Inventory control

Schedule
Basics of inventory
management
Inventory models
continuous review
periodic review
other models
K&R:
chapter 15,E12,D
L e c t u r e
Basics of inventory management
OM 12-13-3
Inventory management depends on demand
- case independent vs. dependent demand items -
How much to order and when?
Independent demand
(often consumer driven)
e.g. 1000 phones
Dependent demand
(often related to companys own
production decisions)
e.g. 1000 instruction booklets
OM 12-13-4
Inventory management depends on demand
- case independent vs. dependent demand items -
Material type End products and spares
Objective Fulfill customer need
Demand
pattern
Sporatic
Forecast Earlier demand
Ordering
philasophy
Fulfilment oriented
Lot size EOQ and other control models
Control Based on ABCD-analysis
Independent demand i tems
COMPUTERS HELP BUT COMPUTERS HELP BUT
OM 12-13-6
Even the inventory control issues are
very inter-departmental
Running an effici ent inventory system is a
comprehensive process
you must be able to categorize your product portfolio and choose
the suitable control models for each product
you have to make reliable demand forecasts
you must estimate correctly each products inventory cost
components (holding, ordering and others)
you must understand order-delivery lead times and their
variability
you must set service levels to fit product and customer variables
your inventory bookkeeping has to be flawless and you must set
up policies that keep the data up-to-date
etc.
OM 12-13-7
Sales influences inventory management
- ABCD -classification -
There are differences between products on how
important they are to the company
sales, number of customers, profit potential, invested capital, stock-out
cost, criticality etc. products should be managed differently
ABCD-classification divides products in 4 categories based on sales
A and B -products objective high turnover and good
service levels
strict control, continuous review (A) and periodic review (B), regular
replenishment (variable lot size) and small delivery batches
C and D -products objective to minimize economic
burden
periodic review and 2-bin system, reducing number of products,
minimizing fulfillment costs, safety stocks
Classification only considers sales
no life-cycles, criticality, strategic importance etc. considered
OM 12-13-8
Not all products are equal
0%
20%
40%
60%
80%
100%
A A A A A B B B B B B B B B B B C C C C C C C C C C C C C C C C D D D D D D D D
1 2 3 4 5 1 2 3 4 5 6 7 8 9 10 11 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 1 2 3 4 5 6 7 8
C
u
m
u
l
a
t
i
v
e

p
e
r
c
e
n
t
a
g
e
sales sales margin inventory value
50% 30% 18% 2%
OM 12-13-9
0
200000
400000
600000
800000
1000000
1200000
A A A A A B B B B B B B B B B B CC C C C C CC C CC C C C CC D DD D DD D D
4 3 2 5 1 1 5 6113108 9 4 7 2131 5 3 9 814415122 611716106 2 7 8 5 4 1 3
I
n
v
e
n
t
o
r
y

v
a
l
u
e
0
10
20
30
40
50
60
T
u
r
n
o
v
e
r
Inventory value turnover
improve
turnover
watch
stock-out
do something or drop
OM 12-13-10
Objectives influence inventory management
Low price
High discounts
Medium margin
Medium turns
Medium price
No discounts
High margin
High turns
High price
No discounts
Medium margin
Low turns
Set high service
levels
Invest in inventory
Improve forecasting
Minimize
extras
Maximize
volume
Minimize
inventory
costs
Swatch Citizen Rolex
Set lower service levels
Invest in central depot
stock location
Replenish/ transfer
among locations
Do market testing and
research at beginning
Use also central
warehousing
Use early sales data to
reorder / cut back
OM 12-13-11
Inventory models
OM 12-13-13
P
r
o
d
u
c
t
s

