Inventory Management

Learning Objectives

Describe the different types and uses of

inventory
Describe the objectives of inventory
management
Calculate inventory performance measures
Understand relevant costs associated with
inventory
Understand the role of cycle counting in
inventory record accuracy
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Learning Objectives cont

Understand inventorys role in service organizations

Calculate order quantities
Evaluate the total relevant costs of different
inventory policies
Understand why companies dont always use the
optimal order quantity
Understand how to justify smaller order sizes
Calculate appropriate safety stock inventory policies
Calculate order quantities for single-period inventory

How Companies Use Their

Inventory
1.
2.
3.
4.
5.
6.

Anticipation or seasonal inventory

Fluctuation Inventory or Safety stock: buffer
demand fluctuations
Lot-size or cycle stock: take advantage of
quantity discounts or purchasing efficiencies
Transportation or Pipeline inventory
Speculative or hedge inventory protects
against some future event, e.g. labor strike
Maintenance, repair, and operating (MRO)
inventories
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Objectives of Inventory
Management
Provide desired customer service level

Customer service is the ability to satisfy

customer requirements

Percentage of orders shipped on schedule

Percentage of line items shipped on
schedule
Percentage of $ volume shipped on schedule
Idle time due to material and component
shortages
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Inventory Objectives cont

Provide for cost-efficient operations:

Buffer stock for smooth production flow

Maintain a level work force
Allowing longer production runs & quantity
discounts

Minimum inventory investments:

Inventory turnover
Weeks, days, or hours of supply

Customer Service Level

Examples

Percentage of Orders Shipped on Schedule

Percentage of Line Items Shipped on Schedule

Good measure if orders have similar value. Does not capture value.
If one company represents 50% of your business but only 5% of your
orders, 95% on schedule could represent only 50% of value
Recognizes that not all orders are equal, but does not capture
$ value of orders. More expensive to measure. Ok for finished goods.
A 90% service level might mean shipping 225 items out of the total
250 line items totaled from 20 orders scheduled

Percentage Of Dollar Volume Shipped on Schedule

Recognizes the differences in orders in terms of both line items and

$ value

Inventory Investment Measures Example: The Coach

Motor Home Company has annual cost of goods sold of
$10,000,000. The average inventory value at any point in
time is $384,615. Calculate inventory turnover and
weeks/days of supply.

Inventory Turnover:

Turnover

annual cost of goods sold $10,000,000

26 inventory turns
average inventory value
$384,615

Weeks/Days of Supply:

Weeks of Supply

average inventory on hand in dollars

$384,615

2weeks
average weekly usage in dollars
$10,000,000/52

$384,615
Days of Supply
10 days
$10,000,000/260
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Relevant Inventory Costs

Item Cost Includes price paid for the item plus
Holding
Costs
Capital
Costs

other direct costs associated with

the purchase
Include the variable expenses
incurred by the plant related to the
volume of inventory held (15-25%)
The higher of the cost of capital or
the opportunity cost for the
company

Relevant Inventory Costs

Ordering
Cost
Shortage
Costs
Risk costs

Storage
costs

Fixed, constant dollar amount

incurred for each order placed
Loss of customer goodwill, back
order handling, and lost sales
Obsolescence, damage,
deterioration, theft, insurance and
taxes
Included the variable expenses for
space, workers, and equipment
related to the volume of inventory
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held

Determining Order
Quantities
Lot-for-lot

Order exactly what is needed

Fixed-order
quantity
Min-max
system

Specifies the number of units to order

whenever an order is placed
Places a replenishment order when the
on-hand inventory falls below the
predetermined minimum level.
Order quantity is determined by total
demand for the item for the next n
periods

Order n
periods

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EOQ Assumptions
Demand is known & constant

- no safety stock is required

Lead time is known &
constant
No quantity discounts are
available
Ordering (or setup) costs are
constant
All demand is satisfied (no
shortages)
The order quantity arrives in a
single shipment

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Total Annual Inventory

Cost with EOQ Model
Total annual cost= annual ordering cost +
annual
holding costs
2DS
D
Q

TCQ

H; and Q

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Continuous (Q) Review System Example: A computer

company has annual demand of 10,000. They want to
determine EOQ for circuit boards which have an annual
holding cost (H) of $6/unit, and an ordering cost (S) of $75.
They want to calculate TC and the reorder point (R) if the
purchasing lead time is 5 days.

