Managing Service Inventory

Replenishment
order

Factory

Production
Delay

Replenishment Replenishment
order
order

Wholesaler

Distributor

Shipping
Delay

Wholesaler
Inventory

Retailer

Shipping
Delay

Distributor
Inventory

Customer
order

Customer

Item Withdrawn

Retailer
Inventory

Learning Objectives

Describe the functions and costs of an inventory system.

Determine the order quantity.
Determine the reorder point and safety stock for inventory
systems with uncertain demand.
Design a continuous or periodic review inventory-control
system.
Conduct an ABC analysis of inventory items.
Determine the order quantity for the single-period
inventory case.
Describe the rationale behind the retail discounting model.

18-2

Role of Inventory

Decoupling inventories
Seasonal inventories
Speculative inventories
Cyclical inventories
In-transit inventories
Safety stocks

18-3

Considerations in Inventory
Systems

Type of customer demand

Planning time horizon

Replenishment lead time

Constraints and relevant costs

18-4

Relevant Inventory Costs

Ordering costs

Receiving and inspections costs

Holding or carrying costs

Shortage costs
18-5

Inventory Management
Questions

What should be the order quantity (Q)?

When should an order be placed, called
a reorder point (ROP)?
How much safety stock (SS) should be
maintained?

18-6

Inventory Models

Economic Order Quantity (EOQ)

Special Inventory Models
With Quantity Discounts
Planned Shortages
Demand Uncertainty - Safety Stocks
Inventory Control Systems
Continuous-Review (Q,r)
Periodic-Review (order-up-to)
Single Period Inventory Model

18-7

17-8

Basic Fixed-Order Quantity Model and Reorder Point Behavior

4. The cycle then repeats.

1. You receive an order quantity Q.

Number
of units
on hand

2. Your start using

them up over time.

R = Reorder point
Q = Economic order quantity
L = Lead time

Time

L
3. When you reach down to
a level of inventory of R,
you place your next Q
sized order.

17-9

Basic Fixed-Order Quantity (EOQ) Model Formula

Total
Annual =
Cost

Annual
Annual
Annual
Purchase + Ordering + Holding
Cost
Cost
Cost

D
Q
TC = DC + S + H
Q
2

TC=Total annual
cost
D =Demand
C =Cost per unit
Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
L =Lead time
H=Annual holding
and storage cost
per unit of
inventory

900
800
700
600
500
400
300
200
100
0
14
0

12
0

10
0

80

60

40

Holding Cost
Ordering Cost
Total Cost

20

Annual Cost, $

Annual Costs For EOQ Model

Order Quantity, Q

18-10

17-11

Deriving the EOQ

Using calculus, we take the first derivative

of the total cost function with respect to
Q, and set the derivative (slope) equal to
zero, solving for the optimized (cost
minimized) value of Qopt
Q OPT =

2DS
=
H

We also need a
reorder point to
tell us when to
place an order

2(Annual Demand)(Order or Setup Cost)

Annual Holding Cost
_

R eorder p oint, R = d L
_

d = average daily demand (constant)

L = Lead time (constant)

17-12

EOQ Example (1) Problem Data

Given the information below, what are the EOQ and

reorder point?

Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15

17-13

EOQ Example (1) Solution

Q OPT =

2DS
=
H

2(1,000 )(10)
= 89.443 units or 90 units
2.50

1,000 units / year

d =
= 2.74 units / day
365 days / year
_

Reorder point, R = d L = 2.74units / day (7days) = 19.18 or 20 units

In summary, you place an optimal order of 90 units. In

the course of using the units to meet demand, when
you only have 20 units left, place the next order of 90
units.

17-14

EOQ Example (2) Problem Data

Determine the economic order quantity

and the reorder point given the following

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of
cost per unit
Lead time = 10 days
Cost per unit = $15

17-15

EOQ Example (2) Solution

Q OPT =

2D S
=
H

2(10,000 )(10)
= 365.148 units, or 366 u n its
1.50

10,000 units / year

d=
= 27.397 units / day
365 days / year
_

R = d L = 27.397 units / day (10 days) = 273.97 or 274 units

Place an order for 366 units. When in the course of

using the inventory you are left with only 274 units,
place the next order of 366 units.

