Inventory Management

Ravindra S. Gokhale

Concepts of Inventory
Inventory is the stock of any item used in an organization
Inventory System - Set of policies and controls for:

Monitoring levels of inventory

For each item determine: When to order? AND How much

to order?

Types of Inventory In Manufacturing Systems

Raw material
Finished products
Component parts
Supplies
Work-in-process

Inventory A Necessary Evil

Arguments in favor of higher inventory

Higher customer service To avoid stockouts

Lower ordering cost Minimize the time and money spent for ordering

Better labor and equipment utilization As a result of planned stable

production

Lower transportation cost As a result of better truckload utilization

Reduce payments to suppliers By taking advantage of quantity

discounts

Inventory A Necessary Evil (cont)

Arguments against higher inventory

Higher inventory carrying costs

Requirement of storage space

Opportunity costs The capital tied up in inventory can be used to

obtain finance for a more promising project

Leads to shrinkage (a) pilferage/theft/deterioration

(b) obsolescence

Key Terms Associated with Inventory

EOQ

p-type of system
q-type of system
safety stock
lead time
service level
re-order point
target inventory level

ABC analysis

Different Costs Associated with Inventory

Inventory holding (or carrying) cost

Includes costs for storage facilities, handling, insurance,
shrinkage, and opportunity costs

Ordering cost
Incurred during purchasing of material and includes clerical
expenses (example: stock counting), preparing purchase
orders, tracking of orders

Shortage cost
Includes cost of a lost order, dissatisfied customer, and
customer waiting costs
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Independent and Dependent Demand

Independent demand

Demands for various items are unrelated to each other

Customer surveys and/or quantitative forecasting techniques are used

to determine their demand

Since the demand is uncertain, certain amount of inventory has to be

carried

Leads to the concept of safety stock

Independent and Dependent Demand (cont)

Dependent demand

Need for an item is a direct result of need for some other item (usually
a higher level item of which it is a part)

A relatively straightforward computational concept

Required quantity is simply computed from the number required in

each higher level item in which it is used

Additionally, the quantity required for spares also needs to be

determined

Types of Inventory Models / Systems

Single period inventory model

Classical example: Newsboy problem

Multi period inventory models

Basic EOQ model and its variants

Model with quantity discounts

Fixed order quantity model with safety stock

Fixed time period model with safety stock

Hybrid systems
Optional replenishment system
Base stock system

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Multi Period Inventory Models

Designed to ensure that items will be available on an ongoing
basis throughout the year
Items are usually ordered multiple times throughout the year

System dictates the actual quantity ordered and the timing of the
order

Principally two kinds of models

Fixed order quantity Event triggered

Periodic order quantity Time triggered

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Multi Period Inventory Models (cont)

Fixed order quantity Event triggered

Counting of inventory is perpetual
Generally has a lower average inventory
Most suitable for important i.e. A-class items

Fixed time period Time triggered

Counting of inventory is only at the review period
Generally has a higher average inventory
Most suitable for less important i.e. C-class items

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The Concept of EOQ

EOQ = Economic order quantity
The optimum lot size that minimizes the total annual inventory
costs

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The Concept of EOQ (cont)

Assumptions:

Demand rate constant and deterministic

No constraints on the size of the lot (example: infinite truck capacity)

Only two relevant inventory costs: ordering cost and carrying cost

Decisions made are independently for each item (i.e. no clubbing of items)

No uncertainty in lead time or supply

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Basic EOQ Model

Assumptions: (in addition to the five assumptions discussed previously)

Zero lead time and infinite replenishment rate
No shortages/backorders allowed

EOQ = Q* =

2DCo
Cc

(D = Annual demand, Co = Ordering cost, Cc = Carrying cost per unit

per year)

Cycle time = t = Q*/D; Number of orders = 1/t = D/Q*

Average inventory = Q*/2

Optimum inventory cost = DCo/Q* + CcQ*/2

This model can be associated with both fixed order quantity and fixed time period
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Numerical Example - Basic EOQ Model

For an item X, the data for inventory is as follows:

Annual demand: 3000 units,

Ordering cost: Rs. 200,

Inventory carrying cost: Rs. 30 per unit per year

Based on this information, determine the following:

Economic order quantity (Q*).
The number of orders per year and the time period between orders.
The average inventory level.
The optimum inventory cost.

