2007 Pearson Education

Role of Inventory
Management in SCM
Chapter 10
By Chandrashekeran
2007 Pearson Education
Need for Inventory
Management
Fulfills the objectives and challenges of
COST AND
RESPONSIVENESS
Inventory OFFERS various models and
SKUs
Pressure on inventory is higher for made to
stock rather than made to engineer or
made to stock
Jewellery, fashion etc.
2007 Pearson Education
Inventory Management
Inventory management is the planning and
controlling of inventories in order to meet the
competitive priorities of the organization.

Effective inventory management is essential for realizing
the full potential of any value chain.

Inventory management requires information about
expected demands (SKU), amounts on hand (Qty)
and amounts on order (EOQ) and price for every
item stocked at all locations.

The appropriate timing and size of the reorder quantities
must also be determined.
2007 Pearson Education
Inventory within supply
chain network
Suppliers
Subcontracting
Direct site
Factory
Wareho
use
Production-
Raw material
Work in process
Finished good
Distribution
channel or
retailer
Customer
2007 Pearson Education
Inventory Basics
Inventory is created when the receipt of
materials, parts, or finished goods exceeds
their disbursement. (HIGH)
Inventory is depleted or replenished when
their disbursement exceeds their
receipt.(LOW)
An inventory managers job is to balance the
advantages and disadvantages of both low
and high inventories.
Both have associated cost characteristics.
2007 Pearson Education
Importance of inventory
Customer service and product availability
Example- Manufacturer of food flavors
Production, purchase and transportation
economy
Price discount, transportation economy
Hedge against price changes. Price of seeds
Hedge against uncertainties in demand and
lead time
Hedge against strikes, fires, calamities and
mismatch between demand and supply
2007 Pearson Education
Types of Inventory
Raw Material- Purchased but not processed
Ensures Material availability for production
Reduces supplier variability in quality, quantity
and time
Work in Process- Reduces cycle time (time to
make a product)
Finished Goods- Reduces mismatch between
demand and supply
Maintenance/ Overhauling/ Repair- Items
consumed in a production but not a part of end
product. Lubricants
2007 Pearson Education
Classification of Inventory
Cycle Inventory: Average inventory of lot or
batch size.
Average cycle inventory =
Where Q= Lot or batch size, d= Demand per
time
Lot Sizing: Lot size refers to quantity that a
supply chain either produces or orders at a given
time.

Cycle inventory takes advantages of economies
of scale but each stages maintains cycle
inventory which increases cost.
Q
2
2007 Pearson Education
Classification of Inventory
Safety Stock Inventory: Surplus inventory that
a company holds to protect against
uncertainties in demand, lead time and supply
changes. Reduces lost sales
Seasonal inventory- Meets the volatility of
demand and supply.
Pipeline Inventory: Inventory moving from
point to point in the materials flow system.

Includes orders that have been placed but not
served. Pipeline inventory = D
L
= dL , L= Lead
time

2007 Pearson Education
2007 Pearson Education
Estimating Inventory Levels
Example 12.1
A plant makes monthly shipments of electric drills to a wholesaler in average
lot sizes of 280 drills. The wholesalers average demand is 70 drills a week.
Lead time is 3 weeks. The wholesaler must pay for the inventory from the
moment the plant makes a shipment. If the wholesaler is willing to increase
its purchase quantity to 350 units, the plant will guarantee a lead time of 2
weeks. What is the effect on cycle and pipeline inventories?
Average cycle inventory = = = 140
Q
2
280
2
Pipeline inventory = D
L
= dL = 70(3) = 210
Under new proposal, the average lot size becomes 350 and lead time of
2 weeks. Average demand remains at 70 drills a week.
Q
2
Average cycle inventory = = = 175
350
2
Pipeline inventory = D
L
= dL = 70(2) = 140
drills
drills
drills
drills
2007 Pearson Education
Pressures for
Low Inventories
Inventory holding cost is the sum of the cost of
capital and the variable costs of keeping items on
hand, such as storage and handling, taxes,
insurance, and shrinkage.
Cost of Capital is the opportunity cost of investing in an
asset relative to the expected return on assets of similar
risk.
Storage and Handling arise from moving in and out of a
storage facility plus the rental cost and/or opportunity cost
of that space.
Taxes, Insurance, and Shrinkage: More taxes are paid and
insurance costs are higher if end-of-the-year inventories
are high. Shrinkage comes from theft, obsolescence and
deterioration.
2007 Pearson Education
Ordering Cost: The cost of preparing a purchase
order for a supplier or a production order for the shop.
Setup Cost: The cost involved in changing over a
machine to produce a different item.
Labor and Equipment: Creating more inventory can
increase workforce productivity and facility utilization.
Transportation Costs: Costs can be reduced.
Quantity Discount: A drop in the price per unit when
an order is sufficiently large.

