Chapter 4

Inventory control

Lecture Outline
Elements of Inventory Management
Inventory Control Systems
Economic Order Quantity Models
Quantity Discounts
Reorder Point
Order Quantity for a Periodic Inventory
System

What Is Inventory?
Stock of items kept to meet future
demand
Purpose of inventory management

how many units to order

when to order

Types of Inventory
Raw materials
Purchased parts and supplies
Work-in-process (partially completed)
products (WIP)
Items being transported
Spare parts, Tools, and equipment

Two Forms of Demand

Independent

Demand for items used by external

customers
Cars, appliances, computers, and
houses are examples of independent
demand inventory

Dependent

Demand for items used to produce

final products
Tires stored at a plant are an example
of a dependent demand item

Inventory and Quality

Management
Customers usually perceive quality
service as availability of goods they want
when they want them
Inventory must be sufficient to provide
high-quality customer service in TQM

Inventory Costs
Carrying cost
cost of holding an item in inventory

Ordering cost
cost of replenishing inventory

Shortage cost
temporary or permanent loss of sales
when demand cannot be met

Inventory Control Systems

Continuous system (fixedorder-quantity)

constant amount ordered

when inventory declines to
predetermined level

Periodic system (fixed-timeperiod)

order placed for variable

amount after fixed passage of
time

Economic Order Quantity

(EOQ) Models
EOQ

optimal order quantity that will

minimize total inventory costs

Basic EOQ model

Production quantity model

Assumptions of Basic
EOQ Model
Demand is known with certainty and
is constant over time
No shortages are allowed
Lead time (time from ordering to
receipt) for the receipt of orders is
constant
Order quantity is received all at once

Inventory Order Cycle

Order quantity, Q
Inventory Level

Demand
rate

Reorder point, R

Lead
time
Order Order
placed receipt

Lead
time
Order Order
placed receipt

Time

EOQ Cost Model

A - cost of placing order
C - annual per-unit carrying cost

D - annual demand
Q - order quantity

Annual ordering cost =

AD
Q

Annual carrying cost =

CQ
2

Total cost =

AD
Q +

CQ
2

EOQ Cost Model

Deriving Qopt
AD
TC = Q
AD
TC
= - Q2
Q
AD
0 = - Q2
Qopt =

CQ
+ 2
C
+ 2
C
+ 2

2AD
C

Proving equality of
costs at optimal point
AD
Q

CQ
= 2

2AD
Q = C
2

Qopt =

2AD
C

EOQ Cost Model (cont.)

Annual
cost ($)

Total Cost
Slope = 0
CQ
Carrying Cost = 2

Minimum
total cost

AD
Ordering Cost = Q
Optimal order
Qopt

Order Quantity, Q

EOQ Example
C = $0.75 per yard
Qopt =
Qopt =

A = $150

2CoD
Cc
2(150)(10,000)
(0.75)

Qopt = 2,000 yards

Orders per year = D/Qopt
= 10,000/2,000
= 5 orders/year

D = 10,000 yards

AD
CQ
TCmin = Q + 2
TCmin =

(150)(10,000) (0.75)(2,000)
+
2,000
2

TCmin = $750 + $750 = $1,500

Order cycle time = 311 days/(D/Qopt)
= 311/5
= 62.2 store days

Reorder Point
Level of inventory at which a new order
is placed
R = dL
where
d = demand rate per period
L = lead time

Reorder Point: Example

Demand = 10,000 yards/year
Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154
yards/day
Lead time = L = 10 days
R = dL = (32.154)(10) = 321.54 yards

Production Quantity
Model
An inventory system in which an order is
received gradually, as inventory is
simultaneously being depleted
Non-instantaneous receipt model

assumption that Q is received all at once is relaxed

p - daily rate at which an order is received over

time, production rate
d - daily rate at which inventory is demanded

Production Quantity Model

(cont.)
Inventory
level

Q(1-d/p)

Maximum
inventory
level

Q
(1-d/p)
2

Average
inventory
level

0
Order
receipt period

Begin
End
order order
receipt receipt

Time

Production Quantity Model

(cont.)
p = production rate

d = demand rate

Maximum inventory level = Q - Q d

p
=Q1- d
p
Q
d
Average inventory level =
12
p
AD
CQ
d
TC = Q + 2 1 - p

2AD
Qopt =

d
C 1p

Production Quantity Model:

Example
C = $0.75 per yard
A = $150
d = 10,000/311 = 32.2 yards per day
2AD
Qopt =

