Chapter 7:

Inventory Decision Making

Learning Objectives - After reading this
chapter, you should be able to do the following:

 Understand the fundamental differences

among approaches to managing inventory.
 Appreciate the rationale and logic behind the
Economic Order Quantity (EOQ) approach to
inventory decision making, and be able to
solve some problems of a relatively
straightforward nature.
 Understand alternative approaches to
managing inventory --- JIT, MRP, and DRP.
Learning Objectives
 Realize how variability in demand and order
cycle length affects inventory decision
making.
 Know how inventory will vary as the number
of stocking points decreases or increases.
 Recognize the contemporary interest in and
relevance of time-based approaches to
inventory management.
Learning Objectives
 Make needed adjustments to the basic EOQ
approach to respond to several special types
of applications.
Fundamental Approaches to
Managing Inventory
 Basic issues are simple…how much to order
and when to order.
 Additional issues are…where to store inventory
and what items to order.
 Traditionally, conflicts were usually present…as
customer service levels increased, investment
in inventory also increased.
 Recent emphasis is on increasing customer
service and reducing inventory investment.
Fundamental Approaches to
Managing Inventory
 Four factors might permit this apparent
paradox, that is, the firm can achieve higher
levels of customer service without actually
increasing inventory:
 More responsive order processing

 Ability to strategically manage logistics data

 More capable and reliable transportation

 Improvements in the location of inventory

Figure 7-1 Relationship between
Inventory and Customer Service Level
Key Differences among
Approaches to Managing Inventory
 Dependent versus Independent Demand
 Dependent demand is directly related to the

demand for another product.

 Independent demand is unrelated to the

demand for another product.

 For many manufacturing processes,

demand is dependent.
 For many end-use items, demand is

independent.
Key Differences among
Approaches to Managing Inventory
 Of the inventory management processes in
this chapter, JIT, MRP and MRPII are
generally associated with items having
dependent demand.
 Alternatively, DRP and the EOQ models are
generally associated with items exhibiting
independent demand.
Key Differences among
Approaches to Managing Inventory
 Pull versus Push
 Pull approach is a “reactive” system, relying

on customer demand to “pull” product

through a logistics system. MacDonald’s is
an example.
 Push approach is a “proactive” system, and

uses inventory replenishment to anticipate

future demand. Catering businesses are
examples of push systems.
Key Differences among
Approaches to Managing Inventory
 Pull versus Push
 Pull systems respond quickly to sudden or

abrupt changes in demand, involve one-way

communications, and apply more to
independent demand situations.
 Push systems use an orderly and disciplined

master plan for inventory management, and

apply more to dependent demand situations.
 On the Line:
American Cancer Society
 ACS constructed a world class automated order
fulfillment center in Atlanta.
 Order cycle time was reduced to five business
days.
 Centralized storage reduced waste and
obsolescence of educational materials.
 Centralized shipment reduced freight rates.
 The new center saved $8 million in the first year
alone.
 Fixed Order Quantity Approach
(Condition of Certainty): Inventory Cycles
 In this example, each cycle starts
with 4,000 units:
 Demand is constant at the rate of
800 units per day.
 When inventory falls below 1,500 units, an

order is placed for an additional 4,000 units.

 After 5 days the inventory is completely used.

 Just as the 4,000th unit is sold, the next order

of 4,000 units arrives and a new cycle begins.

Figure 7-2 Fixed Order Quantity
Model under the Condition of Certainty
Fixed Order Quantity Approach
(Condition of Certainty): Simple EOQ
Model
 Simple EOQ Model Assumptions
 Continuous, constant, known and infinite rate
of demand on one item of inventory.
 A constant and known replenishment time.
 Satisfaction of all demand.
 Constant cost, independent of order quantity
or time.
 No inventory in transit costs.
 No limits on capital availability.
Fixed Order Quantity Approach
(Condition of Certainty): Simple EOQ
Model
 Simple EOQ Model Variables
 R = annual rate of demand
 Q = quantity ordered (lot size in units)
 A = order or setup cost
 V = value or cost of one unit in dollars
 W = carrying cost per dollar value in percent
 S = VW = annual storage cost in $/unit per year
 t = time in days
 TAC = total annual costs in dollars per year
Figure 7-3
Inventory Carrying Cost
Figure 7-4
Order or Setup Cost
Figure 7-5
Inventory Costs
 Fixed Order Quantity Approach (Condition
of Certainty): Simple EOQ Model

