Inventory Systems

Characteristics of Inventory Systems

1. Demand: Assumptions about pattern and characteristics of the demand
determine the complexity of the inventory models.
a.) Demand is either assumed i) constant, or ii) variable
b.) Demand can also be assumed to be known (deterministic) or random (stochastic).
2. Lead time: If items are ordered from outside, the lead time is the amount
of time that elapses from the instant that an order is placed until it
arrives. If items are produced internally, then interpret lead time as the
amount of time required to produce a batch of items.
3. Review time: It is characterised as continuous or periodic. In continuous
review, inventory levels are known at all times (inventory levels are
updated after every transaction). In periodic review, inventory levels are
known at distinct points in time (say, weekly, monthly etc.)
4. Excess demand: This characteristic determines how the system
reacts to excess demand. Excess demand can be backordered (held
over to be satisfied later after replenishing of the stock levels) or
lost.
5. Type of inventory: Perishable or Durable.
Relevant costs
1. Holding costs: Also known as the carrying costs signify the resources attributed
to maintaining inventory. They are proportional to the amount of inventory on
hand at any point in time. Carrying costs have the following components—

I. Opportunity cost of investment (Cost of capital)

II. Taxes and insurance paid on inventory. Inventory is an asset.
III. Breakage, spoilage, depreciation and obsolescence costs.
IV. Cost of providing storage space to inventory items.

The above cost components are accounted in terms of interest rate charged to the
price of an inventory items.
E.g. Holding costs = I+II+III+IV
= 28%+2%+1%+6%
= 37%
If inventory is valued at $180, then holding costs are= 0.37*180= $ 66.6
Assuming interest rates are charged annually, customarily holding costs are computed
annually.
Average inventory calculation
2. Ordering costs: This depends on the amount of inventory that is
ordered. It has fixed and variable components (vary with the
amount of inventory). However, usually only fixed components are
considered. The components of this cost are:
I. Bookkeeping expense associated with the order.
II. Costs of order generation, receiving and handling.
III. Set-up costs in manufacturing
3. Penalty costs: They are incurred because the demand was not met
from the available inventory. E.g. Backordering costs, Loss of
goodwill costs, Lost sales cost etc.
The EOQ (Economic order quantity) model
•
Proof of the EOQ Model
Depicting the change in Holding costs and
Order costs with economic order quantity
Practice Question
A large automobile repair shop installs about 1,250 mufflers per year,
18 percent of which are for imported cars. All the imported-car
mufflers are purchased from a single local supplier at a cost of $18.50
each. The shop uses a holding cost based on a 25 percent annual
interest rate. The setup cost for placing an order is estimated to be
$28.
a.) Determine the optimal number of imported-car mufflers the shop
should purchase each time an order is placed, and the time between
placement of orders.
b.) If the replenishment lead time is six weeks, what is the reorder
point based on the level of on-hand inventory?
Practice question
Industrial washers in a specific workshop in United States are required
at a fairly steady rate of 60 per week. The washers cost 2 cents each. It
costs the workshop $12 to initiate an order and holding costs are based
on an annual interest rate of 25%. Determine the optimal number of
washers that the workshop should procure in one order and the time
between placement of orders. What are the yearly holding and order
costs for this item.

Q*=3870 units
Cycle time =1.24 years
Annual order costs= $9.675
Annual holding costs= $9.675
Inclusion of
Lead time

Parker Pens example

Practice question
Demand for the Deskpro computer at Best Buy is 1,000 units per month. Best
Buy incurs a fixed order placement, transportation, and receiving cost of
$4,000 each time an order is placed. Each computer costs Best Buy $500 and
the retailer has a holding cost of 20 percent. Evaluate the number of
computers that the store manager should order in each replenishment lot.
Also evaluate annual holding and order costs and number of orders.
Determine the reorder point if the lead time is a) 15 days and b) 45 days

