Quantitative

Methods in
Administration
INVENTORY
DECISIONS

HAZEL ANN M. GABRIEL

 INVENTORY

Inventories are stock of goods held for expected

future use or for potential future use.

Defined as an itemized list of current assets.

Most business organization carry some forms of
inventory, depending on the nature of the organization’s
business. These might include raw materials, purchased
parts, work-in process, finished goods, supplies and
spare parts.
The reasons of carrying inventories, and the way that
they are manage similar regardless of the specific
items.
 FUNCTIONS OF INVENTORIES

To meet anticipated demand

To be able to buy or produce in economic lot
sizes
To separate stages of operations
To guard against stock outs
To maintain flexibility in scheduling
To display items in order to accommodate
customer selection
To allow for goods in transit (pipeline)
 INFORMATION REQUIREMENTS

Successful inventory management is

predicated on accurate information about
demand, lead times needed to replenish
inventories, the costs associated with
ordering and holding inventory, and
quantities of inventory on hand.
 INFORMATION REQUIREMENTS

Demand
Inventory decisions rely heavily on demand
forecasts.

Lead time
It includes the time necessary to decide.
 MAJOR INVENTORY DECISIONS

How much of an item to order when it is

time for the inventory of that item to be replenished.

When to replenish the inventory of that item

 Selective Approach in Managing Inventory
ABC Analysis

It is a simple procedure that can be used

to classify SKUs (Stock keeping Units) based
on some measure importance. In ABC
analysis, the items are divided into three
classes:
Class A items- the top 50% of sales
Class B items- the items in between A & C
Class C items- the bottom 50% of the
items sold
 Economic Order Quantity:
The basic “how much to buy model”

It is the oldest and the best-known

inventory model. The purpose of using the
EOQ is to find the particular quantity to order
that will minimize the inventory cost.

Inventory Cost
a. Ordering Cost
b. Carrying Cost
 Economic Order Quantity:
The basic “how much to buy model”

Inventory Cost
a. Ordering Cost- basically the costs of
getting an item into the firm’s inventory.
b. Carrying Cost- also referred to as
holding costs incurred because a firm owns
or maintains inventories. It includes:
• Interest on money invested in inventory
• Obsolescence
• Storage space cost
• Taxes, insurance and pilferage
 CONCEPTOF AVERAGE INVENTORY

To minimize inventory cost, management

tries to minimize ordering costs and carrying
costs. Having seen how the incremental
ordering costs, the carrying cost and the
average inventory costs are determined. The
EOQ is the size order which minimizes the
total annual cost of ordering and carrying
inventory.
 HOW MUCH TO ORDER DECISION:

THE EOQ WHEN DEMAND IS KNOWN AND CONSTANT

In deriving EOQ formulas,

Let P- cost of placing an order

C- carrying cost expressed as a percentage or average
inventory
A- annual total sales in pesos
D- annual usage (demand) in units
R- price per unit
Qu- optimum number of units per day
Qn- optimum number of order per day
 HOW MUCH TO ORDER DECISION:

THE EOQ WHEN DEMAND IS KNOWN AND CONSTANT

In deriving EOQ formulas,

Qn= D/ Qu
Average inventory= A/2Qu
Carrying cost= A/Qn x ½ x C
Ordering Cost= Qn x P
Total inventory cost= ordering cost + carrying cost
 HOW MUCH TO ORDER DECISION:

THE EOQ WHEN DEMAND IS KNOWN AND CONSTANT

In deriving EOQ formulas,

Optimal Number of Orders per year

Qn=

Optimal Number of Day’s Supply Per Order

How many days usage should provide for each time the company orders

Qd=
 HOW MUCH TO ORDER DECISION:

THE EOQ WHEN DEMAND IS KNOWN AND CONSTANT

In deriving EOQ formulas,

Optimal Amount of Peso Per Order

Qp=

Optimal Number of Units Per Order

Qu=
 HOW MUCH TO ORDER DECISION:

 In the EOQ models presented we have

assumed that all of the inventory which is
ordered arrives simultaneously- that the
inventory rises to its maximum level
instantaneously.
 HOW MUCH TO ORDER DECISION:

The four derived EOQ formulas will work best

only under the following assumptions:
1. That the demand is known and constant
2. That when an order is placed the orders are received all at
one time in a all at one time in a lot of size Qu.
3. And that estimation of costs figures or ordering and carrying
costs are reasonably accurate.

