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CHAPTER 12

MANAGING INVENTORIES

CHAPTER 12

DAVID A. COLLIER
AND
JAMES R. EVANS

 Inventory is any asset held for future use or sale.

Objectives:
Maintain sufficient inventory
Incur lowest possible cost
Inventory Management involves planning,
coordinating, and controlling the acquisition,
storage, handling, movement, distribution, and
possible sale of raw materials, component parts
and subassemblies, supplies and tools, replacement
parts, and other assets that are needed to meet
customer wants and needs.

Understanding Inventory

Raw materials, component parts, subassemblies,

and supplies are inputs to manufacturing and servicedelivery processes.

Work-in-process (WIP) inventory consists

partially finished products in various stages
completion that are awaiting further processing.

Finished goods inventory is completed products

ready for distribution or sale to customers.

Safety stock inventory is an additional amount of

inventory that is kept over and above the average
amount required to meet demand.

of
of

Exhibit 12.1

Role of Inventory in the Value Chain

Managing Inventories in Global Supply Chains

Purchasing, tracking, and managing such a variety of items in

global supply chains requires good technology, processes, and

information technology (IT) support.
Purchasing must focus on global sourcing and total system
cost; ensure quality, delivery performance, and technical
support; and seek new suppliers and products and be able to
evaluate their potential to the company.
Environmentally Preferable Purchasing (EPP), or
green purchasing, is the affirmative selection and
acquisition of products and services that most effectively
minimize negative environmental impacts over their life cycle
of manufacturing, transportation, use, and recycling or
disposal.

Inventory Management Decisions and Costs

Inventory managers deal with two fundamental
decisions:
1.

When to order items from a supplier or

when to initiate production runs if the firm
makes its own items

2.

How much to order or produce each time a

supplier or production order is placed

Inventory Management Decisions and Costs

Four categories of inventory costs:

1. Ordering or setup costs

2. Inventory-holding costs
3. Shortage costs
4. Unit cost of the stock-keeping units
(SKUs)

Chapter 12 Managing Inventories

Inventory Management Decisions & Costs

Ordering costs or setup costs are

incurred as a result of the work involved in

placing purchase orders with suppliers or
configuring tools, equipment, and machines
within a factory to produce an item.

Inventory-holding costs or inventory-

carrying costs are the expenses associated

with carrying inventory.

Chapter 12 Managing Inventories

Inventory Management Decisions & Costs

Shortage costs or stockout costs are

the costs associated with a SKU being

unavailable when needed to meet
demand.

Unit cost is the price paid for purchased

goods or the internal cost of producing

them.

Chapter 12 Managing Inventories

Inventory Characteristics

Number of items: each item is identified by a

unique identifier, called a stock-keeping unit
(SKU).

A stock-keeping unit (SKU) is a single

item or asset stored at a particular location.

Chapter 12 Managing Inventories

Inventory Characteristics
Nature of Demand:

Independent demand is demand for an SKU that is

unrelated to the demand for other SKUs and needs to be
forecast.
Dependent demand is demand directly related to the
demand for other SKUs and can be calculated without
needing to be forecast.
Demand can either be constant (deterministic) or
uncertain (stochastic)
Static demand is stable demand.
Dynamic demand varies over time.

Chapter 12 Managing Inventories

Inventory Characteristics
Number and Duration of Time Periods:
Single period

Multiple time periods

Lead Time:
The lead time is the time between

placement of an order and its receipt.

Chapter 12 Managing Inventories

Inventory Characteristics
Stockouts:
A stockout is the inability to satisfy demand

for an item.

A backorder occurs when a customer is

willing to wait for an item.

A lost sale occurs when the customer is

unwilling to wait and purchases the item

elsewhere.

Chapter 12 ABC Inventory Analysis

ABC Inventory Analysis

ABC inventory analysis categorizes SKUs into three
groups according to their total annual dollar usage
1.A items account for a large dollar value but a
relatively small percentage of total items
2.C items account for a small dollar value but a
large percentage of total items

3.B items are between A and C

Chapter 12 ABC Inventory Analysis

ABC Inventory (Pareto) Analysis

A items account for a large dollar value but
relatively small percentage of total items (e.g., 10%
to 30 % of items, yet 60% to 80% of total dollar
value).
C items account for a small dollar value but a
large percentage of total items (e.g., 50% to 60%
of items, yet about 5% to 15% of total dollar value).
These can be managed using automated computer
systems.

B items are between A and C.

Exhibit 12.2

Solved Problem
The data show
projected annual
dollar usage for 20
items. Exhibit 12.3
shows the data
sorted, and indicates
that about 70% of
total dollar usage is
accounted for by the
first 5 items.

Excel ABC Template Before Sorting

Exhibit 12.3

Excel ABC Template After Sorting

Exhibit 12.4

ABC Histogram for the Results from Exhibit 12.3

Chapter 12 Managing Inventories

Managing Fixed Quantity Inventory Systems

In a fixed quantity system (FQS), the order

quantity or lot size is fixed; the same amount, Q,

is ordered every time.

