Chapter 12

Inventory Management

Slides prepared by Laurel Donaldson Douglas College

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives
LO 1 LO 2 LO 3

Define the term inventory, list major reasons for holding inventory, and discuss the objectives of inventory management. List the main requirements for effective inventory management, and describe A-B-C classification and perform it. Describe the basic EOQ model, the economic production quantity model, the quantity discount model, and the planned shortage model and solve typical problems. Describe how to determine the reorder point and solve typical problems. Describe the fixed order interval model and solve typical problems. Describe the single period model and solve typical problems.

LO 4 LO 5 LO 6

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Chapter Outline
Introduction Requirements for Effective Inventory Management Fixed Order Quantity/Reorder Point Model (FOQRP) FOQRP: Determining the Reorder Point Fixed Order Interval Model The Single Period Model

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What Is Inventory?
Stock of items kept to meet future demand Decisions of inventory management
how many units to order when to order

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LO 1
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Inventory
Independent Demand

Retail items, finished goods, supplies and parts, some raw materials C(2)

B(4)

D(2)

E(1)

D(3)

F(2)

Dependent Demand Manufactured parts

Independent demand is uncertain. Dependent demand is certain.

LO 1
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Types of Inventories
Raw materials & purchased parts

Partially completed items called work in process (WIP)

Finished-goods (or merchandise)

Spare parts, tools, & supplies

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LO 1
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Functions of Inventory
To take advantage of quantity discounts To hedge against price increases

To wait while in transit

To protect against stockouts

To smooth production requirements

To decouple operations

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LO 1
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Objective of Inventory Control

To achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds
Level of customer service (not understock)
Fill rate

Costs of ordering and carrying inventory (not overstock)

Inventory turnover

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LO 1
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Effective Inventory Management

A reliable forecast of demand Knowledge of lead times Reasonable estimates of
Holding costs Ordering costs Shortage costs

Quantity Costs

Control A classification system A system to keep track of inventory

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Safely Storing Inventory

Warehouse Management System (WMS) computer software that controls the movement and storage of materials within a warehouse, and processes the associated transactions

Warehouse/storeroom concerns
Security Safety Obsolescence

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Inventory Counting Systems

Periodic counting Physical count of items made at periodic intervals

Perpetual (or continual) tracking keeps track of removals from and additions to inventory continuously, thus providing current levels of each item 11
LO 2
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Inventory Replenishment
Fixed Order Quantity/Reorder Point Model An order of a fixed size is placed when the amount on hand drops below a minimum quantity called the reorder point Two-Bin System Two containers of inventory; reorder when the first is empty Bar Code A number assigned to an item or location, made of a group of vertical bars of different thickness that are readable by a scanner Universal Product Code (UPC)

Radio Frequency Identification (RFID)0

technology that uses a RFID tag attached to the item that emits radio waves to identify items.
LO 2
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214800 232087768

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Forecasting Demand
Lead time time interval between ordering and receiving the order Point of Sale (POS) system Software for electronically recording actual sales at the time and location of sale

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Inventory Costs
Ordering or Setup costs Holding (carrying) costs

Shortage costs

Inventory costs
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Inventory Costs
Holding (carrying) costs cost to carry an item in inventory Ordering costs costs determining order quantity, preparing purchase orders, and fixed cost portion of receiving, inspection, and material handling Setup costs Time spent preparing equipment for the job by adjusting machine, changing tools, etc Shortage costs costs when demand exceeds supply; often unrealized profit per unit 15
LO 2
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ABC Classification System

Classifying inventory according to some measure of importance and allocating control efforts accordingly.

A - very important B - mod. important C - least important

A items should receive more attention!