TAC = QVW + AR or TAC = QS + AR

2 Q 2 Q

First term is the average carrying cost

Second term is order or setup costs per year

Figure 7-6
Sawtooth Model
 Fixed Order Quantity Approach (Condition
of Certainty): Simple EOQ Model

TAC = QVW + AR or TAC = QS + AR

2 Q 2 Q

Solving for Q gives the following expressions:

Q = √ 2 RA or Q = √ 2RA or Q = √ 2RA
VW or S VW S
 Fixed Order Quantity Approach
(Condition of Certainty): Simple EOQ
Model

Where R = 3600 units V = $100; W = 25%;

S (or VW)= $25; A = $200 per order

Q= √ 2 RA or Q= √ 2RA or Q= √ 2RA
VW or S VW S

√ 2*3600*$200 √ 2*3600*$200
$100*25% $25

Q = 240 units Q = 240 units

Figure 7-7
Sawtooth Models
Table 7-1
Total Costs for Various EOQ Amounts
Figure 7-8 Graphical Representation of
the EOQ Example
 Fixed Order Quantity Approach
(Condition of Certainty)
 Summary and Evaluation of the Fixed
Order Quantity Approach:
 EOQ is a popular inventory model.
 EOQ doesn’t handle multiple locations as well as a
single location.
 EOQ doesn’t do well when demand is not constant.
 Minor adjustments can be made to the basic model.
 Newer techniques will ultimately take the place of EOQ.
Fixed Order Quantity Approach
(Condition of Uncertainty)
 Uncertainty is a more normal condition.
 Demand is often affected by exogenous

factors---weather, forgetfulness, etc.

 Lead times often vary regardless of carrier

intentions.
 Examine out Figure 7-9.
 Note the variability in lead times and

demand.
Figure 7-9 Fixed Order Quantity Model
under Conditions of
Uncertainty
Fixed Order Quantity Approach
(Condition of Uncertainty)
 Reorder Point – A Special Note
 With uncertainty of demand, the reorder

point becomes the average daily demand

during lead time plus the safety stock.
 Examine Figure 7-9 again.
Fixed Order Quantity Approach
(Condition of Uncertainty)
 Uncertainty of Demand Affects Simple EOQ
Model Assumptions:
 a constant and known replenishment time.
 constant cost/price, independent of order
quantity or time.
 no inventory in transit costs.
 one item and no interaction among the
inventory items.
 infinite planning horizon.
 no limit on capital availability.
Table 7-2 Probability Distribution
of Demand during Lead Time
Demand Probability
100 units 0.01
110 0.06
120 0.24
130 0.38
140 0.24
150 0.06
160 0.01
 Table 7-3 Possible Units of Inventory
Short or in Excess during Lead Time with
Various Reorder Points

Actual Reorder Points

Demand 100 110 120 130 140 150 160

100 0 10 20 30 40 50 60
110 -10 0 10 20 30 40 50
120 -20 -10 0 10 20 30 40
130 -30 -20 -10 0 10 20 30
140 -40 -30 -20 -10 0 10 20
150 -50 -40 -30 -20 -10 0 10
160 -60 -50 -40 -30 -20 -10 0
 Table 7-3 Possible Units of Inventory
Short or in Excess during Lead Time with
Various Reorder Points
Reorder Points
Actual Proba-
Demand bility 100 110 120 130 140 150 160

100 0.01 0.0 0.1 0.2 0.3 0.4 0.5 0.6

110 0.06 -0.6 0 0.6 1.2 1.8 2.4 3.0
120 0.24 -4.8 -2.4 0 2.4 4.8 7.2 9.6
130 0.38 -11.4 -7.6 -3.8 0 3.8 7.6 11.4
140 0.24 -9.6 -7.2 -4.8 -2.4 0 2.4 4.8
150 0.06 -3.0 -2.4 -1.8 -1.2 -0.6 0 0.6
160 0.01 -0.6 -0.5 -0.4 -0.3 -0.2 -0.1 0
 Table 7-4 Calculation of Lowest-Cost Reorder Point

