UCAM MBA

Supply Chain Planning, Modelling

and Analytics

Inventory Control & Management

Sidath Waidyasekera
MBA(PIM-USJ), PG Dip Mkt(UK), MCIM(UK), MILT(UK),
MIDPM(UK), MSLIM(SL), MIM(SL)
Chartered Marketer

Winfield Academy of Business

& Finance
1
 Inventory Management
The objective of inventory management is to
strike a balance between inventory investment
and customer service

What is inventory?

Inventory is the raw materials, component

parts, work-in-process, or finished products
that are held at a location in the supply chain.
Why do we care Inventory?
At the macro level:

Inventory is one of the biggest corporate assets

Enormous potential for efficiency increase by

controlling inventories
Why do we care Inventory?
At the firm level:

– Sales growth: right inventory at the right place

at the right time

– Cost reduction: less money tied up in inventory,

inventory management, obsolescence

Higher profit
What Do you Consider?

• Cost of not having it.

• Cost of going to the grocery or gas station (time,
money), cost of drawing money.
• Cost of holding and storing, lost interest.
• Price discounts.
• How much you consume.
• Some safety against uncertainty.
 Importance of Inventory

◆ One of the most expensive assets of

many companies representing as much
as 50% of total invested capital
◆ Operations managers must balance
inventory investment and customer
service
Costs of Inventory
• Physical holding costs:
– out of pocket expenses for storing inventory (insurance,
security, warehouse rental, cooling)
– All costs that may be entailed before you sell it
(obsolescence, spoilage, rework...)
• Opportunity cost of inventory: foregone return on
the funds invested.
• Operational costs:
– Delay in detection of quality problems.
– Delay the introduction of new products.
– Increase throughput times.
 Types of Inventory
◆ Raw material
Purchased but not processed
◆ Work-in-process
Undergone some change but not completed
A function of cycle time for a product
◆ Maintenance/repair/operating (MRO)
Necessary to keep machinery and processes
productive
◆ Finished goods
Completed product awaiting shipment
 The Material Flow Cycle

Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time

Figure 12.1
 Managing Inventory

1. How inventory items can be classified

2. How accurate inventory records can be
maintained
 ABC Analysis
◆ Divides inventory into three classes based
on annual value volume
◆ Class A - High annual value volume
◆ Class B - Medium annual value volume
◆ Class C - Low annual value volume
◆ Used to establish policies that focus on the
few critical parts and not the many trivial
ones
 ABC Analysis

Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Value of Value of
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 90.00 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

 ABC Analysis

Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Value of Value of
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 14.17 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 232,057 100.0%

 ABC Analysis

A Items
–
Percent of annual dollar usage

80
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percent of inventory items
 ABC Analysis

◆ Policies employed may include

◆ More emphasis on supplier development
for A items
◆ Tighter physical inventory control for A
items
◆ More care in forecasting A items
 Record Accuracy
◆ Accurate records are a critical ingredient
in production and inventory systems
◆ Allows organization to focus on what is
needed
◆ Necessary to make precise decisions about
ordering, scheduling, and shipping
◆ Incoming and outgoing record keeping
must be accurate
◆ Stockrooms should be secure
 Cycle Counting
◆ Items are counted and records updated on a
periodic basis
◆ Often used with ABC analysis
to determine cycle
◆ Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and
corrected
5. Maintains accurate inventory records
 Cycle Counting Example
5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C items
Policy is to count A items every month (20 working days), B items
every quarter (60 days), and C items every six months (120 days)

Item Number of Items

Class Quantity Cycle Counting Policy Counted per Day
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day
C 2,750 Every 6 months 2,750/120 = 23/day
77/day
 Control of Service Inventories

◆ Can be a critical component

of profitability
◆ Losses may come from
shrinkage or pilferage
◆ Applicable techniques include
1. Good personnel selection, training, and discipline
2. Tight control on incoming shipments
3. Effective control on all goods leaving facility
 Independent Versus
Dependent Demand
◆ Independent demand
The demand for item is independent of
the demand for any other item in
inventory
◆ Dependent demand
The demand for item is dependent upon
the demand for some other item in the
inventory
 Holding, Ordering, and Setup
Costs
◆ Holding costs
The costs of holding or “carrying” inventory
over time
◆ Ordering costs
The costs of placing an order and receiving
goods
◆ Setup costs
Cost to prepare a machine or process for
manufacturing an order
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value
Housing costs (building rent or 6% (3 - 10%)
depreciation, operating costs, taxes,
insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
and insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value
Housing costs (building rent or 6% (3 - 10%)
depreciation, operating costs, taxes,
insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
and insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
 Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided
Different types of inventory models

1. Multi-period model
• Repeat business, multiple orders
2. Single period models
• Single selling season, single order
Multiperiod model – The Economic Order Quantity

Supplier Retailer Demand

• Demand is known and deterministic: D units/year

• We have a known ordering cost, S, and immediate
replenishment
• Annual holding cost of average inventory is H per unit
• Purchasing cost C per unit
What is the optimal quantity to order?

