OPERATIONS

MANAGEMENT
Inventory Management

The objective of inventory management is to strike a

balance between inventory investment and customer service
Importance of Inventory
▶One of the most expensive assets of
many companies representing as much as
50% of total invested capital
▶Less inventory lowers costs but increases
chances of running out
▶More inventory raises costs but always
keeps customers happy
Functions of Inventory
1. To provide a selection of goods for
anticipated demand and to separate the
firm from fluctuations in demand
2. To decouple or separate various parts of
the production process
3. To take advantage of quantity discounts
4. To hedge against inflation
Types of Inventory
▶Raw material
▶Purchased but not processed
▶Work-in-process (WIP)
▶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
Record Accuracy
► Accurate records are a
critical ingredient in
production and inventory
systems
► Periodic systems require
regular checks of inventory
► Two-bin system
► Perpetual inventory tracks receipts and
subtractions on a continuing basis
► May be semi-automated
Record Accuracy

► Incoming and outgoing

record keeping must be
accurate
► Stockrooms should be secure
► Necessary to make precise decisions
about ordering, scheduling, and shipping
Inventory Models
▶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
Inventory Models
▶Holding costs - the costs of holding or “carrying” inventory
over time
▶Ordering cost - the costs of placing an order and receiving
goods
▶Setup cost - cost to prepare a machine or process for
manufacturing an order
▶May be highly correlated with setup time
Holding Costs
TABLE 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT OF
CATEGORY INVENTORY VALUE
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance on inventory)
Pilferage, space, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change like
tablets and smart phones)
Overall carrying cost 26%
Holding Costs
TABLE 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT OF
CATEGORY INVENTORY VALUE
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance on inventory)
Pilferage, space, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change like
PCs and cell phones)
Overall carrying cost 26%
Inventory Models for Independent
Demand
Need to determine when and how
much to order

1. Basic economic order quantity

(EOQ) model
2. Production order quantity model
3. Quantity discount model
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 (or ordering) and
holding
6. Stockouts can be completely avoided
 Inventory Usage Over Time
Figure 12.3

Total order received

Average
Order quantity Usage rate inventory on
= Q (maximum hand
Inventory level

inventory level)
Q
2

Minimum
inventory 0
Time
Minimizing Costs
Objective is to minimize total costs
Table 12.4(c)

Total cost of
holding and setup
(order)

Minimum
total cost
Annual cost

Holding cost

Setup (order) cost

Optimal order Order quantity

quantity (Q*)
Ordering Cost Implications
• https://www.youtube.com/watch?v=bGJZcHgqX1g
Minimizing Costs
▶By minimizing the sum of setup (or ordering) and holding
costs, total costs are minimized
▶Optimal order size Q* will minimize total cost
▶A reduction in either cost reduces the total cost
▶Optimal order quantity occurs when holding cost and setup
cost are equal
Minimizing Costs
Q = Number of units per order
Q* = Optimal number of units per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)
x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order
æ Dö
= ç ÷S
èQø
Minimizing Costs Annual setup cost =
D
Q
S

Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)
x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order
æ Dö
= ç ÷S
èQø
Minimizing Costs Annual setup cost =
D
Q
S
Q
Q = Number of pieces per order Annual holding cost = H
2
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual holding cost = (Average inventory level)
x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2
æQö
= ç ÷H
è2ø
Minimizing Costs Annual setup cost =
D
Q
S
Q
Q = Number of pieces per order Annual holding cost = H
2
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Optimal order quantity is found when annual setup

cost equals annual holding cost

æ Dö æQ ö Solving for Q* 2DS = Q 2 H

ç ÷S = ç ÷ H 2DS
èQø è2ø Q2 =
H
2DS
Q* =
H
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H

2(1,000)(10)
Q =
*
= 40,000 = 200 units
0.50
An EOQ Example
Determine expected number of orders
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year
An EOQ Example
Determine expected number of orders
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected Demand D
number of = N = =
orders Order quantity Q*

