1

WHAT IS INVENTORY?

+ An inventory is an idle stock of material

used to facilitate production or to satisfy
customer needs
 3

WHY DO WE NEED INVENTORY?

• Economies of scales in ordering or

production - cycle stock
- trade-off setup cost vs carrying cost
+ Smooth production when
requirements
have predictable variability -
seasonal stock
- trade-off production adjustment cost vs carrying
cost
 4

WHY DO WE NEED INVENTORY?

(CONT'D)
+ Provide immediate service when
requirements are uncertain (unpredicatable
variability) -safety stock
- trade-off shortage cost versus carrying cost
• Decoupling of stages in
production/distribution systems -decoupling
stock
- trade-off interdependence between stages vs
carrying cost
 Introduction to Operations M anagement

WHY DO WE NEED INVENTORY?

(CONT'D
• Production is not instantaneous, there is
always material either being processed or
in transit - pipeline stock
- trade-off cost of speed vs carrying cost
 Introduction to Operations M anagement

WHY_ CARRYING INVENTORY

• A s you can see from the above list,

there are economic reasons,
technological reasons as well as
management/operations reasons.
 Introduction to Operations M anagement

7
WHY CARRYING INVENTORY IS COSTLY?

• Traditionally, carrying costs

are attributed to:
- Opportunity cost (financial cost)
- Physical cost
(storage/handling/insurance/theft/ob
s olescence/ ...)
 Inventory
8

Management Independent Demand

/ Dependent
Demand

B (4) C(2)

Independent demand is uncertain. Dependent demand is certain.

 9

TYPES OF INVENTORIES

• • Raw materials & purchased parts

• • Partially completed goods called
• work in progress
• • F inished-goods inventories
• - ( manufacturing firms)
• or merchandise
• ( retail stores)
10

TYPES OF INVENTORIES
(CONT'D)
• + Replacement parts, tools , & supplies
• + Goods-in-transit to wa rehouses or customers
 11

INVENTORY COUNTING SYSTEMS

• Periodic System
Physical count of items made at periodic intervals
• Perpetual Inventor y System
System that keeps track
of removals from inventory
continuously, thus
monitoring .,..,-'-'--, current levels of
each item
 12

INVENTORY COUNTING SYSTEMS

(CONT'Q)
• Two-Bin System - Two containers
of inventory ; reorder when the f irst is
empty
• Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached o

214800
232087768
 13

ABC Classification System

Classifying inventory according to

some measure of importance and
allocating control efforts accordingly.

A- very important High

Annual A
B - mod. $ volume
.
B
of items c
important C - least Low
important Few Many
Number of Items
 14 What are we tackling in
inventory management?
+ All models are trying to answer the following
questions for given informational, economic and
technological characteristics of the operating
environment:
- How much to order (produce)?
- When to order (produce) ?
- How often to review inventory ?
- Where to place/position inventory ?
 Introduction to Operations M anagement

15

THE INVENTORY MODELS

+ The quantitative inventory management
models range from simple to very
complicated ones. However, there are
two simple models that capture the
essential tradeoffs in inventory theory
- The newsboy (newsvendor) model
- The EOQ (Economic Ordering Quantity)
model
16

THE NEWSBOY MODEL

• • The newsboy model is a single-period stocking

problem with uncertain demand: Choose stock level
and then observe actual demand.
• - Tradeoff : overstock cost versus
opportunity cost (lost of profit
because of under stocking)
 17

THE NEWSBOY MODEL

+ Shortage cost (C5 ) - the opportunity cost

for lost of sales as well as the cost of losing
customer goodwill.
C5 = revenue per unit - cost per unit
• Excess cost (C8 ) - the over-stocki ng
cost (the cost per item not being able to
sell)
Ce = Cost per unit - salvage value per unit
 18

THE NEWSBOY MODEL

+ In this model, we have to consider two
factors (decision variables) : the supply
(X), also know as the stock level, and the
demand (Y). The supply is a controllable
variable in this case and the demand is
not in our control. We need to determine
the quantity to order so that long-run
expected cost (excess and shortage) is
minimized.
19

