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Inventory Management

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

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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

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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.

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Why hold inventory?
✔ Unexpected changes in customer demand
(always hard to predict, and uncertainty is
growing)
– Short product life cycles
– Product proliferation

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Why hold inventory?
✔ Uncertain supply
– Quantity
– Quality
– Costs
– Delivery time

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Why hold inventory?
✔ What if there was no uncertainty in supply
or demand—would it still be necessary to
hold inventory?

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Inventory’s Impact
✔ Inventory can increase amount of demand that can be met by
increasing product availability.

 Inventory can reduce costs by exploiting economies of


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).

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Inventory’s Impact
✔ Inventory can significantly affect material flow/cycle/
throughput time.

Little’s law: Inventory = flow time x throughput rate.

In other words: If you move your inventory faster, you don’t


need as much inventory (inventory velocity)

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Types of Inventory Needed
✔ Cycle Inventory
– Think convenience (no customer buys eggs one
by one)

✔ The average amount of inventory used to meet


demand between replenishments.

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Types of Inventory Needed
✔ Seasonal Inventory
– Think bathing suits and snow-shovels

✔ Inventory that is built up to meet predictable


variation in demand.
– Amount of seasonal inventory depends on how quickly
and inexpensively a firm can change its rate of
production.

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Types of Inventory
✔ Safety Inventory
– Random, unpredictable, unexpected
✔ Inventory held to counter uncertainty in demand
or supply (“just-in-case” inventory).

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Types of Inventory
✔ Pipeline Inventory
– Work-in process of transit
✔ Inventory held to do business.

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Forms of Inventories
✔ Raw Materials
✔ Maintenance, repair, and operating supplies
✔ Work-In-Process (WIP)
✔ Finished Goods

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Decisions in Inventory
Management
✔ When to order?

✔ How much to order?

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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.

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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 & Dynamic Models


– 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
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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.

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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.

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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.

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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.

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Cost v/s Lot size
Total variable Costs

Carrying Costs
Minimum Costs
Annual Costs Rs.

Ordering Costs

Q = EOQ

Lot Size Q units

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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.

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Selective Control Techniques
(continued)
A B C Analysis

100 Y
X C

B
Value of Items %

The 2 points X & Y


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.

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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 combine control


ABC VED Classification
Classification V items E items D items

A items Regular stocks with Medium stock No Stock


constant control
B items Medium Stock Medium Stock Very low Stocks

C items High Stock Medium Stock Low Stock

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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

A items Attempts to reduce Attempt to convert Items are with in


stocks Z items control
B items Review Stock & Items are with in Review items bi-
consumption more control annually
often

C items Dispose of the Check & maintain Review annually


surplus control
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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

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Summary of Selective Control
Techniques
Selective Control Basis of classification Chief Use
Technique

ABC Consumption value Controlling RM, WIP and


components

VED Criticality of item Determining the inventory level of


spare parts

XYZ Value of item in storage Reviewing the inventories & other


uses

FNSD Consumption rate of Controlling obsolescence


item

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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.
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Economic Order Quantity Model
✔ Notations

Minimum Costs
Total variable
– Q = order quantities in units
Costs

Annual Costs Rs.


– 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

Graphical representation of EOQ Ordering Costs g(Q)

model Q = EOQ

T=Q/D Lot Size Q units


Q Y
Inventory on hand

Average inventory

Q/2

December 2009 X Z Time


Inventory Management, by Prof. 31
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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)

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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).

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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.

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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

EOQ = Q* = √(2DS/hC) = √(2x2500x20)/(0.2x2) = 500 units


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
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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

minimum cost region which


Annual Costs Rs.

suggests that there will be but


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

Lot Size Q units

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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

Graphical representation of EOQ model with Finite rate


of Production
Maximum Inventory = (p – d)t
M
P
Inventory

O2

O1 Time
December 2009 Inventory Management, by Prof. 38
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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

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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

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✔ 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

Optimum inventory cycle time t* = Q*/d = 104445/10000 = 10.44 days

December 2009 Inventory Management, by Prof. 41


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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
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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
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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

Requires perpetual auditing of Facilitates planning and control & is


inventory on hand preferable for multiplant organization
where bulk orders could be placed
covering the requirements of various
plants

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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
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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

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

✔ When a demand for an item exceeds stocks on


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
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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
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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

December 2009 Inventory Management, by Prof. 49


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Single Period (Static Inventory Model)

✔ There is only a single time period for making a single


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

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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)

The decision rule is


“ 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
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