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By

Prof. Nadpurohit

ABC Ltd.

✔ 60% of orders received contain mistakes

✔ Salespeople spend 40% of time fixing

problems instead of selling

✔ ABC estimates that electronic commerce

will reduce cost of processing purchase

order from Rs.150 to Rs.25

Nadpurohit

ABC Ltd. continued

✔ Developed system to link its 50 wholesalers

to its central warehouse

✔ If customer needs product and wholesaler is

low, product shipped directly from central

warehouse to customer

Nadpurohit

Inventory

All of the raw materials, work in process (WIP), and

finished goods within the supply chain. Inventory

policies can dramatically alter a supply chain’s efficiency

and responsiveness.

Nadpurohit

Why hold inventory?

✔ Unexpected changes in customer demand

(always hard to predict, and uncertainty is

growing)

– Short product life cycles

– Product proliferation

Nadpurohit

Why hold inventory?

✔ Uncertain supply

– Quantity

– Quality

– Costs

– Delivery time

Nadpurohit

Why hold inventory?

✔ What if there was no uncertainty in supply

or demand—would it still be necessary to

hold inventory?

Nadpurohit

Inventory’s Impact

✔ Inventory can increase amount of demand that can be met by

increasing product availability.

scale in production, transportation, and purchasing.

Inventory can be used to support a firm’s competitive

strategy. More inventory increases responsiveness, less

inventory increases efficiency (reduces cost).

Nadpurohit

Inventory’s Impact

✔ Inventory can significantly affect material flow/cycle/

throughput time.

need as much inventory (inventory velocity)

Nadpurohit

Types of Inventory Needed

✔ Cycle Inventory

– Think convenience (no customer buys eggs one

by one)

demand between replenishments.

Nadpurohit

Types of Inventory Needed

✔ Seasonal Inventory

– Think bathing suits and snow-shovels

variation in demand.

– Amount of seasonal inventory depends on how quickly

and inexpensively a firm can change its rate of

production.

Nadpurohit

Types of Inventory

✔ Safety Inventory

– Random, unpredictable, unexpected

✔ Inventory held to counter uncertainty in demand

or supply (“just-in-case” inventory).

Nadpurohit

Types of Inventory

✔ Pipeline Inventory

– Work-in process of transit

✔ Inventory held to do business.

Nadpurohit

Forms of Inventories

✔ Raw Materials

✔ Maintenance, repair, and operating supplies

✔ Work-In-Process (WIP)

✔ Finished Goods

Nadpurohit

Decisions in Inventory

Management

✔ When to order?

Nadpurohit

Classification of Inventory Models

✔ Deterministic Models

– Demand or consumption rate is known with certainty.

– Constant Lead time involved in procurement

Lead time:

It is the time lag between the recognition of the

need of an item and its availability. This includes the

administrative time for initiating action for

procurement of an item, time for supplying including

transit and the time for receiving and inspection.

Nadpurohit

Classification of Inventory Models (continued)

✔ Probabilistic Models

– Demand follows a known probability distribution.

– Lead time involved in procurement is constant or variable

with a known probability distribution.

– Static models relate to one shot decision process in which

only 1 single purchase order can be placed to meet the

demand.

– In case of Dynamic models, the decision on 1 procurement

process will affect the subsequent procurement decisions.

December 2009 Inventory Management, by Prof. 17

Nadpurohit

Classification of Inventory Models (continued)

✔ Nature of Supply

The treatment of inventory problems of a firm procuring its

requirements from an external source is quite different

from the one which manufactures to meet its own

requirements.

Nadpurohit

Cost considerations in Inventory

✔ Ordering or Setup Costs

– It the cost of processing an order. If the item

is self supplied then the cost corresponds to

Setup cost in a manufacturing shop.

– Although semi- variable in nature,

Ordering / setup costs are expressed as cost

per set-up or cost per order.

Nadpurohit

Cost considerations in Inventory

(continued)

✔ Inventory carrying costs

– These costs closely depend upon the

quantities ordered and comprise of elements

like insurance, deterioration, rental for

storage space, operating cost for store and

the cost of funds locked up in inventory.

– This cost is expressed as cost per unit time

per rupee invested in inventory.

Nadpurohit

Cost considerations in Inventory

(continued)

✔ Shortage costs

– If a firm is not able to meet the demand of

customer for want of stock on hand, we can

attribute a certain cost to this.

• Loss of sale case

• Back ordering

• Cost of procuring an item on an emergency basis.

Nadpurohit

Cost v/s Lot size

Total variable Costs

Carrying Costs

Minimum Costs

Annual Costs Rs.

