Chapter 12

Inventory Management
Operations
Operations Management
Management -- 55thth Edition
Edition
Roberta Russell & Bernard W. Taylor, III

Copyright 2006 John Wiley & Sons, Inc.

Beni Asllani
University of Tennessee at Chattanooga

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 2006 John Wiley & Sons, Inc.

12-2

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

how many units to order

when to order

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12-3

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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12-4

Inventory and 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 stop-pages
Copyright 2006 John Wiley & Sons, Inc.

12-5

Two Forms of Demand

Dependent

Demand for items used to produce

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

Independent

Demand for items used by external

customers
Cars, appliances, computers, and
houses are examples of independent
demand inventory
Copyright 2006 John Wiley & Sons, Inc.

12-6

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

Copyright 2006 John Wiley & Sons, Inc.

12-7

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
Copyright 2006 John Wiley & Sons, Inc.

12-8

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

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12-9

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
Copyright 2006 John Wiley & Sons, Inc.

12-10

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

Copyright 2006 John Wiley & Sons, Inc.

12-11

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
CLASS
3,000
7
2,400
A
8
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
VALUE
3.510
13.0
12.0
9, 8,2.8
2
71.0
320
17.0
1, 4,2.0
3
16.5
5107
6, 5, 10,
12.5

20

Copyright 2006 John Wiley & Sons, Inc.

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
83.0
50 15.0
100.0
25.0
60 60.0
120

Example 10.1

12-12

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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12-13

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

Copyright 2006 John Wiley & Sons, Inc.

12-14

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

Copyright 2006 John Wiley & Sons, Inc.

Time

12-15

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 =

CoD
Q

Co D
Q
CcQ
2
CcQ
2

Copyright 2006 John Wiley & Sons, Inc.

12-16

EOQ Cost Model

Deriving Qopt
TC =

Co D
Q

CoD

CcQ

Proving equality of
costs at optimal point

2
Cc

TC
=
+
Q2
Q
2
0=
Qopt =

C0 D
Q2

Cc

Co D
Q

Q =
2

2CoD
Cc

Copyright 2006 John Wiley & Sons, Inc.

Qopt =

CcQ
2
2CoD
Cc
2CoD
Cc

12-17

EOQ Cost Model (cont.)

Annual
cost ($)

Total Cost
Slope = 0
Carrying Cost =

Minimum
total cost

Ordering Cost =
Optimal order
Qopt
Copyright 2006 John Wiley & Sons, Inc.

CcQ
2

CoD
Q

Order Quantity, Q

12-18

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

Co = $150

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

Qopt = 2,000 yards

Orders per year = D/Qopt

TCmin =
TCmin =

D = 10,000 yards
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)

= 10,000/2,000
= 5 orders/year
Copyright 2006 John Wiley & Sons, Inc.

= 311/5
= 62.2 store days
12-19

Production Quantity
Model
An inventory system in which an 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
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12-20

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

Copyright 2006 John Wiley & Sons, Inc.

Time

12-21

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

Qopt =

2CoD
d
Cc 1 - p

CoD CcQ
d
TC =
+
1- p
Q
2
Copyright 2006 John Wiley & Sons, Inc.

12-22

Production Quantity Model:

Example
Cc = $0.75 per yard

Co = $150

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

2CoD
Qopt =

d
Cc 1 p

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

2(150)(10,000)
=

Co D CcQ
d
TC =
+
1- p
Q
2

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
Copyright 2006 John Wiley & Sons, Inc.

12-23

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 -

32.2
150

= 1,772 yards

Copyright 2006 John Wiley & Sons, Inc.

12-24

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
Copyright 2006 John Wiley & Sons, Inc.

12-25

Quantity Discount Model (cont.)

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

Q(d2 ) = 200

Copyright 2006 John Wiley & Sons, Inc.

12-26

Quantity Discount: Example

QUANTITY

PRICE

1 - 49
50 - 89
90+

$1,400
1,100
900

Qopt =

2 Co D

For Q = 72.5
TC =
For Q = 90
TC =

Cc
CoD
Qopt
Co D
Q

Co = $2,500
Cc = $190 per computer
D = 200
2(2500)(200)
= 72.5 PCs
190

CcQopt
2
CcQ
2

+ PD = $233,784

+ PD = $194,105

Copyright 2006 John Wiley & Sons, Inc.

12-27

Reorder Point
Level of inventory at which a new order
is placed
R = dL
where
d = demand rate per period
L = lead time
Copyright 2006 John Wiley & Sons, Inc.

12-28

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
Copyright 2006 John Wiley & Sons, Inc.

12-29

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

Copyright 2006 John Wiley & Sons, Inc.

12-30

Variable Demand with

a Reorder Point
Inventory level

Reorder
point, R

LT

LT
Time

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12-31

Inventory level

Reorder Point with

a Safety Stock

Q
Reorder
point, R

Safety Stock

LT

LT
Time

Copyright 2006 John Wiley & Sons, Inc.

12-32

Reorder Point With

Variable Demand
R = dL + z d 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
Copyright 2006 John Wiley & Sons, Inc.

12-33

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
Copyright 2006 John Wiley & Sons, Inc.

R
12-34

Reorder Point for

Variable Demand
The carpet store wants a reorder point with a 95%
service level and a 5% stockout probability
d = 30 yards per day
L = 10 days
d = 5 yards 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 yards

= 26.1 yards

Copyright 2006 John Wiley & Sons, Inc.

12-35

Order Quantity for a

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

tb + L - I

where
d
tb
L
d
z d

= average demand rate

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

tb + L = safety stock
I = inventory level
Copyright 2006 John Wiley & Sons, Inc.

12-36

Fixed-Period Model with

Variable Demand
d = 6 bottles per day
d = 1.2 bottles
tb = 60 days
L = 5 days
I = 8 bottles
z = 1.65 (for a 95% service level)
Q = d(tb + L) + z d

tb + L - I

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

60 + 5 - 8

= 397.96 bottles
Copyright 2006 John Wiley & Sons, Inc.

12-37

Copyright 2006 John Wiley & Sons, Inc.

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Copyright
2006by
John
Wiley
& Sons,
Inc.