High
(70-80)

A B C
Low
(15-20)

Annual $ value of items Low

(5-10)

High
(50-60)

Percentage of Items

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Example: A-B-C Classification

Item Number
8 10 2 5 3 1 7 9 6 4

Annual Demand

Unit Cost

Annual Dollar Volume (ADV)

% of Total ADV

1,000 500 1,550 350 1,000 600 2,000 100 1,200 250

$ 90.00 154.00 17.00 42.86 12.50 14.17 .60 8.50 .42 .60

$ 90,000 77,000 26,350 15,000 12,500 8,500 1,200 850 504 150

38.8% 33.2% 11.3% 6.4% 5.4% 3.7% .5% .4% .2% .1%

A 72% B 23%

C 5%

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LO 2

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Cycle Counting
Regular actual count of the items in inventory on a cyclic schedule Cycle counting management
How much accuracy is needed? When kind of counting cycle should be used? Who should do it?
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Fixed Order Quantity/Reorder Point Model: Determining Economic Order Quantity

economic order quantity (EOQ) The order size that minimizes total inventory control cost

basic economic order quantity (EOQ)

economic production quantity (EPQ)

EOQ with quantity discount

LO 3

EOQ with planned shortage 19

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Assumptions of EOQ Model

1. Only one product is involved . 2. Annual demand requirements known 3. Demand is even throughout the year 4. Lead time does not vary 5. Each order is received in a single delivery 6. There are no quantity discounts 7. Shortage is not allowed
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Inventory Cycles with EOQ

1. You receive an order (size = Q) 4. Order received after lead time (LT) expires, when 0 on hand. The cycle then repeats.

Q
Quantity on hand

R
2. Quantity decreases by demand rate (d)

LT

Time

LT
3. When quantity reaches reorder point quantity (R), place another order (size = Q).

R = Reorder point Q = Economic order quantity LT = Lead time LO 3

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EOQ: Minimizing Total Costs

Total cost = Holding + Ordering Costs Total cost is minimized at Q0 where holding = ordering cost
A N N U A L C O S T

Total Cost Holding Costs

Ordering Costs
QO LO 3 Order Quantity (Q)

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Basic Economic Order Quantity (EOQ)

Total Annual = Cost Annual Annual Holding + Ordering Cost Cost
TC = Total annual cost Q = Order quantity (units) H = Annual holding cost per unit D = Annual Demand S = Ordering (or setup) cost per order Q0 = EOQ

Q D TC ! H  S 2 Q

2DS 2(Annual Demand) (Order or Setup Cost) QO = = H Annual Holding Cost

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EOQ Example 1
A phone company has annual demand of 10,000. A component has annual holding cost of $6 per unit, and ordering cost of $75. Calculate EOQ, Total Cost, number of orders per year and the order cycle time. H = $6 per unit 2DS QH DS S = $75 Qo = TC = + D = 10,000 units H Q 2

Qo =

2(10,000) (75) (6)

TC =

(500)(6) 2

(10,000)(75) 500

Qo = 500 units

TC = $1500 + $1500= $3000

Length of order cycle = 250 days/(D/Qo) Orders per year = D/Qo = 250/20 = 10,000/500 = 12.5 days = 20 orders/year

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EOQ Example 2a
A phone company has annual demand of 15,000. A component has annual holding cost of $6 per unit, and ordering cost of $75. Calculate EOQ, Total Cost, number of orders per year and the order cycle time. H = $6 per unit 2DS QH DS S = $75 Qo = TC = + D = 15,000 units Q H 2 (15,000)(75) (612)(6) 2(15,000) (75) TC = + 612 2 Qo = (6)

Qo = 612 units
EOQ is 22% more than 500

TCmin = $1836 + $1838 = $3674 Total cost is 22% more than $3000

LO 3

Length of order cycle = 250 days/(D/Qo) Orders per year = D/Qopt = 250/25 = 15,000/612 25 = 10 days = 25 orders/year Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

EOQ Example 2b
A phone company has annual demand of 15,000. A component has annual holding cost of $6 per unit, and ordering cost of $75.

H = $6 per unit S = $75 D = 15,000 units Qo =

2(15,000) (75) (6)

Qo =

2DS H

QH DS TC = + 2 Q

Qo = 612 units
Total cost is only an extra 2% more if still use EOQ of 500
LO 3

What if we still use EOQ of 500? What is total cost? TC =

(15,000)(75) (500)(6) + 500 2

TC = $1500 + $2250 = $3750 26

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Robust Model
The EOQ model is robust It works even if all parameters and assumptions are not met The total cost curve is relatively flat near the EOQ (especially to the right)

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Economic Production Quantity (EPQ)

Production done in batches or lots production capacity > usage or demand rate for a part for the part Assumptions of EPQ similar to EOQ except orders are received incrementally during production
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Economic Production Quantity (EPQ)

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Economic Production Quantity (EPQ)

Annual Annual I max D TC ! Holding  Setup ! H  S Q 2 Cost Cost Q Q Q Cycle length ! ; Run length ! ; I max ! p  d d p p

TC = Total annual cost Q = Order quantity (units) H = Annual holding cost per unit D = Annual Demand S = Ordering (or setup) cost per order
LO 3

Q0 !