Ordering Costs

Q = EOQ

Nadpurohit

Selective Control Techniques

✔ A B C Analysis

– Based on the Annual usage value of various

items.

– It separates inventory items into 3 classes

viz. A, B, C in the descending order of usage

value.

Nadpurohit

Selective Control Techniques

(continued)

A B C Analysis

✔

100 Y

X C

B

Value of Items %

where the Curve

changes its shape

A

provide the 3

segments A, B, C

0 100

No. of items %

December 2009 Inventory Management, by Prof. 24

Nadpurohit

Selective Control Techniques

(continued)

✔ A B C Analysis

– Helps to concentrate in efforts in area where it

is needed most

– Gives most effective and rewarding control with

least amount of controlling

– With ABC control it is possible to reduce

investments in inventories.

Nadpurohit

Selective Control Techniques

(continued)

✔ V E D Control:

– V: Vital items

– E: Essential items

– D: Desirable items

– The basis of control is the criticality of the item

ABC VED Classification

Classification V items E items D items

constant control

B items Medium Stock Medium Stock Very low Stocks

Nadpurohit

Selective Control Techniques

(continued)

✔ X Y Z Control:

– X: Items with high inventory value

– Y: Items with moderate inventory value

– Z: Items with low inventory value

– The basis of control is the annual closing inventory value

ABC – XYZ combine control

ABC XYZ Classification

Classification X items Y items Z items

stocks Z items control

B items Review Stock & Items are with in Review items bi-

consumption more control annually

often

surplus control

December 2009 Inventory Management, by Prof. 27

Nadpurohit

Selective Control Techniques

(continued)

✔ FNSD Control:

– F: Fast moving Items

– N: Normal moving Items

– S: Slow moving Items

– D: Dead items

– The basis of control is the Usage rate

Nadpurohit

Summary of Selective Control

Techniques

Selective Control Basis of classification Chief Use

Technique

components

spare parts

uses

item

Nadpurohit

Economic Order Quantity Model

✔ Assumptions

– The demand is known, is constant & occurs

uniformly over time.

– The replenishment of supply of item is

instantaneous and no Lead time is involved (cost

of shortage is assumed to be infinite and there is

abundant availability)

– The cost on the units ordered is same irrespective

of the lot size.

December 2009 Inventory Management, by Prof. 30

Nadpurohit

Economic Order Quantity Model

✔ Notations

Minimum Costs

Total variable

– Q = order quantities in units

Costs

– S = Cost of placing an order or cost of set up Carrying Costs f(Q)

– D = Average annual consumption in units

– h = Annual cost per Rupee value of inventory held.

– C = unit cost of procuring an item

model Q = EOQ

Q Y

Inventory on hand

Average inventory

Q/2

Inventory Management, by Prof. 31

Nadpurohit

T=Q/D

Q Y

Inventory

on hand

Average inventory

Q/2

X Z Time

Consider there are n cycles in a year and T is the duration of each cycle then

1 year = nT Hence T = 1/n

D is annual demand in units and Q is the no. of units ordered per cycle

Hence D = nQ.

Hence n = D/Q and T = Q/D years

Average inventory at any point of time = Total inventory held during the cycle / Time of cycle

= (QT)/2T = Q/2

Inventory carrying cost = (Q/2)hC; Ordering costs = (no. of orders)cost of placing an order =

(D/Q)S

Total variable annual cost V = QhC/2 + DS/Q

For order quantity to be optimal dV/dQ = 0 i.e. d(QhC/2 + DS/Q)/dQ = 0

i.e. hC/2 – DS/Q2 = 0

Hence Q2 = (2DS)/hC i.e. Q* = √ (2DS)/hC

Optimal cycle time T* = Q*/D and optimal Total variable annual cost V* = Q* (hC/2) + DS/Q*

December 2009 Inventory Management, by Prof. 32

Nadpurohit

✔ A wholesaler supplies 20 tins of special additive each weekday to various service stations.

There are 250 weekdays in a year. Tins are purchased from a manufacturer in lots of 100 each

for Rs. 1000/- per lot. Multiple and fractional can be ordered at any time and all the orders are

filled the next day. Each order placed with the manufacturer incurs a handling charge of Rs.

50/- and a freight charge of Rs. 200/- per lot. The incremental cost is Rs. 0.50/- per year to

store a tin in inventory. The wholesaler finances inventory investments by paying its holding

company 1.5% monthly for borrowed funds. How many tins should be ordered , and how

often, in order to minimize the total annual inventory cost? Also compute the minimum total

annual inventory cost

Solution:

Annual demand D = 20x250 = 5000 tins per year

Unit cost of purchase C = 1000/100 = Rs. 10/-

Ordering cost / order = S = Cost of handling / per order + Frieight charges / per order = Rs. 50 +

Rs. 200 = Rs. 250/- per order.

