You should be able to:

1. Define the term inventory, list the major reasons for holding inventories,
and list the main requirements for effective inventory management
2. Discuss the nature and importance of service inventories
3. Explain periodic and perpetual review systems
4. Explain the objectives of inventory management
5. Describe the A-B-C approach and explain how it is useful
6. Describe the basic EOQ model and its assumptions and solve typical
problems
7. Describe the economic production quantity model and solve typical
problems
8. Describe the quantity discount model and solve typical problems
9. Describe reorder point models and solve typical problems
10. Describe situations in which the single-period model would be
appropriate, and solve typical problems

13-1
 Inventory
A stock or store of goods
Independent demand items
Items that are ready to be sold or used

Inventories are a vital part of business: (1) necessary for operations and (2)
contribute to customer satisfaction
A typical firm has roughly 30% of its current assets and as much as
90% of its working capital invested in inventory

13-2
 Raw materials and purchased parts
Work-in-process (WIP)
Finished goods inventories or merchandise
Tools and supplies
Maintenance and repairs (MRO) inventory
Goods-in-transit to warehouses or customers
(pipeline inventory)

13-3
 Inventory management has two main concerns:
Level of customer service
Having the right goods available in the right quantity in the
right place at the right time

Costs of ordering and carrying inventories

The overall objective of inventory management is to achieve
satisfactory levels of customer service while keeping
inventory costs within reasonable bounds
Measures of performance
Customer satisfaction
Number and quantity of backorders
Customer complaints
Inventory turnover
13-4
 Management has two basic functions concerning
inventory:
Establish a system for tracking items in inventory
Make decisions about
When to order
How much to order

13-5
 Requires:
A system keep track of inventory
A reliable forecast of demand
Knowledge of lead time and lead time variability
Reasonable estimates of
holding costs
ordering costs
shortage costs
A classification system for inventory items

13-6
 Periodic System
Physical count of items in inventory made at periodic
intervals
Perpetual Inventory System
System that keeps track of removals from inventory
continuously, thus monitoring current levels of each
item
An order is placed when inventory drops to a predetermined
minimum level
Two-bin system
Two containers of inventory; reorder
when the first is empty

13-7
 Forecasts
Inventories are necessary to satisfy customer demands,
so it is important to have a reliable estimates of the
amount and timing of demand
Point-of-sale (POS) systems
A system that electronically records actual sales
Such demand information is very useful for enhancing
forecasting and inventory management
Lead time
Time interval between ordering and receiving the order

13-8
 Purchase cost
The amount paid to buy the inventory
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
Setup costs
The costs involved in preparing equipment for a job
Analogous to ordering costs

13-9
 Shortage costs
Costs resulting when demand exceeds the supply of
inventory; often unrealized profit per unit

13-10
 A-B-C approach
Classifying inventory according to some measure of
importance, and allocating control efforts accordingly
A items (very important)
10 to 20 percent of the number of items in inventory and
about 60 to 70 percent of the annual dollar value
B items (moderately important)
C items (least important)
50 to 60 percent of the number
of items in inventory but only
about 10 to 15 percent of the
annual dollar value
13-11
 Class A: 10 to 20% of items, 60-70% annual $ usage
Percent of annual dollar usage

80 A Items Class B: Intermediate

Class C: 50 to 60% of items, <= 15% annual $ usage
70
60
50
40
30 B Items
20 C Items
10
0 | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percent of inventory items
 Cycle counting
A physical count of items in inventory
Cycle counting management
How much accuracy is needed?
A items: 0.2 percent
B items: 1 percent
C items: 5 percent
When should cycle counting be performed?
Who should do it?

13-13
 Economic order quantity models identify the
optimal order quantity by minimizing the sum
of annual costs that vary with order size and
frequency
The basic economic order quantity model
The economic production quantity model
The quantity discount model

13-14
 The basic EOQ model is used to find a fixed
order quantity that will minimize total annual
inventory costs
Assumptions:
Only one product is involved
Annual demand requirements are known
Demand is even throughout the year
Lead time does not vary
Each order is received in a single delivery
There are no quantity discounts

13-15
 Average
inventory
Q Usage on hand
Quantity rate
on hand
Q
2

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order

Lead time

Profile of Inventory Level Over Time 13-16

 Annual Holding cost + Annual Ordering cost

Annual Holding cost

(Average inventory) x Holding cost per unit per year
(Q/2) x H

Annual Ordering cost

Number of orders placed per year x Cost to place one
order
(D/Q) x S
Total Cost Annual Holding Cost Annual Ordering Cost
Q D
H S
2 Q
where
Q Order quantity in units
H Holding (carrying) cost per unit, usually per year
D Demand, usually in units per year
S Ordering cost per order

13-18
 The Total-Cost Curve is U-Shaped
Annual Cost

Q D
TC H S
2 Q

Holding Costs

Ordering Costs

Order Quantity
QO (optimal order quantity) (Q)

13-19
 Using calculus, we take the derivative of the total
cost function and set the derivative (slope) equal
to zero and solve for Q.
The total cost curve reaches its minimum where
the carrying and ordering costs are equal.

