Inventory Management

Part-II

Inventory Management
EOQ Problem 1:
Let monthly demand at a retailer is 1000 units. Fixed

ordering costs are Rs 4000 per order. Item cost is 500 per
item. Inventory holding costs are 20%.
Determine:
1. Nos. of units in each replenishment lot.
2. Cycle inventory
3. Nos. of orders per year
4. Annual Inventory related costs (ordering and inventory
holding costs)
5. Average material flow time
4-2

Inventory Management
Annual demand, D = 1,000 x 12 = 12,000 units
Order cost per lot, Co = Rs 4,000
Unit cost of item, C = Rs500
Inventory holding cost per unit per year (as a fraction of unit
cost) Cc = 0.2 x 500 = Rs 100

Qopt = 2 Co D / Cc = 2 x 4000 x 12000 / 100

= 980 units

4-3

Inventory Management
Cycle Inventory = Qopt / 2 = 980/2 = 490
Nos. of orders per year = D / Qopt = 12000 / 980 =

12.24
Annual ordering and inventory holding costs

= (D / Qopt )x Co + (Qopt / 2 ) x Cc

= 12.24 x 4000 + 490 x 100 = Rs 97960

Average material flow time = Qopt / 2 D
= 980 / 2 x 12000 = .041 year = .49 months =
14.96 days
4-4

Inventory Management
Now if in the previous example, manager wants to
reduce the lot size to 200, then what are the annual
inventory related costs. With Q=200
(D / Q )x Co + (Q / 2 ) x Cc = Rs 250,000. This lot size is
undesirable as total costs have increased.

What need to be done make the lot size reduction

optimal ?
Qopt = 200, D = 1000x12=12000, Cc = .2 x 500 = 100
Qopt = 2 Co D / Cc can be written as :
Co = Cc (Qopt)^2 / 2 x D = 166.7
Manager has to reduce the ordering cost from Rs 4000 to Rs
166.7 for the lot size of 200 to be optimal.
4-5

Inventory Management
EOQ Problem 2:
The epaint store stocks paint in its warehouse and sells it

online on its internet website. The store stocks several

brands of paint. However its biggest seller is SharmanWilson Ironcoat paint. The company wants to determine
the optimal order size and total inventory cost for Ironcoat
paint given an estimated annual demand of 10,000 gallons
of paint, an annual carrying cost of $ 0.75 per gallon and an
ordering cost of $150 per order. Also determine the nos. of
orders per annum and time between orders (i.e. order cycle
time) with 311 working days per year.
4-6

EOQ Problem 2
Cc = $0.75 per gallon

Qopt =

2CoD
Cc

Qopt =

2(150)(10,000)
(0.75)

Co = $150

Qopt = 2,000 gallons

Orders per year = D/Qopt
= 10,000/2,000
= 5 orders/year

D = 10,000 gallons

CoD
TCmin =
+
Q
TCmin

CcQ
2

(150)(10,000)
=
2,000 +

(0.75)(2,000)
2

TCmin = $750 + $750 = $1,500

Order cycle time = 311 days/(D/Qopt)
= 311/5
= 62.2 store days
13-7

Production Quantity Model

Problem:
Assume that epaint store has its own manufacturing facility

in which it produces ironcoat paint. The ordering cost Co is

the cost of setting up the production process. Co = $150.
Cc= $0.75 per gallon and D=10,000 gallons per year. The
manufacturing facility operates for 311 days in a year, same
as store. Manufacturing facility produces 150 gallons per
day. Determine the optimal order size, total inventory cost,
length of time to receive an order, number of orders per
year and maximum inventory level with 311 working days
per year.

