By: Mehdi Abbas

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 Describe the different types and uses of
inventory
 Describe the objectives of inventory

management
 Calculate inventory performance measures
 Understand relevant costs associated with

inventory
 Perform ABC inventory control & analysis
 Understand the role of cycle counting in

inventory record accuracy© Wiley 2010 2

 Understand inventory’s role in service
organizations
 Calculate order quantities
 Evaluate the total relevant costs of different
inventory policies
 Understand why companies don’t always use the
optimal order quantity
 Understand how to justify smaller order sizes
 Calculate appropriate safety stock inventory
policies
 Calculate order quantities for single-period
inventory

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Provide for cost-efficient operations:
◦ Buffer stock for smooth production flow
◦ Maintain a level work force
◦ Allowing longer production runs & quantity
discounts

 Minimum inventory investments:

◦ Inventory turnover
◦ Weeks, days, or hours of supply

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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

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 A items are the few most expensive ones that
need special care.
 B items are ordinary ones that need standard

care
 C items are the large number of cheap items

that need little care.

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 The A items (106 and 110) account for 60.5% of the value and 13.3% of the items
 The B items (115,105,111,and 104) account for 25% of the value and 26.7% of
the items
 The C items make up the last 14.5% of the value and 60% of the items
 How might you control each item classification? Different ordering rules for each?

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 A company manufactures a line of ten items. The usage and unit cost are shown in
the following table, along with the annual dollar usage. The latter is obtained by
multiplying the unit usage by the unit cost.
 a. Calculate the annual dollar usage for each item.
 b. List the items according to their annual dollar usage.
 c. Calculate the cumulative annual dollar usage and the cumulative percentage of
items.
 d. Group items into an A, B, C classification
 ,

 ,
 Inaccurate inventory records can cause:
◦ Lost sales
◦ Disrupted operations
◦ Poor customer service
◦ Lower productivity
◦ Planning errors and expediting

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Two methods for checking record accuracy:
◦ Periodic counting - physical inventory is taken
periodically, usually annually
◦ Cycle counting - daily counting of prespecified
items provides the following advantages:
 Timely detection and correction of inaccurate records
 Elimination of lost production time due to unexpected stock
outs
 Structured approach using employees trained in cycle
counting

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 Achieving good inventory control may require
the following:
◦ Select, train and discipline personnel
◦ Maintain tight control over incoming shipments
◦ Maintain tight control over outgoing shipments

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Inventory management policies affect
functional areas throughout
◦ Accounting is concerned of the cost implications of
inventory
◦ Marketing is concerned as stocking decision affect
the level of customer service
◦ Information Systems tracks and controls inventory
records

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 Areas with uncertainty
 The models we developed in the last
chapter assumed that costs, demand, lead
time and all other variables are known
exactly. In other words, there is no
uncertainty about the stocks.
 In practice, there is almost always some
uncertainty in stocks - as prices rise with
inflation, operations change, new products
become available, supply chains are
disrupted, competition alters, new laws are
introduced, the economy varies, customers
and suppliers move, and so on.
 From an organization's point of view, the
main uncertainty is likely to be in customer
demand, which might appear to fluctuate
randomly or follow some long-term trend.
 In this chapter we will develop some models

to deal with this uncertainty.

 For inventory management this means that a
value is not known exactly, but follows a
known probability distribution.
 Long-term demand for a product might, for
example, be Normally distributed with a
mean of 10 units a week and variance of 2
units a week. We cannot say exactly what
demand in a particular week will be, but know
that it is a figure drawn from this distribution.
 unknown - in which case we have complete
ignorance of the situation and any analysis is
difficult;
 known (and either constant or variable) - in which

case we know the values taken by parameters and

can use deterministic models;
 uncertain - in which case we have probability

distributions for the variables and can use

probabilistic or stochastic( 隨機的 ) models.
 You can find uncertainty in many aspects of stock.
Sometimes this is due to internal operations. No
matter how good the operations are, there is
always some variation that can lead to uncertainty.
 Differences in materials, weather, tools,
employees, moods( 情緒 ), time, stress, and a
whole range of other things combine to give
apparently random variations.
 The traditional way of dealing with these was to set
a tolerance( 公差 ) in the specifications.
 Provided performance is within a specified
range it is considered acceptable.
 A 250 g bar of chocolate might weigh

between 249.9 g and 250.1 g and still be

considered the right weight; a train might
arrive within ten minutes of its published
time and still be considered on time.
 Performance was only considered to be a

problem when it fell outside the tolerance.

