Inventory

Management
Inventory Management
• Important for all businesses
• Inventory is created when receipt exceeds
disbursement
• It is depleted when disbursement exceeds receipt
• Challenge for a manager is not to cut cost by
reducing inventory to such level so as to have
dissatisfied customers (unfulfilled orders) or to have
plenty to satisfy all demands
• Challenge is to have right amount of inventory to
achieve competitive priority
 Inventory Costs
• Interest or
Opportunity Costs
• Storage and
Handling Costs
• Taxes, Insurance, and
Shrinkage Costs
• Ordering and Setup Costs
• Transportation Costs
Why have low inventory?
• To control
– Inventory holding cost
– Interest or opportunity cost
– Storage & handling cost
– Taxes, Insurance & Shrinkage
• Shrinkages: Pilferage, Obsolescence &
Spoilage/Damage
Why have high inventory?
• Improved customer service
– Speed up delivery, Improve on time delivery,
reduced chances of stock outs & no back orders
• Lower ordering cost & set up cost
• Maximize labour & equipment utilization
• Reduced transportation cost: transport in bulk
• Avail quantity discounts while purchasing in
bulk
Types of Inventory
Types of Inventory
Cycle Inventory
Q+0
Average cycle inventory =
2
Types of Inventory
Cycle Inventory
Q+0
Average cycle inventory =
2

Safety Stock Inventory

Types of Inventory
Cycle Inventory
Q+0
Average cycle inventory =
2

Safety Stock Inventory

Anticipation Inventory
Types of Inventory
Cycle Inventory
Q+0
Average cycle inventory =
2

Safety Stock Inventory

Anticipation Inventory
Pipeline Inventory

Pipeline inventory = DL = dL
Types of Inventory
• Cycle inventory
– Portion of total inventory that varies with lot size is called
cycle inventory. It follows two principles
• Lot size varies directly with the time gap between orders
• Larger the time gap, greater the cycle inventory
• Safety Stock inventory
– It is held to avoid customer service problems and hidden
costs of unavailable components
– Protects against uncertainties in demand, supply and
lead time
– To create safety stock firm places orders earlier than the
time when the item is actually needed
Types of Inventory
• Anticipation inventory
– When an inventory is built up in anticipation of
demand (AC manufacturers face maximum
demand during few months in summer – inventory
is built up throughout the year)
• Pipeline inventory
– Inventory moving from point to point in the
materials flow system is called pipeline inventory
– It is computed by multiplying average demand by
lead time
Types of Inventory
• A plant makes monthly shipments of electric drills to
a wholesaler in average lot size of 280 drills. The
wholesaler’s average demand is 70 drills a week, and
the lead time from the plant is three weeks. The
wholesalers must pay for the inventory from the
moment the plant makes a shipment. If the
wholesaler is willing to increase its purchase quantity
to 350 units, the plant will guarantee a lead time of
two weeks. What is the effect on cycle and pipe line
inventories?
 Types of Inventory

Cycle inventory = Q/2

Example 13.1
 Types of Inventory

Cycle inventory = Q/2

= 280/2
= 140 drills

Example 13.1
 Types of Inventory

Cycle inventory = Q/2

= 280/2
= 140 drills

Pipeline inventory = DL = dL

Example 13.1
 Types of Inventory

Cycle inventory = Q/2

= 280/2
= 140 drills

Pipeline inventory = DL = dL
= (70 drills/week)(3 weeks)
= 210 drills

Example 13.1
 Types of Inventory

Figure 13.1
Inventory reduction tactics
• For Cycle Inventory
– Primary lever: Reduce lot size
– Secondary lever:
• Streamline order placement and set up
• Increase repeatability
• For Safety Stock Inventory
– Primary lever: Place order closer to the time it may be received – this
may lead to unacceptable customer service level
– Secondary lever:
• Improve demand forecast
• Cut lead time of produced or purchased items
• Reduce supply uncertainties
• Rely more on equipment & labour buffers
Inventory reduction tactics
• For Anticipation Inventory
– Primary lever: Match demand rate with production rate
– Secondary levers are used to level customer demand
• Add new products with different demand cycles
• Provide off season promotional campaigns
• Offer seasonal pricing plans
• For Pipeline Inventory
– Primary lever: Reduce lead time (Because pipeline inventory is
function of demand during lead time)
– Secondary lever:
• Find more responsive suppliers, improve shipping time between two
stocking locations
• Decrease lot size – at least in those cases where lead time depends
on lot size
ABC Analysis
• Vifredo Pareto – a nineteenth century
Italian scientist proposed
• Commonly known as 80 – 20 Rule
• Also known as
– Vital Essential Desirable Analysis
ABC Analysis
100 —

90 —
Percentage of dollar value
80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Figure 13.2 Percentage of items
ABC Analysis
100 —

90 —
Percentage of dollar value
80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Figure 13.2 Percentage of items
ABC Analysis
Class C
100 — Class B

90 —
Percentage of dollar value Class A
80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Figure 13.2 Percentage of items
ABC Analysis
Class C
100 — Class B