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EOQ Model with Uniform Replenishment (EPQ)

One assumption from the basic EOQ model is relaxed, i.e. now the
replenishment is not instantaneous, but uniform (like a steady production)

EOQ = Q* =

2DCo
Cc

P
P D

(P = Replenishment or Production Rate)

Cycle time = t = Q*/D; Number of orders (or setups) = 1/t = D/Q*

Maximum Inventory Level = M* =

Average inventory = M*/2

Length of production cycle = Q*/P

Optimum inventory cost =

D
Q* 1
P

DCo/Q* + (Cc x Average inventory)

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EOQ Model with Uniform Replenishment (EPQ)

Example:

Data

Demand: 1250 units per month

Annual production rate: 25000 units

Inventory carrying cost: Re. 1 per unit per week

Setup cost: Rs. 500

Calculate:

Economic lot size

Maximum inventory level

Average inventory level

Length of time to produce a lot

Length of inventory cycle

Length of time to deplete the maximum inventory

Total annual cost

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EOQ Model with Shortages

One assumption from the basic EOQ model is relaxed, i.e. now backorders are
allowed and filled immediately after the material is available

EOQ = Q* =

2DCo
Cc

Cs Cc
Cs

(Cs = Shortage cost per unit per year)

Cycle time = t = Q*/D; Number of orders = 1/t = D/Q*

Maximum Shortage = S* =

Maximum inventory = M* = Q* - S*

Q*

CC
Cs Cc

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EOQ Model with Shortages (cont)

Average (positive) inventory = (Q* - S*)/2

Proportion of time with positive inventory = (Q* - S*)/ Q*

Average (positive) shortage = S*/2

Proportion of time with positive shortage = S*/ Q*

Optimum inventory cost =

DCo/Q* + (Cc x Average inventory x proportion of time with positive inventory)

+ (Cs x Average shortage x proportion of time with positive shortage)
= DCo/Q* + Cc x (Q* - S*)2/2Q* + Cs x (S*)2/2Q*

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EOQ Model with Planned Shortages (cont)

Example:

Data

Demand: 100000 units per year

Inventory carrying cost: Rs. 50 per unit per year

Backorder cost: Re. 15 per unit per year

Ordering cost: Rs. 750

Calculate:

Economic order quantity

Optimal shortage

Number of orders per year

Length of inventory cycle

Total annual cost

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Quantity Discounts

In practice, there are some slabs of purchase price of a product depending on

the quantity

Called as price breaks or quantity discounts

Higher the quantity, lower the price per unit

In such case, the optimum inventory cost should also consider the material cost

Two types: All-Units Discount and Incremental Quantity Discount

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All-Units Discounts
Procedure for determining the optimum lot size

Step 1: Beginning with the lowest price, calculate the EOQ for each price level
until a feasible EOQ is found.
(What is a feasible EOQ?)

Step 2: Comparing

If the first feasible EOQ is found at the lowest price level, this quantity is the best
lot size

Else, calculate the total cost for first feasible EOQ and for larger price break
quantity at each lower price level
The quantity with lowest cost is the optimum lot size

Total Cost = (Material cost) + (Inventory cost)

= (unit cost x D) + (DCo/Q* + CcQ*/2)

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Numerical Example All Units Discounts

A small office consumes a can of packaged drinking water every day, 365 days a year.
Fortunately, a local distributor offers all-units quantity discounts for large orders as

shown in the table below, where the price for each category applies to every can
purchased.
Discount category

Quantity purchased

Price (per can)

1 to 60

Rs. 80

61 to 120

Rs. 77

121 or more

Rs. 75

The distributor charges Rs. 100 per order for delivery, regardless of the size of the order.

The inventory carrying cost is based on an interest rate of 8% per annum.

Determine the optimal order quantity. What is the resulting total cost per year?
With this order quantity, how many orders need to be placed per year? What is the
time interval between orders?
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Incremental Quantity Discounts

Procedure for determining the optimum lot size

Step 1: Determine an algebraic expression for cost corresponding to each price

interval, and subsequently use that to determine the cost per unit in each
interval.

Step 2: Substitute the cost per unit expressions, into total cost expressions and
compute the optimum value of Q. This is to be done for all the intervals.

Step 3: Select only those minima that are feasible

Step 4: Compute the total cost for each feasible mimimum and select the
quantity corresponding to the total minimum cost.

