Materials Accounting, Flow of Costs and Inventory Valuation, Physical Verification, Security and

 Materials Accounting,
 Flow of Costs And Inventory Valuation,

Physical Verification, Security And
 Materials Audit
 Scrap Management-
 Regulations And Procedures-
12-1
Inventory Management
 Inventory is an unused asset, which lies in stock without

participating in value adding process.
The objective of inventory management is to strike a balance

between inventory investment and customer service
© 2011 Pearson
Inventory Control
 Inventory control is a method to identify those

stocks of goods, which can be used for the
production of finished goods.
 When, how much , how often

Controlling Inventory
 STEP 1: Inventory Planning

 STEP 2: Establish order cycles
 STEP 3: Balance Inventory Levels
 STEP 4: Review Stocks
 STEP 5: Follow-up and Control
Types of Inventory Control
systems
- ABC
- Two Bin Method
- Three Bin Method
- Fixed Order Quantity
- Fixed Period Ordering
- Just In Time
- Vendor Managed Inventory
- Max- min system
ABC Classification System
Classifying inventory according to some
measure of importance and allocating control
efforts accordingly.
High
A - very important A
B - mod. important Annual
$ value
B
C - least important of items
C
Low
Low High
Percentage of Items
12-6
TWO BIN Method :
 an item is stored in two locations or bins
in a warehouse and the stock is
replenished in the first bin from the
second bin once the first bin is
consumed completely.
 The required quantity to be filled in the
second bin is placed for ordering.
 Two containers of inventory; reorder
when the first is empty
THREE BIN Method :
 with a third bin at the suppliers' location.
 The supplier will not manufacture spare parts
for the manufacturer until the reserve bin is
emptied.
 Once the inventory in manufacturing/shop floor
bin/display is consumed/sold, it is replenished
with the complete bin from the back store/shop.
 Later the back store bin is sent to the supplier
and replace with a complete bin from the
supplier.
FIXED ORDER QUANTITY :
 used to avoid ordering mistakes and ensure regular
replenishment of existing products.
 Only a fixed quantity can be ordered at one time for the
item.
 used in auto replenishment of goods where in auto
reordering point is set in system and when the product's
inventory level hits the reordering point or minimum stock
levels, an order is placed to the maximum stocking
capacity of the product.
 should know the minimum and maximum stocking capacity
of the product based on space allocated and the sales
trend.
FIXED PERIOD ORDERING :
 In this system there is fixed time interval

between every order placed for the item.
 done in small format stores like pharmacies

and grocery stores
JUST IN TIME :
 to increase the inventory turnover and at the
same time reduce the inventory holding cost.

 JIT inventory system also exposes the
unwanted or the dead inventory held my the
retailer/ manufacturer.
VENDOR MANAGED INVENTORY
:
 SKUs managed directly by the supplier.
 Inventory is replenished based on the sales
on regular intervals by the vendor.
 The retailer provides shop floor space and
the vendor is charged a consignment rate on
every product sold at the location.
 The ownership of the items from receiving to
sales and inventory loss if any will be with
the supplier.
 Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached
214800 232087768
12-15
Inventory control model
Supply Demand Model
Static Certain NA
Static Risk Service level
Static Uncertain Regret matrix
Dynamic Certain EOQ
Dynamic Risk P,Q,S
Dynamic Uncertain Not exist
A) known demand- certain
b) range, probable- risk
c) unknown- uncertain
Economic Order Quantity Models
 Economic order quantity (EOQ) model

 The order size that minimizes total annual cost
 Economic production model

 Quantity discount model
12-17
Assumptions of EOQ Model
 Relatively uniform & known demand rate

 Fixed item cost
 Fixed ordering and holding cost
 Constant lead time
12-18
The Inventory Cycle
Figure 12.2
Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand
Reorder
point
Time
Receive Place Receive Place Receive
order order order order order
Lead time
12-19
Total Cost
Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q
12-20
Cost Minimization Goal
Figure 12.4C
The Total-Cost Curve is U-Shaped

Q D
TC  H  S
Annual Cost
2 Q
Ordering Costs
Order Quantity
QO (optimal order quantity)
(Q)
12-21
Deriving the EOQ
2DS 2(Annual Demand)(Order or Setup Cost )

Q OPT = =
H Annual Holding Cost
12-22
Minimum Total Cost
The total cost curve reaches its minimum

where the carrying and ordering costs are
equal.
Q = DS
H
2 Q
12-23
Economic Production Quantity
(EPQ)
 Production done in batches or lots
 Capacity to produce a part exceeds the
part’s usage or demand rate
 Assumptions of EPQ are similar to EOQ
except orders are received
incrementally during production
12-24
Economic Production
Quantity Assumptions
 Only one item is involved
 Annual demand is known
 Usage rate is constant
 Usage occurs continually
 Production rate is constant
 Lead time does not vary
 No quantity discounts
12-25
Economic Run Size
2DS p
Q0 
H p u
12-26
Total Costs with
Purchasing Cost
Annual Annual Purchasing

