What is Inventory?

Definition--The stock of any item or

resource used in an organization

Raw materials

Finished products

Component parts

Supplies

Work in process

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Inventory System Purpose

The set of policies and controls

that determine what inventory
levels should be maintained, when
stock should be replenished, and
how large orders should be

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Purposes of Inventory
1. To maintain independence of operations
2. To meet variation in product demand
3. To allow flexibility in production scheduling
4. To provide a safeguard for variation in raw
material delivery time
5. To take advantage of economic purchaseorder size

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Inventory Costs

Holding (or carrying) costs

Setup (or production change) costs

Ordering costs

Shortage (or backlog) costs

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Independent vs. Dependent

Demand

Independent Demand
(Demand not related to other items)
Dependent Demand
(Derived/Calculated)

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Classifying Inventory
Models

Fixed-Order Quantity Models

Event triggered
Make exactly the same amount
Use re-order point to determine timing

Fixed-Time Period Models

Time triggered
Count the number needed to re-order

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Inventory Control

Inventory Models

Inventory
Fixed Order
Quantity Models
Constant
Demand

Uncertainty
in Demand

Simple
EOQ

EOQ
w/usage

EOQ w/
Quantity
Discounts

Find the
EOQ and R

Determine
p and d

Calculate
Total costs

Find the
EOQ and R

Select Q
and find R

Fixed Time
Period Models

Single
Period Models

Fixed-Order Quantity
Models
Demand for the product is constant and uniform
Assumptions
throughout the period

Lead time (time from ordering to receipt) is

constant

Price per unit of product is constant

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)

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EOQ Model--Basic
Fixed-Order Quantity
Model
Inventory
Level

R
L

L
Time

R = Reorder point
Q = Economic order quantity
L = Lead time
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Basic Fixed-Order Quantity

Model
Total Annual Cost =

Annual
Annual
Purchase + Ordering +
Cost
Cost

Annual
Holding
Cost

Derive the Total annual Cost Equation, where:

TC - Total annual cost
D - Annual demand (and d-bar = average daily demand = D/365)
C - Cost per unit
Q - Order quantity
S - Cost of placing an order or setup cost
R - Reorder point
L - Lead time
H - Annual holding and storage cost per unit of inventory
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Cost Minimization Goal

C
O
S
T

Total Cost
Holding
Costs
Annual Cost of
Items (DC)
Ordering Costs
QOPT
Order Quantity (Q)

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Deriving the EOQ

Using calculus, we take the derivative of the total cost

function and set the derivative (slope) equal to zero

Q OPT

2DS
2(Annual Demand)(Order or Setup Cost)
=
=
H
Annual Holding Cost
Reorder Point, R = dL
_

d = average demand per time unit

L = Lead time (constant)
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EOQ Example
Annual Demand (D) = 1,000 units
Days per year considered in average daily demand = 365
Cost to place an order (S) = $10
Holding cost per unit per year (H) = $2.40
Lead time (L) = 7 days
Cost per unit (C) = $15

Determine the economic order quantity and the reorder point.

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Solution
Q OPT =

2DS
=
H

2(1,000 )(10)
= 91.287 units
2.40
91 or 92 units???

1,000 units / year

d =
= 2.74 units / day
365 days / year
Why do we round up?
_

Reorder point, R = d L = 2.74units / day (7days) = 19.18 or 20 units

When the inventory level reaches 20, order 91 units.
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Problem

Retailer of Satellite Dishes

D = 1000 units
S = $ 25
H = $ 100

How much should we order?

What are the Total Annual Stocking
Costs?
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EOQ with Quantity

Discounts

What if we get a price break for buying a

larger quantity?
To find the lowest cost order quantity:

Since C changes for each price-break, H=iC

Where, i = percentage of unit cost attributed to
carrying inventory
and , C = cost (or price) per unit
Find the EOQ at each price break.
Identify relevant and feasible order quantities.
Compare total annual costs
The lowest cost wins.