Total Cost = Purchasing Cost + Ordering Cost + Inventory Cost

Purchasing Cost = (total units) x (cost per unit)

Ordering Cost = (number of orders) x (cost per order)

Inventory Cost = (average inventory) x (holding cost)

 Finding the optimal quantity to order…
Let’s say we decide to order in batches of Q…

Inventory position Number of D

periods will be Q

The average
inventory for
each period is…
Period over which demand for Q has occurred Time
Q
2
Total Time
Finding the optimal quantity to order…

Purchasing cost = D x C

D
Ordering cost = x S
Q

Q
Inventory cost = x H
2
So what is the total cost?
D Q
TC = D C + S + H
Q 2

In order now to find the optimal quantity we need to

optimize the total cost with respect to the decision
variable (the variable we control)

Which one is
the decision
variable?
What is the main insight from EOQ?
There is a tradeoff between holding costs and ordering costs

Total cost

Cost
Holding costs

Ordering costs

Order Quantity (Q*)

Optimal order quantity is found when annual
ordering cost equals annual holding cost
D Q
S = H
Q 2
2
2DS = Q H

2
Q = 2DS/H

Q= 2SD
H
Economic Order Quantity - EOQ
2SD
EOQ =
H

Example:
Assume a car dealer that faces demand for 5,000 cars per year, and
that it costs $15,000 to have the cars shipped to the dealership.
Holding cost is estimated at $500 per car per year. How many
times should the dealer order, and what should be the order size?

2(15,000)(5,000)
EOQ = = 548
500
 If delivery is not instantaneous,
but there is a Lead Time - L
When to order? How much to order?
Order
Quantity
Q
Inventory

Lead Time
Time
Place Receive
order order
 If demand is known exactly, place an order when
inventory equals demand during lead time.

Order Q: When shall we order?

Quantity A: When inventory = ROP
Q
Q: How much shall we order?
Inventory

A: Q = EOQ

Reorder
Point
(ROP)
ROP = LxD

Lead Time
Time
D: demand per period
Place Receive
L: Lead time in periods
order order
Example (continued)…
What if the lead time to receive cars is 10 days?
(when should you place your order?)

Since D is given in years, first convert: 10 days = 10/365yrs

10 10
R = D = 5,000 = 137
365 365

So, when the number of cars on the lot reaches 137,

order 548 more cars.
 But demand is rarely predictable!

Inventory
Level

Order
Quantity

ROP = ???
Demand???

Place Receive Time

order Lead Time order
 Actual Demand < Expected Demand
Inventory
Level

Order
Quantity
Lead Time Demand X

ROP

Inventory at time of receipt

Lead Time Time

Place Receive
order order
If Actual Demand > Expected, we Stock Out
Order
Quantity

Stockout
Point
Inventory

Time

Lead Time Unfilled demand

Place Receive
order order
 If ROP = expected demand, service level is
50%. Inventory left 50% of the time, stock
outs 50% of the time.
Inventory
Level

Order
Quantity
ROP = Expected Demand

Uncertain Demand
Average

Time
 To reduce stockouts we add safety stock
Inventory
Level

Order Quantity
ROP = Q = EOQ
Safety
Stock + Expected
Expected LT Demand
LT
Demand Safety Stock
Lead Time Time

Place Receive
order order
 Decide what Service Level you want to provide
(Service level = probability of NOT stocking out)

Service level Probability

of stock-out

Safety
Stock
Example (continued)…
Back to the car lot… recall that the lead time is 10 days
and the expected yearly demand is 5000. You estimate the
standard deviation of daily demand to be d = 6. When
should you re-order if you want to be 95% sure you don’t
run out of cars?
Since the expected yearly demand is 5,000, the expected
demand over the lead time is 5,000(10/365) = 137. The z-
value corresponding to a service level of 0.95 is 1.65. So
ROP = 137 + 1.65 10 (36 ) =168

Order 548 cars when the inventory level drops to 168.