35A00210 Lecture 13

Operations Management Inventory control

Lecture 13
Inventory control Basics of inventory control
Basics of inventory control
Inventory models
• continuous review
• periodic review
• other models

Inventory control is boring but

Inventory management decisions
important

What?

How
much?

Operations try to meet When?

customer requirements!
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 Sales influences inventory
Not all products are equal
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
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Objectives influence inventory

management
Swatch Citizen Rolex

• Low price • Medium price • High price

• High discounts • No discounts • No discounts
•Medium margin • High margin • Medium margin
• Medium turns • High turns • Low turns

Minimize
Minimize Maximize
inventory
extras volume
costs
Do market testing and Set high service levels Set lower service levels
research at beginning Invest in inventory Invest in “central depot”
improve
do something or drop watch Use also central warehousing Improve forecasting stock location
stock-out Use early sales data to
turnover Replenish/ transfer among
reorder / cut back locations
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 Lecture 13
Inventory control
Inventory models
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
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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.
12
Inventory control simple in theory
Products in
inventory
Q
Time
One product, level demand, fixed delivery time
etc.
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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
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 Basic models are opposites of
Continuous review system
each other
In continuous review orders of fixed size are made after periods
with variable length
- central questions: order quantity, timing of the order, pursued service level, size of
safety stock
- requires a lot especially from inventory IT systems as balances have to be correct all
the time
- instructing and motivating employees very important
Inventory

Order
point
R

lead time
Time
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Trade-off between costs Shape of cost functions and

- economic order quantity - common sense
Smaller order quantity Larger order quantity means
means more orders more products to be inventoried

Order
Costs

Costs
Ordering/set up costs Order
Ordering costs

Economic Size of Size of

order quantity order quantity order quantity
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 EOQ depends on
Calculating EOQ
the size of cost components
1. Determine ordering costs (not necessarily easy)

average
inventory
2. Determine holding costs (not necessarily easy)
average
inventory

3. Calculate EOQ
5 orders and 3 orders and
lower average inventory higher average inventory
vs.
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Determining reorder point in EOQ- Notice:

EOQ example EOQ -formula’s units
model - R = dL - must be remembered!

Sam’s Cat Hotel needs a lot of kitty liter to operate. Hotel entrepreneur purchases
Inventory litter at the price of $11,70/bag and average demand is 90 bags per week. Ordering
cost has been estimated to be $54 per order and annual holding cost 27% from
purchasing costs. Delivery lead time is currently 3 weeks (18 work days). Hotel uses
usage rate d continuous review inventory system and is open around the year (52 weeks, 6 days
Lot a week). Calculate economic order quantity, time between orders, reorder point and
size
Q
total annual costs.
Reorder
point Order quantity:
aver. inventory
R demand during lead time 200 units

order- delivery Time between

moment moment Time
orders: 11,7 orders per year
Lead time
L Reorder point:
Order EOQ volume when
inventory drops to reorder point Total costs:
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 EOQ example EOQ’s 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 cost variables’ 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

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EOQ -models main assumptions EOQ -models extensions

- variability in demand -
Demand is constant and known Demand is seldom stable and stock-out cost
- demand is fulfilled from inventory; no stock-outs, no back
orders and no uncertainty what so ever
can be the highest cost variable
- service level thinking eases optimization
Lead time is constant and known
- higher service level means higher safety stock
Products’ unit price is fixed
- no volume discounts
How Manager’s
decision

Deliveries are complete lots

realistic Service level (z Inventory
L)

- single delivery, no constraints on size of each lot

are Probability Lot size

Limited cost functions

these? P(Stockout) order
point
- only cost are ordering and holding; ordering assumed to R A
B
be fixed and holding is based on average inventory Safety stock (S)
A B C
Products independent from each other Demand order C delivery Time
moment moment
S lead time
Distribution of demand
during lead time Lower order quantity often leads to
larger safety stock!
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 Standard deviation of
Safety stock example
delivery lead time’s demand
Week 1 Week 2 Week 3 Use of kitty liter in Sam’s Cat Hotel is not totally steady. Due to liter’s criticality
demand demand demand entrepreneur wants to be prepared also for higher consumption levels. Desired
service level has been estimated to be 80%. Standard deviation of weekly demand
t = 15 t = 15 t = 15 has been estimated from historical data to be 15 bags per week. How do safety
stocks change key inventory management numbers?
+ +
Order quantity and 400 units and 4,44 weeks
90 units 90 units 90 units time between orders: (stays the same)

lead time’s one “periods" delivery lead

= delivery lead time safety
stock:
st. deviation st. deviation time Reorder point: 22 bags
t = 26

