MANAGEMENT OF INVENTORY

SYSTEMS
 Importance of Inventory Management
Systems
• Almost all organizations use, transform, distribute, or sell
materials of one kind or another.
• Inventory/Materials Management is one of the most important
functions in any organization.
• The performance (operational and financial) of an
organization -manufacturing or service, government or non-
government - is significantly dependent on effective
management of materials or inventory.
• Materials management may influence tremendously the cost
of production as well as of product.
 Importance of Inventory Management
Systems
A good and acceptable materials or inventory management
system ensures a smooth flow of materials within an
organization or a plant. This flow should connect the suppliers to
the production systems and subsequently to the customers/end
users of the products through the distribution system with
generation of minimum or no wastes.

For achieving the main objectives of materials management

function as stated above, a total and an integrated inventory
management system needs to be developed and used.
 Inventory and its Definition

The core issue of materials management is maintenance and

control of inventory.
The term ‘inventory’ can be defined in a number of ways

➢ Stock on hand of materials at a given time.

➢ Tangible asset that can be seen, measured, and counted.
➢ List of items (physical assets).
➢ Quantity of items on hand.
➢ Value of stock of goods owned by an organization at a
particular time.
 Inventory and its Definition

➢ In view of all these interpretations, ‘inventory’ is defined

as ‘an idle resource that has an economic value’.

When a resource loses its economic value (after its use in one
or multiple cycles), it ceases to be an inventory
 Types of Inventory

The classification of inventory is based on two aspects:

i. State of inventory
ii. Utility of inventory
As state of inventory changes, the function or use of each
category of inventory change. Based on this it classified into 4
types
• Supplies (in the form of maintenance, repair, and operating
supplies or MRO)
• Raw materials (R/M)
• Work-in-process (WIP)
• Finished goods (F/G)

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 Types of Inventory

• MRO – not part of final product.

• R/M – inputs to production process, usually purchased from
suppliers.
• WIP – partially completed products still in production process.
• F/G – final product, ready for storage, distribution, and sale.
• In a production system for a product, these categories of
inventory need to be explicitly defined.
• As the state of inventory changes, the function or the use of
each category of the inventory also changes.

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 Types of Inventory
Based on utility of inventory, inventory is classified under six
categories:
i.Working stock (cycle or lot size stock): amount of inventory as
determined by its lot size as required to meet its demand for a
specific time period.

ii. Safety stock (buffer or fluctuation stock): amount of additional

inventory required exclusively as a protection against stock-out
situation due to fluctuations of demand during replenishment
period.

iii. Anticipation stock (seasonal or stabilization stock): amount of

inventory built up to meet the higher or pick seasonal demand

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 Types of Inventory

iv. Pipeline stock (transit or work-in-process stock): amount of

inventory being processed or waiting to be processed, both
internally and externally.

v. Decoupling stock: amount of inventory accumulated between

dependent processes or stages so that it can operate
independently.

vi. Psychic stock: amount of inventory required to stimulate

demand.

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 Inventory Cost

• While formulating any class of problem, we need to know the

working of the inventory control system, its parameters, the
constraints, if any, and assumptions for modelling.

• Usually the values of these parameters are determined such

that the cost of the inventory control system under
consideration is held at a minimum level.

• In this context, the types of inventory-related costs are to

be identified.

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 Inventory Cost
There are a number of inventory-related costs that need to be
considered.
These costs are as follows:
i. Purchase Cost: This is also known as procurement cost. While
an item is purchased from an outside source (supplier), unit
purchase price for the item determines the purchase cost.

ii. Setup Cost: This cost is relevant when the item is supplied
from within (self-supply). The cost associated with setting up of
the process or the machinery as per production run and lot size
is the setup cost. It is usually measured per setup basis.

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 Inventory Cost

iii) Production Cost: This is incurred when the item in required

quantity is produced by the production department (self-supply).
The production cost per unit is its measure.

iv) Order Cost: This cost is relevant when the item is supplied
from outside (supplier). An authorization note in the form of
purchase order, is to be placed to the supplier. The cost of
preparing and placing the order for the item in required quantity
and quality under agreed terms and conditions is referred to as
the order cost. Usually, it is measured per order basis.

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 Inventory Cost

v. Inventory Carrying or Holding Cost: This is essentially the cost

of money tied up in inventory. There is a time lag between the
arrival/production of inventory and its use. While it is stored for
the time period, it is essential that it is kept in good condition.

