Chapter 13

Inventory
Management

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter 13: Learning Objectives
 You should be able to:
1. Define the term inventory, list the major reasons for holding inventories,
and list the main requirements for effective inventory management
2. Discuss the nature and importance of service inventories
3. Explain periodic and perpetual review systems
4. Explain the objectives of inventory management
5. Describe the A-B-C approach and explain how it is useful
6. Describe the basic EOQ model and its assumptions and solve typical
problems
7. Describe the economic production quantity model and solve typical
problems
8. Describe the quantity discount model and solve typical problems
9. Describe reorder point models and solve typical problems
10. Describe situations in which the single-period model would be
appropriate, and solve typical problems

Instructor Slides 13-2

 Inventory
Inventory
 A stock or store of goods
Independent demand items
 Items that are ready to be sold or used

Inventories are a vital part of business: (1) necessary for

operations and (2) contribute to customer satisfaction
A “typical” firm has roughly 30% of its current
assets and as much as 90% of its working capital
invested in inventory

Instructor Slides 13-3

 Types of Inventory
 Raw materials and purchased parts
 Work-in-process (WIP)
 Finished goods inventories or merchandise
 Tools and supplies
 Maintenance and repairs (MRO) inventory
 Goods-in-transit to warehouses or customers (pipeline
inventory)

Instructor Slides 13-4

 Inventory
Inventory: a stock or store of goods 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. 12-5
 Objectives of Inventory Control
Inventory management has two main concerns:
1. Level of customer service
 Having the right goods available in the right quantity in the right
place at the right time
2. Costs of ordering and carrying inventories

 The overall objective of inventory management is to achieve

satisfactory levels of customer service while keeping inventory costs
within reasonable bounds
1. Measures of performance
2. Customer satisfaction
 Number and quantity of backorders
 Customer complaints

3. Inventory turnover

Instructor Slides 13-6

 Inventory Management
Management has two basic functions concerning
inventory:
1. Establish a system for tracking items in inventory
2. Make decisions about
When to order
How much to order

Instructor Slides 13-7

 Effective Inventory Management
 Requires:
1. A system keep track of inventory
2. A reliable forecast of demand
3. Knowledge of lead time and lead time variability
4. Reasonable estimates of
 holding costs
 ordering costs
 shortage costs
5. A classification system for inventory items

Instructor Slides 13-8

 Inventory Counting Systems
Periodic System
Physical count of items in inventory made at periodic
intervals
Perpetual Inventory System
 System that keeps track of removals from inventory
continuously, thus monitoring current levels of each
item
An order is placed when inventory drops to a
predetermined minimum level
 Two-bin system
 Two containers of inventory; reorder
when the first is empty

Instructor Slides 13-9

 Demand Forecasts and Lead Time
 Forecasts
 Inventories are necessary to satisfy customer demands, so it is
important to have a reliable estimates of the amount and timing of
demand
 Point-of-sale (POS) systems
 A system that electronically records actual sales
 Such demand information is very useful for enhancing forecasting and
inventory management
Lead time
 Time interval between ordering and receiving the order

Instructor Slides 13-10

 Inventory Costs
Purchase cost
 The amount paid to buy the inventory
Holding (carrying) costs
 Cost to carry an item in inventory for a length of time, usually a year
Ordering costs
 Costs of ordering and receiving inventory
Setup costs
 The costs involved in preparing equipment for a job
 Analogous to ordering costs
Shortage costs
 Costs resulting when demand exceeds the supply of inventory;
often unrealized profit per unit

Instructor Slides 13-11

 ABC Classification System
 A-B-C approach
 Classifying inventory according to some measure of importance, and
allocating control efforts accordingly
 A items (very important)
 10 to 20 percent of the number of items in inventory and about 60 to 70
percent of the annual dollar value
 B items (moderately important)
 C items (least important)
 50 to 60 percent of the number
of items in inventory but only
about 10 to 15 percent of the
annual dollar value

Instructor Slides 13-12

 Cycle Counting
 Cycle counting
 A physical count of items in inventory
 Cycle counting management
 How much accuracy is needed?
 A items: ± 0.2 percent
 B items: ± 1 percent
 C items: ± 5 percent
 When should cycle counting be performed?
 Who should do it?

