Inventory Management

P.Chandiran
LIBA
Inventory System
Defined
Inventory
raw materials, finished products, component parts,
supplies, and work-in-process.

An inventory system is the set of policies and controls

that monitor levels of inventory and determines what levels
should be maintained, when stock should be replenished,
and how large orders should be.
 What is Inventory?
• Stock of materials
• Stored capacity © 1995
Corel Corp.

• Examples

© 1984-1994 T/Maker Co. © 1984-1994 T/Maker Co.

© 1995 Corel Corp.
 The Functions of Inventory
• To ”decouple” or separate various parts
of the production process
• To take advantage of quantity discounts
• To hedge against inflation and upward
price changes
 Purposes of Inventory
1. To maintain independence of operations.
2. To meet variation in product demand.
3. To allow flexibility in production scheduling.
4. To provide a safeguard for variation in raw
material delivery time.
5. To take advantage of economic purchase-order
size.
 Types of Inventory
• Raw material
• Work-in-progress
• Maintenance/repair/operating supply
• Finished goods
The Material Flow Cycle
 Disadvantages of Inventory
• Higher costs
– Item cost (if purchased)
– Ordering (or setup) cost
• Costs of forms, clerks’ wages etc.
– Holding (or carrying) cost
• Building lease, insurance, taxes etc.

• Difficult to control
• Hides production problems
Independent Demand
 Examples

• Spare parts
• FMCG
• Consumer Durables
Dependent Demand
 Examples

• Raw Materials
• Sub-assemblies
• Components
• Consumables
 Inventories at All Levels
• Inventories can be found throughout the
supply chain
• From Suppliers to Manufacturers,
Assemblers, Distributors and to Retailers
• Inventories also kept at end-customer
level
• Warehouses and In-transit
• Commonly called as Multiechelon
Inventory
 Inventory as Buffer
• It act as a buffer that decouples the
supplier from the discontinuousness of
customer demand on the one hand, and
limitations in vendor capabilities to ensure
delivery timing and quantity availabilities
on the other.
 Excess Inventory or Stock out
occurs because
• Wrong forecasting and Planning
• No communication between partners
• No trust between partners
• Shipping delay
• Surge in demand
• Lack of Inter-functional co-ordination
• Design of Products/ Process without considering
the supply chain
• Market failure
 Basic EOQ model
• Assumptions
– Known and constant demand
– Known and constant lead time
– Instantaneous receipt of material
– No quantity discounts
– Only order (setup) cost and holding cost
– No stock outs
Economic Order Quantity
On-hand inventory (units)

Time
Economic Order Quantity
Receive
order
On-hand inventory (units)

Time
Economic Order Quantity
Receive
order
On-hand inventory (units)

1 cycle
Time
Economic Order Quantity
Receive
order
On-hand inventory (units)

1 cycle
Time
Economic Order Quantity
Receive Inventory depletion
order (demand rate)
On-hand inventory (units)

1 cycle
Time
Economic Order Quantity
Receive Inventory depletion
order (demand rate)
On-hand inventory (units)

1 cycle
Time
Economic Order Quantity
Receive Inventory depletion
order (demand rate)
On-hand inventory (units)

Q Average
— cycle
2
inventory

1 cycle
Time
Total Cost = Holding Cost + Order Cost
Total Cost = Holding Cost + Order Cost
Annual cost (dollars)

Lot Size (Q)

 Total Cost = Holding Cost + Order Cost
Annual cost (dollars)

Holding cost (HC)

Lot Size (Q)

 Why Holding Costs Increase
• More units must be stored if more are ordered

Purchase Order Purchase Order

Description Qty. Description Qty.
Microwave 1 Microwave 1000
Order quantity Order quantity
 Total Cost = Holding Cost + Order Cost

Annual cost (dollars)

Holding cost (HC)

Ordering cost (OC)

Lot Size (Q)

 Why Order Costs Decrease
• If we order more when we place Order cost $10
an order, then we order fewer
times over the year. Purchase Order
• Example: You expect to order 10 Description Qty.
microwave ovens over a year for a Microwave 1
retail store like Sears. It cost $10
to place an order.
• If you order 1 microwave, how
many orders will you place over Order Cost $10
the year? what is the ordering
Purchase Order
cost? What is the ordering cost
Description Qty.
per microwave?
• If you order 10 microwaves, how Microwave 10
many orders will you place over the
year? What is the ordering cost?
What is the ordering cost per
 Total Cost = Holding Cost + Order Cost

Total cost = HC + OC
Annual cost (dollars)

Holding cost (HC)

Ordering cost (OC)

