INventory MGT (OM)

Inventory Management
What Is Inventory?
Any resource that has value and which can be used
at a later time, when the demand for the items will
arise.
Stock of items kept to meet future demand.
13-2
Types of Inventory
Raw materials
Purchased parts and supplies
Work-in-process (partially completed) products
(WIP)
Items being transported
Tools and equipment
Ex. a) manufacturing industry b)service industry(Hospital)
Copyright 2011 John Wiley & Sons, Inc.
13-3
Purpose of Inventory
Inventory is required to meet the anticipated
demand.
Inventory guards against stock-out situation.
Ensures smooth flow of production process.
In process Inventory acts as buffer so that the
itermediate processes do not stop.
Finished item inventory is the item ready for
consumtion by the cosumers.
13-4
Understanding Inventory
The inventory policy is affected by:
Demand Characteristics
Lead Time
Number of Products
Objectives
Service level
Minimize costs
13-5
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
13-6
Classification of Inventory
Basis of classification:
Items being critical or non critical
Vital or costly.
Trade off between cost of inventory and cost of
control
13-7
Pareto Analysis
Known as the 80/20 rule (Pareto principle):
Doing 20% of the work you can generate 80% of the benefit.
Quality improvement: Majority of problems (80%) are produced by
a few key causes (20%).
Inventory Mgt: 80% of problem is caused by 20 % of stocks. 20 %
of stocks values 80%
Joseph M. Juran (1940) suggested the principle and named it after
Italian economist Vilfredo Pareto, who observed that 80% of income
in Italy went to 20% of the population
Contd..
The 80/20 rule can be applied to almost anything:
80% of customer complaints arise from 20% of your products and services.
80% of delays in the schedule result from 20% of the possible causes of the
delays.
20% of your products and services account for 80% of your profit.
20% of your sales-force produces 80% of your company revenues.
20% of a systems defects cause 80% of its problems.
Pareto in Inventory Mgt

To apply Pareto in stock management, steps involved are:
Diagnose and list your issues
Inaccurate stock records

Delivery errors
Out of stocks or low buffer stocks
Picking and delivery inaccuracies or
Inventory price volatility
Root cause each and categorise
Inaccurate goods receipt recording due to lack of training

Too many daily stock adjustments due to poor timing of system updates
Wrong warehouse stock movements due to poor signage
Inaccurate picking and packing due to lack of training and lack of staff
No processes for managing price volatility when purchasing stock, etc.
Contd..
Score
Number of reported errors or complaints

Frequency %
Stock value
Volume throughput
Stock volatility
Stock budget variance
Group by root cause and sum the scores

Find a solution and implement
Example
Website Errors
Error (Cause)
Broken Image
Broken Links
Browser Compatibility
Incorrect Use of Headings
Missing ALT tags
Missing Description Tag
Missing Title Tag
Script Error
Security Warning
Spelling Errors
Count
45
349
12
15
14
50
76
30
9
300
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
13-13
ABC Classification: Class Assignment

PART
UNIT COST
ANNUAL USAGE
$ 60
350
30
80
30
20
10
320
510
20
90
40
130
60
100
180
170
50
60
120
1
2
3
4
5
6
7
8
9
10
13-15
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
6.0
5.0
4.0
9.0
6.0
10.0
18.0
13.0
12.0
17.0
% CUMMULATIVE
A
B
C
6.0
11.0
15.0
24.0
30.0
40.0
58.0
71.0
83.0
100.0
Example 10.1
13-16
ABC Classification
CLASS
A
B
C
ITEMS
9, 8, 2
1, 4, 3
6, 5, 10, 7
% OF TOTAL
VALUE
% OF TOTAL
QUANTITY
71.0
16.5
12.5
15.0
25.0
60.0
Example 10.1
13-17
Other Approaches
VED: (Vital, essential and desirable): Based on
criticality .
HML(High, medium, low): Based on unit price of

