CHAPTER 2:

INVENTORY MANAGEMENT

Mai Thuy Dung, MSc

mtdung@hcmiu.edu.vn
Room A2.603
International University
Vietnam National University HCMC
 CONTENTS
1. What is inventory?
2. EOQ model
3. The effects of demand
uncertainty
3.1. Single period model
3.2. Multiple order
opportunities
3.3. Continuous review
policy
3.4. Variable lead time
3.5. Period review policy
3.6. Service level
optimization
4. Risk Pool
5. Centralized vs. Decentralized
systems
6. Managing inventory in the
supply chain.
7. Practical issues
8. Demand Forecasting
 1. WHAT IS
INVENTORY?
 WHAT IS INVENTORY?
• Inventory is stock of items kept to meet future demand;
• Three forms:
- Raw material inventory;
- Work-in-process inventory;
- Finished product inventory;
Firm or organization
Work in C
progress u
s
Work in Finish t
Raw
progress goods o
material
m
Work in
e
progress
r
 INVENTORY
MANAGEMENT
• The objective of inventory management is to strive a balance
between inventory investment and customer service
Lead
time

Why
Economies
of scales holding Uncertainty
inventory?

Short
product
life cycle
2. EOQ MODEL
• Economic Order Quantity (EOQ) is the order quantity that
minimizes the total holding costs and ordering costs.
• Assumptions:
- Demand is constant at the rate of D items/day
- Order quantity is fixed at Q items/order
- A fixed cost (setup/order cost), Cp, is incurred when an order
is placed
- An inventory carrying cost (holding cost), Ch, is accrued per
unit held in inventory per holding day
- The lead time = 0; Initial inventory = 0;
- The planning horizon is infinite
 A cycle time T

Usage rate

Average
inventory
Inventory level on hand
z
Q/2

Initial inventory

0
Time

  Inventory cost in a cycle time:

Demand in a cycle time:
 Objective is to minimize total costs
Cost
Total cost of
holding and
setup (order)

Minimum
total cost
Holding cost

Setup (or order)

cost

Optimal order
quantity (Q*)
O
qu rde
 Average an r
inventory per day: tit
y
The order quantity minimizes the above cost function (EOQ):
 EXAMPLE
1. Determine optimal number of needles to order:
D = 2,000 units Ch = $0.5 per unit per year
Cp = $20 per order

2. Calculate expected number of orders per year, N

 EXAMPLE (CONT.)
3. Determine the length of a cycle time, assuming that there are
250 working days per year

4. Calculate the total annual costs, TC

• The EOQ model is robust, illustrating the trade-offs between
set-up costs and inventory holding costs.
• The total cost is insensitive to order quantities

Example
Calculate TC when the actual EOQ for new demand is 500 units
D = 2,000 units Q = 500 units
Cp = $20 per order N = 5 orders per year
Ch = $0.5 per unit per year T = 50 days
3. THE EFFECTS OF
DEMAND
UNCERTAINTIES
 DEMAND UNCERTAINTIES

• Most companies treat the world as if it were predictable.

Production and inventory planning are based on forecasts of
demand made far in advance of the selling season;
- Short product life-cycle adds more uncertainties.

What are the rules of thumb for demand forecasting?

 SINGLE PERIOD MODEL

• Assumption:
- Product has a short life-cycle, that the firm only has one ordering
opportunity
• SnowTime Sporting goods example:
- New designs are completed and One production opportunity;
- Based on past sales, knowledge of the industry, and economic
conditions, the marketing department has a probabilistic forecast;
 EXAMPLE
Demand Scenarios
35%
28%
21%
Probability

14%
7%
0%

Sales

Variable cost (C) = $80/unit Salvage value for excessive

inventory (V): $20/ unit
Selling price (P): $125/unit
Fixed production cost (F):
$100,000
 EXAMPLE (CONT.)