2 DS p H pd

Q0 = Optimal run or order quantity p = Production rate d = Usage or demand rate Imax = Maximum inventory level

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EPQ Example
Holdit Inc. produces reusable shopping bags. Demand is 20,000 bags per day, 5 days per week, 50 weeks per year. Production is 50,000 per day. The setup cost is $200 and the annual holding cost rate is $.55 per bag. Calculate the EPQ, the total cost, the cycle length and optimal production run length. H = $0.55 per bag S = $200 D = 20,000 bags x 50 wks x 5 days d = 20,000 bags per day p = 50,000 bags per day

2 DS p Q0 ! pd H

2(5,000,000)(200) 50G Q0 ! ! 77,850 .55 50G  20G

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EPQ Example
Holdit Inc. produces reusable shopping bags. Demand is 20,000 bags per day, 5 days per wk, 50 wks per yr. Production is 50,000 per day. Setup cost is $200 and annual holding cost rate is $.55 per bag. Calculate total cost. H = $0.55 per bag S = $200 D = 20,000 bags x 50 wks x 5 days d = 20,000 bags per day p = 50,000 bags per day

D I max TC ! H  S Q 2

I max

Q ! p  d p

I max

77,850 30000 ! 46,710 bags ! 50,000

5million 46,710 TC ! 200 ! $25,690 (.55)  2 77,850

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EPQ Example
Holdit Inc. produces reusable shopping bags. Demand is 20,000 bags per day, 5 days per week, 50 weeks per year. Production is 50,000 per day. The setup cost is $200 and the annual holding cost rate is $.55 per bag. Calculate cycle length and optimal production run length. H = $0.55 per bag S = $200 D = 20,000 bags x 50 wks x 5 days d = 20,000 bags per day p = 50,000 bags per day

Q Q Cycle length ! ; Run length ! d p

77,850 Cycle length ! ! every 3.89 days 20,000

77,850 Run length ! ! 1.56 days per order 50,000

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EOQ with Quantity Discounts

Price reductions are often offered as incentive to buy larger quantities Weigh benefits of reduced purchase price against increased holding cost Annual holding cost Q H 2 Annual ordering cost D S Q + Purchasing cost + RD

TC =

+ +

TC =

R = per unit price of the item D = annual demand

LO 3
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Total Cost with Purchase Cost

Cost
Adding Purchasing cost TC with PD doesnt change EOQ

TC without PD

PD

0
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EOQ

Quantity

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Total Cost with Quantity Discounts

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Best Purchase Quantity Procedure

begin with the lowest unit price compute the EOQ for each price range stop when find a feasible EOQ Is EOQ for the lowest unit price feasible? Yes: it is the optimal order quantity No: compare total cost at all break quantities larger than feasible EOQ

The quantity that yields the lowest total cost is optimum 37

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Example: Quantity Discounts

Below is a quantity discount schedule for an item with an annual demand of 10,000 units that a company orders regularly at an ordering cost of $4. The annual holding cost is 2% of the purchase price per year. Determine the optimal order quantity.
Order Quantity(units) Price/unit($) 0 to 2,499 $1.20 2,500 to 3,999 1.00 4,000 or more .98

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Example: Quantity Discounts

D = 10,000 units H = .02R S = $4 R = $1.20, 1.00, 0.98
Order Quantity Price/unit($) 0 to 2,499 $1.20 2,500 to 3,999 1.00 4,000 or more .98

2(10,000)(4) 2DS = 1,826 units = QO = 0.02(1.20) H Interval from 0 to 2499,

2DS 2(10,000)(4) QO = = = 2,000 units H 0.02(1.00) Interval from 2500-3999, 2DS 2(10,000)(4) QO = = = 2,020 units H 0.02(0.98) Interval from 4000 & up,
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the Qo value is feasible

