CHAPTER 7

INVENTORY MANAGEMENT
Learning Objectives

1. To learn about the ways that inventory can be classified

2. To discuss inventory costs and the trade-offs that exist among them
3. To identify when to order and how much to order, with a particular emphasis
on the economic order quantity
4. To differentiate the various inventory flow patterns
5. To discuss special concerns with inventory management
6. To identify several contemporary approaches to managing inventory

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Reasons for Holding Inventory
• Achieve economies of scale.
• Balances supply and demand.
• Enables specialization in manufacturing.
• Provides protection from uncertainties in demand and order cycle.
• Acts as a buffer between critical interfaces within the supply
chain.

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 Economies of Scale

• Can be realised in purchasing, transportation and

manufacturing.
• Volume purchase leads to lower per-unit price.
• Full truckload shipment leads to lower per-unit transportation
cost.
• Greater plant capacity leads to lower per-unit manufacturing
cost ( long production runs, few line changes).

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Balancing Supply and Demand

• Seasonal supply/demand makes it necessary to hold inventory

(why?).
• Produce to demand leads to idle capacity and wide
fluctuations in labour force.
• Stable production leads to inventory build-up.
• Raw materials available only at certain times; need to produce
in excess and hold in inventory.

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Specialization in Manufacturing

• Longer production runs increase the learning curve. Why?

• Reduction in transportation costs. Why?
• Increase in handling and warehousing costs. Is this
worrisome?

Not necessarily. Look at cost trade-off.

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Protection From Uncertainties

• Raw materials – future price increase, strikes, seasonal availability.

• Work-in-process – inventories needed to maintain manufacturing
operations and avoid shutdowns.
• Finished goods – reduce stockouts, increase customer satisfaction.

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 A Buffer Throughout Supply Chain
• Inventory acts as buffer for the following critical interfaces:
* Supplier – Procurement

* Procurement – Production
* Production – Marketing
* Marketing – Distribution
* Distribution – Intermediary
* Intermediary – Consumer

• Can achieve time and place utility due to members being

geographically separated.
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Inventory Carrying Costs

• Capital costs – money tied up in inventories cannot be

used for other types of investment.
• Service costs – taxes, insurance
• Storage space costs – warehousing costs, materials
handling costs, transportation costs.
• Risk costs – obsolescence, damage, pilferage, relocation
costs (goods transport for sale from one location to another
to avoid obsolescence).

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 Types of Inventory
• Cycle Stock
– to replenish supply when demand & lead (replenishment) time is certain.
• In-Transit Inventories
– items en route from one location to another.
• Safety (Buffer) Stock
– held in excess of cycle stock due to uncertainty in demand & lead time.
• Speculative Stock
– produced & held in anticipation of price increase, strikes, raw materials
shortage.
• Seasonal Stock
– held before a season begins.
• Dead Stock
– no demand for some specified period of time.
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 The Effect of Reorder Quantity on
Average Inventory Investment with
Constant Demand and Lead Time
20 units/day 10 days
A. Order quantity of 400 units
Inventory Order Order
arrival arrival
400
Order Order
placed placed Average
cycle
inventory
200

0
Days 10 20 30 40 50 60

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 The Effect of Reorder Quantity on
Average Inventory Investment with
Constant Demand and Lead Time

20 units/day 10 days
Order Order arrival
placed
B. Order quantity of 200 units
Inventory
Average
200 Order Order cycle
placed arrival inventory
100

0
Days 10 20 30 40 50 60

An order is placed the moment an earlier order arrives.

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 The Effect of Reorder Quantity on
Average Inventory Investment with
Constant Demand and Lead Time
20 units/day 10 days
Inventory C. Order quantity of 600 units
600 Order
arrival

Order Average
placed cycle
inventory
300

0
Days 10 20 30 40 50 60
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 Average Inventory Investment
Under Conditions of Uncertainty
Demand is 25 units/day instead of
20 units/day. Stocks out in 8 days.
A. With variable demand
Needs stocks for 2 extra days.
Inventory

200 Average
cycle

{
inventory
100

{
Average
inventor y
(150) S afety 8 10 20 30 40
s tock
(50) Days

2 days x 25 units

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 Average Inventory Investment
Under Conditions of Uncertainty
Lead time is +/- 2 days, i.e.
B. With variable lead time from 8 to 12 days. Needs
stocks for 2 extra days.
Inventory

200 Average
cycle

{
inventory
100
8

{
Average
inventor y
(140) S afety 10 12 20 30 40
s tock
(40) Days

2 days x 20 units

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 Average Inventory Investment
Under Conditions of Uncertainty
Demand is 25 units/day
instead of 20 units/day

C. With variable demand and lead time Lead time is +/- 2 days,
i.e. 8 days to 12 days
Inventory

200 Average

{
cycle
inventory
100

{
Average
inventor y
(200) S afety 8 10 12 20 30 40
s tock Days
(10 0)

( 2 + 2 ) days x 25 units
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Inventory Management
(The Objectives)

Increase corporate Predict impact of corporate

profitability policies on inventory level

Minimise total cost of

logistics activities

• Reduce number of back orders

• Reduce expedited shipments
• Purge obsolete or dead stocks
• Improve accuracy of forecasts
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Inventory Management
(Under Conditions of Certainty)

• Assumes that there is certainty in demand, lead time,

purchase price, transportation costs, etc.

• Uses the Economic Order Quantity (EOQ) model to

determine best ordering policy.

• Questions asked:
* Quantity to order – 200, 400 or 600?
* Time period – 10, 20 or 30 days?
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The EOQ Model

2PD
E OQ = CV

where:
P = The ordering cost (dollars per order)
D = Annual demand or usage of the product
(number of units)
C = Annual inventory carrying cost (as a percentage
of product cost or value)
V = Average cost or value of one unit of inventory
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 Example…

• Determine the best ordering policy if:

* Order cost is $40 per order
* Annual demand is 4,800 units
* Average unit cost of inventory is $100
* Annual inventory carrying cost (as a percentage of
product cost) is 25% (0.25)

Answer: 124 units

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Cost Trade-offs Required to
Determine the Most Economic Order Quantity
Inventory
Number Ordering Carrying
Order of Orders Cost Cost Total
Quantity (D/Q) PX (D/Q) 1/2 Q X C X V Cost

40 120 $ 4,800 $ 500 $ 5,300

60 80 3,200 750 3,950
80 60 2,400 1,000 3,400
100 48 1,920 1,250 3,170
120 40 1,600 1,500 3,100
140 35 1,400 1,750 3,150
160 30 1,200 2,000 3,200
200 24 960 2,500 4,460
300 18 720 3,750 4,470
400 12 480 5,000 5,480
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Cost Trade-offs to Determine the
Most Economic Order Quantity
Total cost
Annual cost
(dollars)

L owes t total cos t

(E OQ) Inventory
carrying
cost

Ordering cost

Size of order
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 Adjustments to the EOQ
• Quantity and/or transportation discounts are factored into the formula.
• Example (for quantity discount):

Q1 = 2(rD/C) + (1 – r) Q0

Where:
Q1 = quantity ordered to qualify for discount
r = % price reduction if larger quantity ordered
D = annual demand in units
C = inventory carrying cost percentage
Q0 = the EOQ based on current price

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Cost trade-offs required to determine EOQ with
transportation costs added

Possible No. of Purchase Transport Annual Annual Inventory Total

order orders per price per cost per ordering transport carrying annual cost
quantity year order order cost cost cost

300 54 2,400 300 540 16,200 338 17,078

*380 43 3,040 380 430 16,340 428 17,198
400 40 3,200 400 400 16,000 450 16,850
800 20 6,400 780 200 15,600 898 16,698
1,200 14 9,600 1,170 140 16,380 1,346 17,866
1,600 10 12,800 1,458 100 14,580 1,782 16,462
2,000 8 16,000 1,820 80 14,560 2,228 16,868

* EOQ calculated without including transportation costs

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 EOQ with Incremental Replenishment

• Deliveries are spread over time, not at a single point in time.

• Need to consider production rate and usage rate. Can lead
to build-ups if production rate exceeds usage rate (see next
slide).
• If company makes the product there are no ordering costs,
but there are setup costs (cleaning, adjusting, changing
tools & fixtures).

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EOQ with Incremental Replenishment
Q
Production Usage Production Usage
& usage only & usage only

Run size,
Q0

Cumulative
production
(No usage) Production
Maximum stops
inventory,
I max
Amount on
hand

Time
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Inventory Management
(Under Uncertainty)

• Uncertainties due to economic conditions, competitive actions, market

shifts, govt regulations, order cycle times, etc.
• Need to consider additional trade-offs: Inventory carrying costs vs
Stockout costs.
• Important consideration is when to order rather than how much to order.

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 Methods of Inventory Control

An order is placed when the inventory

Fixed Order Point,
on hand and on order reaches a
Fixed Order Quantity
predetermined minimum level required
Model
to satisfy demand during the order cycle.

Compares current inventory with

Fixed Order Interval forecast demand and places an order
Model for the necessary quantity
at a regular, specified time.

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Fixed Order Point, Fixed Order Quantity Model
Units
Assumption: Order cycle is 5 days
500

400

300

200
Reorder
point
100

15 20 27 40 52 60 Days

Order placed 29
Fixed Order Interval Model
Units

Order placed
500

Order interval is
400
20 days, order
cycle is 5 days
300

200

100

15 20 35 40 55 60 Days

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Determining Safety Stock Requirements
• Can be done by statistical techniques or computer
simulation.
• Safety stocks requirement is calculated by using the formula:

σc =
√R σs
2
+S
2
σR
2

σc = Units of safety stocks needed to satisfy 68% of all probabilities

R = Average replenishment cycle

σs = Standard deviation of daily sales
S = Average daily sales
σR = Standard deviation of the replenishment cycle
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 Fixed Quantity vs Fixed Interval
Fixed Quantity Model
• Orders triggered by quantity.
• Needs protection only during
lead time because additional
orders can be placed at any time.
• Higher than normal demand
causes a shorter time between orders.
• Requires close monitoring of
inventory levels.
• Requires a lower level of safety stock.
Fixed Interval Model
• Orders triggered by time.
• Must have stock-out protection for
lead time plus the next order cycle.
• Higher than normal demand
causes a larger order size.
• Requires only a periodic review.
• Requires a higher level of safety stock.
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 Symptoms of Poor Inventory
1. Increasing numbers of back orders
2. Increasing dollar investment in inventory with back orders remaining
constant.
3. High customer turnover rate.
4. Increasing number of orders being canceled.
5. Periodic lack of sufficient storage space.
6. Wide variance in inventory turnover among distribution centers and
major inventory items.
7. Deteriorating relationships with intermediaries (order cancellation,
declining orders).
8. Large quantities of obsolete items.

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 Ways to reduce inventory levels

1. Multi-echelon inventory planning, e.g. ABC analysis.

2. Lead time analysis.
3. Delivery-time analysis.
4. Elimination of low turnover and obsolete items.
5. Analysis of pack size and discount structure.
6. Examination of returned goods procedures
7. Encouragement of product substitution.
8. Installation of formal reorder review systems.

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 Improving Inventory Management

• ABC analysis
• Forecasting
• Enterprise resource planning systems (ERPS)
• Order processing systems (OPS)

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 ABC Analysis

• 20% of firm’s customers/products account for 80% of the sales or

profits (Pareto Principle).
• Based on ranking products by sales or contribution to firm’s profits.
• Also check for differences between high-volume and low-volume
items.
• Consider review of inventory status, e.g. A – review daily, B –
review weekly, etc.

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Customer Service Level Using ABC Analysis

Category Percentage of Customer service

sales level

A 70 98%

B 20 90%

C 10 85%

Overall 100 95.1%

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 Distribution-by-Value Report
Rank of Part Annual Cumulative Classification
items number dollar sales dollar sales of item
1 K410 $ 126,773 $ 126,733 A
3 9999 74,130 285,602 A
35 2601 16,899 1,158,439 A
126 1101 9,388 2,191,561 A
839 920L 2,000 5,231,186 A
1000 K82T 1,635 5,508,045 B
1632 5304 831 6,127,337 B
2452 3501 463 6,570,312 B
2920 460P 300 6,787,428 C
3186 131M 250 6,906,187 C

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Forecasting Methods

• Using mail questionnaires, telephone

Survey Buyer
interviews, personal interviews.
Intentions
• Costly, accuracy questionable.

• Solicit opinions of salespeople or known

Judgment
experts in the field.
Sampling
• Subject to personal biases.

• Develop forecasting at company level or

Past Sales product line using a forecasting model.
Data • Then break that forecast down by product
class and stock-keeping unit (SKU).

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 ERP Systems

• Enterprise resource planning (ERP) are transactional tools

which capture data and reduce the manual tasks associated
with processing financial, inventory and customer- order
information.

• The German firm SAP AG is the world leader in ERP software,

especially its R/3 software system (Realtime application of
database, server and client software).

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 Some modules in the R/3

• Materials management
• Plant maintenance
Manufacturing • Quality management
and Logistics Module • Production planning and control
• Project management system

• Customer management
• Sales order management
Sales and • Configuration management
Distribution Module • Distribution/transport management
• Billing, invoicing, rebate processing

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 Order Processing System
• Provides members of the supply chain with timely and accurate
product usage information.

• Can reduce the time needed to perform order entry, order

processing & inventory replenishment.

• Reduces levels of safety stocks & gain substantial cost savings.

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Thank you !

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