Inventory

Management

One of the most expensive assets

of many companies representing as
much as 50% of total invested
capital
Operations managers must
balance inventory investment and
customer service

Types of Inventories
Raw materials & purchased parts
Incoming students

Work in progress
Current students

Finished-goods inventories
(manufacturing firms) or merchandise
(retail stores)
Graduating students

Replacement parts, tools, & supplies

Goods-in-transit to warehouses or
customers
Students on leave

The Material Flow Cycle

Cycle time
95%

Input

Wait for
inspection

Wait to
be moved

5%

Move Wait in queue Setup Run

time for operator time time

Output

Functions of Inventory

To meet anticipated demand

To smooth production requirements

To decouple components of the production-distribution

To protect against stock-outs

To take advantage of order cycles

To help hedge against price increases or to take advantage of

quantity discounts

To permit operations

Inventory performance measures

and levers
Inventory level
Low or high

Customer service levels

Can you deliver what customer wants?
Right goods, right place, right time, right quantity

Inventory turnover
Cost of goods sold per year / average inventory investment

Inventory costs, more will come

Costs of ordering & carrying inventories

Decisions: Order size and time

Inventory Counting Systems

A physical count of items in inventory

Periodic/Cycle Counting System:

Physical count of items made at
periodic intervals
How much accuracy is needed?
When should cycle counting be performed?
Who should do it?

Continuous Counting System

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

Inventory Counting Systems (Contd)

Two-Bin System - Two containers of inventory; reorder when the

first is empty

Universal Bar Code - Bar code

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

0
214800 232087768

RFID: Radio frequency identification

Key Inventory Terms

Lead time: time interval between ordering and receiving the order,
denoted by LT

Holding (carrying) costs: cost to carry an item in inventory for a length

of time, usually a year, denoted by H

Ordering costs: costs of ordering and receiving inventory, denoted by

Shortage costs: costs when demand exceeds supply

Effective Inventory Management

A system to keep track of inventory

A reliable forecast of demand

Knowledge of lead times

Reasonable estimates of

Holding costs

Ordering costs

Shortage costs

A classification system

ABC Classification System

Classifying inventory according to some measure of importance
and allocating control efforts accordingly.
Importance measure= price*annual sales
High

ABC-

very important
mod. important
least important

Annual
$ volume
of items

A
B
C

Low
Few

Many

Number of Items

Other criteria than annual dollar

volume may be used
Anticipated engineering changes
Delivery problems
Quality problems
High unit cost

Inventory Models

Fixed Order Size - Variable Order Interval Models:

1. Economic Order Quantity, EOQ

2. Economic Production Quantity, EPQ

3. EOQ with quantity discounts

All units quantity discount

3.1. Constant holding cost

3.2. Proportional holding cost

4. Reorder point, ROP

Lead time service level
Fill rate

Fixed Order Interval - Variable Order Size Model

5. Fixed Order Interval model, FOI

Single Order Model

6. Newsboy model

1. EOQ Model

Assumptions:

Only one product is involved

Annual demand requirements known

Demand is even throughout the year

Lead time does not vary

Each order is received in a single delivery

Infinite production capacity

There are no quantity discounts

The Inventory Cycle

Profile of Inventory Level Over Time

Usage
rate

Quantity
on hand
Reorder
point

Receive
order

Place Receive
order order

Lead time

Place Receive
order order

Time

Figure 11-4

Average inventory held

Length of an inventory cycle

From one order to the next = Q/D

Inventory held over entire inventory cycle

Area under the inventory level = Q (Q/D)

Average inventory held

= Inventory held over a cycle / cycle length
= Q/2

Total Cost

Annual
Annual
Total cost = carrying + ordering
cost
cost
TC =

Q
H
2

DS
Q

Cost Minimization Goal

Annual Cost

The Total-Cost Curve is U-Shaped

Q
D
TC H S
2
Q

Ordering Costs
QO (optimal order quantity)

Order Quantity
(Q)

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.

2DS
2(Annual Demand)(Order or Setup Cost)
The =
total cost curve
reaches its minimum where the carrying and
Q OPT
=
H are equal.
Annual Holding Cost
ordering costs

Total cost(Q EOQ) 2 DSH

EOQ example
Demand, D = 12,000 computers per year.
Holding cost, H = 100 per item per year. Fixed cost, S =
$4,000/order.
Find EOQ, Cycle Inventory, Optimal Reorder Interval and
Optimal Ordering Frequency.

EOQ = 979.79, say 980 computers

Cycle inventory = EOQ/2 = 490 units
Optimal Reorder interval, T = 0.0816 year = 0.98 month
Optimal ordering frequency, n=12.24 orders per year.

Optimal Quantity is robust

Total Costs with Purchasing Cost

Annual
Annual
Purchasing
+
TC = carrying + ordering cost
cost
cost
Q
H
TC =
2

DS
Q

Note that P is the price.

