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Chapter 5
INVENTORY MANAGEMENT
Inventory management is mainly about specifying locations, size and
placement of stocked goods so as to assure that supply chain
activities do not run out of goods or supply

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Learning Objectives

❖ Understand the inventory system

❖ Describe ABC classification
❖ Describe the inventory models and its underlying
assumptions.
❖ Analyse the replenishment policies
❖ Describe the continuous review and periodic review
systems.

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Main content

1. Inventory System

2. Inventory Models

3. Replenishment Policies

4. Vendor Managed Inventory

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1. INVENTORY
SYSTEM

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Stock vs. Inventory

❖ Stock consists of all the goods and materials that are held by an
organisation → They are formed whenever the organisation’s inputs
or outputs are not used at the time they become available.

❖ An inventory is a list of items held in stock.

❖ The main purpose of stocks is to act as a buffer between supply

and demand → Allow operations to continue smoothly and avoid
disruptions.

❖ Recently, Inventory is used for both the list of items and the
stock itself, and the two terms then become interchangeable.

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Inventory System

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Types of Inventory

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Inventory Profile
Inventory (Stock) level

Usage rate Avg.

Order inventory
quantity = Q on hand
(max. inventory
level, lot size) Q
2

Min.
inventory

0
Stock Cycle Time
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Purpose Of Inventory

Lead
time

Economies
Why
of scales holding Uncertainty
inventory?

Short
product 9
life cycle
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ABC Inventory Control System

❖ A useful tool to determine which inventories should be counted

more frequently and managed more closely and which others
should not.

❖ ABC analysis is often combined with the 80/20 rule or Pareto

analysis.

▪ This rule suggests that 80 percent of the objective can be

achieved by doing 20 percent of the tasks,

▪ but the remaining 20 percent of the objective will take up 80

percent of the tasks.

❖ This system classifies inventory items into groups A, B, and C.

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ABC Inventory Classification

❖ The A items are given the highest priority, while C items have the
lowest priority and the B items fall somewhere in between.

❖ The priority is most often determined by annual dollar usage.

However, priority may also be determined by product shelf life,
sales volume, whether the materials are critical components, or
some other criteria.

❖ A summary of the classification is provided

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Inventory Classification

Annual Annual Percentage of

Unit Cost
Item Usage Usage Total Annual
($)
(Units) ($) Dollar Usage (%)
1 1.50 5,000 7,500 2.9
2 8.00 1,500 12,000 4.7
3 10.50 10,000 105,000 41.2
4 2.00 6,000 12,000 4.7
5 0.50 7,500 3,750 1.5
6 13.60 6,000 81,600 32.0
7 0.75 5,000 3,750 1.5
8 1.25 4,500 5,625 2.2
9 2.50 7,000 17,500 6.9
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10 2.00 3,000 6,000 2.4
Total Annual Dollar Usage: $254,725 100
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Pareto Chart

45.0% 120.0%

40.0%
A B C 100.0%

Cumulative % Usage
35.0%
Percent Usage

30.0% 80.0%

25.0%
60.0%
20.0%

15.0% 40.0%

10.0%
20.0%
5.0%

0.0% 0.0%
3 6 9 2 4 1 10 8 5 7

Item No.

Percentage of Total Dollar Usage Cumulative Percentage 13

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2. INVENTORY
MODELS

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Economic order quantity (EOQ) model

❖ The model is a classic independent demand inventory system that

provides many useful ordering decisions.

❖ The basic order decision is to determine the optimal order size

that minimizes total annual inventory costs (the sum of the
annual order cost and the annual inventory holding cost).

❖ In EOQ computations, the term carrying cost is often used in place

of holding cost and setup cost is used in place of order cost.

▪ Ordering cost/ Setup cost: Direct variable costs associated with

placing an order with the supplier.

▪ Holding cost/ Carrying cost: The costs incurred for holding

inventory in storage

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Assumptions of EOQ Model

❖ The demand is known and constant.