+
TC = carrying + ordering cost
cost cost
Q + DS + PD
TC = H
2 Q
12-27
Total Costs with PD
Figure 12.7
Cost
Adding Purchasing cost TC with PD

doesn’t change EOQ
TC without PD
PD
0 EOQ Quantity
12-28
Total Cost with Constant
Carrying
Figure 12.9 Costs
TCa
Total Cost
TCb
Decreasing
TCc Price
CC a,b,c
OC
EOQ Quantity
12-29
When to Reorder with EOQ
Ordering
 Reorder Point - When the quantity on
hand of an item drops to this amount,
the item is reordered
 Safety Stock - Stock that is held in
excess of expected demand due to
variable demand rate and/or lead time.
 Service Level - Probability that demand
will not exceed supply during lead time.
12-31
Determinants of the
Reorder Point
 The rate of demand
 The lead time
 Demand and/or lead time variability
 Stockout risk (safety stock)
12-32
Safety Stock
Figure 12.12
Quantity
Maximum probable demand

during lead time
Expected demand
during lead time
ROP
Safety stock reduces risk of Safety stock

stockout during lead time LT Time
12-33
Reorder Point
Figure 12.13
The ROP based on a normal

Distribution of lead time demand
Service level
Risk of
a stockout
Probability of
no stockout
ROP Quantity
Expected
demand Safety
stock
0 z z-scale
12-34
Fixed-Order-Interval
Model
 Orders are placed at fixed time intervals

 Order quantity for next interval?
 Suppliers might encourage fixed
intervals
 May require only periodic checks of
inventory levels
 Risk of stockout
 Fill rate – the percentage of demand
filled by the stock on hand 12-35
Fixed-Interval Benefits
 Tight control of inventory items

 Items from same supplier may yield
savings in:
 Ordering
 Packing
 Shipping costs
 May be practical when inventories
cannot be closely monitored
12-36
Single Period Model
 Single period model: model for ordering

of perishables and other items with
limited useful lives
 Shortage cost: generally the unrealized
profits per unit
 Excess cost: difference between
purchase cost and salvage value of
items left over at the end of a period
12-37
Single Period Model
 Continuous stocking levels
 Identifies optimal stocking levels
 Optimal stocking level balances unit shortage
and excess cost
 Discrete stocking levels
 Service levels are discrete rather than
continuous
 Desired service level is equaled or exceeded
12-38
Optimal Stocking Level
Cs Cs = Shortage cost per unit
Service level =
Cs + Ce Ce = Excess cost per unit
Ce Cs
Service Level
Quantity
So
Balance point
12-39
Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided
Inventory Usage Over Time
Usage rate Average

Order inventory
quantity = Q on hand
Inventory level
(maximum
inventory Q
level) 2
Minimum
inventory
Time
Figure 12.3
Minimizing Costs
Objective is to minimize total costs
Curve for total
cost of holding
and setup
Minimum
total cost
Annual cost
Holding cost
curve
Setup (or order)

cost curve
Optimal Order quantity
Table 11.5 order
quantity
The EOQ Model
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the Inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)
Annual demand Setup or order

=
Number of units in each order cost per order
D
= (S)
Q
D
Annual setup cost = S
Q
The EOQ Model Annual setup cost =
D
Q
S
Q
Annual holding cost = H
Q = Number of pieces per order 2
Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)
Order quantity
= (Holding cost per unit per year)
2
Q
= (H)
2
D
Q
S
Q
Optimal order quantity is found when annual setup cost

equals annual holding cost
D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year
2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
An EOQ Example
D = 1,000 units Q* = 200 units
S = $10 per order
Expected Demand D
number of =N=
orders Order quantity = Q*
1,000
N =200 = 5 orders per year
An EOQ Example
S = $10 per order N = 5 orders per year
Number of working
Expected time days per year
between orders =T= N
250
T =5 = 50 days between orders
An EOQ Example
H = $.50 per unit per year T = 50 days
Total annual cost = Setup cost + Holding cost
D Q
TC = Q S + 2H
1,000 200
TC = 200 ($10) + ($.50)
2
TC = (5)($10) + (100)($.50) = $50 + $50 = $100

Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells when to
order
Demand Lead time for a
ROP = per day new order in days
=dxL
D
d= Number of working days in a year
Reorder Point Curve
Q*
Inventory level (units)
Slope = units/day = d
ROP
(units)
Time (days)
Figure 12.5 Lead time = L
Production Order
Quantity Model
 Used when inventory builds up over a
period of time after an order is placed
 Used when units are produced and
sold simultaneously
Production Order
Quantity Model
Part of inventory cycle during
which production (and usage) is
taking place
Inventory level
Demand part of cycle

with no production
Maximum
inventory
t Time
Figure 12.6
Production Order
Quantity Model
Q= Number of pieces per order p = Daily production rate
H= Holding cost per unit per year d = Daily demand/usage rate
D= Annual demand
Setup cost = (D/Q)S