The fixed order (lot) size, Q, can be a box,

pallet, container, or truck load.

Q does not have to be economically

determined, as we will do for the EOQ
model later.

Chapter 12 Managing Inventories

Managing Fixed Quantity Inventory Systems

The process of triggering an order is based on
the inventory position.
Inventory position (IP) is the on-hand

quantity (OH) plus any orders placed but which

have not arrived (scheduled receipts, or SR),
minus any backorders (BO).
IP = OH + SR BO

[12.1]

Chapter 12 Managing Inventories

Managing Fixed Quantity Inventory Systems

When inventory falls at or below a certain
value, r, called the reorder point, a new
order is placed.
The reorder point is the value of the

inventory position that triggers a new order.

Exhibit 12.5

Summary of Fixed Quantity System (FQS)

Exhibit 12.6

Fixed Quantity System (FQS) under Stable Demand

Exhibit 12.7

Fixed Quantity System (FQS) with Highly Variable Demand

Chapter 12 Managing Inventories

The EOQ Model

The Economic Order Quantity (EOQ) model

is a classic economic model developed in the

early 1900s that minimizes total cost, which is
the sum of the inventory-holding cost and the
ordering cost.

Chapter 12 Managing Inventories

The EOQ Model

Assumptions:
Only a single item (SKU) is considered.
The entire order quantity (Q) arrives in the inventory
at one time.
Only two types of costs are relevantorder/setup
and inventory holding costs.
No stockouts are allowed.
The demand for the item is deterministic and
continuous over time.
Lead time is constant.

Chapter 12 Managing Inventories

The EOQ Model

Cycle inventory (also called order or lot size
inventory) is inventory that results from

purchasing or producing in larger lots than are

needed for immediate consumption or sale.

Average cycle inventory

= (Maximum inventory + Minimum inventory)/2
= Q/2
[12.2]

Exhibit 12.8

Cycle Inventory Pattern for the EOQ Model

Chapter 12 Managing Inventories

The EOQ Model

Inventory Holding Cost

The cost of storing one unit in inventory for the

year, Ch, is
Ch = (I)(C)

[12.3]

where
I = annual inventory-holding charge expressed as a
percent of unit cost
C = unit cost of the inventory item or SKU

Chapter 12 Managing Inventories

The EOQ Model

Annual inventory-holding cost is computed as:

annual inventory
holding cost

)(

average
inventory

)=

annual holding
cost per unit

1
QCh
2

[12.4]

The EOQ Model

Ordering Cost
If D = annual demand and we order Q units each time,
then we place D/Q orders/year.
Annual ordering cost is computed as :
annual
ordering cost

)(

number of
orders per year

) ()

cost
per order

where C0 is the cost of placing one order

D
Q

Co

[12.5]

Chapter 12 Managing Inventories

The EOQ Model

Total Annual Cost

Total annual cost is the sum of the inventory holding

cost plus the order or setup cost:

1
D
Co
TC = QCh +
Q
2

[12.6]

Chapter 12 Managing Inventories

The EOQ Model

Economic Order Quantity
The EOQ is the order quantity that minimizes the total
annual cost

Q* =

2DCo
Ch

[12.7]

Chapter 12 Managing Inventories

The EOQ Model

Calculating the Reorder Point
The reorder point, r, depends on the lead time and
demand rate.

Multiply the fixed demand rate d by the length of the

lead time L (making sure they are expressed in the same
units, e.g., days or months):

r = Lead time demand = (demand rate)(lead time)

= (d)(L)

[12.8]

Chapter 12 Managing Inventories

Solved Problem
D = 24,000 cases per year.
Co = $38 per order.
I = 18 percent.
C = $12.00 per case.
Ch = IC = $2.16.
1
24,000
TC = Q($2.16) +
($38.00)
2
Q
2(24,000)(38)
EOQ =
= 919 cases rounded to a whole number.
2.16

Exhibit 12.9

Excel Spreadsheet from EOQ Model Template

Chapter 12 Managing Inventories

Safety Stock and Uncertain Demand in a Fixed

Order Quantity System
When demand is uncertain, using EOQ based on
the average demand will result in a high
probability of a stockout.
Safety stock is additional planned on-hand
inventory that acts as a buffer to reduce the risk of
a stockout.
A service level is the desired probability of not
having a stockout during a lead-time period.

Chapter 12 Managing Inventories

Safety Stock and Uncertain Demand in a

Fixed Order Quantity System
When a normal probability distribution provides a good
approximation of lead time demand, the general expression
for reorder point is
r = mL + zsL
[12.9]
where
mL = average demand during the lead time
sL = standard deviation of demand during the lead time
z = the number of standard deviations necessary to
achieve the acceptable service level
zsL represents the amount of safety stock.