Weeks 1-3 from normal distribution

demand
Total costs:
+69,50
270 units per year
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Safety stock example EOQ -models extensions

- variability in delivery lead times -
Unfortunately there is variability also in delivery
lead times

Inventory

Likelyhood
Lot size
order
point
R A
B
Safety stock (S)
A B C C
Time Time
S expected
order
Distribution of lead time delivery
moment
lead time moment

Decreasing the variably in lead times can be more

advantageous than cutting the lead times themselves
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 EOQ -model extensions EOQ -models extensions
- volume discounts - - volume discounts -

Base price 1. discount 2. discount

Total cost.
Total cost: base price
Total cost
1. discount

Total costs
Total cost
2. discount
P
Costs

1’
1 2’
Purchasing price
Holding cost 2

Order size
Ordering cost

Lowest cost not in the area of Order sizes with which orders
minimum discount volume are feasible
Order size
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EOQ -models extensions Volume discount example

- volume discounts -
A baseball-team is trying to decide the size of an order from the manufacturer. To make an
Base price 1. discount 2. discount analytical decision, team’s purchaser has been going around the organization and collected
Total cost. information he needs to make the order quantity decision. The total demand is 208 bats per
base price year, the order cost is $70 per order, and the annual holding cost per bat per year is 38% of
Total cost the purchase price. The bat selling company has priced its product in the following way:
1. discount order 1-11 at $54,00 per bat, order 12-143 at $51,00 per bat, and in larger orders the price is
Total costs

$48,50 per bat. How many bats should purchaser order?

Total cost
2. discount Price 54,00: EOQ= (2*208*70)/(54,00*38%)= 37,7 order EOQ - 38
P
1’
2’

Price 51,00: EOQ= (2*208*70)/(51,00*38%)= 38,7 order EOQ - 39

cheapest
Order size
Price 48,50: EOQ= (2*208*70)/(48,50*38%)= 39,7 must order at least 144
Lowest costs in this case by ordering this
amount every time

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 Volume discount example 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 it’s 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)

Inventory build up rate

= (p-d)
production quantity

Imax demand rate = d

Production Production Time

period period
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Economic Lot Sizing (ELS)

ELS example
example
Vertically integrated carpet company produces popular Super Shag model. Number of orders per year:
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). SS’s 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 SS’s production speed is 150 meters per day.
Calculate Super Shag carpet’s economic lot size, number of orders per
Production time: Maximum inventory:
year, how long it takes to produce each batch, maximum inventory level,
and total inventory costs.

Lot size:
Total costs:

10,000/311
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 ELS example EOQ -model extensions
- noninstantaneous replenishment -
If inventory would be refilled
with instantaneous 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 ( JIT-production)

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Periodic review system Periodic review system

Periodic review is used because continuous In periodic review models orders of variable
review is not always economically feasible and size are made after regular time intervals
takes too long time - central questions are the length of review interval, order quantity,
- part of the orders can be done only with fixed intervals pursued service level and size of safety stock
- e.g. in grocery stores fixed schedules and routes Inventory
- method is also used when several orders to one supplier are
combined Order
-up-to
Periodic review increases stock-out risk -level
T
- 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
Lead time

Time
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 Periodic review systems formulas Periodic review example
stable demand Due to constant hurry Sam’s Cat Hotel is moving to periodic review system.
Review interval / assumed 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
time between orders
demand* safety
(rev.interval+lead time) stock
Review interval / time between orders:
Target inventory level:
(rev.interval+ Be accurate
lead time) about time demand lead time norm. deviation
Standard deviation of demand units!
Target inventory level: per day (=3w*6 day) distribution per day
(=90/6) (80%) (=15/SQRT(6))
during the protection interval:
inventory position
Order quantity: (inventory + scheduled
receipts - backorders)
Order quantity:

Total costs: Total costs:

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Periodic review example Other inventory models

- bin systems -

Two bin system

Order one box
to inventory
e.g. reminder if checkbook,
Full Empty ”notify salespeople” in hardware
store, bottom of label in a bar,
line in the wall

One bin system

Order enough to fill up
the box again

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