Chapter 15: Inventory Systems For

Independent Demand
Definition of Inventory
-Stock of any item or resource used in
the organization.
Inventory System Set of policies and
controls
that
monitors
levels
of
inventory, determines what level should
be maintained, when stock should be
replenished, , and how large orders
should be.
Manufacturing inventory Raw materials,
1
finished products, component parts,
supplies, and work in process (WIP)

Basic Purpose
Analysis

of

Inventory

-To determine (a) when item

should be ordered, and (b) how
large the order should be.

Purposes of Inventory

To
maintain
independence
of
operations A supply of materials at a
work
center
allows
that
center
flexibility in operations. Independence
of
workstations
is
desirable
on
assembly lines as well. The time that it
takes to do identical operations will
naturally vary from one unit to
another. Therefore, it is desirable to
have a cushion of several parts within
the
workstation
so
that
shorter
3
performance times can compensate for
longer performance times.

Purposes of Inventory (Continued)

To variation in product demand Demand

is not completely known. Therefore, a
safety
or
buffer
stock
must
be
maintained to absorb variation.

To
allow
flexibility
in
production
scheduling A stock of inventory
relieves the pressure on the production
system to get the goods out. This causes
longer
lead
times
which
permit
production planning for smoother flow
lower-cost operation through larger 4lotsize production.

Purposes of Inventory (Continued)

To provide a safeguard for variation in raw

material delivery time When material is
ordered from a vendor, delays can occur for
a variety of reasons: a normal variation in
shipping time, a shortage of material at the
vendors plant causing backlog, unexpected
strike at the vendors plant or at one of the
shipping companies etc. Inventory will play
as a safeguard.
To take advantage of economic purchaseorder size There are costs to place an
order: labor, communication cost, handling
cost, etc. The larger the order, the lower the
5
per-unit cost.

Inventory Costs

Holding (or carrying cost): costs for

storage facilities, handling, insurance,
pilferage,
breakage,
obsolescence,
depreciation, taxes, opportunity cost of
the capital, etc.

Set-up (or production change) costs:

Costs to obtain necessary materials,
arranging specific equipments set-up,
filling-out
the
required
papers,
appropriately
charging
time
and
6
materials, moving out the previous
stock of material, etc.

Inventory Costs (Continued)

Ordering
costs:
Managerial
clerical
costs
to
prepare
purchase or production order

and
the

Shortage costs: Costs for unfilled

demand, lost customers effect, etc.

Inventory Models
- Fixed-order quantity models (economic
order quantity model, Q-model), and
Fixed-time
period
models
(periodic
system, periodic review system, fixedorder interval system, P-model)
- Fixed-order quantity models are event
triggered and fixed-time period models
are time triggered
- A fixed-order quantity model initiates an
order when the event of reaching a
specified reorder level occurs. In contrast,
8
a fixed-time period model initiate an order
after a predetermined time elapses.

Fixed-order vs. Fixed-time

The fixed-time period model has a larger average

inventory because it must also protect against
stock out during the review period, T: the fixedorder quantity model has no review period.
The fixed-order quantity model favors more
expensive items because average inventory is
lower.
The
fixed-order
quantity
model
is
more
appropriate for important items such as critical
repair parts because there is closer monitoring
and therefore quicker response to potential stock
out.
The fixed-order quantity model requires more
time to maintain because every addition9 or
withdrawal is logged.

Fixed-Order Quantity Models

- Determine the specific point, R, at
which an order will be placed and
the size of that order, Q.
- R is always a specified number of
units. An order of size Q is placed
when the inventory available
(currently available and on order)
reaches the point R.
Inventory position = On-hand + Onorder Back-ordered
10

Assumptions

Demand for the product is constant and

uniform throughout the period

Lead time (time from ordering to receipt) is

constant

Price per unit of product is constant

Inventory holding cost is based on average

inventory

Ordering or setup costs are constant

All demands for the product will be satisfied

(No back orders are allowed)

11

BASIC FIXED-ORDER QUANTITY MODEL

AND REORDER POINT BEHAVIOR
4. The cycle then repeats.