items.
FSN(Fast moving, slow moving and non

moving): based on consumption rate of inventory.
SOS(Seasonal, Off seasonal): Based on nature of
supply
13-18
Inventory Control/Management:
Process of finding optimal level of inventory of
each items involved, at each place and finding
their replenishment cycle such that
a) Total cost of inventory is minimum
b) Service level is maximum.
13-19
Managing inventory:Effectively
Xerox eliminated $700 million inventory from its
supply chain
Wal-Mart became the largest retail company utilizing
efficient inventory management
GM has reduced parts inventory and transportation
costs by 26% annually
13-20
Managing inventory :Unsuccessfully

In 1994, IBM continues to struggle with shortages in
their ThinkPad line (WSJ, Oct 7, 1994)
In 1993, Liz Claiborne said its unexpected earning
decline is the consequence of higher than anticipated
excess inventory (WSJ, July 15, 1993)
In 1993, Dell Computers predicts a loss; Stock
plunges. Dell acknowledged that the company was
sharply off in its forecast of demand, resulting in
inventory write downs (WSJ, August 1993)
13-21
Type of Inventory Costs

Carrying cost(Handling cost)
cost of holding an item in inventory
Ordering/setup cost
cost of replenishing inventory
Costs, incurred when producing goods for sale to others
Shortage cost
temporary or permanent loss of sales when demand
cannot be met.
Procurement/Manufacturing costs
13-22
Types of Inventory Costs

Carrying cost (Handling cost)
These costs depend on the order size
Storage space rental cost

Costs of utilities
Labor
Insurance
Security
Theft and breakage
Deterioration or Obsolescence
13-23

Order/Setup Costs
These costs are independent of the order size.
Order costs are incurred when purchasing a good from a
supplier. They include costs such as
Telephone
Order checking
Labor
Transportation
Setup costs are incurred when producing goods for sale to
others. They can include costs of
Cleaning machines
Calibrating equipment
Training staff
13-24

Customer Satisfaction Costs (Shortage cost)
Measure the degree to which a customer is satisfied.
Unsatisfied customers may:
Switch to the competition (lost sales).
Wait until an order is supplied.
When customers are willing to wait there are two types of costs
incurred (Fixed administrative costs & Annualized cost of a customer awaiting
an out of stock item)
Procurement/Manufacturing Cost
Represents the unit purchase cost (including transportation) in
case of a purchase.
Unit production cost in case of in-house manufacturing
13-25
Inventory Control Systems

Continuous system (fixed-order-quantity)
The system is continuously monitored.
A new order is placed when the inventory reaches a
critical point.
Periodic system (fixed-time-period)

The inventory position is investigated on a regular
basis.
An order is placed only at these times.
13-26
Inventory Control Systems

Continuous review (Q) system
Reorder point system (ROP) and fixed order
quantity system
For independent demand items
Tracks inventory position (IP)
Includes scheduled receipts (SR), on-hand
inventory (OH), and back orders (BO)
osition = On-hand inventory + Scheduled receipts

Backorders
IP = OH + SR BO
Selecting the Reorder Point
On-hand
inventory
Order
received
IP
Order
received
IP
Order
received
Q
OH
OH
IP
Order
received
Q
OH
R
Order
placed
Order
placed
L
TBO
Order
placed
L
TBO
Time
TBO
Figure 12.6 Q System When Demand and Lead Time Are Constant and Certain
Example
The on-hand inventory is only 10 units, and the reorder point R is
100. There are no backorders and one open order for 200 units.
Should a new order be placed?. Continuous review is applied.
SOLUTION
IP = OH + SR BO = 10 + 200 0 = 210
R = 100
Decision: Place no new order
Placing a New Order

