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Logistics and Supply Chain Management

Chapter 10

Inventory Management

Trung Thao (

Reasons for Holding Stocks

Aggregate Stockholdings

Buffering Supply and Demand

Types of Stock: Raw material, WIP, Finished goods

Cost of Carrying Stock: Unit, Reorder, Holding, and Shortage Cost

Economic Order Quantity (EOQ)

Finding the order size

Finding the time to place orders

Sensitivity Analysis

Weakness of EOQ approach

Uncertain Demand and Safety Stock

Periodic Review Systems
Effort of Stock Control

ABC Analysis

Vendor Manage Inventory


Aggregate Stockholdings
When and how much an organization should buy materials.
Ideally, materials move smoothly and continuously through a supply chain.
When materials stop moving they form stocks. All organizations hold
stocks of some kind.
supplies of goods and materials that are held by an organization.
a list of things held in stock.

Buffering Supply and Demand

Many organizations cannot reduce them.
Ex: - Farmers grow one crop of hay a year,
and then store it to feed animals
throughout the year.
- A distiller stores whisky in barrels for
at least three years before selling it.
- A video store buys copies of videos and
keeps them in stock until people want to
hire them.

These organizations do not want to eliminate stocks,

but they want to control them properly.

Stocks give a buffer between variable and uncertain supply and demand.

They allow operations to continue smoothly and avoid disruptions.

To be more specific, stocks:
act as a buffer between different parts of the supply chain
allow for demands that are larger than expected, or at unexpected times
allow for deliveries that are delayed or too small
take advantage of price discounts on large orders
allow the purchase of items when the price is low and expected to rise
allow the purchase of items that are going out of production
allow for seasonal operations
make full loads and reduce transport costs
give cover for emergencies
can be profitable when inflation is high.

Types of Stock
Raw materials the materials, parts and components
that have been delivered to an organization, but are not yet
being used.

Work in process materials that have started,

but not yet finished their journey through the production

Finished goods goods that have finished

the process and are waiting to be shipped out to customers.

Some stock items do not fall easily into these categories, and
we can define two additional types:
Spare parts for machinery, equipment, and so on
Consumables such as oil, fuel, paper, and so on.

Types of stock (cont.)

Independent Demand System

Dependent demand system: the demand for an item is
found directly from a master schedule.
Independent demand system: the total demand for an
item is made up of lots of separate demands that are not
related to each other.
Ex: The overall demand for bread in a supermarket is made up of lots of
demands from separate customers who act independently.

Independent demand systems control stocks by finding

the best balance between various costs.

Three basic questions

1. What items should we stock?

2. When should we place an order?
3. How much should we order?

Costs of Carrying Stock

Unit Cost (U)
Price charged by the suppliers for one unit of item, or
Total cost to organization of acquiring one unit
$ / unit
Reorder cost (R)
Cost of placing a routine order
$ / order, $/setup
(Estimately, Reorder cost = the total annual cost of the purchasing dept. )
the number of orders it sends out
Holding cost (H)
Cost of holding one unit of the item in stock for one period of
$ / unit-period
Shortage cost (SC)
Cost of having a shortage and not being able to meet demand
from stock
$ / unit-period
Note: The total cost of holding stock is around 25% of its value a year

Janet is a purchasing clerk at Overton Travel Group. She earns
16,000 a year, with other employment costs of 3,000, and has
a budget of 6,200 for telephone, communications, stationery
and postage. In a typical month Janet places 100 orders. When
goods arrive there is an inspection that costs about 15 an order.
The cost of borrowing money is 9%, the obsolescence rate is 5%
and insurance and other costs average 4%.

How can Overton estimate their reorder and

holding costs?

The total number of orders a year:12mon.100order/mon.= 1200 orders/yr.
The reorder cost includes all costs that occur for an order:
salary = 16,000/1200ord./yr = 13.33 an order
employment costs = 3000/1200ord/yr = 2.50 an order
expenses = 6200/1200ord./yr = 5.17 an order
inspection = 15 an order

So the reorder cost is 13.33 + 2.50 + 5.17 + 15 = 36 an order.