T HE NEWSBOY
MODEL
• + Let X = n and P(n) = P(Y>n) . The question is:
Based on what should we stock this n-th unit?
• + The opportunity cost (expected loss of profit)for
this n-th unit is P(n) C 8
• + The expected cost for not being able to sell this n-th
unit (expected loss)
• (1-P(n)) Ce
 Introduction to Operations M anagement

THE NEWSBOY MODEL

• Stock the n-th unit if P(n)C5 > (1-

P(n))Ce

+ Do not stock if P(n)Cs < (1-P(n))Ce

20
 Introduction to Operations Management

21

THE NEWSBOY MODEL

• The equilibrium point occurs at
P(n)C5 = (1-P(n)) Ce

Solving the equation

P(n) = Ce/(C5 + Ce)
 Introduction to Operations Management

22

NEWSBOY MODEL

+ Service level is the probability that

demand will not exceed the stocking level
and is the key to determine the optimal
stocking level.

+ In our notation, it is the probability

that Y<X (=n), which is given by
 23

EXAMPLE (P.564)

Demand for long-stemmed red roses at a small flower shop can be

approximated using a Poisson distribution that has a mean of four
dozen per day. Profit on the roses is $3 per dozen. Leftover are
marked down and sold the next day at a loss of $2 per dozen. Assume
that all marked down flowers are sold. What is the optimal stocking
level?
 EXAMPLE (SOLUTIONS)
Cumulative frequencies for
•+ Cs = $3, Ce = $2 Poisson distribution, mean =
4
• Opportunity cost is P(n)C 5 Cumulative
Demand (dzn
• Expected loss for over­ per day) frequency
stocking (1 - P(n)) Ce 0 0.018
1 0.092
2 0.238
•+ P(Y < n) = C /(C
5 5 + 3 0.434
Ce) = 4 0.629
5 0.785
• 3/((3+2) = 0.6
• From the table , it is
between 3 and 4 , round up
give you optimal stock of 4
2-
1
 25
THE INVENTORY
CYCLE
Profile of Inventory Level Over
Time
a - Usage
/ rate

Quantity
on hand

Reorde
r ----+ - - - - - - - - - - - - - -
--- - --- -- - - - - -
point
-- - - - - -
Time
Receive Place Receive Plac Receive
order o r er o r er e order
Le a d r t i m n to Operations order
Management
 ESTIMATING THE INVENTORY
COSTS
• Q = quantity to order in each cycle
+ S = fixed cost or set up cost for each
order
+ D = demand rate or demand per unit time
+ H = holding cost per unit inventory per
unit time
+ c = unit cost of the commodity

+ TC = total holding cost per unit time

 Introduction to Operations Management

ESTIMATING THE INVENTORY

COST
+ The cost per order = S + cQ

+ The length of order cycle = Q/ D unit

time

+ The average inventory level = Q/2

• Thus the inventory carrying cost
= (Q/2) H (Q/ D) = HQ 2/(2D)
 Introduction to Operations Management

ESTIMATING THE INVENTORY

COST
• The total cost per order cycle
= S + cQ + HQ2/(2D)

Thus the total cost per unit time is dividing

the above expression by Q/ D, I.e.,

TC = {S + cQ + HQ2/ (2D)} {D/Q}

= DS/Q + cD + HQ/2
 Introduction to Operations Management

Annua Annua
Total cost carrying + orderin
lcost lg cost
=

TC + D
= s
Q
 DERIVING THE EOQ

Using calculus, we take the

derivative of the total cost tunction
and set the derivative (slope) equal
to zero and solve for Q .
= 2DS 2(Annual Demand )(Order or Setup Cost )
0 =
OPT H Annual Holding Cost
 COST MINIMIZATION
GOAL
The Total- Cost Curve is U-
Shaped
Q D
+-' TC = - H + -
Q
CJ)
0
() S 2
ct
l:::l
cc
<(

Ordering Costs

Q0 (optimal order quantity) Order Quantity (Q)

 MINIMUM TOTAL COST

The total cost curve reaches its

minimum where the carrying and
ordering costs are equal.

