Chapter 17

Inventory Control

McGraw-Hill/Irwin Copyright 2011 The McGraw-Hill Companies, All Rights Reserved

 Learning Objectives

1. Explain the different purposes for keeping inventory.

2. Understand that the type of inventory system logic that
is appropriate for an item depends on the type of
demand for that item.
3. Calculate the appropriate order size when a one-time
purchase must be made.
4. Describe what the economic order quantity is and how
to calculate it.
5. Summarize fixedorder quantity and fixedtime period
models, including ways to determine safety stock when
there is variability in demand.
6. Discuss why inventory turn is directly related to order
quantity and safety stock.

17-2
 Inventory

You should visualize inventory as stacks of

money sitting on forklifts, on shelves, and in
trucks and planes while in transit
For many businesses, inventory is the largest
asset on the balance sheet at any given time
Inventory is often not very liquid
It is a good idea to try to get your inventory
down as far as possible
The average cost of inventory in the United States
is 30 to 35 percent of its value

LO 1
17-3
 Supply Chain InventoriesMake-
to-Stock Environment

LO 1
17-4
 Models Discussed

1. The single-period model

Used when we are making a one-time
purchase of an item
2. Fixedorder quantity model
Used when we want to maintain an item
in-stock, and when we restock, a certain
number of units must be ordered
3. Fixedtime period model
The item is ordered at certain intervals of
time
LO 2
17-5
 Definition of Inventory

Inventory: the stock of any item or resource

used in an organization and can include: raw
materials, finished products, component parts,
supplies, and work-in-process
Manufacturing inventory: refers to items that
contribute to or become part of a firms product
Inventory system: the set of policies and
controls that monitor levels of inventory and
determines what levels should be maintained,
when stock should be replenished, and how
large orders should be
LO 2
17-6
 Purposes of Inventory

1. To maintain independence of
operations
2. To meet variation in product demand
3. To allow flexibility in production
scheduling
4. To provide a safeguard for variation in
raw material delivery time
5. To take advantage of economic
purchase-order size
LO 2
17-7
 Inventory Costs

1. Holding (or carrying) costs

Costs for storage, handling, insurance,
and so on
2. Setup (or production change) costs
Costs for arranging specific equipment
setups, and so on
3. Ordering costs
Costs of placing an order
4. Shortage costs
Costs of running out
LO 3
17-8
 Independent Versus Dependent
Demand

Independent demand: the demands

for various items are unrelated to each
other
For example, a workstation may produce
many parts that are unrelated but meet
some external demand requirement
Dependent demand: the need for any
one item is a direct result of the need
for some other item
Usually a higher-level item of which it is
part
LO 2
17-9
 Inventory Control-System Design Matrix:
Framework Describing Inventory Control
Logic

LO 2
17-10
 Inventory Systems

Single-period inventory model

One time purchasing decision (Example:
vendor selling t-shirts at a football game)
Seeks to balance the costs of inventory
overstock and under stock
Multi-period inventory models
Fixed-order quantity models
Event triggered (Example: running out of stock)
Fixed-time period models
Time triggered (Example: Monthly sales call by
sales representative)
LO 2
17-11
 A Single-Period Inventory Model

Consider the problem of deciding how

many newspapers to put in a hotel
lobby
Too few papers and some customers
will not be able to purchase a paper
and they will lose the profit associated
with these sales
Too many papers and will have paid for
papers that were not sold during the
day, lowering profit
LO 3
17-12
 A Simple View of the Problem

Consider how much risk we are willing

to take for running out of inventory
Assume a mean of 90 papers and a
standard deviation of 10 papers
Assume they want an 80 percent
chance of not running out
Assuming that the probability
distribution associated of sales is
normal, stocking 90 papers yields a 50
percent chance of stocking out
LO 3
17-13
 A Simple View of the Problem Continued

To be 80 percent sure of not stocking

out, we need to carry a few more than
90 papers
From the cumulative standard normal
distribution table, we see that we need
approximately 0.85 standard deviation
of extra papers to be 80 percent sure of
not stocking out
With Excel, =NORMSINV(0.8) = 0.84162

LO 3
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 Single-Period Inventory Model
Formulas
Cu
P
Co Cu

Where :
Co Cost per unit of demand over estimated
Cu Cost per unit of demand under estimated
P Probability that the unit will be sold

We should increase the size of the inventory so

long as the probability of selling the last unit added
is equal to or greater than the ratio of Cu/Co+Cu
LO 3
17-15
 Multi-Period Models

There are two general types of multi-

period inventory systems
1. Fixedorder quantity models
Also called the economic order quantity, EOQ,
and Q-model
Event triggered
2. Fixedtime period models
Also called the periodic system, periodic
review system, fixed-order interval system,
and P-model
Time triggered
LO 5
17-16
 Key Differences