Holding costs include all costs that occur for holding stock:
borrowing = 9%
obsolescence = 5%
insurance and taxes = 4%

So the holding cost is 9 + 5 + 4 = 18% of inventory value a year.


Costs of Carrying Stock (cont.)

Cost Flow Assumption
In practice, the most common costing is based on the amount paid and
can use:

FIFO (first in, first out): assumes that stock is sold in the order it
was bought, so the remaining stock is valued at the current
replacement cost

LIFO (last in, first out): assumes that the latest stock is used first,
so the remainder is valued at earlier acquisition costs

Average cost: uses a moving average cost over some periods.


A company bought the following numbers of an item. In July it had 8 units in stock.
What was the value of this stock?
Number bought
Unit price














No right answer to this, it depends on the conventions that we choose to use.
FIFO assumes that the remaining units are the last that were bought, and the value of
the last eight units is
(226) + (324) + (322) = 190
LIFO assumes that the first units bought are still in stock, and the value of these first
eight units is
(621) + (219) = 164
Current replacement cost gives a value of
(826) = 206
A three-month moving average gives a unit price of (22+24+26)/3 = 24, and a value
(824) = 192.


Finding the Order Size
The EOQ:
remains the best way of tackling a wide range of inventory problems.
Imagine a single item, held in stock to meet a constant demand of D per unit
time. Assume that we know:

unit cost
reorder cost (R)
holding cost (H)
no shortages are allowed.

The item is bought in batches from a supplier who delivers after a constant
lead time (L).
Find the best order quantity (Q) and always place orders of this size. There is
no point in carrying spare stock, so we time orders to arrive just as existing
stock runs out. Then we get a series of stock cycles.

Inventory (Stock) level

Finding the Order Size (cont.)

quantity = Q

Usage rate

(max. inventory

on hand

Stock Cycle


Derivation of the EOQ

EOQ: the lot size or order size that minimizes
total annual inventory holding and ordering cost
Under basic EOQ
Amount entering
stock in cycle,

Total cost per cycle

Unit cost

Amount leaving stock

in cycle,


Finding the Order Size (cont.)

At some point an order of size Q arrives. This is used
at a constant rate, D, until no stock is left.
We can find the total cost for the cycle
(= unit cost + reorder cost + holding cost + shortage cost)

No shortages are allowed, so we can ignore

shortages cost, and the cost of buying the item is
constant regardless of the ordering policy.
The cost per unit time (Variable cost) is
C = total reorder costs + total holding costs
+ HQ/2

Variation of Cost with Order Sizes

Optimal Order Quantity is when the Total Cost curve is at its lowest .
This occurs when the Ordering Cost = Holding Cost

Curve of Total Cost

of Holing
and Ordering

Holding Cost Curve
Ordering Cost Curve


Order Quantity

Finding the Order Size (cont.)

From the graph:
the total holding cost rises linearly with order size
the total reorder cost falls as the order quantity increases
large infrequent orders give high total holding costs and low total reorder costs
small frequent orders give low total holding costs and high total reorder costs
adding the two costs gives a total cost curve that is an asymmetric U shape
with a distinct minimum

this minimum cost shows the optimal order size, the economic order quantity, EOQ.
D = demand
R = reorder cost
H = holding cost
Economic order quantity Q:

2 RD
(Stock) cycle length T




John Pritchard buys stationery for Penwynn Motors.

The demand for printed forms is constant at 20 boxes a
month. Each box of forms costs 50, the cost of processing
an order and arranging delivery is 60, and holding cost is
18 a box a year.
What are the economic order quantity, cycle length
and costs?

Listing the values we know in consistent units:

D = 20unit/mon. 12mon. = 240 units a year

U = 50 a unit
R = 60 an order
H = 18 a unit a year.

