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14

e
Operations and
Supply Chain
Management
CHASE | SHANKAR | JACOBS

201

INVENTORY
MANAGEMENT

Chapter Twenty
McGraw-Hill/Irwin

Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.


202

LO201: Explain how inventory is


used and understand what it costs
LO202: Analyze how different
inventory control systems work

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Learning Objectives

LO203: Analyze inventory using the


Pareto principle
203

Inventory can be visualized as stacks of money


sitting on forklifts, on shelves, and in trucks and
planes while in transit.
For many businesses, inventory is the largest asset
on the balance sheet at any given time.
Inventory can be difficult to convert back into
cash.
It is a good idea to try to get your inventory down
as far as possible.

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Inventory

The average cost of inventory in the United States is 30


to 35 percent of its value.
204

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reserved.

Supply Chain
Inventory Models

205

Single-period model
Used when we are making a one-time purchase of
an item
Fixed-order quantity model
Used when we want to maintain an item in-stock,
and when we restock, a certain number of units
must be ordered

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Inventory Models

Fixedtime period model


Item is ordered at certain intervals of time

206

Inventory: the stock of any item or resource used


in an organization
Includes raw materials, finished products, component
parts, supplies, and work-in-process
Manufacturing inventory: refers to items that
contribute to or become part of a firms product

Inventory system: the set of policies and controls


that monitor levels of inventory

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Definitions

Determines what levels should be maintained, when


stock should be replenished, and how large orders
should be
207

To maintain
independence of
operations

To meet variation
in product demand

To provide a
safeguard for
variation in raw
material delivery
time

To allow flexibility
in production
scheduling

To take advantage
of economic
purchase order
size

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Purposes of Inventory

208

Holding (or carrying)


costs
Costs for storage, handling,
insurance, and so on

Ordering costs
Costs of placing an order

Setup (or production


change) costs
Costs for arranging specific
equipment setups, and so
on

Costs
Shortage costs
Costs of running out

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Inventory Costs

209

Independent demand the


demands for various items are
unrelated to each other
For example, a workstation may
produce many parts that are
unrelated but meet some external
demand requirement

Dependent demand the


need for any one item is a
direct result of the need for
some other item

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Demand Types

Usually a higher-level item of which it


is part

2010

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reserved.

Inventory Control-System
Design Matrix

2011

Single-period inventory
model
One-time purchasing decision
(e.g., vendor selling T-shirts at
a football game)
Seeks to balance the costs of
inventory overstock and under
stock

Multi-period inventory models

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Inventory Systems
Comparison

Fixed-order quantity models


Event triggered (e.g., running out of
stock)
Fixed-time period models
Time triggered (e.g., monthly sales
call by sales representative)
2012

Consider the problem of


deciding how many
newspapers to put in a hotel
lobby
Too few papers and some
customers will not be
able to purchase a paper,
and profits associated
with these potential sales
are lost.

Too many papers and the


price paid for papers that
were not sold during the
day will be wasted,
lowering profit.

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Single Period
Inventory Model

2013

Consider how much risk we are willing to take of running


out of inventory.
Assume a mean of 90 papers and a standard deviation of
10 papers.
Assume we want an 80 percent chance of not running
out.
Assume that the probability distribution associated of
sales is normal, stocking 90 papers yields a 50 percent
chance of stocking out.

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Solving the
Newspaper Problem

2014

From Appendix E, we see that


we need approximately 0.85
standard deviation of extra
papers to be 80 percent sure of
not stocking out.
Using Excel, =NORMSINV(0.8) =
0.84162

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Solving the
Newspaper Problem

2015

Where:
Co = cost per unit of demand over stocking level
Cu = cost per unit of demand under stocking level
P = probability that a given unit will be sold

We should increase the size of the


inventory so long as the probability
of selling the last unit added is equal

to or greater than the ratio

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Single-Period
Inventory Models

2016

Mean demand is 5
Standard deviation of demand is 3
Room rate is $80 (this is the cost if
overbookings are less than cancelations - Cu)
Penalty for overbooking is $200 (this is the cost
if overbookings are more than cancelations Co)
For the Excel template visit
www.mhhe.com/sie-chase14e

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Example 20.1

Excel: Overbo
oking
2017

From Appendix E, we see that our


desired level falls about 0.55
standard deviations below the mean
(z = -0.55)
Using Excel,
=NORMSINV(0.2857)
= 0.56599

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Example 20.1

2018

and we have zero noshows, we incur the


penalty of $200 one
person must be
compensated for
having no room.
If we overbook by 1
and we have three noshows, we have lost
sales of $80.

Total cost of a policy of


overbooking by 9
rooms is the weighted
average of the events
(number of no-shows)
and the outcome of
those events.