1. You receive an order quantity Q.

Number
of units
on hand

R
2. Your start using
them up over time.

Time
R = Reorder point
Q = Economic order quantity
L = Lead time

3. When you reach down to a

level of inventory of R, you
place your next Q sized order.

COST MINIMIZATION GOAL

By
Byadding
addingthe
theitem,
item,holding,
holding,and
andordering
orderingcosts
costs
together,
together,we
wedetermine
determinethe
thetotal
totalcost
costcurve,
curve,which
whichin
in
turn
inventory order point that
turnis
isused
usedto
tofind
findthe
theQ
Qopt
opt inventory order point that
minimizes
minimizestotal
totalcosts
costs
Total Cost
C
O
S
T

Holding
Costs
Annual Cost of
Items (DC)
Ordering Costs
QOPT
Order Quantity (Q)

BASIC FIXED-ORDER
QUANTITY (EOQ) MODEL
FORMULA
Total
Annual =
Cost

Annual
Annual
Annual
Purchase + Ordering + Holding
Cost
Cost
Cost

D
Q
TC = DC + S + H
Q
2

TC=Total
TC=Totalannual
annual
cost
cost
DD=Demand
=Demand
CC=Cost
=Costper
perunit
unit
QQ=Order
=Orderquantity
quantity
SS=Cost
=Costof
ofplacing
placing
an
anorder
orderor
orsetup
setup
cost
cost
RR=Reorder
=Reorderpoint
point
LL=Lead
=Leadtime
time
H=Annual
H=Annualholding
holding
and
andstorage
storagecost
cost
per
perunit
unitof
ofinventory
inventory

DERIVING THE EOQ

Using
Using calculus,
calculus, we
we take
take the
the first
first derivative
derivative of
of
the
the total
total cost
cost function
function with
with respect
respect to
to Q,
Q, and
and
set
set the
the derivative
derivative (slope)
(slope) equal
equal to
to zero,
zero,
solving
solving for
for the
the optimized
optimized (cost
(cost minimized)
minimized)
value
value of
of Q
Qopt
opt
Q OPT =

2DS
=
H

We
Wealso
alsoneed
needaa
reorder
reorderpoint
pointto
totell
tellus
us
when
whento
toplace
placean
an
order
order

2(Annual Demand)(Order or Setup Cost)

Annual Holding Cost
_

Reorder point, R = d L
_

d = average daily demand (constant)

L = Lead time (constant)

EOQ EXAMPLE (1) PROBLEM

DATA
Given
Giventhe
theinformation
informationbelow,
below,what
whatare
arethe
theEOQ
EOQand
andreorder
reorderpoint?
point?

Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15

EOQ EXAMPLE (1) SOLUTION

Q OPT =

2DS
=
H

2(1,000 )(10)
= 89.443 units or 90 units
2.50

1,000 units / year

d =
= 2.74 units / day
365 days / year
_

Reorder point, R = d L = 2.74units / day (7days) = 19.18 or 20 units

In
Insummary,
summary,you
youplace
placean
anoptimal
optimalorder
orderof
of90
90units.
units. In
In
the
thecourse
courseof
ofusing
usingthe
theunits
unitsto
tomeet
meetdemand,
demand,when
when
you
youonly
onlyhave
have20
20units
unitsleft,
left,place
placethe
thenext
nextorder
orderof
of90
90
units.
units.

EOQ EXAMPLE (2) PROBLEM

DATA
Determine
Determine the
the economic
economic order
order quantity
quantity
and
and the
the reorder
reorder point
point given
given the
the following
following

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost
per unit
Lead time = 10 days
Cost per unit = $15

EOQ EXAMPLE (2) SOLUTION

Q OPT =

2DS
=
H

2(10,000 )(10)
= 365.148 units, or 366 units
1.50

10,000 units / year

d=
= 27.397 units / day
365 days / year
_

R = d L = 27.397 units / day (10 days) = 273.97 or 274 units

Place
Placean
anorder
orderfor
for366
366units.
units. When
Whenin
inthe
thecourse
courseof
ofusing
usingthe
the
inventory
inventoryyou
youare
areleft
leftwith
withonly
only274
274units,
units,place
placethe
thenext
nextorder
orderof
of366
366
units.
units.