PD

Cost

Total Costs with PD

Adding Purchasing cost

doesnt change EOQ

TC with PD

TC without PD

PD

EOQ

Quantity

2. Economic Production Quantity

Production done in batches or lots

Capacity to produce a part exceeds the parts usage or

demand rate

Assumptions of EPQ are similar to EOQ except orders are

received incrementally during production

This corresponds to producing for an order with finite production

capacity

Economic Production Quantity

Assumptions

Only one item is involved

Annual demand is known

Usage rate is constant

Usage occurs continually

Production rate

Lead time does not vary

No quantity discounts

is constant

Usage

Production
& Usage

Production
& Usage

Economic Production
Quantity
Usage
In
v

en

to
ry

Le
v

el

Average inventory held

p-D
Q/p

(Q/p)(p-D)

Time

Q/D
Average inventory held=(1/2)(Q/p)(p-D)
Total cost=(1/2)(Q/p)(p-D)H+(D/Q)S
Q

2 DS
H

p
pD

EPQ example
Demand, D = 12,000 computers per year. p=20,000 per year.
Holding cost, H = 100 per item per year. Fixed cost, S =
$4,000/order.
Find EPQ.

EPQ = EOQ*sqrt(p/(p-D))
=979.79*sqrt(20/8)=1549 computers

3. All unit quantity discount

Cost/Unit
$3

$2.96

$2.92

5,000 10,000
Order Quantity

Two versions
Constant H
Proportional H

3.1.Total Cost with Constant Carrying

Costs
Total Cost

TCa
TCb
TCc

Decreasing
Price

Annual demand*discount

EOQ

Quantity

3.1.Total Cost with Constant Carrying Costs

Total Cost

TCa
TCb
TCc

Decreasing
Price

Annual demand*discount

EOQ

Quantity

Example Scenario 1
Total Cost

Price a > Price b > Price c

TCa
TCb
TCc

Q*=EOQ

Quantity

Example Scenario 2
Total Cost

Price a > Price b > Price c

TCa
TCb
TCc

EOQ

Q*

Quantity

Example Scenario 3

Total Cost

Price a > Price b > Price c

TCa
TCb
TCc

EOQ

Q*

Quantity

Example Scenario 4

Total Cost

Price a > Price b > Price c

TCc
TCa
TCb

Q*=EOQ

Quantity

3.1. Finding Q with all units discount

with constant holding cost

Total
Cost

Note all the price ranges have the same EOQ.

Stop if EOQ=Q1 is in the lowest cost range (highest
quantity range), otherwise continue towards
quantity break points which give lower costs

Q1

2 DS
H

2
Quantity

All-units quantity discounts

Constant holding cost
A popular shoe store sells 8000 pairs per year. The
fixed cost of ordering shoes from the distribution
center is $15 and holding costs are taken as $12.5
per shoe per year. The per unit purchase costs from
the distribution center is given as

C3=60, if 0 < Q < 50

C2=55, if 50 <= Q < 150
C1=50, if 150 <= Q
where Q is the order size. Determine the optimal order
quantity.

Solution
There are three ranges for lot sizes in this problem:
(0, q2=50),
(q2=50, q1=150)
(q1=150,infinite).
2(15)(8000)
138.6
Holding costs in all there ranges of shoe prices EOQ
12.5
are given as H=12.5,
EOQ is not feasible in the lowest price range because
138.6 < 150.
The order quantity q1=150 is a candidate with cost
TC(150)=8000(50)+8000(15)/150+(12.5)(150)/2
=401,900
Let us go to a higher cost level of (q 2=50, q1=150).
EOQ=138.6 is in the appropriate range, so it is another
candidate with cost
TC(138.6)=8000(55)+8000(15)/138.6+(12.5)(138.6)/2
=441,732
Since TC(150) < TC(132.1), Q=150 is the optimal solution.
Remark: In these computations, we do not need to compute
TC(50), why? Because TC(50) >= TC(132.1).

Total Cost

3.2. Summary of finding Q with all units

discount with proportional holding
Note
each price range has a different EOQ.
cost
Stop if Q1=EOQ of the lowest price feasible
Otherwise continue towards higher costs until an EOQ
becomes feasible.
In each price range, evaluate the lowest cost.
Lowest cost is either at an EOQ or price break quantity

Pick the minimum cost among all evaluated

2 DS
Q1
H1

Example: Q1
feasible stop

1
Quantity

Total Cost

3.2. Finding Q with all units

discount with proportional holding
cost

2 DS
Q1
H1

1
Q2

2 DS
H2

Example: Q1 infeasible, Q2
feasible, Break point 1 is
selected since TC1 < TC2
Quantity

Total Cost

3.2. Finding Q with all units

discount with proportional
holding
cost
Stop
if 1 is feasible, otherwise
continue towards higher costs until a
EOQ becomes feasible. Evaluate
cost at all alternatives

1
Quantity

All-units quantity discounts

Proportional holding cost
A popular shoe store sells 8000 pairs per year. The
fixed cost of ordering shoes from the distribution
center is $15 and holding costs are taken as 25% of
the shoe costs. The per unit purchase costs from the
distribution center is given as

C3=60, if 0 < Q < 50

C2=55, if 50 <= Q < 150
C1=50, if 150 <= Q
where Q is the order size. Determine the optimal order
quantity.

