Inventory management

PHAM THI TRANG, Ph.D

Learning Objectives
◦ Describe the four basic types of inventories& their functions

◦ Discuss inventory costs and the trade-offs that exist among them

◦ Identify when to order and howmuch to order

◦ Differentiate the various inventory flowpatterns

◦ Discuss special concerns with inventory management

◦ Identify several contemporary approaches to managing inventory

05/05/2024 2
Contents
Introduction

Inventory Management

Inventory models

Inventory Management: Special Concerns

Contemporary Issues with managing
inventory

05/05/2024 3
 Inventory Management
Key Terms
• ABC analysis of • Fixed order interval
inventory system
• Back order • Fixed order
• Complementary quantity system
products • Inventory
• Cycle (base) stock • Inventory carrying
• Dead inventory (dead (holding) costs
stock) • Inventory shrinkage
• Economic order
quantity (EOQ)
8-4
 Inventory Management
Key Terms
• Inventory turnover • Reorder (trigger)
• Just-in-time (JIT) point (ROP)
approach • Safety (buffer) stock
• Lean manufacturing • Service parts logistics
(lean) • Speculative stock
• Ordering costs • Stockout costs
• Pipeline (in-transit) • Substitute products
stock
• Vendor-managed
• Psychic stock inventory (VMI)

8-5
What is inventory?
Inventory is a stock or store of goods or services, kept for
use or sale in the future.

Inventory types:

Raw materials & purchased parts

Partially completed goods called work in progress (WIP)

Finished-goods inventories

Goods-in-transit to warehouses or customers (GIT)

05/05/2024 6
 What is inventory?
 Let us look at a typical supply chain consists of suppliers and manufacturers, who
convert raw materials into finished materials, and distribution centers and warehouses,
form which finished products are distributed to customers. This implies that inventory
appears in the supply chain in several forms:
Finished product
Raw materials
Goods-in-transit
Work-in-process
(GIP)
(WIP)

suppliers Transportation distributors Transportation retailers Transportation customers

plants warehouses
cost cost cost

Production/ Inventory & Inventory &

purchase costs warehousing costs warehousing costs

05/05/2024 7
Example

05/05/2024 8
What is inventory?
 Inventory can be one of the most expensive assets of an organization
 Inventory may account for more than 10% of total revenue or total
assets
 Management must reduce inventory levels yet avoid stockouts and
other problems
 Effective inventory management is important to both manufacturers
and service organizations
 Excessive inventory is a sign of poor inventory management

05/05/2024 9
The motive for inventory
There are three motives for holding inventory, similar to cash:
 Transaction motive: Economies of scale is achieved when the
number of set-ups are reduced or the number of transactions are
minimized.
Precautionary motive: hedge against uncertainty, including demand
uncertainty, supply uncertainty.
 Speculative motive: hedge against price increases in materials or
labor.

05/05/2024 10
What is inventory management?
 The objective of inventory is to achieve satisfactory levels of customer service
while keeping inventory costs within reasonable bounds.

 Level of customer service: (1) in-stock (fill) rate (2) number of back orders (3)
inventory turnover rate: the ratio of average cost of goods sold to average
inventory

 Inventory cost: cost of ordering and carrying trade-off

05/05/2024 11
What is inventory management?
Inventory Management Questions to answer:
•What items to carry as inventory?
•Where should these be maintained?
•In what form should they be maintained?
•How much of each should be held?
Things to consider in inventory decision
•Benefits of having inventory
•Total cost of inventory
•Potential alternatives for inventory

05/05/2024 12
Characteristics of inventory items
 Demand: Demand is generated by people outside the firm, and therefore is
mostly uncontrollable.
 Replenishment Lead Time: Lead time is the time between placement of a
replenishment order and the actual receipt of stock.
 Inventory Level and Review Times: The inventory level of an item may be
known at all times.
 Lifetime & Reparability: An item may not always have an indefinite lifetime. Its
utility value may drop to zero at some point after which it may not have any
takers. Also, an item may fail but may be repairable.

05/05/2024 13
Characteristics of inventory items
Table 2: Terms used to describe demand

05/05/2024 14
 Mathematically,
Function if Qofisthis
theinventory
size of it to
the order, thenfor
account CI,uncertainties
the average in supply

Functions of Inventory cycle inventory, isleadgiven

CI = Q/2 PI = DL
by
time.