Dmnd 100 110 120 130 140 150 160

(e) 0.0 0.1 0.8 3.9 10.8 20.1 30.0

(VW) 0 $2.50 $20 $97.50 $270 $502.50 $750

(g) 30 20.1 10.8 3.9 0.8 0.1 0.0

G=gw $300 $201 $108 $39 $8 $1 $0

GR/Q $4500 $3015 $1620 $585 $120 $15 $0

TAC $4500 $3018 $1640 $682.50 $390 $517.50 $750

 Fixed Order Quantity Approach
(Condition of Certainty): Expanded EOQ
Model

Where R = 3600 units V = $100; W = 25%;

A = $200 per order; G = 8

Q= √ 2 R(A + G)
VW

√ 2 * 3600 * ($200 + 8)
$100 * 25%

Q = approximately 242 units

 Fixed Order Quantity Approach
(Condition of Certainty): Expanded EOQ
Model

Where R = 3600 units V = $100; W = 25%;

A = $200 per order; G = 8; Q = 242; e = 10.8
TAC = QVW + AR + eVW + GR
2 Q Q
TAC = (242*$100*25%) + (200*3600) + (10.8*$100*25%) + (8*3600)
2 242 242

TAC = $3025 + $2975 + $270 + $119

TAC = $6389 (New value for TAC when uncertainty introduced)

 Fixed Order Quantity Approach
(Condition of Uncertainty): Conclusions

 Following costs will rise to cover the uncertainty:

 Stockout costs.

 Inventory carrying costs of safety stock

 Results may or may not be significant.

 In text example, TAC rose $389 or

approximately 6.5%.
 The greater the dispersion of the probability

distribution, the greater the cost disparity.

Figure 7-10
Area under the Normal Curve
Table 7-5 Reorder Point Alternatives and
Stockout Possibilities
Fixed Order Interval Approach
 A second basic approach
 Involves ordering at fixed intervals and
varying Q depending upon the remaining
stock at the time the order is placed.
 Less monitoring than the basic model
 Examine Figure 7-11.
 Amount ordered over each five weeks in the
example varies each week.
Figure 7-11 Fixed Order Interval Model
(with Safety Stock)
 Summary and Evaluation of EOQ
Approaches to Inventory Management
 Four basic inventory models:
 Fixed quantity/fixed interval
 Fixed quantity/irregular interval
 Irregular quantity/fixed interval
 Irregular quantity/irregular interval
 Where demand and lead time are known,
basic EOQ or fixed order interval model best.
 If demand or lead time varies, then safety
stock model should be used
 Summary and Evaluation of EOQ
Approaches to Inventory Management
 Relationship to ABC analysis
 “A” items suited to a fixed quantity/irregular

interval approach.
 “C” items best suited to a irregular

quantity/fixed interval approach.

 Importance of trade-offs
 Familiarity with EOQ approaches assists the

manager in trade-offs inherent in inventory

management.
 Summary and Evaluation of EOQ
Approaches to Inventory Management
 New concepts
 JIT, MRP, MRPII, DRP, QR, and ECR also

take into account a knowledge and

understanding of applicable logistics trade-offs.
 Number of DCs
 The issue of inventory at multiple locations in a

logistics network raises some interesting

questions concerning the number of DCs, the
SKUs at each, and their strategic positioning.
Additional Approaches to
Inventory Management
 Three approaches to inventory management
that have special relevance to supply chain
management:
 JIT (Just in Time)

 MRP (Materials Requirements into

Planning)
 DRP (Distribution Resource Planning)
 Time-Based Approaches to
Replenishment Logistics: JIT
 Definition and Components of JIT Systems - designed
to manage lead times and eliminate waste.
 Kanban - refers to the informative signboards on

carts in a Toyota system of delivering parts to the

production line. Each signboard details the exact
quantities and necessary time of replenishment.
 JIT operations - Kanban cards and light warning

system communicate possible production

interruptions.
 Fundamental concepts - JIT can substantially

reduce inventory and related costs.

 Time-Based Approaches to
Replenishment Logistics: JIT
 Definition and Components of JIT Systems -
designed to manage lead times and eliminate
waste.
 Goal is zero inventory, and zero defects.

 Similarity to the two-bin system - one bin fills

demand for part, the other is used when the

first is empty.
 Reduces lead times through requiring small

and frequent replenishment.