Holding cost = 1/2 HQ[1 - (d/p)]
(D/Q)S = 1/2 HQ[1 - (d/p)]
2DS
Q =
2
H[1 - (d/p)]
2DS
Q* = H[1 - (d/p)]
Production Order
Quantity Example
D= 1,000 units p = 8 units per day
S= $10 d = 4 units per day
H= $0.50 per unit per year
2DS
Q* = H[1 - (d/p)]
2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]
= 282.8 or 283 hubcaps

Quantity Discount Models
 Reduced prices are often available when
larger quantities are purchased
 Trade-off is between reduced product cost
and increased holding cost
Total cost = Setup cost + Holding cost + Product cost
D QH
TC = Q S + 2 + PD
A typical quantity discount schedule
Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75
Table 12.2
Steps in analyzing a quantity discount
1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify, choose
the smallest possible order size to get the
discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total
cost
Quantity Discount
Example
Calculate Q* for every discount 2DS
Q* =
IP
2(5,000)(49)
Q1* = = 700 cars order
(.2)(5.00)
2(5,000)(49)
(.2)(4.80)
2(5,000)(49)
(.2)(4.75)
Quantity Discount
Example
Q* =
IP
2(5,000)(49)
(.2)(5.00)
2(5,000)(49)
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
(.2)(4.75) 2,000 — adjusted
Quantity Discount
Example
Annual Annual Annual
Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700
2 $4.80 1,000 $24,000 $245 $480 $24,725
3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50
Table 12.3
Choose the price and quantity that gives the lowest total
cost
Buy 1,000 units at $4.80 per unit
ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A
#12760 1,550 17.00 26,350 11.3% B
#10867 30% 350 42.86 15,001 6.4% 23% B
#10500 1,000 12.50 12,500 5.4% B
© 2011 Pearson
ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C
#14075 2,000 .60 1,200 .5% C
#01036 50% 100 8.50 850 .4% 5% C
#01307 1,200 .42 504 .2% C
#10572 250 .60 150 .1% C
8,550 $232,057 100.0%
© 2011 Pearson
ABC Analysis
Percent of annual dollar usage
A Items
80 –
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |
10 20 30 40 50 60 70 80 90 100
Percent of inventory items
Figure 12.2
© 2011 Pearson
Inventory Models for
Independent Demand
Need to determine when and how
much to order
1. Basic economic order quantity

2. Production order quantity
3. Quantity discount model
© 2011 Pearson
Basic EOQ Model
1. Demand is known, constant, and
independent
complete
© 2011 Pearson
Usage rate Average

Order inventory
quantity = Q
Inventory level
on hand
(maximum
inventory Q
level) 2
Minimum
inventory
0
Time
Figure 12.3
© 2011 Pearson
Minimizing Costs
Total cost of
holding and
setup (order)
Minimum
total cost
Annual cost
Holding cost
Setup (or order)

cost
Optimal order Order quantity
quantity (Q*)
Table 12.4(c)
© 2011 Pearson
D
Q
S

D = Annual demand in units for the inventory item


=
= D (S)
Q
© 2011 Pearson
D
Q
S
Q
Q = Number of pieces per order Annual holding cost = H
2

Order quantity
2
= Q (H)
2
© 2011 Pearson
D
Q
S
Q
Q = Number of pieces per order Annual holding cost = H
2

D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
© 2011 Pearson
An EOQ Example
D = 1,000 units
S = $10 per order
2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
© 2011 Pearson
An EOQ Example
S = $10 per order
Expected Demand D
number of = N = Order quantity =
orders Q*
1,000
© 2011 Pearson
An EOQ Example
Number of working
250
© 2011 Pearson
An EOQ Example
D Q
TC = Q S + 2H
1,000 200
TC = 200 ($10) + ($.50)
2
TC = (5)($10) + (100)($.50) = $50 + $50 = $100
© 2011 Pearson
Robust Model
 The EOQ model is robust