Demand for chicken soup at a supermarket is always 25 cases a
day and the lead time is always 4 days. The shelves were just
restocked with chicken soup, leaving an on-hand inventory of only
10 cases. No backorders currently exist, but there is one open order
in the pipeline for 200 cases. What is the inventory position? Should
a new order be placed?
SOLUTION
R = Total demand during lead time =
IP = OH + SR BO
= 10 + 200 0 = 210 cases
(25)(4) = 100 cases
Periodic Review System (P)

Fixed interval reorder system or periodic reorder
system
Four of the original EOQ assumptions maintained
No constraints are placed on lot size

Holding and ordering costs only
Independent demand
Lead times are certain
Order is placed to bring the inventory position up

to the target inventory level, T, when the
predetermined time, P, has elapsed
Periodic Review System (P)
On-hand inventory
IP
Order
received
Q1
OH
IP
Q2
Order
receiv
ed
OH
IP
Q3
Order
receiv
ed
IP1
IP3
IP2
Order
placed
Order
placed
L
P
L
P
Protection interval
Figure 12.10 P System When Demand Is Uncertain
Time
How Much to Order in a P System

A distribution center has a backorder for five 36-inch color TV sets.
No inventory is currently on hand, and now is the time to review.
How many should be reordered if T = 400 and no receipts are
scheduled?. Periodic review applied.
SOLUTION
IP = OH + SR BO
= 0 + 0 5 = 5 sets
T IP = 400 (5) = 405 sets
That is, 405 sets must be ordered to bring the inventory

position up to T sets.
Example
The on-hand inventory is 10 units, and T is 400. There are no back
orders, but one scheduled receipt of 200 units. Now is the time to
review. How much should be reordered?
SOLUTION
IP = OH + SR BO
= 10 + 200 0 = 210
T IP = 400 210 = 190
The decision is to order 190 units
Inventory Replenishment policy

Fixed order inventory (Q,S):
fixed quantity is replenished in each order.
Up-to fixed level inventory(R,S):

Inventory to fixed level is maintained. Quantity
replenished each order is sum of R + back order
quantity.
13-35
Economic Order Quantity

(EOQ) Models
EOQ
optimal order quantity that will minimize
total inventory costs
Basic EOQ model
13-36
Assumptions of Basic EOQ Model

Demand is known with certainty and is constant
over time
No shortages are allowed
Lead time for the receipt of orders is constant(or
JIT)
Order quantity is received all at once.
Instantenious replenishment.
Infinite Production rate.
13-37
Inventory Order Cycle
Inventory Level
Order quantity, Q
Demand
rate
Average
inventory
Q
2
Reorder point, R
Lead
time
Order Order
placed receipt
Lead
time
Order Order
placed receipt
Time
13-38
EOQ Cost Model

Co - cost of placing order
Cc - annual per-unit carrying cost
D - annual demand
Q - order quantity
Annual ordering cost =

Annual carrying cost =
Total cost =
Co D
Q
Co D
Q
CcQ
2
CcQ
2
13-39
EOQ Cost Model

Deriving Qopt
TC =
CoD
Q
Co D
CcQ
2
Cc
TC
=
+
Q2
Q
2
0=
Qopt =
C0D
Q2
Cc
2CoD
Cc
Proving equality of
costs at optimal point
CoD
Q
Q =
2
2
Qopt =
CcQ
2
2CoD
Cc
2CoD
Cc
13-40
EOQ Cost Model

Annual
cost ($)
Total Cost
Slope = 0
Carrying Cost =
Minimum
total cost
Ordering Cost =
Optimal order
Qopt
CcQ
2
Co D
Q
Order Quantity, Q
13-41
EOQ Example
Cc = $0.75 per gallon
Co = $150

gallons
2CoD
Qopt =
Cc
Qopt =
2(150)(10,000)
(0.75)
Qopt = 2,000 gallons
Co = $150
TCmin =
TCmin =
D = 10,000
CoD
Q
CcQ
2
(150)(10,000) (0.75)(2,000)
+
2,000
2
TCmin = $750 + $750 = $1,500
Orders per year = D/Qopt