Lot Size (Q)

 Gift Shop
• A museum of natural history is having
problems managing their inventories. Low
inventory turnover is squeezing profit
margins and causing cash-flow problems.
• A Class A item, a birdfeeder is also a top-
selling item.
– Sales: 18 units/week
– Purchase cost: $60
– Order cost: $45
– Annual holding cost: 25% of purchase cost
– 52-week year
• Management has been ordering in lots of
390 units.
What is the annual cost of the
current policy?
• Q – order quantity Q

• TC – Total cost
– Annual Time

– Monthly
– ??
 Holding Cost
AnnualHoldingCost 
( AveInventory )( HoldingCost / unit / year )

Q
AnnualHoldingCost    H
2
 Holding cost

3000 —
Annual cost (dollars)

2000 — Q
Holding cost = (H)
2

1000 —

| | | | | | | |
0— 50 100 150 200 250 300 350 400

Lot Size (Q)

 Ordering cost

AnnualDemand
AnnualOrderCost  (OrderCost)
OrderQuantity

D
AnnualOrderCost  S
Q
Holding & Ordering Cost

3000 —
Annual cost (dollars)

2000 — Q
Holding cost = (H)
2

1000 — D
Ordering cost = (S)
Q

| | | | | | | |
0— 50 100 150 200 250 300 350 400

Lot Size (Q)

 Total Cost

3000 — Q D
Annual cost (dollars)

Total cost = (H) + (S)

2 Q

2000 — Q
Holding cost = (H)
2

1000 — D
Ordering cost = (S)
Q

| | | | | | | |
0— 50 100 150 200 250 300 350 400

Lot Size (Q)

 Total cost:

TotalCost  TotalOrder Cost  TotalHoldi ngCost

D Q
TC  S  H
Q 2
 What is the annual cost of the current
policy?
D Q
D – Total demand TC  S  H
Q 2
Q – Order quantity

S – Setup/order cost

H – Holding cost
 What is the annual cost of the current
policy?
D Q
D – Total demand
936/year
TC  S  H
Q 2
Q – Order quantity 936 390
390/order TC  45  15
390 2
S – Setup/order cost
$45/order TC  108  2925
H – Holding cost
TC  3033
= 0.25*60
 Total Cost for Q = 390
Current
cost

3000 — Q D
Annual cost (dollars)

Total cost = (H) + (S)

2 Q

2000 — Q
Holding cost = (H)
2

1000 — D
Ordering cost = (S)
Q

| | | | | | | |
0— 50 100 150 200 250 300 350 400
Current
Lot Size (Q)
Q
 Can the gift shop do better?

Current
cost

3000 — Q D
Annual cost (dollars)

Total cost = (H) + (S)

2 Q

2000 — Q
Holding cost = (H)
2

1000 — D
Ordering cost = (S)
Q

| | | | | | | |
0— 50 100 150 200 250 300 350 400
Current
Lot Size (Q)
Q
 Economic Order Quantity – Q*

3000 —
Annual cost (dollars)

2000 —

1000 —
Setup cost = Holding Cost
| | | | | | | |
0— 50 100 150 200 250 300 350 400

Q* Lot Size (Q)

 Economic Order Quantity (EOQ) – Q*

2 DS
Q* 
H

2(936)(45)
Q*   74.94  75units / order
15
Total Cost of Economic Order Quantity (EOQ) –
Q*

D Q*
TC  S H
Q* 2
936 75
TC  45  15
75 2
When Q = 390
TC  1124.10 TC  3033
 When to order?
• Reorder point (ROP)
– Lead time – amount of time from order
placement to receipt of goods
– Lead time demand – the demand the occurs
during the lead time
 Reorder point

Order
received
On-hand inventory

OH
 Reorder point

Order
received
On-hand inventory

OH

TBO Time between orders

 Reorder point

Order
received
On-hand inventory

OH

L
TBO
Lead time
 Reorder point

Order
received
On-hand inventory

OH

R
Order
placed

L
TBO
 Gift shop reorder point

• Demand: 18 birdfeeders/week

• Lead time: 2 weeks

• Lead time demand: 36 birdfeeders

• ROP: 36 birdfeeders
 Gift shop order policy
• Place order when the on-hand inventory is
36 birdfeeders.
• Order 75 birdfeeders
• Order received in 2 weeks
• Place next order when the on-hand
inventory is 36 birdfeeders
 Gift shop order policy

Order
received
On-hand inventory

75

OH

36
Order
placed

2 wks
 Distribution Game
• What is the EOQ
for the central
warehouse in the
distribution game?
• Order cost: S = $200