2007 Pearson Education
Inventory Models
EOQ Model
Production Order Quantity Model
Quantity Discount Model
2007 Pearson Education
BASIC EOQ Model
Q=EOQ Economic Order Quantity
R=Reorder Level
L=Lead time
Cycle
inventory
2007 Pearson Education
Economic Order Quantity (EOQ) is the lot
size that minimizes total annual inventory
holding and ordering costs.
Assumptions of EOQ
1. The demand rate is constant and known with
certainty.
2. There are no constraints on lot size.
3. The only relevant costs are holding costs and
ordering/setup costs.
4. Decisions for items can be made independently
of other items.
5. Lead time is constant and known with certainty.
Economic Order Quantity
2007 Pearson Education
Annual set up/ ordering cost=D.S/Q
Annual Holding cost=Q.H/2
At EOQ, Annual set up cost= Annual holding
cost
Reorder level=d.L
Time between order=(Order size/ annual
demand) x time fraction/year
2007 Pearson Education
A
n
n
u
a
l

c
o
s
t

(
d
o
l
l
a
r
s
)

Lot Size (Q)
Total Annual
Cycle-Inventory Costs
Holding cost = (H)
Q
2
Ordering cost = (S)
D
Q
Total cost = (H) + (S)
D
Q
Q
2
Q = lot size; C = total annual cycle-inventory cost
H = holding cost per unit; D = annual demand
S = ordering or setup costs per lot
2007 Pearson Education
Costing out a Lot Sizing Policy
Example 12.2
Bird feeder sales are 18 units per week, and the
supplier charges $60 per unit. The cost of placing an
order (S) with the supplier is $45.
Annual holding cost (H) is 25% of a feeders value,
based on operations 52 weeks per year.
Management chose a 390-unit lot size (Q) so that
new orders could be placed less frequently.
What is the annual cycle-inventory cost (C) of the
current policy of using a 390-unit lot size?
Museum of Natural History Gift Shop:
2007 Pearson Education
Costing out a Lot Sizing Policy
Example 12.2

What is the annual cycle-inventory cost (C) of the
current policy of using a 390-unit lot size?
D = (18 /week)(52 weeks) = 936 units H = 0.25 ($60/unit) = $15
C = $2925 + $108 = $3033
C = (H) + (S) = (15) + (45)
Q
2
D
Q
936
390
390
2
Museum of Natural History Gift Shop:
2007 Pearson Education
3000
2000
1000
0 | | | | | | | |
50 100 150 200 250 300 350 400
Lot Size (Q)
A
n
n
u
a
l

c
o
s
t

(
d
o
l
l
a
r
s
)

Total cost
Holding cost
Ordering cost
Current
cost
Current
Q
Lowest
cost
Best Q (EOQ)
Lot Sizing at the Museum
of Natural History Gift Shop
2007 Pearson Education
EOQ POLICY

C = (H) + (S)
Q
2
D
Q
EOQ =
2DS
H
D = annual demand
S = ordering or setup costs per lot
H = holding costs per unit
D = 936 units
H = $15
S = $45
EOQ =
2(936)45
15
= 74.94 or 75 units
C = (15) + (45)
75
2
936
75
C = $1,124.10
Bird Feeders:
2007 Pearson Education
ABC Cycle Ltd. A manufacturer of sports
bikes, has an annual demand of 240,000
units in a year. On an average, delivery of
an order takes seven working days.
What is the reorder level?
2007 Pearson Education
Application 12.1
2007 Pearson Education
Application 12.1
2007 Pearson Education
Application 12.2
2007 Pearson Education
Application 12.2
continued
2007 Pearson Education
EOQ, is 75 units when annual demand, D, is 936 units/year,
setup cost, S, is $45, and holding cost, H, is $15/unit/year. If we
mistakenly estimate inventory holding cost to be $30/unit/year,
what is the new order quantity, Q, if D = 936 units/year, S = $45,
and H = $30/unit/year? What is the change in order quantity,
expressed as a percentage of the EOQ (75 units)?
The new order quantity is
The change in percentage is
Solved Problem 3
2007 Pearson Education
Problem: Best Buy
Demand for deskpro computer at Best Buy is 1000 units per
month. Best buy incurs a fixed order placement cost of $4000
each time an order is placed. Each component costs Best Buy
$500 and the retailer has a holding cost of 20%.
Calculate the optimal order size and cycle inventory cost. If
management chose a 900-unit lot size (Q) so that new orders
could be placed less frequently, What is the annual cycle-
inventory cost (C) of the current policy of using a 900-unit lot
size?
Show these two situation in cost diagram.
If delivery of an order takes place in each month, calculate
reorder level.
What is the Time Between Orders (TBO) expressed in months.

2007 Pearson Education
Dominick Supermarket
Dominick Supermarket sells nut flakes. Demand
for nut flakes is 1000 boxes per week. Dominicks
has a holding cost of 25% and incurs $200 for
each replenishment order. Calculate the cycle
inventory cost.
If the ordering cost decreases to $150 then
calculate the % change of cycle inventory cost.