Unfilled Notes for Chapter 13: Inventory Control

Chapter 13: Learning Objectives

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 (P) and perpetual review (Q) systems
4. Describe the A-B-C approach and explain how it is useful
5. Describe the basic EOQ model and its assumptions and solve typical problems

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

Types of Inventory:
1.
2.
3.
4.
5.
6.

Raw material and purchased parts

Tools and supplies
Work-in-process
Finished goods inventories
Pipeline inventory
Maintenance and repairs inventory

Objectives of Inventory Control

Inventory management has two main concerns:
1. Level of customer service
Having the right goods available in the right quantity in the right place at the
right time
2. Costs of ordering and carrying inventory
The overall objective of inventory management is to achieve satisfactory levels
of customer service while keeping inventory costs within reasonable bounds
1. Measures of performance
2. Customer satisfaction

a. Number and quantity of backorders

b. Customer complaints
3. Inventory turnover

Inventory Management
Management has two basic functions concerning inventory:
1. Establish a system for tracking items in inventory
2. Make decisions about
When to order
How much to order

Effective Inventory Management

Requires:
1. A system keep track of inventory
2. A reliable forecast of demand
3. Knowledge of lead time and its variability
4. Reasonable estimates of

holding costs

ordering costs

shortage costs

5. A classification system for inventory items

Inventory Counting Systems

Periodic System
o

Perpetual System
o

Physical count of items in inventory made at periodic intervals

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

Demand Forecasts and Lead Time

Forecasts
o

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
o

Time interval between ordering and receiving the order

Inventory Costs

Purchase cost

Holding (carrying) costs

Cost to carry an item in inventory for a length of time, usually a year

Ordering costs

The amount paid to buy the inventory

Costs of ordering and receiving inventory

Setup costs

The costs involved in preparing equipment for a job

Analogous to ordering costs

Shortage costs

Costs resulting when demand exceeds the supply of inventory; often unrealized
profit per unit

ABC Classification System

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

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?

Typical Inventory Control Problem

o

A typical Inventory control problem deal with three types of costs: Carrying,
Replenishment, and shortage costs.

Typically we deal with four parameters: Reorder Point (R), Order Target Level (T),
Lot-size (Q), Periodic Review (P).

Based on the nature of the problem, an inventory problem can be deterministic, or

stochastic (demand and supply)

Dependent vs. Independent inventory control

Economic Order Quantity (EOQ)

The lot size, Q, that minimizes total annual inventory holding and ordering costs

Five assumptions: (Demand, Supply, independent, no shortage, q)

1) Demand rate is constant and known with certainty
2) No constraints are placed on the size of each lot
3) The only two relevant costs are the inventory holding cost and the fixed cost per lot for
ordering or setup
4) Decisions for one item can be made independently of decisions for other items
5) The lead time is constant and known with certainty

Dont use the EOQ

o Make-to-order strategy
o Order size is constrained
Modify the EOQ
o Quantity discounts
o Replenishment not instantaneous
Use the EOQ
o Make-to-stock (MTS)
o Carrying and setup costs are known and relatively stable

Total Annual Cost

Deriving EOQ
o

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.
Qo = sqrt(2DS/H)

Example of EOQ Model:

o

A museum of natural history opened a gift shop which operates 52 weeks per year.

Managing inventories has become a problem.

Top-selling SKU is a bird feeder.

Sales are 18 units per week, the supplier charges $60 per unit.

Ordering cost is $45.

Annual holding cost is 25 percent of a feeders value.

Management chose a 390-unit lot size.

What is the annual cycle-inventory cost of the current policy of using a 390-unit lot size?

Would a lot size of 468 be better?

Calculating EOQ
o The EOQ formula

o Time between orders

Example: Calculate EOQ, TC, and TBO

o

For the bird feeders, calculate the EOQ and its total annual cycle-inventory cost. How
frequently will orders be placed if the EOQ is used?

Calculating EOQ
The EOQ formula: sqrt(2DS/H)
Time between orders: EOQ/D
Total Cost of EOQ model: ____________________________________
Inventory Control System

Four variables: s, S, t, q

Two important questions:

How much?
When?

Nature of demand
Independent demand
Dependent demand

Continuous review (Q) system

Reorder point system (ROP) and fixed order quantity system

For independent demand items

Tracks inventory position (IP)

Includes scheduled receipts (SR), on-hand inventory (OH), and back orders (BO)

Inventory position = On-hand inventory + scheduled receipts - backorders

IP = OH + SR - BO

Example of Q system:
The on-hand inventory is only 10 units, and the reorder point R is 100. There are no
backorders and one open order for 200 units. Should a new order be placed?
Solution:
IP = OH + SR BO = 10 + 200 0 = 210
R = 100
Decision: Place no new order