PI is the pipeline inventory, D is the

demand, and L is the lead time
 Cycle stock (base stock) You eat 1 egg a day and
buy eggs by the dozen.
 Pipeline stock (in-transit stock)  Buy a new container of
eggs every 12 days
 Safety stock (buffer stock)

 Speculative stock

 Psychic stock

05/05/2024 15
 Case Study: Tequila Production Process
Julius Tequila is a world famous distillery located in the state of Guanajuato, Mexico. The distillery makes the Julius brand
of premium tequila. The distillery procures tons of full-grown agave pinas from the farms all over Mexico. An agave plant
that has grown for about 8 years to the size of a soccer ball is considered to be good for producing tequila. The pinas are
first cut into several uniform pieces and washed with clean water. The cut pieces of pinas, the insides of which are white in
color, are then fed into an autoclave, a chamber that functions like a pressure cooker. The pieces of raw pinas are cooked
for about 72 h in the autoclave. At the end of the cooking process, the color of the pinas turns golden brown. The cooked
golden brown pinas pieces are then conveyed to a crusher where a screw-crushing facility, consisting of several parallel
rotating screw crushers, is employed to continuously crush and extract the pinas juice. The juice extracted from the pinas
is separated from its fiber using a simple, sieve-based filtering process. The distilled juice is then transferred to another
chamber where it is mixed with yeast. The mixture of juice and yeast is allowed to ferment and settle. This settling down
process takes a long time, and it does so in three layers. The top (the head) and the bottom layers (the tail) of the settled
partially fermented liquid is used in making lower grades of tequila while the middle one is used in making the premium
version. The different versions of the partially fermented liquid are then transferred to wooden barrels that are stored in
dark, cool storage chambers for several hours (minimum 20,000). After more than 2 years of storage, the liquid is taken
out of the barrels and transferred into blue-hued bottles (capacity of 2 liters each). These bottles with tequila are now
ready for commercial sale. These bottles are ferried to distributor warehouses around the world. Mild, food-quality
compliant detergents are used to clean the continuous process machines before the next load of agave pinas are loaded
into the system.
Case Study Questions
From the above case, classify the inventory in tequila production into
(a) raw materials
(b) work-in-process, and
(c) finished goods inventory

05/05/2024 16
Problem 1.1
A shoe manufacturer has a daily requirement of 100 shoe soles. The
manufacturer places an order for a batch size of 1000 shoe soles
from a supplier. Once an order is placed, it takes 3 days to reach the
manufacturing location. Determine cycle and pipeline inventory.

05/05/2024 17
Problem 1.2
At the beginning of every month, a bicycle manufacturer, based in
Monterrey, Mexico, places an order to procure lightweight steel tubes
from their suppliers based in Leon, Mexico. Their average requirement
is 1000 tons per week, and the procurement lead time is 14 days.
Determine cycle and pipeline inventory. Assume 4 weeks in a month

05/05/2024 18
Inventory costs
Inventory costs
Inventory Costs
 Inventory costs in the twenty-first century represent approximately
one-third of total logistics costs.

 Inventory cost should factor into an organization’s inventory

management policy.

 Inventory costs include:

– Carrying cost
– Ordering cost
– Shortage cost

05/05/2024 19
 Inventory Costs
Inventory carrying (holding) costs

◦ The costs associated with holding inventory.

Ch/unit = iC
where
Ch/unit is the carrying cost per unit; i is the inventory carrying rate, expressed in
% per year, and C is the unit price (cost) of the item, also expressed in $ per unit

05/05/2024 20
 Carrying cost or Holding cost
Carrying cost
components  Vary from product to product

Obsolescence Inventory Storage Handling Insurance Interest

Taxes
costs shrinkage costs costs costs costs

Cost of servicing inventory

Opportunity cost

Specialized storage
Cost of inventory risk requirements result in Costs for keeping
higher costs “products” alive
05/05/2024 21
Problem 2.1
Data for Solved Problem 2.1

Compute the following:

(a) Inventory carrying rate
(b) The annual carrying cost of an item that costs $20
(c) The total carrying cost for 15 items that cost $20 per unit and are held in
inventory for a period of 2 years

05/05/2024 22
Inventory Costs
• Ordering costs - direct variable costs for making an order. In
manufacturing, setup costs are related to machine setups.