Substituting these values into the economic order quantity gives:

= 40 units
Then the variable cost is:
C = total reorder costs + total holding costs
= RD/Q + HQ/2 = 60 240/40 + 18 40/2
= 360 + 360 = 720 a year
(You can see that the total reorder costs equal the total holding costs. This is always
true if we order the economic order quantity, so we can simplify the calculation to twice
the total holding cost or C = HQ = 18 40 = 720)

The fixed cost of buying boxes is the number of boxes bought a
year, D, times the cost of each box, U.
total cost = fixed cost + variable cost
= UD

+ C

= 50 240 + 720 = 12,720 a year

We buy 40 boxes at a time, and use 20 boxes a month, so the
stock cycle length is 2 months.
stock cycle length: T = Q/D
T = Q/D
= 40/240 = 1/6 years or 2 months
The best policy, with total costs of 12,720 a year, is to order 40
boxes of paper every 2 months.

Finding the Time to Place Orders

Lead time

When an organization buys materials, there is a lead time between placing

the order and having the materials arrive in stock.

This is the time taken

to prepare an order,
send it to the supplier,
allow the supplier to make or assemble the materials and
prepare them for shipment,
ship the goods back to the customer,
allow the customer to receive and
check the materials and
put them into stock.

Depending on circumstances, this lead time can vary between a few minutes
and months or even years.

Finding the Time to Place Orders (cont.)


the lead time, L: constant

the demand, D: constant

Place an order when the stock level falls to LD. This point is the reorder level (ROL).

Reorder level = lead time demand = lead time demand




Demand for an item is constant at 20 units a week, the reorder cost is 125 an
order and holding cost is 2 an unit a week.
If suppliers guarantee delivery within 2 weeks, what is the best ordering policy
for the item?

Listing the variables in consistent units:

D= 20 units a week

R = 125 an order

H= 2 a unit a week

L = 2 weeks

Substituting these gives:

= 50 units
Reorder level = lead time demand = LD = 2 20 = 40 units
The best policy is to place an order for 50 units whenever stock falls to 40 units.

Reorder Level with Longer Lead Time

When lead time is longer than the
stock cycle
There is always one order outstanding.
when it is time to place order B, there is
one order, A outstanding and due to arrive
before B.

The stock on hand plus the outstanding

order must be enough to last until
B arrive or equal the lead time demand

Stock on hand

Lx D


Stock on order
Stock on order

Lx D

Reorder Level with Longer Lead Time

When lead time is very long
Several orders are outstanding at anytime
When lead time is between n and n+1 cycle length

There are n orders


n x T < L < (n+1) x T


Lead time demand

Stock on order

Lx D

n x Qo

Demand for an item is 5200 units a year and the EOQ is 250 units.
If the lead time is 2 weeks, then ROL = (5200 / 52) 2 = 200 units.
This means that as soon as the stock level falls to 200 units an order equal to EOQ = 250 units should be
This rule of ordering is applicable only if the lead time is shorter than the stock cycle. Here, the stock cycle
is T = Q*/d = 250/100 = 2.5 weeks.
If the lead time is 3 weeks, then the ROL = 100 3 = 300 units. Since EOQ = 250 units, therefore stock
level varies between zero and 250 units.
Thus lead time demand of 300 units suggests that there should be one outstanding order.
In such cases, an order is placed when
Lead time demand = stock on hand + stock on order or ROL = Lead time demand stock on hand
In general, an ordering policy is stated as: when lead time is between n T and (n+1) T, order an amount
Q* whenever stock on hand falls to L D n Q*, where n is number of stock cycle and lead time
exceeds cycle time T.
In this example, lead time of 3 weeks is between 1 and 2 stock cycles, so n = 1, then
ROL = L D n Q*= 3x100 1 250 = 50 units.
i.e each time the stock on hand declines to 50 units, an order of 250 units is placed.

EOQ= 250

EOQ= 250

ROL= 50

ROL= 50


Sensitivity Analysis
Cheng Tau Hang notices that demand for an item his company supplies
is constant at 500 units a month. Unit cost is $100 and shortage costs
are known to be very high.
The purchasing department sends out an average of 3000 orders a
year, and their total operating costs are $180,000. Any stocks have
financing charges of 15%, warehouse charges of 7% and other
overheads of 8% a year.
The lead time is constant at one week.
Find a good ordering policy for the item.
What is the reorder level if the lead time increases to 3 weeks?
What range of order size keeps variable costs within 10% of optimal?
What is the variable cost if orders are placed for 200 units at a time?