The costs associated with the lost earning power (due to cost of
the money tied up in inventory without getting the return if this
tied up money were invested elsewhere), storage, deterioration,
insurance, and other prevention measures taken to maintain
inventory of the item in acceptable/usable condition. This cost is
measured either as a proportion/percent of the cost of average
inventory or as a cost per unit price of the item (in absolute
term).

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 Inventory cost

vi. Overstock Cost: This cost is incurred when supply is more than
demand, and at the end of the selling season, an extra amount of
inventory beyond demand is kept. Elimination or at least, minimization
of overstock amount is one of the main objectives of any inventory
control system.

vii. Understock Cost: Also referred to as ‘out-of-stock’ or ‘stockout’ cost,

this is incurred when supply is less than demand during a period of
time.
Depending on the response of the customer to unfulfilled demand,
there may be two types of understock cost: Backordering Cost (in case
unfulfilled demand remains and can be met later or next time period)
and Lost Sales Cost (in case unfulfilled demand is lost forever and
cannot be met later or next time period).

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 Determination of Lot Size for a single Product
(EOQ)
Let D : Annual demand of the product
S: Fixed cost incurred per order
C: cost per unit
h: Holding cost per year as a fraction of product cost
Purchase Manager makes the lot sizing decision to minimize the
total cost the store incurs. He or she must consider three costs
when deciding on the lot size:
• Annual material cost = CD
• Annual ordering cost = (D/Q)*S
• Annual holding cost = (Q/2)*H where H=hC

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Cost versus Order Quantity’ Curve

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 Role of Cycle inventory in a Supply chain
Cycle inventory = (lot size/2)=Q/2
Average flow time = (cycle inventory)/demand = Q/2D
Eg: For lot sizes of 1,000 pairs of jeans and daily demand of 100 pairs
of jeans, we obtain
Average flow time = (1000)/2x100 = 5 days
• Cycle inventory at the Jean-Mart store thus adds five days to the
average amount of time that jeans spend in the supply chain.
• The larger the cycle inventory, the longer the lag time between when
a product is produced and when it is sold.
• A lower level of cycle inventory is always desirable, because long
time lags leave a firm vulnerable to demand changes in the
marketplace.
• A lower cycle inventory also decreases a firm’s working capital
requirement
NOTE: Cycle inventory exists in a supply chain because different
stages exploit economies of scale to lower total cost. The costs
considered include material cost, fixed ordering cost, and holding cost.
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 Numerical example
Demand for the computer at Best Buy company is 1,000 units per
month. Best Buy incurs a fixed order placement, transportation,
and receiving cost of Rs. 4,000 each time an order is placed. Each
computer costs Best Buy Rs.500 and the retailer has a holding
cost of 20 percent. Evaluate the number of computers that the
store manager should order in each replenishment lot.
Given input
Annual Demand, D = 1000x12 = 12000 units
Order Cost per lot, S = Rs 4000
Unit cost per computer, C= Rs 500
Holding cost per year as a fraction of inventory value, h= 0.2

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Solution

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 Numerical illustrations

There are 3 (X,Y and Z) models of computers. Annual demand of

the 3 models are DX = 12000units, DY = 1200units and Dz=120
units. Each model cost is Rs.500. A fixed transportation cost is
Rs.4000 is incurred each time an order is delivered. For each
model ordered and delivered on the same truck, an additional
fixed cost of Rs.1000 is incurred for receiving and storage.
Given
DX = 12000units, DY = 1200units and Dz=120 units
Cx = Cy = Cz = Rs.500
S = Rs.4000, sx = sy = sz= Rs.1000, h=0.2
H= hC = 0.2*500 = 1000
Fixed cost/ order = Rs.5000(4000+1000)

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 Solution
X Y Z
Demand per year 12000 1200 120
Fixed Cost /order Rs.5000 Rs.5000 Rs.5000
Optimal order size (Q*) 1095 346 110
Cycle Inventory (Q*/2) 548 173 55
Annual holding cost (Q/2)H Rs. 54700 Rs.17300 Rs.5500

Order frequency(D/Q*) 11/ year 3.5/ year 1.1/ year

Annual ordering cost (D/Q*)S Rs.54750 Rs.17500 Rs.5500

Average flow time (Q*/2D) 2.4 weeks 7.5weeks 23.7weeks

Annual cost (Annual holding Rs.109500 Rs.34800 Rs.11000

cost + Annual ordering cost)
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 Aggregating multiple products in a single order
Product managers to coordinate their purchasing to ensure that
all three products arrive on the same truck so that the major
source in the fixed order cost in transportation can be reduced.
As a result of aggregating orders and spreading the fixed
transportation cost across multiple products originating from the
same supplier, it becomes financially optimal for
• The store manager to reduce the lot size for each individual
product.
• This action significantly reduces the cycle inventory, as well
as the cost.
Aggregating replenishment across products, retailers, or
suppliers in a single order allows for a reduction in lot size for
individual products because fixed ordering and transportation
costs are now spread across multiple products, retailers, or
suppliers.
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 Lot Sizing with Multiple Products or Customers
Our objective is to arrive at lot sizes and an ordering policy that minimize
the total cost. We assume the following inputs:
• Di: Annual demand for product i
• S: Order cost incurred each time an order is placed, independent of
the variety of products included in the order
• si: Additional order cost incurred if product i is included in the order