4-8

Production Quantity Model Problem

(related to Problem 2)
Cc = $0.75 per gallon
Co = $150
d = 10,000/311 = 32.2 gallons per day

2CoD
Qopt =

Cc 1 - d
p

D = 10,000 gallons
p = 150 gallons per day

2(150)(10,000)
=

32.2
0.75 1 150

= 2,256.8 gallons

CoD
CcQ
d
TC = Q + 2 1 - p = $1,329
2,256.8
Q
Production run =
=
= 15.05 days per order= Length
150
p
of time to receive an order
13-9

Production Quantity Model

10,000
D
Number of production runs =
=
= 4.43 runs/year
2,256.8
Q
= Nos. of orders per year
Maximum inventory level = Q 1 -

d
= 2,256.8 1 p

32.2
150

= 1,772 gallons

13-10

Inventory Management
Safety Inventory :

Cycle Safety Inventory model assumed that there is no

uncertainty in demand and supply.

Actual Demand may differ from the forecasted demand

for a given period due to demand fluctuations or forecast
errors Demand Uncertainty

Also, supplier lead time may be uncertain Supply

Uncertainty
4-11

Inventory Management

The uncertainty in demand or supply may lead to a

stockout situation.

To take care of stockout situations, firms carry safety

inventory

4-12

Safety Inventory Model:

Safety Inventory is the average inventory in hand

when the replenishment lot arrives.
R= reorder point

Inventory Management
Cycle Stock + Safety Stock
Inventory

Average
Inventory

Cycle Inventory
Safety Inventory
Time

Average inventory carried by the firm is the average

cycle inventory plus safety inventory.

Inventory Management
Tradeoff Increase in safety inventory improves
product availability i.e. decrease stock out costs but it
also increases inventory carrying costs of the firm.
In todays business environment, a firm faces:
a. Pressure to improve product availability
b. Increased product variety
c. Shorter product life cycle

a and b pushes a firm to increase safety inventory whereas

c pushes it to decrease safety inventory.
4-15

Inventory Management
Level of Safety inventory is decided by capturing :
1. Uncertainty in demand

2. Uncertainty in supply

for a given Target service level

4-16

Inventory Management
Capturing Uncertainty:
Uncertainty in demand is captured using demand distribution.
In real life situations, demand can be assumed to follow a normal

distribution.
Uncertainty is measured using: Standard deviation ,

Coefficient of variation, Range.

Standard deviation is most widely used measure.

4-17

Inventory Management

Coefficient of Variation = Standard deviation / Mean

Slow moving items typically have higher uncertainty and

higher CV while fast moving items have lower uncertainty and
lower CV.

For a new item or new supplier where past data is not available,
a subjective assessment of standard deviation can be made as :
Standard Deviation =
Range (i.e optimistic estimate pessimistic estimate)/ 6

4-18

Inventory Management
Demand distribution is characterized by mean demand

and standard deviation of demand.

Let d1, d2, d3, d4.. dn

be the demand observed for n

days.
Mean or average demand = d=(d1 + d2+ d3+ d4 . dn )/ n
Standard deviation of daily demand = d
= ((d1 - d)^2 + (d2 - d)^2 + .(dn - d)^2) / n
Similarly for supply uncertainty, mean lead time

be L and standard deviation of lead time is L

4-19

Safety Inventory Model:

Referring to the model, there is no possibility of stockout between the point

the replenishment arrives and reorder point.
Firm is exposed to stockout only after placement of order and arrival of
replenishment i.e. during the lead time.

Inventory Management

Let LTD denotes the mean value of the total lead time

demand and Lead Time Demand is the standard deviation of

lead time demand.

Uncertainty during the lead time is because of

uncertainty in actual demand and/or uncertainty is

supply.

