Inventory Control Models

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• This section is based on chapter 6 of Render, Stair, and Hanna text

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Introduction
• Inventory represents as much as 50% of total invested capital.

• A firm can try to reduce costs by reducing on-hand inventory.

• However, customers become dissatisfied when frequent inventory outages
called stockouts occur.

• Balance low and high inventory levels through cost minimization.

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Introduction
• Inventory is any stored resource that is used to satisfy a current or a
future need.
• Raw materials, work-in-process, and finished goods

• Inventory levels for finished goods are a direct function of demand.

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Inventory Planning and Control

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Importance of Inventory Control
• Five Uses of Inventory:
1. The decoupling function
2. Storing resources
3. Irregular supply and demand
4. Quantity discounts
5. Avoiding stockouts and shortages

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Decoupling Function
• If you did not store inventory, there could be many delays and
inefficiencies.

• When one manufacturing activity has to be completed before a

second activity can be started, it could stop the entire process.

• If, however, you have some stored inventory between processes, it

could act as a buffer.

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Storing Resources
• Seasonally produced products with constant demand (Agriculture and
fishing)

• Raw materials can be stored by themselves, in work-in-process, or in

the finished product.

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Irregular Supply and Demand
• Store product for times of higher demand

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Quantity Discounts
• Quantity Discounts: When suppliers offer reduced prices for large
orders.

• Tradeoff between discount and higher storage costs.

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Avoiding Stockouts and Shortages
• If you are repeatedly out of stock, customers are likely to go
elsewhere to satisfy their needs.

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Inventory Decisions
• Two fundamental decisions that you have to make when
controlling inventory:
1. How much to order
2. When to order

• A major objective in controlling inventory is to minimize

total inventory costs.

• Some of the most significant inventory costs follow:

1. Cost of the items (purchase cost or material cost)
2. Cost of ordering
3. Cost of carrying, or holding, inventory
4. Cost of stockouts
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Inventory Cost Factors

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 Economic Order Quantity:
Determining How Much to Order
• Economic Order Quantity (EOQ): The amount of inventory ordered that will minimize
the total inventory cost. It is also called the optimal order quantity, or Q*.

• Important Assumptions:
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.
• The inventory from an order arrives in one batch, at one point in time.
4. The purchase cost per unit is constant throughout the year.
• 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, holding or carrying cost.
• The holding cost per unit per year and the ordering cost per order are constant throughout the year.
6. Orders are placed so that stockouts or shortages are avoided completely.

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Inventory Usage Over Time

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Inventory Costs in the EOQ Situation
• The objective of most inventory models is to minimize the total costs.

• The relevant costs are the ordering cost and the carrying, or holding
cost.

• All other costs, such as the cost of the inventory itself (the purchase
cost), are constant.

• If we minimize the sum of the ordering and carrying costs, we are also
minimizing the total costs.
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Inventory Costs in the EOQ Situation
• The annual ordering cost is the number of orders per year times the cost of
placing each order.

• Use the average inventory level to determine annual holding or carrying

cost.

• The annual carrying cost will equal the average inventory times the
inventory carrying cost per unit per year.

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Inventory Costs in the EOQ Situation

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Inventory Costs in the EOQ Situation

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Total Cost as a Function of Order Quantity

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Finding the EOQ
• Total Cost is minimized when:

• Solving for Q gives us the optimal order quantity:

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Sumco Pump Company Example
• Sumco would like to reduce its inventory cost by determining the
optimal number of pump housings to obtain per order.

• Relevant Information:
• The annual demand is 1,000 units.
• The ordering cost is $10 per order.
• The average carrying cost per unit per year is $0.50.

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Sumco Pump Company Example
• If the EOQ assumptions are met, we can calculate the optimal
number of units per order:

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Sumco Pump Company Example

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Purchase Cost of Inventory Items
• Sometimes the total inventory cost expression is written to include
the actual cost of the material purchased.

• With the variable Q representing the quantity of units ordered, and

assuming a unit cost of C, we can determine the average dollar value
of inventory:

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Purchase Cost of Inventory Items
• Inventory carrying costs for many businesses and industries are also often
expressed as an annual percentage of the unit cost or price.

• Let I be the annual inventory holding charge as a percent of unit price or

cost.