EOQ (Q)
Q

2DS

2 * 10,000 * $75
500 units
$6

Reorder Point (R)

R Daily Demand x Lead Time

10,000
* 5 days 200 units
250 days

Total Inventory Cost (TC)

10,000
500
$75

$6 $1500 $1500 $3000

500
2

TC

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Economic Production
Quantity (EPQ)
Same assumptions as the EOQ except: inventory
arrives in increments & draws down as it arrives

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Calculating EPQ

Total cost:
TC EPQ

Maximum inventory:

D I MAX

S
H
Q 2

I MAX
d=avg. daily demand rate
p=daily production rate

Calculating EPQ

d
1
p

EPQ

H
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2DS
d
1
p

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EPQ Problem: HP Ltd. Produces premium plant food in 50#

bags. Demand is 100,000 lbs/week. They operate 50

wks/year; HP produces 250,000 lbs/week. Setup cost is
$200 and the annual holding cost rate is $.55/bag.
Calculate the EPQ. Determine the maximum inventory
level. Calculate the total cost of using the EPQ policy.
EPQ

2DS
d
1
p

I MAX

d
Q 1
p

TC EPQ

D I MAX

S
H
Q 2

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EPQ Problem Solution

EPQ

I MAX

2DS
d
1
p

d
Q 1
p

EPQ

2(50)(100,000)(200)
77,850 Bags
100,000

.55 1

250000

100 , 000
MAX 77 , 850 1

250
,
000

46 , 710 bags

5,000,000
46,710

TC
200
.55 $25,690
2

77,850
D I MAX
S
H
Q
2

TC EPQ

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Quantity Discount Model

Same as the EOQ model, except:

Unit price depends upon the quantity

ordered

The total cost equation becomes:

TC QD

D Q
S H
Q 2

CD

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Quantity Discount
Procedure

Calculate the EOQ at the lowest price

Determine whether the EOQ is
feasible at that price

Will the vendor sell that quantity at that

price?

If yes, stop if no, continue

Check the feasibility of EOQ at the
next higher price
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QD Procedure cont

Continue until you identify a feasible EOQ

Calculate the total costs (including total
item cost) for the feasible EOQ model
Calculate the total costs of buying at the
minimum quantity required for each of the
cheaper unit prices
Compare the total cost of each option
& choose the lowest cost alternative
Any other issues to consider?
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Quantity Discount Example: Collins Sport store is

considering going to a different hat supplier. The present

supplier charges $10/hat and requires minimum quantities
of 490 hats. The annual demand is 12,000 hats, the
ordering cost is $20, and the inventory carrying cost is
20% of the hat cost, a new supplier is offering hats at $9 in
lots at
of 4000.
Who
should
heitbuy
from?
EOQ
lowest
price
$9. Is
feasible?
EOQ$9

2(12,000)(20)
516 hats
$1.80

Since the EOQ of 516 is not feasible, calculate the

total cost (C) for each price to make the decision

12,000
$20 490 $2 $10 12,000 $120,980
490
2
12,000
$20 4000 $1.80 $9 12,000 $101,660
C$9
4000
2
C$10

4000 hats at $9 each saves $19,320 annually. Space?

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Why Companies Dont Always

Use Optimal Order Quantity
It is not unusual for companies to order less
or more than the EOQ for several reasons:
They may not have a known uniform
demand;
Some suppliers have minimum order
quantity that are beyond the demand.

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Justifying Smaller Order

Quantities
JIT or Lean Systems would recommend reducing order quantities
to the lowest practical levels

Benefits from reducing Qs:

Improved customer responsiveness (inventory = Lead time)

Reduced Cycle Inventory
Reduced raw materials and purchased components

Justifying smaller EOQs:

2DS
H

Reduce Qs by reducing setup time (S). Setup reduction is

a well documented, structured approach to reducing S

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Determining Safety Stock and

Service Levels

If demand or lead time is

uncertain, safety stock can be
added to improve order-cycle
service levels

R = dL +SS
Where SS =zdL, and Z is the
number of standard
deviations and dL is
standard deviation of the
demand during lead time

Order-cycle service level

The probability that demand
during lead time will not
exceed on-hand inventory
A 95% service level (stockout
risk of 5%) has a Z=1.645

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Periodic Review Systems

Orders are placed at specified, fixed-time intervals

(e.g. every Friday), for a order size (Q) to bring onhand inventory (OH) up to the target inventory
(TI), similar to the min-max system.
Advantages are:

No need for a system to continuously monitor item

Items ordered from the same supplier can be reviewed on
the same day saving purchase order costs

Disadvantages:

Replenishment quantities (Q) vary

Order quantities may not quality for quantity discounts
On the average, inventory levels will be higher than Q
systems-more stockroom space needed
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Periodic Review Systems:

Calculations for TI

Targeted Inventory level:

TI = d(RP + L) + SS
d = average period demand
RP = review period (days, wks)
L = lead time (days, wks)
SS = zRP+L
Replenishment Quantity (Q)=TI-OH
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P System: an auto parts store calculated the EOQ for Drive