4-21

Inventory Management
Value of LTD and Lead Time Demand can be calculated from lead

time demand distribution, if it is available from historical

data.
Or by using the formulas as:
(L= Average Lead time, d = Average Daily Demand)
LTD = L x d

Lead Time Demand = L d2 + d2 L2

4-22

Inventory Management
Safety Stock = K x Lead Time Demand

Here K is the Safety Factor= Nos. of standard

deviation corresponding to service level probability.
K indicates product availability.
Safety Stock = K d L

if L

is zero

Reorder Point (when to place the order)=

LTD + Safety Stock = LTD + K Lead Time Demand

4-23

Inventory Management

Distribution of Demand During Lead Time

Probability of Stockout

LTD = d L

Safety Stock

Reorder Point For a Service Level

Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
Kd L
dL
Demand

13-25

Safety Stock For Variable Demand with supply

uncertainty
Illustration - 1
Determine safety stock, Reorder point with a 95% service
level and a 5% stockout probability. Basic demand and leadtime data is given.
Demand Data
d1
Demand 115
Lead-time data
L1
Lead12
time

d2 d3
d4
d5 d6 d7 d 8
95 150 125 28 90 93 115

d 9 d10

L2 L3
15 4

L 9 L10
19 20

L4
21

L5 L6 L7 L 8
18 11 12 18

93 96

Inventory Management

Daily Demand d, Mean d = 100 , d = 30

Supplier Performance
Mean lead time = L= 15 Days , L = 5
LTD = 100 x 15=1500
Lead Time Demand = 513
Now,
Safety Stock = K x Lead Time Demand
For a 95% service level, K = 1.65
Safety Stock = 846
Reorder Point = 1500 +846 = 2346

Inventory Management
There exists a relationship between service level and K (which is

non-linear). Given the desired service level, value of K can be

determined or vice versa
( Using excel function :Service level = NORM.DIST(K,0,1,1) or K
= NORM.INV (s/100, 0,1); or K = NORMSINV(s); Alternatively z
table can be used.
In the present problem, if K=1 then Service Level = 84.1%,

then Safety stock = 513 units.

It means with this safety stock chances of stockout in a

replenishment cycle are 15.9 percent only (100-84.1).

4-28

Impact of Service Level On Safety Stock

Inventory Management

Measuring Product Availability

Cycle service level (CSL)

Fraction of replenishment cycles that end with all customer

demand being met.

It is the probability of not having stockout in a replenishment

cycle

Product fill rate (fr) : Fraction of product demand satisfied

from product in inventory

Order fill rate: Fraction of orders filled from available inventory

Safety Stock For Variable Demand but no supply

uncertainty
Illustration - 2
Daily demand of a product at a paint store is 30 gallons and standard deviation of 5
gallons per day. Demand is normally distributed. Lead time for receiving a new order
is 10 days with no uncertainty. The paint store wants a reorder point with a 95% CSL
and a 5% stockout probability

d = 30 gallons per day

L = 10 days
d = 5 gallons per day
LTD= Lead Time Demand= d L
For a 95% service level, K = 1.65
R = dL + K d L

Safety stock = K d L

= 30(10) + (1.65)(5)( 10)

= (1.65)(5)( 10)

= 326.1 gallons

= 26.1 gallons
Copyright 2011 John Wiley & Sons, Inc.

13-31

Inventory Control Systems

Continuous system (fixed-order-quantity)
Constant amount ordered when inventory declines to
predetermined level
Inventory is tracked continuously
Time between orders is not fixed
Order quantity is fixed
Periodic system (fixed-time-period)
Order placed for variable amount after fixed passage of time
Order is placed to raise the inventory to prespecified threshold.
Inventory is not tracked continuously
Time between orders is fixed
Order quantity is not fixed

13-32

Inventory Management
Impact of Supply Chain Redesign on Inventory: Impact of
Aggregation : Centralisation vs Decentralisation
Any supply chain redesign has a significant impact on costs
especially inventory and transportation costs.
With centralization, firm will be able to reduce inventory related
costs but will increase its transportation cost to maintain same
service level.
Supply chain managers need to justify the same with rigorous cost
benefit analysis by taking into account inventory related costs
and transportation costs.
4-33