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Example 20.1 Overbooking


Table
If we overbook by 1

2019

Overbooking of airline flights

Ordering of clothing and other fashion items

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Single Period Model


Applications

One-time order for events e.g., t-shirts for a


concert

2020

Fixed-order quantity models


- Also called the economic
order quantity, EOQ, and Qmodel
- Event triggered

Fixedtime period models


- Also called the periodic system,
periodic review system, fixedorder interval system, and P-mode
- Time triggered

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Multi-Period Models

2021

Fixed-Order Quantity
Inventory remaining must
be continually monitored
Has a smaller average
inventory
Favors more expensive
items
Is more appropriate for
important items
Requires more time to
maintain but is usually
more automated
Is more expensive to
implement

Fixed-Time Period
Counting takes place only at
the end of the review period
Has a larger average
inventory
Favors less expensive items
Is sufficient for lessimportant items
Requires less time to
maintain
Is less expensive to
implement

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Multi-Period Models
Comparison

2022

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reserved.

Multi-Period Models
Comparison

2023

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Multi-Period Models
Process

2024

Demand for the product is constant and


uniform throughout the period.
Lead time (time from ordering to receipt) is
constant.
Price per unit of product is constant.
Inventory holding cost is based on average
inventory.

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Fixed-Order Quantity Models


Assumptions

Ordering or setup costs are constant.


All demands for the product will be satisfied.
2025

Always order Q units when


inventory reaches reorder
point (R).

Inventory is consumed at
a constant rate, with a
new order placed when
the reorder point (R) is
reached once again.

Inventory arrives after


lead time (L). Inventory
is raised to maximum
level (Q).

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Fixed-Order Quantity
Model

2026

The optimal order


quantity (Qopt) occurs
where total costs are at
their minimum

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Economic Order
Quantity (EOQ)

2027

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Example 20.2
Annual
demand (D) =

1,000 units
Average daily demand
= =

2.74 units

Ordering cost (S) = $5


per order
Holding cost (H) =
$1.25 per unit per year
Lead time (L) = 5 days
Cost per unit (C) =
$12.50
For the Excel template visit
www.mhhe.com/sie-chase14e

Excel: Economi
c Order Quanti
ty
2028

Safety stock refers to the amount of inventory


carried in addition to expected demand.
Safety stock can be determined based on many different criteria.
A common approach is to simply keep a certain
number of weeks of supply.

A better approach is to use probability.

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Establishing Safety
Stock Levels

Assume demand is normally distributed.


Assume we know mean and standard deviation.
To determine probability, we plot a normal distribution for expected demand
and note where the amount we have lies on the curve.
2029

Demand is variable,
but follows a known
distribution/

After the reorder is placed,


demand during the lead time
may be higher than expected,
consuming some (or all) of the
safety stock/

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Fixed-Order Quantity Model


with Safety Stock

2030

daily demand
Average

() = 60

Annual demand (D) =


60(365) = 21,900

Standard deviation of
demand during lead time
(D) = 7

Ordering cost (S) = $10


per order

Holding cost (H) = $0.50


per unit per year

Lead time (L) = 6 days


For the Excel template visit
www.mhhe.com/sie-chase14e

Policy place a new


order for 936 units
whenever stock
falls to 388 units on
hand. This results in
a 95% probability of
not stocking out
during the lead
time.

For 95%
probabilit
y, z =
1.64.

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Example 20.4

Excel: Reorder
Point
2031

q
= quantity to be ordered
T = number of days between reviews
L = lead time in days
= forecast average daily demand
Z = number of standard deviations required for
specific service level
T+L= standard deviation of demand during the
review and lead time
I = current inventory level (including items on
order)

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Fixed-Time Period
Model

2032

Time periods
are equal,
but ending
inventory
varies.

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Fixed-Time Period
Model

Reorder quantity varies,


depending upon ending
inventory level. Beginning
inventory is always the
same.
2033

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Example 20.5
Daily

demand () of 10

units
Daily standard deviation
() of 3 units
Review period (T) of 30
days
Lead time (L) of 14 days
98 percent of demand
should be met from
items in stock
150 units in inventory (I)
For the Excel template visit
www.mhhe.com/sie-chase14e

Excel: Fixed Ti
me Period Model
2034

Average inventory
expected
amount of
inventory over
time
Inventory turns
number of times
inventory is cycled
through over time
a measure of
how efficiently

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Inventory Control and Supply


Chain Management

2035

Price varies with the order size.


To find the lowest-cost, calculate the order
quantity for each price and see if the quantity
is feasible.
Sort prices from lowest to highest and calculate the order
quantity for each price until a feasible order quantity is
found.

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Inventory Models with Price


Breaks

If the first feasible order quantity is the lowest price, this is


best; otherwise, calculate the total cost for the first
feasible quantity and calculate total cost at each price
lower than the first feasible order quantity.
2036

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Inventory Models with Price


Breaks

2037

Annual demand (D ) =
10,000
Ordering cost (S ) =
$20 per order
Interest/carrying cost (i
) = 20%

Cost per unit (C )


1499 $5.00
500999 $4.50

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Example 20.8

1000 or more $3.90


2038

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reserved.

Example 20.8

2039

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reserved.

ABC Classification

2040

Inventory accuracy
refers to how well the
inventory records
agree with physical
count

Cycle counting a
physical inventorytaking technique in
which inventory is
counted on a frequent
basis rather than once
or twice a year

Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights
reserved.

Inventory
Management

2041