Inventory Management

• Reference Books:
• Operations and supply chain management: The
core; By F, Robert Jacobs and Richard B. Chase.
• Operations Management By William J. Stevenson
• Production and Operations Management Systems;
By Sushil Gupta and Martin Starr.
• Operations management By R. Dan Reid and Nada
R. Sanders.
• Operations Management By- Gérard Cachon
and Christian Terwiesch.
 Inventory
• Inventory is the stock of any item or resource
used in an organization.
• An inventory system is the set of policies and
controls that monitor levels of inventory and
determine what levels should be maintained,
when stock should be replenished, and how
large orders should be.
 Basic purpose of inventory analysis

• The basic purpose of inventory analysis,

whether in manufacturing, distribution, retail,
or services, is to specify (1) when items should
be ordered and (2) how large the order should
be. Many firms are tending to enter into
longer-term relationships with vendors to
supply their needs for perhaps the entire year.
This changes the “when” and “how many to
order” to “when” and “how many to deliver.”
 Purposes of inventory

• To maintain independence of operations.

• To meet variation in product demand.
• To allow flexibility in production scheduling.
• To provide a safeguard for variation in raw
material delivery time.
• To take advantage of economic purchase
order size.
• Many other domain-specific reasons.
 Objectives of Inventory Control
1. To ensure adequate supply of products to customer and avoid
shortages as far as possible.
2. To make sure that the financial investment in inventories is
minimum (i.e., to see that the working capital is blocked to the
minimum possible extent).
3. Efficient purchasing, storing, consumption and accounting for
materials is an important objective.
4. To maintain timely record of inventories of all the items and to
maintain the stock within the desired limits
5. To ensure timely action for replenishment.
6. To provide a reserve stock for variations in lead times of delivery
of materials.
7. To provide a scientific base for both short-term and long-term
planning of materials.
 Benefits of Inventory Control
It is an established fact that through the practice of
scientific inventory control, following are the benefits of
inventory control:
1. Improvement in customer’s relationship because of
the timely delivery of goods and service.
2. Smooth and uninterrupted production and, hence,
no stock out.
3. Efficient utilization of working capital. Helps in
minimizing loss due to deterioration, obsolescence
damage and pilferage.
4. Economy in purchasing.
5. Eliminates the possibility of duplicate ordering.
 Techniques of Inventory Control
1. ABC analysis:
2. HML analysis: In this analysis, the classification of existing inventory is based on
unit price of the items. They are classified as high price, medium price and low cost
items.
3. VED analysis: In this analysis, the classification of existing inventory is based on
criticality of the items. They are classified as vital, essential and desirable items. It
is mainly used in spare parts inventory.
4. FSN analysis: In this analysis, the classification of existing inventory is based
consumption of the items. They are classified as fast moving, slow moving and
non-moving items.
5. SDE analysis: In this analysis, the classification of existing inventory is based on the
items.
6. GOLF analysis: In this analysis, the classification of existing inventory is based
sources of the items. They are classified as Government supply, ordinarily
available, local availability and foreign source of supply items.
7. SOS analysis: In this analysis, the classification of existing inventory is based nature
of supply of items. They are classified as seasonal and off-seasonal items.
 ABC Analysis
An analysis that divides inventory into three
groups: Group A is more important than group B,
which is more important than group C

