PURCHASING MANAGEMENT

CHAPTER 5
INVENTORY MANAGEMENT

Instructor: Arafat aljebrini

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 LEARNING OBJECTIVES

1. To learn the relationship between the

purchasing function and inventory control.
2. To learn the primary reasons for holding inventory.
3. To identify the necessary requirements for effective
inventory management.
4. To learn about ABC analysis.
5. To identify the cost components of the classical
EOQ model.
6. To learn the basic assumptions of the EOQ model.
7. To learn about quantity discounts.
8. To learn about service levels.
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 DEPENDENT VERSUS INDEPENDENT
DEMAND
• • In order to manage the various types of inventory, attributes
of the items first must be analyzed in terms of cost, lead time,
past usage, and the nature of demand.
• • The nature of demand is perhaps the most important
attribute. The nature of demand can be either independent
or dependent.
• • Independent demand is unrelated to the demand for other
items. In other words, an independent item must be
forecasted independently.
• • Dependent demand is directly derived from demand for
another inventoried item demand

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 Importance of Inventory Control

■ Five uses of inventory:

■ The decoupling function
■ Storing resources
■ Irregular supply and demand
■ Quantity discounts
■ Avoiding stockouts and shortages
■ Decouple manufacturing processes.
■ Inventory is used as a buffer between stages
in a manufacturing process.
■ This reduces delays and improves efficiency.

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 Importance of Inventory Control

■ Storing resources.
■ Seasonal products may stored to satisfy
be
off-season demand.
■ Materials can be stored as raw materials,
work-in-process, or finished goods.
■ Labor can be stored as a component of
partially completed subassemblies.
■ Compensate for irregular supply and
demand.
■ Demand and may not be constant over
supply time.
■ Inventory can be used to buffer the variability.
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 Importance of Inventory Control

■ Take advantage of quantity discounts.

■ Lower prices may be available for
larger orders.
■ Extra costs associated with holding more
inventory must be balanced against lower
purchase price.
■ Avoid stockouts and shortages.
■ Stockouts may result in lost sales.
■ Dissatisfied may choose to buy
customers from
another supplier.
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 Inventory Decisions
■ There are two decisions in
fundamental
controlling inventory:
■ How much to order.
■ When to order.
■ The major objectiv is to minimize total
e
inventory costs.
■ Common inventory are:
costs
■ Cost of the items (purchas or material cost).
■ Cost of ordering. e
 ■ Cost of carrying, or holding, inventory.
■ Cost of stockouts.

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 Inventory Cost Factors
ORDERING COST FACTORS CARRYING COST FACTORS
Developing and sending purchase orders Cost of capital
Processing and inspecting incoming
inventory Taxes

Bill paying Insurance

Inventory inquiries Spoilage

Utilities, phone bills, and so on, for the
purchasing department Theft

Salaries and wages for the purchasing

department employees
Supplies, such as forms and paper, for Salaries and wages for
the purchasing department warehouse employees
Utilities and building costs for the
warehouse
Supplies, such as forms and paper, for
the warehouse

Table 6.1
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 Inventory Cost Factors
■ Ordering costs are generally independent
of order quantity.
■ Many involve personnel time.
■ The amount of work is the same no matter the
size of the order.
■ Carrying costs generally varies with the
amount of inventory, or the order size.
■ The labor, space, and other costs increase the
as
order size increases.
■ The actual cost of items purchased can vary
if there are quantity discounts available.
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ABC CLASSIFICATION OF INVENTORY
ITEMS
• The purpose of ABC analysis is to divide the inventory into
three groups based on the overall inventory value of the
items.
• Group A items account for the major portion of
inventory costs.
• Typically about 70% of the dollar value but only 10% of the quantity
of items.
• Forecasting and inventory management must be done carefully.
• Group B items are more moderately priced.
• May represent 20% of the cost and 20% of the quantity.
• Group C items are very low cost but high volume.
• It is not cost effective to spend a lot of time managing these items.
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 ABC CLASSIFICATION

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 Summary of ABC Analysis

INVENTORY
GROUP DOLLAR INVENTORY ARE QUANTITATIVE CONTROL
USAGE (%) ITEMS (%) TECHNIQUES USED?

A 70 10 Yes
B 20 20 In some cases
C 10 70 No

Table 6.8
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ight ©
2012
Pears
on
Educa
tion
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 INDEPENDENT DEMAND

we are concerned with the control of end items.