= 10,000/2,000
= 5 orders/year
D = 10,000 gallons
Order cycle time = 311 days/(D/Qopt)

= 311/5
= 62.2 store days
13-42
Assignment -1
An cement supplier sells Birla low grade cements to a
construction company. The annual demand is approximately
12000 bags. The supplier pays Rs150 for each bags and
estimates that the annual holding cost is 30 percent of the
bags value. It costs approximately Rs 120 to place an order
(managerial and clerical costs). The supplier currently orders
500 bags fortnightly.
a. Determine the ordering, holding, and total inventory costs for the
current order quantity.
b. Determine the economic order quantity (EOQ).
c. How many orders will be placed per year using the EOQ ?
d. Determine the ordering, holding, and total inventory costs for the EOQ.
How has ordering cost changed? Holding cost? Total inventory cost?
e. Do sensitivity Analysis of the result with respect to decision variable.
13-43
Production Quantity Model

Order is received gradually, as inventory is
simultaneously being depleted
non-instantaneous receipt model
assumption that Q is received all at once is relaxed
p - daily rate at which an order is received over

time, a.k.a. production rate
d - daily rate at which inventory is demanded
13-44

Inventory
level
Q(1-d/p)
Maximum
inventory
level
Q
(1-d/p)
2
Average
inventory
level
0
Order
receipt period
Begin
End
order order
receipt receipt
Time
13-45

p = production rate
d = demand rate
Maximum inventory level = Q - Q d

p
=Q1- d
p
Average inventory level =
Q
12
d
p
Qopt =
2CoD
d
Cc 1 - p
CoD CcQ
d
TC =
+
1- p
Q
2
13-46
Production Quantity Model-Assignment-2

Co = $150
D = 10,000 gallons
d = 10,000/311 = 32.2 gallons per day

2CoD
Qopt =
d
Cc 1 p
2(150)(10,000)
=
CoD CcQ
d
TC =
+
1- p
Q
2
Q
Production run =
p
p = 150 gallons per day
32.2
0.75 1 150
= 2,256.8 gallons
= $1,329
2,256.8
= 150
= 15.05 days per order
13-47

Number of production runs =
10,000
D
=
= 4.43 runs/year
2,256.8
Q
d
Maximum inventory level = Q 1 p
= 2,256.8 1 -
32.2
150
= 1,772 gallons
13-48
Solution of EOQ Models With Excel
The optimal order

size, Q, in cell D8
13-49
Solution of EOQ Models With Excel
The formula for Q

in cell D10
=(D4*D5/D10)+(D3*D10/2)*(1-(D7/D8))
=D10*(1-(D7/D8))
13-50
PLANNED SHORTAGE MODEL

Assumes no customers will be lost because of
stockouts
Instantaneous reordering
This can be modified later using standard reorder
point analyses
Stockout costs:
Cb -- fixed administrative cost/stockout
Cs -- annualized cost per unit short
Acts like a holding cost in reverse
Reorder when there are S backorders
PLANNED SHORTAGE MODEL
13-52
PROPORTION OF TIME IN/OUT OF

STOCK
t1 = time of a cycle with inventory

t2 = time of a cycle out of stock
t = t1 + t2 = time of a cycle
IMAX = Q-S = total demand while in stock.
t1 /t = Proportion of time in stock.
Multiplying by D/D gives T1D/TD =
(Demand while in stock)/(Demand for cycle) = (Q-S)/Q
t2 /t = Proportion of time out of stock

Multiplying by D/D gives T2D/TD =
(Demand while out of stock)/(Demand for cycle) = S/Q
Average Inventory
Average Number of Backorders
Average Inventory =
(Avg. Inv. When In Stock)(Proportion of time in
stock)
=(IMAX/2)((Q-S)/Q) = ((Q-S)/2)((Q-S)/Q) = (Q-S)2/2Q
Average Backorders =
(Average B/O When Out of Stock)(Proportion of time out of
stock)
= (S/2)(S/Q) = S2/2Q
TOTAL ANNUAL COST EQUATION