Text book : page 264 + 265


Listing the values we know and making sure the units are consistent:
D = 500units/ mon. 12mon./ yr. = 6000 units a year
U = $100 a unit
R = annual cost of purchasing department = 180,000 = $60 an order
number of orders a year
H = (15% + 7% + 8%) of unit cost a year = (0.3) U = $30 a unit a year
L = 1 week
Find the best ordering policy by substituting these values into the equations:
order quantity,
Q = 2RD/H = 2x60x600/30 = 154.9 units
cycle length,
T = Q/D = 154.9/6000 = 0.026 years or 1.3 weeks
variable cost a year C = HQ = 30 154.9 = $4647 a year
total cost a year
= UD + C = 100 6000 + 4647 = $604,647 a year.
The lead time is less than the stock cycle, so:
Reorder level = LD = 1wk 6000unit a yr./52wk/yr. = 115.4 units
The optimal policy is to order 154.9 units whenever stock falls to 115.4 units.
The lead time is greater than the stock cycle (L = 3 weeks), there will be 2 orders outstanding when it is
time to place another. Then:
n =1
n= 2

nT < L < (n+1)T

1x1.3 < 3 > 2 x 1.3
2x1.3 < 3 < 3x1.3. Hence n=2)

Reorder level = lead time demand stock on order

= LD 2Q = 3wk 6000units a yr. / 52wk/yr 2 154.9units = 36.4 units.
To keep variable costs within 10% of optimal, the quantity ordered can vary between 64% and 156% of the economic order quantity, which is 99.1 units to 241.6

If fixed order sizes of 200 units are used the variable costs are:
C = total reorder costs + total holding costs
= RD / Q + HQ / 2 = 60 6000 / 200 + 30 200 / 2 = $4800 a year
We are not using the economic order quantity, so the variable cost is higher and the total reorder costs no longer
equal the total holding costs.

Advantages of this approach

easy to understand and use

giving good guidelines for order size
finding other values (like costs and cycle lengths)
easy to implement and automate
encouraging stability
easy to extend, allowing for different circumstances.


takes a simplified view of inventory systems
assumes demand is known and constant
assumes all costs are known and fixed
assumes a constant lead time and no uncertainty in supplies
gives awkward order sizes at varying times
assumes each item is independent of others
does not encourage improvement, in the way that JIT does.
We can overcome some of these problems by developing more
complicated models.



Demand varies more widely. We will illustrate one approach where
the demand is normally distributed.
Safety stocks: additional stocks to add a margin of safety.
REORDER LEVEL = lead time demand + safety stock = LD + SS



Service level: the probability that a demand is met directly from stock.
Cycle-service level: Service level as the probability of not running out of
stock in a stock cycle.
Suppose that:
Demand for an item is normally distributed with a mean of D per unit time
and standard deviation of . If the lead time is constant at L, the lead-time
demand is normally distributed with mean of LD.
The lead-time demand has a variance of 2L and standard deviation of L.
demand in a single period has mean D and variance 2,
demand in L periods has mean LD and variance L2.
when lead-time demand is normally distributed the safety stock is:
SAFETY STOCK = Z standard deviation of lead-time demand
= ZL


Associated Kitchen Furnishings runs a retail shop to sell a range of
kitchen cabinets.
The demand for cabinets is normally distributed with a mean of 200
units a week and a standard deviation of 40 units.
The reorder cost, including delivery, is 200, holding cost is 6 per
unit a year and lead time is fixed at 3 weeks.
Describe an ordering policy that gives the shop a 95% cycle-service
What is the cost of holding the safety stock in this case?
How much does the cost rise if the service level is set at 97%?