Optimal order quantity: 980

Annual order and holding costs= 97980
Number of orders per year= 12.24
Cycle time= 0.0817 year or 0.98 months or 29.8 days
Reorder point (a)= 493.15 or 494 units
Reorder point (b)= 500 units
An manufacturer of office furniture produces metal desks at a rate of
200 per month. Each desk requires 40 Philips head metal screws
purchased from a supplier in North Carolina. The screws cost 3 cents
each. Fixed delivery charges and costs of receiving and storing
shipments of the screws amount to about $100 per shipment,
independently of the size of the shipment. The firm uses a 25 percent
to determine holding costs. Manufacturer would like to establish a
standing order with supplier and is considering several alternatives.
EOQ= 50597
What Cycle
standing order
time= .527 year orsize
6.324should
months they use?
Case_a( lead time =4 months)
ROP_a= 32000 units
Case_b (lead time= 8 months)
ROP_b=13154 units
 EOQ model is very robust!
•

The curve is flat at Q*, especially

on the right side i.e. slight increases
From Q* hardly affect G(Q).
Insights from the EOQ model
• EOQ model demonstrates a trade-off relationship between various
inventory cost components, namely, holding and order costs.
• Reconciling EOQ and JIT approaches: Just-in-time is a philosophy
which minimizes inventory. EOQ model suggests keeping an optimal
stock of inventory. Are they diverging viewpoints?
1) An essential part of JIT approaches is reducing setup times and costs. As
setup costs (corresponding to order costs) decrease, the lot sizes calculated
by the EOQ model also decrease. Thus they tend to be compatible.
2) Neither of the approach can be deemed to be comprehensive on their own.
Elements of both need to be investigated for finding the best-suited
inventory policy for the firm.
3) JIT (pioneered by Toyota) is a philosophy. EOQ model is an operational
metric.
EOQ model in production settings
•
•
Practice problem
A company produces RAM for various industrial clients. It has experienced a relatively flat demand of 2500 units
per year for the product. The RAM is produced at a rate of 10,000 units per year. The accounting department has
estimated that it costs 50 USD to initiate a production run, each unit costs the company 2 USD to manufacture,
and the cost of holding is based on a 30 percent annual interest rate. Determine the optimal size of a production
run, the length of each production run, and the average annual cost of holding and setup. What is the maximum
level of on-hand inventory of the RAM units?

Answer:
Q*=745
Cycle time (T)= 0.298 year
Uptime (T1)= 0.0745 year
Average annual cost of holding and setup= 335.41
Maximum level of on-hand inventory is 559 units.
Aggregation in inventory lot sizes
• No aggregation
• Complete aggregation
• Partial aggregation
Aggregating Multiple Products in
a Single Order
• Savings in transportation costs
• Reduces fixed cost for each product
• Lot size for each product can be reduced
• Cycle inventory is reduced
• Single delivery from multiple suppliers or single truck
delivering to multiple retailers
• Reduce receiving and loading costs to reduce cycle
inventory
Lot Sizing with Multiple Products
or Customers (1 of 2)
• Ordering, transportation, and receiving costs grow with
the variety of products or pickup points
• Lot sizes and ordering policy that minimize total cost
D i: Annual demand for product i
S: Order cost incurred each time an order is placed,
independent of the variety of products in the order
si: Additional order cost incurred if product i is included
in the order
Lot Sizing with Multiple Products or
Customers (2 of 2)
• Three approaches

1. Each product manager orders his or her model

independently
2. The product managers jointly order every product in
each lot
3. Product managers order jointly but not every order
contains every product; that is, each lot contains a
selected subset of the products
Multiple Products Ordered and Delivered
Independently (1 of 2)
Demand

Common order cost

S = $4,000
Product-specific order cost

Holding cost
h = 0.2
Unit cost
Multiple Products Ordered and Delivered
Independently (2 of 2)
Table 11-1 Lot Sizes and Costs for Independent Ordering

Blank Litepro Medpro Heavypro

Demand per year 12,000 1,200 120
Fixed cost/order $5,000 $5,000 $5,000
Optimal order size 1,095 346 110
Cycle inventory 548 173 55
Annual holding cost $54,772 $17,321 $5,477
Order frequency 11.0 per year 3.5 per year 1.1 per year
Annual ordering cost $54,772 $17,321 $5,477
Average flow time 2.4 weeks 7.5 weeks 23.7 weeks
Annual cost $109,544 $34,642 $10,954

