Inventory Management

Session 11-12
 Functions of Inventory

1. To provide a selection of goods for anticipated customer demand and to separate

the firm from fluctuations in that demand. Such inventories are typical in retail
establishments.

2. To decouple various parts of the production process . For example, if a firm’s

supplies fluctuate, extra inventory may be necessary to decouple the production
process from suppliers.

3. To take advantage of quantity discounts , because purchases in larger quantities

may reduce the cost of goods or their delivery.

4. To hedge against inflation and upward price changes.

 Types of Inventory

To accommodate the functions of inventory, firms maintain four types of inventories:

(1)Raw material inventory,
(2)work-in-process inventory,
(3)maintenance/repair/operating supply (MRO) inventory, and
(4)finished-goods inventory.

MRO : safety equipment, maintenance and repair supplies, technology, office supplies and
laboratory equipment.
 Managing Inventory

ABC Analysis
ABC analysis divides on-hand inventory into three classifications on the basis of
annual dollar volume.
In ABC analysis, we measure the annual demand of each inventory item times the cost
per unit .
Class A items are those on which the annual dollar volume is high. Although such
items may represent only about 15% of the total inventory items, they represent 70%
to 80% of the total dollar usage.

Class B items are those inventory items of medium annual dollar volume. These
items may represent about 30% of inventory items and 15% to 25% of the total value.

Those with low annual dollar volume are Class C , which may represent only 5% of
the annual dollar volume but about 55% of the total inventory items.
 Step 1: Multiply the total number of items by the
cost of each unit to find the annual usage value.

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Step 2: After noting all the products of the inventory,
it’s time to list them in the descending order based on
annual consumption value.
Step 3: Sum up and add the total number of units
sold and the annual consumption value.
Step 4: Find out the cumulative percentage of
products sold along with the percentage of
annual consumption value.
Step 5: In the last step, split the data and numbers
into the three A, B, and C categories. Remember, it’s
essential to set the data in the ratio of 80:15:5.
 Record Accuracy

Inventory Record Accuracy (IRA) is a measure of how closely official inventory records
match the physical inventory.
Accuracy can be maintained by either periodic or perpetual systems.

two-bin system.
 Cycle Counting

A continuing reconciliation of inventory with inventory records

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 Inventory Models
Independent vs. Dependent Demand

Independent demand is demand for a finished product, such

as a computer, a bicycle, or a pizza. Dependent demand, on
the other hand, is demand for component parts o
subassemblies. For example, this would be the microchips in
the computer, the wheels on the bicycle, or the cheese on the
pizza

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 Holding, Ordering, and Setup Costs
• Inventory holding cost
• Cost of capital
• Obsolescence cost
• Handling cost
• Occupancy cost
• Order cost
• Buyer time
• Transportation costs
• Receiving costs
• Setup cost
• The cost to prepare a machine or process for manufacturing
• This includes time and labor to clean and change tools or holders. Operations
.
 Inventory Models for Independent Demand

In this section, we introduce three inventory models that address two important
questions:
when to order and how much to order . These independent demand models are:
1. Basic economic order quantity (EOQ) model
2. Production order quantity model
3. Quantity discount model
 The Basic Economic Order Quantity (EOQ) Model

The economic order quantity (EOQ) model is one of the most commonly used inventory-
control techniques.
This technique is relatively easy to use but is based on several assumptions:
1. Demand for an item is known, reasonably constant, and independent of decisions for other
items.
2. Lead time—that is, the time between placement and receipt of the order—is known and
consistent.
3. Receipt of inventory is instantaneous and complete. In other words, the inventory from
an order arrives in one batch at one time.
4. Quantity discounts are not possible.
5. The only variable costs are the cost of setting up or placing an order (setup or ordering cost)
and the cost of holding or storing inventory over time (holding or carrying cost). These costs
were discussed in the previous section.
6. Stockouts (shortages) can be completely avoided if orders are placed at the right time
Basic EOQ model

 Assumptions of the model

• Demand is deterministic and
demand rate is constant
• Lead Time is zero
• Infinite production/procurement
rate
• No backordering is allowed
• The only relevant costs are
inventory carrying cost and
ordering cost
Costs as a Function of Order Quantity
 Calculation of Ordering Cost
• No. of orders placed =
• Total Setup/Ordering Cost =
 Calculation of Inventory Holding Cost
• In every cycle beginning inventory = Q and ending
inventory=0
• Average inventory per cycle =
• Average inventory in the entire time horizon =
• Total inventory carrying cost =
 Basic EOQ model

The objective of basic EOQ modelling is to minimize the total cost.