❖ Order lead time is known and constant.

❖ Replenishment is instantaneous. The entire order is delivered at one

time and partial shipments are not allowed.

❖ Price is constant. Quantity or price discounts are not allowed.

❖ The holding cost is known and constant.

❖ The order cost is known and constant.

❖ Stockouts are not allowed. Inventory must be available at all times.

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Optimal Order Size (1/2)
The EOQ can be derived from the total cost formula as follows:
Total Cost = Purchase cost + Holding/Carrying cost + Ordering/Setup cost
𝑻𝑪 = 𝑫∗𝑪 + (𝑸/𝟐) ∗ 𝑯 + (𝑫/𝑸) ∗ 𝑺

Total inventory cost (𝑻𝑰𝑪) = (𝑸/𝟐) ∗ 𝑯 + (𝑫/𝑸) ∗ 𝑺

The optimum Q (the EOQ) can be obtained by taking the first derivative of
TC with respect to Q and then setting it equal to zero.
𝒅𝑻𝑪 𝟐𝑫𝑺 𝟐𝑫𝑺
= 𝟎 → 𝑬𝑶𝑸 = 𝑸∗ = =
𝒅𝑸 𝑯 𝒉𝑪

Q: Quantity in a lot or batch size/Order size (units)

D: Demand per unit time
C: Unit cost = average price/unit purchased ($/unit)
S: Cost per order placed or setup cost, ($/order) 17
H: Holding/Carrying cost = hC ($/unit/year)
h: fraction of the unit cost of the product
N: Number of orders per time period
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Optimal Order Size (2/2)

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Example

• The store S has observed a stable monthly demand for its line of
mobile phone iPhone of 100 pcs per month. The store incurs a
setup cost of $2,000 every time it places an order for additional
iPhones. The store pays $200 per iPhone. The store’s out-of-
pocket costs of storing an iPhone for a year are about 10% and
the opportunity cost of capital is 15%.

Question: What order size do you recommend for the S store?

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Solution
• D = 1200 pcs/ year, S = $2,000 / order,

• H = (0.15 + 0.10) 200 = $50 /pcs/ year

➔ Q* = (2 x 1200 x 2000/50)= 309.8

➔ round to Q* = 310

• Total inventory cost:

TIC(Q*) = S  (D/Q*) + H  (Q*/2)

= 2000  (1200/310) + 50  (310/2)

= $7,745 + $7,745

= $15,492 / year

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Quantity Discount Model (QDM)

❖ The quantity discount model is one variation of the EOQ model.

❖ It relaxes the constant unit price assumption by allowing purchase

quantity discounts → the unit price of an item is allowed to vary with
the order size.

❖ Discounts offerings with quantity constitute motives for ordering

higher quantities and hence, holding larger inventories.

❖ Therefore, it becomes crucial to find the trade-off between price

discount and cost increase due to keeping larger inventory.

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Total Cost Curve for QDM

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Quantity Discount Steps

1. For each discount price level (P), compute EOQ:

𝟐𝑫𝑺 𝟐𝑫𝑺
𝑬𝑶𝑸 = 𝑸∗ = =
𝑯 𝒉𝑷

2. If EOQ < Minimum for discount, then adjust the quantity to

𝑸 = 𝑴𝒊𝒏𝒊𝒎𝒖𝒎 𝒇𝒐𝒓 𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕
3. For each EOQ, compute the total cost:
𝑪 = 𝑫 ∗ 𝑷 + (𝑸/𝟐) ∗ 𝑯 + (𝑫/𝑸) ∗ 𝑺
4. Compare total cost and choose the lowest cost quantity from all
levels.

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Example
❖ The retailer of Heat International is negotiating the air-conditioning
units’ respective purchase cost along with the quantity ordered. Heat
International offers the discounts summarized:

❖ The total demand for air-conditioning units is 6,500 units/year.

