INVENTORY MANAGEMENT

Reference Text:

■ Chapter 13: Inventory Management

– William Stevenson, Operations Management — 13th ed., McGraw Hill
Education, NY
 Defining Inventory

▪ Inventory is an array of raw materials, partially finished goods, finished goods (both, in-
stock & in-transit).

▪ Inventory can include small things (such as safety pins) to large items (such as trucks
and airplanes).
Different Types of Inventory
The different kinds of inventories include :

■ Raw materials and purchased parts.

■ Partially completed goods, called work-in-process (WIP).

■ Finished-goods inventories (manufacturing firms) or merchandise (retail stores).

■ Maintenance, repairs & overhauling (MRO) inventory.

■ Goods-in-transit to warehouses, distributors, or customers (pipeline inventory).

Importance of Inventories
Why is it important to pay attention at Inventory Management ?

• Inventory requires proper allocation of space (e.g. stores and warehouses).

• Inventory may be perishable such a fruits and vegetables
• Inventory may be critical for saving life (such as drugs supplies and blood banks)
• Inventory requires a substantial investments in working capital
 Functions of Inventory
1. To satisfy the ‘anticipated demand’
2. To smooth production in ‘seasonal demands’
3. To insulate production from disruption (of supplies) -
Maintain Buffer inventory
4. To reduce the risk of stock outs (sudden rise in demand)
– Maintain Safety stocks
5. To take advantage of the order cycles Little’s law (to quantify the pipeline inventory):
6. To take advantage of quantity discounts
Pipeline inventory in a system =
7. To hedge against price increases Average rate at with inventory leaves the
system (i.e. Avg. demand) * Average time a
8. To permit operations – WIP unit is in the system.
 Inventory Costs
■ Unit cost :
– The amount paid to buy an inventory
■ Holding/Carrying cost for a length of time
– Includes insurances, taxes, depreciation, obsolescence, deterioration, tracking cost, picking
and warehousing cost, etc.
■ Ordering Cost
– Cost of ordering and receiving an inventory
– Includes preparing invoices, quality inspections, temporary storage of received items etc.
■ Set-Up Cost
– When a firm produces its own inventory instead of ordering it from a supplier
– Includes setting up the equipment for the job by adjusting the machine, changing tools etc.
■ Shortage Cost
– Result when demand exceeds the supply of inventory on hand.
– Includes opportunity cost, loss of customer goodwill, late charges etc.
 Inventory Management Tasks
■ Fundamental tasks:

1. Record Keeping
■ Have reasonable estimates of inventory holding costs, ordering cost, and shortage costs

2. Decide when and how much to order (Ordering Policy)

■ Have a reliable forecast of the demand Lead time: The time between ordering a
■ Be aware of your lead time good or service and receiving it.
■ Know your lead time and variability in lead times
■ Have an inventory classification system (e.g., ABC classification)

3. Measuring the performance of inventory management

Inventory Turnover = COGS (i.e. cost of goods sold)/Avg Inventory Cost
 Inventory Counting Systems
■ Periodic Systems
– Counting weekly, monthly etc. in order to decide how much to
order of each item
– Seasonal inventory count- e.g., in clothing business

■ Perpetual inventory system (Continuous review system)

– Keeps track of removals from inventory on a continuous basis,
When the amount on hand reaches a predetermined minimum, a
fixed quantity, Q, is ordered
– Uses UPC/bar codes & RFID Codes
■ Increases speed and accuracy of real time demand information
■ Reduce the need of periodic review and order size determination
 Inventory Classification
A B C Classification:
A firm holds a large variety of inventory items or stock keeping units (SKUs), each of which may have
different value and annual consumption. Applying same degree of control on all the items is not
desirable.

