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12/1/2015
Chapter 13
Inventory Management
Learning Outcomes
Explain how effective inventory management contributes to
the competitive advantages of the firm;
Describe all the costs associated with inventory and to
indicate the various ways in which these costs could be
minimized;
Differentiate between continuous inventory systems and
periodic inventory systems and to provide examples of their
deployment in both manufacturing and service enterprises;
Use the basic EOQ model to determine the optimal size of
an inventory order and to specify the assumptions of the
model;
Use the quantity discount Model to determine the optimal Q;
Calculate the reorder point in a continuous inventory system
Copyright 2011 John Wiley & Sons, Inc.
13-2
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What Is Inventory?
Stock of items kept to meet future demand
Purpose of inventory management
how many units to order
when to order
13-3
Supply Chain Management

Bullwhip effect
demand information is distorted as it moves away
from the end-use customer
higher safety stock inventories to are stored to
compensate
Seasonal or cyclical demand

Inventory provides independence from vendors
Take advantage of price discounts
Inventory provides independence between
stages and avoids work stoppages
13-4
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Quality Management in the Supply Chain

Customers usually perceive quality service as
availability of goods they want when they want
them
Inventory must be sufficient to provide highquality customer service in QM
13-5
Types of Inventory
Raw materials
Purchased parts and supplies
Work-in-process (partially completed) products
(WIP)
Items being transported
Tools and equipment
13-6
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Two Forms of Demand

Dependent
Demand for items used to produce final
products
Tires for autos are a dependent demand item
Independent
Demand for items used by external customers
Cars, appliances, computers, and houses are
examples of independent demand inventory
13-7
Inventory Costs
Carrying cost
cost of holding an item in inventory
Ordering cost
cost of replenishing inventory
Shortage cost
temporary or permanent loss of sales when
demand cannot be met
13-8
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Inventory Control Systems

Continuous system (fixed-order-quantity)
constant amount ordered when inventory declines to
predetermined level
Periodic system (fixed-time-period)

order placed for variable amount after fixed passage
of time
13-9
ABC Classification
Class A
5 15 % of units
70 80 % of value
Class B
30 % of units
15 % of value
Class C
50 60 % of units
5 10 % of value
13-10
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ABC Classification
PART
UNIT COST
ANNUAL USAGE
1
2
3
4
5
6
7
8
9
10
$ 60
350
30
80
30
20
10
320
510
20
90
40
130
60
100
180
170
50
60
120
13-11
ABC Classification
PART
9
8
2
1
4
3
6
5
10
7
TOTAL
VALUE
% OF TOTAL
VALUE
$30,600
16,000
14,000
5,400
4,800
3,900
3,600
3,000
2,400
1,700
35.9
18.7
16.4
6.3
5.6
4.6
4.2
3.5
2.8
2.0
% OF TOTAL
QUANTITY
6.0
5.0
4.0
9.0
6.0
10.0
18.0
13.0
12.0
17.0
% CUMMULATIVE
A
B
C
6.0
11.0
15.0
24.0
30.0
40.0
58.0
71.0
83.0
100.0
$85,400
Example 10.1
13-12
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ABC Classification
CLASS
A
B
C
ITEMS
9, 8, 2
1, 4, 3
6, 5, 10, 7
% OF TOTAL
VALUE
% OF TOTAL
QUANTITY
71.0
16.5
12.5
15.0
25.0
60.0
Example 10.1
13-13
Economic Order Quantity

(EOQ) Models
EOQ
optimal order quantity that will minimize
total inventory costs
Basic EOQ model

Production quantity model
13-14
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Assumptions of Basic EOQ Model

Demand is known with certainty and is constant
over time
No shortages are allowed
Lead time for the receipt of orders is constant
Order quantity is received all at once
13-15
Inventory Order Cycle
Inventory Level
Order quantity, Q
Demand
rate
Average
inventory
Q
2
Reorder point, R
Lead
time
Order Order
placed receipt
Lead
time
Order Order
placed receipt
Time
13-16
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EOQ Cost Model

Co - cost of placing order
Cc - annual per-unit carrying cost
D - annual demand
Q - order quantity
Annual ordering cost =
CoD
Q
Annual carrying cost =
CcQ
2
Total cost =
CoD
+
Q
CcQ
2
13-17
EOQ Cost Model