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Numerical Example Incremental Quantity

Discounts
A small office consumes a can of packaged drinking water every day, 365 days a year.
Fortunately, a local distributor offers incremental quantity discounts for large orders as

shown in the table below, where the price for each category applies to every can
purchased.
Discount category

Quantity purchased

Price (per can)

1 to 60

Rs. 80

61 to 120

Rs. 77

121 or more

Rs. 75

The distributor charges Rs. 100 per order for delivery, regardless of the size of the order.

The inventory carrying cost is based on an interest rate of 8% per annum.

Determine the optimal order quantity. What is the resulting total cost per year?
With this order quantity, how many orders need to be placed per year? What is the
time interval between orders?
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Concept of Safety Stock and Service Level

EOQ models assume: Demand rate is constant and deterministic

Not realistic in actual practice

Demand varies from period-to-period

Safety stock: Protection against stock out situations

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Concept of Safety Stock and Service Level

(cont)

Probability approach

Assume that demand over a period of time is normally distributed

with mean and standard deviation i.e. D ~ Normal (, 2)

Considers only the probability of running out of stock and not how
many units short

Service Level: Probability of not running out of stock

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Concept of Safety Stock and Service Level

(cont)
If quantity ordered = , then

Safety stock = 0

Service level = 50%

The risk period = time interval in which one can run out-of-stock
Relation between safety stock and service level
(safety stock) = z x Risk Period

z-value from the standard normal

standard deviation of the demand

distribution corresponding to the

during the risk period

required service level

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Variation in demand and lead time four cases

Case 1: Both demand and lead time are constant

Straightforward case, similar to EOQ, but with some positive constant
lead time

Case 2: Demand varied, lead time constant

Case 3: Demand constant, lead time varies
Case 4: Both demand and lead time vary
* In this course we will do only Case 1 and Case 2

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Fixed Order Quantity Model (General)

Ordering quantity (at the time of each order) is fixed
Time period between the orders may vary depending on the
demand rate
The re-order point (ROP) is fixed.
When to order?

What should be the re-order point?

How much to order?

What should be the fixed ordering quantity?

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Fixed Order Quantity Model with Safety Stock

Place a new order when the stock reaches Re-order Point

Order quantity is same as the EOQ, only ordering time changed

What is the risk period here?

In this case: (risk period) = (lead time)

[How???]

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Fixed Order Quantity Model with Safety Stock

(cont)
When to order?

Re-order point should be such that it includes estimated demand during

the risk period plus probability of stock-outs during the risk period

Re-order point =
(Average demand over the risk period) + (Safety stock)
i.e. (Average demand over the lead time) + (Safety stock)

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Numerical Example - Fixed Order Quantity Model with

Safety Stock
One of the largest selling items in a home appliances store is a new model

of refrigerator that is highly energy-efficient. On an average, 40 of these

refrigerators are being sold per month (that is, 1.33 refrigerators per day)
and the demand pattern follows a normal distribution. The variance of the
daily demand is 4. It takes one calendar week for the store to obtain more

refrigerators from a wholesaler. The administrative cost of placing each

order is Rs. 100. For each refrigerator, the holding cost per month is Rs.
20. The stores inventory manager has decided to use continuous-review
model with a service level of 0.8 (that is, 80%).

Determine the order quantity, re-order point and safety stock.

What will be the average number of stock outs per year with this
inventory policy?
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Fixed Time Period Model (General)

Ordering quantity (at the time of each order) may vary depending

on the demand rate

Time period between the orders is fixed (i.e. constant)
The target inventory level (also called as order up to level) is

constant
No concept of Re-order Point
When to order?

What should be the fixed time period between orders?

How much to order?

What should be the target inventory level?

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Fixed Time Period Model with Safety Stock

The review period is equal to the time between orders that is

obtained by considering the model as EOQ model.

What is the risk period here?

In this case: (risk period) = (review period) + (lead time)

[[How???]

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Fixed Time Period Model with Safety Stock

(cont)
How much to order?