o
n

i
n
v
e
n
t
o
r
y
Time
Q
Inventory control is in theory simple
One product, level demand, fixed delivery time etc.
OM 12-13-14
There are varied inventory control models
Number and nature of
products
one vs. many products
non-perishable vs. perishable
Type of demand
constant, random, unknown
demand
stationary- vs.
non-stationary model
back-order vs. losing orders
Inventory control model
continuous vs. periodic review
Nature of deliveries
immediate, delayed, gradual,
occasional replenishment
Time horizon
one period, several periods,
infinite time horizon
Number of warehouses
one, parallel, network of
warehouses
Nature of
costs/expenses
average cost, present value of
costs etc.
OM 12-13-15
Basic inventory control models
Continuous review (Q) system
time between orders varies, lot size is fixed
- economic order quantity
- volume discounts
- economic production lot size
requires continuous inventory control!
- became more popular lately due to improved computerized solutions
and lower prices (e.g. bar code, point-of-sale, voice recognition)
Periodic review (P) system
time between orders is fixed, lot size varies
is based on periodic inventory control
- still the more used control method
Other systems
e.g. bin systems
OM 12-13-16
Basic models are exact opposites of each other
Continuous
review system
Peri odic revi ew
system
Time between orders
Varies
(when inventory
reaches reorder point)
Fixed
(schedule)
Order quanti ty
Fixed Varies
Operati ve costs
Higher Lower
Size of i nventory
Smaller Larger
Products
Critical, popular
and expensive
products
Less critical
products
OM 12-13-17
Continuous review system
Time
Order
point
R
In continuous review models orders of fixed size are
made after periods with variable lengt
central questions are the order quantity, timing of the order, pursued
service level and size of safety stock
requires a lot especially from inventory information systems because
balances have to be correct all the time
- instructing and motivating employees very important
Inventory
lead time
orders
OM 12-13-18
C
o
s
t
s
Ordering/set up costs
Economic
order quantity
Trade-off between costs
- economic order quantity -
Size of
order quantity
OM 12-13-19
Order
Order
Larger order quantity means
more products to be inventori ed
Smaller order quantity
means more orders
Shape of cost functions and common sense
Ordering costs
C
o
s
t
s
Size of
order quantity
OM 12-13-20
Economic order quantity (EOQ) depends on
the size of cost components
3 orders and
higher average inventory
5 orders and
lower average inventory
average
inventory
average
inventory
vs.
OM 12-13-21
Calculating EOQ
1. Determi ne ordering costs (not necessaril y easy)
2. Determi ne holding costs (not necessaril y easy)
3. Calculate the derivative of the total cost i n
point Q and set i t equal to zero
unit per cost Holding
order one per cost Order * Demand * 2
=
H
2DS
= EOQ
order one per cost Order *
size Lot
Demand
(S)
Q
D
= costs Ordering =
unit per cost Holding *
2
size Lot
(H)
2
Q
= costs Holding =
OM 12-13-22
Inventory
Time
Lot
size
Q
Reorder
point
R
Lead time
L
demand during lead time
Determining reorder point in EOQ-model
- R = dL -
usage rate d
order-
moment
delivery
moment
Order EOQ volume when
inventory drops to reorder point
OM 12-13-23
EOQ example
Sams Cat Hotel needs a lot of kitty liter to operate. Hotel entrepreneur purchases
litter at the price of $11,70/bagand average demand is 90bags per week. Ordering
cost has been estimated to be $54per order and annual holding cost 27%from
purchasing costs. Delivery lead time is currently 3 weeks (18 work days). Hotel uses
continuous review inventory system and is open around the year (52 weeks, 6 days
a week). Calculate economic order quantity, time between orders, reorder point and
total annual costs.
Order quantity:
units 400
27% * 11,70
54 * 52) * (90 * 2
H
2DS
EOQ = = =
Time between
orders:
weeks 4,44 years 0,08547
52 * 90
400