17-16

Price-Break Model Formula

Based on the same assumptions as the EOQ model,

the price-break model has a similar Qopt formula:

2DS
2(Annual Demand)(Order or Setup Cost)
Q OPT =
=
iC
Annual Holding Cost
i = percentage of unit cost attributed to carrying inventory
C = cost per unit
Since C changes for each price-break, the formula
above will have to be used with each price-break cost
value

17-17

Price-Break Example Problem Data

(Part 1)

A company has a chance to reduce their inventory

ordering costs by placing larger quantity orders using
the price-break order quantity schedule below. What
should their optimal order quantity be if this company
purchases this single inventory item with an e-mail
ordering cost of $4, a carrying cost rate of 2% of the
inventory cost of the item, and an annual demand of
10,000 units?
Order Quantity(units) Price/unit($)
0 to 2,499
$1.20
2,500 to 3,999 1.00
4,000 or more .98

17-18

Price-Break Example Solution (Part 2)

First, plug data into formula for each price-break value of C

Annual Demand (D)= 10,000 units
Cost to place an order (S)= $4

Carrying cost % of total cost (i)= 2%

Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 2499, the
Qopt value is feasible
Interval from 2500-3999, the
Qopt value is not feasible
Interval from 4000 & more,
the Qopt value is not feasible

Q OPT =

2DS
=
iC

2(10,000)(4)
= 1,826 units
0.02(1.20)

Q OPT =

2DS
=
iC

2(10,000)(4)
= 2,000 units
0.02(1.00)

Q OPT =

2DS
=
iC

2(10,000)(4)
= 2,020 units
0.02(0.98)

17-19

Price-Break Example Solution (Part 3)

Since the feasible solution occurred in the first pricebreak, it means that all the other true Qopt values occur
at the beginnings of each price-break interval. Why?
Because the total annual cost function is
a u shaped function

Total
annual
costs

So the candidates
for the pricebreaks are 1826,
2500, and 4000
units
0

1826

2500

4000

Order Quantity

17-20

Price-Break Example Solution (Part 4)

Next, we plug the true Qopt values into the total cost
annual cost function to determine the total cost under
each price-break

D
Q
TC = DC +
S+
iC
Q
2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
= $12,043.82
TC(2500-3999)= $10,041
TC(4000&more)= $9,949.20

Finally, we select the least costly Qopt, which is this

problem occurs in the 4000 & more interval. In summary,
our optimal order quantity is 4000 units

Questions
18.7
18.9
A.D. Small Consulting

Demand During Lead Time

Example
L 3
15
.

u=3

u=3

15
.

15
.

15
.

u=3

u=3

d L 12

ROP

ss

Four Days Lead Time

Demand During Lead time

18-22

Safety Stock (SS)

Demand During Lead Time (LT) has

Normal Distribution with
Mean(d L ) ( LT )
Std . Dev.( L ) LT
SS with r% service level
SS zr LT
Reorder Point

ROP SS d L
18-23

Continuous Review System (Q,r)

Amount used during first lead time
Inventory on hand

EOQ
Reorder point, ROP

d3

Average lead time usage, dL

Safety stock, SS

d1

d2 EOQ

First lead
time, LT1

LT2

LT3

Time
Order 1 placed

Order 2 placed

Shipment 1 received

Order 3 placed

Shipment 2 received

Shipment 3 received

18-24

Periodic Review System

(order-up-to)
Inventory on Hand

Target inventory level, TIL

Review period

RP

RP

RP

First order quantity, Q1

Q3

Q2

d3

d1

Amount used during

first lead time

d2

Safety stock, SS

First lead time, LT1

LT2

LT3
Time

Order 1 placed

Order 2 placed

Shipment 1 received

Order 3 placed

Shipment 2 received Shipment 3 received

18-25

Inventory Control Systems

Continuous Review System

2 DS
EOQ
H
ROP SS LT
SS zr LT

Periodic Review System

RP EOQ /
TIL SS ( RP LT )
SS zr RP LT
18-26

80
90
10
0

60
70

40
50

20
30

110
100
90
80
70
60
50
40
30
20
10
0

0
10

Percentage of dollar volume

ABC Classification of Inventory

Items

Percentage of inventory items (SKUs)