Calculate SnowTime’s profit in the following scenarios:

• Scenario 1: Suppose you make 12,000 jackets and demand ends
up being 13,000 jackets
• Scenario 2: Suppose you make 12,000 jackets and demand ends
up being 11,000 jackets
 EXAMPLE (CONT.)
Weighted Profit as per Demand scenarios
500000
Profit

375000

250000

125000

0
5000

6500

8000

12500

13500
14000

15000
15500
5500
6000

7000
7500

8500
9000
9500
10000
10500
11000
11500
12000

13000

14500

16000
16500
Production Quantity

The optimal order quantity is NOT necessarily equal to

forecast/ average demand
 MULTIPLE ORDER OPPORTUNITY

• Initial inventory:
- Can be used to meet demand;
- Avoids fixed costs for a new order/production
• Besides fashion industry, the decision maker may:
- Order products repeatedly at any time during the year;
- Wait for a delivery lead time to have his order fulfilled.
• 2 types of inventory policies
- Continuous review policy: inventory is reviewed continuously,
and an order is placed when the inventory reaches the reorder point.
- Periodic review policy: inventory is reviewed at regular intervals,
and an appropriate quantity is ordered after each review.
 CONTINUOUS REVIEW POLICY (1 OF
4)

••  Assumptions:

– Daily demand is random, and follow a normal distribution, which is

characterized with average demand AVG, and standard deviation
STD;
– A fixed cost (setup/order cost), Cp, is incurred when an order is
placed;
– An inventory carrying cost (holding cost), Ch, is charged per unit
held in inventory per unit time.
– It takes a lead time, L, to fulfill the order after the order is placed;
– The distributor commits a service level, , which implies the
probability of not stocking out during lead time
– Inventory Position = actual inventory + items already ordered but
not delivered - items backordered
 CONTINUOUS REVIEW POLICY (2 OF
4)

••  Continuous review policy is known as (Q, R) policy:

R: reorder point Q: order quantity
• R has two components:
– To account for average demand during lead time:
– To account for deviations from average (we call this safety stock):
where z is referred as the safety factor to ensure that the probability
of stock-out during lead time is exactly
 CONTINUOUS REVIEW POLICY (3 OF
4)

Inventory level as a function of time in a (Q, R) policy

  Inventory before receiving an order

Inventory after receiving an order
 Average inventory
 CONTINUOUS REVIEW POLICY (4 OF
4)

 • Reorder level:
• Order quantity (recalled from EOQ model):
 Average inventory

Service level and service factor, z

Service
90% 91% 92% 93% 94% 95% 96% 97% 98% 99% 99.9%
level
z 1.29 1.34 1.41 1.48 1.56 1.65 1.75 1.88 2.05 2.33 3.08
 EXAMPLE

A distributor of TV sets is trying to set inventory policies for one

of the TV models. There is a fixed ordering cost of $4,500
whenever the distributor places an order for TV sets. The cost of
a TV set to the distributor is $250, and annual inventory holding
cost is about 18% of the product cost. Replenishment time is
about 2 weeks. The following table provides data on the number
of TV sets sold to retailers in each of the last 12 months. Given
that the distributor would like to ensure 97% of service level,
what is the reorder level and the order quantity that the
distributor should use? We assume 30 days in a month, and 52
weeks in a year.

Month Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
Sales 200 152 100 221 287 176 151 198 246 309 98 156
 VARIABLE LEAD TIME

 • In many practical situations, the lead time to the warehouse may

be random and unknown in advance.
• We typically assume that the lead time is normally distributed
with average lead time, , and the standard deviation, .
• The reorder point also has two components:
- Average demand during lead time:
- Safety stock during lead time:
 PERIOD REVIEW POLICY (1 OF 3)

 • When inventory is reviewed periodically at regular intervals,

the (Q, R) policy can’t be directly implemented, since the
inventory position may fall below the reorder point.
• Periodic Review Policy is referred as (s,S) policy, where:

• Base-stock level is the target inventory level, to which the

warehouse will order enough to raise the inventory level
after each review period.
• is the length of the review period—> The next order arrives
after a period of days
 PERIOD REVIEW POLICY (2 OF 3)

Inventory level as a function of time in a periodic review

 PERIOD REVIEW POLICY (3 OF 3)