TC(Q,S) = CO(Number of Cycles Per Year) +
CH(Average Inv.) +
Cs (Average Backorders) +
= CO(D/Q) + Ch((Q-S)2/2Q) +
Cs(S2/2Q)
Relationships
13-56
OPTIMAL ORDER QUANTITY, Q*

OPTIMAL # BACKORDERS, S*
Take partial derivatives with respect to Q and S and set
= 0.
Solve the two equations for the two unknowns Q and
S.
Assignment-3
Problem
A sauna costs $2400.
Annual holding cost per unit $525.
Fixed ordering cost $1250 (fairly high, due to costly transportation).
Demand is 15 saunas per week on the average.
Scanlon estimates a $20 goodwill cost for each week a customer who
orders a sauna has to wait for delivery
Find
The optimal order quantity.
The optimal number of backorders
Total variable cost of Inventory
Max Inventory
Cycle time
13-58
Multi-Item inventory models

n=number of items, Coi=ordering cost for item I,
Cci=carrying(holding) cost for item I, Di=demand of item i,
Qi= order quantity for item i
A. Unconstraint problem
. Total ordering cost=
. Total carrying/holding cost=
. Total relevent cost of inventory=TC

13-59
Solution
Solving for ith item, take first derivative of TC wrt
Qi
We get Optimal Q,
and total cost, TC,
13-60
Constraint model
Let there be limitation on total capital or space.
Let ai =area required for item I, A= maximum limitation on space
for all ite. The problem become
TC
Sub. To.
Using Lagrangian operater above problem can be written as
13-61
Solution
Take first derivative of TC wrt Q of all the item
and .
Then find Q for all the items for the optimal value
of . Value of can be found by systematic trial
and error method.
13-62
EOQ Models with Quantity Discounts

Quantity Discounts are Common Practice in Business
By offering discounts buyers are encouraged to increase
their order sizes, thus reducing the sellers holding costs.
Quantity discounts reflect the savings inherent in large
orders.
With quantity discounts sellers can reward their biggest
customers without violating the Robinson - Patman Act.
63
Quantity Discounts
Price per unit decreases as order
quantity increases
TC =
CoD
Q
CcQ
2
+ PD
where
P = per unit price of the item
D = annual demand
13-64
EOQ Models with Quantity Discounts

Quantity Discount Schedule
This is a list of per unit discounts and their
corresponding purchase volumes.
Normally, the price per unit declines as the order
quantity increases.
The order quantity at which the unit price changes is
called a break point.
There are two main discount plans:
All unit schedules - the price paid for all the units
purchased is based on the total purchase.
Incremental schedules - The price discount is based only
on the additional units ordered beyond each break point.
65
Quantity Discount Model

ORDER SIZE
0 - 99
100 199
200+
PRICE
$10
8 (d1)
6 (d2)
TC = ($10 )
TC (d1 = $8 )
Inventory cost ($)
TC (d2 = $6 )
Carrying cost
Ordering cost
Q(d1 ) = 100 Qopt
Q(d2 ) = 200
13-66
Procedure
For case with discount schedule:
Order quantity
Unit price
1-b1
b1-b2
b2+
C1
C2
C3
1. Calculate Q3* at lowest price first and compare it with b2. if