ABC Analysis is one of the important techniques which is

based on grading the items according to the importance
of materials. This method is popularly known as Always
Better Control.
Materials are grouped into three categories on the basis
of the money value of importance of materials. (1) High
Value Materials – A, (2) Medium Value Materials – B, (3)
Low Value Materials – C .
▪The items in the A group are critical.
▪The B group items are important but not critical.
▪The C group items are not as important as the others in
terms of annual dollar value.
 ABC Inventory Classification
• ABC classification is a method for determining level of control
and frequency of review of inventory items
• A Pareto analysis can be done to segment items into value
categories depending on annual dollar volume
• A Items – typically 20% of the items accounting for 80% of the
inventory value-use Q system
• B Items – typically an additional 30% of the items accounting
for 15% of the inventory value-use Q or P
• C Items – Typically the remaining 50% of the items accounting
for only 5% of the inventory value-use P .
ABC Example: the table below shows a solution to an ABC analysis. The information
that is required to do the analysis is: Item #, Unit $ Value, and Annual Unit Usage. The
analysis requires a calculation of Annual Usage $ and sorting that column from
highest to lowest $ value, calculating the cumulative annual $ volume, and grouping
into typical ABC classifications.
 Advantages of ABC Analysis
(1) Exercise selective control is possible.
(2) Focus high attention on high value items is
possible.
(3) It helps to reduce the clerical efforts and costs.
(4) It facilitates better planning and improved
inventory turnover.
(5) It facilitates goods storekeeping and effective
materials handling.
 Types of Inventories
a) Raw materials inventory as input to
manufacturing system.
b) Bought-out-parts (BOP) inventory which directly
go to the assembly of product as it is.
c) Work-in-progress (WIP) or work-in-process
inventory or pipeline inventory.
d) Finished goods inventory for supporting the
distribution to the customers.
e) Maintenance, repair, and operating (MRO)
supplies. These include spare parts, indirect
materials, and all other sundry items required for
production/service systems.
 Inventory costs
In making any decision that affects inventory size, the following costs must be considered.
1. Holding (or carrying) costs. This broad category includes the costs for storage facilities,
handling, insurance, pilferage, breakage, obsolescence, depreciation, taxes, and the
opportunity cost of capital. Obviously, high holding costs tend to favor low inventory levels
and frequent replenishment.

2. Setup (or production change) costs. To make each different product involves obtaining
the necessary materials, arranging specific equipment setups, filling out the required
papers, appropriately charging time and materials, and moving out the previous stock of
material. If there were no costs or loss of time in changing from one product to another,
many small lots would be produced. This would reduce inventory levels, with a resulting
savings in cost. One challenge today is to try to reduce these setup costs to permit smaller
lot sizes. (This is the goal of a JIT system.)

3. Ordering costs. These costs refer to the managerial and clerical costs to prepare the
purchase or production order. Ordering costs include all the details, such as counting items
and calculating order quantities. The costs associated with maintaining the system needed
to track orders are also included in ordering costs.
Inventory Cost Factors
 Relevant Inventory Costs

Item Cost Cost per item plus any other direct costs
associated with getting the item to the
plant
Holding Capital, storage, and risk cost typically
Costs stated as a % of the unit value,
e.g. 15-25%
Ordering Fixed, constant dollar amount incurred
Cost for each order placed

Shortage Loss of customer goodwill, back order

Costs handling, and lost sales
 Order Quantity Strategies
Lot-for-lot Order exactly what is needed for the
next period
Fixed-order Order a predetermined amount each
quantity time an order is placed
Min-max When on-hand inventory falls below a
system predetermined minimum level, order
enough to refill up to maximum level
Order n Order enough to satisfy demand for
periods the next n periods
 Variables used in the analysis
• Unit Cost (UC)
o Price charged by the suppliers for one unit of item, or
o Total cost to organization of acquiring one unit
o $ / unit

• Reorder cost (RC)

o Cost of placing a routine order
o $ / order, $/setup

• Holding cost (HC)

o Cost of holding one unit of the item in stock for one period of
o Time
o $ / unit-period

• Shortage cost (SC)

o Cost of having a shortage and not being able to meet demand from stock
o $ / unit-period
 Variables used in the analysis

Order quantity (Q)

• Fixed order size
Cycle time (T)
• Time between two consecutive replenishment
• Depends on Q
Demand (D)
• The number of units to be supplied from stock in a
given time period
• Basic EOQ assumes known constant demand
 Components of total cost