90 —
Percentage of dollar value Class A
80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Figure 13.2 Percentage of items
ABC Analysis
Class C
100 — Class B

90 —
Percentage of dollar value Class A
80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Figure 13.2 Percentage of items
ABC Analysis
Class C
100 — Class B

90 —
Percentage of dollar value Class A
80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Figure 13.2 Percentage of items
How
Much?
When!
Inventory Management
• Decision making in production and inventory
management involves dealing with large
number of items, with very diverse
characteristics and with external factors.
• We want to resolve:
– How often the inventory status (of an item) should
be determined ?
– When a replenishment order should be placed ?
– How large a replenishment order should be?
Economic
Order
Quantity
Economic Order Quantity
Assumptions
1. Demand rate is constant
2. No constraints on lot size
3. Only relevant costs are holding and
ordering/setup
4. Decisions for items are independent
from other items
5. No uncertainty in lead time or supply
Economic Order Quantity
Economic Order Quantity
On-hand inventory (units)

Figure 13.3 Time

Economic Order Quantity
On-hand inventory (units)

Figure 13.3 Time

Economic Order Quantity
Receive
order
Q
On-hand inventory (units)

Figure 13.3 Time

Economic Order Quantity
Receive
order
Q
On-hand inventory (units)

1 cycle
Figure 13.3 Time
Economic Order Quantity
Receive
order
Q
On-hand inventory (units)

1 cycle
Figure 13.3 Time
Economic Order Quantity
Receive Inventory depletion
order (demand rate)
Q
On-hand inventory (units)

1 cycle
Figure 13.3 Time
Economic Order Quantity
Receive Inventory depletion
order (demand rate)
Q
On-hand inventory (units)

1 cycle
Figure 13.3 Time
Economic Order Quantity
Receive Inventory depletion
order (demand rate)
Q
On-hand inventory (units)

Q Average
— cycle
2
inventory

1 cycle
Figure 13.3 Time
Economic Order Quantity
EOQ: Assumptions
• The demand rate is known and
constant.
– Therefore the depletion of inventory results
in a straight line with slope equal to the
negative of the demand rate.
EOQ: Assumptions
• Replenishments arrive in a batch equal
to the order quantity rather than
piecemeal. There are no limitations on
lot size.
– The replenishment results in a vertical line
on the graph, rather than a line with a
positive finite slope.
EOQ: Assumptions
• Annual holding cost and annual
ordering cost are the only costs that are
relevant to the order quantity decision.
– There are no quantity discounts, so per-
unit price is irrelevant.
EOQ: Assumptions
• Replenishment decisions for one item
(say doughnuts) are made
independently from replenishment
decisions for other items (say coffee).
– Model enhancements are required to
consider situations where several items are
purchased from the same supplier, or
several items belong to a product family
that can share the same setup.
EOQ: Assumptions
• There is no uncertainty in lead time or
supply.
– Therefore, replenishment orders can be
timed so that no stockouts occur. Because
none occur, stockout costs are irrelevant to
the decision.
– The minimum inventory equals zero, the
maximum inventory equals the EOQ, and
the average cycle inventory equals EOQ/2.
Economic Order Quantity
Annual cost (dollars)

Figure 13.4 Lot Size (Q)

Economic Order Quantity
Annual cost (dollars)

Holding cost (HC)

Figure 13.4 Lot Size (Q)

Economic Order Quantity
Annual cost (dollars)

Holding cost (HC)

Ordering cost (OC)

Figure 13.4 Lot Size (Q)

Economic Order Quantity

Total cost = HC + OC
Annual cost (dollars)

Holding cost (HC)

Ordering cost (OC)

Figure 13.4 Lot Size (Q)

Economic Order Quantity
A museum of natural history opened a gift shop two years
ago. Managing inventories has become a problem. Low
inventory is squeezing profit margins and causing cash
flow problems.
One of the top selling items in the container group at the
museum’s gift shop is a bird feeder. Sales are 18 units
per week, and the supplier charges $ 60 per unit. The
cost of placing an order with the supplier is $ 45. Annual
holding cost is 25 per cent of a feeder’s value, and the
museum operates 52 weeks per year. Management
chose a 390-unit lot size so that new orders could be
placed less frequently.
What is the annual cost of the current policy of using a 390-
unit lot size? Would a lot size of 468 be better?
Economic Order Quantity
Example 13.2

3000 —
Annual cost (dollars)

2000 —

1000 —

0—

| | | | | | | |
50 100 150 200 250 300 350 400

Lot Size (Q)

Economic Order Quantity
Example 13.2

3000 —
Q D
Total cost = (H) + (S)
Annual cost (dollars)

2 Q
2000 —
Q
Holding cost = (H)
2
1000 —

D
Ordering cost = (S)
0— Q

| | | | | | | |
50 100 150 200 250 300 350 400

Lot Size (Q)

Economic Order Quantity
Example 13.2

3000 —
Q D
Total cost = (H) + (S)
Annual cost (dollars)