Instructor Slides 13-13

ABC Classification Example
Annual Unit Cost Annual $
Item Demand ($) Value Classification
1 1,000 4300 4,300,000 A
2 5,000 720 3,600,000 A
3 1,900 500 950,000 B
4 1,000 710 710,000 B
5 2,500 250 625,000 B
6 2,500 192 480,000 B
7 400 200 80,000 C
8 500 100 50,000 C
9 200 210 42,000 C
10 1,000 35 35,000 C
11 3,000 10 30,000 C
12 9,000 3 27,000 C 12-14
 How Much to Order: EOQ Models
Economic order quantity models identify the optimal
order quantity by minimizing the sum of annual costs
that vary with order size and frequency
1. The basic economic order quantity model
2. The economic production quantity model
3. The quantity discount model

Instructor Slides 13-15

 Basic EOQ Model
 The basic EOQ model is used to find a fixed order
quantity that will minimize total annual inventory
costs
 Assumptions:
1. Only one product is involved
2. Annual demand requirements are known
3. Demand is even throughout the year
4. Lead time does not vary
5. Each order is received in a single delivery
6. There are no quantity discounts

Instructor Slides 13-16

 Assumptions of EOQ Model

H: Holding cost

S: Ordering cost
Q: Quantity
TC: Total Inventory Costs
 = Ordering Costs + Holding Costs

12-17
 The Inventory Cycle

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order

Lead time

Instructor Slides 13-18

EOQ Example

12-19
Average Inventory

12-20
EOQ Total Costs Components

12-21
 Total Annual Cost

Total Cost  Annual Holding Cost  Annual Ordering Cost

Q D
 H  S
2 Q
where
Q  Order quantity in units
H  Holding (carrying) cost per unit, usually per year
D  Demand, usually in units per year
S  Ordering cost per order

Instructor Slides 13-22

 Goal: Total Cost Minimization

The Total-Cost Curve is U-Shaped

Annual Cost

Q D
TC  H  S
2 Q

Holding Costs

Ordering Costs

Order Quantity
QO (optimal order quantity) (Q)

Instructor Slides 13-23

Minimum Total Cost

The total cost curve reaches its minimum

where the carrying and ordering costs are
equal.

Q = DS
H
2 Q
TC = 2 (Q/2)H = 2 (D/Q)S

12-24
 Deriving EOQ
 Using calculus, we take the derivative of the total cost
function and set the derivative (slope) equal to zero and
solve for Q.
 The total cost curve reaches its minimum where the
carrying and ordering costs are equal.

2 DS 2(annual demand)(or der cost)

QO  
H annual per unit holding cost

Instructor Slides 13-25

EOQ Example 1
Annual Demand: D = 9,600 tires
Carrying Cost: H = $16/unit/year
Ordering Cost: S = $75/order
Annual Number of Business days: 288
Q: What is EOQ?
A:

2 DS (2)(9,600)(75)
Q   300 tires
H 16
12-26
EOQ Example 1
Q: What is the number of orders per year?
A: D 9,600
  32
Q 300
Q: What is the length of an order cycle?
A:

Q 300 300 1 1
   year  X 288  9 days
D 9,600 9,600 32 32
12-27
EOQ Example 1
Q: What is the total minimum inventory costs?
A:

TC  (Q / 2) H  ( D / Q) S
TC  (300 / 2)(16)  (9,600 / 300)(75)
TC  $2,400  $2,400  $4,800

12-28
 Economic Production Quantity (EPQ)
 The batch mode is widely used in production. In certain
instances, the capacity to produce a part exceeds its usage
(demand rate)
 Assumptions
1. Only one item is involved
2. Annual demand requirements are known
3. Usage rate is constant
4. Usage occurs continually, but production occurs periodically
5. The production rate is constant
6. Lead time does not vary
7. There are no quantity discounts

