13-1

 Inventory
 A stock or store of goods
 Independent demand items
 Items that are ready to be sold or used

Inventories are a vital part of business: (1) necessary for

operations and (2) contribute to customer satisfaction
A “typical” firm has roughly 30% of its current
assets and as much as 90% of its working capital
invested in inventory

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 Raw materials and purchased parts
 Work-in-process (WIP)
 Finished goods inventories or merchandise
 Tools and supplies
 Maintenance and repairs (MRO) inventory:
 items are used in production and plant maintenance and can be items such
as maintenance supplies, spare parts, and consumables used in the
production process (lubricant oil , soap)
 Goods-in-transit to warehouses or customers (pipeline
inventory)

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 Contd…
1. Cycle Inventory- produce or sell the products in batches
2. Safety Stock- safeguard against uncertainty of supply and demand
3. Decoupling Stocks
4. Anticipation Inventory: to handle peak sales or some special event-
that is irregular
• Seasonal stock
• Speculation stock- for specific events –after the temporary
phase – should not hold any inventory
5. Pipeline Inventory
6. Dead Stock

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 Inventory related Costs

• Ordering costs
Administration cost, transportation cost and receiving
cost

• Inventory- carrying Costs

Inventory risk, storage and handling cost , financing
cost

• Stockout Costs
• Lost Sales Cost
• Backorder Cost

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 Inventories serve a number of functions such as:
1. To meet anticipated customer demand
2. To smooth production requirements
3. To decouple operations
4. To protect against stockouts
5. To take advantage of order cycles
6. To hedge against price increases
7. To permit operations
8. To take advantage of quantity discounts

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  Requires:
1. A system keep track of inventory
2. A reliable forecast of demand
3. Knowledge of lead time and lead time variability
4. Reasonable estimates of
 holding costs
 ordering costs
 shortage costs
5. A classification system for inventory items

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LO 13.4
 Inventory management has two main concerns:
1. Level of customer service
 Having the right goods available in the right quantity in the
right place at the right time
2. Costs of ordering and carrying inventories

 The overall objective of inventory management is to achieve

satisfactory levels of customer service while keeping
inventory costs within reasonable bounds
1. Measures of performance
2. Customer satisfaction
 Number and quantity of backorders
 Customer complaints
3. Inventory turnover

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  Periodic System
 Physical count of items in inventory made at periodic
intervals (weekly, monthly)
 Retailers
 Economies in processing and shipping orders
 Extra stock to be carried
 Perpetual Inventory System
 System that keeps track of removals from inventory
continuously, thus monitoring current levels of each
item
 Bank transactions
 An order is placed when inventory drops to a
predetermined minimum level
 Two-bin system
 Two containers of inventory; reorder when the first is empty
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LO 13.5
13-10
 Reorder point
 When the quantity on hand of an item drops to this amount, the
item is reordered.
 Expected demand during lead time
 Extra cushion of stock- to overcome the stock out during lead times
 perpetual /continuous inventory monitoring required

 Determinants of the reorder point

1. The rate of demand (based on forecast)
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management

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ROP  d  LT
where
d  Demand rate (units per period, per day, per week)
LT  Lead time (in same time units as d )

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1. X takes Two-a-Day vitamins, which are delivered to his home
by a route man seven days,after an order is called in. At what
point should Tingly reorder?
Usage=2 vitamins a day
Lead time= 7 days
ROP= Usage *Lead time
2 vitamins per day *7 days= 14 vitamins

Thus, X should reorder when 14 vitamin tablets are left, which is

equal to a seven-day supply of two vitamins a day.

2. Demand = 10,000 gallons/year

Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154 gallons/day
Lead time = L = 10 days

R = dL = (32.154)(10) = 321.54 gallons

Copyright 2011 John Wiley & Sons, Inc. 13-13
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 Demand or lead time uncertainty creates the possibility that demand

will be greater than available supply

 To reduce the likelihood of a stockout, it becomes necessary to carry

safety stock
 Safety stock

 Stock that is held in excess of expected demand due to variable demand

and/or lead time

Expected demand
ROP   Safety Stock
during lead time
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13-15
 As the amount of safety stock carried increases, the
risk of stockout decreases.
 This improves customer service level

 Service level
 The probability that demand will not exceed supply during lead
time
 Service level = 100% - Stockout risk

 Note that stockout protection is needed only during lead time. If

there is a sudden surge at any point during the cycle, that will
trigger another order. Once that order is received, the danger of
an imminent stockout is negligible.
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 manager must carefully weigh the cost of carrying
safety stock against the reduction in stockout risk it
provides.

