5

Inventory
Management
OPERATIONS
MANAGEMENT
BY
DR. ASIF MAHMOOD
drasif@uet.edu.pk

Institute of Business & Management

University of Engineering and Technology,
Lahore

Inventory
Inventory: a stock or store of goods
Independent Demand

Independent demand
finished goods, items that are
ready to be sold
Demand is uncertain.
E.g. a computer
D(2)

Dependent Demand

A
C(2)

B(4)
E(1)

D(3)

Dependent demand components of finished

products
Demand is certain.
E.g. parts that make up the computer

F(2)

Types of Inventories
Raw materials & purchased parts
Partially completed goods called
work in progress
Finished-goods inventories

(manufacturing firms) or

Merchandise

(retail stores)

Replacement parts, tools, & supplies

Goods-in-transit to warehouses or customers

Functions of Inventory
Meet anticipated demand
Smooth production requirements
Decouple operations
Protect against stock-outs
Take advantage of order cycles
Help hedge against price increases
Permit operations
Take advantage of quantity discounts
Level of customer service vs costs of ordering and
carrying inventory

Inventory Counting Systems

Periodic System
Physical count of items made at periodic intervals

Perpetual Inventory System

System that keeps track of removals from inventory continuously,
thus monitoring current levels of each item

Two-Bin System
Two containers of inventory;
reorder when the first is empty

Universal Product Code

Bar code printed on a label that has
information about the item to which it
is attached

0
214800 232087768

Key Inventory Terms

Lead time: time interval between
ordering and receiving the order
Holding (carrying) costs: cost to carry
an item in inventory for a length of time,
usually a year
Ordering costs: costs of ordering and
receiving inventory
Shortage costs: costs when demand
exceeds supply

Classification Systems
ABC Approach
Classifying inventory according to some
measure of importance and allocating
control efforts accordingly.

A - very important
B - mod. important
C - least important

High
Annual
$ value
of items

A
B
C

Low
Low

High

Percentage of Items

Economic Order Quantity Models

Economic order quantity (EOQ) model
The order size that minimizes total annual
cost

The Inventory Cycle

Total Cost

Total cost =
TC =

Annual
carrying
cost
Q
H
2

Annual
ordering
cost

DS
Q

Total Cost

Cost Minimization Goal

Linear and positive

Non-linear and inverse

Carrying and ordering

costs are equal

U-Shaped

Deriving the EOQ

Using calculus, we take the derivative of
the total cost function and set the
derivative (slope) equal to zero and solve
for Q.
Q OPT =

2DS
=
H

2(Annual Demand)(Order or Setup Cost)

Annual Holding Cost

Length of order cycle = Q0/D

Example 1
A local distributor for a national tire company
expects to sell approximately 9,600 steel-belted
radial tires of a certain size and tread design next
year. Annual carrying costs are $16 per tire, and
ordering costs are $75. The distributor operates
288 days a year.
a.What is the EOQ? (300 tires)
b.How many times per year does the store reorder?
(32)
c. What is the length of an order cycle? (nine
working days)

Example 2
Piddling Manufacturing assembles television
sets. It purchases 3,600 black and white
pictures tubes a year at $65 each. Ordering
costs are $31, and annual carrying costs
20% of the purchase price. Compute the
optimal quantity and the total annual cost of
ordering and carrying the inventory.
Q0 = 131 picture tubes
TC = $852+$852 = $1,704

When to Reorder with EOQ

Ordering
Safety Stock - Stock that is held in excess of expected
demand due to variable demand rate and/or lead time.

ROP =

Expected Demand
+ Safety Stock
during Lead time

Optimal Stocking Level

Order Cycle Service Level - Probability that demand
will not exceed supply during lead time.
Service level =

Cs
Cs + Ce

Cs = Shortage cost per unit

Ce = Excess cost per unit

Ce

Cs

Service Level
Quantity
So

Balance point

Example 15

Ce = $0.20 per unit

Cs = $0.60 per unit
Service level = Cs/(Cs+Ce) = .6/(.6+.2)
Service level = .75
Ce

Cs

Service Level = 75%

Quantity

Stockout risk = 1.00 0.75 = 0.25

Reorder Point
Reorder Point - When the quantity on hand of an item
drops to this amount, the item is reordered
ROP = Demand (per

day/week) X Lead time (day/week)

The ROP based on a normal
Distribution of lead time demand
Service level

Risk of
a stockout

Probability of
no stockout
Expected
demand
0

ROP
Safety
stock

Quantity

z-scale

Fixed-Order-Interval Model
Orders are placed at fixed time intervals
Order quantity for next interval?
Suppliers might encourage fixed intervals
May require only periodic checks of
inventory levels
Risk of stockout
Fill rate the percentage of demand filled
by the stock on hand

Fixed-Interval Benefits
Tight control of inventory items
Items from same supplier may yield
savings in:
Ordering
Packing
Shipping costs

May be practical when inventories

cannot be closely monitored

Fixed-Interval Disadvantages
Requires a larger safety stock
Increases carrying cost
Costs of periodic reviews

Single Period Model

Single period model: model for ordering
of perishables and other items with
limited useful lives
Shortage cost: generally the unrealized
profits per unit
Excess cost: difference between
purchase cost and salvage value of
items left over at the end of a period

Single Period Model

Continuous stocking levels
Identifies optimal stocking levels
Optimal stocking level balances unit
shortage and excess cost

Discrete stocking levels

Service levels are discrete rather than
continuous
Desired service level is equaled or exceeded

Operations Strategy
Too much inventory
Tends to hide problems
Easier to live with problems than to
eliminate them
Costly to maintain

Wise strategy
Reduce lot sizes
Reduce safety stock