Qo value is NOT feasible

Qo value is NOT feasible

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Quantity Discount Models

1st range total cost curve

2nd range total cost curve

Annual cost

EOQ

3rd range total cost curve

EOQs (not feasible) 1st break quantity 2nd break quantity

0 LO 3

2500

4000

Quantity

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Example: Quantity Discounts

Q TC = H 2 + DS Q + RD

TC(0-2499) = (1826/2)(0.02*1.20) + (10000/1826)*4+(10000*1.20) = $12,043.82 TC(2500-3999)= $10,041 TC(4000&more)= $9,949.20

Therefore the optimal order quantity is 4000 units

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EOQ with Planned Shortages

Assumptions:
all shorted demand is back-ordered back-orders incur shortage costs shortage cost is proportional to waiting time all other basic EOQ assumptions

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EOQ with Planned Shortages

Annual Annual Annual TC ! Holding  Ordering  Back Order Cost Cost Cost Q  Qb 2 Qb2 D TC ! 2Q H  Q S  2Q B Q! 2 DS H  B H B

B ! back  order cost per unit per year Qb ! quantity back - ordered per order cycle H ! annual holding cost per unit D ! annual demand S ! ordering (or setup) cost per order

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Example: EOQ with Planned Shortage

Annual demand for a refrigerator is 50 units. Holding cost per unit per year is $200. Back-order cost per unit per year is estimated to be $500. Ordering cost from the manufacturer is $10 per order. Determine order quantity and back-order quantity per order cycle.

D = 50
Q!

H = $200

B = $500

S = $10

2 DS H  B ! H B

2(50)(10) 200  500 ! 2.65, round to 3 units. 200 B

H 200 Qb ! Q ! 3 ! 0.86, round to 1. H B 200  500

Allow inventory to drop to zero. When another unit is demanded, order 3 units. 44
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Concept Check
Which of the following is FALSE about EOQ? A. It determines how many to order. B. The EOQ always results in the lowest total cost. C. The model minimizes total cost by balancing carrying and order costs. D. The model is robust and works even if all assumptions are not exact.

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Concept Check
Which is NOT a difference between EOQ and EPQ? A. A different formula is used. B. EPQ is used mainly for producing batches, and EOQ is for receiving orders. C. Quantity is received gradually in EPQ. D. Demand can be variable for EPQ but not for EOQ.

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Concept Check
Which is NOT an assumption of both EOQ and EPQ? A. Demand is known with certainty and is constant over time B. No shortages are allowed C. Order quantity is received all at once D. Lead time for the receipt of orders is constant

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Whats next?
EOQ models give HOW MANY to order Now look at WHEN to order
Reorder Point (ROP)

ROP = d v LT
d = Demand rate (units per day or week) LT = Lead time (in days or weeks) Note: Demand and lead time must have the same time units. 48
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Example: ROP
Annual Demand = 1,000 units Days per year = 365 Lead time = 7 days

1,000 units/year d= = 2.74 units/day 365 days/year

ROP = d L = 2.74 units/day (7days) = 19.18 or 20 units
When inventory level reaches 20 units, place the next order.

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Fixed Order Quantity/Reorder Point Model

Reorder Point = Expected demand + Safety Stock (ROP) during lead time
Safety Stock 1. Variability of demand and lead time 2. Service Level 2a. Lead time service level 2b. Annual service level 50
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When to Reorder with EOQ Ordering

Reorder Point When inventory level drops to this amount, the item is reordered. Safety Stock - Stock that is held in excess of expected demand due to variability of demand and/or lead time. Service Level Probability demand will not exceed supply.
Lead time service level: probability that demand will not exceed supply during lead time. Annual service level: percentage of annual demand filled.

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Determinants of the Reorder Point

Rate of demand Demand and/or lead time variability Lead time

Stockout risk (safety stock)

ROP ! Expected demand  Safety stock during lead time

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Safety Stock
Quantity Safety stock reduces risk of stockout during lead time Maximum probable demand during lead time Expected demand during lead time

ROP Safety stock

LT LO 4
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Time

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Reorder Point
The ROP based on a normal Distribution of lead time demand

Safety Stock = z.WdLT

z = Safety factor; number of standard deviations above expected demand WdLT = The standard deviation of demand during lead time
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Demand During Lead Time

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ROP with Lead Time Service Level

variable demand during a lead time
ROP = expected demand during lead time + safety stock