 • The base-stock level include two components:

- Average demand during days =;
- Safety stock protecting against deviations from average
demand during days = ;
• Inventory level:
- Expected inventory level before an order arrives:

- Expected inventory level after receiving an order:

Average inventory level:

 EXAMPLE

Continuing with the previous example, we assume that the

distributor places an order for TV sets every three weeks. What is
their base-stock level, and average inventory level? On average,
how many weeks of supply does the distributor keep?
 SERVICE LEVEL OPTIMIZATION (1
OF 3)

• So far the objective of inventory

management is to determine the
optimal inventory policy given a
specific service level target.
- The service level target is decided
by the downstream customers.
• In other cases, the facility has the
flexibility to choose the appropriate
service level.
- What can you comment on the
trade-offs between service level
and inventory level? Marginal
impact of inventory level on Service level vs. inventory level as
service level? function of lead time
 SERVICE LEVEL OPTIMIZATION (2
OF 3)

• In retailing, one possible strategy to determine service level for

each SKU is to determine service level for each SKU given a target
service level across all products, so as to maximize expected profit.
• Everything else being equal, service level will be higher for
product with:
- High profit margin;
- High volume;
- Low variability;
- Short lead time.
 SERVICE LEVEL OPTIMIZATION (3
OF 3)

Service level optimization by SKU

Each circle is associated with a product, and the size of the circle is
proportional to profit margin. FR stands for service level.
4. RISK POOL
 •Risk pooling is one of the most powerful tools to address
variability in the supply chain.
• Risk pooling suggests that demand variability is reduced if one
aggregates demand across locations.
- Once demand is aggregated across different locations, it is
more likely that high demand from one customer will be
offset by low demand from another. This reduction in
variability allows a decrease in safety stock, and therefore
reduces average inventory.
• While standard deviation is a measure of how much demand
tends to vary around the average, the coefficient of variation is
the ratio of standard deviation to average demand:
 EXAMPLE

ACME is an electronic equip producer and distributor

Current Strategy Alternative Strategy
Market 1
Warehouse MA Market 1
ACME Centralized
ACME
warehouse
Warehouse NJ Market 2 Market 2

 Transportationcost:
 
- Current strategy:
- Alternative strategy:
 EXAMPLE (CONT.)

ACME’s historical data

PRODUCT A
Week 1 2 3 4 5 6 7 8
Massachusetts 33 45 37 38 55 30 18 58
New Jersey 46 35 41 40 26 48 18 55
Total 79 80 78 78 81 78 36 113
PRODUCT B
Massachusetts 0 3 3 0 0 1 3 0
New Jersey 2 4 3 0 3 1 0 0
Total 2 6 3 0 3 2 3 0

How much average inventory the Alternative strategy save compared

with the current one?
 Three
critical points about risk pooling:
• Centralizing inventory reduces both safety stock, and average
inventory in the system
• The higher the coefficient of variation, the greater the benefit
from risk pooling, or from the centralized systems.
- Recall that average inventory = . Since the reduction in
average inventory is mainly achieved through a reduction in
safety stock, the higher the coefficient of variation, the larger
the impact of safety stock on inventory reduction.
Three critical points about risk pooling:
• The benefits from risk pooling depend on the behavior of
demand from one market relative to demand from other.
- Demand from two market is positively correlated if it is very
likely that whenever demand from one market is greater than
average, demand from other market is also greater than
average
- Does the benefit from risk pooling decrease or increase as
the correlation between demand from the two markets
becomes more positive?
5. CENTRALIZED VS.
DECENTRALIZED
SYSTEM
Trade-offs between centralized and decentralized distribution
system
• Safety stock: decreases as a firm moves from a decentralized to
a centralized system. The amount of decrease depends on a
number of parameters, which are they?
• Service level: provided by the centralized system is higher,
given the same total safety stock in the two systems. The
magnitude of the increase in service level depends on which
parameters?
• Overhead cost: are much greater in a decentralized system.
• Customer lead time: is much shorter in a decentralized system.
• Transportation costs: On one hand, the outbound
transportation costs decrease in a decentralized system. On the
other hand, inbound transportation costs increase. How about
the total transportation costs?
 6. MANAGING
INVENTORY IN THE
SUPPLY CHAIN
 SERIAL SUPPLY CHAIN
• We consider a multifacility serial supply chain in a single firm.
- A serial supply chain is one in which there are a series of
stages, each of which supplies a single downstream stage. The
final stage meets end-customer demand
• Assumptions:
- Inventory decisions are made by a single decision maker
whose objective is to minimize systemwide cost.
- The decision maker has access to inventory information at
each of the retailers and at the warehouse.
• Echelon inventory policy is an effective way to manage the
system.
- In a distribution system, each stage or level often is referred to
as an echelon
- The echelon inventory at any stage = on-hand inventory at the
 ECHELON INVENTORY POLICY (1
OF 4)