– Holding cost: H = $14.70/unit/year

– Demand: D= 2190
 Distribution Game
2 DS
Q* 
H

2(2190)(200)
Q* 
14.7

Q*  244.1  244units
 Problem 1
• Alpha industry estimates that it will sell
12,000 units of a product. The ordering
cost is Rs.100 per order and the carrying
cost is 20% of the purchase price per unit.
The purchase price per unit is Rs. 50. Find
• a. Economic order quantity
• b. No. of orders per year
• c. Time gap between successive orders
 Problem 2
• A Hospital procures its supplies of a material
once a year. The total number procured is 2400
packages in a year. This policy of procuring
material once a year is being questioned. The
accountants calculate the cost of inventory
holding at Rs. 36 per package per year. It is also
figured out that the costs of procurement add up
to Rs. 1,200 per order. What inventory policy
would you advise to this hospital?
 Problem 3
• Suppose that the R & B Beverage company has a soft-
drink product that has a constant annual demand rate of
3600 cases. A case of the soft-drink costs $3. Ordering
costs are $20 per order and holding costs are charged at
25% of the cost per unit. There are 250 working days per
year and the lead time is 5 days. Identify the following
aspects of the inventory policy.
• Economic order quantity
• Reorder point
• Cycle time
• Total annual cost
 Average Inventory
• The average inventory in EOG practice is
Q/2
• When order size decreases, the average
inventory decreases.
• When average inventory decreases, the
capital locked in inventory also decreases.
 Inventory Turnover Ratio
• A measure supply chain performance
• Inventory Turnover ratio= Total Rupee
sales per period /Average inventory per
period
• If you sell more with less inventory , you
are better
 ABC Analysis

• Divides on-hand inventory into 3 classes

– A class, B class, C class
• Basis is usually annual $ volume
– Rs. volume = Annual demand x Unit cost
• Policies based on ABC analysis
– Develop class A suppliers more
– Give tighter physical control of A items
– Forecast A items more carefully
 Classifying Items as ABC
% Annual $ Usage Class % $ Vol % Items
100 A 80 15
B 15 30
80
C 5 55
60
40
A
B
20 C
0
0 50 100
% of Inventory Items
 Benefits of ABC classification
• Level of control can be varied based on
category- A category need at most
attention
• Staggering the delivery of A class items
may reduce the average inventory.
• More reliable supply is expected for A
class items.
 FSN analysis
• Based on sales rate
• High value non-moving items are liability
• Low value fast moving item should be kept
in large quantities
• In retail, this can be used to control
inventory
 HML Classification
• Based on Rs. Value of the items
• High value items
• Medium value items
• Low value items
• It determines security requirements
• High priced items should be verified frequently
• High value items should be purchased then and
there
 Probabilistic Models

• Answer how much & when to order

• Allow demand to vary
– Follows normal distribution
– Other EOQ assumptions apply
• Consider service level & safety stock
– Service level = 1 - Probability of stockout
– Higher service level means more safety stock
• More safety stock means higher ROP
 Safety Stock
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
 Safety Stock (SS)
• Demand During Lead Time (LT) has
Normal Distribution with
- Mean( d L )   ( LT )
-
Std . Dev.( L )   LT
• SS with r% service level
SS  zr LT
• Reorder Point
ROP  SS  d L
 Problem
1. Prefab, a furniture manufacturer uses 20,000 square
feet of plywood per month. The trucking company
charges Prefab $400 per shipment independent of the
quantity purchased. The manufacturer offers an all-unit
quantity discount with a price of $1 per square foot for
orders under 5,000 square feet, $0.98 per square foot
for orders between 5,000 and 10,000 square feet,
$0.96 per square foot for orders larger than 10,000
square feet. Prefab incurs a holding cost of 20 per cent
of purchase price. What is the optimal lot size for
Prefab? What is the annual cost of such a policy? How
does it compare with the cost if the manufacturer does
not offer the discount?
Annual demand for an item is 4800 units. Ordering cost is Rs. 500
per order. Inventory carrying cost is 24% of the purchase price per
unit, per year.
The price breaks are shown below.