Fixed-Order Quantity Model With

Usage During Production Time

The previous model assumed that the quantity

ordered would be received in one lot, but
frequently this is not the case.
In many situations, production of an inventory
item and usage of that item take place
simultaneously
(where
one
part
of
a
production system acts as supply to another
part).
Also, companies are beginning to longer-term
arrangements with supplier. Under such
contracts, a single order may cover product or
material needs over a six-month or year
period, with the vendor making deliveries
20
weekly or sometimes more frequently.

Fixed-Order
Quantity
Model
With Usage During Production
Time (Continued)
TC = DC + (D/Q)*S + ((p-d)/2p)*QH
p = Production rate, d = Daily demand
rate

After differentiating with respect to Q

and setting
2 DS the pequation to 0,
(

pd

Qopt =
21

Standard Deviation

Standard
deviation,
,
is
a
measurement of deviation from mean.
In case of demand, it is a measurement
of deviation from average demand.
2
(
d

d
)
i1 i
n

d
=standard
demand=

deviation
L

for

n daily

If lead time is L, then L =

22

Establishing Safety Stock Levels

Up to now, the assumption is that demand is
constant and is precisely known.
On the contrary, in the majority of the case
demand is not constant but varies from day to
day. Hence, safety stock must be maintained to
provide some level of protection against stockouts.
Safety stock can be defined as the amount of
inventory carried in addition to the expected
demand.
If demand is assumed to follow normal distribution,
then the expected demand is the mean.
If average weekly demand is 100 units and the
demand for next week is expected to be same,
then if 120 units is carried in inventory, then
safety stock is (120 100) = 20 units.

Service Level
Service level refers to the number of units
demanded that can be supplied from stock
currently on hand.
For example, if annual demand for an item
is 1000 units, a 95% service level means
that
950
units
can
be
supplied
immediately from stock and 50 units are
short
The discussion on service levels is based on
a statistical concept known as Expected z
or E(z). E(z) is the expected number of
units short during each lead time
(assumption is that demand is normally
distributed)

Service Level (Continued)

For example, assume that the average
weekly demand for an item is 100 units with
a standard deviation of 10 units. If there is
110 units in the inventory at the beginning
of the week, how many items will be short?

If the demand comes out to be from 111

units to
the number of units short is 1, 2, 3,.,
respectively.

Expected number of short = 1*P(demand =

111 units) + 2*P(demand = 112 units) +
3*P(demand = 113 units) + .+
*P(demand =
)

Service Level
If z = 1 and standard deviation, L = 10
units, then amount of safety stock = z
L = 1*10=10 units
Then, expected number of short is E(z)*
L [E(z) have to be determined from
Exhibit 15.6 for value of z]
Service level = (1 E(z)* L /Inventory or
Ordered Amount)*100%

Service Level Example 1

Consider an economic order quantity

case where annual demand D = 1000
units, economic order quantity Qopt =
200 units, the desired service level P =
0.95, the standard deviation of demand
during lead time L = 25 units, and lead
time L = 15 days. Determine the
reorder point.

Service Level Example 2

Daily demand for a certain product is

normally distributed with a mean of 60
and standard deviation of 7. The source
of supply is reliable and maintains a
constant lead time of 6 days. The cost of
placing an order is $10 and annual
holding costs are $0.50 per unit. There
are no stock-out costs, and unfilled
orders are filled as soon as the order
arrives. Assume sales occur over the
entire year. Find the economic order
quantity and reorder point to satisfy 95%
of the customers from stock on hand.

