Inventories in the Supply
Chain
Independent vs.
Dependent Demand
Independent demand items are
finished goods or other items sold
to someone outside the company
Dependent demand items are
materials or component parts used
in the production of another item
(e.g., finished product)
Types of Inventory:
How Inventory is Used
Anticipation or seasonal inventory
Safety stock: buffer demand fluctuations
Lot-size or cycle stock: take advantage of
quantity discounts or purchasing efficiencies
Pipeline or transportation inventory
Speculative or hedge inventory protects
against some future event, e.g. labor strike
Maintenance, repair, and operating (MRO)
inventories
Objectives of Inventory
Management
Provide acceptable level of
customer service (on-time
delivery)
Allow cost-efficient operations
Minimize inventory investment
Relevant Inventory Costs
Item Cost Cost per item plus any other direct
costs associated with getting the
item to the plant
Holding
Costs
Capital, storage, and risk cost
typically stated as a % of the unit
value,
e.g. 15-25%
Ordering
Cost
Shortage
Costs
Fixed, constant dollar amount
incurred for each order placed
Loss of customer goodwill, back
order handling, and lost sales
Order Quantity Strategies
Lot-for-lot Order exactly what is needed for
the next period
FixedOrder a predetermined amount
order
each time an order is placed
quantity
Min-max
system
When on-hand inventory falls
below a predetermined minimum
level, order enough to refill up to
maximum level
Order n
Order enough to satisfy demand
Examples of Ordering
Approaches
Three Mathematical Models
for Determining Order
Quantity
Economic Order Quantity (EOQ or Q
System)
Economic Production Quantity (EPQ)
An optimizing method used for determining order
quantity and reorder points
Part of continuous review system which tracks onhand inventory each time a withdrawal is made
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
TC EOQ
D Q
S
H
Q 2
Where
TC total annual cost
D annual demand
Q quantity to be ordered
H annual holding cost
S ordering or setup cost
EOQ Total Costs
Total annual costs = annual ordering costs + annual
holding costs
The EOQ Formula
Minimize the TC by ordering the
EOQ:
2 DS
EOQ
H
When to Order:
The Reorder Point
Without safety stock:
R dL
where R reorder point in units
d daily/weekly demand in units
L lead time in days/weeks
With safety stock:
R dL SS
where SS safety stock in units
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
D 52 240 12,480 units / year
H 0.2 15 $3 per unit per year
2 DS
2 12,480 50
Q
644.98 645 units
H
3
D Q 12,480
645
TC
S
H
50
3
2
Q 2 645
967.44 967.5 $1,934.94
R dL 240 2 480 units
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: TC EPQ
Maximum inventory:I MAX
D I MAX
S
H
Q 2
d
Q 1
p
Adjusted order quantity:
EPQ
2 DS
d
H 1
p
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
EPQ Example Solution
d
18,000
1500 units / month; p 2500 units / month
12
2 DS
2 18,000 800
2000 units
1500
d
18
H 1
2500
p
d
1500
Q 1 2000 1
800 units
p
2500
I MAX
D I MAX 18,000
800
S
H
800
18
2000
2
Q 2
TC
7,200 7,200 14,400
EPQ Example Solution
(cont.)
The reorder point:
1500
R dL
5 375 units
20
With safety stock of 200 units:
1500
R dL SS
5 200 575 units
20
Quantity Discount Model
Assumptions
Same as the EOQ, except:
Unit price depends upon the quantity
ordered
Adjusted total cost equation:
TCQD
D Q
S
H PD
Q 2
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 = 5000 units
Ordering cost = $49
Annual carrying charge = 20%
Unit price schedule:
Quantity
Unit Price
0 to 999
$5.00
1000 to 1999
$4.80
2000 and over
$4.75
QD Example Solution
Step 1
QP $4.75
2 5,000 49
718 not feasible
0.2 4.75
QP $4.80
QP $5.00
2 5,000 49
714 not feasible
0.2 4.80
2 5,000 49
700 feasible
0.2 5.00
QD Example Solution
(Cont.)
Step 2
TCQ 700
5,000
700
49
0.2 5.00 5.00 5000 $25,700
700
2
TCQ 1000
5,000
1000
49
0.2 4.80 4.80 5000 $24,725
1000
2
TCQ 2000
5,000
2000
49
0.2 4.75 4.75 5000 $24,822.50
2000
2
What if Demand is
Uncertain?
Safety Stock and Service
Level
Order-cycle service level is the
probability that demand during lead
time wont 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:
R dL
where R reorder point in units
d daily demand in units
L lead time in days
With safety stock:
R dL SS
where SS safety stock in units
Reorder Point
Determination
SS z dL
i.e.,
R dL z dL
R = reorder point
d = average daily demand
L = lead time in days
z = number of standard deviations associated with
desired service level
= 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
From Appendix B : z 1.28
Step 2 determine safety stock
SS 1.28 50 64 units
Step 3 determine reorder point
R dL SS 20 10 64 264 units
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.
Item
Annual Usage ($) Percentage of Total $ Cumulative Percentage of Total $
106
16,500
34.4
34.4
110
12,500
26.1
60.5
115
4500
9.4
69.9
105
3200
6.7
76.6
111
2250
4.7
81.3
104
2000
4.2
85.5
114
1200
2.5
88
107
1000
2.1
90.1
101
960
2
92.1
113
875
1.8
93.9
103
750
1.6
95.5
108
600
1.3
96.8
112
600
1.3
98.1
102
500
1
99.1
109
500
1
100.1
Item Classification
A
A
B
B
B
B
C
C
C
C
C
C
C
C
C
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
