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Chapter 17. Inventory Control

Inventory is the stock of any item or resource used in an
organization and can include: 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
Firms invest 25-35 percent of assets in inventory but many do
not manage inventories well
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Purposes of Inventory
1. To maintain independence of operations
Provide optimal amount of cushion between work centers
Ensure smooth work flow
2. To allow flexibility in production scheduling
3. To meet variation in product demand
4. To provide a safeguard for variation in raw material
or parts delivery time
Protect against supply delivery problems (strikes, weather,
natural disasters, war, etc.)
5. To take advantage of economic purchase-order size
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Independent vs. Dependent Demand
Inventory costs
Single-Period Model
Multi-Period Models: Basic Fixed-Order Quantity Models
Event triggered (Example: running out of stock, or dropping below
a reorder point)
EOQ, EOQ with reorder point (ROP) , and with safety stock
Multi-Period Models: Basic Fixed-Time Period Model
EOQ with Quantity Discounts
ABC analysis
Inventory Control (Management)
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E(1
)
Independent vs. Dependent Demand
Independent Demand (Demand not related to other
items or the final end-product)
Dependent Demand
(Derived demand
items for component
parts,
subassemblies,
raw materials, etc.)
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Inventory Costs
Holding (or carrying) costs.
Costs for capital, taxes, insurance, etc.
(Dealing with storage and handling)

Setup (or production change) costs. (manufacturing)
Costs for arranging specific equipment setups, etc.

Ordering costs (services & manufacturing)
Costs of someone placing an order, etc.

Shortage (backordering) costs.
Costs of canceling an order, customer goodwill, etc.
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A Single-Period Model
Sometimes referred to as the newsboy problem
Is used to handle ordering of perishables (fresh seafood, cut
flowers, etc.) and items that have a limited useful life
(newspaper, magazines, high fashion goods, some high tech
components, etc)
The optimal stocking level uses marginal analysis is where the
expected profit (benefit from derived from carrying the next
unit) is less than the expected cost of that unit (minus salvage
value)
C
o
= Cost/unit of overestimated demand (excess demand)
C
o
= Cost per unit salvage value per unit
C
u
= Cost/unit of underestimated demand
C
u
= Price/unit cost/unit + cost of loss of goodwill per unit
Optimal order level is where P <= C
u
/(C
o
+ C
u
)
This model states that 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 of: C
u
/C
o
+C
u
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Single Period Model Example
UNC Charlotte basketball team is playing in a
tournament game this weekend. Based on our past
experience we sell on average 2,400 shirts with a
standard deviation of 350. We make $10 on every
shirt we sell at the game, but lose $5 on every shirt
not sold. How many shirts should we make for the
game?
1. Determine C
u
= $10 and C
o
= $5 (this time, these were directly given)
2. Compute P $10 / ($10 + $5) = 0.667 66.7%
3. Order up to ~ 66.7% of the demand
4. How do you determine it?
5. Normal distribution, Z transformation,
6. Z
0.667
= 0.432 (use NORMSDIST(.667) or Appendix E)
7. Therefore we need 2,400 +0.432(350) = 2,551 shirts
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Single Period Model, Marginal Analysis
Marginal analysis approach.
Consider solved problem 1, p. 617
1. Determine C
u
= 100-70 = $30 and C
o
= 70-20 = $50
2. Compute P 30/(30+50) 0.375
3. Develop a full marginal analysis table (Excel time!)
4. Assume we purchase 35 units, compute the expected total cost



5. Repeat step 4, for 36,, 40






The optimal order (purchase) size is the no. of units with the minimum expected
total cost
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Fixed-Order Quantity Models: Assumptions
Demand for the product is constant and uniform throughout the
period.
Inventory holding cost is based on average inventory.
Ordering or setup costs are constant.
All demands for the product will be satisfied. (No back orders
are allowed.)
Lead time (time from ordering to receipt) is constant (later, this
assumption is relaxed with safety stocks).
Price per unit of product is constant.
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Basic Fixed-Order Quantity Model and Reorder
Point Behavior
R = Reorder point
Q = Economic order quantity
L = Lead time
L
L
Q Q Q
R
Time
Number
of units
on hand
1. You receive an order quantity Q.
2. Your start using
them up over time.
3. When you reach down to
a level of inventory of R,
you place your next Q
sized order.
4. The cycle then repeats.
17-10
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Cost Minimization Goal
Ordering Costs
Holding
Costs
Q
OPTIMAL
Order Quantity (Q)
C
O
S
T
Annual Cost of
Items (DC)
Total Cost
By adding the item, holding, and ordering costs together, we
determine the total cost curve, which in turn is used to find the
Q
optimal
(a.k.a. EOQ) inventory order point that minimizes total
costs.
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Basic Fixed-Order Quantity (EOQ) Model
Annual
Holding
Cost
Total Annual Cost =
Annual
Purchase
Cost
Annual
Ordering
Cost
+ +
S
Q
D
H
Q
DC TC
2
A little bit of calculus
H
DS
EOQ
2