Instructor Slides 13-29

 EPQ: Inventory Profile
Q
Production Usage Production Usage Production
and usage only and usage only and usage
Qp
Cumulative
production
Imax

Amount
on hand

Time

Instructor Slides 13-30

EPQ Example 1
Given:
 D = 1,000,000 units per year
 p = 8,000 units per day
 u = 4,000 units per day
 H = $2/unit/year
 S = $200 per setup
 Q = 20,000 units

12-31
EPQ Example 1
Q: At what rate the inventory is built up?
A: p – u = 8000 – 4000 = 4000 per day
Q: What is the Run Time? This is the production
phase of the cycle (the length of the production
time per cycle)
A: 20,000/8000 = 2.5 days = Q/p
Q: What is the maximum inventory?
A: (4000 units per day) X (2.5 days) = 10,000 units = Imax =
(p – u)(Q/p)

12-32
 EPQ – Total Cost
TC min  Carrying Cost  Setup Cost
I  D
  max  H  S
 2  Q
where
I max  Maximum inventory
Qp
  p  u
p
p  Production or delivery rate
u  Usage rate

Instructor Slides 13-33

EPQ Example 1
Given:
 D = 1,000,000 units per year
 p = 8,000 units per day
 u = 4,000 units per day
 H = $2/unit/year
 S = $200 per setup
 Q = 20,000 units

12-34
EPQ Example 1
Q: What is the number of runs per year?
1,000,000/20,000 = 50 = D/Q

Q: What is the annual setup cost?

(50 setups) X ($200 per setup) = $10,000
=(D/Q)S
Q: What is the cycle time?
20,000/4,000 = 5 days = Q/u

12-35
 EPQ

2 DS p
Qp 
H p u

Instructor Slides 13-36

 Quantity Discount Model
Quantity discount
 Price reduction for larger orders offered to customers to
induce them to buy in large quantities
Total Cost  Carrying Cost  Ordering Cost  Purchasing Cost
Q D
 H  S  PD
2 Q
where
P  Unit price

Instructor Slides 13-37

EPQ Model Example 2
Given:
 D = 48,000 units per year
 p = 800 units per day
 u = 200 units per day
 H = $1/unit/year
 S = $45 per setup

12-38
EPQ Model Example 2
Optimal run size (Q) is:

2 DS p
Q
H pu
2(48,000)((45) 800
Q  2,400 units
1 800  200

12-39
EPQ Model Example 2
Total minimum cost:
TC = ((2400)/(2x800))(800-200)x1 +
(48000/2400)x45 = $900 + $900 = $1,800

12-40
 Quantity Discounts

Adding PD does not change EOQ

Instructor Slides 13-41

Quantity Discount Model
When price reduction for large orders is
offered the economic order quantity may
change.
Example:
Order Quantity Unit Price ($)
0 – 399 2.2
400 – 699 2.0
700+ 1.8

D = 10,000 units
S = $5.5 per order
H = .2P or 20% of price
EOQ Model
12-42
 Example

(2)(10,000)(5.5)
Price $1.8/unit: Q   552.8 units < 700 units (infeasible)
(.2)(1.8)

(2)(10,000)(5.5)
Price $2/unit: Q  524.4 units (feasible)
(.2)(2)

(2)(10,000)(5.5)
Price $2.2/unit: Q   500 units > 399 (infeasible)
(.2)(2.2)

12-43
Total Costs with Purchasing Cost

Annual Annual Purchasing

+
TC = carrying + ordering cost
cost cost

Q + DS + PD
TC = H
2 Q

12-44
 Total Costs with PD @ $1.8 Per Unit
Cost

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without PD

PD
Lowest cost
order 700
552.8
0 EOQ Quantity 12-45
Total Costs with PD @ $2 Per Unit
Cost