ROP =

+ z.WdLT

z = Safety factor; number of standard deviations above expected demand WdLT = The standard deviation of demand during lead time

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ROP with Lead Time Service Level

variable demand and constant lead time
ROP =
(average demand x lead time) + z x st. dev. of demand during lead time (demand and lead time measures in same time units)

Wd = standard deviation of demand per day WdLT = Wd LT

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ROP with Lead Time Service Level

both demand and lead time are variable
ROP = (avg. demand x avg. lead time) + z x st. dev. of demand in lead time
(demand and lead time measures in same time units)

Wd= standard deviation of demand per day WLT= standard deviation of lead time WdLT = (average lead time x Wd2) + (average daily demand) 2WLT2

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Example 1: ROP with Lead Time Service Level

Calculate the ROP required to achieve a 95% service level for a product with average demand of 350 units per week and a standard deviation of demand during lead time of 10. Lead time averages one week. From Table 12-3 (p434), z for 95% = 1.65

ROP = 350 + ZWdLT = 350 + 1.65 (10) = 350 + 16.5 = 366.5 367
A new order should be placed when inventory level reaches 367 units.
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Example 2: ROP with Lead Time Service Level

Calculate the ROP and amount of safety stock required to achieve a 90% service level for a product with variable demand that averages 15 units per day with a standard deviation of 5. Lead time is consistently 2 days. From Table 12-3 (p434), z for 90% = 1.28

ROP = (15 units x 2 days) + ZWdLT = 30 + 1.28 ( 2) (5) = 30 + 8.96 = 38.96 39

Safety stock is about 9 units and a new order should be placed when inventory level reaches 39 units.
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Example 3: ROP with Lead Time Service Level

Calculate the ROP for a product that has an average demand of 150 units per day and a standard deviation of 16. Lead time averages 5 days, with a standard deviation of 2. The company wants no more than 5% stockouts.

service level = 1 5% = 95% From Table 12-3 (p434), z for 95% = 1.65 ROP = (150 units x 5 days) + 1.65Wdlt = (150 x 5) + 1.65 (5 days x 162) + (1502 x 12) = 750 + 1.65 (154) = 1,004 units Place a new order when inventory level reaches 1004 units 61
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ROP Using Annual Service Level

1. Calculate

Q(1  SLannual ) E( z) ! W dLT

2. Use a table to find the z value associated with E(z) 3. Use the z value in the appropriate ROP formula,
ROP ! expected demand during lead time  zW dLT
SLannual = annual service level E(z) = standardized expected number of units short during an order cycle.

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Min/Max model
similar to fixed order-quantity/reorder point (ROP) model difference:
if at order time, Q on hand < min (ROP), then order quantity = max Q on hand (max $ EOQ + ROP)

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Inventory Models
EOQ/ROP model
Order size constant, time between orders changes

Fixed Order Interval/Order up to Level Model

orders placed at fixed time intervals determine how much to order to bring inventory level up to a predetermined point (order up to level) used widely for retail consider expected demand during lead time, safety stock, and amount on hand demand or lead time can be variable

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Comparing Inventory Models

EOQ/ROP

Fixed Interval/ Order up to

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Fixed Order Interval: Benefits and Disadvantages

Benefits grouping items from same supplier can reduce ordering/shipping costs practical when inventories cannot be closely monitored Disadvantages requires a larger safety stock increases carrying cost costs of periodic reviews
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Fixed Order Interval/Order up to Level Model Determining the order interval

Total Annual Inventory Cost:

D j .OI 1 TC = R j .i  ( S  ns) 2 OI
*

Optimal Order Interval:

2 ( S  ns ) OI ! i DjRj

OI = order interval (in fraction of a year) S = fixed ordering cost per purchase order s = variable ordering cost per SKU included in the order (line item) (assume s is the same for every SKU) n = n number of SKUs purchased from the supplier Rj = unit cost of SKUj , j = 1, , n i = annual holding cost rate Dj = annual demand of SKUj , j = 1, ., n

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Fixed Order Interval/Order up to Level Model Determining the Order up to Level

Q ! I max  Amount on hand I max Expected demand Safety ! during protection  Stock ! interval

! d OI  LT  zW d OI  LT
= Average daily or weekly or monthly demand OI = Order interval (length of time between orders LT = Lead time in days or weeks or months z = Safety factor; # of standard deviations above expected demand Wd = Standard deviation of daily or weekly or monthly demand
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Example: Fixed Order Interval Model

Average daily demand for a product is 20 units, with a standard deviation of 4 units. The order interval is 30 days, and lead time is 10 days. Desired service level is 99%. If there are currently 200 units on hand, how many should be ordered?