Impact of Aggregation on
Safety Inventory
Aggregation and safety inventories in Centralisation
Di: Mean weekly demand in region i, i = 1,, k

i: Standard deviation of weekly demand in region i, i = 1,, k

rij: Correlation

of

weekly

demand

for

regions

i,

1ijk

D C : Demand faced by Central location

C
D

: Standard Deviation of weekly demand for central location

DC = Di ;
k

i=1

( )

var DC = s i2 + 2 rijs is j ;
i=1

( )

s DC = var DC

i> j

j,

Inventory Management
Centralization vs Decentralization
Illustration:
Let us consider the case of a company that currently has 16 regional
stock points/warehouses and serves its dealers from the closest
stock point.
The supply chain manager is exploring the option of centralising its
inventory.
Let each region have similar demand distribution with mean
daily demand=d= 100 and standard deviation = 30.
Demand of different regions in independent
Each stock point/ warehouse in both centralisation and
decentralization gets served by plant with lead time of exactly 15
4-35
days.

Inventory Management
Average transportation cost in decentralization case is Rs 1 / unit

and in centralization case increases by 10% i.e. Rs 1.1 / unit.

Ordering Cost = Co (or S) = Rs 256 / order

Inventory holding cost per unit per year = Cc = Rs 6

Required service level = 97.7% (K=2)
Working days per year = 300

4-36

Inventory Management
Cycle Inventory:
Centralized case

D = 16 x 100 x 300; Qopt = 6400,

Hence Cycle Inventory = 6400/2 = 3200
Decentralized case

D for each Stock point in decentralized case = 100 x 300;

Qopt = 1600, Hence Cycle Inventory = 1600/2 = 800

4-37

Inventory Management
Safety Inventory:
Demand faced by centralized stock point:
d = d1 +d2 + d3dn
D = d12 + d22 + d32 . dn2
The phenomenon is called Risk Pooling which
suggests that demand uncertainty is reduced when
demand across demand locations is pooled.
It happens because higher demand in one loaction
offsets lower demand in another location.
Lower demand uncertainty leads to lower safety stock
in the centralized case.
4-38

Inventory Management
Safety Stock:
In case of centralisation

D = 302 x 16 = 120

Safety stock = K D L = 2 x 120 x 15 = 928

In case of Decentralisation

For each regional stock point,

d= 30, K=2, Safety stock

= K d L = 2 x 30 x 15 = 232

For all 16 locations, Safety Inventory = 16 x 232

4-39

Inventory Management
Decentralised system 16
stock points

Centralised
stock point

Cycle stock/stock point =

Qopt / 2

800

3200

Safety Stock per stock point

232

928

Total Inv. in units for the

system

(232+800) 16
= 16512

928+3200
= 4128

Total Inv. carrying cost

16512 6
= 99072

4128 6
= 24768

Incremental
cost

Transportation

system

300100160.1
=48,000

Option of centralising the inventory should be chosen

4-40

Inventory Management
Note:
Safety stock decreases due to risk pooling and lower
demand uncertainty faced by centralised location.
Cycle stock in centralized case reduces because of

aggregation.
If in this case, transportation costs say increases by say 25%

, then centralisation will not be beneficial.

Benefit of centralization / aggregation decreases as

demand of different decentralized locations become

positively correlated.
4-41

Impact of Aggregation on
Safety Inventory

The Square-Root Law

If nos. of independent stocking locations decreases by m, the

average safety inventory decreases by a factor of m

Inventory Management
Centralisation vs Decentralisation:
i.

Higher the demand uncertainty of the product, higher will be

the savings in safety stock when moving from decentralisation
to centralisation.

ii.

For fast moving products like salt, wheat with low demand
uncertainty and high transportation cost, centralisation is not
beneficial.

iii.

For slow moving products with high demand uncertainty, it is

better to centralise.

iv.

Higher the nos. regional stock points, higher will be the savings
in cycle inventory in case of centralization because of
economies of scale (square root law).
4-43

Inventory Management

Two possible disadvantages to aggregation

Increase in response time to customer order

Increase in transportation cost to customer

Inventory Management
Managerial Levers to Reduce safety Stock:
1.

Reduction in Demand Uncertainty:

This can be achieved with better forecasting or entering into
contracts with some customers with assured stable demand.