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

0 =
OPT
H Annual Holding Cost
 Introduction to Operations Management

TOTAL COSTS
.....
I/)
.0 I
0 \ Adding Purchasing cost TC with PD
\
doesn't change EOQ
-
\
\

-
\

--
\

-
\

- -
\

-- -
\
'' ,
_ - - -r -----
.......
-- -
- -
TC
-
without PD

- - --

PD

0 EOQ Quantity
 34
Total Cost with Constant Carrying Costs

-
(/)
0
Decreasing

-
(_)

m ' Price
\\
\ \
\
\

'''
' CC a,b,c
''
' ' ..... ...
..

-- -------- oc

EOQ Quantity
 EXAMPLE (EXAMPLE 2, P.541)

A local distributor for a national tire company expects to sell

approximately 9600 steel-belted radial tires of a certain size and tread
design next year. Annual carrying costs are $16 per tire, and ordering
costs are $75. This distributor operate 288 days a year.
a. What is the EOQ?
b. How many times per year does the store reorder?
c. What is the length or an order cycle?
d. What is the total ordering and inventory cost?
 36
Solution (Exam le 2, p.541)

D = 9600 tires per year, H = $16 per unit per year, S =

$75 a. 0 0 = '1{2DS/H} = '1{2(9600)75/ 16} = 300

b. Number of orders per year = DI 0 0 = 9600 I 300 =

32
d
c.. The
Totallength
ordering andorder
of one inventory = QH/2
cycle = 1 I 32 years = +288/32
DS/Q
costdays = 9 days = 2400 + 2400 =
4800
 EOQ WITH QUANTITY
DISCOUNT
• This is a variant of the EOQ model.
Quantity discount is another form of
economies of scale: pay less for each
unit if you order more. The essential
trade-off is between economies of scale
and carrying cost.
 EOQ WITH QUANTITY DISCOUNT

• To tackle the problem, there will be a separate

(TC) curve for each discount quantity price. The
objective is to identify an order quantity that will
represent the lowest total cost for the entire set of
curves in which the solution is feasible. There
are two general cases:
- The holding cost is constant
- The holding cost is a percentage of
the purchasing price.
QUANTITY DISCOUNT (CONSTANT
HOLDING COST)
• Total cost per cycle
= setup cost + purchase cost + carrying cost
• Setup cost = S
• Purchase cost = ciQ, if the order quantity Q
is in the range where unit cost is ci.
• Carrying cost = (Q/2) h(Q/D)

• TC = {S+ciQ+hQ2/(2D)}{ D/Q} (annual cost)

QUANTITY DISCOUNT (CONSTANT
HOLDING COST)
Differentiating, we obtain an optimal order quantity
which is independent of the price of the good

2DS
h

The questions is: Is this 0 0 a feasible solution to

our problem?

41
 41

QUANTITY DISCOUNT (CONSTANT

HOLDING COST)
+ Solution steps:
1.Compute the EOQ.
2. If the feasible EOQ is on the lowest price
curve, then it is the optimal order quantity.
3.If the feasible EOQ is on other curve , find
the total cost for this EOQ and the total costs
for the break points of all the lower cost
curves. Compare these total costs. The
point (EOQ point or break point) that yields
the lowest total cost is the optimal order
quantity.
 Introduction to Operations Management

EXAMPLE
+ The maintenance department of a large hospital uses
about 816 cases of liquid cleanser annually. Ordering
costs are $12, carrying cost are $4 per case a year,
and the new price schedule indicates that orders of
less
than 50 cases will cost $20 per case, 50 to 79 cases will
cost $18 per case, 80 to 99 cases will cost $17 per
case, and larger orders will cost $16 per case.
Determine the optimal order quantity and the total cost.
 EXAMPLE (SOLUTIONS)
1. The common EOQ: = '1{2(816) (12)/4} = 70

2. 70 falls in the range of 50 to 79, at $18 per case.