2 Q
2000 — Birdfeeder costs
Q
Holding cost = (H)
D = (18 /week)(52 weeks) = 936 units 2
H =1000
0.25—($60/unit) = $15
S = $45 Q = 390 units

Q D D
Ordering cost = (S)
0—C = (H) + (S) Q
2 Q
| | | | | | | |
50 100 150 200 250 300 350 400

Lot Size (Q)

Economic Order Quantity
Example 13.2

3000 —
Q D
Total cost = (H) + (S)
Annual cost (dollars)

2 Q
2000 — Bird feeder costs
Q
Holding cost = (H)
D = (18 /week)(52 weeks) = 936 units 2
H =1000
0.25—($60/unit) = $15
S = $45 Q = 390 units

Q D D
Ordering cost = (S)
0—C = (H) + (S) Q
2 Q
| | | | | | | |
C = $2925
50 + $108
100 =150
$3033
200 250 300 350 400

Lot Size (Q)

Economic Order Quantity
Current
cost Example 13.2

3000 —
Q D
Total cost = (H) + (S)
Annual cost (dollars)

2 Q
2000 — Bird feeder costs
Q
Holding cost = (H)
D = (18 /week)(52 weeks) = 936 units 2
H =1000
0.25—($60/unit) = $15
S = $45 Q = 390 units

Q D D
Ordering cost = (S)
0—C = (H) + (S) Q
2 Q
| | | | | | | |
C = $2925
50 + $108
100 =150
$3033
200 250 300 350 400
Current
Lot Size (Q)
Q
Economic Order Quantity
Current
cost Example 13.2

3000 —
Q D
Total cost = (H) + (S)
Annual cost (dollars)

2 Q
2000 — Bird feeder costs
Q
Holding cost = (H)
D = (18 /week)(52 weeks) = 936 units 2
H =1000
0.25—($60/unit) = $15
S = $45 Q = 390 units

Q D D
Ordering cost = (S)
0—C = (H) + (S) Q
2 Q
| | | | | | | |
C = $2925
50 + $108
100 =150
$3033
200 250 300 350 400
Current
Lot Size (Q)
Q
Economic Order Quantity
Current
cost Example 13.2

3000 —
Q D
Total cost = (H) + (S)
Annual cost (dollars)

2 Q
2000 — Bird feeder costs
Q
Holding cost = (H)
D = (18 /week)(52 weeks) = 936 units 2
H =1000
0.25—($60/unit) = $15
S = $45 Q = 468 units

Q D D
Ordering cost = (S)
0—C = (H) + (S) Q
2 Q
| | | | | | | |
50 100 150 200 250 300 350 400
Current
Lot Size (Q)
Q
Economic Order Quantity
Current
cost Example 13.2

3000 —
Q D
Total cost = (H) + (S)
Annual cost (dollars)

2 Q
2000 — Bird feeder costs
Q
Holding cost = (H)
D = (18 /week)(52 weeks) = 936 units 2
H =1000
0.25—($60/unit) = $15
S = $45 Q = 468 units

Q D D
Ordering cost = (S)
0—C = (H) + (S) Q
2 Q
| | | | | | | |
C = $3510
50 + $90
100 = 150
$3600200 250 300 350 400
Current
Lot Size (Q)
Q
Economic Order Quantity
Current
cost Figure 13.4

3000 —
Q D
Total cost = (H) + (S)
Annual cost (dollars)

2 Q
2000 —
Q
Holding cost = (H)
2
1000 —

D
Ordering cost = (S)
0— Q

| | | | | | | |
50 100 150 200 250 300 350 400
Current
Lot Size (Q)
Q
Economic Order Quantity
Current
cost
Bird feeder costs
3000 —
Q D
Total cost = D = (18Q/week)(52
(H) + (S) weeks) = 936 units
Annual cost (dollars)

2
H = 0.25 ($60/unit) = $15
2000 — S = $45 Q = EOQ
Q
2DS Holding cost
Q = (H)
D
EOQ = C= (H) +2 (S)
1000 —
H 2 Q

D
Ordering cost = (S)
0— Q

| | | | | | | |
50 100 150 200 250 300 350 400
Current
Example 13.3 Lot Size (Q)
Q
Economic Order Quantity
Current
cost
Bird feeder costs
3000 —
Q D
Total cost = D = (18Q/week)(52
(H) + (S) weeks) = 936 units
Annual cost (dollars)

2
H = 0.25 ($60/unit) = $15
2000 — S = $45 Q = 75 units
Q
2DS Holding cost
Q = (H)
D
EOQ = C= (H) +2 (S)
1000 —
H 2 Q

D
Ordering cost = (S)
0— Q

| | | | | | | |
50 100 150 200 250 300 350 400
Current
Example 13.3 Lot Size (Q)
Q
Economic Order Quantity
Current
cost
Bird feeder costs
3000 —
Q D
Total cost = D = (18Q/week)(52
(H) + (S) weeks) = 936 units
Annual cost (dollars)