D
EOQ
~ = =
units 270 3 * 90 dL R = = =
Reorder point:
aver. inventory
200 units
11,7 orders per year
Total costs:
60 , 1263 $ 54 *
400
4680
%) 27 * 70 , 11 ( *
2
400
TC = + =
#15-10
12-10
Notice:
EOQ -formulas units
must be remembered!
OM 12-13-24
EOQ example
OM 12-13-25
EOQs sensitivity analysis
Close to EOQ volume the total costs function
is rather flat
impact of wrongly estimating the cost variables rather small
especially to the right from EOQ (larger lot size) the total costs
increase only slowly
Impact of different costs vari ables change to
total costs can be seen from the formula
increase in demand increases lot size
increase in ordering costs increases lot size
increase in holding costs decreases lot size
- increase in interest rate decreases lot size
- increase in unit price decreases lot size
H
2DS
EOQ=
OM 12-13-26
How
realistic
are
these?
EOQ -models main assumptions
Demand is constant and known
demand is fulfilled from inventory; no stock-outs, no back
orders and no uncertainty what so ever
Lead time is constant and known
Products unit price is fixed
no volume discounts
Deliveries are complete lots
single delivery, no constraints on size of each lot
Limited cost functions
only cost are ordering and holding; ordering assumed to
be fixed and holding is based on average inventory
Products independent from each other
OM 12-13-27
Demand is seldom stable and stock-out cost
can be the highest cost variable
service level thinking eases optimization
- higher service level means higher safety stock
S
Demand
Service level (zo
L
)
P(Stockout)
P
r
o
b
a
b
i
l
i
t
y
B A C
Time
Inventory
A
B
C
order
moment
delivery
moment
lead time
order
point
R
Safety stock (S)
Lot size
L
z dL = R o +
Managers
decision
EOQ -models extensions
- variability in demand -
Lower order quantity leads often to
larger safety stock!
Distribution of demand
during lead time
OM 12-13-28
Standard deviation of
delivery lead times demand
o
t
= 15
+
90 units
Week 1
demand
o
t
= 15
90 units
Week 2
demand
o
t
= 15
90 units
Week 3
demand
+
=
270 units
Weeks 1-3
demand
o
t
= 26
L
t L
=
3 * 15 =
26 =
delivery lead
time
lead times
st. deviation
one periods"
st. deviation
OM 12-13-29
Order quantity and
time between orders:
Reorder point:
Total costs:
Safety stock example
Use of kitty liter in Sams Cat Hotel is not totally steady. Due to liters criticality
entrepreneur wants to be prepared also for higher consumption levels. Desired
service level has been estimated to be 80%. Standard deviation of weekly demand
has been estimated from historical data to be 15 bags per week. How do safety
stocks change key inventory management numbers?
400 units and 4,44 weeks
(stays the same)
L z dL dL R
t L
+ = + =
292 3 * 15 * 0,84 3 * 90 = + =
delivery lead time
safety
stock:
22 bags
#15-10
12-10
$1333,10 54 *
400
4680
27%) * (11,70 * 22
2
400
TC = +
|
.
|

\
|
+ =
S *
Q
D
H *
2
Q
TC
L
+
|
.
|

\
|
+ =
from normal
distribution
+$69,50
per year
OM 12-13-30
Safety stock example
OM 12-13-31
There is unfortunately variability in delivery
lead times
Time
Inventory
A
B
C
order
moment
expected
delivery
moment
lead time
order
point
R
Safety stock (S)
Lot size
EOQ -models extensions
- variability in delivery lead times -
S
Time
L
i
k
e
l
y
h
o
o
d
A C
Distribution of lead time
B
Decreasi ng the vari ably in lead times can be more
advantageous than cutting the lead times themselves
OM 12-13-32
PD + S
Q
D
H
2
Q
= TC +
Ordering cost
Purchasing price
Holding cost
Order size
Total cost:
C
o
s
t
s
EOQ -model extensions
- volume discounts -
OM 12-13-33
EOQ -models extensions
- volume discounts -
Order size
T
o
t
a
l

c
o
s
t
s
Base price 1. discount 2. discount
Total cost.
base price
Total cost
1. discount
Total cost
2. discount
Order sizes what with
orders are possible to do
2
1
P
1
2
Lowest cost not in the area of
minimum discount volume
OM 12-13-34
2
1
P
Lowest costs in this case by ordering this
amount every time
Order size
T
o
t
a
l