TC = DS/Q+c p +hQ/2
= 816(12)n o + 18(816) + 4(70)/2 = 14,968

3. Total cost at 80 cases per order

TC = 816(12)/80 + 17(816) + 4(80)/2 = 14,154
Total cost at 100 cases per order
TC = 8 16(12)/ 100 + 16(816) + 4(100)/2 =13 ,354

The minimum occurs at the break point 100. Thus order 100
cases each time
 Quantity discount (h =
re)
+ Using the same argument as in the constant
holding cost case, Let TCi be the total cost
when the unit quantity is ci.
TCi = rciQ/2 + DS/Q + ciD
Therefore EOQ = '1{2DS/(rcJ}

In this case, the carrying cost will decrease

with the unit price. Thus the EOQ will shift to
the right as the unit price decreases.
 Quantity discount (h =
re)
• Steps to identify optimal order quantity

1.Beginning with the lowest price, find the EOQs for

each price range until a feasible EOQ is found.
2.If the EOQ for the lowest price is feasible, then it is
the Optimal order quantity.
3. Same as step (3) in the constant carrying case.
 EXAMPLE (P.549)

Surge Electric uses 4000 toggle switches a year. Switches are priced
as follows: 1 to 499 at $0.9 each ; 500 to 999 at $.85 each ; and
1000 or more will be at $0.82 each. It costs approximately $18 to
prepare an order and receive it. Carrying cost is 18o/o of purchased
price per unit on an annual basis. Determine the optimal order
quantity and the total annual cost.
 Introduction to Operations M anagement

SOLUTION
D = 4000 per year; S = 18 ; h = 0.18 {price}

Step 1. Find the EOQ for each price, starting with the lowest price
EOQ(0.82) = ---1{2(4000)(18)/((0 .18)(0.82)]} = 988 (Not feasible for the price

range). EOQ(0.85)= 970 (feasible for the range 500 to 999)

Step 2. Feasible solution is not on the lowest cost curve
Step 3. TC(970) = 970(.18)(.85)/2 + 4000(18)/970 + .85(4000) =
3548 TC(1000) = 1000(.18)(.82)/2 + 4000(18)/1000 + .82(4000)
= 3426

Thus the minimum total cost is 3426 and the minimum cost order size is
1000 units per order.
 Introduction to Operations M anagement

• We have settled the problem of how

much to order. The next decision problem
is when to order.
 Introduction to Operations Management

REORDER POINT

• In the EOQ model, we assume that the

delivery of goods is instantaneous. However, in
real life situation, there is a time lag between
the time an order is placed and the receiving of
the ordered goods. We call this period of time
the lead time. Demand is still occurring during
the lead time and thus inventory is required to
meet customer demand . This is why we need
to consider when to order !
 Introduction to Operations Management

WHEN TO REORDER

• We can reorder based on:

- time , say weekly, monthly,
etc
- quantity of goods on hand
 Introduction to Operations Management

WHEN TO REORDER WITH EOQ

ORDERING
I
+ Reorder Point - When the quantity on hand
of an item drops to this amount, the item is
I

reordered
+ Safety Stock - Stock that is held in
$

of expected demand due to variable demand

excess
rate and/or lead time.
+ Service Level - Probability that demand will
_ not exceed supply during lead time . _ _
.
 SAFETY STOCK
Maximum probable demand
r during lead time
.>....
Expected demand
... during lead time
\_""'

a __________\ _ _____ \.._ _

I

-+
ROP-
\
\ Safety stock
\

LT Time -
-
 WHEN TO REORDER

•+ In genera l, we need to consider the

• following four factors when deciding when to order :
• - The rate of demand (usually
based on a forecast)
• - The length of lead time.
• - The extent of demand and lead
time variability.
• - The degree of stock-out risk
acceptable to management.
 Introduction to Operations Management