2
H = 0.25 ($60/unit) = $15
2000 — S = $45 Q = 75 units
Q
2DS Holding cost
Q = (H)
D
EOQ = C= (H) +2 (S)
1000 —
H 2 Q

C = $562 + $562 = $1124

D
Ordering cost = (S)
0— Q

| | | | | | | |
50 100 150 200 250 300 350 400
Current
Example 13.3 Lot Size (Q)
Q
Economic Order Quantity
Current
cost
Bird feeder costs
3000 —
Q D
Total cost = D = (18Q/week)(52
(H) + (S) weeks) = 936 units
Annual cost (dollars)

2
H = 0.25 ($60/unit) = $15
2000 — S = $45 Q = 75 units
Q
2DS Holding cost
Q = (H)
D
EOQ = C= (H) +2 (S)
1000 —
H 2 Q

C = $562 + $562 = $1124

D
Ordering cost = (S)
0— Q

| | | | | | | |
50 100 150 200 250 300 350 400
Current
Example 13.3 Lot Size (Q)
Q
Economic Order Quantity
Current
cost
Bird feeder costs
3000 —
Q D
Total cost = D = (18Q/week)(52
(H) + (S) weeks) = 936 units
Annual cost (dollars)

2
H = 0.25 ($60/unit) = $15
2000 — S = $45 Q = 75 units
Q
2DS Holding cost
Q = (H)
D
EOQ = C= (H) +2 (S)
1000 —
H 2 Q

C = $562 + $562 = $1124

D
Lowest Ordering cost = (S)
0— Q
cost
| | | | | | | |
50 100 150 200 250 300 350 400
Best Q Current
Example 13.3 Lot Size (Q)
(EOQ) Q
Economic Order Quantity
Current
cost
Bird feeder costs
3000 —
Q D
Total cost = D = (18Q/week)(52
(H) + (S) weeks) = 936 units
Annual cost (dollars)

2
H = 0.25 ($60/unit) = $15
2000 — S = $45 Q = 75 units

2DS D Q
EOQ = C= (H) + (S)
1000 —
H Q 2

C = $562 + $562 = $1124

Lowest
0—
cost
| | | | | | | |
50 100 150 200 250 300 350 400
Best Q Current
Example 13.3 Lot Size (Q)
(EOQ) Q
Economic Order Quantity
Current
cost
Birdfeeder costs
3000 — Time between orders
Q D
Total cost = D(H)
= (18
+ /week)(52
(S) weeks) = 936 units
Annual cost (dollars)

2 Q
HTBO EOQ = $15
= 0.25 ($60/unit)
= = 75/936 = 0.080 year
2000 —
EOQ
S = $45 D Q = 75 units

2DS D Q
EOQ = C= (H) + (S)
1000 —
H Q 2

C = $562 + $562 = $1124

Lowest
0—
cost
| | | | | | | |
50 100 150 200 250 300 350 400
Best Q Current
Example 13.3 Lot Size (Q)
(EOQ) Q
Economic Order Quantity
Current
cost
Birdfeeder costs
3000 — Time between orders
Q D
Total cost = D(H)
= (18
+ /week)(52
(S) weeks) = 936 units
Annual cost (dollars)

2 Q
HTBO EOQ = $15
= 0.25 ($60/unit)
= = 75/936 = 0.080 year
2000 —
EOQ
S = $45 D Q = 75 units

TBOEOQ = (75/936)(12) = 0.96 months

1000 —
TBOEOQ = (75/936)(52) = 4.17 weeks

Lowest TBOEOQ = (75/936)(365) = 29.25 days

0—
cost
| | | | | | | |
50 100 150 200 250 300 350 400
Best Q Current
Example 13.3 Lot Size (Q)
(EOQ) Q
Economic Order Quantity
Current
cost

3000 —
Q D
Total cost = (H) + (S)
Annual cost (dollars)

2 Q
2000 —
Q
Holding cost = (H)
2
1000 —

D
Lowest Ordering cost = (S)
0— Q
cost
| | | | | | | |
50 100 150 200 250 300 350 400
Best Q Current
Figure 13.5 Lot Size (Q)
(EOQ) Q
How
Much?
When!
 up
So
Soup

Soup
Continuous Review
• IP = Inventory Position
• SR = Scheduled receipt
On-hand inventory

• OH = On hand
inventory
• BO = Back orders

Time

Figure 13.7
 up
So
Soup

Soup
Continuous Review

Order
received
On-hand inventory

OH

Time

Figure 13.7
 up
So
Soup

Soup
Continuous Review
IP

Order
received
On-hand inventory

OH

R
Order
placed

L
TBO
Figure 13.7
 up
So
Soup

Soup
Continuous Review
IP IP IP

Order Order Order Order

received received received received
On-hand inventory

Q Q Q

OH OH OH

R
Order Order Order
placed placed placed

L L L Time
TBO TBO TBO
Figure 13.7
Continuous Review
• Demand for Chicken soup at a super market
is 25cases a day and the lead time is four
days. The shelves were just restocked with
chicken soup, leaving an on hand inventory
of only 10 cases. There are no back orders,
but there is an open order for 200 cases.
What is the inventory position? Should a new
order be placed?
 up
So
Soup

