Chapter 12: Inventory Management

1. The Importance of Inventory Management.

• Most expensive asset of a company.
• Can reduce cost by reducing inventory.
• Objective: Strike a balance between inventory investment and
costumer service.
• Low cost strategy without inventory management is impossible.
• Functions of inventory
▪ To provide a selection of goods for anticipated costumer
demand.
• Retail establishments.
▪ To separate various parts of the production process.
• Extra inventory may be necessary to separate production
process from suppliers.
▪ To take advantage of quantity discounts.
• Purchase in large quantity may reduce costs of goods.
▪ Hedge against inflation.
• Types of Inventories
▪ Each firm must have the four types of inventories.
• Raw Material Inventory
▪ Material that has been purchased by not proceeded.
▪ Separate supplier from production process.
• Work-In-Process (WIP) Inventory.
▪ Raw material that have gone through some change
but are not complete yet.
▪ Exists only because of the flowtime (time for a
product to be made.)
▪ Reducing flowtime reduces this inventory.
• Maintenance-Repair-Operating (MRO) Inventory
▪ Everything necessary to keep machines productive.
 • Finished-Goods Inventories
▪ Completed products awaiting shipment.
▪ May be stored because future costumer demand is
unknown.
2. Managing Inventory
• ABC Analysis
▪ Divides on-hand inventory into three classifications on basic of
annual dollar value.
▪ Application of the Pareto Principle.
• Critical few and trivial many.
• Establishes policies that focus on the critical few rather
than the trivial many.
• Unrealistic to monitor inexpensive items as much as
expensive items.
▪ To determine the annual dollar volume using the ABC method,
we compute the following
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑜𝑙𝑙𝑎𝑟 𝑉𝑜𝑙𝑢𝑚𝑒 = 𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑 ∗ 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
▪ Divide items into three classes.
• Classes A
▪ Annual dollar volume is the highest.
▪ Represent about 15% of total items.
▪ 70-80% of annual dollar volume.
• Class B
▪ Medium annual dollar volume.
▪ Represent about 30% of inventory.
▪ 15-25% of annual dollar volume.
• Class C
▪ Annual dollar volume is the lowest.
▪ Represent about 55% of inventory.
▪ 5% of annual dollar volume.
 ▪ Calculation would look something like the following.

▪ Other criteria can determine classification.

