Managing Inventory
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Why inventory is kept at all?
• Customer service: ensuring right product at the right place at the right time
• Operational costs: inventory holding cost, opportunity cost and their tradeoff
with cost of lost sales
E = amount of equity
D = amount of debt
Rf = risk-free rate of return
β = the firm’s beta
MRP = market risk premium
Rb = rate at which the firm can borrow money
t = tax rate
■ Obsolescence cost
■ Handling cost
■ Occupancy cost
■ Miscellaneous costs
■ Theft, security, damage, tax, insurance
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Costs in order processing
■ Ordering cost:
■ Buyer time
■ Transportation costs
■ Receiving costs
■ Other costs
■ Procurement cost
■ Backorder costs
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Choosing an inventory model
■ Defining the annual cost as C(q) with ‘q’ as number of units ordered:
■ C(q) = (Annual ordering cost) + (Annual holding cost) + (Procurement
Cost)
■ Assumptions:
■ No demand uncertainty and constant demand across time
■ Immediate replenishment of demand: zero lead time for order fulfillment
■ Fixed ordering cost, i.e. independent of number of units ordered
Finding the optimal order quantity to
order
Inventory position
Number of periods D
will be
Q
The average
inventory for each
period is…
D
Ordering cost = x S
Q
Q
Inventory cost = x H
2
Total cost expression
D Q
TC = DC + S + H
Q 2
Which one is
the decision
variable?
Insight from EOQ
There is a tradeoff between holding costs and ordering costs
Total cost
Cost
Holding costs
Ordering costs
Example:
Assume a car dealer that faces demand for 5,000 cars per year, and that it costs
$15,000 to have the cars shipped to the dealership. Holding cost is estimated at
$500 per car per year. How many times should the dealer order, and what should
be the order size?
Economic Order Quantity (EOQ)
2SD
Q* =
H
Example:
Assume a car dealer that faces demand for 5,000 cars per year, and that it costs
$15,000 to have the cars shipped to the dealership. Holding cost is estimated at
$500 per car per year. How many times should the dealer order, and what should
be the order size?
Lot Sizing for a Single Product
■ Cycle inventory:
Example:
Assume a car dealer that faces demand for 5,000 cars per year, and that it costs
$15,000 to have the cars shipped to the dealership. Holding cost is estimated at
$500 per car per year. How many times should the dealer order, and what should
be the order size?
Lot Sizing for a Single Product
■ Parameters involved:
■ Di: Annual demand of product i
■ S: Ordering cost incurred each time an order is placed
■ si: Additional order cost incurred if product i is included in the order
■ Three approaches:
1. Each product manager orders his or her model independently
2. The product managers jointly order every product in each lot
3. Product managers order jointly but not every order contains every
product; that is, each lot contains a selected subset of the products
Lot Sizing with Multiple Products
Annual ordering
and holding cost = Rs 61,512 + Rs 6,151 + Rs 615 + Rs 68,250
= Rs 136,528
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Products Ordered and Delivered Jointly
Order
Quantity
Q If delivery is not instantaneous, but there is a lead time
L:
Inventory
Lead Time
Time
Place Receive
order order
+If demand is known exactly, place an order when
inventory equals demand during lead time.
A: Q = EOQ
Reorder
Point
(ROP)
ROP = LxD
Lead Time
Time
D: demand per period
L: Lead time in periods Place Receive
order order
Lead time in delivery
10 10
R = D = 5000 = 137
365 365
So, when the number of cars on the lot reaches 137, order 548
more cars.