 It works even if all parameters
and assumptions are not met
 The total cost curve is relatively
flat in the area of the EOQ
© 2011 Pearson
An EOQ Example
Management underestimated demand by 50%
D = 1,000 units 1,500 units Q* = 200 units
D Q
TC = Q S + 2H
1,500 200
TC200
= ($10) + ($.50) = $75 + $50 = $125
2
Total annual cost increases by only 25%
© 2011 Pearson
An EOQ Example
Actual EOQ for new demand is 244.9 units
D = 1,000 units 1,500 units Q* = 244.9 units
D Q
TC = Q S + 2H
Only 2% less than
1,500 244.9 the total cost of
TC =244.9 ($10) + ($.50) $125 when the
2 order quantity was
200
TC = $61.24 + $61.24 = $122.48
© 2011 Pearson
Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells “when” to
order
=dxL
D
© 2011 Pearson
Reorder Point Curve
Q*
Resupply takes place as order arrives
ROP
(units)
Time (days)
Figure 12.5
Lead time = L
© 2011 Pearson
Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days
D
= 8,000/250 = 32 units
ROP = d x L
= 32 units per day x 3 days = 96 units
© 2011 Pearson
Production Order
Quantity Model
 Used when inventory builds up
over a period of time after an
order is placed
 Used when units are produced
and sold simultaneously
© 2011 Pearson
Production Order
Quantity Model
which production (and usage)
is taking place
Inventory level

with no production
Maximum
inventory
t Time
Figure 12.6
© 2011 Pearson
Production Order
Quantity Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days
Annual inventory Holding cost

= (Average inventory level) x
holding cost per unit per year
Annual inventory
= (Maximum inventory level)/2
level
Maximum Total produced during Total used during

= –
inventory level the production run the production run
= pt – dt
© 2011 Pearson
Production Order
Quantity Model
t = Length of the production run in days
Maximum Total produced during Total used during

= –
inventory level the production run the production run
= pt – dt
However, Q = total produced = pt ; thus t = Q/p
Maximum Q Q d
inventory level = p –d =Q 1–
p p p
Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p
© 2011 Pearson
Production Order
Quantity Model
D = Annual demand
Setup cost = (D/Q)S

Holding cost =1 HQ[1 - (d/p)]
2
(D/Q)S = 1 HQ[1 - (d/p)]
2
2DS
Q =
2
H[1 - (d/p)]
2DS
Q* = H[1 - (d/p)]
p
© 2011 Pearson
Production Order
Quantity Example
D = 1,000 units p = 8 units per day
S = $10 d = 4 units per day
H = $0.50 per unit per year
2DS
Q* = H[1 - (d/p)]
2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]
© 2011 Pearson
Production Order
Quantity Model
Note:
D 1,000
d=4= =
Number of days the plant is in operation 250
When annual data are used the equation becomes
2DS
Q* =
annual demand rate
H 1– annual production rate
© 2011 Pearson
 Reduced prices are often available when
 Trade-off is between reduced product cost
D Q
TC = Q S+ 2 H + PD
© 2011 Pearson
Discount Discount
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75
Table 12.2
© 2011 Pearson
2. If Q* for a discount doesn’t qualify,
choose the smallest possible order size
to get the discount
cost
© 2011 Pearson
Total cost curve for discount 2
Total cost
curve for
discount 1
Total cost $
Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a
and must be adjusted upward to 1,000 units at point b
1st price 2nd price

break break
0 1,000 2,000
Figure 12.7
Order quantity
© 2011 Pearson
Quantity Discount
Example
Q* =
IP
2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)
2(5,000)(49)
(.2)(4.80)
2(5,000)(49)
(.2)(4.75)
© 2011 Pearson
Quantity Discount
Example
Q* =
IP
2(5,000)(49)
(.2)(5.00)
2(5,000)(49)
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
(.2)(4.75) 2,000 — adjusted
© 2011 Pearson
Quantity Discount
Example
1 $5.00 700 $25,000 $350 $350 $25,700
2 $4.80 1,000 $24,000 $245 $480 $24,725
3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50
Table 12.3
Choose the price and quantity that gives the lowest
total cost
© 2011 Pearson
Probabilistic Models and
Safety Stock
 Used when demand is not constant
or certain
 Use safety stock to achieve a desired
service level and avoid stockouts
ROP = d x L + ss
Annual stockout costs = the sum of the units short x the probability
x the stockout cost/unit
x the number of orders per year
© 2011 Pearson
Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year
Number of Units Probability

30 .2
40 .2
ROP  50 .3
60 .2
70 .1
1.0
© 2011 Pearson
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year
Safety Additional Total

Stock Holding Cost Stockout Cost Cost
20 (20)($5) = $100 $0 $100
10 (10)($5) = $ 50 (10)(.1)($40)(6) = $240 $290
0 $ 0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960 $960
A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
© 2011 Pearson
Probabilistic Demand
Minimum demand during lead time

Inventory level
Maximum demand during lead time
Mean demand during lead time

ROP = 350 + safety stock of 16.5 = 366.5
ROP 
Normal distribution probability of
demand during lead time
Expected demand during lead time (350 kits)
Safety stock 16.5 units
0 Lead
time Time
Figure 12.8 Place Receive
order order
© 2011 Pearson
Use prescribed service levels to set safety
stock when the cost of stockouts cannot be
determined
ROP = demand during lead time + ZdLT
where Z= number of standard deviations

dLT = standard deviation of demand during
lead time
© 2011 Pearson
Probability of Risk of a stockout

no stockout (5% of area of
95% of the time normal curve)
Mean ROP = ? kits Quantity

demand
350
Safety
stock
0 z
Number of
standard deviations
© 2011 Pearson
Probabilistic Example
Average demand =  = 350 kits
Standard deviation of demand during lead time = dLT = 10 kits
5% stockout policy (service level = 95%)
Using Appendix I, for an area under the curve of 95%, the Z =