D Q
• Total Cost, TC  Q   CO  h
Q 2

• First order condition gives dTC Q  D h

  2 CO   0
dQ Q 2

• Thus, 2 DCO
Q 
*

h
• Second order condition gives

d 2TC Q  2 D
2
 3 CO  0 The second order derivative positive indicate that total cost
dQ Q is minimum at Q.
 Basic EOQ model

• No. of orders = D/Q* 

D

Dh
2 DCO 2CO
h

• Time between two consecutive orders = 365/ No. of orders

2 DCO
*
D Q D
• Total Cost = TC Q*   CO  h CO  h h 2 DCO h
Q* 2 2 DCO 2
h
 Basic EOQ model- example 1

 A firm faces a demand of 96000 units annually. To place an order, it

requires a total cost of $320 per order while the cost of holding the item in
warehouse requires an annual cost of $6 per unit. The cost of this item is
$60 per unit. Calculate the EOQ, and time between orders.

2 DCO
Q *

h
 Basic EOQ example 1- solution

• Here, D= 96000 2 DCO

Q *

h
• CO=$320 per order
• h=$6 per unit
• Using the formula for EOQ we get
• Q*= 3200
• Thus, number of orders = 30
• Time between to consecutive orders = 365/30= 12.16 days

Note: Here, EOQ is independent of material price… But what happens when holding cost depends on the material price.
 Basic EOQ model- extension

 A firm faces a demand of 96000 units annually. To place an order, it

requires a total cost of $320 per order while the cost of holding the item
in warehouse requires an annual cost of 15% of the item cost. The cost
of this item is $60 per unit. Calculate the EOQ.

Here, D= 96000
CO=$320 per order 2 DCO
Q *

h=$9 per unit h

Q * = 2613

Note: Increasing in holding cost from $6 to $9 reduces the EOQ from 3200 to 2613 units.
 Basic EOQ model- example 2

 A firm produces painless hypodermic needles to hospitals and would like to reduce
its inventory cost by producing optimal number of hypodermic needles per order.
The annual demand is 1000 units, set up cost is $10 per order. The holding cost per
year is $ 0.5. Calculate the total minimum cost (annual ordering and holding cost).

Here, D= 1000
2 DCO Q * = 200 units
CO=$10 per order Q 
*

h
h=$0.5 per unit

D Q
TC  Q   CO  h TC = (1000/200)*10+ (200/2)*0.5 =50+50= $100
Q 2
The total cost we find is the set up cost plus holding cost only. However material also have some cost !!

 If order policy includes some discounts like quantity discounts, then material cost to be included in
the total cost calculation.
 Key Points from EOQ Model

• In deciding the optimal lot size, the tradeoff is between setup (order)
cost and holding cost.

• If demand increases by a factor of 4, it is optimal to increase batch size

by a factor of 2 and produce (order) twice as often. Cycle inventory (in
days of demand) should decrease as demand increases.

• If lot size is to be reduced, one has to reduce fixed order cost. To reduce
lot size by a factor of 2, order cost has to be reduced by a factor of 4.
 Quantity discount model

 Quantity discounts is very prevalent nowadays. A quantity discounts is simply a reduced price (P)
for an item when it is purchased in a large amount.

Thus three cost considered here:

 Material cost
 Ordering cost
 Holding cost (in terms of material cost)

Here, EOQ is calculated same as discussed

In the basic EOQ model.

Total cost
Options Quantity Price
Initial price 1-49 1400
Discount price 1 50-89 1100
Discount price 2 90+ 900
 Quantity discount model

Options Quantity Price

Initial price 1-49 1400
Discount price 1 50-89 1100
Discount price 2 90+ 900

The question comes how we decide these price-break quantities ??

Similarly, management must decided when and how much to order to minimize the total cost.

cost

𝑇𝐶 ( 𝑄 )= ( )𝐷
𝑄
𝑄
𝐶 𝑠 + (h)+𝑝𝐷
2
Where, p is the unit price.
Solution Procedure

STEP 1: Starting with the lowest possible purchase price in a quantity discount
schedule and working toward the highest price, keep calculating Q*, until the first
feasible EOQ is found. The first feasible EOQ is a possible best order quantity, along
with all price-break quantities for all lower prices.