Q3*>=b2, Place order for Q3*, else
2. Calculate Q2* at next higher price compare with b1, if Q2* >=b1,
calculate TC1 at Q2* and TC2 at b2 and determine the optimal order
quantity for lowest cost. Else
3. Calculate Q1* at highest price and compare TC at Q1*, TC at b1
and TC at b2 to determine the optimal order quantity for lowest cost
13-67
Quantity Discount
QUANTITY
PRICE
1 - 49
50 - 89
90+
$1,400
1,100
900
Qopt =
2CoD
For Q = 72.5
TC =
For Q = 90
TC =
Cc
Co D
Qopt
Co D
Q
Co = $2,500
Cc = $190 per TV
D = 200 TVs per year
2(2500)(200)
= 72.5 TVs
190
CcQopt
2
CcQ
2
+ PD = $233,784
+ PD = $194,105
13-68
Quantity Discount Model With Excel
=IF(D10>B10,D10,B10)
=(D4*D5/E10)+(D3*E10/2)+C10*D5
13-69
Assignment
Find the optimal order quantity Qi* for each
discount level i based on the EOQ formula:
D=15000, Co=$30, Cc=50% of C.
13-70
Assignment
An office supplies wholesaler sells copier paper by the
ream. Ordering cost is $20/order. Carrying cost rate is 30%
of the dollar value per year. Annual demand is 1000 reams.
#Reams Cost/Ream
1-49 3.90
50-199 3.75
200-499 3.65
500+ 3.60
EOQ3.90 =
EOQ3.75 =
EOQ3.65 =
EOQ3.60 =
Calculate TC for:
199 reams @ $3.75
200 reams @ $3.65
500 reams @ $3.60
TC = CoD/Q + CcQ/2 + DC
TC3.75 =
TC3.65 =
TC3.60 =
Reorder Point
Inventory level at which a new order is placed
R = dL
where
d = demand rate per period
L = lead time
13-74
Reorder Point
Demand = 10,000 gallons/year
Store open 311 days/year
Lead time = L = 10 days
R=?
Daily demand = 10,000 / 311 = 32.154 gallons/day

R = dL = (32.154)(10) = 321.54 gallons
13-75
Safety Stock
Safety stock
buffer added to on hand inventory during lead time
Stockout
an inventory shortage
Service level
probability that the inventory available during lead
time will meet demand
P(Demand during lead time <= Reorder Point)
13-76
Single Period Inventory Model Assumptions

Demand
At the
the end
end of
of each
each period,
period,
Demandisisstochastic
stochasticwith
withaa At
unsold
inventory
isis
known
unsold
inventory
knowndistribution.
distribution.
Shelf
Shelflife
lifeof
ofthe
theitem
itemisis
limited.
limited.
Inventory
Inventoryisissaleable
saleableonly
only
within
withinaasingle
singletime
timeperiod.
period.
Inventory
Inventoryisisdelivered
deliveredonly
only
once
onceduring
duringaatime
timeperiod.
period.
disposed
disposed of
of for
for some
some
salvage.
salvage.
The
The salvage
salvage value
value isis less
less
than
thanthe
thecost
costper
peritem.
item.
Unsatisfied
Unsatisfied demand
demand may
may
result
resultin
inshortage
shortagecosts.
costs.
77
The Expected Profit Function

To find an optimal order quantity we need to balance the
expected cost of over-ordering and under ordering.
Expected Profit = S(Profit when Demand=D) Prob(Demand=D)

x
The expected profit is a function of the order size, the

random demand, and the various costs.
78

Developing an expression for EP(Q)
Notation
p = per unit selling price of the good.
c = per unit cost of the good.
g= opportunity cost lost
s = per unit salvage value of unsold good.
K = fixed purchasing costs
Q = order quantity.
EP(Q) = Expected Profit if Q units are ordered.
Scenarios
Demand D is less than the order quantity (D< Q).
Demand D is greater than or equal to the order
quantity (D Q).
79

Scenario 1: Demand D is less than or equal to the units
stocked, Q.
Profit = pD + s(Q - D) - cQ - K
Scenario 2: Demand D is greater than the units stocked.

Profit = pQ - g(D - Q) - cQ - K
EP(Q) = [pD+s(Q - D) - cQ - K]P(DQ) +[pQ - g(D - Q) - cQ - K]P(D>Q)
80
The Optimal Solution

To maximize the expected profit order Q*:
Take first derivatives of expected cost (EP) with respect
to Q and equate to zero.
We Know sum of P(DQ) and P(D>Q) is one(1), hence
P(DQ) =1-P(D>Q)
Now solve for P(DQ). We get
P(D Q*) (p - c + g)(p - s + g)
81
THE SENTINEL NEWSPAPER

Management at Sentinel wishes to know how many
newspapers to put in a new vending machine.
Data
Demand is uniformly distributed with upper
and lower value of 20 and 40 newspapers.
Unit selling price is $0.30

Unit production cost is $0.38.
Advertising revenue is $0.18 per newspaper.
Unsold newspaper can be recycled and net $0.01.
Unsatisfied demand costs $0.10 per newspaper.
Filling a vending machine costs $1.20.
82
SENTINEL - Solution
Input to the optimal order quantity formula
p = 0.30
c = 0.20 [0.38-0.18]
s = 0.01
The probability of the optimal service level =
g = 0.10
K = 1.20
0.30 + 0.10 - 0.20
0.30 + 0.10 - 0.01
p+ g - c
p+ g - s
= 0.513
Q*=20+(40-20)*.513=31
83
WENDELLS BAKERY
Management in Wendells wishes to determine the
number of donuts to prepare for sale, on weekday
evenings
Demand is normally distributed with a
mean of 120, and a standard deviation
of 20 donuts.
Data
Unit cost is $0.15.
Unit selling price is $0.35.
Unsold donuts are donated to charity for a tax credit of
$0.05 per donut.
Customer goodwill cost is $0.25.
Fixed costs are $15 per evening.
84
WENDELLS BAKERY - Solution

Input to the optimal order quantity formula
p = $0.35
c = $0.15
s = $0.05
g = $0.25
K = $15.00
p+ g - c
The optimal service level = p+ g - s
0.35+ 0.25 - 0.15

= 0.8182
=
0.35+0.25 - 0.05
85
WENDELLS BAKERY - Solution

Finding the optimal order quantity
From the relationship F(Q*) = 0.8182 we find the
corresponding z value.
From the standard normal table we have z = 0.9.
The optimal order quantity is calculated by
Q* = + z
.8182
=120
Q*
For Wendells Q* = 120 + (0.9)(20) = 138

86
Types of Service Level

Service levels can be viewed in two ways.
The cycle service level The unit service level
The probability of not
incurring a stock out
during an inventory
cycle.
Applied when the
likelihood of a stock out,
and not its magnitude, is
important for the firm.
The percentage of
demands that are filled
without incurring any
delay.
Applied when the
percentage of
unsatisfied demand
should be under control.
87
Example
Suppose that the EOQ is 100, average annual demand is1,000
units, and the lead time demand is a random variable having
the distribution shown in Table .
a. What value of SLM1 corresponds to a reorder point of 25?
b. If we wanted to attain a 95% value of SLM1, what reorder point
should we choose?
c If we wanted an average of at most two stock-outs per year, what is
the service level?
13-88
The Service Level Approach- Safety

stock
In many cases short run demand is variable even
though long run demand is assumed constant.
Therefore, stockout events during lead time may
occur unexpectedly in each cycle.
Stockouts occur only if demand during lead time
is greater than the reorder point.
89
The Service Level Approach

To determine the reorder point we need to know:
The lead time demand distribution.
The required service level.
In many cases lead time demand is approximately

normally distributed. For the normal distribution
case the reorder point is calculated by
R = L + zL
1 = service level
90
The Service Level Approach

Service level =
P(DL<R) =
1
P(DL>R) =
=192 R
P(DL> R) = P(Z > (R L)/L) = . Since
P(Z > Z) = , we have Z = (R L)/L,
which gives
R = L + zL
91
AAC Service Level Approach

