) Cost (S) is
$49 per each order.
Annual Demand (D) is 5000 units, and
Inventory carrying charge is a percentage
(I=0.20) of product cost (P).
Question: What order quantity will minimize
the total inventory cost.
59
Example
Answer:
Step 1: Compute Q* for every discount range.
order units
IP
DS
Q / 700
) 5 )( 2 (.
) 49 )( 5000 ( 2 2
*
1
= = =
order units
IP
DS
Q / 714
) 8 . 4 )( 2 (.
) 49 )( 5000 ( 2 2
*
2
= = =
order units
IP
DS
Q / 718
) 75 . 4 )( 2 (.
) 49 )( 5000 ( 2 2
*
3
= = =
60
Example
Step 2: Adjust values of Q* that are below allowable
discount ranges.
- For Q1, allowable range is 0-999. Since Q1* = 700 is
between 0 and 999, It does not have to be adjusted.
- For Q2, allowable range is 1000-1999. Since Q2* =
714 is not in the allowed range, we adjust it to the
lowest allowable value, That is Q2* = 1000.
- For Q3, allowable range is 2000-. Since Q3* = 718 is
not in the allowed range, we adjust it to the lowest
allowable value, That is Q3* = 2000.
61
Example
Step 3: Compute total cost for each of the
order quantities (Q*):


5000 x Unit price
$49 x (5000 / 700)
(Average Inventory x Holding Cost) =
(Q / 2) x (I x P) =
(700 / 2) x (5 x 0,20)
62
Example
Step 4: An Order quantity of 1000 units will
minimize the total cost.

However, if the third discount cost is lowered to
$4.65, selecting this discount alternative
(2000 units) would be the optimum solution.
63
Probabilistic Models
So far we assumed that demand is constant
and uniform.

However, In Probabilistic models, demand is
specified as a probability distribution.

Uncertain demand raises the possibility of a
stock out (or shortage). (Why?)
64
Probabilistic Models
One method of reducing stock outs is to hold extra
inventory (called Safety Stock).
In this case, we change the ROP formula to include that
safety stock (ss).

ROP = d . L
d = daily demand, and L = Order Lead Time

Now it will be as follows:
ROP = d . L + (ss)
where (ss) is the safety stock
65
Example
AMP Ltd. company determined its ROP = 50 units.
Its holding cost (H) is $5 per unit per year.
Its stock out cost (B) is $40 per unit.
Probability of stock out is based on the following probability
distribution:
Question: Find the Level of Safety Stock (ss) that minimizes the
total additional holding cost and Stock out costs (annually).
66
Example
Stock out cost is an expected cost; That is:
67
Example
Possible stock outs per year is actually the number of
orders per year (D/Q).
Since it is not known (or not given) assume that it is 6
times / year.
For zero safety stock, there is no additional holding cost
for extra (safety) stock.
But there are stock out costs for two levels:
1) If demand is 60 units at the ROP, Then a shortage of
10 units will occur.
(Because, ROP is 50 units)
2) If demand is 70 units at the ROP, Then a shortage of
20 units will occur.
68
Results of the example
The safety stock with the lowest total cost is
(ss = 20) units.

Therefore, ROP = 50 + 20 = 70 units.
69
Finding A Safety Stock Level
Managers may want to limit the possibility of
stock out only to a small percentage, say 5%.
If demand level is assumed to be a normal
distribution,
By using mean and standard deviation of the
normal distribution,
We can determine a safety stock that is
necessary for %95 service level.
70
Example
The SAC company carries an inventory item
that has a normally distributed demand.

The mean demand is ( = 350) units and
standard deviation is (o = 10).
71
Example
x : mean demand + safety stock
x -
z = ------
o

Using a standard Normal table we find z = 1.65 for 95% confidence.
We use the properties
of a standardized
normal curve to get a z
value that corresponds
to the.95 of the curve.
72
Example
Therefore,
x - ss
z = ------ = ---- = 1.65
o o

ss = 16.5 units

Reorder point is elevated up by 16.5 units.
73
Example