Placing a New Order

Demand for chicken soup at a supermarket is always 25 cases a day and the lead time is
always 4 days. The shelves were just restocked with chicken soup, leaving an on-hand
inventory of only 10 cases. No backorders currently exist, but there is one open order in the
pipeline for 200 cases. What is the inventory position? Should a new order be placed?
Solution:
R = Total demand during lead time = (25)(4) = 100 cases
IP = OH + SR BO = 10 + 200 0 = 210
Decision: Place no new order

Continuous Review Systems: Selecting the reorder point with variable demand and constant
lead time

Reorder Point
1. Choose an appropriate service-level policy

Select service level or cycle service level

Protection interval

2. Determine the demand during lead time probability distribution

3. Determine the safety stock and reorder point levels

Example for Reorder Point for Variable Demand Bird Feeder

Let us return to the bird feeder example. The EOQ is 75 units. Suppose that the average
demand is 18 units per week with a standard deviation of 5 units. The lead time is constant
at two weeks. Determine the safety stock and reorder point if management wants a 90
percent cycle-service level.
Solution:

Suppose that the demand during lead time is normally distributed with an average of 85 and
dLT = 40. Find the safety stock, and reorder point R, for a 95 percent cycle-service level.

Example Office Supply Shop

The Office Supply Shop estimates that the average demand for a popular ball-point pen is
12,000 pens per week with a standard deviation of 3,000 pens. The current inventory policy calls
for replenishment orders of 156,000 pens. The average lead time from the distributor is 5 weeks,
with a standard deviation of 2 weeks. If management wants a 95 percent cycle-service level,
what should the reorder point be?

Periodic Review System (P)

Fixed interval reorder system or periodic reorder system

Four of the original EOQ assumptions maintained
1. No constraints are placed on lot size
2. Holding and ordering costs
3. Independent demand
4. Lead times are certain
Order is placed to bring the inventory position up to the target inventory level, T, when the
predetermined time, P, has elapsed

Example: How much to order in a P system Distribution Center

A distribution center has a backorder for five 36-inch color TV sets. No inventory is currently
on hand, and now is the time to review. How many should be reordered if T = 400 and no
receipts are scheduled?
Solution:
IP = OH + SR BO
= 0 + 0 5 = -5 sets
T IP = 400 (-5) = 405 sets
That is, 405 sets must be ordered to bring the inventory position up to T sets.
The on-hand inventory is 10 units, and T is 400. There are no back orders, but one scheduled
receipt of 200 units. Now is the time to review. How much should be reordered?
Solution:
IP = OH + SR BO
= 10 + 200 0 = 210 units
T IP = 400 (210) = 109 units
The decision is to order 190 units.

Example: Calculating P and T in P system Bird Feeder

Again, let us return to the bird feeder example. Recall that demand for the bird feeder is
normally distributed with a mean of 18 units per week and a standard deviation in weekly
demand of 5 units. The lead time is 2 weeks, and the business operates 52 weeks per year.
The Q system developed in Example 12.4 called for an EOQ of 75 units and a safety stock of
9 units for a cycle-service level of 90 percent. What is the equivalent P system? Answers are
to be rounded to the nearest integer.
Solution:
We first define D and then P. Here, P is the time between reviews, expressed in weeks
because the data are expressed as demand per week:
D = (18 units/week) ( 52 weeks/year) = 936 units
P = (52)EOQ/D = (52)(75)/936 = 4.2 or 4 weeks
With average d = 18 units per week, an alternative approach is to calculate P by dividing the
EOQ by average d to get 75/18 = 4.2 or 4 weeks. Either way, we would review the bird
feeder inventory every 4 weeks.

More about Periodic Review System

o

Use simulation when both demand and lead time are variable

Suitable to single-bin systems

Total costs for the P system are the sum of the same three cost elements as in the Q
system

Order quantity and safety stock are calculated differently

Example of P system:
Return to Discount Appliance Store, but now use the P system for the item.
Previous information
Demand = 10 units/wk (assume 52 weeks per year) = 520
EOQ = 62 units (with reorder point system)

Lead time (L) = 3 weeks

Standard deviation in weekly demand = 8 units
z = 0.525 (for cycle-service level of 70%)
Reorder interval P, if you make the average lot size using the Periodic Review System
approximate the EOQ.
Solution:
Reorder interval P, if you make the average lot size using the Periodic Review System
approximate the EOQ.
P = (EOQ/D)(52) = (62/529)(52) = 6.2 or 6 weeks
Safety stock:

Target inventory:

Total Cost:

Comparative Advantages

Primary advantages of P systems

Convenient

Orders can be combined

Only need to know IP when review is made

Primary advantages of Q systems

o

Review frequency may be individualized

Fixed lot sizes can result in quantity discounts

Lower safety stocks

Hybrid System
Optional replenishment systems
o Optimal review, min-max, or (s,S) system, like the P system
o Reviews IP at fixed time intervals and places a variable-sized order to cover
expected needs
o Ensures that a reasonable large order is placed
Base-stock system
o Replenishment order is issued each time a withdrawal is made
o Order quantities vary to keep the inventory position at R
o Minimizes cycle inventory, but increases ordering costs
o Appropriate for expensive items