Ordering cost is €50 and the annual inventory holding cost is
estimated 25% of the unit’s price.
Question: How many air-conditioning units should the retailer order to
minimize its total annual cost?

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Solution (1/2)
• For the lowest price:

2 DS 2  6500  50
EOQ57 = = = 213.57  500 => Invalid => Buy 𝑄 = 500
H 0.25  57

• For the next price:

2 DS 2  6500  50
EOQ58.8 = = = 210.28  300 => Invalid => Buy 𝑄 = 300
H 0.25  58.8

• For the last price:

2 DS 2  6500  50
EOQ60 = = = 208,16 => Valid => Buy 𝑄 = 208
H 0,25  60

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Solution (2/2)
• The total cost for EOQ is:
Q D 208 6500
C208 = H + S + PD = 0.25  60 + 50 + 60  6500 = 393,122.5
2 Q 2 208
• The total cost when ordering 300 units:
300 6500
C300 = 0.25  58.8 + 50 + 58.8  6500 = 385,488.3
2 300
• The total cost when ordering 500 units:
500 6500
C500 = 0.25  57 + 50 + 57  6500 = 374,712.5
2 500
• Since €374,712.5 is the minimum total annual cost → the
optimum ordering quantity is 500 units. 26
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3. REPLENISHMENT
POLICIES

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Continuous and Periodic Review
❖ Continuous Review: Inventory is continuously monitored and an
order fixed quantity Q is placed when the inventory reaches the
Reorder Point (ROP).

❖ Periodic Review: Inventory is checked at regular/periodic intervals T

and an order is placed to raise total inventory to the Order up to
Level (OUL).

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Continuous Review System

❖ (s, Q) continuous review policy: This policy orders the same

quantity Q when the inventory reaches the reorder point s. The
quantity Q can be determined by one of the fixed order quantity
methods (such as the EOQ).

❖ (s, S) continuous review policy: When current inventory reaches or

falls below the reorder point s sufficient units are ordered to bring the
inventory up to a predetermined level S.

❖ For instance: suppose 𝒔 = 𝟏𝟎, 𝑺 = 𝟏𝟐𝟎, and current inventory is

11 units. If the next demand is 3 units, then on-hand inventory will
be reduced to 8 units. Consequently, an order size of 112 units
would be released.
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Periodic Review System (1/2)

❖ (nQ, s, R) periodic review policy: If at the time of inventory

review, the inventory is equal to or less than the reorder point s,
the quantity nQ is ordered to bring the inventory up to the level
between s and (s + Q).

❖ Recall that n= 1, 2, 3, …, and the order size is then some multiple

of Q. No order is placed if the current inventory is higher than the
reorder point.

❖ For example: let 𝒔 = 𝟏𝟎𝟎, 𝑸 = 𝟓𝟎. If the current inventory is 20

units at the time of the review, then 2Q quantities (2 x 50 = 100)
are ordered to bring the inventory level up to 120 units.

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Periodic Review System (2/2)

❖ (s, S, R) periodic review policy: If at the time of inventory review,

the physical inventory is equal to or less than the reorder point s, a
sufficient quantity is ordered to bring the inventory level up to the
maximum inventory level S.

❖ However, if the physical inventory is higher than the reorder point s,

no order is placed. This policy addresses the major deficiency of the
(S, R) policy.

❖ (S, R) periodic review policy: At each review time, a sufficient

quantity is ordered to bring the inventory up to a predetermined
maximum inventory level S.

❖ This policy places a variable-sized order as long as the inventory is

less than the maximum inventory level S.
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4. VENDOR
MANAGED
INVENTORY

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Vendor Managed Inventory

• If an organisation is trying to reduce the amount of effort it

puts into inventory control → Leave the whole problem to
a third party.

• Another organization deal with the stock control → The

most common arrangement is Vendor managed inventory.

• With vendor managed inventory, the wholesaler controls

the stocks, and sends more along when they are
needed.

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