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EOQ with Quantity

Discounts Example

Copper may be purchased for

$ .82 per pound for up to 2,499 pounds
$ .81 per pound for 2,500 to 5,000 pounds
$ .80 per pound for orders greater than 5,000
pounds
Demand (D) = 50,000 pounds per year
Holding costs (H) are 20% of the purchase price per
unit
Ordering costs (S) = $30
How much should the company order to
minimize total costs?
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Problem 28

44

(Costs in $,000)

43
Feasible
<2500

42

<2500 - 4999
>5000

41

40
0

20

40

60

(Order Quantity 100's of units)

80

100

Inventory Control

Inventory Models

Inventory
Fixed Order
Quantity Models
Constant
Demand

Fixed Time
Period Models

Uncertainty
in Demand
Find the L
Find Z
Safety Stock
Find the
EOQ and R

Single
Period Models

What if demand is not

Certain?

Use safety stock to cover uncertainty in demand.

Given: service probability which is the probability
demand will NOT exceed some amount.
The safety stock level is set by increasing the
reorder point by the amount of safety stock.
The safety stock equals zL
where,
L = the standard deviation of demand during the
lead time.
For example for a 5% chance of running out z
1.65

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Problem
Annual Demand = 25,750 or 515/wk @ 50 wks/year
Annual Holding costs = 33% of item cost ($10/unit)
Ordering costs are $250.00
d = 25 per week
Leadtime = 1 week
Service Probability = 95%
Find:
a.) the EOQ and R
b.) annual holding costs and annual setup costs
c.) Would you accept a price break of $50 per order
for lot sizes that are larger than 2000?

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Inventory Control

Inventory Models

Inventory
Fixed Order
Quantity Models

Fixed Time
Period Models
Current Inventory
Find theT+L
Find Z
Find order
quantity (q)

Single
Period Models

Fixed-Time Period Models

Check the inventory every review period and

then order a quantity that is large enough to
cover demand until the next order will come in.

The model assumes uncertainty in demand with

safety stock added to the order quantity.

More exposure to variability than fixed-order

models

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Fixed-Time Period Model with

Safety Stock Formula
q = Average demand + Safety stock - Inventory currently on hand

q = d(T + L) + Z T + L - I
Where :
q = quantity to be ordered
T = the number of days between reviews
L = lead time in days
d = forecast average daily demand
z = the number of standard deviations for a specified service probability
T + L = standard deviation of demand over the review and lead time
I = current inventory level (includes items on order)
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Determining the Value of

T+L
T+L =

T +L
i 1

di

Since each day is independent and d is constant,

T + L = (T + L) d

The standard deviation of a sequence of

random events equals the square root of
the sum of the variances.

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Example of the Fixed-Time

Period Model
Given the information below, how many units should be ordered?

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.

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Example of the Fixed-Time

Period Model: Solution
T+ L =

(T + L) d =
2

30 + 10 4 = 25.298
2

q = d(T + L) + Z T + L - I
q = 20(30 + 10) + (1.75)(25.298) - 200
q = 800 44.272 - 200 = 644.272, or 645 units
So, to satisfy 96 percent of the demand, you should
place an order of 645 units at this review period.
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Problem
A pharmacy orders antibiotics every two
weeks (14 days).

the daily demand equals 2000

the daily standard deviation of demand =

800

lead time is 5 days

service level is 99 %

present inventory level is 25,000 units

What is the correct quantity to order to
minimize costs?

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Inventory Control

Inventory Models

Inventory
Fixed Order
Quantity Models
Constant
Demand

Uncertainty
in Demand

Fixed Time
Period Models

Single
Period Models

Single Period Model for

items w/obsolescence
problem)
For(newsboy
a single purchase
Amount to order is when marginal profit
(MP) is equal to marginal loss (ML).
Adding probabilities
(P = probability of that unit being sold)
for the last unit ordered we want
P(MP)(1-P)ML or P ML /(MP+ML)

Increase order quantity as long as this holds.

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SinglePeriod Model

(Text Prob.

#21)

Famous Alberts Cookie King

Demand Probability of
(dozen)
Demand
1,800

0.05

2,000

0.10

2,200

0.20

2,400

0.30

2,600

0.20

2,800

0.10

3,000

0.05

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Each dozen sells for $0.69

and costs $0.49 with a
salvage value of $0.29.

How many cookies

should he bake?
31

ABC Classification
System

Items kept in inventory are not of equal

importance in terms of:
60

% of
$ Value 30

dollars invested

profit potential

sales or usage volume % of

30

Use

A
B

60

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 50% are the C items.
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Inventory Accuracy
and Cycle Counting

Inventory accuracy

Do inventory records agree with

physical count?

Cycle Counting
Frequent counts
When? (zero balance, backorder,
specified level of activity, level of
important item, etc.)

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