DAO2703 OTM / DSC2006 OM

Week 7
MANAGING INVENTORIES
– NO DEMAND UNCERTAINTY
Why is inventory management important?

Do you have toilet papers at home now?

When there is panic buying…

Store in Singapore Store in Taiwan
Store in USA
 Why is inventory management important?
In addition to panic buying, we have seen all kinds of supply chain disruptions

How to ensure supply chain resilience:

◦ For example, how to ensure food security in Singapore?
◦ Stockpile (FairPrice) – what to stock and how many to stock? (Inventory management)
◦ Understanding uncertainty and supply chain characteristics are the keys
◦ Understanding the basics – no uncertainty cases
◦ Understanding how to manage uncertainty
◦ The importance of knowing the supply chain characteristics
 Customers,
Field demand
Sources: Regional Warehouses: centers
plants Warehouses: stocking sinks
vendors stocking points
ports points

How do we manage
inventories in supply
Supply chain back in the
days when there is
no panic buying?
Inventory &
warehousing
costs
Production/
purchase Transportation Transportation
costs costs costs
Inventory &
warehousing costs
Inventory
Where do we hold inventory?
◦ Suppliers and manufacturers
◦ warehouses and distribution centers
◦ retailers

Types of Inventory
◦ WIP
◦ raw materials
◦ finished goods

Why do we hold inventory?

◦ Economies of scale
◦ Uncertainty in supply and demand
What can you do after learning inventory management?

Case about a global manufacturer with a factory

in Singapore
A Global Manufacturer with a Factory in SG
re-order point Jan 13 _Report_Sample.xls

• Can you save S$2.7-2.8 Million of inventory cost out of a S$4

million system in 9 months?
→ Yes, you can! That’s one learning objective for this course!
Questions to ask when you face an inventory management problem

• Is it a Single Period or Multi-Period Problem?

• Understanding the data you have and data quality
• In addition to the issues on the data quality, what can we do to improve
a company’s inventory replenishment policy?
→ When should we order (that is, how to set Re-order Point)?
→ How much to order when it is time for us to place an order? That is, how
much to order when “re-order point” is reached?
 A Single Period Inventory Model
▪ For perishable goods
▪ Also called newsvendor model
▪ We will not teach this model in this course since we
want to spend more time to talk about general OM
issues. You can consider taking more advanced courses
in Operations and Supply Chain Specialization offered
by NUS business school, such as "DOS3701 Supply
Chain Management" if you want to learn more about
this model
 A Multi-Period Inventory Model
Often, there are multiple reorder opportunities
Consider, for example,
◦ the Global Manufacturer we talked about just now, or
◦ a central distribution facility which orders from a manufacturer and delivers to
retailers. The distributor periodically places orders to replenish its inventory
Is there demand uncertainty?
◦ No – use EOQ Model (we will learn today!)
◦ Yes –> how often can you review your inventory?
◦ Continuous review policy (we will learn next week!)
◦ Periodic review policy (we will learn next week!)
EOQ: A Simple Model (no demand uncertainty)
In inventory management, economic order quantity (EOQ) is the order quantity that
minimizes the total holding costs and ordering costs.
Typical information given in this setting:
◦ Demand is constant at a rate of D items per day (or per unit of time, which can be day, week, month,
year, etc.)
◦ A fixed cost (setup cost), K, is incurred every time an order is placed
◦ An inventory carrying cost, h, also referred to as a holding cost, is accrued per unit of product held in
inventory per day (or per unit of time) that the unit is held. To be more precise, we should call
“holding cost” defined this way “holding cost rate”. But in practice, many people just call it “holding
cost”.
◦ Lead time L: the time that elapses between the placement of an order and its receipt.
Question
◦ When, and how many to order? (so that you can minimize the total holding costs and ordering costs.)
EOQ: A Simple Model (no demand uncertainty
and no lead time, lead time L=0)
Example: Book Store Mug Sales
◦ Demand is constant, at D = 20 units a week
◦ Fixed order cost of K = $12.00, no lead time
◦ For each order you place, you need to pay a fixed order cost K
◦ Holding cost rate h is 25% of inventory value annually
◦ Note: Holding Cost Rate h is the cost for holding one unit of product for one unit of time
◦ Mugs cost C = $1.00 each, sell for $5.00 each

Question
◦ When, and how many to order? (so that you can minimize the total holding costs and ordering costs.)
 EOQ: A View of Inventory – (L=0)
How to decide Q & T to minimize the total holding and ordering costs?
Note:
• No Stockouts
Inventory • Order when no inventory
• Order Size determines policy
Order Size Q

Q/2
Average Inventory Level
0
Cycle Time
T 2T …… Timeline
=T
EOQ: A Simple Model (no demand uncertainty, no lead time,
lead time L=0)
If you order a lot each time (i.e., Q is large) → this Q of inventory can last very long, thus T is
large too.
Note: DT = Q (same as T = Q/D)
◦ Why? Recall that the inventory level changes from Q to 0 during a cycle of T units of time, and demand
is constant at a rate of D units per unit time, thus DT is the total number of units consumed in one cycle
time of T, which is Q.