• Echelon inventory policy is an effective way to manage the

system.
- In a distribution system, each stage or level often is referred to
as an echelon
- The echelon inventory at any stage = on-hand inventory at the
echelon + all downstream inventory.
Supplier
Echelon inventory
position at supplier

Distributor

Echelon inventory
position at distributor

Retailer
 ECHELON INVENTORY POLICY (2
OF 4)

 • Echelon inventory policy suggests the following approach to

managing this serial system:
- The retailer inventory is managed using the (Q, R) policy with
the reorder level and order quantity:

- The distributor echelon inventory position is calculated:

, where:
echelon lead time, defined as the lead time between the
retailer and the distributor + the lead time between the
distributor and its supplier (i.e. wholesaler)
average demand at the retailer
standard deviation of demand at the retailer.
 EXAMPLE

Consider the four-stage supply chain. Suppose that the average

weekly demand faced by the retailer is 45, with a standard
deviation of 32. Also assume that at each stage, management is
attempting to maintain a service level of 97%; and that lead time
between each of the stages is one week. The fixed ordering and
holding costs at each of the stages are given as follows.
Determine the order quantity, and reorder point for each stage.
Ordering cost Holding cost
Retailer 250 1.2
Distributor 200 0.9
Wholesaler 205 0.8
Manufacturer 500 0.7
 ECHELON INVENTORY POLICY (3
OF 4)

• In case of multiple facilities at a particular stage, we consider a

two-stage supply chain where a warehouse supplies a set of
retailers.
Supplier Warehouse
echelon
inventory
Warehouse
echelon lead Warehouse
time

Retailer

• The reorder point, R, and order quantity, Q, for each retailer are
calculated as the (Q, R) policy.
 ECHELON INVENTORY POLICY (4
OF 4)

 • For the warehouse echelon inventory position, the reorder point

is:
, where:
echelon lead time, defined as the lead time between the
retailer and the warehouse + the lead time between
the warehouse and its supplier
average demand across all retailers
standard deviation of (aggregate) demand across all
retailers.
7. PRACTICAL ISSUES
Here are seven effective inventory reduction strategies
recommended by materials and inventory managers
1. Perform periodic inventory review: The periodic inventory
review policy makes it possible to identify slow-moving and
obsolete products and allows management to continuously
reduce inventory levels.
2. Provide tight management of usage rates, lead times, and
safety stock: This allows the firm to make sure inventory is
kept at the appropriate level.
3. Reduce safety stock levels: This can be accomplished by
reducing lead time.
4. Introduce or enhance cycle counting practice: Instead of
annual physical inventory count, part of the inventory is
counted every day, and each item is counted several times per
year.
5. Follow ABC approach: In this strategy, items are classified
into three categories:
- Class A: high-revenue products, typically accounting for
about 80% of annual sales and representing about 20% of
inventory SKUs  high-frequency periodic review policy.
- Class B: products accounting for 15% of annual sales 
frequent periodic review policy.
- Class C: low-revenue products, accounting for no more than
5% of sales  The firm can either keep no inventory of
expensive Class C products, or keeps a high inventory of
inexpensive Class C products.
6. Shift more inventory or inventory ownership to suppliers
7. Follow quantitative approaches: to balance between
inventory holding and ordering costs.
 • In the last decades, many firms attempt to increase the inventory
turnover ratio to decrease average inventory levels

• However, a low inventory level is not always appropriate since

it increases the risks of lost sales
What are the appropriate inventory turns that the firms should
use in practice?