WHEN TO REORDER

• We will just cover two simple cases:

- The demand rate and lead time are
constant
- Variable demand rate and constant
lead time .
REORDER POINT

Service level
Risk of
a stockout
Probability of
no stockout
Expected
demand ROP Qua ntity

Safet
stock
0 z z-scale
ROP - CONSTANT DEMAND AND
LEAD TIME

• Let d be the demand rate per unit time and

LT be the lead time in unit time.
+ The reorder point quantity is given by
ROP = expected demand during lead time +
safety stock during lead time
+ In this case, safety stock required is
0 Thus ROP = d (LT)

Example: See Example 7 on page 551

 ROP - VARIABLE DEMAND
RATE
+ The lead time is constant. In this case , we need
extra buffer of safety stock to insure against stock­
out risk.
+ Since it cost money to carry safety stocks , a
manager must weigh carefully the cost of carrying
safety stock against the reduction in stock-out risk
(provided by the safety stock)
 ROP - VARIABLE DEMAND
RATE
• In other words, he needs to trade-off the cost of
safety stock and the service level.
+ Service level = 1 - stock-out risk
• ROP = Expected lead time demand + safety
stock
= d (LT) + z a
Where cr is the standard deviation of the lead time
demand = {-YLT} crd

Therefore ROP = d(LT) + z {'1LT} a d

 EXAMPLE (PROBLEM 4, P.569)
The housekeeping department of a hotel uses approximately 400
washc loths per day. The actual amount tends to vary with the number of
guests on any given night. Usage can be approximated by a normal
distribution that has a mean of 400 and a standard deviation of 9
washc loths per day. A linen supply company delivers towels and
washcloths with a lead time of three days . If the hotel policy is to
maintain a stock-out risk of 2 percent, what is the minimum number of
washcloths that must be on hand at reorder time, and how much of that
amount can be considered safety stock?

Solution:

d = 400, LT = 3 days, crd = 9 , service level = 1 - risk = 0.98

 EXAMPLE (SOLUTION)

Z = 2.055 (from normal distribution table)

Thus ROP = 400 (3) + 2.055 ('13) crd = 1200 + 32.03 = 1232

The safety stock is approximately 32 washcloths, providing a service

level of 98°/o.
Introduction to Operations Management

FIXED-ORDER-INTERVAL MODEL

• + In the EOQ/ ROP models , fixed quantities of

items are ordered at varying time interval.
However , many companies ordered at fixed intervals:
weekly , biweekly, monthly, etc. They order varying
quantity at fixed intervals. We called this class of
decision models fixed-order­ interval
(FOi) model.
 Introduction to Operations Management

FOI MODEL

• Why use FOi model?

+ Is it optimal?

• What are decision variables in the

FOi model?
 Introduction to Operations Management

FOI MODEL

+ Assuming lead time is constant , we

need to consider the following factors
- the expected demand during the ordering
interval and the lead time
- the safety stock for the ordering interval
and lead time
- the amount of inventory on hand at the time
of ordering
 Introduction to Operations Management

FOI MODEL

• We use the following notations

0 1 = Length of order interval
A = amount of inventory on hand
LT = lead time
crd = Standard deviation of
demand
 FOI MODEL

• Amount to order
= expected demand during protection interval
+ Safety stock for protection interval
- amount on hand at time of placing order

- d(OI + L1 ) + zo-d .JOI + LT - A

 EXAMPLE (P.560)
The following information is given for a FOi system . Determine the
amount to order.
d = 30 units per day, crd = 3 units per day, LT = 2 days ; 0 1 = 7
days Amount on hand = 71 units, Desired serve level = 99°/o.

Solution: z = 2.33 for 99°/o service level.

Amount to order = 30 (7 + 2) + 2.33 (3) '1(7 + 2) - 71 = 270 + 20.97 - 71 =
220