Inventory carrying cost per tin = hC = Incremental cost of storage + charges on inventory

investment = Rs. 0.50/- + 12 x (1.5/100) x 10 = Rs. 2.30/- per tin

Economic Lot size Q* = √(2DS/hC) = √(2x5000x250/2.3 = 1043 tins

Number of orders to be placed = n = D/Q* = 5000/1043 = 4.79 = 5 orders

Minimum total annual inventory cost = V* = Q* (hC/2) + DS/Q* = 1043x(2.30/2) +

5000x250/1043 = Rs. 2398/- (Note: This minimum cost does not include the acquisition cost)

Nadpurohit

EOQ under Price Breaks

✔ The EOQ is based on uniform price irrespective of

order size.

✔ Often suppliers specify bulk discounts specifying a

certain rate of discount beyond a stipulated order

quantity.

✔ When the EOQ is > the stipulated order quantity for

discount, then the buyer avails of the discount, but

when it is not then a study of the behavior of cost wrt.

increase in in order quantity needs to be done.

✔ The decision about availing the discount will depend on

the impact on total cost (cost including acquisition).

Nadpurohit

EOQ under Price Breaks

✔ With increase in order size beyond EOQ

to avail of discount we have

– An increase in inventory carrying costs

– A reduction in annual ordering cost and

– A reduction in the acquisition cost due to

discounts.

Nadpurohit

EOQ under Price Breaks

✔ A company requires 2500 units of a product per year. An offer has been received for supply of this product

at the rate of Rs. 2/- per piece. The supplier has offered a discount of 3% for purchase lot size between

1500 to 2499 units. Any order of 2500 units and above will be supplied at a discount of 5% on the base

price. If the company expects 20% return on its working capital, and the cost of transport of each lot from

the supplier works out to be Rs. 20/- per lot, is it advantageous to change the order quantity to get

discount? If so by how much?

Solution:

Given – Annual Demand = D = 2500 units; Ordering cost / order Rs. 20 / lot; Unit price Rs. 2/- per unit;

company ROI 20% = h

a) To get 3% discount, the minimum order size = 1500

Increase in inventory carrying cost = 0.2(1500x1.94 – 500x2) / 2 = Rs. 191/-

Decrease in no. of orders per year = 2500/500 – 2500/1500 = 5-1.67 = 3.33

Hence decrease in ordering cost = 20x3.33 = Rs. 66.6 i.e. Rs. 67/-

Decrease in acquisition cost = 2500x2x0.03 = Rs. 150/-

Net change in cost = (150+67) – 191 = A decrease of Rs. 26/- per annum

b) To get 5% discount, the minimum order size = 2500

Increase in inventory carrying cost = 0.2(2500x1.90 – 500x2) / 2 = Rs. 375/-

Decrease in no. of orders per year = 2500/500 – 2500/2500 = 5-1.0 = 4

Hence decrease in ordering cost = 20x4.0 = Rs. 80

Decrease in acquisition cost = 2500x2x0.05 = Rs. 250/-

Net change in cost = 375 - (250+80) = An increase of Rs. 45/- per annum

Hence it is advantageous to increase the order quantity to 1500 per lot and avail a discount of

3%

December 2009 Inventory Management, by Prof. 36

Nadpurohit

Sensitivity Analysis of EOQ

✔ The derivation of EOQ is based

on balancing 2 opposing costs.

Total variable

Costs

✔ The Total variable cost curve is

Carrying Costs f(Q) relatively flat around the

Minimum Costs

Annual Costs Rs.

little variation in the cost for

fairly wide changes in order

quantity around the EOQ region

✔ Similarly errors in forecast of

Ordering Costs g(Q) demand may not appreciably

affect EOQ.

Q = EOQ

Nadpurohit

Economic Order Quantity Model for Finite

Production Rate

✔ Notations

p = Production rate (units per day) ; d = Demand rate (sales or consumption in units per day); M

= Maximum inventory; Q = Batch size; C = cost per unit of Product; Inventory carrying cost per

day as a ratio of value of inventory; S = Setup cost (Rs. Per change over); V = Total variable cost;

t = no. of days for completion of each batch; t1 = time for consumption of M qty of inventory

✔ Assumptions

a) Demand rate is constant and < Production rate & b) Production rate is constant

of Production

Maximum Inventory = (p – d)t

M

P

Inventory

O2

O1 Time

December 2009 Inventory Management, by Prof. 38

Nadpurohit

Maximum Inventory = (p – d)t

M

P

Inventory

Time

O1 O2

Rate at which inventory builds up is (p – d)

Maximum inventory = M = (p – d)t

Having reached the maximum level, the inventory will reduce at the rate of d units per day till it

reaches zero level, when the next production batch starts.