1. Cost of the items

2. Cost of ordering
3. Cost of carrying, or holding,
inventory
4. Cost of stockouts
5. Cost of safety stock, the additional
inventory that may be held to help avoid
stockouts
An oil engine manufacturer purchases lubricants at the rate of Rs. 42 per piece from a
vendor. The requirements of these lubricants are 1800 per year. What should be the
ordering quantity per order, if the cost per placement of an order is Rs. 16 and
inventory carrying charges per rupee per year is 20 paise.
A manufacturing company purchase 9000 parts of a machine for its annual
requirements ordering for month usage at a time, each part costs Rs. 20. The
ordering cost per order is Rs. 15 and carrying charges are 15% of the average
inventory per year. You have been assigned to suggest a more economical purchase
policy for the company. What advice you offer and how much would it save the
company per year?
Tacky Souvenirs sells lovely handmade tablecloths at its island store. These tablecloths
cost Tacky $15 each. Customers want to buy the tablecloths at a rate of 240 per week.
The company operates 52 weeks per year. Tacky, the owner, estimates his ordering cost
at $50. Annual holding costs are 20 percent of the unit cost. Lead time is 2 weeks.
Using the information given,
(a) Calculate the economic order quantity.
(b) Calculate the total annual costs using the EOQ.
(c) Determine the reorder point.
Jack’s Packs manufactures backpacks made from microfabrics. The cutting
department prepares the material for use by the backpack stitching department. The
cutting department can cut enough material to make 200 backpacks per day. The
backpack stitching department produces 90 backpacks per day. Annual demand for
the product is 22,500 units. The company operates 250 days per year. Estimated setup
cost is $60. Annual holding cost is $6 per backpack.
(a) Calculate the economic production quantity for the cutting department.
(b) Calculate the total annual costs for the EPQ.
 Assumptions of the EOQ model.
1. Demand is known and constant.
2. The lead time—that is, the time between the placement of
the order and the receipt of the order—is known and
constant.
3. The receipt of inventory is instantaneous. In other words,
the inventory from an order arrives in one batch, at one
point in time.
4. Quantity discounts are not possible.
5. The only variable costs are the cost of placing an order,
ordering cost, and the cost of holding or storing
inventory over time, carrying, or holding, cost.
6. If orders are placed at the right time, stockouts and
shortages can be avoided completely.
Inventory Usage over
Time
Examples of Ordering Approaches
 Three Mathematical Models for
Determining Order Quantity
• Economic Order Quantity (EOQ or Q System)
– An optimizing method used for determining order quantity
and reorder points
– Part of continuous review system which tracks on-hand
inventory each time a withdrawal is made
• Economic Production Quantity (EPQ)
– A model that allows for incremental product delivery
• Quantity Discount Model
– Modifies the EOQ process to consider cases where quantity
discounts are available
 Economic Order Quantity

• EOQ Assumptions:
– Demand is known & constant - no
safety stock is required
– Lead time is known & constant
– No quantity discounts are
available
– Ordering (or setup) costs are
constant
– All demand is satisfied (no
shortages)
– The order quantity arrives in a
single shipment
EOQ: Total Cost Equation
 EOQ Total Costs
Total annual costs = annual ordering costs + annual holding costs
 The EOQ Formula
Minimize the TC by ordering the EOQ:
 EOQ Example
• Weekly demand = 240 units
• No. of weeks per year = 52
• Ordering cost = $50
• Unit cost = $15
• Annual carrying charge = 20%
• Lead time = 2 weeks
EOQ Example Solution
 Inventory costs
• Holding (or carrying) costs: This broad category includes the
costs for storage facilities, handling, insurance, pilferage,
breakage, obsolescence, depreciation, taxes, and the
opportunity cost of capital. Obviously, high holding costs tend
to favor low inventory levels and frequent replenishment.
• Setup (or production change) costs: To make each different
product involves obtaining the necessary materials, arranging
specific equipment setups, filling out the required papers,
appropriately charging time and materials, and moving out
the previous stock of material. If there were no costs or loss
of time in changing from one product to another, many small
lots would be produced. This would reduce inventory levels,
with a resulting savings in cost. One challenge today is to try
to reduce these setup costs to permit smaller lot sizes. (This is
the goal of a JIT system.)
• Ordering costs: These costs refer to the managerial and
clerical costs to prepare the purchase or production order.
Ordering costs include all the details, such as counting items
and calculating order quantities. The costs associated with
maintaining the system needed to track orders are also
included in ordering costs.
• Shortage costs: When the stock of an item is depleted, an
order for that item must either wait until the stock is
replenished or be canceled. When the demand is not met
and the order is canceled, this is referred to as a stock out.
A backorder is when the order is held and filled at a later
date when the inventory for the item is replenished. There
is a trade-off between carrying stock to satisfy demand and
the costs resulting from stock outs and backorders. This
balance is sometimes difficult to obtain because it may not
be possible to estimate lost profits, the effects of lost
customers, or lateness penalties. Frequently, the assumed
shortage cost is little more than a guess, although it is
usually possible to specify a range of such costs.
 Independent versus Dependent demand
• Independent demand: The demands for various items
are unrelated to each other.
• Dependent demand: The need for any one item is a
direct result of the need for some other item, usually an
item of which it is a part.
• For example, if an automobile company plans on
producing 500 cars per day, then obviously it will need
2,000 wheels and tires (plus spares). The number of
wheels and tires needed is dependent on the
production levels and is not derived separately. The
demand for cars, on the other hand, is independent—it
comes from many sources external to the automobile
firm and is not a part of other products; it is unrelated
to the demand for other products.
Independent and Dependent Demand
Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
Dr. M.A. Shahid/MRP 40
 Inventory systems
• A Single-Period Inventory Model
• Multi period Inventory Systems
– Fixed–order quantity model (Q-model)
– Fixed–time period model (P-model)
• Fixed–order quantity model (Q-model): An
inventory control model where the amount
requisitioned is fixed and the actual ordering is
triggered by inventory dropping to a specified
level of inventory.
• Fixed–time period model (P-model): An inventory
control model that specifies inventory is ordered
at the end of a predetermined time period. The
interval of time between orders is fixed and the
order quantity varies
Basic Fixed–Order Quantity Model
Total Cost as a Function of Order Quantity
Figure: Annual Product Costs, Based on Size of the Order
 Finding the Economic Order Quantity