• High shortage
• Holding cost
• Anticipated engineering changes.
• Delivery problems
• Quality problems
▪ Policies that may be based on ABC analysis include
• Purchasing resources expended on supplier development
should be much higher for individual A items than C
items.
• A items should have tighter physical control than B and
C items.
• A items should belong in a more secure area than B and
C items.
• Forecasting A items may warrant more care than
forecasting other items.
• Record Accuracy (Check Chapter 6 of ACCT 210)
▪ Prerequisite to inventory management, production scheduling,
and sales.
▪ Can be maintained with perpetual or periodic systems.
• Periodic System
 ▪ Requires regular checks to determine the quantity
on hand.
▪ Small retailers use the periodic system.
▪ Downside is the lack of control between reviews
and necessity.
▪ Variation: Two-Bin System
• Manager sets two containers
• Place order when first container is empty.
• Adequate inventory is calculated.
• Perpetual Inventory
▪ Tracks changes in inventory on continual basis.
▪ Receipts are noted in the receiving department.
▪ Both systems require outgoing record keeping and security.
• Cycle Counting
▪ Cycle counting: records must be verified through continuing
audits.
▪ Historically, companies perform physical inventories.
• Not very good.
• Use cycle counting instead.
▪ Cycle counting uses inventory classification developed in ABC
analysis.
• Items are counted and records are verified.
• Inaccuracies are documented.
• Cause of inaccuracy is traced back to origin.
• Action is taken to remediate the inaccuracy.
• Counting of items.
▪ Class A will be counted frequently (every month)
▪ Class B will be counted less frequently (every
quarter).
▪ Class C will be counted the least frequently (every
half of a year).
• Cycle counting has the following advantages
▪ Eliminate shutdown and interruptions of
production necessary for annual physical
inventories.
▪ Eliminate annual inventory adjustments.
 ▪ Trained personnel audit accuracy of inventory.
▪ Allows causes of errors to be identified. Remedial
action can be taken.
▪ Maintains accurate inventory records.
• Control of Service Inventories.
▪ Common misconception is that service sectors don’t have
inventories.
▪ Inventory that is in transit or idle is lost value.
▪ Shrinkage: the inventory that is stolen or damaged, occurring
from damage or theft.
▪ Inventory control is critical, and can be achieved in the few
following ways
• Good personnel selection, personnel and discipline.
▪ Necessary.
• Tight control of incoming shipments.
▪ Universal postal codes and radio frequency ID
▪ Read at every incoming shipment.
• Effective control of all goods leaving the facility.
▪ Bar codes, RFID tags, magnetic strips and direct
observations.
3. Inventory Models
• Independent vs. Dependent Demand
▪ Assume that demand is either dependent or independent on the
demand of the item.
▪ Example: demand of refrigerators is independent from the
demand of toaster ovens.
▪ Demand for toaster oven components is dependent on
requirements on toaster ovens.
• Holding, Ordering and Setup Cost
▪ Holding cost
• Costs associated with holding inventory over time.
• Includes insurance, extra staffing and interest payments.
• Inventory holding costs are often understated.
▪ Ordering cost
• Cost of supplies, purchasing and so forth.
 • When products are being manufactured, ordering costs
also exist.
▪ However, they are part of setup costs.
▪ Setup cost
• Cost to prepare the machine.
• Includes time to clean and change gears in a machine.
• Managers can lower ordering costs by reducing setup
costs.
• Highly related to setup time
▪ Time required to prepare a machine for work.
▪ Constantly improving with technological
improvements.
4. Inventory Models For Independent Demand
• The Basic Economic Order Quantity (EOQ) Model
▪ Most used inventory control techniques.
▪ Several assumptions for technique to work.
• Demand for an item is known, constant and independent
of decisions for other items.
• Lead time (Placement between placement and receipt of
order) is known and constant.
• Receipt of inventory is instantaneous and complete
(arrives one batch at the time).
• Quantity discount is impossible.
• Only variable cost are cost of setting up and placing an
order, and the cost of holding inventory over time.
• Stockout can be avoided if orders are placed at the right
time.
▪ The graph of inventory usage over time will look like this.
 ▪ Inventory increases from 0 to Q units (here 500) when inventory
arrives.
▪ Demand is constant so inventory drops at a constant and uniform
rate over time.
▪ When inventory is received, the inventory jumps back to Q units.
• Minimizing Cost
▪ Objective of most inventory models is to minimize cost.
▪ Significant costs: Ordering (setup) and holding cost.
• All other costs are constant.
• Minimize both costs and we will minimize all costs.
▪ Q* is the optimal ordering quantity that minimizes cost.
▪ When Q increases, the total orders placed in a year will decrease.
• When Q increases, the annual ordering cost will decrease.
• When Q increases, the holding cost will increase.

▪ Reduction in either cost will reduce total cost curve.

▪ Optimal order quantity point Q*
• Occurs when ordering cost curve interests the holding
cost curve.
• This is not by chance.
• It will help create a formula to find Q*.
▪ The formulas derived are the following.
• Consider the following abbreviations.
Q= Number of Units per order.
Q*= Optimal number of units per order (EOQ).
D= Annual demand in units for inventory item.
S= Setup (Ordering) cost for each order.
H= Holding cost per unit per year.

• (All demonstrations are in the book in Chapter 12 starting

page 530.)
𝐷
𝐴𝑛𝑢𝑎𝑙 𝑆𝑒𝑡𝑢𝑝 𝐶𝑜𝑠𝑡 = ( ) 𝑆
𝑄
𝑄
𝐴𝑛𝑢𝑎𝑙 𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = ( ) 𝐻
2
2𝐷𝑆
𝑄∗ = √
𝐻
• We can also determine
N= Expected number of orders during a year.
T= Expected time between orders.

• (All demonstrations are in the book in Chapter 12 starting

page 530.)
𝐷
𝑁= ∗
𝑄
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
𝑇=
𝑁

• We can also compute the total cost (Holding cost +

ordering cost).
𝐷 𝑄
𝑇𝐶 = ( ) 𝑆 + ( ) 𝐻
𝑄 2
▪ Robust Model
• Benefit of the EOQ is that it is robust.
 • Even if there is some change in the parameters, it still
gives us satisfactory answers.
• Accurate ordering costs can be hard.
• Result change a little in the neighborhood of the
minimum.
▪ Re-Ordering Point (ROP)
• Second question: When to order or reorder?
• Assumption (previously made): receipt of order is
instantaneous. This means that
▪ Firm will place an order when inventory level
reaches 0.
▪ It will receive the order immediately.