2 DS 2(annual demand)(or der cost)

QO
H annual per unit holding cost

13-20
 The batch mode is widely used in production. In
certain instances, the capacity to produce a part
exceeds its usage (demand rate)
Assumptions
Only one item is involved
Annual demand requirements are known
Usage rate is constant
Usage occurs continually, but production occurs
periodically
The production rate is constant
Lead time does not vary
There are no quantity discounts

13-21
 Q
Production Usage Production Usage Production
and usage only and usage only and usage
Qp
Cumulative
production
Imax

Amount
on hand

Time

13-22
TC min Carrying Cost Setup Cost
I D
max H S
2 Q
where
I max Maximum inventory
Qp
p u
p
p Production or delivery rate
u Usage rate

13-23
 2 DS p
Qp
H p u

13-24
 Quantity discount
Price reduction for larger orders offered to customers to
induce them to buy in large quantities
Total Cost Carrying Cost Ordering Cost Purchasing Cost
Q D
H S PD
2 Q
where
P Unit price

13-25
Adding PD does not change EOQ

13-26
The total-cost curve
with quantity discounts
is composed of a
portion of the total-cost
curve for each price

13-27
 Reorder point
When the quantity on hand of an item drops to this
amount, the item is reordered.
Determinants of the reorder point
The rate of demand
The lead time
The extent of demand and/or lead time variability
The degree of stockout risk acceptable to management

13-28
ROP d LT
where
d Demand rate (units per period, per day, per week)
LT Lead time (in same time units as d )

13-29
 Demand or lead time uncertainty creates the
possibility that demand will be greater than
available supply
To reduce the likelihood of a stockout, it
becomes necessary to carry safety stock
Safety stock
Stock that is held in excess of expected demand due to
variable demand and/or lead time

Expected demand
ROP Safety Stock
during lead time
13-30
13-31
 As the amount of safety stock carried increases,
the risk of stockout decreases.
This improves customer service level
Service level
The probability that demand will not exceed supply
during lead time
Service level = 100% - Stockout risk

13-32
 The amount of safety stock that is appropriate
for a given situation depends upon:
The average demand rate and average lead time
Demand and lead time variability
The desired service level

Expected demand
ROP z dLT
during lead time
where
z Number of standard deviations
dLT The standard deviation of lead time demand
13-33
ROP d LT z d LT
where
z Number of standard deviations
d Average demand per period (per day, per week)
d The stdev. of demand per period (same time units as d )
LT Lead time (same time units as d )
Note: If only demand is variable, then dLT d LT

13-34
ROP d LT zd LT
where
z Number of standard deviations
d Demand per period (per day, per week)
LT The stddev. of lead time (same time units as d )
LT Average lead time (same time units as d )
Note: If only lead time is variable, then dLT d LT

13-35
ROP d LT zd LT
where
z Number of standard deviations
d Average demand per period (per day, per week)
LT The stddev. of lead time (same time units as d )
LT Average lead time (same time units as d )

Note: If both demand and lead time is

variable, then
dLT LT d LT
2 2 2
d
13-36
 Fixed-order-interval (FOI) model
Orders are placed at fixed time intervals
Reasons for using the FOI model
Suppliers policy may encourage its use
Grouping orders from the same supplier can produce
savings in shipping costs
Some circumstances do not lend themselves to
continuously monitoring inventory position

13-37
Fixed Quantity

Fixed Interval

13-38
 Expected demand
Amount during protection Safety Amount on hand
to Order stock at reorder ti me
interval
d (OI LT) z d OI LT A
where
OI Order interval (length of time between orders)
A Amount on hand at reorder ti me

13-39
 Single-period model
Model for ordering of perishables and other items with
limited useful lives
Shortage cost
Generally, the unrealized profit per unit
Cshortage = Cs = Revenue per unit Cost per unit
Excess cost
Different between purchase cost and salvage value of items
left over at the end of the period
Cexcess = Ce = Cost per unit Salvage value per unit

13-40
 The goal of the single-period model is to identify
the order quantity that will minimize the long-
run excess and shortage costs
Two categories of problem:
Demand can be characterized by a continuous
distribution
Demand can be characterized by a discrete distribution

13-41
 Cs
Service level
C s Ce
where
Cs shortage cost per unit
Ce excess cost per unit
Cs Ce

Service level

Quantity
So So =Optimum
Balance Point Stocking Quantity

13-42
 Improving inventory processes can offer
significant cost reduction and customer
satisfaction benefits
Areas that may lead to improvement:
Record keeping
Records and data must be accurate and up-to-date
Variation reduction
Lead variation
Forecast errors
Lean operations
Supply chain management

13-43