Soup
Continuous Review
IP IP IP

Order Order Order Order

received received received received
On-hand inventory

Q Q
Chicken Soup
Q

OH OH OH

R
Order Order Order
placed placed placed

L L L Time
TBO TBO TBO
Example 13.4
 up
So
Soup

Soup
Continuous Review
IP IP IP

Order Order Order Order

received received received received
On-hand inventory

Q Q Q
Chicken Soup
OH OH R = Average demand
OH during lead time
R = (25)(4) = 100 cases
Order Order Order
placed placed placed

L L L Time
TBO TBO TBO
Example 13.4
 up
So
Soup

Soup
Continuous Review
IP IP IP

Order Order Order Order

received received received received
On-hand inventory

Chicken Soup
Q Q Q
R = Average demand during lead time
OH OH = (25)(4) = 100
OH cases

R
IP = OH + SR – BO
Order Order Order
placed
=
placed
10 + 200 – 0 = 210 cases
placed

L L L Time
TBO TBO TBO
Example 13.4
Uncertain Demand
Uncertain Demand
Figure 13.8
On-hand inventory

Time
Uncertain Demand
Figure 13.6
IP
IP
Order
Order
Order received
received
received Order
received
On-hand inventory

Q
Q Q
OH

R
Order Order Order
placed placed placed

L1 L2 L3 Time
TBO1 TBO2 TBO3
Reorder Point / Safety Stock
• Records show that the demand for
dishwasher detergent during the lead
time is normally distributed, with an
average of 250 boxes and standard
deviation = 22. What safety stock
should be carried for a 99 percent cycle
service level? What is R?
Reorder Point / Safety Stock

Average
demand
during
lead time

Figure 13.9
Reorder Point / Safety Stock

Cycle-service level = 85%

Probability of stockout
(1.0 – 0.85 = 0.15)
Average
demand
during
lead time R

zσ L

Figure 13.9
Reorder Point / Safety Stock
Safety Stock/R

Cycle-service level = 85%

Probability of stockout
(1.0 –
- 0.85
0.85 == 0.15)
0.15)
Average
demand
during
lead time R

zσ L

Example 13.5
Reorder Point / Safety Stock
Safety Stock/R
Safety stock = zσ L
= 2.33(22) = 51.3 Cycle-service level = 85%
= 51 boxes

Probability of stockout
(1.0 - 0.85 = 0.15)
Average
demand
during
lead time R

zσ L

Example 13.5
Reorder Point / Safety Stock
Safety Stock/R
Safety stock = zσ L
= 2.33(22) = 51.3 Cycle-service level = 85%
= 51 boxes

Reorder point = ADDLT + SS

= 250 + 51
Probability of stockout
= 301 boxes
(1.0 - 0.85 = 0.15)
Average
demand
during
lead time R

zσ L

Example 13.5
Lead Time Distributions
Lead Time Distributions
σ t = 15

+
75
Demand for week 1

Figure 13.10
Lead Time Distributions
σ t = 15

+
75
Demand for week 1
σ t = 15

+
75
Demand for week 2

Figure 13.10
Lead Time Distributions
σ t = 15

+
75
Demand for week 1
σ t = 15

+
75
Demand for week 2
σ t = 15

Figure 13.10
=
75
Demand for week 3
Lead Time Distributions
σ t = 15
σ t = 26

+
75
Demand for week 1
σ t = 15

+ 225
Demand for
75
Demand for week 2 three-week lead time
σ t = 15

Figure 13.10
=
75
Demand for week 3
Lead Time Distributions
σ t = 15
σ t = 26

+ Bird feeder Lead Time Distribution

75
Demand for week 1
σ t = 15

+ 225
Demand for
75
Demand for week 2 three-week lead time
σ t = 15

Example 13.6
=
75
Demand for week 3
Lead Time Distributions
σ t = 15
σ t = 26

+ Bird feeder Lead Time Distribution

75
Demand for week 1
t = 1 week
σ t = 15 d = 18 L=2

+ 225
Demand for
75
Demand for week 2 three-week lead time
σ t = 15

Example 13.6
=
75
Demand for week 3
Lead Time Distributions
σ t = 15
σ t = 26

+ Bird feeder Lead Time Distribution

75
Demand for week 1
t = 1 week
σ t = 15 d = 18 L=2

+ σ L =σ t L =5 2 = 7.1
225
Demand for
75
Demand for week 2 three-week lead time
σ t = 15

Example 13.6
=
75
Demand for week 3
Lead Time Distributions
σ t = 15
σ t = 26

+ Bird feeder Lead Time Distribution

75
Demand for week 1
t = 1 week
σ t = 15 d = 18 L=2

+ σ L =σ t L =5 2 = 7.1
225
75 Safety stock = zσ L = 1.28(7.1)Demand
= 9.1 for
or 9 units
Demand for week 2 three-week lead time
σ t = 15
Reorder point = dL + Safety stock

