Inventory Management

Operations Management II

Saurabh Chandra, IIM Indore

What is OM 2 all about?

• Some of the biggest challenges faced by managers:

• Materials and supplies

• People

• Sustaining quality

• Managing flow
What is inventory management?
• Inventory?
• Stock of items kept to meet future demand
• Purpose of keeping inventory?
• To meet anticipated customer demand
• Protect against stock-outs
• To take advantages of economies of scale through economic order quantities
• Maintain independence of operations
• To allow for smooth and flexible production operations
• To guard against price increase
How to measure inventory
Handout page 431
What is inventory management? Contd.
• Problems with less inventory?
• Customer service
• Ordering/setup cost
• Resource utilization
• Payments to suppliers
• Problems with more inventory?
• Holding/carrying cost
• Cost of capital
• Storage and handling cost
• Taxes, insurance, shrinkage
• Wastage, confusion, hindrance
What is inventory management? Contd.
• Inventory management?
To have the correct inventory at the right place at the right time to
minimize system costs while satisfying customer service requirements

• Inventory policy?
The strategy, approach, or set of techniques used to determine how to
manage inventory.
• How to classify the items
• How to collect data related to inventory
• How much to order and when to order
Supply Chain Inventory models
 Inventory types

Process Demand
Purpose Others
stage Type

Raw Materials
WIP Independent Cycle Spares
Finished Goods Dependent Safety Consumable
Seasonal
Pipeline
Independent vs Dependent demand
Independent Demand
(demand for item is independent
of demand for any other item)

Dependent Demand
(demand for item is dependent
upon the demand for some
other item)
Independent vs Dependent demand
Materials With Materials With
Item
Independent Demand Dependent Demand

Demand
Company Customers Parent Items
Source
Material
Finished Goods WIP & Raw Materials
Type
Method of
Forecast & Booked Calculated
Estimating
Customer Orders
Demand
Planning
EOQ & ROP MRP
Method
 Inventory models

Single-period model

●
Used when we are making a one-time purchase of an item

Fixed-order quantity model

●
Used when we want to maintain an item “in-stock,” and when we restock, a certain
number of units must be ordered

Fixed–time period model

●
Item is ordered at certain intervals of time
 Comparing multi-period models:
• Fixed-Order Quantity
– Inventory remaining must be
continually monitored
– Has a smaller average inventory
– Favors more expensive items
– Is more appropriate for important
items
– Requires more time to maintain – but
is usually more automated
– Is more expensive to implement
• Fixed-Time Period
– Counting takes place only at the
end of the review period
– Has a larger average inventory
– Favors less expensive items
– Is sufficient for less-important
items
– Requires less time to maintain
– Is less expensive to implement
Comparing multi-period models:
 ABC analysis

• Stock-keeping units (SKU)

• Identify the classes so management can control inventory levels
• A Pareto chart
 ABC Classification
• Class A
• 5 – 15 % of units
• 70 – 80 % of value
• Class B
• 30 % of units
• 15 % of value
• Class C
• 50 – 60 % of units
• 5 – 10 % of value
 ABC Classification
PART UNIT COST ANNUAL USAGE TOTAL VALUE

1 $ 60 90 (60 * 90) 5400

2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120
 ABC Classification
TOTAL % OF TOTAL % OF TOTAL
PART VALUE VALUE QUANTITY % CUMMULATIVE
9 $30,600 35.9 6.0 6.0
8 16,000 18.7 5.0 11.0
2 14,000 16.4 4.0 15.0
A
1 5,400 6.3 9.0 24.0
4 4,800 5.6 6.0 30.0 B
3 3,900 4.6 10.0 40.0
6 3,600 4.2 18.0 58.0
5 3,000 3.5 13.0 71.0
10 2,400 2.8 12.0 83.0 C
7 1,700 2.0 17.0 100.0
$85,400
 ABC classification

% OF TOTAL % OF TOTAL
CLASS ITEMS VALUE QUANTITY
A 9, 8, 2 71.0 15.0
B 1, 4, 3 16.5 25.0
C 6, 5, 10, 7 12.5 60.0
Inventory related costs

• Holding cost
• Ordering cost
• Buyer time
 Time of buyer for placing extra order, ZERO otherwise
 Internet and communication has reduced this cost significantly

• Receiving costs
 Administrative work such as purchase order matching with updating inventory records
 Quantity dependent should not be included here

• Transportation costs
 Fixed cost should be included here
Inventory related costs

Any other cost related to inventory?

