Managing Service

Inventory
Replenishment
order

Factory
Production
Delay

Replenishment Replenishment
order
order

Wholesaler

Distributor

Shipping
Delay
Wholesaler
Inventory

Retailer

Shipping
Delay
Distributor
Inventory

Customer
order

Customer

Item Withdrawn

Retailer
Inventory

Learning Objectives

Describe the functions and costs of an inventory

system.
Determine the order quantity.
Determine the reorder point and safety stock for
inventory systems with uncertain demand.
Design a continuous or periodic review inventorycontrol system.
Conduct an ABC analysis of inventory items.
Determine the order quantity for the single-period
inventory case.
Describe the rationale behind the retail discounting
model.
18-2

Role of Inventory

Decoupling inventories
Seasonal inventories
Speculative inventories
Cyclical inventories
In-transit inventories
Safety stocks

18-3

Considerations in Inventory
Systems

Type of customer demand

Planning time horizon

Replenishment lead time

Constraints and relevant costs

18-4

Relevant Inventory Costs

Ordering costs

Receiving and inspections costs

Holding or carrying costs

Shortage costs
18-5

Inventory Management
Questions

What should be the order quantity

(Q)?
When should an order be placed,
called a reorder point (ROP)?
How much safety stock (SS) should
be maintained?

18-6

Inventory Models

Economic Order Quantity (EOQ)

Special Inventory Models
With Quantity Discounts
Planned Shortages
Demand Uncertainty - Safety Stocks
Inventory Control Systems
Continuous-Review (Q,r)
Periodic-Review (order-up-to)
Single Period Inventory Model
18-7

17-8

Basic Fixed-Order Quantity Model and Reorder Point Behavior

4. The cycle then repeats.

1. You receive an order quantity Q.

Number
of units
on hand

2. Your start using

them up over time.

R = Reorder point
Q = Economic order quantity
L = Lead time

Time

L
3. When you reach down to
a level of inventory of R,
you place your next Q
sized order.

17-9

Basic Fixed-Order Quantity (EOQ) Model

Formula

Total
Annual
Annual
Annual
Annual = Purchase + Ordering+ Holding
Cost
Cost
Cost
Cost

D
Q
D
Q
TC
TC == DC
DC ++ SS++ H
H
Q
22
Q

TC=Total
TC=Totalannual
annual
cost
cost
DD=Demand
=Demand
CC=Cost
=Costper
perunit
unit
QQ=Order
=Order
quantity
quantity
SS=Cost
=Costof
of
placing
placingan
anorder
order
or
orsetup
setupcost
cost
RR=Reorder
=Reorderpoint
point
LL=Lead
=Leadtime
time
H=Annual
H=Annual
holding
holdingand
and
storage
storagecost
costper
per
unit
unitof
ofinventory
inventory

Annual Costs For EOQ

Model

18-10

17-11

Deriving the EOQ

Using
Using calculus,
calculus, we
we take
take the
the first
first derivative
derivative
of
of the
the total
total cost
cost function
function with
with respect
respect to
to
Q,
Q, and
and set
set the
the derivative
derivative (slope)
(slope) equal
equal to
to
zero,
zero, solving
solving for
for the
the optimized
optimized (cost
(cost
minimized)
minimized) value
value of
of Q
Qopt
opt
QQOPT
=
OPT =

2DS
2DS =
=
HH

We
Wealso
alsoneed
needaa
reorder
reorderpoint
pointto
to
tell
tellus
uswhen
whento
to
place
placean
anorder
order

2(Annual
2(AnnualDemand)(Order
Demand)(Orderor
orSetup
SetupCost)
Cost)
Annual
AnnualHolding
HoldingCost
Cost
__

Reorder
Reorder point,
point, R
R == ddLL

d = average daily demand (constant)

L = Lead time (constant)

17-12

EOQ Example (1) Problem Data

Given
Giventhe
theinformation
informationbelow,
below,what
what are
arethe
theEOQ
EOQ and
and
reorder
reorderpoint?
point?

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

17-13

EOQ Example (1) Solution

Q
=
QOPT
OPT =

2DS
2DS =
=
H
H

2(1,000
2(1,000)(10)
)(10) = 89.443 units or 90 units
= 89.443 units or 90 units
2.50
2.50

1,000
units
//year
1,000
units
year = 2.74 units / day
dd ==
= 2.74 units / day
365
days
/
year
365 days / year
__

Reorder
Reorderpoint,
point, RR==dd LL==2.74units
2.74units//day
day(7days)
(7days)==19.18
19.18or
or 20
20units
units

In
Insummary,
summary,you
youplace
placean
anoptimal
optimalorder
orderof
of90
90units.
units. In
In
the
thecourse
courseof
ofusing
usingthe
theunits
unitsto
tomeet
meetdemand,
demand,when
when
you
youonly
onlyhave
have20
20units
unitsleft,
left,place
placethe
thenext
nextorder
orderof
of90
90
units.
units.