Time-Based Approaches to
Replenishment Logistics: JIT
 JIT is a widely used and effective strategy for
managing the movement of parts, materials,
semi-finished products from points of supply
to production facilities.
 Product should arrive exactly when a firm
needs it, with no tolerance for early or late
deliveries.
 JIT systems place a high priority on short,
consistent lead times.
JIT versus EOQ Approaches to
Inventory Management
 Six major differences:
 First, JIT attempts to eliminate excess

inventories for both buyer and seller.

 Second, JIT systems involve short

production runs with frequent changeovers.

 Third, JIT minimizes waiting lines by

delivering goods when and where needed.

JIT versus EOQ Approaches to
Inventory Management
 Fourth, JIT uses short, consistent lead
times to satisfy inventory needs in a timely
manner.
 Fifth, JIT relies on high-quality incoming
products and on exceptionally high-quality
inbound logistics operations.
 Sixth, JIT requires a strong, mutual
commitment between buyer and seller,
emphasizing quality and win-win outcomes
for both partners.
Table 7-6 EOQ versus JIT Attitudes and
Behaviors
 Time-Based Approaches to
Replenishment Logistics: JIT
 JIT versus Traditional Inventory Management
 Reduces excess inventories

 Shorter, more frequent production runs

 Minimize waiting lines by delivering materials when

and where needed

 Short, consistent lead times through proximate

location
 Quality stressed throughout supply chain

 Win-win relationships necessary to a healthy supply

chain
Time-Based Approaches to
Replenishment Logistics: JIT
 Examples of JIT Successes:
 Apple Computer’s increase in IT from 10 weeks
to 2 weeks resulted in 18-month $20 million
payback on plant.
 GM increased production by 100%, but
inventories increased by only 6%.
 Norfolk Southern mini-train hauls direct from
one GM plant to another without switching
delays.
 Ryder handles all inbound logistics for Saturn.
Figure 7-12
The Orderly Pickup Concept
Time-Based Approaches to
Replenishment Logistics: MRP
 A Materials Requirements Planning (MRP)
system consists of a set of logically related
procedures, decision rules, and records
designed to translate a master production
schedule into time-phased net inventory
requirements for each component item
needed to implement this schedule.
 MRPs re-plan net requirements based on
changes in schedule, demand, etc.
 Time-Based Approaches to
Replenishment Logistics: MRP
 Goals of an MRP:
 Ensure the availability of materials,

components, and products for

planned production.
 Maintain lowest possible inventory level.
 Plan manufacturing activities, delivery

schedules, and purchasing activities.

Time-Based Approaches to
Replenishment Logistics: MRP
 Key elements of an MRP:
 Master production schedule

 Bill of materials file

 Inventory status file

 MRP program

 Outputs and reports

 Figure 7-13
An MRP System

Customer Orders Demand Forecasts

Master Production Schedule

Bill of Material File MRP Program Inventory Status File

Output and Reports

Figure 7-14 Relationship of Parts to
Finished Product: MRP Egg Timer Example

1 Egg Timer

2 Ends 1 Bulb 3 Supports

1 Gram of Sand
 Table 7-7 Inventory Status File:
MRP Egg Timer Example
Gross
Product Inventory Net Req. Lead Time
Req.
Egg Timers 1 0 1 1

Ends 2 0 2 5

Supports 3 2 1 1

Bulbs 1 0 1 1

Sand 1 0 1 4
Figure 7-15 Master Schedule: MRP
Egg Timer Example
Time-Based Approaches to
Replenishment Logistics: MRP
 Principal advantages of MRP:
 Maintain reasonable safety stock.

 Minimize or eliminate inventories.

 Identification of process problems.

 Production schedules based on actual

demand.
 Coordination of materials ordering.

 Most suitable for batch or intermittent

production schedules.
Time-Based Approaches to
Replenishment Logistics: MRP
 Principal shortcomings of MRP:
 Computer intensive.

 Difficult to make changes once operating.

 Ordering and transportation costs may rise.

 Not usually as sensitive to short-term

fluctuations in demand.
 Frequently become quite complex.

 May not work exactly as intended.