STEP 2: Calculate the total annual cost TC using, for each of the possible best order
quantities determined in Step 1. Select the quantity that has the lowest total cost.
Note that no quantities need to be considered for any prices greater than the first
feasible EOQ found in Step 1. This occurs because if an EOQ for a given price is
feasible, then the EOQ for any higher price cannot lead to a lower cost.
 Quantity discount model-example 1
Question. A firm can order an item at three different costs as shown below. Monthly demand is 5000 units and holding
cost is 20% of purchasing price. The ordering cost is $49 per order. What is the economic order quantity to minimize total
cost.
Options Quantity Price ($)
Initial price 0-999 5
= $49 per order

√
Discount price 1 1000-1999 4.8 D= 5000
∗2 𝐷 𝐶𝑜
Discount price 2 2000+ 4.75 h= 20% of price per year 𝑄 =𝑝
h
Here, we need to calculate the EOQ in three price levels and then decide, which one is in the feasible range.

@ 𝑝=5.0 , 𝑄 = ∗
𝑝
√
2 ∗5000 ∗ 49
5 ∗ 0.2
=700 EOQ= 700

@ 𝑝=4.8 ,𝑄 = ∗
𝑝
√
2∗ 5000 ∗ 49
4.8 ∗ 0.2
=714 Adjusted EOQ= 1000

@ 𝑝=4.75 ,𝑄 = ∗
𝑝
√
2∗ 5000 ∗ 49
4.75 ∗ 0.2
=718 Adjusted EOQ= 2000
 Quantity discount model-example 1

√
2 ∗5000 ∗ 49
∗
0
@ 𝑝=5.0 , 𝑄 = 𝑝 =700
5 ∗ 0.2

@ 𝑝=4.8 ,𝑄 = ∗
𝑝
√
2∗ 5000 ∗ 49
4.8 ∗ 0.2
=714 𝑇𝐶 ( 𝑄 )=
5000
1000
49+
1000
2 ( )
( 4.8 ∗0.2 )+ 4.8 ∗ 5000=24725

@ 𝑝=4.75 ,𝑄 = ∗
𝑝
√
2∗ 5000 ∗ 49
4.75 ∗ 0.2
=718 𝑇𝐶 ( 𝑄 ) =
5000
2000
49+
2 (
2000
)
( 4.75 ∗ 0.2 ) +4.75 ∗ 5000=24822

Compare all three costs

Options Quantity Price ($) Adjusted EOQ Total cost
Initial price 0-999 5 700 25700
Discount price 1 1000-1999 4.8 1000 24725
Discount price 2 2000+ 4.75 2000 24822

Discount price 1 minimizes the total cost.

All-Unit Quantity Discount: Example
Order quantity Unit Price
0-5000 $3.00
5001-10000 $2.96
Over 10000 $2.92

D = 120000 units/year, S = $100/lot, h = 0.2

 All-Unit Quantity Discount: Example
Step 1: Calculate Q2* = Sqrt[(2DS)/hC2]
= Sqrt[(2)(120000)(100)/(0.2)(2.92)] = 6410
Not feasible (6410 < 10001)
Calculate TC2 using C2 = $2.92 and q2 = 10001
TC2 = (120000/10001)(100)+(10001/2)(0.2)(2.92)+(120000)(2.92)
= $354,520
Step 2: Calculate Q1* = Sqrt[(2DS)/hC1]
=Sqrt[(2)(120000)(100)/(0.2)(2.96)] = 6367
Feasible (5000<6367<10000)  Stop
TC1 = (120000/6367)(100)+(6367/2)(0.2)(2.96)+(120000)(2.96)
= $358,969
TC2 < TC1  The optimal order quantity Q* is q2 = 10001
Replenishment Policies
• Replenishment policy: decisions regarding when to reorder and how
much to reorder
• Continuous review: inventory is continuously monitored and an order of
size Q is placed when the inventory level reaches the reorder point ROP.