17-14

EOQ Example (2) Problem Data

Determine
Determine the
the economic
economic order
order quantity
quantity
and
and the
the reorder
reorder point
point given
given the
the
following
following
Annual Demand = 10,000 units
Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10%
of cost per unit
Lead time = 10 days
Cost per unit = $15

17-15

EOQ Example (2) Solution

2DS
2(10,000
)(10)
2DS
2(10,000
)(10) = 365.148 units, or 366 units
Q
=
=
QOPT
=
= 365.148 units, or 366 units
OPT =
H
1.50
H
1.50

10,000
units
//year
10,000
units
year = 27.397 units / day
dd==
= 27.397 units / day
365
days
/
year
365 days / year
__

R
R ==dd LL==27.397
27.397units
units//day
day(10
(10days)
days)==273.97
273.97or
or 274
274units
units

Place
Placean
anorder
orderfor
for366
366units.
units. When
Whenin
in the
thecourse
courseof
of
using
usingthe
theinventory
inventoryyou
you are
areleft
left with
with only
only274
274units,
units,
place
placethe
thenext
next order
orderof
of366
366units.
units.

17-16

Price-Break Model Formula

Based on the same assumptions as the EOQ model,

the price-break model has a similar Qopt formula:

Q OPT

2DS
2(Annual Demand)(Order or Setup Cost)
=
=
iC
Annual Holding Cost

i = percentage of unit cost attributed to carrying inventory

C = cost per unit
Since C changes for each price-break, the formula
above will have to be used with each price-break cost
value

17-17

Price-Break Example Problem Data

(Part 1)

A
Acompany
company has
has aa chance
chance to
to reduce
reduce their
theirinventory
inventory
ordering
ordering costs
costs by
by placing
placing larger
largerquantity
quantity orders
orders using
using
the
the price-break
price-breakorder
orderquantity
quantity schedule
schedule below.
below. What
What
should
should their
theiroptimal
optimal order
orderquantity
quantity be
be ifif this
this company
company
purchases
purchases this
this single
single inventory
inventoryitem
item with
with an
an e-mail
e-mail
ordering
ordering cost
cost of
of $4,
$4, aa carrying
carrying cost
cost rate
rate of
of 2%
2%of
of the
the
inventory
inventory cost
cost of
of the
the item,
item, and
and an
an annual
annual demand
demand of
of
10,000
10,000 units?
units?
Order Quantity(units) Price/unit($)
0 to 2,499
$1.20
2,500 to 3,999 1.00
4,000 or more .98

17-18

Price-Break Example Solution (Part 2)

First, plug data into formula for each price-break value of C

Annual Demand (D)= 10,000 units
Carrying cost % of total cost (i)= 2%
Cost to place an order (S)= $4 Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 2499,
the Qopt value is feasible
Interval from 2500-3999,
the Qopt value is not
feasible
Interval from 4000 &
more, the Qopt value is not
feasible

Q OPT =

2DS
=
iC

2(10,000)(4)
= 1,826 units
0.02(1.20)

Q OPT =

2DS
=
iC

2(10,000)(4)
= 2,000 units
0.02(1.00)

Q OPT =

2DS
=
iC

2(10,000)(4)
= 2,020 units
0.02(0.98)

17-19

Price-Break Example Solution (Part 3)

Since
Sincethe
thefeasible
feasiblesolution
solution occurred
occurredin
inthe
thefirst
firstpricepricebreak,
values occur
break,itit means
means that
thatall
all the
theother
othertrue
trueQ
Qopt
opt values occur
at
at the
thebeginnings
beginningsof
ofeach
eachprice-break
price-breakinterval.
interval. Why?
Why?
Because
Becausethe
thetotal
total annual
annualcost
costfunction
functionis
is
aau
ushaped
shapedfunction
function

Total
annual
costs

So
So the
thecandidates
candidates
for
forthe
thepricepricebreaks
breaks are
are1826,
1826,
2500,
2500,and
and4000
4000
units
units
0

1826

2500

4000

Order Quantity

17-20

Price-Break Example Solution (Part 4)

Next,
values into the total cost
Next,we
weplug
plugthe
thetrue
trueQ
Qopt
opt values into the total cost
annual
annualcost
costfunction
functionto
todetermine
determinethe
thetotal
total cost
costunder
under
each
eachprice-break
price-break

D
Q
D
Q iC
TC
=
DC
+
S
+
TC = DC +
S+
iC
Q
2
Q
2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
==$12,043.82
$12,043.82
TC(2500-3999)=
TC(2500-3999)=$10,041
$10,041
TC(4000&more)=
TC(4000&more)=$9,949.20
$9,949.20

Finally,
, which is this
Finally,we
weselect
select the
theleast
least costly
costlyQ
Qopt
opt, which is this
problem
problem occurs
occursin
in the
the4000
4000 &&more
more interval.
interval. In
In summary,
summary,
our
ouroptimal
optimal order
orderquantity
quantityis
is4000
4000units
units

Questions
18.7
18.9
A.D. Small Consulting

Demand During Lead Time

Example
L 3
15
.

u=3

u=3

15
.

15
.