Belts at 236 units and wants to compare the Total Inventory
Costs for a Q vs. a P Review System. Annual demand (D)
is 2704, avg. weekly demand is 52, weekly is 1.77 belts,
and lead time is 3 weeks. The annual TC for the Q system is
$229;
H=$97, S=$10.
Q
236

Review Period RP

x 52weeks

2704

x52 5wks

Target Inventory for 95% Service Level

TI d(RP L) SS d(RP L) zRP L

TI 52 units 5 3 1.645 1.77 5 3 416 8 424 belts

Average On-Hand
OHavg= TI-dL=424-(52belts)(3wks) = 268 belts

Annual Total Cost (P System)

52
268
$10
$0.97 115 130 $245
TCp
5
2
Annual Cost Difference $245 $229 $16
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Single Period Inventory

Model
The SPI model is designed for products that
share the following characteristics:

Sold at their regular price only during a single-time period

Demand is highly variable but follows a known probability
distribution
Salvage value is less than its original cost so money is lost
when these products are sold for their salvage value

Objective is to balance the gross profit of the

sale of a unit with the cost incurred when a
unit is sold after its primary selling period
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SPI Model Example: T-shirts are purchase in multiples of

10 for a charity event for $8 each. When sold during the
event the selling price is $20. After the event their salvage
value is just $2. From past events the organizers know the
probability of selling different quantities of t-shirts within a
range from 80 to 120

Payoff

Prob. Of Occurrence
Customer Demand 80
# of Shirts Ordered
80 $960 $960 $960
90 $900 $1080 $1080
Buy 100
$840
110
$780 $ 960
120
$720 $ 900

Table

.20
90
Profit
$960
$1080
$1020
$1140
$1080

.25
100

.30
110

.15
120

.10

$960 $960
$1080 $1040
$1200 $1200 $1200 $1083
$1320 $1320 $1068
$1260 $1440 $1026

Sample calculations:
Payoff (Buy 110)= sell 100($20-$8) ((110-100) x ($8-$2))= $1140
Expected Profit (Buy 100)= ($840 X .20)+($1020 x .25)+($1200 x .30) +
($1200 x .15)+($1200 x .10) = $1083
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Inventory management
within OM: How it all fits
together
Inventory management provides the materials and supplies

needed to support actual manufacturing or service

operations. Inventory replenishment policies guide the
master production scheduler when determining which jobs
and what quantity should be scheduled (Supplement D).
Inventory management policies also affect the layout of the
facility. A policy of small lot sizes and frequent shipments
reduces the space needed to store materials (Ch 7).
Longer throughput times reduce an organizations ability to
respond quickly to changing customer demands (Ch 4).
Good inventory management assures continuous supply and
minimizes inventory investment while achieving customer
service objectives.

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Inventory Management
Across the Organization
Inventory management policies affect
functional areas throughout

Accounting is concerned of the cost

implications of inventory
Marketing is concerned as stocking
decision affect the level of customer
service
Information Systems tracks and controls
inventory records
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Exercise 1

A toy manufacturer uses approximately 36,000

silicon chips annually. The chips are used at a steady
rate during the 240 days the plant operates. Annual
holding cost is 50 cents per chip, and ordering cost
(per order) is $25/order. Assume that each of their
orders comes in one batch. Determine:

a. .the best order quantity

b. demonstrate that your order quantity is optimal by
showing that annual ordering costs = annual holding costs
c. the average inventory level
d. the number of orders per year
e. the number of working days between orders (Hint: days
between orders = # days in a year / # of orders per year.
Why?)

Exercise 2

Problem 2. The Dine Corporation is both a producer

and a user of brass couplings. The firm operates
200 days a year and uses the couplings at a steady
rate of 50 per day. Couplings can be produced at a
rate of 150 per day. Inventory holding cost is
estimated at $5 per unit per year. Machine setup
costs are $40 per production run. Determine:

a. the best production run size

b. demonstrate that your production run size is optimal by
showing that annual set up costs = annual holding costs
(Hint: find the formula of holding and setup cost for EPQ
model in my lecture note.)
c. the maximum inventory level (Hint: find the formula in
the derivation of EPQ)
d. the number of production runs per year
e. the cycle time and the production time within each cycle
(Hint: cycle time is given by Q/d and production time is
given by Q/p. Why? Think before using the formula)

Exercise 3

Problem 3
A small manufacturing firm used roughly 3,400
pounds of chemical dye each year. Currently the firm
purchases 300 pounds per order and pays $3 per
pound. The supplier has just announced that orders
of 1,000 pounds or more will be filled at a price of
$2.5 per pound. The manufacturing firm incurs a cost
of $100 each time it submits an order and assigns an
annual holding cost of 20% of the purchase price per
pound.

a. determine the best order size that minimizes the total cost
b. if the supplier offered the discount at 2,500 pounds instead
of at 1,000 pounds, what order size would minimize total
cost?