• Then the cost of storing one unit of inventory for the year, Ch, is given by Ch
= IC, where C s the unit price or cost of an inventory item.

• Q* can be expressed, in this case, as:

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 Practice Question 1
Patterson Electronics supplies microcomputer circuitry to a company that
incorporates microprocessors into refrigerators and other home appliances.
One of the components has an annual demand of 250 units, and this is
constant throughout the year. Carrying cost is estimated to be $1 per unit
per year, and the ordering cost is $20 per order.

a) To minimize cost, how many units should be ordered each time an order
is placed?
b) How many orders per year are needed with the optimal policy?
c) What is the average inventory if costs are minimized?
d) Suppose the ordering cost is not $20, and Patterson has been ordering
150 units each time an order is placed. For this order policy to be
optimal, what would the ordering cost have to be?

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Reorder Point:
Determining When to Reorder
• Lead Time: The time between the placing and receipt of an order.

• Inventory Position: The amount of inventory on hand plus the

amount in any orders that have been placed but not yet received.

• Thus, the when to order decision is usually expressed in terms of a

reorder point (ROP), the inventory position at which an order
should be placed.

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Reorder Point Graph 1

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Reoder Point Graph 2

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Procomp’s Computer Chip Example**
• Procomp’s demand for computer chips is 8,000 per year.

• The firm has a daily demand of 40 units, and the order quantity is 400
units.

• Delivery of an order takes three working days.

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Procomp’s Computer Chip Example

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Procomp’s Computer Chip Example
• Suppose the lead time for Procomp Computer Chips was 12 days
instead of 3 days.

• The reorder point would be:

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Procomp’s Computer Chip Example
• Since the maximum on-hand inventory level is the order
quantity of 400, an inventory position of 480 would be:

• Thus, a new order would have to be placed when the on-

hand inventory fell to 80 while there was one other order
in-transit.

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Practice Question 2
The F. W. Harris Company sells an industrial cleaner to a large number
of manufacturing plants in the Houston area. An analysis of the
demand and costs has resulted in a policy of ordering 300 units of this
product every time an order is placed. The demand is constant, at 25
units per day. In an agreement with the supplier, F. W. Harris is willing
to accept a lead time of 20 days since the supplier has provided an
excellent price. What is the reorder point? How many units are actually
in inventory when an order should be placed?

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EOQ without
Instantaneous Receipt Assumption
• Instantaneous Inventory Receipt: A system in which inventory is
received or obtained at one point in time and not over a period of
time.
• Need a new model when violated

• Production Run Model: An inventory model in which inventory is

produced or manufactured instead of being ordered or purchased.
This model eliminates the instantaneous receipt assumption.

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Inventory Control and
the Production Process

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EOQ without
Instantaneous Receipt Assumption
• “Setup cost” instead of “ordering cost”

• Setup Cost: Cost of setting up the production facility to manufacture

the desired product.
• Includes the salaries and wages of employees who are responsible for setting
up the equipment, engineering and design costs of making the setup,
paperwork, supplies, utilities, and so on.

• The optimal production quantity can be derived by setting setup costs

equal to holding or carrying costs and solving for the order quantity.
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Annual Carrying Cost for
Production Run Model
• We can develop the annual carrying, or holding, cost expression using
the following variables:

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Annual Carrying Cost for
Production Run Model
• Maximum Inventory Level: (see board)

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Annual Setup Cost or
Annual Ordering Cost
• When a product is produced over time, setup cost replaces ordering
cost.

• This cost is simply the number of orders (or production runs) times
the ordering cost (setup cost).

• See Board

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Determining the Optimal
Production Quantity
• When the assumptions of the production run model are met, costs
are minimized when the setup cost equals the holding cost.

• See Board

• If the situation does not involve production but rather involves the
receipt of inventory over a period of time, this same model is
appropriate, but Co replaces Cs in the formula.

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 Brown Manufacturing Example
• Brown Manufacturing produces commercial refrigeration units in batches.

• Estimated demand for the year is 10,000 units.

• It costs about $100 to set up the manufacturing process

• The carrying cost is about 50 cents per unit per year.

• When the production process has been set up, 80 refrigeration units can be manufactured daily.

• The demand during the production period has traditionally been 60 units each day.

• Brown operates its refrigeration unit production area 167 days per year.

