KKG-GS/POM-03 1

Inventory Management
POM 2003
KKG-GS/POM-03 2
Inventory Management
Introduction
Inventory System: an Input-output Description
Inventory-related Costs
Inventory Model Building
Economic-order-quantity (EOQ Model
Economic-production-quantity (EPQ) Model
Inventory Model Allowing Shortages
Inventory Model Allowing Price Discounts
KKG-GS/POM-03 3
Inventory Management
Definition
In operations management, inventory
refers to any scarce resource that
remains idle in anticipation of satisfying
a future demand for it.

KKG-GS/POM-03 4
Inventory Management
System Inventories
Factory: Raw materials, Spare-parts Semi-finished goods
Finished goods

Commercial bank: Cash reserves, Tellers


Hospital: Number of beds, Specialized personnel, drugs, etc.


Airline company: Aircraft seat miles per route, engine parts for
repairs

KKG-GS/POM-03 5
Inventory Management
The inventory problem involves the formulation of
decision rules that answer two important questions :
1.When is it necessary to place an order (or set up for
production) to replenish inventory?
2.How much is to be ordered (or produced) for each
replenishment?

The decision rules must aim at satisfying anticipated
demand at minimum cost or maximum profit.

KKG-GS/POM-03 6
Inventory Management
Types of Inventory
Pipeline (or transit) ) inventories
Economic order quantities
Safety (or buffer) stocks
Decoupling inventories
Seasonal inventories

KKG-GS/POM-03 7
Inventory Management

Inventory system
Input

Output
Operating decision
rules
When?
How much?
Operating
constraints
Replenishment
(Physical
inflow)
Demand
(Physical
outflow)
Total Inventory cost
Figure-1: An input-output representation of an inventory system


KKG-GS/POM-03 8
Inventory Management
Decision-making mechanism The decision-
making mechanism is designed to respond to
when inventory must be replenished t
how much must be ordered (or produced
internally) for each replenishment Q.

KKG-GS/POM-03 9
Inventory Management
(1) Replenishment may take place at fixed time
intervals (t = constant), by orders of variable
size (Q = variable) to bring inventory to a
desired level

(1) Replenish by a fixed amount (Q = constant)
when inventory drops to a certain reorder
level, an event which may happen at
variable cycle times (t = variable).
KKG-GS/POM-03 10
Inventory Management
Types of inventory cost
C
B
= purchase cost = cost of buying items placed on
inventory
C
H
= holding cost = cost incurred from having surplus
inventories
C
S
= shortage cost = cost incurred from shortages or
lack of inventories
C
R
= replenishment cost = cost of placing an order
with an outside supplier or setting up production



KKG-GS/POM-03 11
Inventory Management
Total Inventory Cost
TC = C
H
+ C
S
+ C
R
+ C
B
=Holding cost + Shortage cost+Replenishment
cost + Purchase cost
Holding Cost
C
H
= c
h
* I
H

c
H
= f .b ( holding cost as fraction * unit cost)
I
H
= l
1*
(I
Max
+

I
min
)/2; where l
1
is % time surplus
exists


KKG-GS/POM-03 12
Inventory Management
Inventory
level
Q(T)
I
max
= 600


I
H
= 400


I
min
= 200

Figure-2(a): Reorder cycle time (without shortage)
t = 3 months
0 Time T
Surplus
KKG-GS/POM-03 13
Inventory Management
Inventory
level Q(T)
Max Surplus

= 600


0


Max.shortage
= 300


Shortage
t
2
= 1 month
t
1
= 2 months
0 Time T
Figure-2(b): Reorder cycle time (with shortage)


Surplus
KKG-GS/POM-03 14
Inventory Management
Shortage cost: C
S
= c
S
I
S *.
l
2
= c
S*.
l
2*.
(I
max+
I
min
)

/2




c
S
is determined by estimating the cost incurred when
demand cannot be satisfied for lack of inventory :
The extra expenses (administrative, clerical, etc.) for
expediting an order
Possible loss in goodwill resulting from failure to satisfy
customer
The forgone profits from lost customers

time unit per
shortage of amount Average
time unit per unit
short being of Cost
t
Shortage



1

cos
=
KKG-GS/POM-03 15
Inventory Management
Shortage Cost




Replenishment Cost
C
R
=
c
R *.
I
R;
where

2
max min
2
l
I I
I
S

+
=
exist shortages time
cycle of percentage cycle during
shortage imum
cycle during
shortage imum
inventory
shortage Average