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without PD

PD
Lowest cost
order 524.4
0 EOQ 524.4 Quantity
12-46
Total Costs with PD @ $2.2 Per Unit
Cost

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without PD

PD
Lowest cost
order 399
0 EOQ 500 Quantity
12-47
Total Costs

12-48
 Compare Total Costs

Price (P) 2.20 2.00 1.80

Quantity 399 524.40 700
Holding cost (HQ/2) 87.78 104.88 126.00
Ordering Cost (DS/Q) 137.84 104.88 78.57
Purchasing Cost (PD) 22,000.00 20,000.00 18,000.00
Total Cost (TC) 22,225.62 20,209.76 18,204.57

The lowest cost is obtained with an order

size of 700 units
12-49
Quantity Discounts Procedure (H = percentage of price)
Beginning with the lowest price, determine the
EOQ for each price range until a feasible EOQ is
found.
 If the feasible EOQ is for the lowest price range it is the
optimal order quantity.
 If the feasible EOQ is not for the lowest price, compare
the total cost (TC) of the feasible EOQ to the total cost
of the lowest price breaks. The order quantity with the
minimum TC is optimal.

12-50
Quantity Discounts Procedure (H = percentage of price)

1. Price $1.8/unit: EOQ = 552.8 < 700 units

(infeasible)
2. Price $2.0/unit: EOQ = 524.4 (feasible)
3. TC1.8 = $18,204.57
4. TC2.0 = $20,209.76
5. Optimum Q = 700

12-51
Compare Total Costs

Price (P) 2.20 2.00 1.80

Quantity 399 524.40 700
Holding cost (HQ/2) 87.78 104.88 126.00
Ordering Cost (DS/Q) 137.84 104.88 78.57
Purchasing Cost (PD) 22,000.00 20,000.00 18,000.00
Total Cost (TC) 22,225.62 20,209.76 18,204.57

12-52
Quantity DiscountsFeasible
Quantity Procedure - Examples
Quantities to
Range Price EOQ investigate
0 - 499 6.95
500 - 999 6.50
1000 - 1999 6.25 1,700 1,700
2000+ 6.10 2,000

0 - 699 43.50 590 590

700 - 1499 36.95 700
1500+ 35.50 1,500

0 - 599 10.50
600 - 749 7.50
750 - 999 7.25
1000+ 7.15 1,200 1,200
12-53
 Total Costs with PD
Figure 12.7
Cost

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without PD

PD

0 EOQ Quantity
12-54
 Total
Figure 12.9 Cost with Constant Carrying Costs

TCa
Total Cost

TCb
Decreasing
TCc Price

CC a,b,c

OC

EOQ Quantity
12-55
Quantity Discounts Procedure - Examples
Quantity Feasible Quantities to
Range Price EOQ investigate
0 - 499 6.95
500 - 999 6.50
1000 - 1999 6.25 1,700 1,700
2000+ 6.10 2,000

0 - 699 43.50 590 590

700 - 1499 36.95 700
1500+ 35.50 1,500

0 - 599 10.50
600 - 749 7.50
750 - 999 7.25
1000+ 7.15 1,200 1,200 12-56
Total Costs

12-57
Total Costs

12-58
Total Cost with Constant Carrying Costs
Figure 13-9

TCa
Total Cost

TCb
Decreasing
TCc Price

CC a,b,c

OC

EOQ Quantity
12-59
Total Costs

12-60
Total Costs

12-61
Total Costs

12-62
Quantity Discounts Procedure (H = constant)

Compute the common minimum point (EOQ).