• How many refrigeration units should Brown Manufacturing produce in each batch? How long should the production
part of the cycle last?

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Quantity Discount Models (See Board)

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Brass Department Store Example
• Stocks toy race cars.

• Quantity Discount Schedule as on slide 45

• The ordering cost is $49 per order.

• The annual demand is 5,000 race cars.

• The inventory carrying charge as a percentage of cost, I, is 20% or 0.2.

• What order quantity will minimize the total inventory cost?

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Problem 3
Flemming Accessories produces paper slicers used in offices and in art
stores. The minislicer has been one of its most popular items: Annual
demand is 6,750 units and is constant throughout the year. Kristen
Flemming, owner of the firm, produces the minislicers in batches. On
average, Kristen can manufacture 125 minislicers per day. Demand for
these slicers during the production process is 30 per day. The setup
cost for the equipment necessary to produce the minislicers is $150.
Carrying costs are $1 per minislicer per year. How many minislicers
should Kristen manufacture in each batch?

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Problem 4
Dorsey Distributors has an annual demand for a metal detector of
1,400. The cost of a typical detector to Dorsey is $400. Carrying cost is
estimated to be 20% of the unit cost, and the ordering cost is $25 per
order. If Dorsey orders in quantities of 300 or more, it can get a 5%
discount on the cost of the detectors. Should Dorsey take the quantity
discount? Assume the demand is constant.

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Use of Safety Stock
• What if the demand or lead time where uncertain?
→Leads to an uncertain ROP

• To prevent stockouts, carry additional inventory called safety stock.

• Used when demand is unusually high

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Use of Safety Stock
• Can adjust ROP to account for safety stock.

• But how do we determine the correct level of safety stock (SS)?

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Use of Safety Stock
• Two factors in determining the correct safety stock level:
1. Stockout cost
2. Holding cost

• The stockout cost usually involves lost sales and lost goodwill, which
results in loss of future sales.

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Use of Safety Stock
• The general approach is to determine what service
level is desired and then to find the safety stock level
that would accomplish this.

• A service level indicates what percentage of the time

customer demand is met.
• In other words, the service level is the percentage of time
that stockouts are avoided.

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Safety Stock with the
Normal Distribution
• When demand during the lead time is normally distributed, the
reorder point becomes:

• The amount of safety stock is simply

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Hinsdale Company Example
• The Hinsdale Company carries a variety of electronic inventory items
identified by SKU.

• SKU A3378 has a demand that is normally distributed during the lead
time with a mean of 350 units and a standard deviation of 10.

• They want that stockouts only occur 5% of the time on any order.

• How much safety stock should be maintained and what is the reorder
point?

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Safety Stock and the
Normal Distribution

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Calculating Lead Time Demand and Standard
Deviation
• If the mean and standard deviation of demand during the lead time
are not known, they must be calculated from historical demand and
lead time data.

• We will assume that if demand fluctuates, the distribution of demand

each day is identical to and independent of demand on other days.
• If both daily demand and lead time fluctuate, they are assumed to be
independent also.

• Three scenarios...

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1. Demand is variable but
lead time is constant:

The term is the square root of the sum of the daily variances
during lead time:

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2. Demand is Constant but
Lead time is Variable

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3. Both demand and lead time are variable:

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 Hinsdale Company Example, Continued
• Hinsdale has decided to determine the safety stock and ROP for three other
items: SKU F5402, SKU B7319, and SKU F9004.

• For SKU F5402, the daily demand is normally distributed, with a mean of 15
units and a standard deviation of 3.

• Lead time is exactly 4 days.

• Hinsdale wants to maintain a 97% service level.

• What is the reorder point, and how much safety stock should be carried?

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Hinsdale Company Example, Continued
• For SKU B7319, the daily demand is constant at 25 units per day, and
the lead time is normally distributed, with a mean of 6 days and a
standard deviation of 3.

• Hinsdale wants to maintain a 98% service level on this particular

product.

• What is the reorder point?

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Hinsdale Company Example, Continued
• For SKU F9004, the daily demand is normally distributed, with a mean
of 20 units and a standard deviation of 4, and the lead time is
normally distributed, with a mean of 5 days and a standard deviation
of 2.

• Hinsdale wants to maintain a 94% service level on this particular

product.

• What is the reorder point?