As the minimum stock is zero and the production and consumption rates are constant

Average inventory = (p – d)t/2

As it takes t days to produce Q units, Q = pt or t = Q/p

Hence Average inventory = (p – d)Q/2p = Q(1 – (d/p))/2

Total variable costs = Variable costs of set ups + Inventory carrying costs

V = Sd/Q + Q(1 – (d/p))hC/2

Differentiating wrt Q and equating to zero for minimum V we get

dV/dQ = - Sd/Q2 + (1 – (d/p))hC/2 = 0

Hence EOQ Q* = √2dS/(1 – (d/p))hC

Nadpurohit

Maximum Inventory = (p – d)t

M

Inventory P

t t1

O1 O2 Time

1 inventory cycle = t+t1

Rate at which inventory builds up is (p – d)

Maximum inventory = M = (p – d)t, also this maximum inventory is consumed in time t1 at a rate

of d. Hence M = dt1

Hence 1 inventory cycle = t+t1 = M/(p-d) + M/d = pM/d(p-d) ----- a

Now Considering I cycle of inventory we get M = (p-d)t Hence t = M/(p-d)

and if Q is the batch size produced in this cycle then we have M = Q –dt. hence we get M = Q –

dM/(p-d) Simplifying this we get M = Q(p-d)/p ------ b

From a and b we get 1 inventory cycle t + t1 = pM/d(p-d) = pQ(p-d)/dp(p-d) = Q/d

1 inventory cycle = t + t1 = Q/d

Optimum inventory cycle for EOQ (Q*) is t* = Q*/d

Nadpurohit

✔ A manufacturer has to supply 10,000 bearings per day to an OEM. He finds that when he

starts a production run, he can produce 25,000 bearings per day. The cost of holding a

bearing in stock for 1 year is Rs. 0.20 and the set up cost for production run is Rs.

180.What is the EOQ and how frequently should he produce

Solution:

Given

Inventory carrying cost per bearing per year = Rs. 0.20

Set up cost per set up = Rs. 180

Replenishment rate = p = 25000 bearings per day

Consumption rate = 10000 bearings per day

Inventory carrying cost per day per bearing = 0.20/365 = Rs. 0.00055 per bearing /day

EOQ Q* = √2dS/(1 – (d/p))hC = √2x10000x180/(1-(10000/25000))0.00055 = 104445 bearings

Nadpurohit

Fixed Order Quantity System or

Reorder Point System

M

Inventory

on hand

Average Inventory

Reorder

point R R’ Reorder point

Q D – Avg. annual

DL consumption

Safety (B+Q/2)

(B+DL) in units

Stocks

in units B Safety Stock

O L

Lead time in yrs.

December 2009

Time

Inventory Management, by Prof. 42

Nadpurohit

Periodic Review System or

Replenishment System

Replenishment Level

P

Inventory on hand

P = B + D(L+T’)

P is Replenishment level

B = Safety stock in units

D(L+T’)

D is Avg annual consumption

L is Lead time in years

T’ is Time between review in yrs.

Safety Stock

B

L L

T’

Time

December 2009 Inventory Management, by Prof. 43

Nadpurohit

Comparison between the 2 systems

Fixed Order Quantity System Periodic Review System

Order quantity is fixed and is equal to No flexibility in the order period and

EOQ. hence the fluctuations in the demand

must be taken care off by the Safety

stocks.

Useful when there is restriction on the Preferred when the supplies are to be

order quantities made on fixed dates

inventory on hand preferable for multiplant organization

where bulk orders could be placed

covering the requirements of various

plants

Nadpurohit

Buffer Stocks

✔ Reorder point is fixed on 2 considerations

– To meet the demand during Lead time

– To reduce the probability of stock out in case of >

average Lead time

✔ A service level of not permitting any shortage in

inventory means a very high level of Buffer stock

at a prohibitive cost

✔ The amount of Buffer stock depends upon

– Estimated maximum demand

– Risk the management is prepared to take and

– The cost of shortage

December 2009 Inventory Management, by Prof. 45

Nadpurohit

Buffer Stocks (continued)

✔ The adequacy of Buffer stock is governed by the

combined effect of variation in the Lead time and

the variation in the rate of demand during the

Lead time.

