Inventory Management

For Operations Management, 9e by

PowerPoint Slides
Krajewski/Ritzman/Malhotra
by Jeff Heyl © 2010 Pearson Education
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 Types of Inventories

• Raw materials & purchased parts

• Partially completed goods called work in
progress
• Finished-goods inventories
(manufacturing firms) or merchandise (retail
stores)

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Types of Inventories (Cont’d)
• Replacement parts, tools, & supplies
• Goods-in-transit to warehouses or
customers

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 Key Inventory Terms

Reorder point: a level of inventory in stock at which a new

order is placed
Lead time: time interval between reordering and receiving
the order
Holding (carrying) costs: costs of holding an item in
inventory, i.e., interest, insurance, utility charge, etc.
Ordering costs: costs of ordering and receiving inventory
(costs of replenishing inventory), i.e., shipping cost,
preparing invoices, inspecting goods upon arrival for
quality and quantity, etc.
Shortage costs: costs when demand exceeds supply
(temporary or permanent loss of sales when demand cannot
be met)

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 The Inventory Cycle
An order quantity, Q, is received and is used up over time at a constant rate.
When the inventory level decreases to the reorder point, R, a new order is
placed; a period of time, refereed to as the lead time, is required for delivery.
The inventory level reaches zero – so there will be no shortages.

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
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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
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Inventory Counting Systems
 Periodic System
Physical count of items made at periodic intervals
 Perpetual Inventory System
A system that keeps track of removals from inventory
continuously, thus monitoring current levels of each
item

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 Inventory Counting Systems
(Cont’d)
 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

214800 232087768

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Cycle Counting
 A physical count of items in inventory
 Cycle counting management
 How much accuracy is needed?
 When should cycle counting be performed?
 Who should do it?

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 ABC Analysis

 Classifying inventory according to some

measure of importance and allocating
control efforts accordingly

 A-Very Important
 B-Moderate Important
 C- Least Important

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ABC Analysis
Class C
100 — Class B
90 —
Percentage of dollar value Class A
80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Percentage of SKUs
Figure 12.1 – Typical Chart Using ABC Analysis
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Economic Order Quantity

 The lot size, Q, that minimizes total annual

inventory holding and ordering costs

 Five assumptions
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

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Calculating EOQ

Receive Inventory depletion

order (demand rate)
On-hand inventory (units)

Average
Q cycle
2 inventory

1 cycle
Time
Figure 12.2 – Cycle-Inventory Levels

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Calculating EOQ

 Annual holding cost

Annual holding cost = (Average cycle inventory)
 (Unit holding cost)

 Annual ordering cost

Annual ordering cost = (Number of orders/Year)
 (Ordering or setup costs)

 Total annual cycle-inventory cost

Total costs = Annual holding cost
+ Annual ordering or setup cost

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Calculating EOQ

Annual cost (dollars)

Total cost

Holding cost

Ordering cost

Lot Size (Q)

Figure 12.3 – Graphs of Annual Holding, Ordering, and Total Costs

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Calculating EOQ

 Total annual cycle-inventory and ordering cost

Q D
C= (H) + (S)
2 Q

where
C = total annual cycle-inventory cost
Q = lot size
H = holding cost per unit per year
D = annual demand
S = ordering or setup costs per lot

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Calculating EOQ

 The EOQ formula:

2DS
EOQ =
H

 Time between orders

EOQ
TBOEOQ = (12 months/year)
D

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Solved Problem 2
Nelson’s Hardware Store stocks a 19.2 volt cordless drill that is
a popular seller. Annual demand is 5,000 units, the ordering
cost is $15, and the inventory holding cost is $4/unit/year.
a. What is the economic order quantity?
b. What is the total annual cost for this inventory item?
SOLUTION
a. The order quantity is

2DS 2(5,000)($15)
EOQ = =
H $4
= 37,500 = 193.65 or 194 drills
b. The total annual cost is
Q D 194 5,000
C= (H) + (S) = ($4) + ($15) = $774.60
2 Q 2 194
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 Inventory Control Systems

 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)

osition = On-hand inventory + Scheduled receipts

– Backorders

IP = OH + SR – BO

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 Continuous Review Systems

 Selecting the reorder point with variable demand

and constant lead time

oint = Average demand during lead time

+ Safety stock
= dL + safety stock

where
d = average demand per week (or day or months)
L = constant lead time in weeks (or days or months)

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Reorder Point

1. Choose an appropriate service-level policy

 Select service level or cycle service level (the desired
probability of not running out of stock in any ordering cycle)
 Protection interval (the period over which safety stock must
protect the user from running out of stock)

2. Determine the demand during lead time probability distribution

3. Determine the safety stock and reorder point levels

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Demand During Lead Time
 Specify mean and standard deviation
 Standard deviation of demand during lead time

σdLT = σd2L = σd L

 Safety stock and reorder point

Safety stock = zσdLT

where
z= number of standard deviations needed to
achieve the cycle-service level
σdLT = stand deviation of demand during lead time