To use the fixedorder quantity model,

the inventory remaining must be
continually monitored
In a fixedtime period model, counting
takes place only at the review period
The fixedtime period model
Has a larger average inventory
Favors more expensive items
Is more appropriate for important items
Requires more time to maintain
LO 5
17-17
 FixedOrder Quantity and Fixed
Time Period Differences

LO 5
17-18
 Comparison for FixedOrder Quantity
and FixedTime Period Inventory
Systems

LO 5
17-19
 Fixed-Order Quantity Model
Models

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
LO 4
17-20
 Basic FixedOrder Quantity Model

LeadOrder
Place time

Receive order

Use inventory

LO 4
17-21
 Basic Fixed-Order Quantity (EOQ)
Model Formula
D Q
TC = DC + S+ H
Q 2

TC Total annual cost

D Demand
C Cost per unit
Q Order quantity
S Cost of placing an order or setup cost
R Reorder point
L Lead time
H Annual holding and storage cost per unit of inventory
LO 4
17-22
 Annual Product Costs, Based on
Size of the Order

LO 4
17-23
 Example 17.2

D 1,000 units
d 1,000/365
S $5 per order
H $1.25 per unit per year
L 5 days
C $12.50
2 DS 21,000 5
Qopt 8,000 89.4 units
H 1.25
1,000
R dL 5 13.7 units
365
D Q
TC DC S H
Q 2
1,000
1,000 $12.50 $5 89 $1.25
89 2
LO 4 $12,500 $56.18 $55.63 $12,611.81
17-24
 Establishing Safety Stock Levels

Safety stock: amount of inventory carried in

addition to expected demand
Safety stock can be determined based on many
different criteria
A common approach is to simply keep a
certain number of weeks of supply
A better approach is to use probability
Assume demand is normally distributed
Assume we know mean and standard deviation
To determine probability, we plot a normal distribution
for expected demand and note where the amount we
have lies on the curve
LO 4
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 FixedOrder Quantity Model with
Safety Stock

LO 5
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 FixedOrder Quantity Model with
Safety Stock
R d L z L

R Reorder point in units

d Average daily demand
L Lead time in days
z Number of standard deviations for a service probability
L Standard deviation of usage during lead time

LO 5
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 Example 17.4

d 60 2 DS
Qopt
D 60 365 21,900 H
d 7 2 21,90010

S $10 0.50
H $0.50 936 units
L6
L

d2 L d2 6 7 17.15
2
L
i 1

R d L z L
60 6 1.6417.15
388 units
LO 5
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 Fixed-Time Period Models

q = d(T + L) + Z T + L - I

Order
Average
quantity
Vulnerable
daily
Safety
period
stock
Inventory on hand
demand
Where :
q = quantitiy to be ordered
T = the number of days between reviews
L = lead time in days
d = forecast average daily demand
z = the number of standard deviations for a specified service probability
T + L = standard deviation of demand over the review and lead time
I = current inventory level (includes items on order)
LO 5
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 FixedTime Period Inventory Model

LO 5
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 Example 17.5

Daily demand of 10 q d T L z T L I
units 10 30 14 2.05 T L 150

Daily standard T L

deviation of 3 units T L
i 1
2
d

Review period of 30 T L d2 30 14 32 19.9

days
Lead time of 14 days q 10 30 14 2.0519.9 150
Satisfying 98 percent 331 units

of demand from items

in stock
150 Units in inventory

LO 5
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 Inventory Control and Supply
Chain Management

Q
Average inventory SS
2

D
Inventory turn
Q SS
2

LO 6
17-32
 Price Break Models

Price varies with the order size

To find the lowest-cost, need to calculate the
order quantity for each price and see if the
quantity is feasible
1. Sort prices from lowest to highest and calculate
the order quantity for each price until a feasible
order quantity is found
2. If the first feasible order quantity is the lowest
price, this is best, otherwise, calculate the total
cost for the first feasible quantity and calculate
total cost at each price lower than the first feasible
order quantity
LO 4
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 Curves for Three Separate Order
Quantity Models in a Three-Price-Break
Situation

LO 4
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 Example 17.8: The Data and Order
Quantities

2 DS
D = 10,000 Q
iC
S = $20 210,000 20
Q1 499 633
i = 20 percent 0.20 5.00
210,000 20
Cost per unit Q500 999 667
0.20 4.50
1-499 $5.00
210,000 20
500-999 $4.50 Q1, 000 716
0.20 3.90
1,000 and up $3.90

LO 4
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 Example 17.8: The Solution

LO 4
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 ABC Classification

LO 2
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 Inventory Accuracy and Cycle
Counting

Inventory accuracy: refers to how well

the inventory records agree with
physical count
Cycle counting: a physical inventory-
taking technique in which inventory is
counted on a frequent basis rather than
once or twice a year

LO 2
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