• Need to consider lead time: time between placing an order

and receiving the order.
• Hence, we calculate ROP (re-ordering point) to know
when to place an order.
 • New variables are
ROP= Re-Order Point.
d= demand per day.
L= lead time.

• ROP is calculated using the following.

𝑅𝑂𝑃 = 𝑑 ∗ 𝐿
𝐷
𝑑=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
• This model works when the demand in the lead time
period is known and constant.
▪ If it is not the case, companies keep a safety stock.
• Production Order Quantity Model
▪ Case: the firm receives its inventory over a period of time (rather
than received at the same time like in the previous model.)
▪ Two situations
• Inventory continuously builds up over a period of time.
• Units are produced and sold simultaneously.
▪ In this case we take into considerations 2 other variables
• Daily production rate.
• Daily demand rate.
▪ Suitable for production environment.
 Q= Number of Units per order.
H= Holding cost per unit year.
p= Daily production rate.
d= Daily demand rate.
t= Length of the production run in days.
▪ The following formulas can be derived
𝑄
𝑡=
𝑝
𝑑
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐿𝑒𝑣𝑒𝑙 = 𝑄(1 − )
𝑝
𝐷
𝑆𝑒𝑡𝑢𝑝 𝐶𝑜𝑠𝑡 = ( ) 𝑆
𝑄
1 𝑑
𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = 𝐻𝑄[1 − ]
2 𝑝
2𝐷𝑆
𝑄∗ = √
𝑑
𝐻(1 − )
𝑝
• Quantity Discount Model
▪ Found everywhere.
• Most companies offer or receive quantity discounts.
▪ Quantity discount is a reduction in price (P) for an item when it
is purchased in large amounts.
▪ An example of quantity discount.

▪ In the table, 120 and 1500 are called price-break quantities, since
they are the first quantity that would lead to a lower price.
▪ Greatest discount may not minimize total cost, and minimizing
total cost is the objective.
• This is due to the fact that holding cost increase.
 • Need to find equilibrium between holding and ordering
cost.
• Total annual cost is calculated as follows
Q= Number of Units per order.
D= Annual demand in units
S= Ordering (Setup) cost
P= Purchase price per unit
I= Holding cost per unit per year as a percentage of price P
𝐷 𝑄
𝑇𝐶 = 𝑆 + 𝐼𝑃 + 𝑃𝐷
𝑄 2
• IP instead of H (From EOQ model)
▪ Price of item is a factor of annual holding cost.
▪ Do not assume holding cost will be constant.
▪ Express holding cost as a percentage (I) of unit price
(P).
• The modified Q* forumla is the following

2𝐷𝑆
𝑄∗ = √
𝐼𝑃

• Concept of feasible EOQ

▪ An EOQ is only feasabile if it lies in the range of
quantity that leads to the same price P used to
compute the Q* equation.
▪ Example (use previouly pasted table for reference):
Suppose D= 5,200 units, S= $200 and I=28%
• If we use P=$96, Q*= 278 units, which is
below 1,500, hence it cannot be done.
• If we use P= $98, Q*= 275, which is between
120 and 1,499.
▪ Solution happens in two steps in the problem.
• Step 1: Identify all possible order quantities.
▪ Start with lowest price and work your way to the
highest.
▪ Keep calculating Q* until feasible EOQ is found.
▪ If EOQ is infeasible, take its value to the smallest
possible value. (ex. Take it in the previous example
to be 1500.)
• Step 2: Calculate TC for each.
▪ Select quantity with the lowest TC.
▪ Note: After finding the first feasible EOQ, there is no need to
compute for any P that is higher since it I guaranteed to lead to a
higher TC at the end.
▪ There is many forms of discounts that can be given, such as buy-
one-get-one free, truckload discounts,…
5. Probabilistic Models and Safety Stock
• The tree previous inventory models assume that demand for a product
is certain and constant.
• In the following model, we assume demand is unknown, but can be
specified according to probability distribution.
• These are the most realistic models.
• Management needs to maintain an adequate level of service in the face
of uncertainty.
• Service level: probability that the demand will not be greater than
supply, resulting in a stockout.
• Uncertain demand raises the probability of a stockout.
▪ One method to avoid stocking out is the keep extra items in an
inventory.
▪ This extra inventory is called safety stock (ss).
𝑅𝑂𝑃 = 𝑑 ∗ 𝐿 + 𝑠𝑠
▪ Amount of safety stock maintained depends on cost of incurring
a stockout and cost of holding extra inventory.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑆𝑡𝑜𝑐𝑘𝑜𝑢𝑡 𝐶𝑜𝑠𝑡
= 𝑆𝑢𝑚 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑠ℎ𝑜𝑟𝑡 𝑓𝑜𝑟 𝑒𝑎𝑐ℎ 𝑑𝑒𝑚𝑎𝑛𝑑 𝑙𝑒𝑣𝑒𝑙
∗ 𝑝𝑟𝑜𝑏𝑎𝑏𝑙𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑎𝑡 𝑑𝑒𝑚𝑎𝑛𝑑 𝑙𝑒𝑣𝑒𝑙
∗ 𝑠𝑡𝑜𝑐𝑘𝑜𝑢𝑡 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 ∗ 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑒𝑟𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟.