Let us consider the case in which Best Buy purchases multiple models of
a product. The store manager may consider three approaches to the lot-
sizing decision:
1. Each product manager orders his or her model independently.
2. The product managers jointly order every product in each lot.
3. Product managers order jointly but not every order contains
every product; that is, each order contains a selected subset of
the products

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 Products ordered and Delivered Jointly
Because all 3 models are included in each order, the combined order
cost is
S* = (S +sx+sy+sz ) = (4000+1000+1000+1000)= Rs.7000
The optimal order frequency is obtained using the equation

we have Annual order cost = 9.75 × 7,000 = Rs. 68,250

The annual ordering and holding cost, across the three sizes, of the
aforementioned policy is given by
Annual ordering and holding cost = Rs. 61,512 + Rs.6,151 + Rs. 615 +
Rs. 68,250 = $ 136,528
Observe that the product managers at Best Buy lower the annual cost
from $155,140 to $136,528 by ordering all products jointly. This
represents a decrease of about 12 percent.

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 Lot Sizes and costs for jointly ordering

X Y Z
Demand per year 12000 1200 120
Order Frequency(n*) 9.75/year 9.75/year 9.75/year
Optimal order size (D/n*)=Q* 1230 123 12.3
Cycle Inventory (Q*/2) 615 61.5 6.15
Annual holding cost (Q/2)H Rs.61512 Rs.6151 Rs.615

Average flow time (Q*/2D) 2.4 weeks 7.5weeks 23.7weeks

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• The main advantage of ordering all products jointly is that the
system is easy to administer and implement.
• The disadvantage is that it is not selective enough in
combining the particular models that should be ordered
together.
• If product-specific order costs are high, joint ordering of all
products is very expensive.
• In our example, product-specific order costs of Rs.1000 are
incurred for all three models with each other.
• Total costs can be reduced if low-demand models are ordered
less frequently.
• “ Lots are ordered and delivered jointly for a selected Subset
of the products”

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 Lot-Size ordered and Delivered jointly for a
selected Subset that varies by order
Recall the same problem:
X Y Z
Demand of the Product 12000 1200 120
Fixed transportation 4000 4000 4000
cost (S)
For each additional 500 500 500
fixed cost (C )
Holding cost (S= 1000 1000 1000
hC)=(0.2C)

S =Rs4000, Sx =Rs1000, Sy=Rs.1000 and Sz = Rs.1000

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 Lot-Size ordered and Delivered jointly for a
selected Subset that varies by order
There are 4 steps to be followed:
Step.1 : Identify the most frequently ordered product assuming each product is
ordered independently

the maximum among all ni The most frequently ordered.

Step.2 : Evaluate the frequency with which Y and Z are included in X in the
order.
Step3 : By equation below, recalculate the ordering frequency of the most
frequently ordered model as

Step 4 : Obtain ordering frequency of each product.

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 Lot sizes and costs for ordering Policy

X Y Z
Demand per Year (D) 12000 1200 120
Order frequency(n) 11.47/year 5.74/year 2.29/year
Order size (D/n) 1046 209 52
Cycle inventory ( Q/2) 523 104.5 26
Average flow time (Q/2D) 2.27weeks 4.53weeks 11.35weeks
Annual holding cost Rs.52310.37 Rs.10452.96 Rs. 2620.08

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 Economics of sale to exploit Quantity
Discounts
There are many instances in business-to-business transactions in
which the pricing schedule displays economies of scale, with prices
decreasing as lot size increases.
A discount is lot-size based if the pricing schedule offers discounts
based on the quantity ordered in a single lot.
A discount is volume based if the discount is based on the total
quantity purchased over a given period, regardless of the number of
lots purchased over that period.
Two commonly used lot-size–based discount schemes are:
• All unit quantity discounts
• Marginal unit quantity discount or multi-block tariffs
To investigate the impact of such quantity discounts on the supply
chain, we must answer two basic questions in this context.