Shortage cost: Two possibilities:
• Permanent
– Lost profits due to unsatisfied demand
– Lost profits of future sales

• Temporary (CB)
– Backordered, so not necessarily lost
– Special clerical & paperwork costs
– Extraordinary transportation cost to customer
Steps in inventory management
• Facts and Data?
• Inventory requirements
• Supply sources
• “Customer” demand
• Replenishment lead time
• Product variety
• Costs
• Service level requirements
• Inventory policy
• Item classification
• Single item/multi-item
A simple EOQ policy
Assumptions:
• Demand is fixed and known
• Lead time to receive an order is fixed and known
• Inventory is updated instantaneously upon receipt

Inventory
25

20

15

10

0
0 1 2 3 4 5 6

Time (Days)
Notations:
D – total demand in the planning horizon (1 year)
d – daily (or weekly) demand
Q – fixed order quantity
S – ordering cost (one time)
H – inventory holding cost per unit (Rs.)
C – product cost per unit
H– inventory holding cost as percentage of product cost (H = h*C)
h (i) – inventory holding cost as percentage of product cost
L – lead time of delivery by the supplier
 A simple EOQ policy contd.

Inventory
25

Q 20

15

10

0
0 1 2 3 4 5 6

Time (Days)

Average inventory level (across a long time horizon) = Q/2

A simple EOQ policy contd.

Average inventory level (across a long time horizon) = Q/2

Time horizon for estimating costs = 1 year (maybe a month/15 days)

Different cost components measured annually:

1. Inventory holding cost
2. Total ordering cost
3. Product purchase cost (?)
A simple EOQ policy contd.

•Annual
  inventory holding cost:

= Average inventory * inventory holding cost per unit

Inventory cost
= 120

100

Or 80

60

= 40

20

0
0 5 10 15 20 25
A simple EOQ policy contd.

•Annual
  ordering cost:

= Number of orders in the year * one-time ordering cost

Ordering cost
= 12000000

10000000

8000000

6000000

4000000

2000000

0
0 2 4 6 8 10 12 14 16
Estimating EOQ 1200

•Total
  cost (relevant to Q) 1000

= 800

Total inventory holding cost

+ Total ordering cost 600

400

= +
200

0
0 2 4 6 8 10 12

Order quantity for minimum cost (Q*)

Estimating EOQ
•TC
  = +
At the lowest total cost:
Inventory holding cost = Ordering cost
=
EOQ, =
Calculus approach:
•TC  = +
Differentiating both sides with Q (for maxima or minima):

EOQ, =
So, we have answered how much to order.
Now what?
When to order?
Reorder point: Inventory level at which we raise the order
If Lead Time, L = 1 day & daily demand, d = 10 units

Inventory
25

20

15
R R = d*L
10

0
0 2 4 6 8 10 12
L = 1 day
Inventory Order Cycle under Certainty

Order quantity, Q
Demand Average
rate inventory
Inventory Level

Q
2

Reorder point, R

0 Lead Time
Lead
time time
Order Order Order Order
placed receipt placed receipt
Let’s include uncertainty
Notations:
d = daily (or weekly) demand
σd = standard deviation of daily demand
L = lead time of delivery in days (or weeks)
σL = standard deviation of lead time
 Variable demand with Reorder Point

Inventory level

Reorder
point, R

0
LT LT
Time
Safety Stock:
Buffer added to the on-hand inventory during lead time

Stock-out:
An inventory shortage

Service level:
• Probability that the inventory available during the lead time will meet
demand
• P(Demand during the lead time <= Reorder point)
 Establishing Safety Stock Levels
Safety stock – refers to the amount of inventory carried in addition
to expected demand.

●
Safety stock can be determined based on many different criteria.

A common approach is to simply keep a certain number of weeks

of supply.

A better approach is to use probability.

●
Assume demand is normally distributed.
●
Assume we know mean and standard deviation.
●
To determine probability, we plot a normal distribution for expected demand and note where the amount we have lies on the curve.
 Reorder point with safety stock

Inventory level
Q
Reorder
point, R

Safety Stock
0
LT LT
Time
 Inventory types

Process Demand
Purpose Others
stage Type

Raw Materials
WIP Independent Cycle Spares
Finished Goods Dependent Safety Consumable
Seasonal
Pipeline
Inventory breakup for Hewlett Packard

Ref: Tom Davis.(1993). “Effective supply chain management”. Sloan Management Review
Reorder point for a service level
Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
  𝑅 − 𝑑´ 𝐿
zDLT 𝑧=
𝜎 𝐷𝐿𝑇
dL R
Demand (during the lead time)
Fixed-Order Quantity Model with Safety Stock
Demand is variable, but
follows a known distribution/

After the reorder is placed, demand

during the lead time may be higher than
expected, consuming some (or all) of the
  ´ 𝐿+ 𝑧 𝜎
𝑅=𝑑
safety stock/ 𝐷𝐿𝑇
Estimating DLT (Standard deviation of demand during the lead time)