So, once the best Q is determined, we know the best T too by using T = Q/D.
We can write T in terms of Q when we calculate for the best Q. (in the next slide)
Goal: Minimize total cost per unit time = (total cost in a cycle time T divided by the cycle time T)
◦ We start from calculating total cost in a cycle time T in the next slide
EOQ: Calculating Total Cost in a Cycle Time T (i.e., total holding
costs and ordering costs in during the cycle time T)
Purchase Cost during the cycle time T: $C per unit of product * Demand during a
period of T units of time = CQ = CDT
Holding Cost during the cycle time T: (Average Inventory level) * (Holding Cost Rate h)
*(Period of T units of time)
= (Q/2)*h*T
Fixed ordering cost (Setup Cost) during the cycle time T :
Fixed Order Cost K
Goal: Find the Order Quantity Q that
Minimizes These Costs:
Note: Holding Cost Rate h is the cost for holding one unit of product for one unit of
time, e.g., h= $7 per unit of product weekly = $1 per unit of product daily
EOQ: Calculating Total Cost in a Cycle Time T (i.e., total holding
costs and ordering costs in during the cycle time T)
Total Cost in a Cycle Time T (from previous slide)
= CDT + (Q/2)*h*T + K
Goal: Minimize total cost per unit time = (total cost in a cycle time T divided by the cycle time T)
= [CDT + (Q/2)*h*T + K] / T
= CD + (hQ/2) + K/T
= CD + (hQ/2) + (KD/Q)
How to choose Q to minimize the above? (Use first order condition in calculus)
If we let f(Q) = CD + (hQ/2) + (KD/Q)
First derivative f’(Q) = 0 + (h/2) – (KD/Q2 ) = (h/2) – (KD/Q2 )
Second derivative f’’(Q) = 2KD/Q3 > 0 Therefore, f(Q) is a convex function, which implies that f’(Q) = 0
(first order condition) will give you the Q value which minimizes the value of f(Q).
We use f’(Q) = (h/2) – (KD/Q2 ) = 0 → Q = ? (next slide)
EOQ: Optimal Order Quantity = Q*
f’(Q) = (h/2) – (KD/Q2 ) = 0 → Best Q (we call Q*)
Q* = Optimal Order Quantity =

(2*Setup Cost*Demand Rate)/holding cost rate =

(2KD)/h

So, for our example on Book Store Mug Sales problem, the optimal
quantity is ~316
Note: make sure D and h use the same time units, e.g., if D is “daily”
demand, then h should be “daily” holding cost per unit of product.
EOQ: How to get Q* ~ 316 from the following example
Example: Book Store Mug Sales
◦ Demand is constant, at D = 20 units a week
◦ Fixed order cost of K = $12.00, no lead time
◦ For each order you place, you need to pay a fixed order cost K
◦ Holding cost rate h is 25% of inventory value annually
◦ Note: Holding Cost Rate h is the cost for holding one unit of product for one unit of time
◦ Mugs cost C = $1.00 each, sell for $5.00 each
Question
◦ How many, when to order? (so that you can minimize the total holding costs and ordering costs.)
Answer: K= 12, D = 20 (weekly),
h = 1*25% (annually) = 1*25%/52 (weekly) = 0.25/52
<assume one year has 52 weeks>
Plug in K, D, h into EOQ formula, you will get Q* = ~ 315.9747 ~ 316
EOQ: Optimal Order Quantity = Q*
Q* = (2KD)/h
Q* is affected by K, D, and h
Recall our Goal: Minimize total cost per unit time = (total cost in a cycle time T divided by
the cycle time T)
= [CDT + (Q/2)*h*T + K] / T
= CD + (hQ/2) + K/T
= CD + (hQ/2) + (KD/Q)
What happens to CD (the first term above)? Why does Cnot affect our decision in Q?
◦ Because we face constant demand D per unit time. No matter what Q we choose, we need to
supply D units per unit time anyway. So we need not consider “purchase cost” when deciding
Q*. (so in the next slide, we exclude “purchase cost in the graph).
EOQ: Total Cost per Unit Time* (excluding
purchase cost per unit time in this slide)
160
140
Total Cost per unit time
120
100
Holding Cost per unit time
Cost

80
60
Fixed Order Cost per unit time
40
20
0
0 500 1000 1500
Order Quantity
EOQ: Important Observations*
Tradeoff between fixed order costs and holding costs when determining order quantity. In fact,
we order so that these costs are equal per unit time
Total Cost is not particularly sensitive to the optimal order quantity

Order 0.8 × Q*
Order Q* Order 1.1 × Q*

Order Quantity 50% 80% 90% 100% 110% 120% 150% 200%
Cost Increase 125% 103% 101% 100% 101% 102% 108% 125%

1.03 × Optimal Total Cost Optimal Total Cost 1.01 × Optimal Total Cost
 EOQ: A View of Inventory – (What to do when L>0)
How to decide Q and T to minimize the total holding & ordering costs?
Note:
• No Stockouts
Inventory • Order when no inventory
• Order Size determines policy
Order Size Q

Q/2
Average Inventory Level
0
Cycle Time
T 2T …… Timeline
=T
The Effect of Demand Uncertainty
EOQ Model does not consider demand uncertainty
What is the effect of demand uncertainty?
◦ We will learn about this next week!