2

max

min



|
|
.
|

\
|
+
|
|
.
|

\
|
=
time unit per setups
or orders of number Average
setup per
or order per Cost
t
t plenishmen





cos
Re
=
Q
D
I
R
=
KKG-GS/POM-03 16
Inventory Management
Cost of Purchase

C
B
= bD



time unit
per Demand
Q is size lot
when unit per ice
t
Purchase




Pr
cos

=
KKG-GS/POM-03 17
Inventory Management
Total Inventory Cost




Total Incremental Inventory Cost
t
purchase
t
ent replenishm
t
shortage
t
holding
t
inventory Total
cos

cos

cos

cos

cos

+ + + =
t
ent replenishm
t
shortage
t
holding
Cost
Inventory
l Incrementa
Total
cos

cos

cos




+ + =
KKG-GS/POM-03 18
Inventory Management
Inventory System Specification
Demand
D = demand rate is known and constant throughout the reorder
cycle time

Replenishment
p = replenishment (or production) rate is infinite (entire
quantity ordered Q is added to existing stock all at once)
L = lead time is known and constant
b = price per unit is constant [no discounts offered: thus, b(Q) =
for all order quantities Q].

KKG-GS/POM-03 19
Inventory Management
Inventory System Specification (contd.)
Costs
c
H
, c
R
= unit costs of holding inventory and ordering
are known and constant
c
S
= unit cost of shortage is infinite (system
operates without shortages; that is, I
s
= 0)

2.Decision variables
Q = order quantity replenishment size
t = reorder cycle time, i.e., time between successive
decisions to replenish


KKG-GS/POM-03 20
Inventory Management
Order
arrives
Maximum
Inventory
I
max
= Q


Reorder point,
R




Order
placed
L t
Time T
Reorder
cycle time

Supply lead
time
KKG-GS/POM-03 21
Inventory Management
start with maximum amount of inventory
equal to the order quantity (I
max
= Q).
inventory level drops at a fixed rate equal to
the demand rate D.
a reorder point R, we have enough inventory
to cover expected demand during the lead
time (R = D L).
order is placed equal to Q, which arrives at
the end of the lead time
KKG-GS/POM-03 22
Inventory Management
shortage cost C
S
will be zero since we do not
allow for any shortages
purchase cost C
B
will remain constant
regardless of Q, because no discounts.
total incremental inventory cost
TIC = C
H
+ C
R

Since we seek to find the value of Q that
makes TIC a minimum, we must express C
H

and C
R
in terms of Q.
KKG-GS/POM-03 23
Inventory Management
Q
D
c I c C
Q
c
Q
c
I I
c I c C
R R R R
H H H H H
= =
=
+
=
+
= =
2 2
0
2
min max
H
Q
D
c
Q
c TIC
R H
+ =
2
KKG-GS/POM-03 24
Inventory Management

Optimal Order Qty (EOQ)

TIC
0
Fig:4-Cost relationships in EOQ model
Holding cost
Ordering cost
TIC
KKG-GS/POM-03 25
Inventory Management
? order much to How
2
H
R
o
c
D c
Q =
? order to When
D
Q
t
o
=
cost inventory l incrementa Minimum
2 D c c TIC
R H o
=
KKG-GS/POM-03 26
Inventory Management
Let us consider an inventory system, where
there is production contributing to inventory
Production is @ p: finite, constant
Demand is @ D
During production, we are adding @ p, while
demand causes inventory to deplete @ D
During no production, depletion @ D
No shortages
KKG-GS/POM-03 27
Inventory Management
Inventory
added @ p
Inventory taken
out @ D
p>D
During
production,
build @ p-D
No
addition
P=0
Inventory
taken out @ D
After production,
depletion
@ D
Figure 7: Inventory fluctuation during production & after production stops
KKG-GS/POM-03 28
Inventory Management
t
p

t
Replenishment cycle t
L
L
Reorder
point
I
max
Maxm.
Inventory
Prodn.
Lot
Size Q
Prodn. End
Prodn. start
KKG-GS/POM-03 29
Inventory Management
If production is @ p over time t
p
Q=p. t
p
During production,inventory is added @ p and depleted @ D
Net inventory build-up = p-D
At the end of production, I
max
=(p-D) t
p
Max.Inventory level=(build-up rate) X (production period)
Total Incremental Inventory Cost=
(Holding cost) + (Set up cost)
TIC= C
H
+ C
R
Holding cost C
H
= C
H
.(1-D/p).Q/2
Set-up cost C
R
= C
R
. I
R
= C
R.
.(D/Q)