•  Demand during the lead time =

• If only d is probabilistic with N.D () and L is certain:
•

• If only L is probabilistic with N.D () and d is certain:

• If both d and L are probabilistic:

Math behind- Wald’s equation

Example
A paint store wants a reorder point with a 95% service level and a 5%
stockout probability. Average demand is 30 L/day, lead time is 10 days
and standard deviation of demand is 5 L/day.
d = 30 Litres per day
L = 10 days
d = 5 Litres per day
For a 95% service level, z = 1.65

R = dL + z d √L Safety stock = z d √L
= 30(10) + (1.65)(5)(√10) = (1.65)(5)(√ 10)
= 326.1 Litres = 26.1 Litres
Production quantity model

• Order is being received gradually, as inventory is simultaneously being

depleted
• aka non-instantaneous receipt model
• Assumption that Q is received all at once is relaxed
• p = daily rate at which order is received/production rate
• d = daily demand rate of the inventory
 Production quantity model

Inventory
level

Maximum
Q(1-d/p) inventory
level

Average
Q (1-d/p)
inventory
2
level

0
Begin End Time
Order order order
receipt period receipt receipt
 Production quantity model

p = production rate d = demand rate

Q
Maximum inventory level = Q - d
p
d
= Q1-
p 2SD
Qopt = d
Q d H 1-
Average inventory level = 1 - p
2 p

SD HQ d
TC = Q + 2 1- p

If p >> d ??
 Production quantity model example

S = $0.75 per litre H = $150 D = 10,000 litres

d = 10,000/311 = 32.2 litres per day p = 150 litres per day

2SD 2(150)(10,000)
Qopt = = = 2,256.8 litres
H 1- d 32.2
0.75 1 -
p 150

SD HQ d
TC = Q + 2 1 - p = $1,329

Q 2,256.8
Production run = = = 15.05 days per order
p 150
 Production quantity model example

D 10,000
Number of production runs = = = 4.43 runs/year
Q 2,256.8

d 32.2
Maximum inventory level = Q 1 - = 2,256.8 1 -
p 150
= 1,772 litres
 Quantity Discounts

Price per unit decreases as order

quantity increases

HD SQ
TC = + + PD
Q 2
where
P = per unit price of the item
D = annual demand
 Quantity Discount Model
ORDER SIZE PRICE
1 - 49 $1400 TC = ($1400)
50 – 89 $1100
90+ $900 TC ($1100)

TC ($900)
Inventory cost ($)

Carrying cost

Ordering cost

Q1 = 49 Qopt=72.5 Q2= 90
 Quantity Discount

QUANTITY PRICE
S = $2,500
1 - 49 $1,400 H = $190 per TV
50 - 89 1,100 D = 200 TVs per year
90+ 900

2SD 2(2500)(200)
Qopt = = = 72.5 TVs
H 190

For Q = 72.5
SD HQopt
TC = + + PD = $233,784
Qopt 2

For Q = 90
SD HQ
TC = + + PD = $194,105
Q 2
Periodic Review System / Fixed-Time period system

A B

Time periods are

equal, but Reorder quantity varies,
ending inventory depending upon ending
varies. inventory level. Beginning
inventory is always the same.
Order quantity for a periodic review system

Q = d(T + L) + zd T+L -I

where
d = average demand rate
T = the fixed time between orders
L = lead time
sd = standard deviation of demand

zd T + L = safety stock

I = inventory level

Do we know what is the best value of T?

Derivation of optimal fixed time interval (T) or frequency (N)
• 
To determine optimum N:

We know that minimum cost occurs at,

Fixed period model with variable demand
d = 6 packages per day
sd = 1.2 packages
T = 60 days
L = 5 days
I = 8 packages
z = 1.65 (for a 95% service level)

Q = d(T + L) + zd T+L -I

= (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8
= 397.96 packages
 Fill Rate:
• CSL
  only says about the probability of stock-out in a single cycle.
• Another important parameter is the expected actual sales fulfilled out of stock in
a cycle:

Where, E(z) = normal loss function with standard normal distribution

Thus, Fill rate:

Expected number of units short per year, E(N) = ?

Fill Rate: concept of ESC
ESC = ò
¥
(x – ROP) f (x) dx
x=ROP

é æ ss öù æ ss ö
ESC =–ss ê1– Fs ç ÷ú+ s L f s ç ÷
  𝑅 − 𝑑´ 𝐿 ê
ë ès L øú
û ès L ø
𝑧= Safety stock
𝜎 𝐷𝐿𝑇
zDLT  𝑬𝑺𝑪 =𝝈 𝑫𝑳𝑻 ∗ 𝑬 ( 𝒛 )
dL R
Probability of
Demand (during the lead time) a stockout