Under these assumptions the economic order

quantity formulas derived will minimize the total
inventory costs.
 1.2 THE ECONOMIC WAY OF THINKING

Responding to Incentives
Incentive
A reward or a penalty—a “carrot” or a “stick”—that
encourages or discourages an action.
 How to eliminate the instantaneous receipt
assumption in EOQ Models

In the EOQ models presented, it was

assumed that all the inventory which is ordered
arrives simultaneously- that the inventory rises
to its maximum level instantaneously.
In this situation, Qu, with instataneous
receipt assumption eliminated could be
expressed as:
Qu=
 How to eliminate the instantaneous receipt
assumption in EOQ Models

where:
U= annual usage
P= ordering cost per order placed
R= price each unit
C= Carrying cost expresses as a
percentage of average inventory
y= use rate in units used daily
x= receipt in units received daily
 APPLYING EOQ MODEL TO PRODUCTION
PROCESS

The concept that there is one best pattern

of ordering to minimize annual inventory
costs can be adapted to the production
process. For instance, many companies
produce certain items among their product
lines in lots of batches instead of
manufacturing at a constant rate all year
long.
 APPLYING EOQ MODEL TO PRODUCTION
PROCESS

These firms incur setup cost each time a batch

is produced. Setup cost is roughly equivalent to
the ordering cost per order. It consists of:
1. Engineering and labor cost of setting up the
production lines or machines.
2. Paperwork cost of processing the work order
and authorizing production
3. Ordering cost to provide raw materials for
batch or order
 OPTIMUM PRODUCTION LOT SIZE:
Production for Stock

Production lot size for stock involves

finished goods which are to be placed in
stock and then sold at a constant rate until a
low level is reached wherein at that point
another lot will be produced.
 OPTIMUM NUMBER OF PRODUCTION
RUNS PER YEAR (Nr)

Nr=
Where:
Nr= optimum number of production runs/ year
A= number of units produced annually
C= carrying cost expressed as a percentage of
annual inventory
S= set up cost (roughly equivalent to ordering cost)
 OPTIMUM PRODUCTION LOT SIZE:
Simultaneous Production and Sales

Simultaneous production and sales

involves the production of finished goods
which are being sold while each lot is being
produced. This way the inventory of the
finished goods builds up gradually as goods
are produced faster than they sold, then the
inventory declines to its lowest point as
production ceases although sales continue.
 OPTIMUM PRODUCTION LOT SIZE:
Simultaneous Production and Sales

Let Qu= economic production quantity

P= annual production rate
d= annual rate of demand
p-d= net inventory increase rate during production
Qu/p= duration of production run
S= set up cost/ production run
A= annual usage in units
Qu/p (p-d) = maximum inventory
Qu/2p (p-d)= average inventory
OPTIMUM PRODUCTION LOT SIZE:
Simultaneous Production and Sales

Qu=
 JUST IN TIME INVENTORY SYSTEM

 This system is called “kaban” inventory system. The

word kaban refers to a card that allows one
department of a company to produce some minimum
quantity of items in response to other department’s
immediate need.
 This concept is to use very small order quantities,
with relatively low order points so that inventory
replenishment arrives “just in time”
 To implement JIT it is necessary that the ordering or
setup cost somehow be lowered from its earlier
value.
 QUANTITY DISCOUNTS
Quantity discount refers to the offer for some
manufacturers to lower the price unit if a larger
quantity is purchased at one time.
There are three basic elements to consider in
evaluating whether or not to pursue or accept a
quantity discount.
1. The benefit of the discount in reduced purchased
cost.
2. The cost of the discount in increased carrying costs
3. The benefit of the reduced number of order per
year.