1.65
Safety stock = ZdLT = 1.65(10) = 16.5 kits
Reorder point = expected demand during lead time + safety

stock
= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits
© 2011 Pearson
Other Probabilistic
Models
When data on demand during lead time is
not available, there are other models
available
1. When demand is variable and lead

time is constant
2. When lead time is variable and
demand is constant
3. When both demand and lead time
are variable
© 2011 Pearson
Other Probabilistic
Models
Demand is variable and lead time is constant
ROP = (average daily demand

x lead time in days) + ZdLT
where d = standard deviation of demand per day

dLT = d lead time
© 2011 Pearson
Average daily demand (normally distributed) = 15
Standard deviation = 5
Lead time is constant at 2 days
90% service level desired Z for 90% = 1.28
From Appendix I
ROP = (15 units x 2 days) + ZdLT

= 30 + 1.28(5)( 2)
= 30 + 9.02 = 39.02 ≈ 39
Safety stock is about 9 iPods
© 2011 Pearson
Other Probabilistic
Models
Lead time is variable and demand is constant
ROP = (daily demand x average

lead time in days)
= Z x (daily demand) x LT
where LT = standard deviation of lead time in days
© 2011 Pearson
Z for 98% = 2.055
Daily demand (constant) = 10 From Appendix I
Average lead time = 6 days
Standard deviation of lead time = LT = 3
98% service level desired
ROP = (10 units x 6 days) + 2.055(10 units)(3)

= 60 + 61.65 = 121.65
Reorder point is about 122 cameras
© 2011 Pearson
Other Probabilistic
Models
Both demand and lead time are variable
ROP = (average daily demand

x average lead time) + ZdLT
d = standard deviation of demand per day

LT = standard deviation of lead time in days
dLT = (average lead time x d2)
+ (average daily demand)2 x LT2
© 2011 Pearson
Average daily demand (normally distributed) = 150
Standard deviation = d = 16
Average lead time 5 days (normally distributed)
Standard deviation = LT = 1 day
95% service level desired
Z for 95% = 1.65
From Appendix I
ROP = (150 packs x 5 days) + 1.65dLT

= (150 x 5) + 1.65 (5 days x 162) + (1502 x 12)
= 750 + 1.65(154) = 1,004 packs
© 2011 Pearson
Single Period Model
 Only one order is placed for a product
 Units have little or no value at the end of the
sales period
Cs = Cost of shortage = Sales price/unit – Cost/unit

Co = Cost of overage = Cost/unit – Salvage value
Cs
Service level =
Cs + Co
© 2011 Pearson
Single Period Example
Average demand =  = 120 papers/day
Standard deviation =  = 15 papers
Cs = cost of shortage = $1.25 - $.70 = $.55
Co = cost of overage = $.70 - $.30 = $.40
Cs
Service level =
Cs + Co
.55 Service
level
= .55 + .40 57.8%
= .55 = .578
.95  = 120
Optimal stocking level
© 2011 Pearson
Single Period Example
From Appendix I, for the area .578, Z  .20

The optimal stocking level
= 120 copies + (.20)()

= 120 + (.20)(15) = 120 + 3 = 123 papers
The stockout risk = 1 – service level
= 1 – .578 = .422 = 42.2%
© 2011 Pearson
Fixed-Period (P)
Systems
 Orders placed at the end of a fixed period
 Inventory counted only at end of period
 Order brings inventory up to target level
 Only relevant costs are ordering and holding

 Lead times are known and constant
 Items are independent from one another
© 2011 Pearson
Fixed-Period (P)
Systems
Target quantity (T)
Q4
Q2
On-hand inventory
Q1 P
Q3
Time Figure 12.9

© 2011 Pearson
Fixed-Period (P)
Example
3 jackets are back ordered No jackets are in stock
It is time to place an order Target value = 50
Order amount (Q) = Target (T) - On-

hand inventory - Earlier orders not yet
received + Back orders
Q = 50 - 0 - 0 + 3 = 53 jackets
© 2011 Pearson
Fixed-Period Systems
 Inventory is only counted at each

review period
 May be scheduled at convenient times
 Appropriate in routine situations
 May result in stockouts between
periods
 May require increased safety stock
© 2011 Pearson
Relevant Inventory
Costs
Item Cost Cost per item plus any other direct costs
associated with getting the item to the
plant
Holding Capital, storage, and risk cost typically
Costs stated as a % of the unit value,
e.g. 15-25%
Ordering Fixed, constant dollar amount incurred
Cost for each order placed
Shortage Loss of customer goodwill, back order