Total annual cost = $155,140

Lots Ordered and Delivered Jointly
Annual order cost = S * n
Products Ordered and Delivered
Jointly (1 of 2)

Annual order cost

Annual ordering
and holding cost = $61,512 + $6,151 + $615 + $68,250
= $136,528
Products Ordered and Delivered
Jointly (2 of 2)
Table 11-2 Lot Sizes and Costs for Joint Ordering at Best Buy

Blank Litepro Medpro Heavypro

Demand per year (D) 12,000 1,200 120
Order frequency (n∗) 9.75 per year 9.75 per year 9.75 per year
Optimal order size (D/n∗) 1,230 123 12.3
Cycle inventory 615 61.5 6.15
Annual holding cost $61,512 $6,151 $615
Average flow time 2.67 weeks 2.67 weeks 2.67 weeks
Lots Ordered and Delivered Jointly for a Selected
Subset (Heuristic for partial aggregation)
Step 1: Identify the most frequently ordered
product assuming each product is
ordered independently

Step 2: For all products i ≠ i*, evaluate the

ordering frequency
Lots Ordered and Delivered Jointly for a
Selected Subset
Step 3: For all i ≠ i*, evaluate the frequency of
product i relative to the most frequently
ordered product i* to be mi

Step 4: Recalculate the ordering frequency of the

most frequently ordered product i* to be n
Lots Ordered and Delivered Jointly for a
Selected Subset
Step 5: Evaluate an order frequency of ni = n/mi and
the total cost of such an ordering policy

Tailored aggregation – higher-demand products

ordered more frequently and lower-demand
products ordered less frequently
Ordered and Delivered Jointly – Frequency
Varies by Order
• Applying Step 1

Thus
Ordered and Delivered Jointly – Frequency
Varies by Order
• Applying Step 2

• Applying Step 3
Ordered and Delivered Jointly – Frequency
Varies by Order
• Applying Step 4

• Applying Step 5

Annual order cost Total annual cost

$130,767
Ordered and Delivered Jointly – Frequency
Varies by Order
Litepro Medpro Heavypro
Demand per year (D) 12,000 1,200 120
Order frequency (n∗) 11.47/year 5.74/year 2.29/year
Optimal order size (D/n∗) 1,046 209 52
Cycle inventory 523 104.5 26
Annual holding cost $52,307 $10,461 $2,615
Average flow time 2.27 weeks 4.53 weeks 11.35 weeks
Key Point
A key to reducing cycle inventory is the reduction
of lot size. A key to reducing lot size without
increasing costs is reducing the fixed cost
associated with each lot. This may be achieved
by reducing the fixed cost itself or by aggregating
lots across multiple products, customers, or
suppliers. When aggregating across multiple
products, customers, or suppliers, simple
aggregation is effective when product-specific
order costs are small, and tailored aggregation is
best if product-specific order costs are large.
Quantity discount models
Four reasons to offer volume discounts:
1. Law of diminishing marginal utility: The concept of “the more one person
consumes within a period, the less they value a product” is a cornerstone of
microeconomic theory. To entice customers to consumer more, per-unit price of
product is reduced by using discounts.
1. There are exceptions to this rule. A larger bottle of champagne is usually priced at a
higher rate than a smaller-sized bottle. Larger bottles (1.5 L) are typically used for festive
purposes and celebrations, thus signifying higher utility.
2. To compete with rivals who offer them: If competition
provides volume discounts and you believe that by not granting
similar price breaks you’ll lose the sale to a rival…offer discounts.
3. To shift the inventory to the downstream partner: By enticing downstream
partner to buy more, inventory shifts from upstream to downstream thus
effectively reducing inventory holding costs.
4. The primary aim of offering volume discounts is increasing sales.
Quantity discount models
• It is assumed until this point that the cost c of each unit is independent of
the size of the order. That is why unit cost of inventory didn’t matter in EOQ
models.
• But in case of, quantity discount models where supplier is willing to charge
less per unit of inventory for larger orders. The purpose of the discount is to
encourage the customer to buy the product in larger batches.
• There are two types of discount schedules: all-units quantity discount and
incremental quantity discount.
• In all-units quantity discount, the discount is applied to all the units in an
order (all-units). In incremental quantity discount models, the discount is
applied only to the additional units beyond the breakpoint (incremental).
• The all-units case is more common.
All units discount model
Practice problem
• Drugs Online (DO) is an online retailer of prescription drugs and
health supplements. Vitamins represent a significant percent of its
sales. Demand for vitamins is 10000 bottles per month. DO incurs a
fixed order placement, transportation and receiving cost of $100 each
time an order for vitamins is placed with the manufacturer. DO incurs
a holding cost of 20 percent. The manufacturer uses the following all
unit price discount schedule. Evaluate the number of bottles that the
DO manager should order in each lot.
Order quantity Unit price
0-4999 $ 3.00
5000-9999 $ 2.96
10,000 or more $ 2.92
• Quantity discounts can also be used for supply chain coordination.
• They help to align the optimal solution for the supply chain with the
locally optimized solution (cost minimization) at every supply chain
echelon.
• Volume/Quantity discounts may be crafted to ensure that “every ship
sails in the same direction” (rhetorical : don’t write in examination).
• The cases discussed in subsequent slides are a case in point (case 6:
commodity products and case 7: products with market power).
Quantity Discounts for Commodity Products
(Case 6 in Inventory cases.pdf)
D = 120,000 bottles/year, SR = $100, hR = 0.2, CR = $3
SM = $250, hM = 0.2, CM = $2