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Calculating Annual Holding Cost with Safety
Stock

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• The B. N. Thayer and D. N. Thaht Computer Company
sells a desktop computer that is popular among
gaming enthusiasts.
• The company orders the computer cases from a
supplier. It places an order for 5,000 cases at the
appropriate time to avoid stockouts.
• The demand during the lead time is normally
distributed, with a mean of 1,000 units and a
standard deviation of 200 units.
• The holding cost per unit per year is estimated to be
$4.
• How much safety stock should the company carry to
maintain a 96% service level? What is the reorder
point? What would the total annual holding cost be if
this policy is followed?
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Single-Period Inventory Models
• Some items have little or no value after a single period.
• Called the news vendor problem or a single-period inventory model.

• Marginal Analysis: A decision-making approach using marginal profit

and marginal loss.
• Marginal profit (MP) is the additional profit achieved if one additional unit is
stocked and sold.
• Marginal loss (ML) is the loss that occurs when an additional unit is stocked
but cannot be sold.

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Single-Period Inventory Models
• Manageable number of alternatives and states of nature and know
the probabilities for each state of nature → marginal analysis with
discrete distributions can be used.

• Very large number of possible alternatives and states of nature and

the probability distribution of the states of nature have a normal
distribution → marginal analysis with the normal distribution are
appropriate.

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Marginal Analysis with
Discrete Distributions
• Only stock a unit if the expected marginal profit is equal to or greater
than the marginal loss.

• P = probability that demand will be greater than or equal to a given

supply (or the probability of selling at least one addition unit)

• 1 - P = probability that demand will be less than supply (or the

probability that one additional unit will not sell)

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Marginal Analysis with
Discrete Distributions
• The expected marginal profit is found by multiplying the probability
that a given unit will be sold by the marginal profit, P(MP).

• The expected marginal loss is the probability of not selling the unit
multiplied by the marginal loss, or (1 - P)(ML)

• The optimal decision rule is to stock the additional unit if:

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Marginal Analysis with
Discrete Distributions
• We can determine the level of P for which this relationship holds (See
Board)

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Café du Donut Example
• Buys donuts from an industrial bakery.

• The café pays $4 for each carton (containing two dozen doughnuts)
delivered each morning.

• Any cartons not sold at the end of the day are thrown away.

• If a carton of doughnuts is sold, the total revenue is $6

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Café du Donut’s
Probability Distribution

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Marginal Analysis for
Café du Donut

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Marginal Analysis with
the Normal Distribution
• Can use when demand follows a normal distribution.

• Values we need to find:

1. The average or mean sales for the product, μ
2. The standard deviation of sales, σ
3. The marginal profit for the product, MP
4. The marginal loss for the product, ML

• Let X* = Optimal stock level

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Newspaper Example
• Demand for copies of the Chicago Tribune newspaper at Joe’s
Newsstand is normally distributed and has averaged 60 papers per
day, with a standard deviation of 10 papers.

• With a marginal loss of 20 cents and a marginal profit of 30 cents,

what daily stocking policy should Joe follow?

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Joe’s Stocking Decision for
the Chicago Tribune

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Newspaper Example
• When P is greater than 0.50, the same basic procedure is used,
although caution should be used when looking up the Z value.

• Example: Let’s say that Joe’s Newsstand also stocks the Chicago Sun-
Times, and its marginal loss is 40 cents and marginal profit is 10 cents.

• The daily sales have averaged 100 copies of the Sun-Times, with a
standard deviation of 10 papers.

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Joe’s Stocking Decision for
the Chicago Sun-Times

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ABC Analysis
• The purpose of ABC analysis is to divide all of a company’s inventory
items into three groups (group A, group B, and group C) based on the
overall inventory value of the items.

• A good manager should spend more time managing those items

representing the greatest dollar inventory cost because this is where
the greatest potential savings are.

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ABC Analysis
• Group A Inventory: Accounts for a major portion of the inventory
costs of the organization.
• Inventory levels must be monitored carefully.

• Typically make up more than 70% of the company’s business in

dollars, but may consist of only 10% of all inventory items.
• A few inventory items that are very costly

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ABC Analysis
• Group B Inventory: Typically moderately priced items and represent
much less investment than the A items.

• May not be appropriate to spend as much time developing optimal

inventory policies for this group as with the A group.