18-27

Inventory Items Listed in

Descending Order of Dollar Volume
Inventory Item

Unit cost
($)

Monthly
Sales
(units)

Dollar
Volume ($)

Home Theater
Computers

5000
2500

30
30

150,000
75,000

Television sets
Refrigerators
Displays

400
1000
250

60
15
40

24,000
15,000
10,000

Speakers
Cameras
Software
Thumb drives
CDs

150
200
50
5
10

60
40
100
1000
400

9,000
8,000
5,000
5,000
4,000

Totals

305,000

Percent of
Dollar
Volume

Percent of
SKUs

Class

74

20

16

30

10

50

100

100

18-28

Single Period Inventory Model

Newsvendor Problem Example
D = newspapers demanded
p(D) = probability of demand
Q = newspapers stocked
P = selling price of newspaper, $10
C = cost of newspaper, $4
S = salvage value of newspaper, $2
Cu = unit contribution: P-C = $6
Co = unit loss: C-S = $2
18-29

Demand

Frequency

10

11

12

Demand

Frequency Probability

0.0278

0.0556

0.0833

0.1111

0.1389

0.1667

0.1389

0.1111

10

0.0833

11

0.0556

12

0.0278

Single Period Inventory Model

Expected Value Analysis
p(D)

Stock Q
8

.028
.055
.083
.111
.139
.167
.139
.111
.083
.055
.028

2
3
4
5
6
7
8
9
10
11
12

4
12
20
28
36
36
36
36
36
36
36

2
10
18
26
34
42
42
42
42
42
42

0
8
16
24
32
40
48
48
48
48
48

-2
6
14
22
30
38
46
54
54
54
54

-4
4
12
20
28
36
44
52
60
60
60

$31.54

$34.43

$35.77

$35.99

$35.33

Expected Profit

10

18-32

Demand

Frequency Probability

P (D<Q)

0.0278

0.0556

0.0278

0.0833

0.0833

0.1111

0.1667

0.1389

0.2778

0.1667

0.4167

0.1389

0.5833

0.1111

0.7222

10

0.0833

10

0.8333

11

0.0556

11

0.9167

12

0.0278

12

0.9722

Single Period Inventory Model

Incremental Analysis

E (revenue on last sale)

P ( revenue) (unit revenue)

E (loss on last sale)

P (loss) (unit loss)

P( D Q)Cu P( D Q)Co

1 P( D Q)C

P ( D Q) Co

Cu
P ( D Q)
Cu Co

(Critical Fractile)

where:
Cu = unit contribution from newspaper sale ( opportunity cost of underestimating demand)
Co = unit loss from not selling newspaper (cost of overestimating demand)
D = demand
Q = newspaper stocked
18-34

Critical Fractile for the

Newsvendor Problem
P(D<Q)
(Co applies)

Probability

P(D>Q)
(Cu applies)

0.722

10

12

14

New spaper demand, Q

18-35

Questions
Example 3 page 501
18.11
18.15
Case last resort restaurant

18-36

Last Resort Restaurant

1.

2.

3.

Assuming that the cost of stockout is the lost

contribution of one dessert, how many portions
of Sweet Revenge should the chef prepare each
weekday?
Based on Martin Quinns estimate of other
stockout costs, how many servings should the
chef prepare?
If, historically, desserts were prepared to cover
95 percent of demand, what was the implied
stockout cost?
18-37

Sweet Revenge Demand

Mon.

Tue.

Wed.

Thurs.

Fri.

250

275

260

300

290

235

250

295

310

360

2430

275

286

236

294

289

315

340

256

311
18-38