2. Reduction in Supplier Lead Time: This can be achieved by

working with supplier and by using faster mode of
transport.
3. Reduction in supply uncertainty: This can be achieved using
more reliable modes of transport and working with supplier.
4-45

Inventory Management
Managing Seasonal Inventory:
A firm that faces seasonal variation in demand can follow

either of the two basic approaches:

Chase Option: Produce as per demand in each season and

carry no seasonal inventory. During peak season demand

can be met by either hiring more labour, running overtime,
outsourcing etc.
Level Option: Produce at the same level through out the

year and build inventory during lean season and use this
inventory to take care of excess demand during the peak
season.
4-46

Inventory Management
Illustration:
A toy manufacturer faces demand for toys as given.
Inventory carrying cost per unit per quarter is Rs3. Each
worker can produce 500 units of toys per quarter.
Each temporary worker hired during the peak demand
quarter (Q4) will result in additional cost of Rs 6000.
Manufacturer needs to decide whether to pursue chase or
level option to meet demand.
Relevant costs to be considered are the incremental costs of

hiring in chase option and inventory carrying costs in case

of level option.
4-47

Inventory Management
Illustration: Managing Seasonal Stock
Q1

Q2

Q3

Q4

8000

8000

8000

12000

Production

9000

9000

9000

9000

Hiring Cost

Inv. C. Cst

3000

6000

9000

Production

8000

8000

8000

12000

Hiring Cost

48000

Inv. C. Cst

Demand
Level option

Chase option

Cost: level option= 18,000 Chase option= 48000

Inventory Management
Short lifecycle products:
1.
2.

3.

4.
5.

Selling season is small.

Either physical deterioration (perishable goods) or
perceived value (style goods) decreases after selling
season.
One does not have opportunity of replenishment
during selling season.
Sales should be anticipated before selling season and
requisite stock carried.
E.g. fashion products, bread, newspaper
4-49

Inventory Management
Optimum Order size for short life cycle products
Cu = Cost of understocking
Co = Cost of Overstocking
Optimal service level = (Cu x 100) / (Cu + Co)
Optimal order size = Mean Demand + K x
standard deviation of demand
K = Service factor
Cost of understocking is an opportunity loss by the
firm for each unit of lost sales.
The cost of overstocking is the loss incurred by a firm
for each unit at the end of the selling season.
4-50

Inventory Management
Illustration: Optimum Order for a New Music CD
CD purchase price = Rs. 200
CD sales price = Rs. 300
CD sales price after first weeks = Rs. 62.
Demand: Average 100 and Standard Deviation 30
Find optimum order quantity.
If manufacturer offers buyback scheme with cost of

administering return- Rs. 53, what would be the

decision?

Inventory Management
With Cu = 100, Co = 138
Optimum service level = .42 = 42 %
Corresponding K = -0.2
Optimum order size = 100 0.2 x 30 = 94
In case of buyback:
Cu = 100, Co = 53
Optimum service level = .655 = 65.5 %
Corresponding K = 0.4
Optimum order size = 100 + 0.4 x 30 = 112
4-52

Inventory Management
Multiple item, Multiple location Inventory
Management:
1.

Managing inventory in actual supply chain involves

dealing a large number of items often stocked at multiple
stock points at various stages in the supply chain.

2.

Inventory management need to be carried out at each of

these stock points and integrated with the rest of the
supply chain.

Inventory Management
For

multiple
items,
theoretically
inventory
management and supply chain analysis is to be carried
out for each and every items.

Since nos. of items are in general large and have

varying importance, managers divide items into

multiple categories and handle different
categories in different ways.
There

are several classification

categorizing items or SKU

schemes

for

4-54

Inventory Management
1. ABC Classification:
Items are classified on the basis of sales on value terms.
A = very Important
B = Moderate Important
C = Little Important
ABC analysis is used for a) allocation of management time b)
Improvement Efforts c) Setting up service levels d)
Stocking decisions e.g. A category items at regional
distribution points, C category items at central warehouse,
B category at few regional locations
4-55

ABC Classification
Class A
5 15 % of units
70 80 % of value

Class B
30 % of units
15 % of value

Class C
50 60 % of units
5 10 % of value
13-56

ABC Classification
Illustration:
The maintenance department for a small manufacturing
firm has responsibility for maintaining an inventory of
spare parts for the machinery it services. The parts
inventory, unit cost, annual usage are given in following
table.
The department manager wants to classify the inventory
parts according to the ABC system to determine which
stocks of parts should be closely monitored.