 Order cycle service level can be defined as the

probability that demand will not exceed supply during
lead time (i.e., that the amount of stock on hand will
be sufficient to meet demand).

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  The amount of safety stock that is appropriate for a given situation
depends upon:
1. The average demand rate and average lead time
2. Demand and lead time variability
3. The desired service level

Model 1: When expected demand during lead time and its standard deviations are
available
Expected demand
ROP   z dLT
during lead time
where
z  Number of standard deviations
 dLT  The standard deviation of lead time demand
Generally, the smaller the risk the manager is willing to accept, the greater the value
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of z.
 The ROP based
on a normal
Distribution of lead
time demand

Increase in the service level increase in the amount of the safety stock
Selection of service level is crucial  stockout cost
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 Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
zd L

dL R
Demand

Copyright 2011 John Wiley & Sons, Inc. 13-20

 Suppose that the manager of a construction supply house
determined from historical records that demand for sand
during lead time averages 50 tons. In addition, suppose the
manager determined that demand during lead time could be
described by a normal distribution that has a mean of 50 tons
and a standard deviation of 5 tons.
 Answer these questions, assuming that the manager is willing to
accept a stockout risk of no more than 3 percent:

a. What value of z is appropriate?

b. How much safety stock should be held?
c. What reorder point should be used?
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When data on lead time demand is not readily available

Model 2: Only demand is variable

ROP  d  LT  z d LT
where
z  Number of standard deviations
d  Average demand per period (per day, per week)
 d  The stdev. of demand per period (same time units as d )
LT  Lead time (same time units as d )
Note: If only demand is variable, then  dLT   d LT

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 Model 3: Only Lead time is variable
ROP  d  LT  zd LT
where
z  Number of standard deviations
d  Demand per period (per day, per week)
 LT  The stddev. of lead time (same time units as d )
LT  Average lead time (same time units as d )
Note: If only lead time is variable, then  dLT  d LT

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LO 13.11
A restaurant uses an average of 50 jars of a special sauce each
week. Weekly usage of sauce has a standard deviation of 3 jars.
The manager is willing to accept no more than a 10 percent risk
of stockout during lead time, which is two weeks. Assume the
distribution of usage is normal.

a. Which of the above formulas is appropriate for this situation?

Why?
b. Determine the value of z.
c. Determine the ROP.

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 If both demand and lead time are variable, then

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 Fill rate : percentage of demand filled directly from
inventory.

 Thus, if D 1,000, and 990 units were filled directly from

inventory (shortages totaling 10 units over the year were
recorded), the annual service level (fill rate) would be

 990/1,000 =99 percent.

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 Fixed-order-interval (FOI) model
 Orders are placed at fixed time intervals
 Reasons for using the FOI model
 Supplier’s policy may encourage its use
 Grouping orders from the same supplier can produce
savings in shipping costs
 Some circumstances do not lend themselves to continuously
monitoring inventory position
 Drugstores, small grocery stores

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 Fixed Quantity
• Demand increases:
frequent ordering
• Perpetual monitoring

Fixed Interval

• Demand increases:
Larger order size
• Periodic review

Use the ROP

for finding
Use the OI for
stockout risk
finding 13-28
stockout risk
 Expected demand
Amount  during protection  Safety  Amount on hand
to Order stock at reorder ti me
interval
 d (OI  LT)  z d OI  LT  A
where
OI  Order interval (length of time between orders)
A  Amount on hand at reorder ti me
Demand is variable the order size varies

Application : Retail businesses

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13-30
13-31
13-32
 The fixed-interval system results in tight control.
 Grouping orders can yield savings in ordering, packing,
and shipping costs.

 Risk of stockouts
 Cost of periodic review

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 Highly perishable products
 fresh fruits, vegetables, seafood, cut flowers
 newspapers, magazines, spare parts for specialized
equipment

 Cost:
 Shortage- lost sales – unrealized profit

 Manufacturing :Actual cost of lost production

 Excess
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 Continuous Stocking Levels
 petroleum, liquids, and gases tends to vary over some
continuous scale
 The service level is the probability that demand will not exceed the
stocking level, and computation of the service level is the key to
determining the optimal stocking level, So .

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13-36
13-37
13-38
 Discrete Stocking Levels
 Demand for tractors, cars, and computers is expressed
in terms of the number of units

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