L d = ROP
_
A little bit of common sense
L
z L d = ROP
_
ROP with safety stock
TC = Total annual cost
D = Demand
C = Cost per unit
Q = Order quantity
S = Cost of placing an order or setup cost
H = Annual holding and storage cost per unit
of inventory
R or ROP = Reorder point
L = Lead time (constant)
= average (daily, weekly, etc) demand

L
= Standard deviation of demand during lead time
_
d
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Basic EOQ & ROP Example
Annual Demand = 1,000 units
Days per year considered in average daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
Given the information below, what are the EOQ, reorder point, and
total annual cost?
EOQ 89.44 89 or 90 units
ROP 2.74*7 19.18 19 or 20 units

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Another example
Days per year considered in average daily demand = 360
Average daily demand is 3.5 units
Standard deviation of daily demand is 0.95 units
Cost to place an order = $50
Holding cost per unit per year = $7.25
Lead time = 4 days

Compute the EOQ, and ROP is the firm wants to
maintain a 97% service level (probability of not stocking out)
2
d
1
2
constant, is and t independen is day each Since

d L
L
i
d L
L
i

L
z L d = ROP
_
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Fixed-Time Period Model with Safety Stock
order) on items (includes level inventory current = I
time lead and review over the demand of deviation standard =
y probabilit service specified a for deviations standard of number the = z
demand daily average forecast = d
days in time lead = L
reviews between days of number the = T
ordered be to quantitiy = q
: Where
I - Z + L) + (T d = q
L + T
L + T

q = Average demand + Safety stock Inventory currently on hand

2
d L + T
d
L + T
1 i
2
d L + T
L) + (T =
constant, is and t independen is day each Since
=
i

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Example of the Fixed-Time Period Model
Average daily demand for a product is 20 units.
The review period is 30 days, and lead time is 10 days.
Management has set a policy of satisfying 96 percent of
demand from items in stock. At the beginning of the
review period there are 200 units in inventory. The daily
demand standard deviation is 4 units.




Given the information below, how many units should be ordered?
25.298 = 4 10 + 30 = L) + (T =
2 2
d L + T

q = 20(30+10) + 1.75(25.30) 200 644.27 units

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A special purpose model
Price-Break Model (Quantity discounts)
Based on the same assumptions as the EOQ model, the price-
break model has a similar EOQ (Q
opt
) formula:



Annual holding cost, H, is calculated using H = iC where
i = percentage of unit cost attributed to carrying inventory
C = cost per unit
Since C changes for each price-break, the formula above
must be applied to each price-break cost value.
Determine the total cost for each price break
The lowest total cost suggests the optimal order size (EOQ)



Cost Holding Annual
Cost) Setup or der Demand)(Or 2(Annual
=
iC
2DS
= Q
OPT
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Price-Break Example
A company has a chance to reduce their inventory ordering costs by
placing larger quantity orders using the price-break order quantity
schedule below. What should their optimal order quantity be if this
company purchases this single inventory item with an e-mail ordering
cost of $4, a carrying cost rate of 2% of the inventory cost of the item,
and an annual demand of 10,000 units?
Order Quantity(units) Price/unit($)
0 to 2,499 $1.20
2,500 to 3,999 $1.00
4,000 or more $0.98
Re-do the example with an order cost of $25 and an inventory carrying cost rate of 45%.
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0 1826 2500 4000 Order Quantity
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ABC Classification System
Items kept in inventory are not of equal importance in terms of:
dollars invested
profit potential
sales or usage volume
stock-out penalties


So, identify inventory items based on percentage of total dollar value,
where A items are roughly top 15 %, B items as next 35 %, and the
lower 65% are the C items

0
30
60
30
60
A
B
C
% of
$ Value
% of
Use
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Inventory Accuracy and Cycle Counting
Inventory accuracy refers to how well the inventory
records agree with physical count
Lock the storeroom
Hire the right personnel for as storeroom manager or
employees
Cycle Counting is a physical inventory-taking technique in
which inventory is counted on a frequent basis rather than
1-2 times a year
Easier to conduct when inventories are low
Randomly (minimize predictability)
Pay more attention to A items, then B, etc.

Suggested problems: 3, 6, 12, 14, 17, 18, 21, 24
Case: Hewlett-Packard