The optimal order quantity, Q*, is the point that minimizes

the total cost, where total cost is the sum of ordering cost and
carrying cost.

We also indicated graphically that the optimal order quantity

was at the point where the ordering cost was equal to the
carrying cost. Let us now define the following parameters
 Total cost =Total purchase cost + Total ordering cost +Total carrying cost

Total ordering cost =D/Q *S

Total carrying cost =Q/2*H

 Q* =Optimal order quantity i.e. EOQ
D =Annual demand, in units, for the inventory item
O =Ordering cost per order
H =Carrying or holding cost per unit per year
P =Purchase cost per unit of the inventory item

The unit carrying cost, H is usually expressed in one of two ways, as

follows:
1. As a fixed cost. For example, H is $0.50 per unit per year.
2. As a percentage (typically denoted by I) of the item’s unit purchase
cost or price. For example, H is 20% of the item’s unit cost. In
general, H =I *P
Sumco, a company that buys pump housings from a manufacturer and
distributes to retailers. Sumco would like to reduce its inventory cost by
determining the optimal number of pump housings to obtain per order. The
annual demand is 1,000 units, the ordering cost is $10 per order, and the
carrying cost is $0.50 per unit per year. Each pump housing has a purchase
cost of $5. How many housings should Sumco order each time?
 Economic Production Quantity (EPQ)

Economic production quantity (EPQ) is the quantity of a

product that should be manufactured in a single batch so
as to minimize the total cost that includes setup costs for
the machines and inventory holding costs.

The basic model of EOQ gives the equation to calculate

EOQ as follows

EPQ= Economic production quantity

S= Setup cost
D= annual demand
d= daily demand rate
p= daily production rate
 EPQ (Economic Production Quantity) Assumptions

• Same as the EOQ except: inventory arrives in increments

& is drawn down as it arrives
 EPQ Equations

• Adjusted total cost:

• Maximum inventory:

• Adjusted order quantity:

 EPQ Example
• Annual demand = 18,000 units
• Production rate = 2500 units/month
• Setup cost = $800
• Annual holding cost = $18 per unit
• Lead time = 5 days
• No. of operating days per month = 20
• Find out i) EPQ ii) Maximum inventory iii) Total
inventory cost
EPQ Example Solution
EPQ Example Solution (cont.)

• The reorder point:

• With safety stock of 200 units:

 Jack’s Packs manufactures backpacks made from microfabrics. The cutting department
prepares the material for use by the backpack stitching department. The cutting
department can cut enough material to make 200 backpacks per day. The backpack
stitching department produces 90 backpacks per day. Annual demand for the product is
22,500 units. The company operates 250 days per year. Estimated setup cost is $60.
Annual holding cost is $6 per backpack.
(a) Calculate the economic production quantity for the cutting department.
(b) Calculate the total annual costs for the EPQ.
I-75 Discount Carpets manufactures Cascade carpet, which it sells in its adjoining
showroom store near the interstate. Estimated annual demand is 20,000 yards of
carpet with an annual carrying cost of $2.75 per yard. The manufacturing facility
operates the same 360 days the store is open and produces 400 yards of carpet per
day. The cost of setting up the manufacturing process for a production run is $720.
Determine the optimal order size, total inventory cost, length of time to receive an
order, and maximum inventory level.
Quantity Discount Model Assumptions
• Same as the EOQ, except:
– Unit price depends upon the quantity ordered
• Adjusted total cost equation:
 Quantity Discount Procedure
• Calculate the EOQ at the lowest price
• Determine whether the EOQ is feasible at that price
– Will the vendor sell that quantity at that price?
• If yes, stop – if no, continue
• Check the feasibility of EOQ at the next higher price

• Continue to the next slide ...