Costs handling, and lost sales
Order Quantity
Strategies
Lot-for-lot Order exactly what is needed for the
next period
Fixed-order Order a predetermined amount each
quantity time an order is placed
Min-max When on-hand inventory falls below a
system predetermined minimum level, order
enough to refill up to maximum level
Order n Order enough to satisfy demand for
periods the next n periods
Examples of Ordering
Approaches
Lot for Lot Example
1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 0 0 0 0 0 0 0
Order Placement 40 70 65 60 55 85 75 85
Fixed Order Quantity Example with Order Quantity of 200

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 160 90 25 165 110 25 150 65
Order Placement 200 200 200
Min-Max Example with min.= 50 and max.= 250 units

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Order Placement 220 140 180 160
Order n Periods with n = 3 periods

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Order Placement 175 200 160
Three Mathematical Models
for Determining Order
Quantity
 Economic Order Quantity (EOQ or Q System)
 An optimizing method used for determining order quantity
and reorder points
 Part of continuous review system which tracks on-hand
inventory each time a withdrawal is made
 Economic Production Quantity (EPQ)
 A model that allows for incremental product delivery
 Quantity Discount Model
 Modifies the EOQ process to consider cases where quantity
discounts are available
Economic Order Quantity
 EOQ Assumptions:
 Demand is known & constant -
no safety stock is required
 Lead time is known & constant
 No quantity discounts are
available
 Ordering (or setup) costs are
constant
 All demand is satisfied (no
shortages)
 The order quantity arrives in a
single shipment
EOQ: Total Cost Equation
 D  Q 
TC EOQ   S    H 
Q   2 
Where
TC  total annual cost
D  annual demand
Q  quantity to be ordered
H  annual holding cost
S  ordering or setup cost
EOQ Total Costs
Total annual costs = annual ordering costs + annual holding costs
The EOQ Formula
Minimize the TC by ordering the EOQ:
2 DS
EOQ 
H
When to Order:
The Reorder Point
 Without safety stock:
R  dL
where R  reorder point in units
d  daily/weekly demand in units
L  lead time in days/weeks
 With safety stock:
R  dL  SS
where SS  safety stock in units
EPQ Equations
 D   I MAX 
 Adjusted total cost: TC EPQ   S    H
Q   2 
 d
 Maximum inventory: I MAX  Q1  
 p
2 DS
EPQ 
 Adjusted order quantity:  d
H 1  
 p
EPQ Example
 Annual demand = 18,000 units

 Production rate = 2500 units/month
 Setup cost = $800
 Annual holding cost = $18 per unit
 Lead time = 5 days
 No. of operating days per month = 20
EPQ Example Solution
18,000
d  1500 units / month; p  2500 units / month
12
2 DS 2  18,000  800
Q   2000 units
 d  1500 
H 1   18  1  
 p  2500 
 d  1500 
I MAX  Q1    2000  1    800 units
 p  2500 
D  I   18,000   800 
TC   S    MAX H     800    18
Q   2   2000   2 
 7,200  7,200  14,400
EPQ Example Solution
(cont.)
 The reorder point:
1500
R  dL   5  375 units
20
 With safety stock of 200 units:
1500
R  dL  SS   5  200  575 units
20
Quantity Discount Model
Assumptions
 Same as the EOQ, except:
 Unit price depends upon the quantity ordered
 Adjusted total cost equation:
 D  Q 
TCQD   S    H   PD
Q   2 
Quantity Discount
Procedure
 Calculate the EOQ at the lowest price
 Determine whether the EOQ is feasible at that
price
 Will the vendor sell that quantity at that price?
 If yes, stop – if no, continue
 Check the feasibility of EOQ at the next higher
price
 Continue to the next slide ...

QD Procedure (continued)
 Continue until you identify a feasible EOQ
 Calculate the total costs (including total item
cost) for the feasible EOQ model
 Calculate the total costs of buying at the
minimum quantity required for each of the
cheaper unit prices
 Compare the total cost of each option &
choose the lowest cost alternative
 Any other issues to consider?
QD Example
 Annual Demand = 5000 units

 Ordering cost = $49
 Annual carrying charge = 20%
 Unit price schedule:
Quantity Unit Price
0 to 999 $5.00
1000 to 1999 $4.80
2000 and over $4.75
QD Example Solution
 Step 1
2  5,000  49
QP $4.75   718  not feasible 
0.2  4.75
2  5,000  49
QP $4.80   714  not feasible 
0.2  4.80
2  5,000  49
QP $5.00   700  feasible 
0.2  5.00
QD Example Solution
(Cont.)
 Step 2
5,000 700
TCQ 700   49   0.2  5.00  5.00  5000  $25,700
700 2
5,000 1000
TCQ 1000   49   0.2  4.80  4.80  5000  $24,725
1000 2
5,000 2000
TCQ  2000   49   0.2  4.75  4.75  5000  $24,822.50
2000 2
What if Demand is
Uncertain?
Safety Stock and Service
Level
 Order-cycle service level is the
probability that demand during lead time
won’t exceed on-hand inventory.
 Risk of a stockout = 1 – (service level)
 More safety stock means greater service
level and smaller risk of stockout
Safety Stock and Reorder
Point
 Without safety stock:
R  dL
where R  reorder point in units
d  daily demand in units
L  lead time in days
 With safety stock:

R  dL  SS
where SS  safety stock in units
Reorder Point
Determination
SS  z dL
i.e.,
R  dL  z dL
R = reorder point
d = average daily demand
L = lead time in days
z = number of standard deviations associated with
desired service level
 = standard deviation of demand during lead time
 Daily demand = 20 units
 Lead time = 10 days
 S.D. of lead time demand = 50 units
 Service level = 90%
Determine:
1. Safety stock
2. Reorder point
Safety Stock Solution
Step 1 – determine z
From Appendix B : z  1.28
Step 2 – determine safety stock
SS  1.28  50  64 units
Step 3 – determine reorder point
R  dL  SS  20  10  64  264 units
ABC Inventory
Classification
 ABC classification is a method for determining level
of control and frequency of review of inventory items
 A Pareto analysis can be done to segment items into
value categories depending on annual dollar volume
 A Items – typically 20% of the items accounting for
80% of the inventory value-use Q system
 B Items – typically an additional 30% of the items
accounting for 15% of the inventory value-use Q or P
 C Items – Typically the remaining 50% of the items
accounting for only 5% of the inventory value-use P
ABC Example: the table below shows a solution to an ABC
analysis. The information that is required to do the analysis is:
Item #, Unit $ Value, and Annual Unit Usage. The analysis
requires a calculation of Annual Usage $ and sorting that
column from highest to lowest $ value, calculating the
cumulative annual $ volume, and grouping into typical ABC
classifications.
Item Annual Usage ($) Percentage of Total $ Cumulative Percentage of Total $ Item Classification
106 16,500 34.4 34.4 A
110 12,500 26.1 60.5 A
115 4500 9.4 69.9 B
105 3200 6.7 76.6 B
111 2250 4.7 81.3 B
104 2000 4.2 85.5 B
114 1200 2.5 88 C
107 1000 2.1 90.1 C
101 960 2 92.1 C
113 875 1.8 93.9 C
103 750 1.6 95.5 C
108 600 1.3 96.8 C
112 600 1.3 98.1 C
102 500 1 99.1 C
109 500 1 100.1 C
Inventory Models for
Independent Demand
Need to determine when and how
much to order
 Basic economic order quantity

 Production order quantity
 Quantity discount model
Basic EOQ Model
1. Demand is known, constant, and independent
complete
Usage rate Average

Order inventory
quantity = Q on hand
Inventory level
(maximum
inventory Q
level) 2
Minimum
inventory
Time
Figure 12.3
Minimizing Costs
Curve for total
cost of holding
and setup
Minimum
total cost
Annual cost
Holding cost
curve
Setup (or order)

cost curve
Optimal Order quantity
Table 11.5 order
quantity
D
Q
S



=
D
= (S)
Q
D
Q
S
Q

Order quantity
2
Q
= (H)
2
D
Q
S
Q

D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
An EOQ Example
D = 1,000 units
S = $10 per order
2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
An EOQ Example
S = $10 per order
Expected Demand D
number of =N=
orders Order quantity = Q*
1,000
An EOQ Example
Number of working
250
An EOQ Example
D Q
TC = Q S + 2H
1,000 200
TC = 200 ($10) + ($.50)
2
TC = (5)($10) + (100)($.50) = $50 + $50 = $100

Robust Model
 The EOQ model is robust

 It works even if all parameters and
assumptions are not met
 The total cost curve is relatively flat
in the area of the EOQ
Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells when to
order
=dxL
D
Reorder Point Curve
Q*
ROP
(units)
Time (days)
Figure 12.5 Lead time = L
Reorder Point Example
Demand = 8,000 DVDs per year
250 working day year
Lead time for orders is 3 working days
D
= 8,000/250 = 32 units
ROP = d x L
= 32 units per day x 3 days = 96 units

Production Order
Quantity Model
 Used when inventory builds up over a
period of time after an order is placed
 Used when units are produced and
sold simultaneously
Production Order
Quantity Model
which production (and usage) is
taking place
Inventory level

with no production
Maximum
inventory
t Time
Figure 12.6
Production Order
Quantity Model
Q= Number of pieces per order p = Daily production rate
H= Holding cost per unit per year d = Daily demand/usage rate
D= Annual demand
Setup cost = (D/Q)S