Solution
There are three ranges for lot sizes in this problem:
(0, q2=50),
(q2=50, q1=150)
(q1=150,infinite).
2(15)(8000)
Holding costs in there ranges of shoe prices
EOQ2
13.75
are given as
H3=(0.25)60=15,
2(15)(8000)
H2 =(0.25)55=13.75
EOQ1
12.5
H1 =(0.25)50=12.5.
EOQ1 is not feasible because 138.6 < 150.
The order quantity q1=150 is a candidate with cost
TC(150)=8000(50)+8000(15)/150+(0.25)(50)(150)/2
=401,900
Let us go to a higher cost level of (q2=50, q1=150).
EOQ2=132.1 is in the appropriate range, so it is another candidate
with cost
TC(132.1)=8000(55)+8000(15)/132.1+(0.25)(55)(132.1)/2
=441,800
Since TC(150) < TC(132.1), Q=150 is the optimal solution.
We do not need to compute TC(50) or EOQ3, why?

132.1
138.6

Types of inventories
(stocks)
by
function
Deterministic demand case
Anticipation stock
For known future demand

Cycle stock
For convenience, some operations are performed
occasionally and stock is used at other times
Why to buy eggs in boxes of 12?

Pipeline stock or Work in Process

Stock in transfer, transformation. Necessary for operations.
Students in the class

Stochastic demand case

Safety stock
Stock against demand variations

4. When to Reorder with EOQ Ordering

Reorder Point - When the quantity on

hand of an item drops to this amount, the

item is reordered. We call it ROP.

Safety Stock - Stock that is held in excess

of expected demand due to variable

demand rate and/or lead time. We call it ss.

(lead time) Service Level - Probability

that demand will not exceed supply during

lead time. We call this cycle service level,
CSL.

inventory

Optimal Safety
Inventory Levels
An inventory cycle

Q
ROP
time
Lead Times
Shortage

Quantity

Safety Stock

Maximum probable demand

during lead time
Expected demand
during lead time

ROP
Safety stock
LT

Time

Inventory and Demand during Lead

Time

ROP

Inventory

0
LT

Demand
During LT

Upside
down

Inventory=
ROP-DLT

ROP

DLT: Demand
During LT

0
ROP

Upside
down

Shortage=
DLT-ROP

ROP

Shortage
LT
Demand
During LT

Shortage max{0, ( DLT ROP)}

DLT: Demand During LT

Shortage and Demand

during Lead Time

Cycle Service Level

Cycle service level: percentage of cycles with shortage
For example consider 10 cycles :
11 0 111 0 1 0 1
CSL
Write 0 if a cycle has shortage, 1 otherwise
10
CSL 0.7
CSL 0.7 Probability that a single cycle has sufficient inventory
[Sufficient inventory] [Demand during lead time ROP]

DLT : Demand during lead time

LT and demand may be
D Average demand per period
uncertain.
2

D Variance of demand
L Average lead time in number of periods
2
LT
Variance of lead time

Expected value of the demand during lead time

LT

E ( Di ) ( L)( D)
i 1

Variance of the demand during lead time

LT

2
2
Var ( Di ) L D D 2 LT
DLT
i 1

Reorder Point

Service level

Risk of
a stockout

Probability of
no stockout
Expected
demand
0

ROP

Quantity

Safety
stock
z

z-scale

ROP = E(DLT) + z DLT

Finding safety stock from

cycle service level CSL

Note we use normal density for the demand

during lead time
2
CSL P( DLT ROP) P( Normal ( L D, DLT
) ROP)

ROP L D
P( z
)
DLT

z : Standard normal variable

ROP L D
normsinv(CSL)
DLT
ROP L D ss DLT normsinv(CSL)
The excel function normsinv has default values of 0 and 1 for the mean and
standard deviation. Defaults are used unless these values are specified.

Example: Safety inventory vs. Lead time

variability
D = 2,500/day;

D = 500

L = 7 days; CSL = 0.90

Normsinv(0.9)=1.3, either from table or Excel
If

LT=0, DLT=sqrt(7)*500=1323
ss=1323*normsinv(0.9)=1719.8
ROP=(D)(L)+ss=17500+1719.8

If

LT=1, DLT=sqrt(7*500*500+2500*2500*1)=2828
ss=2828*normsinv(0.9)=3676
ROP=(D)(L)+ss=17500+3676

Expected shortage per cycle

First let us study
shortage during the
lead time
Expected
shortage E (0, max( DLT ROP))

( D ROP) f

( D)dD where f D is pdf of DLT.

D ROP

Ex:

d1 9 with prob p1 1/4

ROP 10, D d 2 10 with prob p2 2/4 , Expected Shortage?

d 11 with prob p 1/4
3
3

Expected shortage max{0, (d i ROP)} pi

i 1

11

(d ROP)}P( D d )

d 10

1
2
1 1
max{0, (9 - 10)} max{0, (10 - 10)} max{0, (11 - 10)}
4
4
4 4

Expected shortage per cycle

Ex:
ROP 10, D Uniform(6,12), Expected Shortage?
D 12

1 10 2

1
1 D2
1 12 2
Expected shortage ( D 10) dD
10 D

10(12)
10(10)
6
6 2
6 2
6 2

D 10
D 10
172 - 170 2
12

If we assume that DLT is normal,

ROP D L
Let z
then E (max(0, DLT ROP )) DLT E ( z ) use Table 11 - 3.
DLT

Example: Finding expected shortage per

cycle
Suppose that the demand during lead time has
expected value 100 and stdev 30, find the expected
shortage if ROP=120.
z=(120-100)/30=0.66.
E(z)=0.153 from Table 11-3.
Expected shortage = 30*0.153=4.59

Fill rate

Fill rate is the percentage of demand filled from the stock

In a cycle

Fill rate = 1-(Expected shortage during LT) / Q

For normally distributed demand

Expected shortage per cycle

Demand per cycle
E( z)
1 DLT
Q
Expected number of units short per year D * (1 Fill rate)
Fill rate 1

DLT E ( z )
Q

Example: computing the fill

rate
Suppose that the demand during lead time has
expected value 100 and stdev 30, find the expected
shortage if ROP=120. Compute the fill rate if order
sizes are 200. Compute the annual expected
shortages if there are 12 order cycles per year.
Expected shortage per cycle=4.59 from the last
example.
Fill rate = 1-4.59/20=0.7705
Annual expected shortage=12*4.59=55.08.

Determinants of the
Reorder
Point
The rate of demand

The lead time

Demand and/or lead time variability

Stockout risk (safety stock)

5. 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

Items from same supplier may yield savings in:

Ordering

Packing

Shipping costs

May be practical when inventories cannot be closely monitored

FOI compared against variable order

interval models
A single order must cover the demand until the next order arrives.
Exposure to random demand during not only lead time but also before.
Requires higher safety stock than variable order interval models.
May provide savings in set up / ordering costs.

6. How many to order for the

winter? Parkas at L.L. Bean

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Parkas at L.L. Bean

Cost per parka = c = $45

Sale price per parka = p = $100
Discount price per parka = $50
Holding and transportation cost = $10

Salvage value per parka = s = $40

Profit from selling parka = p-c = 100-45 = $55

Underage cost=$55
Cost of overstocking = c-s = 45-40 = $5
Overage cost=$5

6. 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, $55 for
L.L.Bean. We call this underage.

Excess cost: difference between purchase cost and salvage value of

items left over at the end of a period, $5 for L.L.Bean. We call this
overage.

Parkas at L.L. Bean

Expected demand = 10 (00) parkas

Expected profit from ordering 10 (00) parkas = $499

The underage and overage probabilities after ordering 1100 parkas

P(D>1100):Probability of underage
P(D<1100):Probability of overage

Optimal level of product

availability
p = sale price; s = outlet or salvage price; c = purchase price
CSL = Probability that demand will be at or below reorder
point
At optimal order size,
Expected Marginal Benefit from raising order size =
=P(Demand is above stock)*(Profit from sales)=(1-CSL*)(p - c)
Expected Marginal Cost =
=P(Demand is below stock)*(Loss from discounting)=CSL*(c - s).
Let Co= c-s; Cu=p-c, then the optimality condition is
(1-CSL*)Cu = CSL* Co,
CSL* = Cu / (Cu + Co)

Parkas at L.L. Bean

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Order Quantity for a Single

Order
Co = Cost of overstocking = $5
Cu = Cost of understocking = $55
Q* = Optimal order size
CSL P( Demand Q* )

Cu
55

0.917
Cu Co 55 5

See the next slide.

If the demand is normally distributed,

Cu

Q norminv
, mean _ demand , stdev _ demand
Cu C o

Optimal Order Quantity

without Normal Demands
0.917

Optimal Order Quantity = 13(00)

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 set ups

Reduce safety stock

Aggregate negatively correlated demands

Remember component commonality
Delayed postponement