 QD Procedure (continued)
• Continue until you identify a feasible EOQ
• Calculate the total costs (including total item cost)
for the feasible EOQ model
• Calculate the total costs of buying at the minimum
quantity required for each of the cheaper unit prices
• Compare the total cost of each option & choose the
lowest cost alternative
• Any other issues to consider?
 QD Example
• Annual Demand = 5,000 units
• Ordering cost, S= $49
• Annual carrying charge H= 20% of product
price
• Unit price schedule:
 QD Example Solution
• Step 1
 QD Example Solution (Cont.)
• Step 2
 Quantity Discount Models
Annual demand D, 5000 units
Ordering cost S, $ 49
Holding cost i, 20%

Steps in analyzing a quantity discount

1. For each discount, calculate Q*
2. If Q* for a discount doesn't qualify, choose the smallest possible
order size to get the discount
3. Compute the total cost for each Q* or adjusted value from Step 2
4. Select the Q* that gives the lowest total cost
VGHC operates its own laboratory on-site. The lab maintains an inventory of
test kits for a variety of procedures. VGHC uses 780 A1C kits each year.
Ordering costs are $15 and holding costs are $3 per kit per year.
The new price list indicates that orders of fewer than 73 kits will cost $60 per
kit, 73 through 144 kits will cost $56 per kit, and orders of more than 144 kits
will cost $53 per kit. Determine the optimal order quantity and the total cost.
 The maintenance department of a large hospital uses about 816 cases of
liquid cleanser annually. Ordering costs are $12, carrying costs are $4 per
case a year, and the new price schedule indicates that orders of less than 50
cases will cost $20 per case, 50 to 79 cases will cost $18 per case, 80 to 99
cases will cost $17 per case, and larger orders will cost $16 per case.
Determine the optimal order quantity and the total cost.

D= 816 cases per year, S=$ 12 per case; H=$ 4 per year

1.
 A small manufacturing firm uses roughly 3,400 pounds of chemical dye a year.
Currently the firm purchases 300 pounds per order and pays $3 per pound. The
supplier has just announced that orders of 1,000 pounds or more will be filled at
a price of $2 per pound. The manufacturing firm incurs a cost of $100 each time
it submits an order and assigns an annual holding cost of 17 percent of the
purchase price per pound.
a. Determine the order size that will minimize the total cost.
b. If the supplier offered the discount at 1,500 pounds instead of 1,000 pounds,
what order size would minimize total cost?
D=3400 pounds per year; S= $ 100 per order; H= 17% of the purchase price
 A toy manufacturer uses 48000 rubber wheels per year. The firm
makes its own wheels at a rate of 800 per day. Carrying cost is $1
per wheel per year. Setup cost for a production run is $45. The
firm operates 240 days per year. Determine the:
1) The optimal run size
2) Minimum total annual cost for carrying and setup.
3) Cycle time for the optimal run size.
4) Run time for the optimal run size
D = 48000 wheels per year, and hence d = 48000/240 = 200 wheels per day. p = 800
wheels per day, and hence P = 800(240) = 192000. co = $45, ch = $1 per wheel per
year,
 Inventory Record Accuracy
• Inaccurate inventory records can cause:
– Lost sales
– Disrupted operations
– Poor customer service
– Lower productivity
– Planning errors and expediting