✔ The Statistical distribution of Lead time demand

may satisfactorily be represented by Normal

distribution for a majority of Inventory problems

Nadpurohit

Reorder Point Model with Probabilistic Demand

and Service level specified by % of Stock outs

hand a shortage occurs.

✔ % of Stock outs per annum = Number of

order cycles in which inventory falls to zero /

Number of order cycles per annum.

✔ The drawback of this method is that the extent

of shortage is ignored i.e. the number of units

short or the time for which the shortage

persists is ignored.

December 2009 Inventory Management, by Prof. 47

Nadpurohit

Reorder Point Model with Probabilistic Demand

and Service level specified by % of Stock outs

Buffer Stock B

α

O μL XL

Demand during Lead time

✔ XL is the demand during Lead time which follows Normal distribution with a

mean μL and standard deviation σL.

✔ If B is the Buffer stock and “α” is the maximum permissible risk of Stock out, it

is see from the above figure that the probability of actual demand during the lead

time exceeding the average demand and the Buffer stock is given by

✔ Pr (XL≥ μL+B) ≤ α = Pr ((XL – μL) ≥ B) ≤ α = Pr ((XL – μL)/ σL ≥ B/ σL) ≤ α

✔ By finding the standard normal variate value from the tables for a given α and

knowing μL and σL the value of B can be found out.

December 2009 Inventory Management, by Prof. 48

Nadpurohit

Reorder Point Model with Probabilistic Demand and Service level specified by %

of Stock outs

Buffer Stock B

α

O μL XL

Demand during Lead time

✔ The average demand for an item is 120units /year. The Lead time is 1 mth. The demand during Lead time

follows a normal distribution with a mean of 10 units and a std. deviation of 2 units. The item is ordered once in

4 months and the policy of the company is that there should not be more than 1 stock out every 2 years,

Determine the reorder level.

✔ Solution

Given: Q = 120/3 = 40 units, D = 120units, μL = 10 and σL = 2

% of Stock outs per annum (α ) = Number of order cycles in which inventory falls to zero / Number of order

cycles per annum.

= 0.5/(D/Q) = 0.5x40/120 = 1/6

Pr ((XL – μL)/ σL ≥ B/ σL) ≤ 1/6

From normal tables the value of (XL – μL)/ σL) corresponding to α = 1/6 = 0.1667 is 0.97

Hence B/ σL = 0.97 and B = 0.97x2 = 1.94

Hence Reorder point = μL + B = 10+1.94 = 11.94 say 12 units

Nadpurohit

Single Period (Static Inventory Model)

procurement.

✔ Costly spares, perishable goods, seasonal items and

fashion goods are all examples of single period model.

✔ Replacement orders are either not possible or are

abnormally expensive and uneconomical.

✔ The decision is of 1 shot type

Nadpurohit

Single Period (Static Inventory Model)

The Model

Let D = Quantity to be bought

p(D) = Probability that the demand is for D units or more

G = Profit per unit sale

L = Loss from each unit that is left unsold

It is assumed that the inventory carrying costs for the season are fixed

and independent of the quantity purchased and further that the

ordering cost is negligible

Expected profit from the sale of the Dth unit = E(D)

= G.p(D)-L(1-p(D))

The term (1-p(D)) is the probability of not selling the Dth unit

E(D) must be > 0 if the Dth unit has to produce profit

i.e. G.p(D)-L(1-p(D)) > 0 or p(D) > L/(G+L)

“ Buy the maximum quantity D such that the probability of selling D or

more is > the ratio L/(G+L)”

December 2009 Inventory Management, by Prof. 51

Nadpurohit

Single Period (Static Inventory Model)

✔ A department store must decide how much of a perishable product it

must buy every day. Past pattern of the sale of the product indicates

that the daily demand to be normally distributed with a mean of 100

and a std. deviation of 10. 1 unit of the product sell for Rs 1.25 and

costs the store Rs. 0.85. Any unsold product by the end of the day can

be sold the next day at Rs. 0.75. Determine the optimal number of the

products to purchase for maximum expected profits

✔ Solution

G = 1.25 – 0.85 = 0.40, L = 0.85 - 0.75 = 0.10

Standard normal variate = Z = (D-100/10)

p(D) = L/(G+L) = 0.1/(0.4+0.1) = 0.2

From Normal tables the value of Z for p(D) = 0.2 is 0.84

Hence (D-100/10) = 0.84

Hence D = 108.4 units say 108 units

December 2009 Inventory Management, by Prof. 52

Nadpurohit

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