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Chapter 13

Inventory Management

Lecture Outline

Elements of Inventory Management


Inventory Control Systems
Economic Order Quantity Models
Quantity Discounts
Reorder Point
Order Quantity for a Periodic Inventory System

Copyright 2011 John Wiley & Sons, Inc.

13-2

What Is Inventory?
Stock of items kept to meet future demand
Purpose of inventory management
how many units to order
when to order

Copyright 2011 John Wiley & Sons, Inc.

13-3

Supply Chain Management


Bullwhip effect

demand information is distorted as it moves away


from the end-use customer
higher safety stock inventories to are stored to
compensate

Seasonal or cyclical demand


Inventory provides independence from vendors
Take advantage of price discounts
Inventory provides independence between
stages and avoids work stoppages

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13-4

Quality Management in the Supply Chain


Customers usually perceive quality service as
availability of goods they want when they want
them
Inventory must be sufficient to provide highquality customer service in QM

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13-5

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

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13-6

Two Forms of Demand


Dependent
Demand for items used to produce final
products
Tires for autos are a dependent demand item

Independent
Demand for items used by external customers
Cars, appliances, computers, and houses are
examples of independent demand inventory

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13-7

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

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13-8

Inventory Control Systems


Continuous system (fixed-order-quantity)
constant amount ordered when inventory declines to
predetermined level

Periodic system (fixed-time-period)


order placed for variable amount after fixed passage
of time

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13-9

ABC Classification
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

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13-10

ABC Classification
PART

UNIT COST

ANNUAL USAGE

$ 60
350
30
80
30
20
10
320
510
20

90
40
130
60
100
180
170
50
60
120

1
2
3
4
5
6
7
8
9
10

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13-11

ABC Classification
PART

9
8
2
1
4
3
6
5
10
7

TOTAL
VALUE

$30,600
16,000
14,000
5,400
4,800
3,900
3,600
3,000
2,400
1,700
$85,400

% OF TOTAL
VALUE

35.9
18.7
16.4
6.3
5.6
4.6
4.2
3.5
2.8
2.0

% OF TOTAL
QUANTITY

6.0
5.0
4.0
9.0
6.0
10.0
18.0
13.0
12.0
17.0

% CUMMULATIVE

A
B
C

6.0
11.0
15.0
24.0
30.0
40.0
58.0
71.0
83.0
100.0

Example 10.1
Copyright 2011 John Wiley & Sons, Inc.

13-12

ABC Classification

CLASS
A
B
C

ITEMS
9, 8, 2
1, 4, 3
6, 5, 10, 7

% OF TOTAL
VALUE

% OF TOTAL
QUANTITY

71.0
16.5
12.5

15.0
25.0
60.0

Example 10.1
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13-13

Economic Order Quantity


(EOQ) Models
EOQ
optimal order quantity that will minimize
total inventory costs

Basic EOQ model


Production quantity model

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13-14

Assumptions of Basic EOQ Model


Demand is known with certainty and is constant
over time
No shortages are allowed
Lead time for the receipt of orders is constant
Order quantity is received all at once

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13-15

Inventory Order Cycle

Inventory Level

Order quantity, Q

Demand
rate

Average
inventory

Q
2

Reorder point, R

Copyright 2011 John Wiley & Sons, Inc.

Lead
time
Order Order
placed receipt

Lead
time
Order Order
placed receipt

Time

13-16

EOQ Cost Model


Co - cost of placing order
Cc - annual per-unit carrying cost

D - annual demand
Q - order quantity

Annual ordering cost =


Annual carrying cost =
Total cost =

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Co D
Q

Co D
Q
CcQ
2
CcQ
2

13-17

EOQ Cost Model


Deriving Qopt
TC =

CoD
Q
Co D

CcQ
2

Cc
TC
=
+
Q2
Q
2
0=
Qopt =

C0D
Q2

Cc

2CoD
Cc

Copyright 2011 John Wiley & Sons, Inc.

Proving equality of
costs at optimal point
CoD
Q

Q =
2

2
Qopt =

CcQ
2
2CoD
Cc
2CoD
Cc

13-18

EOQ Cost Model


Annual
cost ($)

Total Cost
Slope = 0
Carrying Cost =

Minimum
total cost

Ordering Cost =
Optimal order
Qopt

Copyright 2011 John Wiley & Sons, Inc.

CcQ
2

Co D
Q

Order Quantity, Q

13-19

EOQ Example
Cc = $0.75 per gallon
Qopt =
Qopt =

Co = $150

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

Qopt = 2,000 gallons


Orders per year = D/Qopt
= 10,000/2,000
= 5 orders/year
Copyright 2011 John Wiley & Sons, Inc.

TCmin =
TCmin =

D = 10,000 gallons

CoD
Q

CcQ
2

(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
13-20

Production Quantity Model


Order is received gradually, as inventory is
simultaneously being depleted
AKA 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, a.k.a. production rate
d - daily rate at which inventory is demanded

Copyright 2011 John Wiley & Sons, Inc.

13-21

Production Quantity Model


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

Copyright 2011 John Wiley & Sons, Inc.