• Example:
▪ Objective: find the amount of safety stock that minimizes the
sum of additional inventory holding costs and stockout costs.
▪ For every level of safety stock, stockout cost is the cost that is
expected to go out of stock.
• Formula already mentioned above.
• Number of items short = Demand – ROP.
▪ Begin by looking at 0 safety stock.
• If demand is 60, shortage of 10 frames will occur (60-50)
• If demand is 70, shortage of 20 frames will occur (70-50)
• Hence, the stockout cost at 0 is
▪ 10 frames * 0.2 * $40 per stockout * 6 possible
stockouts per year + 20 frames * 0.1 * $40 * 6.
• Following table summarizes the annual stockout costs

▪ The stockout cost can be hard to calculate: in this case, managers

might choose to keep enough stock on hand to meet the demand.
▪ Managers usually define service level as meeting 95% of the
demand (or having a 5% chance of stockout).
▪ We assume that demand during lead time follows a normal curve.
• In this case, only the mean (µ) and standard deviation (σ)
are needed to define the inventory requirements.
 ▪ For a 95% service level, we use the following formula
Z= Number of Standard Deviations.
𝜎𝑑𝐿𝑇 = Standard Deviation of Demand during Lead time.
𝑅𝑂𝑃 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑒𝑚𝑎𝑛𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 + 𝑍 ∗ 𝜎𝑑𝐿𝑇
𝑆𝑎𝑓𝑒𝑡𝑦 𝑆𝑡𝑜𝑐𝑘 = 𝑍 ∗ 𝜎𝑑𝐿𝑇
▪ Example:

µ = Mean demand = 350 Kits

𝜎𝑑𝐿𝑇 = 10 kits
Z= Number of Standard Deviations.

• Hence the standard deviation curve would be

• Other Probability Models
▪ The previous assumes that both expected demand and standard
deviation are available during the lead time.
▪ When this data is not available, these formulas can’t be applied.
 ▪ Three other models can be applied to solve this.
• Demand is Variable and Lead Time is Constant.
▪ When only the demand is variable then
𝑅𝑂𝑃 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐷𝑒𝑚𝑎𝑛𝑑 ∗ 𝐿𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑖𝑛 𝐷𝑎𝑦𝑠 + 𝑍 ∗ 𝜎𝑑𝐿𝑇
𝜎𝑑𝐿𝑇 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒
𝜎𝑑𝐿𝑇 = 𝜎𝑑 √𝐿𝑒𝑎𝑑 𝑡𝑖𝑚𝑒
𝜎𝑑 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦
• Lead time is Variable and Demand is Constant
▪ When only the lead time is variable
𝑅𝑂𝑃 = (𝐷𝑎𝑖𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑 ∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑑𝑎𝑦𝑠) + 𝑍
∗ 𝐷𝑎𝑖𝑙𝑦 𝐷𝑒𝑚𝑎𝑛𝑑 ∗ 𝜎𝐿𝑇
𝜎𝐿𝑇 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑖𝑛 𝑑𝑎𝑦𝑠
• Lead time and Demand are both variable
▪ Things get more complex here.
𝑅𝑂𝑃 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐷𝑒𝑚𝑎𝑛𝑑 ∗ 𝐿𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑖𝑛 𝐷𝑎𝑦𝑠 + 𝑍 ∗ 𝜎𝑑𝐿𝑇
𝜎𝐿𝑇 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑑𝑎𝑦𝑠
𝜎𝑑 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓𝑑𝑒𝑚𝑎𝑛𝑑 𝑖𝑛 𝑑𝑎𝑦𝑠
𝜎𝑑𝐿𝑇
= √(𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 ∗ 𝜎𝑑 2 ) + ((𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑)2 𝜎𝐿𝑇 2 )