• Periodic review: inventory is checked at regular (periodic) intervals and

an order is placed to raise the inventory to a specified threshold (the
“order-up-to” level)

11-36
Product fill rate (fr): fraction of demand that is satisfied from
product in inventory

Order fill rate: fraction of orders that are filled from available
inventory

Cycle service level (CSL): fraction of replenishment cycles that

end with all customer demand met
11-38
 Inventory Turnover Ratio

The inventory turnover ratio is the number of times a company has sold and
replenished its inventory over a specific amount of time. The formula can also be
used to calculate the number of days it will take to sell the inventory on hand.

The turnover ratio is derived from a mathematical calculation, where the cost of
goods sold is divided by the average inventory for the same period. A higher ratio
is more desirable than a low one as a high ratio tends to point to strong sales.

Knowing your turnover ratio depends on effective

inventory control, also known as stock control, where the company has good
insight into what it has on hand.
Example of an Inventory Turnover Calculation Walmart Inc. (WMT)
For fiscal year 2022, Walmart Inc. (WMT) reported cost of sales of $429 billion and
year-end inventory of $56.5 billion, up from $44.9 billion a year earlier.

Walmart’s inventory turnover ratio for the year was:

$429 billion ÷ [($56.5 billion + $44.9 billion)/2]=8.5

Its days inventory equaled:

(365 ÷ 8.5), or about 42 days
This showed that Walmart turned over its inventory every 42 days on average during
the year.

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 What Can Inventory Turnover Tell You?

Inventory turnover measures how often a company replaces inventory relative

to its cost of sales. Generally, the higher the ratio, the better.

A low inventory turnover ratio might be a sign of weak sales or excessive

inventory, also known as overstocking. It could indicate a problem with a retail
chain’s merchandising strategy, or inadequate marketing.

A high inventory turnover ratio, on the other hand, suggests strong sales.
 Probabilistic Models and Safety Stock

 The following inventory models apply when product demand is not known but
can be specified by means of a probability distribution. These types of models are
called probabilistic models .

 Probabilistic models are a real-world adjustment because demand and lead time
won’t always be known and constant.

 An important concern of management is maintaining an adequate service level in

the face of uncertain demand. The service level is the complement of the
probability of a stockout. For instance, if the probability of a stockout is 0.05,
then the service level is .95.

 Uncertain demand raises the possibility of a stockout. One method of reducing

stockouts is to hold extra units in inventory. As we noted earlier such inventory
is referred to as safety stock.
 Safety stock = Z *L
Z= NORMSINV (Excel)
L: Lead time for replenishment
D:
time
Average demand per unit
D L
 DL
D: Standard deviation of demand per
period  L
 L D
ss  F S (CSL)  L
DL: Mean demand during lead time 1
L: Standard deviation of demand
during lead time
CSL: Cycle service level ROP  D L  ss
CSL  F ( ROP, D L , L )
ss: Safety inventory
ROP: Reorder point

= NORMDIST (DL + ss, DL, L)

Average Inventory = Q/2 + ss
11-44
 Example Estimating Safety Inventory
D = 2,500/week; D = 500
L = 2 weeks; Q = 10,000; ROP = 6,000

DL = DL = (2500)(2) = 5000
ss = ROP - DL = 6000 - 5000 = 1000

11-45
 Example : Estimating Cycle Service Level
D = 2,500/week; D = 500
L = 2 weeks; Q = 10,000; ROP = 6,000

  L R
L  (500) 2  707
Cycle service level, CSL = F(DL + ss, DL, L) =
= NORMDIST (DL + ss, DL, L) = NORMDIST(6000,5000,707,1)
= 0.92 (This value can also be determined from a Normal probability
distribution table)
A CSL of 0.92 implies that in 92 percent of the replenishment cycles, B&M
supplies all demand from available inventory. In the remaining 8 percent of the
cycles, stockouts occur and some demand is not satisfied because of the lack of
inventory. 11-46
ROP FOR VARIABLE DEMAND AND CONSTANT LEAD TIME

Safety Stock Calculation

Memphis Regional Hospital stocks a “code blue” resuscitation kit that has a
normally distributed demand during the reorder period. The mean (average)
demand during the reorder period is 350 kits, and the standard deviation is 10
kits. The hospital administrator wants to follow a policy that results in stockouts
only 5% of the time.
(a) What is the appropriate value of Z ?
(b) How much safety stock should the hospital maintain?
(c) What reorder point should be used?

Confidence level = 1 - Significance level (alpha)

Thank You