• Typically, the group B items represent about 20% of the company’s

business in dollars, and about 20% of the items in inventory.

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ABC Analysis
• Group C Inventory: very low-cost items that represent very little in
terms of the total dollars invested in inventory.

• These items may constitute only 10% of the company’s business in

dollars, but they may consist of 70% of the items in inventory.

• Not good to spend as much time managing these items as the A and B
items.

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ABC Analysis
• Group A: Relatively low safety stock. Take more care in determining
demand.

• Group C: Relatively high safety stock. Take less care in determining

demand.

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Summary of ABC Analysis

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Dependent Demand: The Case for Material
Requirements Planning
• Previously: We assume that the demand for one item is independent of
the demand for other items.

• Many inventory problems, however, are interrelated.

• The demand for one item is dependent on the demand for another item.

• Example: Demand for lawn mower wheels are dependent on the

demand for lawn mowers.

• You should forecast the demand for the final products and compute the
requirements for component parts.

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Dependent Demand: The Case for Material
Requirements Planning
• Major questions: how much to order and when to order?

• Material Requirements Planning (MRP): An inventory model that can

handle dependent demand.

• Benefits of MRP:
• Increased customer service and satisfaction
• Reduced inventory costs
• Better inventory planning and scheduling
• Higher total sales
• Faster response to market changes and shifts
• Reduced inventory levels without reduced customer service

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Material Structure Tree
• Bill of Materials (BOM): Identifies the components, their
descriptions, and the number required in the production of one unit
of the final product.
• Develop a material structure tree from the BOM

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Material Structure Tree
for Item A

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Material Structure Tree
• Items above any level are called parents, and items below any level
are called components.

• See Board

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Material Structure Tree**
• After the material structure tree has been developed, the number of
units of each item required to satisfy demand can be determined.

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Gross and Net
Material Requirements Plan (MRP)**
• The Gross Material Requirements Plan is a time schedule that shows:
• When an item must be ordered from suppliers when there is no inventory on hand,
or
• When the production of an item must be started in order to satisfy the demand for
the finished product at a particular date.

• Use this information to develop a Net Material Requirements plan that

includes:
• Gross requirements,
• On-hand inventory,
• Net requirements,
• Planned-order receipts, and
• Planned-order releases for each item.

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Material Structure Tree
for Item A

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Gross Material Requirements Plan for 50 Units of A

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Net Material Requirements Plan
for 50 units of A
• See next slide

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Two or More End Products**
• Introduce another end product called AA.

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Net Material Requirements Plan, Including AA
• Next Slide

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Just in Time (JIT) Inventory
• Movement towards having less in-process inventory on hand.

• Just in Time (JIT) Inventory: An approach whereby inventory arrives

just in time to be used in the manufacturing process.

• One technique of implementing JIT is a manual procedure called

kanban (card system).
• With a dual-card kanban system, there is a conveyance kanban, or C-kanban,
and a production kanban, or Pkanban.

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Four Steps of Kanban
1. A user takes a container of parts or inventory along
with its accompanying C-kanban to his or her work
area.
• When there are no more parts or the container is empty, the
user returns the empty container along with the C-kanban to
the producer area.

2. At the producer area, there is a full container of parts

along with a P-kanban.
• The user detaches the P-kanban from the full container of
parts.
• Then the user takes the full container of parts along with the
original C-kanban back to his or her area for immediate use.

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Four Steps of Kanban
3. The detached P-kanban goes back to the producer area
along with the empty container.
• The P-kanban is a signal that new parts are to be
manufactured or that new parts are to be placed into the
container.
• When the container is filled, the P-kanban is attached to the
container.

4. This process repeats itself during the typical workday.

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Kanban System

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 The Kanban System
• At a minimum, two containers are required using the kanban system.
• One container is used at the user area, and another container is being refilled for
future use.

• Usually more than 2 containers

• The kanban system can also be very effective in controlling inventory costs
and in uncovering production bottlenecks.

• Inventory arrives at the user area or on the manufacturing line just when it is
needed.
• Inventory does not build up unnecessarily, cluttering the production line or adding to
unnecessary inventory expense.

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Production Rules in the Kanban System
• No containers are filled without the appropriate P-kanban.

• Each container must hold exactly the specified number of parts or

inventory items.

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