Identify the quantity range which contains the
minimum point. Only one of the unit prices
will have the minimum point in its feasible
range.
 If the feasible minimum point is on the lowest price
range, that is the optimum order quantity.
 If the feasible EOQ is not for the lowest price, compare
the total cost (TC) of the feasible minimum point to the
total cost of the lowest price breaks. The order quantity
with the minimum TC is optimal
12-63
Constant Carrying Cost Example
Example:
Order Quantity Unit Price ($)
 0 – 399 2.2
 400 – 699 2.0
 700+ 1.8
D = 10,000 units
S = $5.5 per order
H = $.4 per unit/year
EOQ Model

12-64
Constant Carrying Cost Example
(2)(10,000)(5.5)
1. Q   524.4 units (feasible for price = $2)
(.4)

2. For Q = 524, P = 2: TC2.0 = $20,209.76

3. For Q = 700, P = 1.8: TC1.8 = $18,218.57

4. Optimal order quantity Q = 700

12-65
Constant Carrying Cost Example

Price (P) 2.00 1.80

Quantity 524.4 700
Holding cost (HQ/2) 104.88 140.00
Ordering Cost (DS/Q) 104.88 78.57
Purchasing Cost (PD) 20,000.00 18,000.00
Total Cost (TC) 20,209.76 18,218.57

12-66
 Quantity Discounts

The total-cost curve

with quantity discounts
is composed of a
portion of the total-cost
curve for each price

Instructor Slides 13-67

 When to Reorder
 Reorder point
 When the quantity on hand of an item drops to this amount, the
item is reordered.
 Determinants of the reorder point
1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management

Instructor Slides 13-68

When to Reorder with EOQ Ordering
Reorder Point - When the quantity on hand of
an item drops to this amount, the item is
reordered
Safety Stock - Stock that is held in excess of
expected demand due to variable demand rate
and/or lead time.
Service Level - Probability that demand will
not exceed supply during lead time.

12-69
ROP Factors
Demand rate (d)
Length of lead time (LT)
Variability and uncertainty of demand and lead
time
The degree of stock-out risk acceptable to
management
 ROP = Demand During Lead Time + Safety Stock

12-70
 Reorder Point: Under Certainty (Constant
Demand and Lead Time Model)

ROP  d  LT
where
d  Demand rate (units per period, per day, per week)
LT  Lead time (in same time units as d )

Instructor Slides 13-71

Constant Demand and Lead Time
Model
Demand rate (d) : constant
Lead Time (LT) : constant
ROP = (d)(LT) (no safety stock)
Example: A Order for 81/2”X11” letter size paper is
delivered 7 days after the order is placed. The usage
rate is 10,00 sheets per day. The reorder point is:
ROP = (1,000)(7) = 7,000 sheets

12-72
 Reorder Point: Under Uncertainty
 Demand or lead time uncertainty creates the possibility
that demand will be greater than available supply
 To reduce the likelihood of a stockout, it becomes
necessary to carry safety stock
 Safety stock
 Stock that is held in excess of expected demand due to variable
demand and/or lead time

Expected demand
ROP   Safety Stock
during lead time

Instructor Slides 13-73

 Reorder Point
Figure 12.13

The ROP based on a normal

Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale

12-74
 Safety Stock

Instructor Slides 13-75

 Safety Stock?
 As the amount of safety stock carried increases, the
risk of stockout decreases.
 This improves customer service level
 Service level
 The probability that demand will not exceed supply during lead
time
 Service level = 100% - Stockout risk

Instructor Slides 13-76

 How Much Safety Stock?
The amount of safety stock that is appropriate for a
given situation depends upon:
1. The average demand rate and average lead time
2. Demand and lead time variability
3. The desired service level

Expected demand
ROP   z dLT
during lead time
where
z  Number of standard deviations
 dLT  The standard deviation of lead time demand
Instructor Slides 13-77
ROP Models
Z is determined by stockout risk or service level
(SL)
SL = 1 – Stockout Risk
 For example 95% service level implies that the
probability that demand will not exceed supply during
lead time is 95%. There is a 5% chance that demand will
exceed supply during the lead time.