Fixed Time Period Models

In a fixed time period system, inventory is

counted only at particular times, such as every
week or every month. Counting inventory and
placing orders on a periodic basis is desirable
in situations such as when vendors make
routine visits to customers and take orders for
their complete line of orders.
Fixed-time period model generate order
quantities that vary from period to period
depending on usage rates. These generally
require a higher level of safety stock than a
fixed-order quantity system. It is possible that
some large demand will draw the stock down
to 0 right after an order is placed. This
condition could go unnoticed until the next
review period.

Fixed-Time Period Model

Specified Service Level

With

In a fixed time period system, reorders

are placed at the time of review (T), and
the safety stock that must be reordered is
Safety Stock = zT+L
The quantity to order, q , is
Order quantity = Average demand over the
vulnerable period + Safety Stock
Inventory Currently On Hand (Plus On
Order, If Any)
q = d(T+L) + zT+L I
(1-P)/ T+L
E(z) = dT

EXAMPLE OF THE FIXED-TIME PERIOD MODEL

Given
Given the
the information
information below,
below, how
how many
many units
units should
should
be
be ordered?
ordered?
Average daily demand for a product is 20
units. The review period is 30 days, and lead
time is 10 days. Management has set a policy
of satisfying 96 percent of demand from
items in stock. At the beginning of the
review period there are 200 units in
inventory. The daily demand standard
deviation is 4 units.

EXAMPLE OF THE FIXED-TIME

PERIOD MODEL: SOLUTION (PART 1)
2
2
T+ L = (T + L) d = 30 + 10 4 = 25.298
E(z)
E(z) ==dd T(1-P)/
T(1-P)/T+L
T+L
== 20*30(1-0.96)/25.298
20*30(1-0.96)/25.298
== 0.949
0.949
If
IfE(z)
E(z)==0.949,
0.949,then
thenzz==-0.84
-0.84
[From
[FromExihibit
Exihibit15.6,
15.6,for
forE(z)
E(z)==1.000,
1.000,zz==-0.90,
-0.90,for
forE(z)
E(z)==0.920,
0.920,zz==
-0.80
-0.80

Fixed-Time
(Continued)

Period

Example

The quantity to order = d (T+L)+zT+L I

=20(30+10) + (0.84)*25.298 200
=578.75 or 579
units

Background
Planning

for

ABC

Inventory

Maintaining inventory through counting,

placing orders, receiving stocks, placing
the units in the right place, and so on
takes personnel time and costs money.
When there are limits on these resources,
the logical move is to try to use the
available resources to control inventory in
the best way.
In other words, focus on the most
important items in inventory.

Pareto Principle

In the 19th Century, Villefredo Pareto, in

a study of the distribution of wealth in
Milan, found that 20% of the people
controlled 80% of the wealth.
This logic of the few having the
greatest importance and many having
little importance has been broadened
to include many situations and is
termed the Pareto Principle.

Pareto Principle (Continued)

Pareto principle is true in our everyday lives

and is certainly true in inventory system
(where a few items account for the bulk of
investment).
Any inventory system must specify when an
order is to be placed for an item and how
many units to order. Most inventory control
systems involve so many items that is not
practical to model and give thorough
treatment to each item.
To resolve this, the ABC classification
scheme divides inventory items into three
different groupings: high dollar volume (A),
moderate dollar volume (B), and low dollar
volume (C).

ABC Classification

If the annual usage of items in inventory is

listed according to dollar volume, generally
the list shows that a small number of items
account for a large dollar volume and that a
large number of items account for a small
dollar volume.
The ABC approach divides the list into three
groupings by value: A items constitute
roughly the top 15 percent of the items, B
items the next 35 percent, and C items the
last 50 percent. A items account for roughly
70 percent of the dollar volume, B items
account for around 20 percent of the dollar
volume, and C items account for close to 10
percent of the total dollar volume.

ABC Classification (Continued)

The values are not exactly fixed. The

objective is to separate the important
from unimportant.
The purpose of classifying items into
groups is to establish the appropriate
degree of control over each item.