 Time-Based Approaches to
Replenishment Logistics: Distribution
Resource Planning
 MRP sets a master production schedule and
“explodes” into gross and net requirements.
 DRP starts with customer demand and works
backwards toward establishing a realistic
system-wide plan for ordering the necessary
finished products.
 Then DRP works to develop a time-phased
plan for distributing product from plants and
warehouses to the consumer.
 Time-Based Approaches to
Replenishment Logistics: Distribution
Resource Planning
 DRP develops a projection for each SKU and
requires17:
 Forecast of demand for each SKU.

 Current inventory level for each SKU.

 Target safety stock.

 Recommended replenishment quantity.

 Lead time for replenishment.

 Table 7-8 DRP Table for
Chicken Noodle Soup
Columbus Distribution Center–Distribution Resource Planning
Month January February March
Week 1 2 3 4 5 6 7 8 9
CN Soup Current BOH=4314; Q=3800; SS=1956; LT=1
Forecast 974 974 974 974 989 1002 1002 1002 1061

Schedule 0 0 3800 0 0 0 3800 0 0

Receipt
BOH-End 3340 2366 5192 4218 3229 2227 5025 4023 2962
Planned 0 3800 0 0 0 3800 0 0 3800
Order
Figure 7-16
Combining DRP Tables
Inventory at Multiple Locations –
The Square Root Law (SQL)
 Used to reduce inventory at multiple locations.
 As locations increase, inventory also
increases, but not in the same ratio as the
growth in facilities.
 The square root law (SRL) states that total
safety stock can be approximated by
multiplying the total inventory by the square
root of the number of future facilities divided by
the current number of facilities.
Inventory at Multiple Locations –
The Square Root Law

X 2 = (X 1 ) * √(n /n )
2 1

 Where:
 n = number of existing facilities
1

 n 2 = number of future facilities

 X 1 = total inventory in existing facilities
 X 2 = total inventory in future facilities
Square Root Law Example
 Current distribution 40,000 units
 Eight facilities shrinking to two
 Using the square root law:

X 2 = (40,000) * √(2/8)
 X 2 = 20,000 units
Table 7-9 Example Impacts of Square Root
Law on Logistics Inventories
Warehouses √n Total Av Inv % Change
1 1.0000 3,885 ---
2 1.4142 5,494 141%
3 1.7321 6,729 173%
4 2.0000 7,770 200%
5 2.2361 8,687 224%
10 3.1623 12,285 316%
15 3.8730 15,047 387%
20 4.4721 17,374 447%
23 4.7958 18,632 480%
25 5.0000 19,425 500%
Figure 7-17 Four Directions for
Replenishment Logistics
 Time-Based Approaches to
Replenishment Logistics: Quick
Response (QR)
 Structure of QR
 Shorter, compressed time horizons.

 Real-time information available by SKU.

 Seamless, integrated logistics networks

with rapid transportation, cross-docking

and effective store receipt and distribution
systems.
 Time-Based Approaches to
Replenishment Logistics: Quick
Response (QR)
 Structure of QR
 Partnership relationships present among

supply chain members.

 Redesign of manufacturing processes to

reduce lot sizes, changeover times and

enhanced flexibility.
 Commitment to TQM.
Figure 7-18
Basic Elements of Quick Response (QR)
 Time-Based Approaches to Replenishment
Logistics: Efficient Consumer Response
(ECR)

 Structure of ECR
 Grocery industry estimates U.S. savings at
approximately $30 billion.
 “Ultimate goal is a responsive, consumer-driven
system in which distributors and suppliers work
together as business allies to maximize consumer
satisfaction and minimize cost. Accurate
information and high-quality products flow through
a paperless system between manufacturing and
check-out counter with minimum degradation or
interruption…”
Figure 7-19 Efficient Consumer
Response: Broad Operating Capabilities
Tailored to Each Unique Partner
 Chapter 7:
Summary and Review Questions
Students should review their knowledge of the chapter
by checking out the Summary and Study Questions
for Chapter 7.

This is the last slide for Chapter 7

Figure A7-1 Sawtooth Model Modified for
Inventory in Transit
Figure A7-2 EOQ Costs Considering
Volume Transportation Rate
Table 7A-1 Annual Savings, Annual
Cost, and Net Savings by Various
Quantities Using Incentive Rates
Figure A7-3 Net Savings Function for
Incentive Rate
End of Chapter 7 and 7A Slides

Inventory Decision Making