Text book, page 269


Listing the values we know:
D = 200 units a week = 10,400 units a year
= 40 units
R = 200 an order

H = 6 a unit a year
L = 3 weeks

Substituting these values gives:

Q = (2RD/H) = (2 200 200 52/6) = 833 (to the nearest integer)
Reorder level = LD + safety stock = 600 + safety stock
For a 95% service level Z = 1.64 standard deviations from the mean. Then:
safety stock = ZL = 1.64 40 3 = 114 (to the nearest integer)
The best policy is to order 833 units whenever stock falls to 600 + 114 = 714
units. On average orders will arrive when there are 114 units left.
The holding cost of safety stock:
= safety stock holding cost = 114 6 = 684 a year
If the service level is set at 97%, Z becomes 1.88 and:
safety stock = ZL = 1.88 40 3 = 130
The cost of holding this is:
= safety stock holding cost = 130 6 = 780 a year


EOQ analysis uses a fixed order quantity for
purchases, so an order of fixed size is placed
whenever stock falls to a certain level.
Periodic review approach:
orders varying amounts at regular intervals.

long should the interval between orders be?

What is the target stock level?




Assume that the demand for each period is normally distributed with a
mean D and standard deviation , and that both the order period (T)
and lead time (L) are fixed.
target stock level = mean demand over (T+L) + safety stock
= D(T+L) + Z(T+L)
order quantity = target stock level stock on hand


Computing Safety Stock

Order-cycle service level is the probability

that demand during lead time will not
exceed on-hand inventory
A 95% service level means the stockout
risk is 5%, and has a z-score Z95=1.645

Area = .45

left of y-axis =

Tail Area = .05
Z95 = 1.645z

Normal distribution
service levels and

unit normal loss function

Demand for an item has a mean of 200 units a week and
standard deviation of 40 units.
Stock is checked every four weeks and lead time is constant
at two weeks.
Describe a policy that will give a 95% service level. If the
holding cost is 2 a unit a week, what is the cost of the safety
stock with this policy?
What is the effect of a 98% service level?

Solution: Text book, page 273


Listing the values given:
D = 200 units;
= 40 units;
H = 2 a unit a week

T = 4 weeks
L = 2 weeks

For a 95% service level, Z is 1.64 (from a standard package or tables). Then:
safety stock = Z(T+L) = 1.64 40 6 = 161units (to the nearest integer)
target stock level = D(T+L) + safety stock = 200 6 + 161 = 1361units.
When it is time to place an order, the policy is to find the stock on hand, and place an
order for:
order size = target stock level stock on hand = 1361 stock on hand.
If, for example, there are 200 units in stock, we place an order for
1361 200 = 1161 units.
The safety stock is not normally used, so the holding cost:
= safety stock holding cost = 161 2 = 322 a week.

Solution ( cont.)

If the service level is increased to 98%, Z = 2.05. Then:

safety stock = Z(T+L)
= 2.05 40 6 = 201 units
target stock level = D(T+L) + safety stock
= 2006 + 201 = 1401 units
cost of the safety stock is safety stock holding cost
= 201unit 2/unit/wk = 402 a week.


ABC analysis
Vendor managed inventory


ABC Analysis
An ABC analysis puts items into categories that show the amount of
effort worth spending on inventory control. This is a standard Pareto
analysis or rule of 80/20, which suggests that 20% of inventory items
need 80% of the attention, while the remaining 80% of items need
only 20% of the attention. ABC analyses define:
A items as expensive and needing special care
B items as ordinary ones needing standard care
C items as cheap and needing little care.

% of items



% of items

% of use
by value

Cumulative % of
use by value

ABC Analysis (cont.)







Vendor Managed Inventory

-Have another organization look after the stock control.
The most common arrangement of this kind is vendor managed inventory.
-With vendor managed inventory, the wholesaler controls the stocks, and
sends more along when they are needed.
The benefits: the supplier can co-ordinate stocks over a wider area, use
optimal inventory policies, organize transport more efficiently, increase
integration in the supply chain, collect more information about demand
patterns, and give a consistent customer service


1,2,3,4,5,6,7,8 page 280

EOQ sensitivity
Comparing the minimum variable cost, VCo, from ordering batches of EOQ size Qo, with the
variable cost, VC, of ordering any other quantity, Q.
We know that:
VCo = HQo and VC = RD/Q + HQ/2
If we take the ratio of these we get:
VC =



+ HQ


+ HQ

We have


2 RD