BUS 105: Production and Operations Management

Chapter 20: Inventory Management

Inventory
money in transit
For many businesses, inventory is the largest asset on the balance sheet
Inventory can be converted back into cash
Businesses must try to sell as much inventory and get the levels to go down as far as possible
Average cost of inventory (holding it) is 30% - 35%


Inventory: Definition & Types
Inventory: the stock of an item or resource used in an organization
Includes raw materials, finished products, component parts, supplies, and work-in-process
Manufacturing inventory: refers to items that contribute to or become part of a firms product
Replacement parts, tools, and supplies
Goods-in transit to warehouse or customers
Inventory Systems
The set of policies and controls that monitor levels of inventory
Determines what levels should be maintained, when stock should be replenished, and how large
orders should be
Purpose of Inventory
Maintain independence of operations
To meet variation product demand
To allow flexibility in production scheduling
To provide a safeguard for variation in raw material delivery (if your supply stock does not arrive
on time)
Take advantage of economic purchase order size (every time you place a work order there is
administrative fees, if you order often you incur this cost more often)
Inventory Costs
1. Holding (Carrying) Costs: cost of storage, handling insurance
2. Setup (Production) Costs: costs for arranging specific equipment setups
3. Ordering Costs: cost of placing order
4. Shortage Cost: cost of running out
BUS 105: Production and Operations Management
Demand Types
Independent Demand: demands for the various items are unrelated to each other (i.e. a
workstation may produce many parts that are unrelated but meet some external demand
requirement)
Dependent Demand: the need for any one item is a direct result of the need for some other item
(usually a higher-level item of which it is part)
Inventory Systems/ Models Comparison
Single-period Inventory Model
o One-time purchasing decision (e.g. vendor selling T-shirts at a football game)
o Seeks to balance the cost of inventory overstock and understock
o Applications: overbooking of airline flights, ordering of clothing and other fashion items,
one time order events
Multi-Period Inventory Model
o Fixed-Order Quantity
o Fixed-Time Period

Multi-Period Inventory Model

Fixed-Order Quantity
(EOQ and Q Model)
Fixed-Time Period
(Periodic system, period review system, fixed-
order interval system, and P-mode)
Event Triggered (such as running out of
stock)
Inventory remaining must be continually
monitored
Has smaller average inventory
Favors more expensive items
Is more appropriate for important items
Requires more time to maintain but is
usually more automated
Is more expensive to implement
Used when we want to maintain an item
in-stock and when we restock, a certain
number of units must be ordered
Time Triggered (such as monthly sales
calls by sales rep)
Counting inventory takes place at end
of the review period
Has larger average inventory
Favors less expensive items
Is sufficient for less-important items
Requires less time to maintain
Is less expensive to implement
Item is ordered at certain intervals of
time


Fixed Order Quantity

ASSUME:
- Demand is constant and uniform throughout period
- Lead time is constant
- Price per unit of product is constant
- Inventory holding cost is based on average inventory
- Ordering or setup costs are constant
- All demands for the product will be satisfied

BUS 105: Production and Operations Management
Fixed Order Quantity Model

TC = Total Cost
D = Annual Demand
C = Cost per unit
Q = Order Quantity
S = Cost of placing an order (setup costs)
H = Annual cost of holding/storing one units in inventory


1. Economic Order Quantity (EOQ)

Reorder Point (ROP) =

* = lead time
*

= average demand per day/week/month/year

2. Inventory Models with Price Break (Quantity Discount Models)
Supplier offers lower unit price if larger quantities are ordered
Model differs from EOQ because purchasing cost (C) varies with the quantity ordered
Purchasing Cost (C) becomes an incremental cost
STEPS FOR INVENTORY MODELS WITH PRICE BREAK

(1) Compute EOQ for each discount price
(For any discount price, if the EOQ falls out of range, adjust the EOQ (the
amount you order) upward to the lowest quantity that will qualify for the
discount)

(2) Compute total cost for each EOQ (after adjustment)

(3) Select EOQ with lowest cost. (It will be the quantity that minimizes the
cost)

(

) (

)

*



BUS 105: Production and Operations Management
3. Fixed-Order Quantity Model with Safety Stock

Safety stock: inventory carried in addition to demand
When the inventory level drops to the Reorder Point (ROP) companies must reorder
inventory reordering inventory starts the lead time (time from ordering inventory
receiving inventory)
During lead time, inventory is vulnerable to a stock out (running out) because customers
continue to decrease stock levels
Customer service level: probability that a stock out will not occur during lead time
Reorder point (ROP): is based on demand during lead time & desired customer service
level
Amount of Safety Stock: is based on customer service level desired & degree of
uncertainty in the demand during the lead time
Establishing Safety Stock Levels
- Best approach to estimate safety stock required is use probability
- Assume demand is normally distributed with mean

and standard deviation

- Lead time () is constant
- The distribution of the demand during the lead time is normal with mean

and
standard deviation

Customer Service level is converted to value (use =NORMSINV(probability given) to
find z value)

Equations for Fixed Order
Safety Stock

Expected Demand
During Lead Time

Reorder Point

Fixed-Time Quantity




Each day is independent and

is constant

BUS 105: Production and Operations Management