C 1-

D = 10,000 yards
p = 150 yards per day

2(150)(10,000)
d
p

AD
CQ
d
TC = Q + 2 1 - p

32.2
0.75 1 150

= 2,256.8 yards

= $1,329

2,256.8
Q
Production run =
=
150 = 15.05 days per order
p

Production Quantity Model:

Example (cont.)
10,000
D
Number of production runs =
=
= 4.43 runs/year
2,256.8
Q
Maximum inventory level = Q 1 -

d
p

= 2,256.8 1 -

= 1,772 yards

32.2
150

3. Quantity Discounts Model

Price per unit decreases as order
quantity increases
AD
CQ
TC = Q + 2 + PD
where
P = per unit price of the item
D = annual demand

Cont
The goal : is to reduce price (P) for an item when it is purchased in
larger quantities
Discount Number Discount Quantity Discount (%) Discount Price (P)
1
2
3

0 to 999
1,000 to 1,999
2,000 and over

no discount
4
5

$5.00
$4.80
$4.75

Total Cost = Setup cost(order cost) + Holding cost + Product cost

TC

= DS/Q + QH/2 + PD

Q : Quantity ordered
D : Annual demand in units
S : Ordering or setup cost per order per setup
P : Price per unit
H : Holding cost per unit per year

 The Steps to determine Optimum Quantity order :

1. Calculate value of optimum order for each discount Q* = 2DS/IP,
Holding cost (I) as percentage of unit price (P)
2. If order quantity is too low, adjust the order qty upward to the lowest
qty that will qualify for the discount
3. Compute Total cost for each
4. Select Q* with the lowest total cost
Example : The store stocks toy race cars. Recently, the store has
been given a quantity discount schedule for these cars. The normal
cost for the race car is $5.00. For orders between 1,000 and 1,999
units, the unit cost drops to $4.80; for orders 2,000 or more units, the
unit cost is only$4.75. Furthermore, ordering cost is $49.00 per order,
annual demand is 5,000 race cars and inventory carrying charge as a
percent of cost is 20%. What order quantity will minimize the total
inventory cost?
1. Q1* = 2DS/IP = 2(5,000)(49)/(20%)(5.00)
= 700 cars order

Q2* = 2DS/IP = 2(5,000)(49)/(20%)(4.80)

= 714 cars order

Q3* = 2DS/IP = 2(5,000)(49)/(20%)(4.75)

= 718 cars order

2.
Q1* =
Q2* =
Q3* =

700
1,000 adjusted
2,000 adjusted

3. Calculate Total Cost each discount

Discount
Annual Product Annual
Annual
Total
TC Unit =riceDS/Q
+ Quantity
QH/2 +Cost
PD
Number
(P) Order
Ordering Cost Holding Cost Cost
1
2
3

$5.00
$4.80
$4.75

700
1,000
2,000

$25,000.00
$24,000.00
$23,750.00

$350
$245
$122,5

Annual Product Cost = PD

Annual ordering cost = DS/Q
Annual Holding cost = QH/2 = QIP/2
4. Select Order Quantity at the lowest cost 1,000 units

$350
$480
$950

$25,700
$24,725
$24,823

Quantity Discount: Example

QUANTITY

PRICE

1 - 49
50 - 89
90+

$1,400
1,100
900

Qopt =

2 Co D
Cc

A=
C=
D=

$2,500
$190 per computer
200

2(2500)(200)
= 72.5 PCs
190

For Q = 72.5

CQopt
AD
TC = Q
+
+ PD = $233,784
2
opt

For Q = 90

AD
TC = Q

CQ
+ 2

+ PD = $194,105

Safety Stocks
Safety stock
buffer added to on hand inventory during lead
time

Stockout
an inventory shortage

Service level
probability that the inventory available during
lead time will meet demand

Inventory level

Reorder Point with

a Safety Stock

Q
Reorder
point, R

Safety Stock

LT

LT
Time

Reorder Point With

Variable Demand
R = dL + z d L
where

zd

d = average daily demand

L = lead time

d = the standard deviation of daily demand

z = number of standard deviations
corresponding to the service level
probability (service factor)
L = safety stock

Reorder Point for

a Service Level
Probability of
meeting demand during
lead time = service level

Probability of
a stockout
Safety stock
z d L

dL
Demand

Service factor values for CSL

Reorder Point for

Variable Demand
The carpet store wants a reorder point with a 95%
service level and a 5% stockout probability
d = 30 m per day
L = 10 days
d = 5 m per day
For a 95% service level, z = 1.64
R = dL + z d L

Safety stock = z d L

= 30(10) + (1.64)(5)( 10)