 Taguchi (1986) pointed out that this approach
has an inherent weakness.
 Suppose a bank sets the acceptable time to open
a new account as between 20 and 30 minutes. If
the time taken is 20, 25 or 30 minutes, the
traditional view says that these are equally
acceptable - the process is achieving its target so
there is no need for improvement.
 But customers would probably not agree that
taking 30 minutes is as good as taking 20
minutes. On the other hand, there might be little
real difference between taking 30 minutes (which
is acceptable) and 31 minutes (which is
unacceptable).
 However, there is still some variability that
comes from external causes and the
organization cannot control it.
 Every organization works within a context that is

set by international trading conditions, the

national economy, government policies, the
business environment, competition, other
organizations in the supply chain, suppliers
operations, and so on.
 Demand.
 Aggregate demand for an item usually comes

from a number of separate customers. The

organization has little real control over who
buys their products, or how many they buy.
Random fluctuations in the number and size
of orders give a variable and uncertain overall
demand.
 Most costs tend to drift upwards with inflation, and
we cannot predict the size and timing of increases.
On top of this underlying trend, are short-term
variations caused by changes to operations,
products, suppliers, competitors, and so on.
 Another point - that we mentioned in Chapter 2 -
is that changing the accounting conventions can
change the apparent costs.
 Lead time. There can be many stages
between the decision to buy an item and
actually having it available for use. Some
variability in this chain is inevitable, especially
if the item has to be made and shipped over
long distances. A hurricane in the Atlantic, or
earthquake in southern Asia can have
surprisingly far-reaching effects on trade.
 Orders are placed for a certain number of units
of a specified item, but there are times when
these are not actually delivered.
 The most obvious problem is a simple mistake in
identifying an item or sending the right number.
 Other problems include quality checks that reject
some delivered units, and damage or loss during
shipping.
 On the other hand, a supplier might allow some
overage and send more units than requested.
The deliveries ultimately depend on - and define
- supplier reliability.
 Overall, the key issue for probabilistic models
is the lead time demand.
 It does not really matter what variations there

are outside the lead time, as we can allow for

them by adjusting the timing and size of the
next order.
 Once we have placed an order, though, and

are working within the lead time it is too late

to make any adjustments.
 If demand outside the lead time is higher than
expected, all that happens is that we reach the
reorder level sooner than expected:
 but if demand inside the lead time is higher than

expected, it is too late to make adjustments and

there will be shortages.
 Our overall conclusion, then, is that uncertainty in

demand and lead time is particularly important for

inventory management.
 Even when the demand varies, we could still use
the mean value in a deterministic model.
 We know that costs rise slowly around the

economic order quantity, so this should give a

reasonable ordering policy.
 In practice, this is often true - but we have to be

careful as the mean value can give very poor

results.
 Actual demand in the lead time exactly matches
expected demand. This gives the ideal pattern of
stock shown in Figure 5.2(a).
 Actual demand in the lead time is less than
expected demand. The resulting stock level is
higher than expected, with the unused stocks
shown in Figure 5.2(b).
 Actual demand in the lead time is greater than
expected demand. This gives shortages, as shown
in Figure 5.2(c).
 With a Normally distributed demand, it is unlikely
that actual lead time demand will exactly equal
the expected demand (we will return to this
problem of forecast errors in Chapter 7). So the
actual lead time demand is likely to be either
above or below the expected value.
 The problem is that a Normal distribution gives
a demand that is higher than expected in 50 per
cent of stock cycles - so we can expect
shortages and unsatisfied customers in half the
cycles.
 Very few organizations would be satisfied with
this level of service, so we need to develop some
models that take this uncertainty into account.
 An order is placed when the on-hand
inventory reaches a predetermined level
(order point)
 Often used with the EOQ model
 Must allow enough stock to satisfy demand
during the lead time (DDLT)
 Suppose that for a particular item the average
demand is 100 units a week and the lead time is
four weeks. If an order is placed when there are 400
units on hand, on the average there will be enough
stock on hand to last until the new stock arrives.
However, demand during any one lead-time period
probably varies from the average—sometimes more
and sometimes less than the 400. Statistically, half
the time the demand is greater than average, and
there is a stockout; half the time the demand is less
than average, and there is extra stock. If it is
necessary to provide some protection against a
stockout, safety stock can be added. The item is
ordered when the quantity on hand falls to a level
equal to the demand during the lead time plus the
safety stock:
Order point = demand during lead time +
safety stock

OP = DDLT + SS
Demand is 200 units per week, the lead time is
three weeks, and the safety stock is 300 units.
Calculate the order point.

OP = DDLT + SS
= 200/wk x 3 weeks + 300
= 900 units
Order when the inventory falls below 900
units
Points to Remember
◦ Order quantities are usually fixed
◦ Order intervals may vary
◦ If the demand or the lead time changes the order
point must be changed (or the safety stock will
change)

Average inventory = order quantity + safety

stock 2
Units on hand

Order Point

Safety Stock

Lead
Time Time
The order quantity is 1,000 units and the safety stock
is 300 units. What is the average inventory?

Average inventory = Q + safety stock

2
= 1,000 + 300
2
= 800 units
 Protection against uncertainty
◦ in supply
◦ in demand
 Safety Stock
◦ covers uncertainty in quantity
 Safety Lead Time
◦ covers uncertainty in timing (late)
delivery
 Both increase inventory
 Amount of Safety Stock Depends
on:

◦ Variability of demand (during the lead

time)
◦ Order frequency
◦ Desired service level
◦ Lead time
 the longer the lead time the more safety stock
 keep the lead time to a minimum
 There is uncertainty in almost all inventory
systems.
 Some of this is under the control of an

organization, and this should be reduced as

much as possible.
 More uncertainty is outside its control, including

costs, demand, lead time and supplier reliability.

 Uncertainty in lead time demand is particularly

important for inventory control.