KKG-GS/POM-03 30
Inventory Management
( )
?
/ 1
2
time each produce to much How
p D c
D c
Q
H
R
o

=
? produce to when
D
Q
t
o
o
=
t inventory l incrementa Minimium
D c
p
D
c TIC
R H o
cos
1 2
|
|
.
|

\
|
=
KKG-GS/POM-03 31
Inventory Management
Inventory Model Allowing Shortages
1.Demand = known and constant
2.Replenishment
P = (instantaneous addition of order quantity to
inventory)
L = known and constant
b(Q) = b (no price discounts allowed)
3.Costs
C
H
, C
S
, C
R
= known and constant unit costs
c
S
= unit cost of shortage is infinite
(system operates without shortages; that is, I
s
= 0)

KKG-GS/POM-03 32
Inventory Management
Inventory Model Allowing Shortages


Maximum
shortage R
t
1
t
1
t
2
t
2
Maximum
Surplus M
Reorder cycle t
M
0
KKG-GS/POM-03 33
Inventory Management
4.Decision variables
Q = size of each order or replenishment
M = desired maximum, i.e., starting inventory at
beginning of cycle time
5.Relationships
Order quantity Q = D t

Reorder level R = M Q

Reorder cycle time t = t
1
+ t
2


KKG-GS/POM-03 34
Inventory Management
t
ordering
t
shortage
t
holding
t inventory
l incrementa Total
cos cos cos cos

+ + =
TIC = C
H
+ C
S
+ C
R

or


t
t
l I M I and
exists surplus
cycle of
surplus
Average
l
I I
I where
I c C
H
H h H
1
1 min max
1
min max
, 0 ,

%

2

cost Holding
= = =
|
|
.
|

\
|
|
|
.
|

\
|
+
=
=
KKG-GS/POM-03 35
Inventory Management
Shortage Cost
t
t
l I Q M R I and
exists shortage
cycle of
shortage
Average
l
I I
I where
I c C
S
S S S
2
2 min max
2
min max
, 0 ,

%

2


= = = =
|
|
.
|

\
|
|
|
.
|

\
|
+
=
=


KKG-GS/POM-03 36
Inventory Management
Shortage Cost =



Ordering Cost =


Holding Cost=


S S s
c
Q
Q M
c
Q
Q M Q M
C

=
2
) (
2
2
Q
D
c I c C
r R r R
. . = =
Q
M
c C
h H
2
2
=
KKG-GS/POM-03 37
Inventory Management
Total Incremental Cost
= Ordering + Shortage + Holding Cost



(

+
(

+
(

=
Q
M
c
Q
D
c c
Q
Q M
TIC
h r S
2
. .
2
) (
2 2
KKG-GS/POM-03 38
Inventory Management





Minimum Incremental Inventory Cost
?
2
0
time each order to much How
c
c c
c
D c
Q
S
S H
H
R
+
=
inventory starting Desired
c c
c
c
D c
M
H S
S
H
R

2
0
+
=
t inventory l incrementa Minimum
c c
c
D c c TIC
S H
S
R H
cos 2
0
+
=
H
c
KKG-GS/POM-03 39
Inventory Management
The reorder cycle time and reorder level are
determined easily as follows :



?
0
0
order to When
D
Q
t =
Re
0 0
level order Q M R =
KKG-GS/POM-03 40
Inventory Management
Inventory Model With Price Discounts
Suppliers offer price discounts to encourage large
orders,price becomes a step-function, instead of fixed


Do savings in the purchase cost due to discounts and
reduction in ordering costs (less number of orders)
absorb the additional holding costs ?
Shortage cost C
s
is not considered
Purchase cost C
B
is now affected by the order quantity
Q. For this case, it is necessary to minimize the total
inventory cost TC.
units k Q when unit dollars b
units k Q when unit dollars b Q b
/
/ ) (
2
1
>
< =
KKG-GS/POM-03 41
Inventory Management
Inventory Model With Price Discounts

t
purchase
t
ordering
t
holding
t
inventory Total
cos cos cos cos

+ + =
D Q b
Q
D
c
Q
Q b f C C C TC
R B R H
) (
2
)] ( [ + + = + + =
KKG-GS/POM-03 42
Inventory Management
Example:
D=3600; f=0.25; c
r
= $16/0rder
Price

> =
< =
=
gal Q if gallon per b
gal Q if gallon per b
Q b
300 6 $
300 8 $
) (
2
1
KKG-GS/POM-03 43
Inventory Management
Example
The EOQ at the lower price $6 will be

order gal
f b
D c
b Q
R
o
/ 13 . 277
800 , 76
) 6 )( 25 (
) 600 , 3 )( 16 )( 2 (

2
) (
2
2
=
=

= =
KKG-GS/POM-03 44
Inventory Management
Example
This amount is less than the order size of 300
needed to take advantage of the discount
offered. Therefore, we must calculate the
total costs incurred for the EOQ at the regular
price and for orders equal to k = 300 at the
discounted price.
KKG-GS/POM-03 45
Inventory Management
yr
b TC
theref ore
D b
Q
D
c
Q
b f b TIC
D b Q where
D b b TIC b TC
o
o
R
o
o
o
/ 280 , 29 $
800 , 28 480 ) (
800 , 28 $ 3600 * 8
480 $ 240 240
2
) (
) , 3600 , 8 $ , 240 ( ,
) ( ) (
1
1
1 1
1
1 1 1
=
+ =
= =
= + = + =
= = =
+ =
KKG-GS/POM-03 46
Inventory Management
When Q = k = 300 gal, we have



. / 017 , 22 $
600 , 21 192 225
) 600 , 3 )( 6 (
300
600 , 3
) 16 (
2
300
) 6 )( 25 (
2
) (
2 2
yr
D b
k
D
c
k
b f b at k Q TC
R e
=
+ + =
+ + =
+ + = =
KKG-GS/POM-03 47
Inventory Management
Thus, to minimize total inventory costs the
maintenance department must order in
amounts equal to Q* = 300 gal

KKG-GS/POM-03 48
Inventory Management


Single-stage Inventory Model Under Conditions Of Risk
For certain items replenishment of inventory occurs only
once during each planning period
Demand is uncertain and can be described with a
statistical distribution, from record of past experience
The cost of each unit stocked C and its selling price B.
If demand is insufficient during the current period, the
leftover units are sold at a reduced price S overstocking
If demand exceeds the number of units stocked, there is a
stock out, cost per unit equal is forgone profit B-C (under
stocking).
Specifying a decision rule that would minimize the
expected cost during the period






KKG-GS/POM-03 49
Inventory Management



The Edelweiss Bakery Shop prepares a deluxe cake each
weekend for its best customers. The demand for this
cake from week to week is uncertain, but the owner of
the bakery has kept a record of sales in past weeks, and
the statistical distribution for demand is shown in
Computation Table

The owner sells the cakes for $8 each and has
estimated that they cost $5 to prepare. If any fresh cakes
are left over after the weekend, they are put on special
sale on Monday and sold at $ 3 and all are sold.
KKG-GS/POM-03 50
Decision Rule A
For the single-stage inventory problem
under conditions of risk, the optimal
action on the number of units to stock
Q
o
is the one yielding the minimum
total expected cost, i.e.,
TEC(Q
o
)
= minimum TED (Q) over all Q values
KKG-GS/POM-03 51
Inventory Management


Table 3: Total Expected cost of inventory decisions

P(y)

.05

.15

.20

.25

.20

.15

TEC
values

Demand

Action

0

1

2

3

4

5

0

0

3

6

9

12

15

8.55

1

2

0

3

6

9

12

5.8

2

4

2

0

3

6

9

3.8

3

6

4

2

0

3

6

2.8

4

8

6

4

2

0

3

3.05

5

10

8

6

4

2

0

4.3

KKG-GS/POM-03 52
Inventory Management


Decision Rule B
For the single-stage inventory problem under
conditions of risk, the optimal action on the number of
units to stock Q
o
corresponds to the largest value of Q
for which:

ratio value Critical
C C
C
Q y P
o u
u
) (
+
s <
KKG-GS/POM-03 53
Inventory Management


600
2 3
3
) (
) (
=
+
s <
+
s <
Q y P or
C C
C
Q y P
o u
u
For the bakery-shop example we have:
KKG-GS/POM-03 54
Inventory Management


For a production quantity Q = 3

40
20 15 05
) 2 ( ) 1 ( ) 0 ( ) 3 (
=
+ + =
= + = + = = < y P y p y P y P
while for a production quantity Q = 4

65
25 20 15 05
) 3 ( ) 2 ( ) 1 ( ) 0 ( ) 4 (
=
+ + + =
= + = + = + = = < y P y P y p y P y P
KKG-GS/POM-03 55
Inventory Management


Therefore, the value of Q, for which
cumulative probability is less than or
equal to 0.60 is Q = 3

The obvious advantage of this method is
that it completely obviates the
calculation of entries in tabular form, for
stock-out and surplus costs and expected
costs for each action.