• Two methods are available for checking record accuracy

– Periodic counting-physical inventory
– Cycle counting-daily counting of pre-specified items provides the
following advantages:
• Timely detection and correction of inaccurate records
• Elimination of lost production time due to unexpected stock outs
• Structured approach using employees trained in cycle counting
 Inventory system
• Single-period inventory models
• Multi-period inventory systems
• Single-period inventory models are useful for a wide variety of service and
manufacturing applications. Consider the following:
• 1. Overbooking of airline flights. It is common for customers to cancel
flight reservations for a variety of reasons. Here the cost of underestimating
the number of cancellations is the revenue lost due to an empty seat on a
flight. The cost of overestimating cancellations is the awards, such as free
flights or cash payments, that are given to customers unable to board the
flight.
• 2. Ordering of fashion items. A problem for a retailer selling fashion
items is that often only a single order can be placed for the entire season.
This is often caused by long lead times and limited life of the merchandise.
The cost of underestimating demand is the lost profit due to sales not made.
The cost of overestimating demand is the cost that results when it is
discounted.
• 3. Any type of one-time order. For example, ordering T-shirts for a
sporting event or printing maps that become obsolete after a certain period
of time.
• Multi-period inventory systems
• There are two general types of multi period
inventory systems: fixed–order quantity models
(also called the economic order quantity, EOQ, and
Q-model) and fixed–time period models (also
referred to variously as the periodic system, periodic
review system, fixed order interval system, and
P-model). Multiperiod inventory systems are
designed to ensure that an item will be available on
an ongoing basis throughout the year. Usually the
item will be ordered multiple times throughout the
year where the logic in the system dictates the actual
quantity ordered and the timing of the order.
Fixed–Order Quantity and Fixed–Time
Period Differences
Fixed–order quantity models attempt to determine the specific
point, R, at which an order will be placed and the size of that
order, Q. The order point, R, is always a specified number of
units. An order of size Q is placed when the inventory available
(currently in stock and on order) reaches the point R. Inventory
position is defined as the on-hand plus on-order minus
backordered quantities. The solution to a fixed–order quantity
model may stipulate something like this: When the inventory
position drops to 36, place an order for 57 more units.
The simplest models in this category occur when all aspects of
the situation are known with certainty. If the annual demand
for a product is 1,000 units, it is precisely 1,000—not 1,000 plus
or minus 10 percent. The same is true for setup costs and
holding costs. Although the assumption of complete certainty is
rarely valid, it provides a good basis for our coverage of
inventory models.
Figure: Basic Fixed–Order Quantity Model
Exhibit the above figure and the discussion about deriving
the optimal order quantity are based on the following
characteristics of the model. These assumptions are
unrealistic, but they represent a starting point and allow us to
use a simple example.
• Demand for the product is constant and uniform throughout
the period.
• Lead time (time from ordering to receipt) is constant.
• Price per unit of product is constant.
• Inventory holding cost is based on average inventory.
• Ordering or setup costs are constant.
• All demands for the product will be satisfied. (No
backorders are allowed).
 The “sawtooth effect” relating Q and R in Exhibit above
figure shows that when the inventory position drops to
point R, a reorder is placed. This order is received at the
end of time period L, which does not vary in this model.
In constructing any inventory model, the first step is to
develop a functional relationship between the variables
of interest and the measure of effectiveness. In this case,
because we are concerned with cost, the following
equation pertains:

TC = Total annual cost; D = Demand (annual)

C = Cost per unit; Q = Quantity to be ordered (the
optimal amount is termed the economic order
quantity—EOQ—or Qopt)
R = Reorder point S = Setup cost or cost of placing an order
L = Lead time
H = Annual holding and storage cost per unit of average inventory (often holding cost
is taken as a percentage of the cost of the item, such as H = iC, where i is the percent carrying
cost)
 Figure: Annual Product Costs, Based on Size of the Order
On the right side of the equation, DC is the annual purchase cost for the units,
(D/Q)S is the annual ordering cost (the actual number of orders placed, D/Q, times
the cost of each order, S), and (Q/2)H is the annual holding cost (the average
inventory, Q/2, times the cost per unit for holding and storage, H). These cost
relationships are graphed in above figure. The second step in model development is
to find that order quantity Qopt at which total cost is a minimum. In above figure,
the total cost is minimal at the point where the slope of the curve is zero.
Using calculus, we take the derivative of total cost with
respect to Q and set this equal to zero. For the basic model
considered here, the calculations are

Because this simple model assumes constant demand and lead

time, neither safety stock nor stockout cost are necessary, and
the reorder point, R, is simply
When to Order: The Reorder Point
• Without safety stock:

• With safety stock:

Find the economic order quantity and the reorder point, given
Annual demand (D) = 1,000 units; Average daily demand (d–) = 1,000/365
Ordering cost (S) = $5 per order; Holding cost (H) = $1.25 per unit per year
Lead time (L) = 5 days; Cost per unit (C) = $12.50
What quantity should be ordered?
 Establishing Safety stock
Safety stock can be defined as the amount of inventory carried in
addition to the expected demand. In a normal distribution, this
would be the mean. For example, if our average monthly demand
is 100 units and we expect next month to be the same, if we carry
120 units, then we have 20 units of safety stock.
Safety stock can be determined based on many different criteria.
A common approach is for a company to simply state that a
certain number of weeks of supply be kept in safety
stock. It is better, though, to use an approach that captures the
variability in demand.
For example, an objective may be something like “set the safety
stock level so that there will only be a 5 percent chance of
stocking out if demand exceeds 300 units.” We call this
approach to setting safety stock the probability approach.
T h e P r o b a b i l i t y A p p r o a c h Using the probability criterion to determine
safety stock is pretty simple. With the models described in this chapter, we assume
that the demand over a period of time is normally distributed with a mean and a
standard deviation. Again, remember that this approach considers only the
probability of running out of stock, not how many units we are short. To determine
the probability of stocking out over the time period, we can simply plot a normal
distribution for the expected demand and note where the amount we have on hand lies
on the curve.
Say we expect demand to be 100 units over the next month, and we know that the
standard deviation is 20 units. If we go into the month with just 100 units, we know
that our probability of stocking out is 50 percent. Half of the months we would
expect demand to be greater than 100 units; half of the months we
would expect it to be less than 100 units. Taking this further, if we ordered a month’s
worth of inventory of 100 units at a time and received it at the beginning of the
month, over the long run we would expect to run out of inventory in six months of
the year.
If running out this often was not acceptable, we would want to carry extra inventory
to reduce this risk of stocking out. One idea might be to carry an extra 20 units of
inventory for the item. In this case, we would still order a month’s worth of
inventory at a time, but we would schedule delivery to arrive when we still have 20
units remaining in inventory. This would give us that little cushion of safety stock to
reduce the probability of stocking out. If the standard deviation associated with our
demand was 20 units, we would then be carrying one standard deviation worth of
safety stock.
Looking at the Cumulative Standard Normal Distribution (Appendix E), and
moving one standard deviation to the right of the mean, gives a
probability of 0.8413. So approximately 84%of the time we would not
expect to stock out, and 16% of the time we would. Now if we order every
month, we would expect to stock out approximately two months per year
(0.16 × 12 = 1.92). For those using Excel, given a z value, the probability
can be obtained with the NORMSDIST function.
It is common for companies using this approach to set the probability of
not stocking out at 95%. This means we would carry about 1.64 standard
deviations of safety stock, or 33 units (1.64 × 20 = 32.8) for our example.
Once again, keep in mind that this does not mean that we would order 33
units extra each month. Rather, it means that we would
still order a month’s worth each time, but we would schedule the receipt
so that we could expect to have 33 units in inventory when the order
arrives. In this case, we would expect to stock out approximately .6 month
per year, or that stockouts would occur in 1 of every 20 months.
The amount of safety stock depends on the service level desired,
as previously discussed. The quantity to be ordered, Q, is
calculated in the usual way considering the demand, shortage
cost, ordering cost, holding cost, and so forth. A fixed–order
quantity model can be used to compute Q, such as the simple Qopt
model previously discussed. The reorder point is then set to cover
the expected demand during the lead time plus a safety stock
determined by the desired service level. Thus, the key difference
between a fixed–order quantity model where demand is known
and one where demand is uncertain is in computing the reorder
point. The order quantity is the same in both cases. The
uncertainty element is taken into account in the safety stock.
The reorder point is
Figure: Fixed–Order Quantity Model with Safety Stock
What if Demand is Uncertain?
 Safety Stock and Service Level
• Order-cycle service level is the probability that
demand during lead time won’t exceed
on-hand inventory.
• Risk of a stockout = 1 – (service level)
• More safety stock means greater service level
and smaller risk of stockout.
 Safety Stock and Reorder Point
• Without safety stock:

• With safety stock:

 Reorder Point Determination

R = reorder point
d = average daily demand
L = lead time in days
z = number of standard deviations associated with desired
service level
σ = standard deviation of demand during lead time
 Safety Stock Example
• Daily demand = 20 units
• Lead time = 10 days
• S.D. of lead time demand = 50 units
• Service level = 90%
Determine:
1. Safety stock
2. Reorder point
 Safety Stock Solution

Step 1 – determine z

Step 2 – determine safety stock

Step 3 – determine reorder point

 Service level
A service level is the percentage of the time that you will
have the item in stock. In other words, the probability of
having a stock out is 1 minus the service level.
That is,
Service level =1-Probability of a stock out
or
Probability of a stock out =1-Service level

To determine the safety stock level, it is only necessary

to know the probability of demand during lead time
(DDLT) and the desired service level.
• Consider an economic order quantity case where annual demand
D =1,000 units, economic order quantity Q=200 units, the desired
probability of not stocking out P=0.95, the standard deviation of
demand during lead time L=25 units, and lead time L=15 days.
Determine the reorder point. Assume that demand is over a
250-workday year.
 Example: Daily demand for a certain product is normally distributed with
a mean of 60 and standard deviation of 7. The source of supply is reliable
and maintains a constant lead time of 6 days. The cost of placing the order
is $10 and annual holding costs are $0.50 per unit. There are no stock-out
costs, and unfilled orders are filled as soon as the order arrives. Assume
sales occur over the entire 365 days of the year. Find the order quantity and
reorder point to satisfy a 95% probability of not stocking out during the
lead time.
 Fixed–time period models
In a fixed–time period system, inventory is counted only
at particular times, such as every week or every month.
Counting inventory and placing orders periodically are
desirable in situations such as when vendors make
routine visits to customers and take orders for their
complete line of products, or when buyers want to
combine orders to save transportation costs.
Fixed–time period models generate order quantities that
vary from period to period, depending on the usage
rates. These generally require a higher level of safety
stock than a fixed–order quantity system.
Example: Quantity to Order
Daily demand for a product is 10 units with a standard
deviation of 3 units. The review period is 30 days, and
lead time is 14 days. Management has set a policy of
satisfying 98% of demand from items in stock. At the
beginning of this review period, there are 150 units in
inventory. How many units should be ordered?
A computer products store stocks color graphics monitors, and the daily demand is
normally distributed with a mean of 1.6 monitors and a standard deviation of 0.4
monitor. The lead time to receive an order from the manufacturer is 15 days.
Determine the reorder point that will achieve a 98% service level.
 Questions
1. Why is inventory an important consideration for managers?
2. What is the purpose of inventory control?
3. Why wouldn’t a company always store large quantities of inventory
to eliminate shortages and stockouts?
4. What are the different kinds of inventories?
5. Describe the major decisions that must be made in inventory
control.
6. What are some of the assumptions made in using the EOQ?
7. Discuss the major inventory costs that are used in determining the
EOQ.
8. What is the ROP? How is it determined?
9. What is the purpose of sensitivity analysis?
10. What assumptions are made in the EPQ model?
11. What happens to the EPQ model when the daily production rate
becomes very large?
12. In the quantity discount model, why is the
carrying cost expressed as a percentage of the
unit cost, instead of the cost per unit per year?
13. Briefly describe what is involved in solving a
quantity discount model.
14. Discuss the methods that are used in determining
safety stock when the stockout cost is known and
when the stockout cost is unknown.
15. Briefly describe what is meant by ABC analysis.
What is the purpose of this inventory technique?
16. Differentiate between EOQ and EPQ models.
 Item X is a standard item stocked in a company’s inventory of
component parts. Each year the firm, on a random basis, uses about
2,000 of item X, which costs $25 each. Storage costs, which include
insurance and cost of capital, amount to $5 per unit of average
inventory. Every time an order is placed for more item X, it costs $10.
a) Whenever item X is ordered, what should the order size be?
b) What is the annual cost for ordering item X?
c) What is the annual cost for storing item X?

Annual demand for a product is 13,000 units; weekly demand is 250

units with a standard deviation of 40 units. The cost of placing an order
is $100, and the time from ordering to receipt is four weeks. The annual
inventory carrying cost is $0.65 per unit. To provide a 98% service
probability, what must the reorder point be?
Suppose the production manager is told to reduce the safety stock of this
item by 100 units. If this is done, what will the new service probability
be?