• High Value Inventory Items:

• Generally consists of 10-20% of SKUs
• 60%-70% of annual dollar spend

• Moderate Value Inventory Items

• Generally consists of 20-30% of SKUs
• 40%-50% of annual dollar spend

• Low Value Inventory Items:

• Generally consists of 60-70% of SKUs
• 10%-15% of annual dollar spend
 Steps to perform ABC analysis:
Dollar
Item Unit Cost Usage Usage Category
The table contains figures on the monthly volume and unit costs for a
K34 10 200 2,000 C
random sample of 15 items for a list of 2,000 inventory items.
K35 25 600 15,000 A
K36 36 150 5,400 B
M10 16 25 400 C
M20 20 80 1,600 C
1. For each item, multiply annual volume by unit price to get the
Z45 80 250 16,000 A
annual dollar value.
F14 20 300 6,000 B
F95 30 800 24,000 2. Arrange
A annual dollar values in descending order.
F99 20 60 1,200 C
3. The few (10 to 20 percent) with the highest annual dollar
D45 10 550 5,500 B
value are A items. The most (about 20 to 30 percent) with the
D48 12 90 1,080 C
lowest annual dollar value are B items. Those in between
D52 15 110 1,650 C
(about 50-70 percent) are C items.
D57 40 120 4,800 B
N08 30 40 1,200 C
P05 16 500 8,000 B
P09 10 30 300 C
(SKUs) Dollar Dollar
Item Unit Cost Usage Usage Category Item Unit Cost Usage Usage Category
K34 10 200 2,000 C K34 10 200 2,000 C
K35 25 600 15,000 A K35 25 600 15,000 A
K36 36 150 5,400 B K36 36 150 5,400 B
M10 16 25 400 C M10 16 25 400 C
M20 20 80 1,600 C M20 20 80 1,600 C
Z45 80 250 16,000 A Z45 80 250 16,000 A
F14 20 300 6,000 B F14 20 300 6,000 B
F95 30 800 24,000 A F95 30 800 24,000 A
F99 20 60 1,200 C F99 20 60 1,200 C
D45 10 550 5,500 B D45 10 550 5,500 B
D48 12 90 1,080 C D48 12 90 1,080 C
D52 15 110 1,650 C D52 15 110 1,650 C
D57 40 120 4,800 B D57 40 120 4,800 B
N08 30 40 1,200 C N08 30 40 1,200 C
P05 16 500 8,000 B P05 16 500 8,000 B
P09 10 30 300 C P09 10 30 300 C
 Inventory Ordering Policies
■ The Scenario:

You are managing a particular item. The item is important enough to your customers that you want to
carry enough inventory to avoid stocking out. However, the item is also expensive enough that you also
want to minimize the amount of cash tied up in inventory. The process of ordering replenishment stock
is expensive and cumbersome that you also want to minimize the number of purchase orders. You also
have a limited space in your organization to store the items. Demand for the item is unpredictable.

Key Inventory Management Decisions :

1. What quantity of inventory should you order?

2. What is the appropriate time to order ?
Economic Order Quantity (EOQ)

■ Economic (Optimal) order quantity is calculated by

minimizing the annual costs that vary with order size and
order frequency

■ It is used to identify a fixed order size that will minimize the

sum of the annual costs of holding inventory and ordering
inventory.
Inventory Profile Over Time (Inventory Cycle)
✓ A cycle begins with receipt of an order of Q (=350) units, which are
withdrawn at a constant rate (50 units per day) over time.

✓ When the quantity on hand is just sufficient to satisfy demand during

lead time, an order for Q units is submitted to the supplier.

Average Inventory
= Q/2 =175
 Basic EOQ Model
Assumptions:
– Annual demand is known and demand rate is
constant
– Inventory ordering and usage occur in cycles.
– Ordering costs are constant
– Price per unit is constant
– The usage rate and the lead time do not vary
– The order will be received at the precise instant that
the inventory on hand falls to zero
– Inventory holding cost is based on average inventory
– All demand for the product will be satisfied (i.e., no
backorders are allowed)
– There are no quantity discounts
Order Size Vs Order Frequency
Order Size is Inversely Proportional to Order Frequency