Time

13-22

Production Quantity Model


p = production rate

d = demand rate

Maximum inventory level = Q - Q d


p
=Q1- d
p
Average inventory level =

Q
12

d
p

Qopt =

2CoD
d
Cc 1 - p

CoD CcQ
d
TC =
+
1- p
Q
2

Copyright 2011 John Wiley & Sons, Inc.

13-23

Production Quantity Model


Cc = $0.75 per gallon

Co = $150

D = 10,000 gallons

d = 10,000/311 = 32.2 gallons per day


2CoD
Qopt =

d
Cc 1 p

2(150)(10,000)
=

CoD CcQ
d
TC =
+
1- p
Q
2
Q
Production run =
p
Copyright 2011 John Wiley & Sons, Inc.

p = 150 gallons per day

32.2
0.75 1 150

= 2,256.8 gallons

= $1,329

2,256.8
= 150

= 15.05 days per order

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Production Quantity Model


Number of production runs =

10,000
D
=
= 4.43 runs/year
2,256.8
Q

d
Maximum inventory level = Q 1 p

= 2,256.8 1 -

32.2
150

= 1,772 gallons

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13-25

Solution of EOQ Models With Excel

The optimal order


size, Q, in cell D8

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13-26

Solution of EOQ Models With Excel

The formula for Q


in cell D10

=(D4*D5/D10)+(D3*D10/2)*(1-(D7/D8))
=D10*(1-(D7/D8))

Copyright 2011 John Wiley & Sons, Inc.

13-27

Solution of EOQ Models With OM Tools

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13-28

Quantity Discounts
Price per unit decreases as order
quantity increases
TC =

CoD
Q

CcQ
2

+ PD

where
P = per unit price of the item
D = annual demand

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13-29

Quantity Discount Model


ORDER SIZE
0 - 99
100 199
200+

PRICE
$10
8 (d1)
6 (d2)

TC = ($10 )
TC (d1 = $8 )

Inventory cost ($)

TC (d2 = $6 )

Carrying cost

Ordering cost
Q(d1 ) = 100 Qopt
Copyright 2011 John Wiley & Sons, Inc.

Q(d2 ) = 200
13-30

Quantity Discount
QUANTITY

PRICE

1 - 49
50 - 89
90+

$1,400
1,100
900

Qopt =

2CoD

For Q = 72.5
TC =
For Q = 90
TC =
Copyright 2011 John Wiley & Sons, Inc.

Cc
Co D
Qopt
Co D
Q

Co = $2,500
Cc = $190 per TV
D = 200 TVs per year
2(2500)(200)
= 72.5 TVs
190

CcQopt
2
CcQ
2

+ PD = $233,784

+ PD = $194,105
13-31

Quantity Discount Model With Excel

=IF(D10>B10,D10,B10)

Copyright 2011 John Wiley & Sons, Inc.

=(D4*D5/E10)+(D3*E10/2)+C10*D5

13-32

Reorder Point

Inventory level at which a new order is placed

R = dL
where
d = demand rate per period
L = lead time

Copyright 2011 John Wiley & Sons, Inc.

13-33

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

Copyright 2011 John Wiley & Sons, Inc.

13-34

Safety Stock
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
P(Demand during lead time <= Reorder Point)

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13-35

Inventory level

Variable Demand With Reorder Point


Q

Reorder
point, R

LT

LT
Time

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13-36

Inventory level

Reorder Point With Safety Stock

Reorder
point, R

Safety Stock

Copyright 2011 John Wiley & Sons, Inc.

LT

Time

LT
13-37

Reorder Point With Variable Demand


R = dL + zd L
where
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
zd L = safety stock

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13-38

Reorder Point For a Service Level


Probability of
meeting demand during
lead time = service level

Probability of
a stockout
Safety stock
zd L
dL
Demand

Copyright 2011 John Wiley & Sons, Inc.

13-39

Reorder Point For Variable Demand


The paint store wants a reorder point with a 95%
service level and a 5% stockout probability
d = 30 gallons per day
L = 10 days
d = 5 gallons per day
For a 95% service level, z = 1.65
R = dL + z d L

Safety stock = z d L

= 30(10) + (1.65)(5)( 10)

= (1.65)(5)( 10)

= 326.1 gallons

= 26.1 gallons

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13-40

Determining Reorder Point with Excel

The reorder point


formula in cell E7

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13-41

Order Quantity for a


Periodic Inventory System
Q = d(tb + L) + zd

tb + L - I

where
d
tb
L
d
zd

= average demand rate


= the fixed time between orders
= lead time
= standard deviation of demand

tb + L = safety stock
I = inventory level

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13-42

Periodic Inventory System

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13-43

Fixed-Period Model With


Variable Demand
d
d
tb
L
I
z

= 6 packages per day


= 1.2 packages
= 60 days
= 5 days
= 8 packages
= 1.65 (for a 95% service level)

Q = d(tb + L) + zd

tb + L - I

= (6)(60 + 5) + (1.65)(1.2)

60 + 5 - 8

= 397.96 packages
Copyright 2011 John Wiley & Sons, Inc.

13-44

Fixed-Period Model with Excel

Formula for order


size, Q, in cell D10

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13-45

Copyright 2011 John Wiley & Sons, Inc.


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13-46