15
.

u=3

u=3

d L 12

ROP

ss

Four Days Lead Time

Demand During Lead time

18-22

Safety Stock (SS)

Demand During Lead Time (LT) has

Normal Distribution with
Mean(d L ) ( LT )

Std . Dev.( L ) LT

SS with r% service level

SS zr LT

Reorder Point

ROP SS d L
18-23

Continuous Review System

(Q,r)
Amount used during first lead time

Reorder point, ROP

Average lead time usage, dL

Safety stock, SS

d1

Order quantity, EOQ

Inventory on hand

EOQ

d3
d2 EOQ

First lead
time, LT1

Order 1 placed

LT2

LT3

Time
Order 2 placed

Shipment 1 received

Order 3 placed

Shipment 2 received

Shipment 3 received

18-24

Periodic Review System

(order-up-to)
Inventory on Hand

Target inventory level, TIL

Review period

RP

RP

RP

First order quantity, Q1

Q3

Q2

d3

d1

Amount used during

first lead time

d2

Safety stock, SS

First lead time, LT1

LT2

LT3
Time

Order 1 placed

Order 2 placed

Shipment 1 received

Order 3 placed

Shipment 2 received Shipment 3 received

18-25

Inventory Control Systems

Continuous Review System

2 DS
EOQ
H
ROP SS LT
SS zr

LT

Periodic Review System

RP EOQ /
TIL SS ( RP LT )
SS zr RP LT
18-26

ABC Classification of
Inventory Items

18-27

Inventory Items Listed in

Descending Order of Dollar
Volume
Inventory Item

Unit cost
($)

Monthly
Sales
(units)

Home Theater
Computers

5000
2500

30
30

150,000
75,000

Television sets
Refrigerators
Displays

400
1000
250

60
15
40

24,000
15,000
10,000

Speakers
Cameras
Software
Thumb drives
CDs

150
200
50
5
10

60
40
100
1000
400

9,000
8,000
5,000
5,000
4,000

Totals

Percent of
Dollar
Dollar
Volume ($)
Volume

305,000

Percent of
SKUs

Class

20

16

30

10

50

100

100

74

18-28

Single Period Inventory

Model
Newsvendor Problem
D = newspapers demanded
Example
p(D) = probability of demand
Q = newspapers stocked
P = selling price of newspaper, $10
C = cost of newspaper, $4
S = salvage value of newspaper, $2
Cu = unit contribution: P-C = $6
Co = unit loss: C-S = $2
18-29

Demand

Frequency

10

11

12

Demand

Frequenc
y

Probabili
ty

0.0278

0.0556

0.0833

0.1111

0.1389

0.1667

0.1389

0.1111

10

0.0833

11

0.0556

12

0.0278

p(D)

Single Period Inventory

Model Expected Value
Analysis

.028
.055
.083
.111
.139
.167
.139
.111
.083
.055
.028
Expected Profit

2
3
4
5
6
7
8
9
10
11
12

4
12
20
28
36
36
36
36
36
36
36

2
10
18
26
34
42
42
42
42
42
42

$31.54

$34.43

Stock Q
8
0
8
16
24
32
40
48
48
48
48
48
$35.77

10

-2
6
14
22
30
38
46
54
54
54
54

-4
4
12
20
28
36
44
52
60
60
60

$35.99

$35.33

18-32

Demand

Frequenc
y

Probabili
ty

P (D<Q)

0.0278

0.0556

0.0278

0.0833

0.0833

0.1111

0.1667

0.1389

0.2778

0.1667

0.4167

0.1389

0.5833

0.1111

0.7222

10

0.0833

10

0.8333

11

0.0556

11

0.9167

12

0.0278

12

0.9722

Single Period Inventory

Model Incremental
Analysis
E (revenue on last sale)

E (loss on last sale)

P ( revenue) (unit revenue)

P (loss) (unit loss)

P( D Q)Cu P( D Q)Co

1 P( D Q) C

P ( D Q) Co

Cu
P ( D Q)
Cu Co

(Critical Fractile)

where:
Cu = unit contribution from newspaper sale ( opportunity cost of underestimating demand)
Co = unit loss from not selling newspaper (cost of overestimating demand)
D = demand
Q = newspaper stocked
18-34

Critical Fractile for the

Newsvendor Problem
P(D<Q)
(Co applies)
P(D>Q)
(Cu applies)

0.722

18-35

Questions
Example 3 page 501
18.11
18.15
Case last resort restaurant

18-36

Last Resort Restaurant

1.

2.

3.

Assuming that the cost of stockout is the

lost contribution of one dessert, how many
portions of Sweet Revenge should the chef
prepare each weekday?
Based on Martin Quinns estimate of other
stockout costs, how many servings should
the chef prepare?
If, historically, desserts were prepared to
cover 95 percent of demand, what was the
implied stockout cost?
18-37

Sweet Revenge Demand

Mon.

Tue.

Wed.

Thurs.

Fri.

250

275

260

300

290

235

250

295

310

360

2430

275

286

236

294

289

315

340

256

311
18-38