Chapter 12

Inventory Management

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Chapter 12: Learning Objectives

You should be able to:
Define the term inventory, list the major reasons for holding
inventories, and list the main requirements for effective inventory
management
Discuss the nature and importance of service inventories
Discuss periodic and perpetual review systems
Discuss the objectives of inventory management
Describe the A-B-C approach
Describe the basic EOQ model and its assumptions and solve
typical problems

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Chapter 12: Learning Objectives (contd.)

You should be able to:
Describe the economic production quantity model and solve
typical problems
Describe the quantity discount model and solve typical problems
Describe reorder point models and solve typical problems
Describe situations in which the single-period model would be
appropriate

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Inventory
Inventory
A stock or store of goods

Independent demand items

Items that are ready to be sold or used

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Inventory Costs
Holding (carrying) costs
Cost to carry an item in inventory for a length of time,
usually a year

Ordering costs
Costs of ordering and receiving inventory

Shortage costs
Costs resulting when demand exceeds the supply of
inventory; often unrealized profit per unit

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Basic EOQ Model

The basic EOQ model is used to find a fixed order
quantity that will minimize total annual inventory costs
Assumptions
Only one product is involved
Annual demand requirements are known
Demand is even throughout the year
Lead time does not vary

Each order is received in a single delivery

There are no quantity discounts

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Deriving EOQ
Using calculus, we take the derivative of the
total cost function and set the derivative (slope)
equal to zero and solve for Q.
The total cost curve reaches its minimum where
the carrying and ordering costs are equal.

2DS
2(annual demand)(order cost)
Q

H
annual per unit holding cost
*

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Economic Production Quantity (EPQ)

Assumptions
Only one product is involved

Annual demand requirements are known

Usage rate is constant
Usage occurs continually, but production occurs periodically
The production rate is constant
Lead time does not vary

There are no quantity discounts

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EPQ

2 DS
Q
H
*
p

p
p u

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When to Reorder
Reorder point
When the quantity on hand of an item drops to this amount, the
item is reordered.
Determinants of the reorder point
1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management

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Reorder Point: Under Certainty

ROP d LT
where
d Demand rate (units per period, per day, per week)
LT Lead time (in same time units as d )

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Reorder Point: Under Uncertainty

Demand or lead time uncertainty creates the possibility
that demand will be greater than available supply
To reduce the likelihood of a stockout, it becomes
necessary to carry safety stock
Safety stock
Stock that is held in excess of expected demand due to
variable demand and/or lead time

Expected demand
ROP
Safety Stock
during lead time

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How Much Safety Stock?

The amount of safety stock that is appropriate
for a given situation depends upon:
1. The average demand rate and average lead time
2. Demand and lead time variability
3. The desired service level

Expected demand
ROP
z dLT
during lead time
where
z Number of standard deviations
dLT The standard deviation of lead time demand
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Reorder Point: Demand Uncertainty

ROP d z d LT
where
z Number of standard deviations
d Average demand per period (per day, per week)

d The stddev. of demand per period (same time units as d )

LT Lead time (same time units as d )

Note : dLT d LT
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Operations Strategy
Improving inventory processes can offer significant cost
reduction and customer satisfaction benefits
Areas that may lead to improvement:
Record keeping
Records and data must be accurate and up-to-date

Variation reduction
Lead variation
Forecast errors

Lean operations
Supply chain management

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