Proving equality of
costs at optimal point
Deriving Qopt
TC =
CcQ
CoD
+
Q
2
CoD
Cc
TC
= Q2 +
2
Q
C0D
Cc
0 = Q2 +
2
Qopt =
2CoD
Cc
CcQ
CoD
=
Q
2
Q2 =
Qopt =
2CoD
Cc
2CoD
Cc
13-18
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EOQ Cost Model

Annual
cost ($)
Total Cost
Slope = 0
Minimum
total cost
Carrying Cost =
CcQ
2
Ordering Cost =
CoD
Q
Order Quantity, Q
Optimal order
Qopt
13-19
EOQ Example
Cc = $0.75 per gallon
Co = $150
D = 10,000 gallons
Qopt =
2CoD
Cc
TCmin =
CoD
CcQ
+
Q
2
Qopt =
2(150)(10,000)
(0.75)
TCmin =
(150)(10,000) (0.75)(2,000)
+
2,000
2
Qopt = 2,000 gallons

Orders per year = D/Qopt
= 10,000/2,000
= 5 orders/year
TCmin = $750 + $750 = $1,500

Order cycle time = 311 days/(D/Qopt)
= 311/5
= 62.2 store days
13-20
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Production Quantity Model

Order is received gradually, as inventory is
simultaneously being depleted
AKA non-instantaneous receipt model
assumption that Q is received all at once is relaxed
p - daily rate at which an order is received over

time, a.k.a. production rate
d - daily rate at which inventory is demanded
13-21

Inventory
level
Q(1-d/p)
Maximum
inventory
level
Q
(1-d/p)
2
Average
inventory
level
0
Order
receipt period
Begin
End
order order
receipt receipt
Time
13-22
11
12/1/2015

p = production rate
d = demand rate
Maximum inventory level = Q - Q d

p
=Q1- d
p
Q
12
Average inventory level =
TC =
2CoD
Qopt =
d
p
Cc 1 -
d
p
CoD CcQ
d
Q + 2 1- p
13-23

Cc = $0.75 per gallon
Co = $150
d = 10,000/311 = 32.2 gallons per day
2CoD
Qopt =
TC =
2(150)(10,000)
Cc 1 - d
p
CoD CcQ
d
Q + 2 1- p
Production run =
D = 10,000 gallons
p = 150 gallons per day
0.75 1 -
32.2
150
= 2,256.8 gallons
= $1,329
2,256.8
Q
=
= 15.05 days per order
150
p
13-24
12
12/1/2015

Number of production runs =
10,000
D
=
= 4.43 runs/year
2,256.8
Q
Maximum inventory level = Q 1 -
d
p
= 2,256.8 1 -
32.2
150
= 1,772 gallons
13-25
Solution of EOQ Models With Excel
The optimal order

size, Q, in cell D8
13-26
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12/1/2015
Solution of EOQ Models With Excel
The formula for Q

in cell D10
=(D4*D5/D10)+(D3*D10/2)*(1-(D7/D8))
=D10*(1-(D7/D8))
13-27
Solution of EOQ Models With OM Tools
13-28
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Quantity Discounts
Price per unit decreases as order
quantity increases
TC =
CoD
CcQ
+
+ PD
Q
2
where
P = per unit price of the item
D = annual demand
13-29
Quantity Discount Model

ORDER SIZE
0 - 99
100 199
200+
PRICE
$10
8 (d1)
6 (d2)
TC = ($10 )
TC (d1 = $8 )
Inventory cost ($)
TC (d2 = $6 )
Carrying cost
Ordering cost
Q(d1 ) = 100 Qopt
Q(d2 ) = 200
13-30
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12/1/2015
Quantity Discount
QUANTITY
PRICE
1 - 49
50 - 89
90+
$1,400
1,100
900
Qopt =
2CoD
=
Cc
For Q = 72.5
Co = $2,500
Cc = $190 per TV
D = 200 TVs per year
2(2500)(200)
= 72.5 TVs
190
TC =
CcQopt
CoD
+
2 + PD = $233,784
Qopt
TC =
CcQ
CoD
+ 2 + PD = $194,105
Q
For Q = 90
13-31
Quantity Discount Model With Excel
=IF(D10>B10,D10,B10)
=(D4*D5/E10)+(D3*E10/2)+C10*D5
13-32
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12/1/2015
Reorder Point
Inventory level at which a new order is placed
R = dL
where
d = demand rate per period
L = lead time
13-33
Reorder Point
Demand = 10,000 gallons/year
Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154
gallons/day
Lead time = L = 10 days
R = dL = (32.154)(10) = 321.54 gallons
13-34
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12/1/2015
Safety Stock
Safety stock
buffer added to on hand inventory during lead time
Stockout
an inventory shortage
Service level
probability that the inventory available during lead
time will meet demand
P(Demand during lead time <= Reorder Point)
13-35
Inventory level
Variable Demand With Reorder Point