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 Question
1. Given a pricing schedule with quantity discounts, what is the optimal
purchasing decision for a buyer seeking to maximize profits? How does
this decision affect the supply chain in terms of lot sizes, cycle
inventories, and flow times?
2. Under what conditions should a supplier offer quantity discounts?
What are appropriate pricing schedules that a supplier seeking to
maximize profits should offer?

By studying the optimal response of a retailer (the buyer) when faced

with either of the two lot-size–based discount schemes offered by a
manufacturer (the supplier). The retailer’s objective is to select lot sizes
to minimize the total annual material, order, and holding costs.

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 All Unit Quantity Discounts
• In all unit quantity discounts, the pricing schedule contains specified
break points q0, q1, … , qr, where q0 = 0. If an order placed is at least
as large as qi but smaller than qi+1, each unit is obtained at a cost of Ci.
• In general, the unit cost decreases as the quantity ordered increases i.e
For all unit discounts, the average unit cost varies with the quantity
ordered, as shown in fig

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 ALL Units Quantity Discount
• The retailer’s objective is to decide on lot sizes to maximize profits or,
equivalently, to minimize the sum of material, order, and holding costs.
• The solution procedure evaluates the optimal lot size for each price and picks the
lot size that minimizes the overall cost.
Procedure
step 1: Evaluate the economic order quantity for each price Ci , 0≤ i≤ r as follows

step 2: We next select the order quantity Q*i for each price Ci. There are two possible
cases for Qi:
• 1. qi ≤ Qi ≤ qi+1
• 2. Qi ≤ qi+1
If qi ≤ Qi ≤ qi+1, then set Q*i = Qi.

• If Qi ≤ qi, then a lot size of Qi does not result in a discount. In this case, set
Q*i = qi to qualify for the discounted price of Ci per unit. Ordering more than
qi unites raises the order and holding costs without reducing the material
cost.

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 Procedure for All units discount
step 3: For each i, calculate the total annual cost of ordering Q*i units
(this includes order cost, holding cost, and material cost) as follows:

step 4: Over all i select order quantity Q*i with the lowest total cost TCi.

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 Numerical Problem
Drugs Online (DO) is an online retailer of prescription drugs and health
supplements. Vitamins represent a significant percentage of its sales.
Demand for vitamins is 10,000 bottles per month. DO incurs a fixed
order placement, transportation, and receiving cost of Rs.100 each time
an order for vitamins is placed with the manufacturer. DO incurs a
holding cost of 20 percent. The manufacturer uses the following all unit
discount pricing schedule. Evaluate the number of bottles that the DO
manager should order in each lot.

Order Quantity Unit Price

0 – 5000 Rs.3.00
5000- 10000 Rs.2.96
10000 or more Rs.2.92

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 Marginal Unit Quantity Discount
• Marginal (or incremental) unit quantity discounts are also referred to
as multi-block tariffs. In this case, the pricing schedule contains
specified break points q0, q1, … , qr. It is not the average cost of a unit
but the marginal cost of a unit that decreases at a breakpoint (in
contrast to the all unit discount scheme). If an order of size q is placed,
the first q1 – q0 units are priced at C0, the next q2 – q1 are priced at C1,
and so on.
• The solution procedure to evaluates the optimal lot size for each
marginal price Ci (this forces a lot size between qi and qi+1) and then
settles on the lot size that minimizes the overall cost.
• For each value of i, 0 ≤ i ≤ r, let Vi be the cost of ordering qi units.
Define V0 = 0 and Vi for as follows:
Vi = C0 (q1 – q0) + C1( q2 – q1) +..........C i-1(qi – qi-1)

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 Marginal Unit Quantity Discount
The various costs associated with such an order are as follows:

The total annual cost is the sum of the three costs and is given by

The optimal lot size for price Ci is obtained by taking the first derivative of the
total cost with respect to the lot size and setting it equal to 0.
 Procedure for Marginal Unit Quantity
Discount

Step 1: Evaluate the optimal lot size for each price Ci.
Step 2: We next select the order quantity Q*i for each price Ci.
There are three possible cases for Qi:
1. If qi ≤ Qi ≤ qi+1 then set Q*i = Qi
2. If Qi < qi then set Q*I = qi
3. If Qi > qi+1 then set Q*I = qi+1
step 3: Calculate the total annual cost of ordering Q*i units as
follows:

Step 4: Over all i, select order size Q*i with the lowest cost TCi
 Numerical Problem for Marginal unit
quantity discount
• Let us return to DO from Example. Assume that the manufacturer
uses the following marginal unit discount pricing schedule:

This implies that if an order is placed for 7,000 bottles, the first 5,000
are at a unit cost of Rs. 3.00, with the remaining 2,000 at a unit cost
of Rs. 2.96. Evaluate the number of bottles that DO should order in
each lot.
 Demonstration with Quantity Discount and
Why?
Thus, quantity discounts lead to a significant buildup of cycle
inventory in a supply chain.
In many supply chains, quantity discounts contribute more to
cycle inventory than fixed ordering costs.
This forces us once again to question the value of quantity
discounts in a supply chain.
Why Do Supplier offer Quantity Discount?
Quantity discounts can increase the supply chain profit for the
following two main reasons:
1. Improved coordination to increase total supply chain profits
2. Extraction of surplus by supplier through price discrimination
 Coordination to increase total supply chain
Profits

• Supply chain is coordinated if the decisions the retailer and

supplier make maximize total supply chain profits.
• In reality, each stage in a supply chain may have a separate
owner and thus attempt to maximize its own profits.
• Here discuss how a manufacturer may use appropriate quantity
discounts to ensure that total supply chain profits are maximized
even if the retailer is acting to maximize its own profits.
1) Quantity discounts for commodity products.
Economists have argued that for commodity products such as milk,
a competitive market exists and prices are driven down to the
products’ marginal cost
In this case, the market sets the price and the firm’s objective is to
lower costs in order to increase profits
 The Impact of Locally Optimal Lot Sizes
on a Supply Chain
• Demand for vitamins is 10,000 bottles per month. DO incurs a fixed order
placement, transportation, and receiving cost of Rs100 each time it places an
order for vitamins with the manufacturer. DO incurs a holding cost of 20
percent. The manufacturer charges Rs.3 for each bottle of vitamins
purchased. Evaluate the optimal lot size for DO.

• Each time DO places an order, the manufacturer must process, pack, and
ship the order. The manufacturer has a line packing bottles at a steady rate
that matches demand. The manufacturer incurs a fixed-order filling cost of
Rs.250, production cost of Rs. 2 per bottle, and a holding cost of 20 percent.
• What is the annual fulfillment and holding cost incurred by the manufacturer
as a result of DO’s ordering policy?
Here
D = 120000/year SR = Rs.100/lot hR =0.2, CR =Rs.3.00
SM = Rs.250/lot, CM =Rs. 2.00 hM =0.2
 .
For Quantity discounts for commodity products
Note: For Commodity products for which price is set by the
market, manufacturers with large fixed costs per lot can use lot
size- based quantity discounts to maximize total supply chain
profits. Lot size-based discounts, however, increase cycle
inventory in the supply chain.

2) Quantity discounts for products for which the firm has market
power.
Consider the scenario in which the manufacturer has invented a
new vitamin pill, Vitaherb, which is derived from herbal
ingredients and has other properties highly valued in the market.
Few competitors have a similar product, so it can be argued that
the price at which the retailer DO sells Vitaherb influences
demand.
 Quantity discounts for products for which the
firm has market power
• Assume that the annual demand faced by DO is given by the
demand curve 360,000 – 60,000p, where p is the price at which
DO(Retailer) sells Vitaherb.
• The manufacturer incurs a production cost of CM = Rs.2 per bottle
of Vitaherb sold.
• The manufacturer must decide on the price CR to charge
DO(Retailer) , and Retailer in turn must decide on the price p to
charge the customer.
• Double Marginalization : It leads to a loss in profit because the
supply chain is divided between two stages but each stages make
its decision considering only its local margin.
Note: The supply chain profit is lower if each stage of the supply
chain makes its pricing decisions independently, with the objective of
maximizing its own profit. A coordinated solution results in higher
profit.
 There are two pricing schemes that the manufacturer may use to achieve
the coordinated solution and maximize supply chain profits even though DO
acts in a way that maximizes its own profit.
1) Two-part tariff: Here the manufacturer charges its entire profit as
an up-front franchise fee ff (which could be anywhere between the
non coordinated manufacturer profit ProfM and the difference
between the coordinated supply chain profit and the non
coordinated retailer profit, ProfSC – ProfR) and then sells to the
retailer at cost; that is, the manufacturer sets its wholesale price
CR = CM.
2) Volume-based quantity discount: Observe that the two-part tariff
is really a volume based quantity discount whereby the retailer
DO pays a lower average unit cost as it purchases larger
quantities each year (the franchise fee ff is amortized over more
units). This observation can be made explicit by designing a
volume-based discount scheme that gets the retailer DO to
purchase and sell the quantity sold when the two stages
coordinate their actions