Primary Inventory Functions
1. Pipeline inventory
2. Cycle stocks
3. Seasonal inventories
4. Safety stocks
5. Decoupling stocks

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 Economic Order Quantity

■ The economic order quantity (EOQ) model

is one of the oldest and most commonly
known inventory control techniques.
■ It is easy to use bu has a number of
t
important assumptions.
■ Objective to minimize total cost of
is
inventory.
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 Inventory Costs in the EOQ Situation

Mathematical equations can be developed using:

Q = number of pieces to order
EOQ = Q* = optimal number of pieces to order
D = annual demand in units the inventory
item for
Co = ordering cost of each order
Ch = holding or carrying per unit per year
cost
Number of Ordering
Annual ordering cost = orders placed cost per
× per year order
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 Inventory Costs in the EOQ Situation

Mathematical equations can be developed using:

Q = number of pieces to order
EOQ = Q* = optimal number of pieces to order
D = annual demand in units the inventory
item for
Co = ordering cost of each order
Ch = holding or carrying per unit per year
cost
Average Carrying
Annual holding cost = inventory cost per unit
× per year
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 Finding the EOQ
According to the graph, when the EOQ assumptions
ar met, total cost is minimized when annual
e
ordering cost equals annual holding cost.

Solving for Q
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 Economic Order Quantity (EOQ) Model

Summary of equations:

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 Sumco Pump Company
■ Sumco Pump Company pump housings to
sells
other companies.
■ The firm would like to reduce inventory costs by
finding optimal order quantity.
■ Annual demand = 1,000 units
■ Ordering cost = $10 per order
■ Average carrying cost per unit year = $0.50
per
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 Sumco Pump Company

Total annual = Order cost + Holding cost

cost
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 CLASSICAL EOQ MODEL
ASSUMPTIONS

1. Demand is continuous at a constant rate

2. Constant lead time

3. Constant unit price

4. Fixed-order cost per order

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 CLASSICAL EOQ MODEL
ASSUMPTIONS (CONT.)

6. Instantaneous replenishment

7. No shortages allowed

8. No demand uncertainty

9. No quantity discounts available

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 Reorder Point:
Determining When To Order
■ Once the order quantity is determined,
the next decision is when to order.
■ The time between placing an order and
its receipt is called the lead time (L) or
delivery time.
■ When to order is generally expressed as a
reorder point (ROP).

ROP = Demand Lead time for a

× per day new order in days

=d×
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 Procomp’s Computer Chips

■ Demand for the computer is 8,000 per year.

chip
■ Daily demand is 40 units.
■ Delivery takes three working days.

ROP = d × L = 40 units per day × 3

days
= 120 units
■ An order based on the EOQ is placed
calculation
when the inventory reaches 120 units.
■ The order arrives 3 depleted.
days inventory is
later just as the

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 Quantity Discount Models
■ Quantity discounts commonl available.
are y
■ The basic EOQ model is adjusted by adding in the
purchase or materials cost.

Total cost Material cost + Ordering cost + Holding

cost =

where
D = annual demand in units
Co = ordering cost of each order
C = cost per unit
 Ch = holding or carrying cost per unit per
year
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 Quantity Discount Models
■Quantity discounts
Because unit are
costcommonly available.
is now variable,
■ The basic EOQ model is adjusted by adding in the
purchase orHolding
materials
I C
cost = Ch =
cost.
I = holding co s t as a percentage of the unit cost
Total
(C) cost = Material cost + Ordering cost + Holding
cost

where
D = annual demand in units
Co = ordering cost of each order
C = cost per unit
Ch = holding or carrying cost per unit per
year
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 Quantity Discount Models
■ A typical quantity discount schedule can look like
the table below.
■ However, buying at the lowest unit cost is not
always the best choice.

1 0 to 999 0
5.00
2 1,000 to 1,999 4
4.80
3 2,000 and over 5
4.75

Table 6.3
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DISCOUNT NUMBER
DISCOUNT QUANTITY DISCOUNT COST ($)
DISCOUNT (%)
 Brass Department Store
■ Brass Store stocks toy race cars.
Department
■ Their supplier ha given them the quantity
s
discount schedule shown in Table 6.3.
■ Annual demand is 5,000 cars, ordering cost is $49, and
holding cost is 20% of the cost of the car
■ The first step is to compute EOQ values for each
discount.
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 Brass Department Store Example

■ The second step is adjust quantities below the

allowable discount range.
■ The EOQ for discount 1 is allowable.
■ The EOQs for discounts 2 and 3 are outside the
allowable range and have to be adjusted to the
smallest quantity possible to purchase and
receive the discount:

Q1 = 700
Q2 = 1,000
Q3 = 2,000

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 Brass Department Store
The third step is to compute the total cost for each
quantity.
ANNUAL ANNUAL ANNUAL
UNIT ORDER MATERIAL ORDERING CARRYING
DISCOUNT PRICE QUANTITY COST ($) COST ($) COST ($)
NUMBER (C) (Q) = DC = (D/Q)Co = (Q/2)Ch TOTAL ($)
1 $5.00 700 25,000 350.00 350.00 25,700.00

2 4.80 1,000 24,00 245.00 480.00 24,725.00

0

3 4.75 2,000 23,75 122.50 950.00 24,822.50

0

The final step is to choose the alternative with the

lowest total cost.
 Table 6.4
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 The END,,,

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