4-57

ABC Classification- Illustration

PART
1
2
3
4
5
6
7
8
9
10

UNIT COST ANNUAL USAGE/Demand

$ 60
350
30
80
30
20
10
320
510
20

90
40
130
60
100
180
170
50
60
120

13-58

ABC Classification
PART

9
8
2
1
4
3
6
5
10
7

TOTAL
VALUE

$30,600
16,000
14,000
5,400
4,800
3,900
3,600
3,000
2,400
1,700
$85,400

% OF TOTAL
VALUE

35.9
18.7
16.4
6.3
5.6
4.6
4.2
3.5
2.8
2.0

% OF TOTAL
QUANTITY % CUMMULATIVE

6.0
5.0
4.0
9.0
6.0
10.0
18.0
13.0
12.0
17.0

A
B
C

6.0
11.0
15.0
24.0
30.0
40.0
58.0
71.0
83.0
100.0

13-59

ABC Classification
CLASS
A
B
C

ITEMS
9, 8, 2
1, 4, 3
6, 5, 10, 7

% OF TOTAL
VALUE
71.0
16.5
12.5

% OF TOTAL
QUANTITY
15.0
25.0
60.0

Example 10.1
13-60

Inventory Management
2. FSN classification
Items are classified as Fast moving , slow moving and
non-moving.
Slow moving items are stored centrally and fast
moving items are stocked de-centrally.
Non-moving items are candidates for disposal.
This type of classification is popular in retail industry.

4-61

Inventory Management
3. VED Classification:
Items are classified on criticality:
Vital = V, Essential = E , Desirable = D
This type of classification is popular in maintenance
management.
One can fix different service levels for different items.

4-62

Two Forms of Demand

Dependent
Demand for items used to produce final products
Tires for autos are a dependent demand item
Independent
Demand for items used by external customers
Cars, appliances, computers, and houses are
examples of independent demand inventory

13-63

Inventory Management
Decoupling Inventory:

Entire supply chain is usually divided into multiple stages with

multiple decision makers.

Decision making units can be both at both organisational and

departmental level.

At organisational and departmental boundaries large

inventories can be held.

The decoupling inventory provides the flexibility needed

by each decision making unit to manage its operations

independently and to optimise its performance.

Improved coordination among stages can reduce decoupling

inventory significantly.

4-64

Inventory Management
Pipeline Inventory:

Also called in-transit inventory.

It consists of materials actually being worked on (workin-process inventory) or being moved from one location

to another in the chain (on transit inventory).

Pipeline inventory of an item between two adjacent

locations is the product of the process time or
transport time and usage rate of an item

Pipeline inventory may be reduced by using faster rater of

transporting or by reducing manufacturing lead time.
4-65

Inventory Management
Illustration :
LT -Shipment by air = 7 days
LT- Shipment by sea = 45 days
Average demand = 100/day
Pipeline Inventory ( Shipment by air) = 700 units
Pipeline Inventory ( Shipment by Sea = 4500 units

Inventory Management
Dead Inventory or Stock:
Dead Stock refers to that part of non-moving
inventory that is unlikely to be of any further use in
supply chain operations or markets.
Dead Stock, essentially includes items that have become
obsolete because of changes in customer preferences,
design, production processes.
Unfortunately, in many firms dead stock is allowed to
accumulate as disposal of dead stock show up in balance
sheets as financial loss. Rather it is wrongly shown as
assets.
Firms should carefully monitor dead stock and find means
to reduce it.
4-67