Example 13.6
=
= 2(18) + 9 = 45 units

75
Demand for week 3
Lead Time Distributions
σ t = 15
σ t = 26

+ Bird feeder Lead Time Distribution

75
Demand for week 1
t = 1 week
σ t = 15 d = 18 L=2
Reorder point = 2(18) + 9 = 45 units

+ 225
Demand for
75
Demand for week 2 three-week lead time
σ t = 15

Example 13.6
=
75
Demand for week 3
Lead Time Distributions
σ t = 15
σ t = 26

+ Bird feeder Lead Time Distribution

75
Demand for week 1
t = 1 week
σ t = 15 d = 18 L=2
Reorder point = 2(18) + 9 = 45 units

C=
+
75
($15) +
936
($45)
225
+ 9($15)
Demand for
75
Demand for week 2
2 75 three-week lead time
σ t = 15
C = $562.50 + $561.60 + $135 = $1259.10

Example 13.6
=
75
Demand for week 3
Periodic Review Systems
Periodic Review Systems
T
On-hand inventory

Time
P P

Figure 13.11
Periodic Review Systems
T
On-hand inventory

Q1

Order
placed

Time
P P

Figure 13.11
Periodic Review Systems
T
On-hand inventory

Q1

Order
placed

L Time
P P

Figure 13.11
Periodic Review Systems
T
Order
received
On-hand inventory

Q1

Order
placed

L Time
P P

Figure 13.11
Periodic Review Systems
T
Order Order Order
received received received
Q3
On-hand inventory

Q1
Q2

Order Order
placed placed

L L L Time
P P

Figure 13.11
Periodic Review Systems
T
IP Order IP IP Order
Order
received received received
Q3
On-hand inventory

Q1 OH
OH Q2
IP1

IP3 Order Order

placed placed

IP2

L L L Time
P P
Protection interval
Figure 13.11
Periodic Review Systems
T
IP TV Set
IP - P System
Order IP Order Order IP Order
received IP = OHreceived
received + SR – BOreceived
Q3
On-hand inventory

Q1 QOH
OH t = T - IPt
Q2
IP1
T = 400 BO = 5
OH = 0 SR = 0
IP3 Order Order
placed placed
IP = 0 + 0 – 5 = –5 sets
IP2
Q = 400 – (–5) = 405 sets
L L L Time
P P
Protection interval
Periodic Review Systems
T
IP Order IP IP Order
Order
received received received
Q3
On-hand inventory

Q1 OH
OH Q2
IP1

IP3 Order Order

placed placed

IP2

L L L Time
P P
Protection interval
Example 13.7
Periodic Review Systems
T
IP Order IP Order IP Order
Bird feeder— Calculating P and T
received received received
Q3
On-hand inventory

Q1 OH
OH Q2
IP1

IP3 Order Order

placed placed

IP2

L L L Time
P P
Protection interval
Example 13.8
Periodic Review Systems
T
IP Order IP Order IP Order
Bird feeder—Calculating P and T
received received received
Q3 = 90%
On-hand inventory

σQt = 18 units L = 2 weeks cycle/service

OH level
1
OH Q2
EOQ = 75 units D = (18 units/week)(52 weeks) = 936 units
IP1

IP3 Order Order

placed placed

IP2

L L L Time
P P
Protection interval
Example 13.8
Periodic Review Systems
T
IP Order IP Order IP Order
Bird feeder—Calculating P and T
received received received
Q3 = 90%
On-hand inventory

σQt = 18 units L = 2 weeks cycle/service

OH level
1
OH Q2
EOQ = 75 units D = (18 units/week)(52 weeks) = 936 units
IP1
EOQ 75
P= (52) = (52) = 4.2 or 4 weeks
IP3 D 936
Order Order
placed σ P+L = σ τ P + L = placed
5 6 = 12 units

IP2

L L L Time
P P
Protection interval
Example 13.8
Periodic Review Systems
T
IP Order IP Order IP Order
Bird feeder—Calculating P and T
received received received
Q3 = 90%
On-hand inventory

σQt = 18 units L = 2 weeks cycle/service

OH level
1
OH Q2
EOQ = 75 units D = (18 units/week)(52 weeks) = 936 units
IP1
EOQ 75
P= (52) = (52) = 4.2 or 4 weeks
IP3 D 936
Order Order
placed σ P+L = σ τ P + L = placed
5 6 = 12 units

IP2
T = Average demand during the protection interval + Safety stock
= d (P + L) + zσ P+L
L L L Time
= (18 units/week)(16
P weeks) + 1.28(12
P units) = 123 units

Protection interval
Example 13.8
Periodic Review Systems
T
IP Order IP Order IP Order
Bird feeder—Calculating P and T
received received received
Q3 = 90%
On-hand inventory

σQt = 18 units L = 2 weeks cycle/service

OH level
1
OH Q2
EOQ = 75 units D = (18 units/week)(52 weeks) = 936 units
IP1
P = 4 weeks T = 123 units
IP3 Order Order
placed placed

IP2

L L L Time
P P
Protection interval
Example 13.8
Periodic Review Systems
T
IP Order IP Order IP Order
Bird feeder—Calculating P and T
received received received
Q3 = 90%
On-hand inventory