Q
Reorder
point, R
0
LT
LT
Time
13-36
18
12/1/2015
Inventory level
Reorder Point With Safety Stock
Reorder
point, R
Safety Stock
0
LT
Time
LT
13-37
Reorder Point With Variable Demand

R = dL + zd L
where
d = average daily demand
L = lead time
d = the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
probability
zd L = safety stock
13-38
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12/1/2015
Reorder Point For a Service Level

Probability of
meeting demand during
lead time = service level
Probability of
a stockout
Safety stock
zd L
dL
Demand
13-39
Reorder Point For Variable Demand

The paint store wants a reorder point with a 95%
service level and a 5% stockout probability
d = 30 gallons per day
L = 10 days
d = 5 gallons per day
For a 95% service level, z = 1.65
R = dL + z d L
Safety stock = z d L
= 30(10) + (1.65)(5)( 10)
= (1.65)(5)( 10)
= 326.1 gallons
= 26.1 gallons
13-40
20
12/1/2015
Determining Reorder Point with Excel
The reorder point

formula in cell E7
13-41
Order Quantity for a

Periodic Inventory System
Q = d(tb + L) + zd
tb + L - I
where
d
tb
L
d
zd
= average demand rate

= the fixed time between orders
= lead time
= standard deviation of demand
tb + L = safety stock
I = inventory level
13-42
21
12/1/2015
Periodic Inventory System
13-43
Fixed-Period Model With

Variable Demand
d
d
tb
L
I
z
= 6 packages per day

= 1.2 packages
= 60 days
= 5 days
= 8 packages
= 1.65 (for a 95% service level)
Q = d(tb + L) + zd
tb + L - I
= (6)(60 + 5) + (1.65)(1.2)
60 + 5 - 8
= 397.96 packages
13-44
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12/1/2015
Fixed-Period Model with Excel
Formula for order

size, Q, in cell D10
13-45

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information herein.
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12/1/2015

Copyright 2011 John Wiley & Sons, Inc.

Supply Chain Management

Seasonal or cyclical demand

Copyright 2011 John Wiley & Sons, Inc.

Quality Management in the Supply Chain

Copyright 2011 John Wiley & Sons, Inc.

Copyright 2011 John Wiley & Sons, Inc.

Two Forms of Demand

Copyright 2011 John Wiley & Sons, Inc.

Copyright 2011 John Wiley & Sons, Inc.

Inventory Control Systems

Periodic system (fixed-time-period)

Copyright 2011 John Wiley & Sons, Inc.

Copyright 2011 John Wiley & Sons, Inc.

Copyright 2011 John Wiley & Sons, Inc.

Economic Order Quantity

Basic EOQ model

Copyright 2011 John Wiley & Sons, Inc.

Assumptions of Basic EOQ Model

Copyright 2011 John Wiley & Sons, Inc.

Inventory Order Cycle

Copyright 2011 John Wiley & Sons, Inc.

EOQ Cost Model

Annual ordering cost =

Annual carrying cost =

Copyright 2011 John Wiley & Sons, Inc.

EOQ Cost Model

Copyright 2011 John Wiley & Sons, Inc.

EOQ Cost Model

Copyright 2011 John Wiley & Sons, Inc.

Qopt = 2,000 gallons

TCmin = $750 + $750 = $1,500

Production Quantity Model

p - daily rate at which an order is received over

Copyright 2011 John Wiley & Sons, Inc.

Production Quantity Model

Copyright 2011 John Wiley & Sons, Inc.

Production Quantity Model

Maximum inventory level = Q - Q d

Average inventory level =

Copyright 2011 John Wiley & Sons, Inc.

Production Quantity Model

Copyright 2011 John Wiley & Sons, Inc.

Production Quantity Model

Maximum inventory level = Q 1 -

Copyright 2011 John Wiley & Sons, Inc.

Solution of EOQ Models With Excel

The optimal order

Copyright 2011 John Wiley & Sons, Inc.

Solution of EOQ Models With Excel

The formula for Q

Copyright 2011 John Wiley & Sons, Inc.

Solution of EOQ Models With OM Tools

Copyright 2011 John Wiley & Sons, Inc.

Copyright 2011 John Wiley & Sons, Inc.

Quantity Discount Model

Inventory cost ($)