Chapter 12 Managing Inventories

Safety Stock and Uncertain Demand in a

Fixed Order Quantity System
We may not know the mean and standard deviation of
demand during the lead time, but only for some other
length of time, t, such as a month or year. Suppose that mt
and st are the mean and standard deviation of demand for
some time interval t, If the distributions of demand for all
time intervals are identical to and independent of each
other, then

mL = mtL
sL = st L

[12.10]
[12.11]

Chapter 12 Managing Inventories

Solved Problem
Southern Office Supplies, Inc. distributes laser printer
paper.
Ordering costs are $45.00 per order,
One ream of paper costs $3.80,
Annual inventory-holding cost rate is 20%.
The average annual demand is 15,000 reams, or
about 15,000/52 = 288.5 per week
The standard deviation of weekly demand is about 71
The lead time from the manufacturer is two weeks.
Inventory-holding cost is Ch = IC = 0.20($3.80) =
$0.76 per ream per year.

Chapter 12 Managing Inventories

Solved Problem
The average demand during the lead time is
(288.5)(2) = 577 reams,
The standard deviation of demand during the
lead time is approximately 712 = 100
reams.
The EOQ model results in an order quantity
of 1333, reorder point of 577, and total
annual cost of $1,012.92.

Chapter 12 Managing Inventories

Solved Problem
Desired service level of 95%, which results in a stockout
of roughly once every 2 years. For a normal distribution,
this corresponds to a standard normal z-value of 1.645.
r = mL + zsL = 577 = 1.645(100) = 742 reams
This policy increases the reorder point by 742 577 =
165 reams, which represents the safety stock.
The cost of the additional safety stock is Ch times the
amount of safety stock, or ($0.76/ream)(165 reams) =
$125.40.

Exhibit 12.10

Excel FQS Safety Stock Template

Chapter 12 Managing Inventories

Managing Fixed Period Inventory Systems

An alternative to a fixed order quantity system is a
fixed period system (FPS)sometimes called a
periodic review systemin which the inventory position
is checked only at fixed intervals of time, T, rather than
on a continuous basis.
Two principal decisions in a FPS:
1. The time interval between reviews (T), and
2. The replenishment level (M)

Chapter 12 Managing Inventories

Managing Fixed Period Inventory Systems

Economic time interval:

T = Q*/D

[12.12]

Optimal replenishment level without safety stock:

M = d (T + L)
where d = average demand per time period

L = lead time in the same time units

M = demand during the lead time plus
review period

[12.13]

Exhibit 12.10

Summary of Fixed Period Inventory Systems

Exhibit 12.11

Operation of a Fixed Period Systems (FPS)

Chapter 12 Special Models for Inventory Management

Managing Fixed Period Inventory Systems

Uncertain Demand
Compute safety stock over the period T + L.
The replenishment level is computed as:

M = mT+L + zT+L

[12.14]

mT+L = mt (T + L)

[12.15]

T+L = t T + L

[12.16]

Exhibit 12.13

Excel FPS Safety Stock Template

Chapter 12 Special Models for Inventory Management

Single-Period Inventory Model

Applies to inventory situations in which one order
is placed for a good in anticipation of a future
selling season where demand is uncertain.

At the end of the period, the product has either

sold out or there is a surplus of unsold items to
sell for a salvage value.
Sometimes called a newsvendor problem,
because newspaper sales are a typical example.

Chapter 12 Special Models for Inventory Management

Single-Period Inventory Model

Solve using marginal economic analysis.

cs = the cost per item of overestimating demand (salvage

cu = the cost per item of underestimating demand

cost); this cost represents the loss of ordering one

additional item and finding that it cannot be sold.

(shortage cost); this cost represents the opportunity loss

of not ordering one additional item and finding that it
could have been sold.

The optimal order quantity Q* must satisfy:

P (demand Q*) =

cu

cu + cs

[12.17]

Chapter 12 Managing Inventories

Solved Problem
A buyer orders fashion swimwear about six months
before the summer season.
Each piece costs $40 and sells for $60.
At the sale price of $30, it is expected that any
remaining stock can be sold during the August sale.
The cost per item of overestimating demand is equal to
the purchase cost per item minus the August sale price
per item:cs = $40 $30 = $10.
The per-item cost of underestimating demand is the
difference between the regular selling price per item and
the purchase cost per item; that is, cu = $60 $40 =
$20.

Exhibit 12.12

Probability Distribution for Single Period Model

Solved Problem
Assume that a uniform probability distribution ranging
from 350 to 650 items describes the demand.

Chapter 12 Managing Inventories

Solved Problem
The optimal order size Q must satisfy:

P(demand Q*) = cu /(cu + cs)

= 20/(20+10) = 2/3
Because the demand distribution is uniform, the
value of Q* is two-thirds of the way from 350 to
650. This results in Q* = 550.

Exhibit 12.15

Excel Single Period Inventory Template