12-78
 Reorder Point: Demand Uncertainty

ROP  d  LT  z d LT
where
z  Number of standard deviations and is determined by
stockout risk or service level
d  Average demand per period (per day, per week)
 d  The stdev. of demand per period (same time units as d )
LT  Lead time (same time units as d )
Note: If only demand is variable, then  dLT   d LT

Instructor Slides 13-79

Variable Demand Rate Constant Lead
Time Example
Assume that the demand rate for a product is
normally distributed with a mean of 10 tons and
the standard deviation of 2 tons. Lead time is 4
days.
Q: What is the expected demand during lead
time?

(d )( LT )  (10)(4)  40 tons
12-80
Variable Demand Rate Constant Lead
Time Example
Q: For a service level of 97%, what is the safety
stock:
 Z = 1.88 (from the standard normal table)

ss =
Z LT (σd)

 = (1.88)(2)(2) = 7.52

12-81
 Reorder Point: Lead Time Uncertainty

ROP  d  LT  zd LT
where
z  Number of standard deviations
d  Demand per period (per day, per week)
 LT  The stddev. of lead time (same time units as d )
LT  Average lead time (same time units as d )
Note: If only lead time is variable, then  dLT  d LT
Example: Page 598, Solved Problem 5

Instructor Slides 13-82

Variable Demand and Lead Time
Demand Rate: Random Variable

Mean: d
Standad Deviation: d
Lead Time: Random Variable

Mean: LT
Standard Deviation:  LT
12-83
Variable Demand and Lead Time
2
ROP = ( d )( LT ) + Z LT 2
d  d  2 LT

Example: Solved problem 6, page 598 (text)

12-84
 Single-Period Model
 Single-period model
 Model for ordering of perishables and other items with limited
useful lives
 Shortage cost
 Generally, the unrealized profit per unit
 Cshortage = Cs = Revenue per unit – Cost per unit
 Excess cost
 Different between purchase cost and salvage value of items left
over at the end of the period
 Cexcess = Ce = Cost per unit – Salvage value per unit

Instructor Slides 13-85

 Single-Period Model
 The goal of the single-period model is to identify the order
quantity that will minimize the long-run excess and
shortage costs
 Two categories of problem:
 Demand can be characterized by a continuous distribution
 Demand can be characterized by a discrete distribution

Instructor Slides 13-86

 Stocking Levels
Cs
Service level 
C s  Ce
where
C s  shortage cost per unit
Ce  excess cost per unit
Cs Ce

Service level

Quantity
So So =Optimum
Balance Point Stocking Quantity

Instructor Slides 13-87

 Single Period Model

Single period model: model for ordering of

perishables and other items with limited
useful lives
Shortage cost: generally the unrealized
profits per unit
Cs = Revenue per unit – Cost per unit
Excess cost: difference between purchase
cost and salvage value of items left over at
the end of a period
 Ce = Original cost per unit – Salvage value per unit

12-88
Single Period Model
Continuous stocking levels
 Identifies optimal stocking levels
 Optimal stocking level balances unit shortage and
excess cost
 Examples 15 & 16; pages 589, 590

Discrete stocking levels

 Service levels are discrete rather than continuous

 Desired service level is equaled or exceeded

 Examples 17 & 18; pages 591 & 592

12-89
Example 15
Ce = $0.20 per unit
Cs = $0.60 per unit
Service level = Cs/(Cs+Ce) = .6/(.6+.2)
Service level = .75

Ce Cs

Service Level = 75%

Quantity

Stockout risk = 1.00 – 0.75 = 0.25 12-90

 Operations Strategy
 Improving inventory processes can offer significant
cost reduction and customer satisfaction benefits
 Areas that may lead to improvement:
 Record keeping
 Records and data must be accurate and up-to-date
 Variation reduction
 Lead variation
 Forecast errors
 Lean operations
 Supply chain management

Instructor Slides 13-91