σQt = 18 units L = 2 weeks cycle/service

OH level
1
OH Q2
EOQ = 75 units D = (18 units/week)(52 weeks) = 936 units
IP1
P = 4 weeks T = 123 units
IP3 Order Order
placed 4(18) 936placed
C= ($15) + ($45) + 15($15)
2 4(18)
IP2
C = $540 + $585 + $225 = $1350
L L L Time
P P
Protection interval
Example 13.8
Comparison of Q and P Systems
P Systems
• Convenient to administer
• Orders may be combined
• IP only required at review
Q Systems
• Individual review frequencies
• Possible quantity discounts
• Lower, less-expensive safety stocks
ABC Analysis — Solved Problem 2
Comparison of P and Q Systems —
Solved Problem 6
 Estimating Inventory Levels
• For one of the products, the average weekly demand
at each distribution center (DC) will be 50 units. The
product is valued at $650 per unit. Average shipment
sizes into each DC will be 350 units per trip. The
average lead time will be two weeks. Each DC will
carry one week’s supply as safety stock, as the
demand during the lead time sometimes exceeds its
average of 100 units (50 units/wk * 2 wk). Anticipation
inventory should be negligible.
 Estimating Inventory Levels
• How many dollars, on the average, of cycle
inventory will be held at each DC?
• How many dollars of safety stock will be held at
each DC?
• How many dollars of pipeline inventory, on the
average, will be in transit for each DC?
• How much inventory, on the average, will be
held at each DC?
• Which type of inventory is your first candidate
for reduction?
Estimating Inventory Levels
 Example 1
• Terminator, Inc., order motorcycle part
in lots of 250 units, which valued at
$450 each. The lead time for delivery is
3 weeks, and annual demand is 4,000
units. Assume 50 working weeks per
year.
– Average cycle inventory in units? Value?
– Average pipeline inventory in units? Value?
 Example 2
• A local retailer faces demand at a rate
of 30,000 unit per year. It cost $10 to
process an order, and annual holding
cost is $1 per unit. Stock is received 4
working days after an order has been
placed. Assume 300 working days a
year.
 Example 2 (Cont’d)
• What is the optimal ordering quantity?
• What is the optimal number of orders per
year?
• What is the optimal interval (in working days)
between orders?
• What is the demand during the lead time?
• What is the reorder point?
• What is the inventory position immediately
after an order has been placed?
Ok, Now What Happens If We
Manufacture the Inventory?
• Well, assuming we’re not producing JIT,
we are producing at a rate faster than
our usage
• We’ll have holding costs for the
inventory we build
• We have setup costs (taking the place
of ordering cost)
• We still have an annual demand
 Profile of Inventory Level Over Time for EOQ. EPQ?
Usage
rate
Q

Quantity
on hand

Receive Place Receive Place Receive

order order order order order
Reorder
point Lead time
 EPQ Model
• Q = production quantity,
units/production run
• D= annual demand, units/year
• S = setup cost, $/production run
• H = inventory-holding cost, $/unit/year
• P = production rate, unit/year
 Calculating EPQ
• Annual holding cost
Q( P − D)
H
2P
Q( P − D)
• 2P= average inventory in cycle stock
• H = cost of holding one unit in inventory
for a year.
 Calculating EPQ
• Annual ordering cost
D
= (S )
Q