Annual supply chain cost

= $6,008 + $3,795 = $9,803
(DO and manufacturer)
Locally Optimal Lot Sizes
Annual cost for DO and
manufacturer

Annual supply chain cost

= $5,106 + $4,059 = $9,165
(DO and manufacturer)
Designing a Suitable Lot Size-Based Quantity
Discount
• Design a suitable quantity discount that gets DO to
order in lots of 9,165 units when its aims to
minimize only its own total costs
• Manufacturer needs to offer an incentive of at
least $264 per year to DO in terms of decreased
material cost if DO orders in lots of 9,165 units
• Appropriate quantity discount is $3 if DO orders in
lots smaller than 9,165 units and $2.9978 for
orders of 9,165 or more
Key Point

For commodity products for which price is set by

the market, manufacturers with large fixed costs
per lot can use lot-size-based quantity discounts
to maximize total supply chain profits.
Lot-size-based discounts, however, increase cycle
inventory in the supply chain.
Quantity Discounts When Firm Has Market
Power (Case 7 in Inventory cases.pdf)
Demand curve = 360,000 – 60,000p
Production cost = CM = $2 per bottle

p to maximize ProfR
Quantity Discounts When
Firm Has Market Power
CR = $4 per bottle, p = $5 per bottle
Total market demand = 360,000 – 60,000p = 60,000
ProfR = (5 – 4)(360,000 – 60,000 × 5) = $60,000
ProfM = (4 – 2)(360,000 – 60,000 × 5) = $120,000

ProfSC = (p – CM)(360,000 – 60,000p)

Coordinated retail price

ProfSC = ($4 – $2) x 120,000 = $240,000

• If the manufacturer charges a discounted price of $ 3.5 or less (but
more than $ 3…why?), the retailer makes atleast $ 60,000 which is
the profit corresponding to locally optimal demand (at p=5). By
offering a discounted price of $3.5 or less (but not less than $3) for
orders of 120,000 or more, it can be ensured that the retailer orders
quantity of 120,000 from the manufacturer even while minimizing its
own costs. That is, locally optimized solution merges with the supply
chain optimal solution.
Key Point

The supply chain profit is lower if each stage of

the supply chain makes its pricing decisions
independently, with the objective of maximizing
its own profit. A coordinated solution results in
higher profit.
Thank you