I max ! d  OI  LT  zW d
= =

OI  LT

I max= 20 (30 + 10) + (2.32) (4) 30 + 10

800 + 2.32 (25.298) 858.7 or 859 units stock up to level

Amount to order = 859 200 = 659 units 69

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Coordinated Periodic Review Model

determines an order interval (OI) and order up to level for reviewing every stock keeping unit (SKU)
calculate a multiple (mi ) of OI for each SKUi use this to determine the optimal OI for each SKUi

To use:
Compare on hand inventory of each SKU to its ROP (forecast demand for next OI + lead time + safety stock) if on hand is less: order a quantity that brings the on hand level to SKUs order up-to level the order up-to level is enough for the next OI + LT. 70
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Single Period Model

Single period model model for ordering of perishables and other items with limited useful lives Shortage cost Cs generally the unrealized profits per unit Revenue per unit Cost per unit Excess cost Ce cost per unit - salvage per unit for items left over at the end of a period GOAL = find order quantity (stock level) that minimizes total excess and shortage costs. 71
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Single Period Model

Continuous stocking levels
Identifies optimal stocking levels Optimal stocking level balances unit shortage and excess cost

Discrete stocking levels

Desired service level is equaled or exceeded
Compare service level to cumulative probability of demand

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Optimal Stocking Level

Cs Service level (SL) = Cs + Ce
Ce

Cs = Shortage cost per unit Ce = Excess cost per unit

Cs

Service Level Quantity Balance point

So = Optimum stocking level (i.e., order quantity So

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Example 1: Single Period Model

Ce = $0.20 per unit Cs = $0.60 per unit Service level = Cs/(Cs+Ce) = .6/(.6+.2) Service level = .75
Ce Cs

Service Level = 75% Quantity

Stockout risk = 1.00 0.75 = 0.25

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Example 2: Single Period Model

A company usually carries 2 units of a spare part that costs $500 and has no salvage value. Part failures can be modeled by a Poisson distribution with a mean of 2 failures during the useful life of the equipment. Estimate the range of shortage cost for which stocking 2 units of this spare part is optimal.
The Poisson table (App. B, Table C) Cs is unknown Ce = $500 provides these values for a mean of 2.0: Cs ! .406, so Cs ! .406($500  Cs ) Number of Failures Cs  $500 Cumulative Probability Cs = $343.17 0 .135 1 Optimum stock .406 Cs level = 2, then .677 ! .677, so Cs ! .677($500  Cs ) 2 Cs  $500 SL between 3 .857 Cs = $1,047.99. 4 .947 The range of shortage cost 5 .983 is $343.17 to $1,047.99.

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Review: Inventory Models

EOQ models used to determine order size
Simple model for many types of inventory Trade-off between carrying and ordering costs Quantity discount model adds purchasing costs and compares total cost for various order sizes (that is still a feasible EOQ)

EPQ models used to determine production lot size

Used when producing and depleting items at same time Trade-off between carrying and setup costs Consider production and usage rate

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Review: Inventory Models

ROP (reorder point) Determines at what quantity (when) to re-order Consider expected demand during lead time and safety stock Trade-off cost of carrying safety stock & risk of stockout Fixed Order Interval Model Used when orders placed at fixed time intervals determine how much to order Used widely for retail Consider expected demand during lead time, safety stock, and amount on hand Demand or lead time can be variable Need more safety stock, but not continuous monitoring Single-Period Model Determines at what quantity (when) to re-order Used when cant carry goods to next period (e.g.. perishables) Trade-off cost of shortages & of excess (wasted) inventory

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Learning Checklist
Define the term inventory and list the major reasons for holding inventories. Discuss the objectives of inventory management. List the main requirements for effective inventory management. Describe the A-B-C approach and perform it. Describe Basic Inventory Control Systems Be able to describe and solve problems using:
EOQ, EPQ, ROP, Fixed Order Interval Model, Single Period Model. 78
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