1,000
N= = 5 orders per year
200
An EOQ Example
Determine optimal time between orders
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year
Consider a year has 250 working days
An EOQ Example
Determine optimal time between orders
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year

Expected time Number of working days per year

between =T =
orders Expected number of orders

250
T= = 50 days between orders
5
An EOQ Example
Determine the total annual cost
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year T = 50 days
An EOQ Example
Determine the total annual cost
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
1,000 200
= ($10) + ($.50)
200 2
= (5)($10) + (100)($.50)
= $50 + $50 = $100
The EOQ Model
When including actual cost of material P

Total annual cost = Setup cost + Holding cost + Product cost

D Q
TC = S + H + PD
Q 2
EOQ Example (1 of 3)
In some cases demand may be given in months. For e.g. D=1000/month
Annual demand, D = 1,000  12 = 12,000units

Order cost per lot, S = $4,000

Unit cost per computer, C = $500
Holding cost per year as a fraction of unit cost, h = 0.2

2  12,000  4,000
Optimal order size = Q* = = 980
0.2  500
EOQ Example (2 of 3)
Q * 980
Cycle inventory = = = 490
2 2
D 12,000
Number of orders per year = = = 12.24
Q* 980
D Q* 
Annual ordering and holding cost = S+  hC = $97,980
Q*  2 
EOQ Example (3 of 3)
• Lot size reduced to Q = 200 units

D Q 
Annual inventory - related costs = S +   hC = $250,000
Q 2
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units 1,500 units
S = $10 per order
H = $.50 per unit per year
N= 5 orders/year
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units/yr 1,500 units/yr Q*Only = 200
1,000 2% lessunits
than the
S = $10 per order total
T = cost of $125
50 days
H = $.50 per unit per year when
Q*1,500 the order
= 244.9 units
N= 5 orders/year quantity was 200

Ordering old Q* Ordering new Q*

D Q
TC = S+ H
Q 2 1,500 244.9
= ($10) + ($.50)
1,500 200 244.9 2
= ($10) + ($.50)
200 2 = 6.125($10) +122.45($.50)
= $75 + $50 = $125 = $61.25 + $61.22 = $122.47
Reorder Points
▶EOQ answers the “how much” question
▶The reorder point (ROP) tells “when” to order
▶Lead time (L) is the time between placing and
receiving an order

Demand per Lead time for a new

ROP = day order in days

ROP = d x L

d= D
Number of working days in a year
Reorder Point Curve
Figure 12.5

Q*
Stock is replenished as order arrives

Inventory level (units) Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
Reorder Point Example
Demand = 8,000 iPhones per year
250 working day year
Lead time for orders is 3 working days, may take 4

D
d=
Number of working days in a year

= 8,000/250 = 32 units

ROP = d x L
= 32 units per day x 3 days = 96 units
= 32 units per day x 4 days = 128 units
An item is used at a uniform rate of 50,000 units per year. No
shortage is allowed and delivery is at an infinite rate. The
ordering, receiving and hauling cost is Rs. 13 per order, while
inspection cost is Rs. 12 per order. Interest costs Rs. 0.056 and
deterioration and obsolescence cost Rs. 0.004 respectively per
year for each item actually held in inventory plus Rs. 0.02 per year
per unit based on the maximum number of units in inventory.
Calculate the EOQ. If lead time is 20 days, find re-order level.
(Assume 365 days in a year)
Probabilistic Models and
Safety Stock
▶Used when demand is not constant or certain
▶Use safety stock to achieve a desired service
level and avoid stockouts

ROP = d x L + ss

Annual stockout costs = The sum of the units short for each
demand level x The probability of that demand level x The
stockout cost/unit
x The number of orders per year
Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

NUMBER OF UNITS PROBABILITY

below 30 .2
30-40 .2
ROP(50)→ 40-50 .3
50-60 .2
60-70 .1
1.0
Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

SAFETY ADDITIONAL TOTAL

STOCK HOLDING COST STOCKOUT COST COST

20 (20)($5) = $100 $0 $100

10 (10)($5) = $ 50 (10)(.1)($40)(6) = $240 $290

0 $ 0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960 $960

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames