School of Business
BSP 236: Operations Management
Unit 2: Inventory Management
Higher Profits
Modelling Inventory in the
SC
Inventory Terminology
Demand-it is the number of items (products)
required per unit time. The demand may be
deterministic or probabilistic in nature.
Order-cycle-the time between two successive
orders.
Lead time-the length of time between placing an
order and receipt of items.
Safety stock-also called buffer stock. It is stock
kept to carter for unforeseen circumstances in the
lead time.
Re-order level (ROL)-it is the point at which
replenishment action is initiated.
Re-order quantity-is the quantity to be ordered
at the ROL. It is normally equal to the EOQ.
Inventory Terminology
Holding costs - the costs of holding
or carrying inventory over time
Ordering costs - the costs of
placing an order and receiving goods
Setup costs - cost to prepare a
machine or process for
manufacturing an order (this is
ordering cost in production set-ups)
Opposing Views of
Inventory
inventory inventory
level level
Q
Q
time time
Independent Demand
Inventory Systems
Demand for an item carried in
inventory is independent of the
demand for any other item in
inventory
Finished goods inventory is an
example
Demands are estimated from
forecasts and/or customer orders
Dependent Demand
Inventory Systems
Items whose demand depends on the
demands for other items
For example, the demand for raw
materials and components can be
calculated from the demand for finished
goods
The systems used to manage these
inventories are different from those used
to manage independent demand items
Independent vs. Dependent
Demand
Independent Demand
(finished goods and spare parts)
A Dependent Demand
(components)
B(4) C(2)
Total Annual
Stocking Costs
Total Annual
Stocking Costs
Annual
Carrying Costs
Lower
Annual
Ordering Costs
Order Quantity
Smaller EOQ Larger
Fixed Order Quantity
Systems
Behavior of Economic Order Quantity
(EOQ) Systems
Determining Order Quantities
Determining Order Points
Behavior of EOQ Systems
As demand for the inventoried item
occurs, the inventory level drops
When the inventory level drops to a
critical point, the order point, the
ordering process is triggered
The amount ordered each time an order
is placed is fixed or constant
When the ordered quantity is received,
the inventory level increases
. . . more
Determining Order
Quantities
Basic economic order quantity-EOQ
Model I
Trial and Error Approach
Production order quantity-EOQ Model
II
Quantity discount model-EOQ Model
III
Model I: Basic EOQ
Typical assumptions made
annual demand (D), carrying cost (C)
and ordering cost (S) can be estimated
average inventory level is the fixed order
quantity (Q) divided by 2 which implies
no safety stock
orders are received all at once
demand occurs at a uniform rate
no inventory when an order arrives
. . . more
Inventory Usage Over Time
Model I: Basic EOQ
Assumptions (continued)
Stockout, customer responsiveness, and other
costs are inconsequential
acquisition cost is fixed, i.e., no quantity
discounts
Annual carrying cost = (average inventory
level) x (carrying cost) = (Q/2)C
Annual ordering cost = (average number of
orders per year) x (ordering cost) =
(D/Q)S
. . . more
EO
Q
=2D
S/C
Model I: Basic EOQ
Total annual stocking cost (TSC) =
annual carrying cost + annual
ordering cost = (Q/2)C + (D/Q)S
The order quantity where the TSC is
at a minimum (EOQ) can be found
using calculus (take the first
derivative, set it equal to zero and
solve for Q)
EOQ = 2 DS / C
Example: Basic EOQ
Zartex Co. produces fertilizer to sell to
wholesalers. One raw material calcium nitrate
is purchased from a nearby supplier at $22.50
per ton. Zartex estimates it will need 5,750,000
tons of calcium nitrate next year.
The annual carrying cost for this material is 40%
of the acquisition cost, and the ordering cost is
$595.
a) What is the most economical order quantity?
b) What is the TSC
c) How many orders will be placed per year?
d) How much time will elapse between orders?
E
O
Q E
O
Q= 2
DS
/
C
=2(5,70)(59.0
Example: Basic EOQ
Economical Order Quantity (EOQ)
D = 5,750,000 tons/year
C = .40(22.50) = $9.00/ton/year
S = $595/order
= 42,455.5
C = .20(10.50) =
Reorder point
ROP Q
replenishment tim
lead time e
Reorder Points
Reorder Point Curve
Reorder Point Example
Demand = 8,000 DVDs per year.
We have 250 working day year
Lead time for orders is 3 working days
D
d=
Number of working days in a year
= 8,000/250 = 32 units
OP=LT(d)+zLT(d2)
Setting Order Point
for a Continuous DDLT
Distribution
The customer service level is converted
into a Z value using the normal
distribution table (to be provided)
The safety stock is computed by
multiplying the Z value by DDLT.
The order point is set using OP = EDDLT
+ SS, or by substitution
Example 1: OP -
Continuous DDLT
Auto Zone Distribution
sells auto parts and supplies
including a popular multi-grade motor oil.
When the stock of this oil drops to 20 gallons,
a replenishment order is placed. The store
manager is concerned that sales are being
lost due to stockouts while waiting for an
order. It has been determined that lead time
demand is normally distributed with a mean
of 15 gallons and a standard deviation of 6
gallons.
The manager would like to know the
probability of a stockout during lead time.
Example: OP -
Continuous DDLT
Distribution
EDDLT = 15 gallons
DDLT = 6 gallons
OP = EDDLT + Z(DDLT )
20 = 15 + Z(6)
5 = Z(6)
Z = 5/6
Z = .833
Example: OP -
Continuous DDLT
Distribution
Standard Normal Distribution
Area = .2967
Area = .2033
Area = .5 z
0 .833
Example: OP -
Continuous DDLT
Distribution
The Standard Normal table shows an
area of .2967 for the region between
the z = 0 line and the z = .833 line.
The shaded tail area is .5 - .2967 = .
2033.
The probability of a stockout during
lead time is .2033
Example 2:
Daily demand for product EPD101 is
normally distributed with a mean of 50
units and a standard deviation of 5
Shipping is usually certain with a lead
time of 6 days. The cost of placing an
order is $8 and annual carrying costs are
20% of unit price of $1.20. A 95% service
level is desired for the customers who
place orders during the recorder period.
Backorders are not allowed. Once stocks
are depleted, orders are filled as soon as
stocks arrive. No stock costs. Assume
Example 1:
Daily demand = 50 units,
the replenishment lead time = 6 days
ac = $1.2 c = 0.20ac S=
$8
EOQ=1103 units
OP=LT(d)+zLT(d2)
Example 1:
From normal distribution, a 0.95
confidence level gives z=1.645.
Thus