Price
Quantity (Rs)
0≤ Q1 10
≤1199
1200≤Q2≤ 9
1999
2000≤Q3 8
(i) Find the optimal order size.
(ii)If the order cost is changed to Rs.300 per order, find the optimal order size.
 Impact of supply uncertainty
• D: Average demand per period
 D: Standard deviation of demand per
period
• L: Average lead time
 sL: Standard deviation of lead time
 SD of demand and supply
during LT
DL  DL

L L D  D
2 2 2
 s L
 SS for supply and demand
uncertainty
• ROP= Ave. demand X Ave. LT + SS

• ROP = DL+Zσ L
 P-System
Periodic Review Method
• an alternative to ROP/Q-system control is periodic
review method
• Q-system - each stock item reordered at different
times - complex, no economies of scope or
common prod./transport runs
• P-system - inventory levels for multiple stock
items reviewed at same time - can be reordered
together
• higher carrying costs - not optimum, but more
practical
 Fixed Period Model
• Answers how much to order
• Orders placed at fixed intervals
– Inventory brought up to target amount
– Amount ordered varies
• No continuous inventory count
– Possibility of stockout between intervals
• Useful when vendors visit routinely
– Example: P&G representative calls every 2
weeks
 Using P-System
• audit inventory level at interval (T)
• quantity to place on order is difference
between max. quantity (S) and amount on
hand at time of review
• management task - set optimal T and S to
balance stock availability and cost
• In ABC analysis, which items would use P-
system???
 Periodic Review System
(order-up-to)
Inventory on Hand
Review period

RP RP RP
Target inventory level, TIL

First order quantity, Q1

Q2 Q3

d1 d3
Amount used during
first lead time

d2

Safety stock, SS First lead time, LT1

LT2 LT3

Time
Order 1 placed Order 2 placed Order 3 placed

Shipment 1 received Shipment 2 received Shipment 3 received

 P-system formula
• S-Max. Inventory level or TIL
• P-review period
• R-demand rate or consumption rate
• L-lead time
• Ih- on hand inventory
• SS-safety stock
 P-System (Cont.)
• Max. Inventory S=Demand rate (review
period + Lead time)+ SS
• S= R(P+L)+SS
• Order placed Q= (S-Ih)
 Quantity Discount Model
• Answers how much to order &
when to order
• Allows quantity discounts
– Reduced price when item is purchased in
larger quantities
– Other EOQ assumptions apply
• Trade-off is between lower price &
increased holding cost
 Special Purpose Model: Price-Break Model Formula

Based on the same assumptions as the EOQ model,

the price-break model has a similar Qopt formula:

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

Q OPT = =
iC Annual Holding Cost

i = annual percentage of unit cost attributed to carrying

inventory
C = cost per unit
Price-Break Example Problem Data
(Part 1)

Order Quantity(units) Price/unit($)

0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
 Price-Break Example Solution (Part 2)
First, start with the lowest price per unit.
Annual Demand (D)= 10,000 units Carrying cost % of total cost (i)= 2%
Cost to place an order (S)= $4 Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not.

Interval from 4000 & more, the 2DS 2(10,000)(4)
Qopt value is not feasible.
Q OPT = = = 2,020 units
iC 0.02(0.98)
Interval from 2500-3999, the 2DS 2(10,000)(4)
Qopt value is not feasible. Q OPT = = = 2,000 units
iC 0.02(1.00)

Interval from 0 to 2499, the 2DS 2(10,000)(4)

Q OPT = = = 1,826 units
Qopt value is feasible. iC 0.02(1.20)
 Price-Break Example Solution (Part 3)

Next, Compare total cost for the feasible root Q and price break
Q values.

D Q
TC = DC + S+ iC
Q 2

TC(1826)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
= $12,043.82

TC(2500) = $10,041

TC(4000) = $9,949.20
 Price-Break Example

Since the feasible solution occurred in the first price-break,

it means that all the other true Qopt values occur at the
beginnings of each price-break interval. Why?

Because the total annual cost function is a

Total “u” shaped function.
annual
costs

0 1826 2500 4000 Order Quantity

Annual demand for an item is 4800 units. Ordering cost is Rs. 500
per order. Inventory carrying cost is 24% of the purchase price per
unit, per year.
The price breaks are shown below.