Reorder point = R = dL + safety stock

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Continuous Review Systems

 Two-Bin system
 Visual system
 An empty first bin signals the need to place an order
 Calculating total systems costs

Total cost = Annual cycle inventory holding cost

+ Annual ordering cost
+ Annual safety stock holding cost

Q D
C= (H) + (S) + (H) (Safety stock)
2 Q

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Periodic Review System (P)

 Fixed interval reorder system or periodic reorder

system

 Four of the original EOQ assumptions maintained

 No constraints are placed on lot size
 Holding and ordering costs only
 Independent demand
 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

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Periodic Review System
 Selecting the time between reviews,
choosing P (length of time between reviews) and T (target
inventory level)
 Selecting T when demand is variable and
lead time is constant
 IP covers demand over a protection interval of
P+L
 The average demand during the protection
interval is d(P + L), or

T = d(P + L) + safety stock for protection interval

Safety stock = zσP + L , where σP + L =  d P  L

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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

 Review frequency may be individualized
 Fixed lot sizes can result in quantity discounts
 Lower safety stocks

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Solved Problem 3
A regional distributor purchases discontinued appliances from
various suppliers and then sells them on demand to retailers in
the region. The distributor operates 5 days per week, 52 weeks
per year. Only when it is open for business can orders be
received. Management wants to reevaluate its current inventory
policy, which calls for order quantities of 440 counter-top
mixers. The following data are estimated for the mixer:
Average daily demand (d) = 100 mixers
Standard deviation of daily demand (σd) = 30 mixers
Lead time (L) = 3 days
Holding cost (H) = $9.40/unit/year
Ordering cost (S) = $35/order
Cycle-service level = 92 percent
The distributor uses a continuous review (Q) system

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Solved Problem 3

a. What order quantity Q, and reorder point, R, should be used?

b. What is the total annual cost of the system?
c. If on-hand inventory is 40 units, one open order for 440
mixers is pending, and no backorders exist, should a new
order be placed?

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Solved Problem 3
SOLUTION
a. Annual demand is
D = (5 days/week)(52 weeks/year)(100 mixers/day)
= 26,000 mixers/year

The order quantity is

2DS 2(26,000)($35)
EOQ = =
H $9.40
= 193,167 = 440.02 or 440 mixers

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Solved Problem 3

The standard deviation of the demand during lead time

distribution is
σdLT = σd L = 30 3 = 51.96

A 92 percent cycle-service level corresponds to z = 1.41

Safety stock = zσdLT = 1.41(51.96 mixers) = 73.26 or 73 mixers

Average demand during lead time = dL = 100(3) = 300 mixers

Reorder point (R) = Average demand during lead time + Safety stock
= 300 mixers + 73 mixers = 373 mixers

With a continuous review system, Q = 440 and R = 373

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Solved Problem 3
b. The total annual cost for the Q systems is
Q D
C= (H) + Q (S) + (H)(Safety stock)
2
440 26,000
C= ($9.40) + ($35) + ($9.40)(73) = $4,822.38
2 440

c. Inventory position = On-hand inventory

+ Scheduled receipts – Backorders

IP = OH + SR – BO = 40 + 440 – 0 = 480 mixers

Because IP (480) exceeds R (373), do not place a new order

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Solved Problem 4
Suppose that a periodic review (P) system is used at the
distributor in Solved Problem 3, but otherwise the data are the
same.
a. Calculate the P (in workdays, rounded to the nearest day)
that gives approximately the same number of orders per
year as the EOQ.
b. What is the target inventory level, T? Compare the P system
to the Q system in Solved Problem 3.
c. What is the total annual cost of the P system?
d. It is time to review the item. On-hand inventory is 40 mixers;
receipt of 440 mixers is scheduled, and no backorders exist.
How much should be reordered?

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Solved Problem 4
SOLUTION
a. The time between orders is

EOQ 440
P= (260 days/year) = (260) = 4.4 or 4 days
D 26,000

b. target inventory level, T = d(P + L) + z d P  L

=100(3+4)+1.41*30*√(3+4)= 812
Safety stock = 1.41*30*√(3+4)= 111.91 or about 112 mixers.
The corresponding Q system for the counter-top mixer
requires less safety stock.

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Solved Problem 4
c. The total annual cost of the P system is
dP D
C = 2 (H) + (S) + (H)(Safety stock)
dP
100(4) 26,000
C= ($9.40) + ($35) + ($9.40)(1.41)(79.37)
2 100(4)
= $5,207.80
d. Inventory position is the amount on hand plus scheduled
receipts minus backorders, or
IP = OH + SR – BO = 40 + 440 – 0 = 480 mixers
The order quantity is the target inventory level minus the
inventory position, or
Q = T – IP = 812 mixers – 480 mixers = 332 mixers
An order for 332 mixers should be placed.
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