Q1

Inventory
Average
Q1/2

Q2

Inventory

Q2/2
Average
 Basic EOQ Model
Identify a fixed order size that minimizes the annual inventory
ordering cost and carrying cost

■ The two main cost components are involved –

– Inventory Carrying cost

– Ordering Cost
Basic EOQ Model
Let’s assume that Q is the periodic order quantity and H is the annual inventory carrying cost per unit

Inventory Carrying Cost (Annual) = Carrying cost * Average Inventory = H * Q/2

Where, Average Inventory =

(Beginning Inventory + Ending Inventory) / 2
= (Q+0) /2 = Q/2
Basic EOQ Model

Ordering Cost

■ If D is the annual demand, and Q is the order size,

– number of orders will be D/Q
■ Ordering cost is treated as a constant per order
■ If S is the ordering cost/order,
– Total Ordering Cost = S * D/Q
Total Cost Curve

Carrying Cost

Ordering Cost

Length of order cycle = Q0/D

Flexibility in EOQ
 Length of Order Cycle
= thrice a month

Total annual cost of ordering and

carrying inventory
Cost Components in EOQ & TC
Impact of Unit Price (or Purchase Cost) on EOQ

Assumptions:
– Annual demand is known and demand rate is constant
– Inventory ordering and usage occur in cycles.
– Ordering costs are constant
– Price per unit is constant What if we relaxing this assumption of the basic EOQ Model ?
– The usage rate and the lead time do not vary
– The order will be received at the precise instant that the inventory on hand falls to zero
– Inventory holding cost is based on average inventory
– All demand for the product will be satisfied (i.e., no backorders are allowed)
– There are no quantity discounts
■ Given: Annual Demand (D) = 1000 units

Ordering Cost (S) = $5 per order

Holding Cost (H) = $1.25 per unit per year
Cost per unit (C) = $ 12.50
Lead Time (L) = 5 days
Reorder Point (ROP)= Avg. Daily Demand*L
Find:
1) EOQ,
Average Daily demand (d)= 1000/365 = 2.74 units
2) Total Inventory Cost (Annual) and
3) Reorder point,
ROP = (1000/365)*5 = 13.7 units

Total Inventory cost (TC)

= Annual Purchasing Cost + Carrying Cost + Ordering Cost
Q0 = √ [(2*1000*12.50)/1.25] = P*D + (Q0/2)H + (D/Q0)*S
= 89.4 units ~ 89 units
= 1000*12.50 + (89/2)*1.25 + (1000/89)*5
= $12,611.80
Impact of Unit Price (or Purchase Cost) on EOQ

Purchase cost
 Quantity Discounts

■ Determination of EOQ does not involve the purchasing cost because of the assumption that
under no quantity discounts, price per unit is the same for all order sizes.

■ If quantity discounts are available, Manager must think of the following concerns:
– Availability of storage space for additional items
– Issue of obsolescence and deterioration
– Availability of fund to invest in additional inventory
 Quantity Discounts
■ When quantity discounts are offered, there is a
separate U-shaped total-cost curve for each unit
price. Each curve will apply to a portion of the
range.

■ Including unit prices merely shifts each curve by

a constant amount.

■ Even though each curve has a minimum, those

points are not necessarily feasible to obtain the
EOQ.

■ The result is a total-cost curve with steps at the

price breaks.
 Determining the optimal order quantity when there are :
1. Quantity discounts &
2. Carrying Costs are Constant

Given: D = 816 cases per year; S = $12; H = $4 per case per year
Given: D = 816 cases per year; S = $12; H = $4 per case per year

Optimal Order Quantity =

100 cases

Total Cost = $13,354

 Determining the optimal order quantity when there are :
1. Quantity discounts &
2. Carrying costs are expressed as a percentage of price

Given: D = 4000 switches per year; S = $30; H = 0.4P

Given: D = 4000 switches per year; S = $30; H = 0.4P

Feasible ??

Optimal Order
Quantity = 840
Total Cost = $3686