Quantity ordered should be such that it includes estimated demand during

the risk period plus probability of stock-outs during the risk period minus
the current level of inventory

(Quantity ordered) = (Target Inventory Level) (Current Inventory)

= (Average demand over risk period) + (Safety stock) (Current Inventory)

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Numerical Example - Fixed Time Period Model with

Safety Stock
One of the largest selling items in a home appliances store is a new model

of refrigerator that is highly energy-efficient. On an average, 40 of these

refrigerators are being sold per month (that is, 1.33 refrigerators per day)
and the demand pattern follows a normal distribution. The variance of the
daily demand is 4. It takes one calendar week for the store to obtain more

refrigerators from a wholesaler. The administrative cost of placing each

order is Rs. 100. For each refrigerator, the holding cost per month is Rs.
20. The stores inventory manager has decided to use the fixed time
period model (with a review period equal to that obtained from an ideal

EOQ model) with a service level of 0.8 (that is, 80%).

What will be the review period? What is the risk period in this case?
What is the safety stock and the corresponding target inventory level?
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Inventory Control Systems P and Q

A comparison
Parameter

Fixed Order Quantity

Fixed Time Period

System

System

(Q System)

(P System)

Time between order

Varies

Constant

Quantity ordered

Constant

Varies

Risk period

Lower

Higher

Safety stock required

Lower

Higher

Monitoring

Continuous

Periodic (not continuous)

Operating costs

Higher

Lower

Advantages

Lowe inventory

Ease of operation
Combine multiple

carrying cost

orders
Recommended for

A-class items

C-class items
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Hybrid Systems
Two types:

Optional replenishment system

Base stock model

Optional Replenishment System (s-S system or min-max system)

Similar to the fixed order period model

If inventory has dropped below a prescribed level (similar to the re-order

point) at the review time

An order is placed
Otherwise, no order is placed

Protects against placing very small orders

Attractive when review and ordering costs are both large

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Hybrid Systems (cont)

Base stock model

Start with a certain inventory level

Whenever a withdrawal is made

An order of equal size is placed

Ensures that inventory maintained at an approximately constant level

Appropriate for very expensive items that are fast moving but with small
ordering costs

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Single Period Inventory Model

Decision has to be taken only for a single period: How much to
order?

Assume: No on-hand inventory

Assume: Demand distribution is known

Let,

c = Cost of purchasing each unit

p = Selling price per unit

h = Salvage value of each unit (may be positive, zero, or negative)

Therefore,

Cost of under ordering = cu = p c = Loss of opportunity

Cost of over ordering = co = c - h

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Single Period Inventory Model (cont)

P(Demand < Stock) <= (cu)/(cu + co)
This is called as the critical fractile
One must order as much as the critical fractile to achieve a trade
off between under ordering and over ordering

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Single Period Inventory Model (cont)

Typical applications

Perishable products (example: newspaper, magazines)

One time event (example: selling T-shirts for Finals of a tournament)

Service industry where cancellations are allowed (example: airline

tickets, hotel bookings)

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Single Period Inventory Model

Numerical Example 1
A wholesaler stocks special high-quality kites for selling them to small size
shops, every year around December. The season lasts for approximately 2
months. Each kite sold by the wholesaler yields him a profit of Rs. 4. At the
end of the season, the wholesaler has to dispose off all the kites for making

room for other goods. There is no salvage value for the unsold kites, and
in fact the wholesaler has to spend Re. 1 per kite to dispose it off properly.
Assume that purchase cost of the price for the wholesaler is Rs. 6 per kite.
Years of data has shown that the demand for kites during this season for

that region, follows

a normal distribution with a mean of 10000 and a

variance 6000. What is the best stocking quantity for the wholesaler at the
beginning of the season?

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Single Period Inventory Model

Numerical Example 1a
If the wholesaler from Numerical Example 1 wants to achieve a
service level of 95%, what should be his ordering quantity?

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Single Period Inventory Model

Numerical Example 2
The management of Quality Airlines has an over booking policy, since the cancellations
(i.e. no-shows) are common in this industry. The policy now needs to be applied to a
new flight from Delhi to Mumbai. The airplane has 125 seats available for a fare of Rs.
2500 each. However, since there commonly are a few no-shows, the airline should
accept a few more than 125 reservations. On those occasions when more than 125

people arrive to take the flight, the airline will find volunteers who are willing to
sacrifice their journey plan in return for being given points worth Rs. 2000 (in addition
to giving full refund of any booking amount, if collected) toward any future travel on
this airline. Based on previous experience with similar flights, it is estimated that the
relative frequency(proportion of the number of no-shows will be as shown below.
# of no shows

Proportion

5%

10%

15%

15%

15%

15%

10%

10%

5%

How many overbooking reservations should Quality Airlines accept for this flight?
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