Holding cost = 1/2 HQ[1 - (d/p)]
(D/Q)S = 1/2 HQ[1 - (d/p)]
2DS
Q =
2
H[1 - (d/p)]
2DS
Q* = H[1 - (d/p)]
Production Order
Quantity Example
D= 1,000 units p = 8 units per day
S= $10 d = 4 units per day
H= $0.50 per unit per year
2DS
Q* = H[1 - (d/p)]
2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]

 Reduced prices are often available when
 Trade-off is between reduced product cost
D QH
TC = Q S + 2 + PD
Discount Discount
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75
Table 12.2
2. If Q* for a discount doesn’t qualify, choose
the smallest possible order size to get the
discount
cost
Quantity Discount
Example
Q* =
IP
2(5,000)(49)
(.2)(5.00)
2(5,000)(49)
(.2)(4.80)
2(5,000)(49)
(.2)(4.75)
Quantity Discount
Example
Q* =
IP
2(5,000)(49)
(.2)(5.00)
2(5,000)(49)
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
(.2)(4.75) 2,000 — adjusted
Quantity Discount
Example
1 $5.00 700 $25,000 $350 $350 $25,700
2 $4.80 1,000 $24,000 $245 $480 $24,725
3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50
Table 12.3
Choose the price and quantity that gives the lowest total
cost
Types of inventory
systems
 - Order point planning (OPP)
- Fixed-Quantity system (Trans, 5-1)
- Fixed-Interval system (Trans, 5-2)
- Minimum-Maximum System, (s,S)-
system
- Material requirement planning (MRP)
- Kanban or just-in-time system
inventory management focuses on three things:
 Correct placement of resources.
 Quick, inexpensive product reordering.
 Efficient product receiving and storage.
Inventory control focuses on these three things:
 Cutting purchases of slow-moving products.
 Keeping up with changes in demand to avoid overstock.
 Avoiding product spoilage by efficiently using inventory.
 Inventory management is the act of directing the affairs
of a business, with a complete listing of merchandise
or stock on hand, raw materials, finished goods, etc.,
made each year by a business organization.
 nventory control methods are practical models that
help the organization to curb overconsumption of a
particular item of the inventory. It also involves the
measurement of time element that is required to
consume a given volume of raw materials.
 "Inventory Control" focuses on the process of movement
and accountability of inventory. This consists of strict
polices and processes in regards to: · The physical and
systemic movement of materials · Physical Inventory and
cycle counting · Measurement of accuracy and tolerances ·
Good Accounting Practices "Inventory Management"
focuses on inventory as an asset or an instrument of value
creation. Inventory is managed to maximize value, exposure,
and/or profit while minimizing cost and spend. This consists
of: · Product smoothing and leveraging · Selective product
placement · Velocity and turns calculation development ·
Inventory reduction and product rationalization · MRP
inventory Control
Systems:
 Inventory Control Systems Continuous

system (fixed-order-quantity) constant
amount ordered when inventory declines
to predetermined level Periodic system
(fixed-time-period) order placed for
variable amount after fixed passage of
time

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 Materials Accounting,

 Flow of Costs And Inventory Valuation,

 Inventory is an unused asset, which lies in stock without

The objective of inventory management is to strike a balance

 Inventory control is a method to identify those

 When, how much , how often

 STEP 1: Inventory Planning

 In this system there is fixed time interval

 done in small format stores like pharmacies

 Economic order quantity (EOQ) model

 Economic production model

 Relatively uniform & known demand rate

Profile of Inventory Level Over Time

The Total-Cost Curve is U-Shaped

2DS 2(Annual Demand)(Order or Setup Cost )

The total cost curve reaches its minimum

Annual Annual Purchasing

Adding Purchasing cost TC with PD

Maximum probable demand

Safety stock reduces risk of Safety stock

The ROP based on a normal

 Orders are placed at fixed time intervals

 Tight control of inventory items

 Single period model: model for ordering

Usage rate Average

Setup (or order)

Annual setup cost = (Number of orders placed per year)

Annual demand Setup or order

Annual holding cost = (Average inventory level)

Optimal order quantity is found when annual setup cost

Total annual cost = Setup cost + Holding cost

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

Demand part of cycle

Setup cost = (D/Q)S

(D/Q)S = 1/2 HQ[1 - (d/p)]

= 282.8 or 283 hubcaps

Total cost = Setup cost + Holding cost + Product cost

3 2,000 and over 5 $4.75

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

1. Basic economic order quantity

Usage rate Average

Setup (or order)

Q = Number of pieces per order

Annual setup cost = (Number of orders placed per year)

Annual demand Setup or order

Annual holding cost = (Average inventory level)

Optimal order quantity is found when annual setup cost

Total annual cost = Setup cost + Holding cost

TC = (5)($10) + (100)($.50) = $50 + $50 = $100