Price
Quantity (Rs)
0≤ Q1 10
≤1199
1200≤Q2≤ 9
1999
2000≤Q3 8
(i) Find the optimal order size.
(ii)If the order cost is changed to Rs.300 per order, find the optimal order size.
 Single Period Models
• Placing orders for one period only
• Newsboy problem
• Marginal analysis is used
• This is to stock that quantity where the
profit from the sale or use of the last unit is
equal to or greater than the losses if the
last unit remains unsold.
 Newsboy Problem
• MP >= ML
• MP-Profit resulting from the nth unit if it is
sold
• ML-Loss resulting from the nth unit if it is
not sold
• Marginal analysis is also valid when we
deal with probabilities.
 Newsboy Problem
• P (MP) >= (1-P) ML
• P-Probability of the ‘n’th unit being sold
• (1-P)- is the probability of the ‘n’th not sold.
• P>= ML/(MP + ML)
• It means, we should continue to increase the
size of the inventory so long as the probability of
selling the last unit added is equal to or greater
than the ratio.
• Salvage value can be included in the problem
 Problem
• A product is priced to sell at $100 per unit and
its cost is constant at $70 per unit. Each unsold
unit has a salvage value of $20. Demand is
expected to range between 35 and 40 units for
the period. 35 units definitely can be sold and no
units over 40 will be sold. The demand
probabilities and the associated cumulative
probability distribution (P) for this situation are
shown in Table. How many units should be
ordered?
 Table
No. units demanded P of this demand
35 0.10
36 O.15
37 0.25
38 0.25
39 0.15
40 0.10
41 0
 Solution
• MP= 100-70=$30
• ML=70-20=$50
• The optimal probability of the last unit
being sold is P>=ML/(MP+ML)
• P>=50/80=0.625
 Table
Units of P of demand P of selling (MP) (ML) Expected Net Profit
Demand ‘n’ th unit Expected marginal loss of (MP-ML)
marginal nth unit=(1-P)*ML
Profit of nth
unit=P*MP
35 0.10 1.00
30 0 30
36 0.15 0.90
27 5 22
37 0.25 0.75
22.50 12.50 10
38 0.25 0.50
15 25 -10
39 0.15 0.25
7.50 37.50 -30
40 0.10 0.10
3 45 -42
41 0.0 0.0
 Solution
• According to cumulative probability table, the
probability of selling the unit must be equal to or
greater than 0.625, so 37 units should be
stocked. The probability of selling 37th unit is
0.75. The net benefit of stocking the 37th item is
the expected marginal profit minus the expected
marginal loss.
• Net= P(MP)-(1-P) (ML)= $10
Inventory policy during trade
promotions
Concept of forward buy
 Trade Promotion
• Offered by manufacturer to
retailer
• It can be a discounted price for
limited time period
• Quite common in consumer
packaged goods
 Objectives of Trade Promotion
• Induce retailers to use price promotions,
displays or advertising to spur sales
• Shift inventory from the manufacturer to
the retailer and the customer
• Defend a brand against competition
 Retailer response to trade
promotion
• Pass through some or all of the promotion
to customers to spur sales
• Pass through very little of the promotion to
customers but purchase in greater quantity
during promotion period to exploit the
temporary reduction in price
 Trade promotion induces forward
buy
• A forward buy is the amount that a retailer
purchases in the current period for sales in
future period
• As a result the cycle inventory and flow
time increases within the supply chain.
• What is the retailer’s optimal response
when faced with promotion?
 Inventory profile for forward buying
I

Qd

Q* Q* Q*

t
Inventory model for forward buying
Annual demand –R; Price per unit- C; Holding cost fraction –
h;
S-ordering cost
_______
Q*= √2RS/hC

Discount offered is Rs ‘d’ per unit for coming four week period
Qd -lot size ordered at discounted price
TC=Holding cost + Ordering cost + Material cost

The retailer must order a lot size which minimizes total cost
 Assumptions made for this
model
• Discount will be offered only once in a
year
• The order quantity Qd is multiple of Q*
• The retailer takes no action to influence
the consumer decision (The customer
demand remains unchanged)
 Optimal order size
• Optimal order size for this situation is
given by the formula Qd= [dR/(C-d)h]+
[CQ*/(C-d)]

• Forward Buy= Qd-Q*

 Problem
• Demand for Vitaherb is 120,000 bottles per
year. The manufacturer currently charges $3
for each bottle, and the retailer incurs a
holding cost of 20%. The retailer orders in lots
of Q*=6,324 bottles. The manufacturer has
offered a discount of $0.15 for all bottles
purchased by retailers over the coming month.
Evaluate the number of bottles of vitaherb that
the retailer should order given the promotion.
 Problem
• The Dominick supermarket chain sells Nut Flakes,
a popular cereal manufactured by the Tastee cereal
company. Demand for Nut Flakes is 1,000 boxes
per week. Dominick has a holding cost of 25% and
incurs a fixed trucking cost of $200 for each
replenishment order it places with Tastee. Given
that Tastee normally charges $2 per box of Nut
Flakes, how much should Dominick order in each
replenishment lot? Tastee runs a trade promotion
lowering the price of Nut Flakes to $1.80 for a
month. How much should Dominicks order given
the short term price reduction.
 Inventory at retail level
• Availability is more important when there is
a demand
• Follow make to order policy for high value
items (if possible with less lead time)
• Forecasting and inventory management
should be linked
Thank You