05/05/2024 23
Inventory Costs
• Examples of order costs include:
– Costs of receiving an order (wages)
– Conducting a credit check
– Verifying inventory availability
– Entering orders into the system
– Preparing invoices
– Receiving payment

05/05/2024 24
Inventory Costs
• Trade-Off between Carrying and
Ordering Costs
– Costs respond in opposite ways to the
number of orders or size of orders
– An increase in the number of orders
leads to higher order costs but lower
carrying costs

05/05/2024 25
Trade-off between Carrying and Ordering costs
Ordering cost for a year CO = no. of orders per year ×
ordering cost per order

= sum of expenses related to

servicing an order

Carrying cost for 1 order Ch= average inventory ×

carrying costs per unit

average inventory = ½ order size

Note: Assume that as many orders as inventories
05/05/2024 MSC. DO THI THU HA 26
 Ordering cost and Carrying cost
Suppose weekly demand is 100 units, order cost per order is £80, the value of an
item is £50 and carrying cost is 20% of the value of an item.
a)If we place one order per year for the product, how much will the ordering cost
for a year and carrying cost for 1 order be?
b)If we place one order per week, how much will those costs be?

Co for a year = number of orders per year × Co per order

Ch for 1 order = ½ order size × Ch per unit

05/05/2024 27
Practice 2:

Janet Long is a purchasing clerk at Overton Travel Group. She earns £16,000 a
year, with other employment costs of £3000, and has a budget of £6200 for
telephone, communications, stationery and postage. In a typical month Janet
places 100 orders. When goods arrive there is an inspection that costs about £15
an order. The cost of borrowing money is 9%, the obsolescence rate is 5% and
insurance and other costs average 4%. How can Overton estimate their reorder
and holding costs?

05/05/2024 28
Shortage Cost
 The cost incurred by an organization when it is unable to satisfy a demand,
a situation referred to as a stockout.

 Stockout cost is an estimated cost or penalty that is realized when a

company is out of stock when a customer wants to buy an item.

 Stockout costs involve an understanding of a customer’s reaction to a

company being out of stock.

05/05/2024 29
Shortage cost
Customer agrees to wait for the item

Customer chooses other products with the same

objectives
Possible
consequences
Customer orders the items (a back-order)

Customer cancels the order, buy products from a

competitor and maybe is no longer a customer
05/05/2024 30
Shortage cost
General Rules Regarding Stockout Costs

◦ The higher the average cost of a stockout, the better it is for the company
to hold some amount of inventory (safety stock) to protect against
stockouts.

◦ The higher the probability of a delayed sale, the lower the average
stockout costs and the lower the inventory that needs to be held by a
company.

05/05/2024 31
Trade-off between
Carrying and Stockout costs

Carrying Stockout
cost cost

05/05/2024 32
 Inventory Control Systems
The core of the inventory management problem is to address the
following issues:
1. How frequently should the inventory status for an item be
reviewed?
2. When should a replenishment order be placed?

3. How much should be ordered?

05/05/2024 33
 Inventory Control Systems
 Review Frequency
• A continuous review inventory system: Point-of-Sale (POS) system
• A periodic review system: the stock level is reviewed every T units of time.
 Timing of Replenishment Order
• Place an order the moment the current inventory level reaches a predetermined level.
• Place an order at predetermined review points (periodic review system)
 Size of Replenishment Order
• Determine and place an order for a fixed quantity.
• Compute an order quantity such that it takes the stock level back to predetermine
maximum level.
05/05/2024 34
Review of Inventory Control Systems
 Continuous Review, Fixed Order Quantity (s, Q) System.

05/05/2024 35
Review of Inventory Control Systems
 Continuous Review, Order-Up-to-Level (s, S) System

05/05/2024 36
Review of Inventory Control Systems
 Periodic Review, Order-Up-to-Level (T, S) System

05/05/2024 37
Inventory Models
Inventory models come in all shapes. We will focus on models for only a single product at a single
location. Essentially each inventory model is determined by three key variables:
Demand:
Deterministic, that is, known exactly and in advance.
Random: Forecasting technique may be used in the latter case when historical data are
available to estimate the average and standard deviation of the demand (will introduce
forecasting techniques later).
Costs:
Order cost: the cost of product and the transportation cost
Inventory holding cost: taxes and insurances, maintenance, etc.
Physical aspects of the system: the physical structure of the inventory system, such as
single or multiple-warehouse
05/05/2024 38
“how much should I order”?
• Economic order quantity (EOQ)
– Deals with calculating the proper order size with respect to two
costs
 Costs of carrying the inventory
 Costs of ordering the inventory
─ Determines the point at which the sum of carrying costs and
ordering costs is minimized, or the point at which carrying costs
equal ordering costs

05/05/2024 39
Basic EOQ assumptions
1.A continuous, constant, and known rate of demand
2.A constant and known replenishment or lead time
3.A constant purchase price that is independent of the order quantity
4.All demand is satisfied
5.No inventory in transit
6.Only one item in inventory or no interaction between inventory items
7.An infinite planning horizon
8.Unlimited capital availability

05/05/2024 40
Economic Order Quantity (EOQ): Analysis
Inventory level (IL) is the quantity on
hand, which is different from inventory
position (IP), which is equal to inventory
on-hand plus quantity on order minus
backorder (if any).

The maximum IL is Q, the minimum is 0,

therefore the average IL is Q/2.

05/05/2024 41
 EOQ cost model
If Q units are ordered:
TC (Q ) = annual ordering cost + annual holding cost + annual purchasing cost

Annual ordering cost = ordering cost per order × orders per year = Co × D/Q
Annual holding cost = holding cost per unit × average inventory = Ch × Q/2
Annual purchasing cost = P × D
D: the number of units demanded per year

⇒ Q: the quantity ordered each time the inventory

level = 0

2 Co: cost of placing 1 order

Then: ⇒
2 Ch: annual holding cost/unit
P: purchase cost/unit
⇒ ∗
Problem is to find Q* that minimizes the annual
05/05/2024
inventory total cost.
MSC. DO THI THU HA 42
How Much to Order
Annual costs

TC

Q* Order quantity
= EOQ
05/05/2024 43
 EOQ model - Practice
A building materials supplier obtains its bagged cement from a single supplier. Demand is reasonably constant
throughout the year and last year the company sold 2000 tons of this product. It estimates the costs of placing an
order at around £25 each time an order is placed and the annual cost of holding inventory is 20% of the purchase
cost. The company purchases the cement at £60 per ton.
a) How much should the company order at a time?
b) How many orders should be placed each year?
c) How much time will elapse between the placements of orders (what is the cycle length)?

 D: the number of units demanded per year.

∗ ⇒
 Q: the quantity ordered each time the ⇒
inventory level = 0.
 Co: cost of placing 1 order.
No. of orders per year = D/Q*
 Ch: annual holding cost/unit.
Time between orders (Cycle) = Q*/D
 P: purchase cost/unit
05/05/2024 44
Problem 3.1
John Pritchard buys stationery for Penwynn Motors. The demand
for printed forms is constant at 20 boxes a month. Each box of
forms costs £50, the cost of processing an order and arranging
delivery is £60, and holding cost is £18 a box a year. What are the
economic order quantity, cycle length and costs?

05/05/2024 45
Problem 3.2
A local distributor for a national tire company expects to sell approximately
9600 steel-belted radical tires of a certain size and tread design next year.
Annual carrying cost is $16 per tire, and ordering cost is $75 per order. The
distributor operates 288 days a year.

1. What is the EOQ?

2. How many times per year would the store reorder if the EOQ is ordered?

05/05/2024 46
Problem 3.3
Leon Cardiology Centre in Mexico buys 25,000 stents each
year from its suppliers in Germany. Each stent costs $1500,
and carrying cost is 26% of the value of the average inventory
of stents per year. If the ordering cost is $270 per order,
determine the economic order quantity for stents. Also,
determine the number of orders and the TC.

05/05/2024 47
 When to order?
FIXED ORDER QUANTITY SYSTEM FIXED TIME PERIOD SYSTEM
(CONTINUOUS SYSTEM) (FIXED ORDER INTERVAL/ PERIODIC SYSTEM)
Orders placed with a constant size in different time Orders placed for variable amount at specific time
period intervals

+ Inventory level continuously monitored. + Proactive occasion.

– Costly.
Reorder point – ROP
The level of inventory at which a
replenishment is placed
05/05/2024
– Less direct control.
ROP = (DD x RC) + SS
DD: average daily demand (units)
RC: length of the replenishment cycle (days)
SS: safety stock
48
 ROP = (DD x RC) + SS
DD: average daily demand

ROP – Reorder point RC: length of the replenishment cycle (days)

SS: safety stock

Demand for chicken soup at a supermarket is always 900

packs a month. The shelves are restocked with chicken
soup after 4 days calculating from the moment an order is
sent. The manager always leaves an on-hand inventory of
at least 10 packs.
What is the reorder point?
What is the meaning of the result?
Note: Assuming a month has 30 days

05/05/2024 49
Exercise 3.4
A firm sells an item that has an annual demand of 1000 units. If the
procurement lead time is a constant 5 days, find the reorder level.
Assume 365 workdays a year.

05/05/2024 50
Exercise 3.5
Demand for an item is constant at 20 units a week, the reorder cost
is £125 an order and holding cost is £2 an unit a week. If suppliers
guarantee delivery within 2 weeks what is the best ordering policy
for the item?

05/05/2024 51
 ABC analysis The ABC analysis states that a company
should rate items from A to C, based on:
• Sales volume in money (high to low value
• Sales volume in units (high to low
quantity)
Standards of evaluation

• Fastest-selling items (high to low speed of

selling)
• Item profitability (bring most to least
revenue)
• Item importance (high to low protective
level)
• Fragileness level

05/05/2024 52
ABC analysis

ABC classification strategy

05/05/2024 53
 Example:
Sample of 16 items at Rosettas. Classify each of these items into A, B,
or C categories.

05/05/2024 54
 Flowers
50 $0.50
ABC analysis
Sally who owns a grocery store is fairly profitable, but would like to focus on
the items that create more revenue.
Apples
Squashes
150
30
$0.10
$0.25
Toothbrushes
100 $4.00

Magazines
200
$1.00
Balloons
Stools
Paper towels 400
100
$15.00 200 $1.50 $1.00
05/05/2024 MSC. DO THI THU HA 55
Inventory turnover
A ratio showing how many times a company's inventory is sold and replaced over a period of time
Inventory turnover measures how fast a company is selling inventory and is generally compared
against industry averages
Beginning inventory: The value of goods, inputs or materials available for use or sale at the beginning
of an inventory accounting period
Ending inventory: The value of goods available for sale at the end of the accounting period.

%!& !' (!!)& &!*)

!"# $" ! "
+ "+( !"#

, ( ( !"# ) ( !"#
+ "+( !"#
2
05/05/2024 56
Inventory turnover – Example

The Hegemony Toy Company is reviewing its inventory levels. The related
information is $8,150,000 of cost of goods sold in the past year, and the
average inventory of $1,630,000.
Calculate the inventory turnover and determine the days number that the
inventory of Hegemoney is on hand.

05/05/2024 57
Contemporary Approaches to Managing
Inventory
• Lean Manufacturing
– Focuses on the elimination of waste and the increase of speed
and flow.
– Identifies seven major sources of waste including:
overproduction, excess inventory, unnecessary motion, defects,
over-processing, waiting, transport.
– Just-in-time (JIT) is one of the best known lean inventory
practices.

05/05/2024 58
Contemporary Approaches to Managing
Inventory
• Service Parts Logistics
– Involves designing a network of facilities to stock service parts:
 Deciding upon inventory ordering policies
 Stocking the required parts
 Transporting parts from stocking facilities to customers

05/05/2024 59
Contemporary Approaches to Managing
Inventory
• Vendor-Managed Inventory (VMI)
– Size and timing of replenishment orders are the responsibility of
the manufacturer
– Allows manufacturers to have access to a distributor’s or
retailer’s sales and inventory data
– Benefits include reduced inventories, fewer stockouts and
improved customer retention

05/05/2024 60