= (1.64)(5)( 10)

= 325.9 m

= 25.9 m

ABC Classification
The items on hand are classified into A, B, and C types
on the basis of the value in terms of capital or annual
dollar usage (i.e., dollar value per unit multiplied by
annual usage rate), and then allocates control efforts
accordingly.
Thus, the items with high value and low volume are kept
in A-type, items with low value and high volume are kept
in C-type, and the items with moderate value and
moderate volumes belong to the B-type.
A ---- very important, B ---- moderately important,
and C-- least important

The actual number of categories varies from

organization to organization, depending on the extent
to which a firm wants to differentiate the control efforts.
Class A

5 15 % of units

70 80 % of value

Class B

30 % of units

15 % of value

Class C

50 60 % of units

5 10 % of value

ABC Classification: Example

PART
1
2
3
4
5
6
7
8
9
10

UNIT COST

ANNUAL USAGE

$ 60
350
30
80
30
20
10
320
510
20

90
40
130
60
100
180
170
50
60
120

ABC Classification:
Example (cont.)
PART

9
8
2
1
4
3
6
5
10
7

TOTAL
PART
VALUE

$30,600
1
16,000
2
14,000
3
5,400
4
4,800
5
3,900
3,600
6
3,000
7
2,400
8
1,700

9
$85,400
10

%UNIT
OF TOTAL
% OFANNUAL
TOTAL
COST
USAGE
VALUE
QUANTITY
% CUMMULATIVE

35.9
$ 60
18.7
350
16.4
30
6.3
5.680
4.630
4.220
3.510
2.8
320
2.0

510
20

6.0
5.0
4.0
9.0
6.0
10.0
18.0
13.0
12.0
17.0

90
A40
130
B60
100
180
170
C
50
60
120

6.0
11.0
15.0
24.0
30.0
40.0
58.0
71.0
83.0
100.0
Example 10.1

ABC Classification:
Example (cont.)
PART

TOTAL
PART
VALUE

9 $30,600
1
8
16,000
2
2
14,000
3
1
5,400
4
4
4,800
5
3
3,900
6
3,600
6
5 CLASS
3,000
7
10
2,400
A8
7
1,700
B
9
C
$85,400

10

%UNIT
OF TOTAL
% OFANNUAL
TOTAL
COST
USAGE
VALUE
QUANTITY
% CUMMULATIVE

35.9
6.0
$ 60
18.7
5.0
350
16.4
4.0
30
6.3
9.0
5.680
6.0
4.630
10.0
4.220% OF TOTAL
18.0
ITEMS
3.510 VALUE
13.0
12.0
9, 8, 22.8
71.0
320
17.0
1, 4, 32.0
16.5
510
6, 5, 10,
7
12.5

20

6.0
90
11.0
A40
15.0
130
24.0
30.0
B60
100
40.0
% OF TOTAL
58.0
180
QUANTITY
71.0
170
C 15.083.0
50
100.0
25.0
60 60.0
120

Example 10.1

Purchasing
Purchasing is an important function of
materials management.
In any industry purchase means buying
of equipments, materials, tools, parts etc.
required for industry.

Objectives of Purchasing
The basic objective of the purchasing
function is to ensure continuity of supply
of raw materials, sub-contracted items
and spare parts and to reduce the
ultimate cost of the finished goods.

Parameters of Purchasing
The success of any manufacturing activity is
largely dependent on the procurement of raw
materials of right quality, in the right quantities,
from right source, at the right time and at right
price popularly known as ten Rs of the art of
efficient purchasing.

Purchase parameters

RIGHT PRICE
RIGHT QUALITY
RIGHT TIME
RIGHT SOURCE
RIGHT QUANTITY
RIGHT ATTITUDE

RIGHT CONTRACT
RIGHT MATERIAL
RIGHT TRANSPORTATION
RIGHT PLACE OF
DELIVERY

Purchasing Procedure

RECOGNITION OF THE NEED

THE SELECTION OF THE SUPPLIER
PLACING THEORDER
FOLLOW-UP OF THEORDER
RECEIVING AND INSPECTION OF THE MATERIALS
PAYMENT OF THEINVOICE
MAINTENANCE OF THE RECORDS
MAINTENANCE OF VENDORRELATIONS

Exercise
The XYZ Ltd. carries a wide assortment of items for its
customers.
One of its popular items has annual demand of 8000 units.
Ordering cost per order is found to be Rs. 12.5. The carrying cost
of average inventory is 20% per year and the cost per unit is Rs.
1.00. Determine the optimal economic quantity and make your
recommendations.