– With Q in the denominator, the annual setup cost

varies inversely with Q
– D = annual demand
– D/Q = number of production run in one year
– S = average cost of setup one run
 Calculating EPQ
• Total inventory costs (C)
Q( P − D) D
C= ( H ) + (S )
2P Q
 EPQ
• Using calculus, we take the derivative
of the total cost function (TC) and set
the derivative (slope) equal to zero and
solve for Q
P 2 DS
QOPT =
P−D H
Pr oduction Rate 2( Annual Dem and )( Setup Cost )
=
Pr oduction Rate − Usage Rate Annual Uni t Holding Cost
 EPQ
• Time between production runs.
TBO = Q / D
 Finding EPQ
• A local company produces EPROM. It
has a demand of 2,500 units per year.
The EPROM is produced at a rate of
10,000 units per year. It costs $50 to
initiate a production run, each unit costs
$2 to manufacture, and cost of holding
is based on a 30% annual interest rate.
 Finding EPQ
• What is the EPQ ?
• What is the total annual cost with using
the EPQ ?
• What is the time between runs for the
EPQ policy, expressed in weeks ?
• What is the maximum level of the on-
hand inventory of the EPROMs?
 Example for EPQ
• A chemical plant faces a steady demand of
30 barrels per day. Production rate is 190
barrels per day, setup cost is $200, annual
holding cost is $0.21 per barrel, and the plant
operates 350 days per year. Determine.
– The economic production quantity (EPQ),
– The total annual cost, the TBO, or cycle length for
the EPQ, the production time per production run.
– What are the advantages of reducing the setup
time by 10 percent?
 Newsvendor Model
• Perishable goods
– Finite lifespan
– Single purchase opportunity
– Shortage cost
– Salvage value
 Optimal Quantity?
• So how would we go about determining
the optimal quantity?
– Define cost equation
– Take partial derivative w.r.t. quantity
– Set to 0
– Solve for Q
Seems Just Like What We Did
for the EOQ
• Seems just like what we did for the
EOQ… so what’s different
• In this case, the item’s demand is
stochastic (i.E. NOT deterministic)
• Defining costs means defining
EXPECTED cost
• Therefore, we’re differentiating a much
more complex equation
 Newsvendor Model
• Let’s consider the cost equation :
• CQ =Cshortage + Cexcess
 But These Costs Are
Dependent on Demand…
• And we don’t know demand (demand is
stochastic)
• But we can determine expected
demand
• Therefore we can determine expected
costs
• We simply need to take the expected
value of our costs
 Calculating Optimal Quantity
• Our expected cost equation now looks
like this…
• E[CQ] =E[Cshortage] + E[Cexcess]
 Calculating Optimal Quantity
• Recall what an expected value is…
• ……
• So we have the formula for the optimal
quantity (Q) of the classic newsvendor
model
• F(Q)= cshortage/(cshortage+ cexcess)
 Optimal Quantity
• This equation tells us the optimal service level
corresponding to the shortage and holding
costs
• This service level corresponds to a
cumulative normal probability (in the
continuous case)
• We can use a cumulative probability table to
find the corresponding optimal order quantity
 Here’s an Example
• Weekly demand for the Journal is
normally distributed with
– Mean = 11.73
– Standard deviation = 4.74
• Magazines cost $0.25 each with a
salvage value of $0.10
• Magazines sell for $0.75 each
 Example Cont’d
• First we find the costs of excess and
shortage
• ce = cost - salvage = 0.25 - 0.10 = 0.15
• cs = revenue – cost =0.75 - 0.25 = 0.50
 Example Cont’d
• Next we find the desired service level
• p = cs/(cs+ce) = 0.50/(0.50+0.15)= 0.7692
 Example Cont’d
• Finally, we calculate the order quantity
• Determine the z corresponding to a
cumulative probability of 0.77
• Calculate the optimal order quantity
– Q = mean + z * standard deviation
– Q =11.73 + 0.74 * 4.74 = 15.25
 Continuous Distribution of
Demand
• The limiting assumptions of the model
– Stationary demand
– Single order opportunity
– Known costs and salvage values
– Known selling price (and corresponding
cost of shortage)
• How to apply this in the case of a
discrete distribution
 Discrete Demand
• If the newsvendor estimate following
probability distribution for the demand of
the Journal
Demand 10 20 30 40 50

Probability 0.2 0.3 0.3 0.1 0.1

 Discrete Demand
• How many copies should the
newsvendor order?
• p = cs/(cs+ce) = 0.50/(0.50+0.15)= 0.7692
• Cumulative probabilities

Demand 10 20 30 40 50

Cumulative 0.2 0.5 0.8 0.9 0.9

Probability
 Discrete Demand
• Optimal order quantity between 20 and
30 (0.5 and 0.8)
• Always round up…
• Q = 30
 Extensions
• This model is an important starting point
for a lot of research.
– Multi-period.
– Multiple purchase opportunities.
– Backordering.
– Stochastic lead time.
– Secondary sources of supply.
– Etc.
Inventory Management IV

More Examples for Newsboy

Model
 Newsboy: Example I
• Demand distribution is continuous.
– Billy’s bakery bakes fresh bagels each morning.
The daily demand for bagels is a random variable
with a normal distribution of mean=18, and
standard deviation of 8.9.
– The bagels cost 8 cents to make, and sole for 35
cents each. Unsold bagels at the end of day are
purchased by a charity soup kitchen for 3 cents
each.
– How many bagels should Billy’s bake at the start
of each day? (Answers should be a multiple of 5).
 Newsboy: Example II
• Demand distribution is discrete.
– Billy’s bakery bakes fresh bagels each morning. The
daily demand for bagels is a random variable with a
distribution given as following.
0 5 10 15 20 25 30 35
0.05 0.10 0.10 0.20 0.25 0.15 0.10 0.05
– Bagels cost 8 cents to make, and sole for 35 cents each.
Unsold bagels at the end of day are purchased by a charity
soup kitchen for 3 cents each.
– How many bagels should Billy’s bake at the start of each day?
 Expected Return
• So, how to find out the expected return?
 Example III
• Discrete Demand
– Irwin’s sell a model of fan, with most sales being
made in the summer months. Irwin’s makes a one-
time purchases of the fans prior to each summer
season at a cost of $40 each and sells each fan
for $60, any fans unsold at the end of the summer
season are marked down to $29. All marked-down
fans are sold. The following is the number of sales
of fans during the past 10 summers:
30,50,30,60,10,40,30,30,20,40.
 Example III Cont’d
• Based on the observed 10 values of the prior
demand, construct an empirical probability
distribution of summer demand, and
• Determine the optimal number of fans for
Irwin’s to buy based on the empirical
distribution, and
• Calculate the expected return when ordering
the optimal number of fans from above