c
o
s
t
s
Base price 1. discount 2. discount
Total cost.
base price
Total cost
1. discount
Total cost
2. discount
EOQ -models extensions
- volume discounts -
OM 12-13-35
A baseball-team is trying to decide size of an order from the manufacturer. To make an
analytical decision, teams purchaser has been going around the organization and collected
information he needs to make the order quantity decision. The total demand is 208 bats per
year, the order cost is $70 per order, and the annual holding cost per bat per year is 38%of
the purchase price. The bat selling company has priced its product in the following way:
order 1-11 at $54,00 per bat, order 12-143 at $51,00 per bat, and in larger orders the price is
$48,50 per bat. How many bats should purchaser order?
11516 208 * 48,50 + 70 *
144
208
38%) * (48,50 *
2
144
= TC = +
11359 208 * 51,00 + 70 *
39
208
38%) * (51,00 *
2
39
= TC = +
12005 208 * 54,00 + 70 *
38
208
38%) * (54,00 *
2
38
= TC = +
Volume discount example
Price 54,00: EOQ=(2*208*70)/(54,00*38%)= 37,7 order EOQ - 38
Price 51,00: EOQ=(2*208*70)/(51,00*38%)= 38,7 order EOQ - 39
Price 48,50: EOQ=(2*208*70)/(48,50*38%)= 39,7 must order at least 144
cheapest
#E-4
D-4
OM 12-13-36
Volume discount example
OM 12-13-37
2DS p
ELS=
H p d
EOQ -model extensions
- noninstantaneous replenishment -
Inventory can also be replenished gradually during
some period (not everything at the same time)
very practical in production environments
- e.g. consecutive steps in the production process or vertical integrated
company with its own sales outlets (so both producer and reseller)
practical also in some other situations
- e.g. order is sent in portions immediately at the rate fulfillment (Amazon)
Time
build up rate
= (p-d)
demand rate = d
Inventory
Production
period
Production
period
I
max
)
p
d - p
( * Q =
production quantity
OM 12-13-38
Economic Lot Sizing (ELS) example
Vertically integrated carpet company produces popular Super Shag model.
Management accounting shows that SS models holding costs are about
0,75 pounds per meter per year and ordering costs are 150 pounds (=set
up cost). SSs demand has been forecasted to be 10 kilometers per year.
Production factory is operating six days a week (just as stores) (311 days a
year), deliveries are daily and SSs production speed is 150 meters per
day.
Calculate Super Shag carpets economic lot size, number of orders per
year, how long it takes to produce each batch, maximum inventory level,
and total inventory costs.
m 257 , 2 1286 , 1 * 2000
15 , 32 150
150
0,75
150 * 10.000 * 2
d p
p
H
2DS
ELS ~ =

=
Lot size:
10,000/311
OM 12-13-39
ELS example
days working 70 every in r times/yea 4,43
2.257m
10.000m
Q
D
~ = =
Number of orders per year:
Production time:
days 15,05
150m/day
2.257m
p
Q
= =
Maximum inventory:
1.773m
150
15 , 32 150
* 2.257
p
d - p
* Q =

=
|
|
.
|

\
|
Total costs:
6 , 1329 150 *
2257
10.000
0,75 *
150
32,15 - 150
*
2
2.257
S
Q
D
)H
p
d - p
(
2
Q
TC = + = + =
OM 12-13-40
ELS example
If inventory
would be refilled
with instantaneous
replenishment
OM 12-13-41
ELS example
- set up costs, lot size and total costs -
OM 12-13-42
EOQ -model extensions
- noninstantaneous replenishment -
Few notes on ELS and EOQ models...
if p is much larger than d, ELS and EOQ are almost equal
- due to slow usage rate the inventory filling resembles EOQ
if p and d are nearly equal, production is less like batch
production and more like a production line
- product usage rate is same as production rate, and production is
almost continuous
lowering set up costs lowers the optimal production lot size
- reduced holding costs will also lead to savings
cooperation between companies and standardization of ordering
costs can dramatically decrease the order size
(J IT-production)
OM 12-13-43
Periodic review system
Peri odic review is used because continuous
review is not always economically feasible
and takes too long time
part of the orders can be done only with fixed intervals
- e.g. in grocery stores fixed schedules and routes
method is also used when several orders to one supplier are
combined
Periodic review increases stock-out risk
requires higher safety stock to guarantee same service level
Demand influences on how much is ordered
e.g. season has to be taken into account
OM 12-13-44
Periodic review system
In periodic review models orders of variable size are
made after regular time intervals
central questions are the length of review interval, order quantity,
pursued service level and size of safety stock
orders
Time
Inventory
Order
-up-to
-level
T
Lead time
OM 12-13-45
Periodic review systems formulas
D
EOQ
= P
L P
z L) (P d = T
+
+ + o Target inventory level:
Order quantity:
IP - T = Q
safety
stock
inventory position
(inventory +scheduled
receipts - backorders)
Total costs:
Review interval /
time between orders
:
Standard deviation of demand
during the protection interval:
L P =
t L P
+
+
S
dP
D
H
2
dP
TC
L P
+
|
.
|