Exercise 4

Problem 4: A product is ordered four times every

year. Inventory carrying cost is $20 per unit per
year, and the cost of shortage for each unit is $40.
Given the following demand probabilities during
the reorder period
Lead Time
Demand

40

80

120

160

Probability

0.1

0.25

0.3

0.25

0.1

Problem 4 (continued)

a) What is the average lead time demand?

b) What would be the reorder point without
safety stock?
c) What would be the probabilities of the
following shortage levels if the company uses
the reorder point without safety stock?

Problem 4 (continued)

Shortage Level
Probability

40

80

d) Follow the Litely example in my lecture to find

out the best safety stock level to minimize the total
cost.
e) What is the reorder point to achieve the 95%
service level? What is the associated safety stock?
(Hint: you need to follow the example in my lecture
note under Case 1)

Inventory turnover

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What is the inventory turnover ratio

as compared to the industry
average?
Inv. turnover

=
=

Inv. T.

Sales
Inventories
$7,036 = 4.10x.
$1,716

2003E

2002

2001

Ind.

4.1x

4.5x

4.8x

6.1x

Comments on Inventory
Turnover

Inventory turnover is below

industry average.
Firm might have old inventory, or
its control might be poor.
No improvement is currently
forecasted.

Advantages of Rapid
Turnover

Increased sales volume

Less risk of obsolescence and
markdowns
Money for market opportunities
Decreased operating expenses
Increased asset turnover

Disadvantages of Rapid
Rate of Turnover

Lowered sales volume.

Increased cost of goods sold.

Increase logistics costs: expanded

buying and ordering time.

Inventory Carrying Costs

Capital costs on inventory

investment.
Inventory service costs.
Storage space costs.
Inventory risk costs.

Capital Costs on Inventory

Opportunity
cost of capital: rate of return
Investment.

if money were invested elsewhere.

Hurdle rate: minimum rate of return on
new investments.
--Can we make more money earning
interest in marketable securities?
--Can we make more money retiring debt,
thus eliminating interest charges?

Capital Costs on Inventory

Investment -- Cash Value of
Inventory

Manufacturers:
--Direct costs: fixed/variable determined
and only variable costs counted.
--Absorption (full costing) fixed
overhead is calculated in inventory
value.
Wholesalers and retailers:
--Replacement cost (plus freight).
--Market price if product phased out.

Inventory Service Costs

Taxes
--Ad valorem (personal property)
taxes.
--Vary with size of inventory.
Insurance
--Somewhat fixed.

Storage Space Costs

Plant warehouses. Fixed costs

(except for variable throughput
costs).
Public warehouses.
Rented or leased warehouses.
Company-owned warehouses.

Inventory Risk Costs

Obsolescence costs.
Damage costs.
Shrinkage costs.
Relocations costs (transshipped to
another warehouse to avoid
obsolescence).

Turnover Affects Inventory

Carrying Costs
Net sales_______
=
$1,000,000
Average inventory at retail =
$1,000,000
Turnover = 1

Turnover Affects Inventory

Carrying Costs
Net sales_______
=
$1,000,000
Average inventory at retail =
$1,000,000
Turnover = 1
Inventory carrying costs = 30%
Inventory carrying costs = $300,000

Turnover Affects Inventory

Carrying Costs
Net sales_______
= $1,000,000
Average inventory at retail = $ 500,000
Turnover = 2
Inventory carrying costs = 30%
Inventory carrying costs = $150,000
Savings = $150,000

Turnover Affects Inventory

Carrying Costs
Inventory
turns

Average
inventory

30% carry
cost

Carry cost
savings (from
$ previous cost)

$1,000,000 $300,000

-0-

$500,000

$150,000

$150,000

$333,333

$100,000

$100,000

$250,000

$75,000

$25,000

Turnover Affects Inventory

Carrying Costs
Inventory
turns

Average
inventory

30% carry
cost

Carry cost
savings (from
$ previous cost)

$1,000,000 $300,000

-0-

$500,000

$150,000

$150,000

$333,333

$100,000

$100,000

$250,000

$75,000

$25,000

Turnover Affects Inventory

Carrying Costs
Inventory
turns

Average
inventory

30% carry
cost

Carry cost
savings (from
$ previous cost)

10

$100,000

$30,000

3,333

11

$ 90,909

$27,273

$2,727

12

$83,333

$25,000

$2273

13

$76,923

$23,077

$1,923