The answer changes from year to year and depends on the

specific industries
8. FORECASTING
 DEMAND FORECASTING
• Forecasting is a critical tool in the management toolbox, which
supports:
- Decisions about whether to enter a particular market at all;
- Whether to expand production capacity;
- Whether to impleemnt a given promotional plan;
- Inventory management decisions.
• Forecasting tools and methods have 4 general categories:
- Judgment methods involve the collection of expert
opinions.
- Market research methods involve qualitative studies of
consumer behavior
- Time-series methods involve using mathematical methods
to extrapolate future performance from the past
- Causal methods are mathematical methods in which
forecasts are generated on a variety of system variables
 Judgment method
• Judgment methods strive to asemble the opinions of a variety
of external or internal experts in a systematic way
• This approach assumes that by communicating and openly
sharing information, a superior forecast can be agreed upon.
• The Delphi method is a structured technique for reaching a
consensus with a panel of experts without gathering them in a
single location
- Each member of the expert group is surveyed for his
opinion, typically in writing.
- After the opinions are compiled and summarized, each
individual is given the opportunity to change his opinion
after seeing the summary.
- This process is repeated till consensus is achieved.
 Market research method
• Market testing and market surveys can be valuable tools for
developing forecasts, particularly of newly introduced products.
• In market testing, focus groups of potential customers are
assembled and tested for their response to products, which is
extrapolated to the entire market to estimate the demand for
product.
• Market surveys involve gathering data from a variety of
potential customers via interviews, telephone-based surveys,
and written surveys.
 Time-series method (1 of 3)
Several common time-series methods:
• Moving average: Each forecast is the average of some number
of previous demand points. The key is to select the number of
points in the moving average so that the effect of irregularities
in the data is minimized
Eg: Calculate a five-year moving average from the following
data: Year 2003 2004 2005 2006 2007 2008
Sales ($m) 4 6 5 8 9 5

• Exponential smoothing: Each forecast is a weighted average

of the previous forecast and last demand point. Comparing with
moving average, this method weights average of all past data
points, with more recent points receiving more weight.
 Time-series method (2 of 3)
• Methods for data with trends: If there is a trend in the data,
methods such as regression analysis and Holt’s method are
more useful. Regression analysis fits a straight line to data
points, while Holt’s method combines the concept of
exponential smoothing with the ability to follow a linear trend
in the data.

Data with trend

 Time-series method (3 of 3)
• Methods for seasonal data: A variety of techniques account
for seasonal changes in demand. For example, seasonal
decomposition methods remove the seasonal patterns from the
data and apply the approaches listed above on these edited data.
Winter’s method is a version of exponential smoothing
accounting for trends and seasonality.

Causal method
• On the contrary to time-series methods, causal methods
generate forecasts based on data other than the data being
predicted.
Eg: The causal sales forecast for the next quarter may be a
function of inflation, GNP, the unemployment rate, or
anything besides the sales in this quarter.
 SELECTING APPROPRIATE
TECHNIQUE
• In order to, answering these questions will help select
appropriate forecasting technique:
- What is the purpose of the forecast? How is it to be
used?
- What are the dynamics of the system for which the
forecast will be made?
- How important is the past in estimating the future?
• Different forecast techniques are appropriate at different stages
of the product life cycle
- Product development phase: market research method
- Testing & introduction phase: additional market research &
judgement methods
- Rapid growth phase: time-series analysis
- Maturity phase: time-series analysis, as well as causal
methods.
 REFERENCE

1. Simchi-Levi, D., Kaminisky, P, Simchi-Levi, E. Designing and

managing the supply chain: Concepts, strategies, and cases
studies, 3 ed. McGraw-Hill Education: 2007, chapter 2.