\
|
+ =
+
demand*
(rev.interval+lead time)
(rev.interval+
lead time)
Be accurate
about time
units!
stable demand
assumed
OM 12-13-46
Periodic review example
Due to constant hurry Sams Cat Hotel is moving to periodic review system.
Calculate the inventory review interval, target inventory level, amount to be ordered
if there are 330 bags in the inventory right now, and annual total inventory costs
days 27 26,67 6 * 52 *
4680
400
D
EOQ
= P ~ = =
units 710 18 27 * 6,124 * 0,84 18) (27 * 15 L P L) (P d = T
t
~ + + + = + + +
Target inventory level:
Order quantity:
units 380 330 - 710 IP - T = Q = =
Total costs:
Review interval / time between orders:
$1373 S
dP
D
H
2
dP
TC
L P
~ +
|
.
|

\
|
+ =
+
deviation
per day
(=15/SQRT(6))
demand
per day
(=90/6)
lead time
(=3w*6 day)
norm.
distribution
(80%)
#15-19
12-19
OM 12-13-47
Periodic review example
OM 12-13-48
Of course also other control systems exist
- case order-point, order-up-to-level system -
Althought the continuous review is used orders of
variable size are made after periods with variable
length
central questions are the order quantity, timing of the order,
pursued service level and size of safety stock
Time
Order
point
R
lead time
Order
-up-to
-level
T
Inventory
orders
OM 12-13-49
Of course other control systems exist
- case order-point, order-up-to-level system -
Replenishment is made whenever the inventory
position drops to order point or lower
Order size determined with order-up-to level amount
if transactions are unit-sized then the system is identical with Q-system
if transactions are larger, the order quantity becomes variable
The system is often referred to as a min-max
system!
inventory position (on-hand inventory & scheduled receipts) is basically
always between order point R (min) and order-up-to-level T (max)
System frequently encountered in practice
finding optimal R and T is time consuming compared to using Q-system
so values are usually set in a rather arbitrary fashion
Variable order quantity have been found to increase
suppliers delivery errors
OM 12-13-50
Other inventory models
- bin systems -
Two bin system
Full Empty
Order one box
to inventory
One bin system
Periodic review
Order enough to fill up
the box again
e.g. reminder if checkbook,
notify salespeople in hardware
store, bottom of label in a bar,
line in the wall
Continuous review
OM 12-13-51
Other inventory models
- conditional fulfillment -
Maximal inventory level, T
Real inventory level, I
q = T - I
If q > Q, order q, otherwise do nothing
(also used with two limits; 1-to allow order, 2-force to order)
Inventory 0
Q = smallest acceptable order size
T
I
OM 12-13-52
A good inventory system is not always enough
OM 12-13-53
A good inventory system is not always enough
Case seasonal products
season has a limited duration
consumption fairly uncertain
replenishments often difficult to
carry out
a sales- and marketing plan is a
cornerstone of inventory control
- ABCD-classification often helps
Productional solutions
often necessary
enhancing flexibility, fast response
-systems
delaying strategies
(postponement)
make-to-order production
Marketi ng and
production have a
signifi cant effect on
warehousi ng!