Inventory Management &

Inventory Models

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Inventory
• Inventory
– A stock or store of goods
• Independent demand items
– Items that are ready to be sold or used

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Types of Inventory
• Raw materials and purchased parts
• Work-in-process
• Finished goods inventories or merchandise
• Maintenance and repairs (MRO) inventory, tools and
supplies
• Goods-in-transit to warehouses or customers (pipeline
inventory)

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Inventory Functions
• Inventories serve a number of functions such as:
1. To meet anticipated customer demand
2. To smooth production requirements
3. To decouple operations
4. To protect against stockouts
5. To take advantage of order cycles
6. To hedge against price increases
7. To permit operations
8. To take advantage of quantity discounts

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Inventory Management
• Management has two basic functions
concerning inventory:
1. Establish a system for tracking items in inventory
2. Make decisions about
• When to order
• How much to order

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Effective Inventory Management
• Requires:
1. A system keep track of inventory
2. A reliable forecast of demand
3. Knowledge of lead time and lead time variability
4. Reasonable estimates of
• holding costs
• ordering costs
• shortage costs
5. A classification system for inventory items

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Inventory Counting Systems
• Periodic System
– Physical count of items in inventory made at
periodic intervals
• Perpetual Inventory System
– System that keeps track of removals from inventory
continuously, thus monitoring current levels of each
item
• Two-bin system
– Two containers of inventory; reorder
when the first is empty

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Inventory Counting Technologies
• Universal product code (UPC)
– Bar code printed on a label that has information about
the item to which it is attached
• Radio frequency identification (RFID) tags
– A technology that uses radio waves to identify objects,
such as goods in supply chains

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Demand Forecasts and Lead Time
• Forecasts
– Inventories are necessary to satisfy customer demands, so it is
important to have a reliable estimates of the amount and timing
of demand
• Lead time
– Time interval between ordering and receiving the order
• Point-of-sale (POS) systems
– A system that electronically records actual sales
– Such demand information is very useful for enhancing
forecasting and inventory management

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ABC Classification System
• A-B-C approach
– Classifying inventory according to some measure of importance, and
allocating control efforts accordingly
– A items (very important)
• 10 to 20 percent of the number of items in inventory and about 60 to
70 percent of the annual dollar value
– B items (moderately important) High
– C items (least important)
• 50 to 60 percent of the number
of items in inventory but only Annual
A
$ value
about 10 to 15 percent of the of items
annual dollar value B
Low
C
Few Many
Number of Items

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Cycle Counting
• Cycle counting
– A physical count of items in inventory
• Cycle counting management
– How much accuracy is needed?
• A items: ± 0.2 percent
• B items: ± 1 percent
• C items: ± 5 percent
– When should cycle counting be performed?
– Who should do it?

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How Much to Order: EOQ Models
• The basic economic order quantity model
• The economic production quantity model
• The quantity discount model

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Basic EOQ Model
• The basic EOQ model is used to find a fixed order
quantity that will minimize total annual inventory costs
• Assumptions
– Only one product is involved
– Annual demand requirements are known
– Demand is even throughout the year
– Lead time does not vary
– Each order is received in a single delivery
– There are no quantity discounts

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The Inventory Cycle

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order

Lead time

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Total Annual Variable Inventory Cost
Total Cost  Annual Holding Cost  Annual Ordering Cost
Q D
 H  S
2 Q
where
Q  Order quantity in units
H  Holding (carrying) cost per unit
D  Demand, usually in unit per year
S  Ordering cost

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Goal: Total Cost Minimization
The Total-Cost Curve is U-Shaped
Annual Cost

Q D
TC  H  S
2 Q

Holding Costs

Ordering Costs

Order Quantity
Q* (optimal order quantity) (Q)

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Deriving EOQ
• Using calculus, we take the derivative of the
total cost function and set the derivative (slope)
equal to zero and solve for Q.
• The total cost curve reaches its minimum where
the carrying and ordering costs are equal.

2 DS 2(annual demand)(or der cost)

Q 
*

H annual per unit holding cost

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Economic Production Quantity (EPQ)

• Assumptions
– Only one product is involved
– Annual demand requirements are known
– Usage rate is constant
– Usage occurs continually, but production occurs periodically
– The production rate is constant
– Lead time does not vary
– There are no quantity discounts

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EPQ: Inventory Profile
Q
Production Usage Production Usage Production
and usage only and usage only and usage
Q*
Cumulative
production
Imax

Amount
on hand

Time

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EPQ – Total Variable Inventory Cost

TC  Carrying Cost  Setup Cost

I  D
  max  H  S
 2  Q
where
I max  Maximum inventory

  p  u
Q
p
p  Production or delivery rate
u  Usage rate

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EPQ

2 DS p
Q 
*

p u
p
H

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When to Reorder
• Reorder point
– When the quantity on hand of an item drops to this amount, the
item is reordered.
– Determinants of the reorder point
1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management

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Reorder Point: Under Certainty

ROP  d  LT
where
d  Demand rate (units per period, per day, per week)
LT  Lead time (in same time units as d )

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Reorder Point: Under Uncertainty

Tingly takes Two-a-Day vitamins,

which are delivered to his home by a
routeman seven days after an order is
called in. At what point should Tingly
order?

ROP=2 vitamins per day x 7days

=14 vitamins
Reorder Point: Under Uncertainty
• Demand or lead time uncertainty creates the possibility
that demand will be greater than available supply
• To reduce the likelihood of a stockout, it becomes
necessary to carry safety stock
– Safety stock
• Stock that is held in excess of expected demand due to
variable demand and/or lead time

Expected demand
ROP   Safety Stock
during lead time

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Reorder Point: Under Uncertainty

If expected demand during lead time is

100 units and the desired amount of
safety stock is 10 units, the ROP
would be 110 units.
Safety Stock
Quantity

Maximum probable demand

during lead time

Expected demand
during lead time

ROP

Safety stock
LT Time

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