Assume that lead time demand is normally distributed.
Estimation of the normal distribution parameters:
Estimation of the mean weekly demand =
ten weeks average demand = 120 juicers per week.
Estimation of the variance of the weekly demand =
Sample variance = 83.33 juicers2.
Lead time= 8 days. Working days=5/week.
a. Find service level if R=205.
b. Management wants to improve the service level to 99%. What
should be new R?
92
AAC Service Level Approach

Find adjusted Land L the parameters
Lead time is 8 days =(8/5) weeks = 1.6 weeks.
Estimates for the lead time mean demand and

variance of demand
L (1.6)(120) = 192;
133.33
2L (1.6)(83.33) =
93
AAC - Level for a given Reorder Point

Let us use the current reorder point of 205 juicers.
205 = 192 + z (11.55)
z = 1.13
133.33
From the normal distribution table we have that a

reorder point of 205 juicers results in an 87%
cycle service level.
94
AAC
Reorder Point for a given Service Level
Management
Management wants
wants to
to improve
improve the
the cycle
cycle
service
service level
level to
to 99%.
99%. What
What should
should be
be new
new R?
R?
The
The zz value
value corresponding
corresponding to
to 1%
1% right
right hand
hand tail
tail
is
is 2.33.
2.33.
R
R == 192
192 ++ 2.33(11.55)
2.33(11.55) == 219
219 juicers
juicers..
95
AAC
Acceptable Number of Stockouts per Year
AAC
AAC is
is willing
willing to
to run
run out
out of
of stock
stock an
an average
average of
of
at
at most
most one
one cycle
cycle per
per year
year with
with an
an order
order
quantity
quantity of
of 327
327 juicers.
juicers. D=6240
D=6240
What
What is
is the
the equivalent
equivalent service
service level
level for
for this
this
strategy?
strategy?
96
AAC
Acceptable Number of Stockouts per Year
There
There will
will be
be an
an average
average of
of
6240327
6240327 == 19.08
19.08 number
number of
of cycle.
cycle.
The
The likelihood
likelihood of
of stock
stock outs
outs == 1/19
1/19 == 0.0524.
0.0524.
This
This translates
translates into
into aa service
service level
level of
of 94.76%
94.76%
97
Assignment
An auto parts supplier sells Hardy-brand batteries to car
dealers and auto mechanics. The annual demand is
approximately 1,200 batteries. The supplier pays $28 for each
battery and estimates that the annual holding cost is 30
percent of the battery's value. It costs approximately $20 to
place an order (managerial and clerical costs). Upon closer
inspection, the supplier determines that the demand for
batteries is normally distributed with mean 4 batteries per day
and standard deviation 3 batteries per day. (The supplier is
open 300 days per year.) It usually takes about 4 days to
receive an order from the factory.
a. Determine Economic order quantity.
b. What is the standard deviation of usage during the lead time?
c. Determine the reorder point needed to achieve a service level of 95
percent. . What is the safety stock? What is the holding cost
associated with this safety stock?
d. How would your analysis change if the service level changed to 98
percent?
13-98
Solution
EOQ = 75.6
L = 6
R = 25.9 26
The safety stock is the inventory in excess of the expected
demand during the lead time. In other words, the safety
stock is 26 -16 = 10 batteries.
The associated holding cost is simply 10 X H = 10 X 8:40 =
$84:00.
z = 2:05 for a service level of 98 percent. R =28.3 29
batteries. Place an order for 76 units when the inventory
level drops to 29 units.
13-99
Reorder Point with Variable Lead Time

For constant demand and variable lead time:
R d L Zd L
where:
d constant daily demand
L average lead time
L standard deviation of lead time
d L standard deviation of demand during lead time
Zd L safety stock
Reorder Point with Variable Lead Time Example

Carpet Discount Store:
d 30 yd per day
L 10 days
L 3 days
Z 1.65 for a 95% service level
R d L Zd L (30)(10) (1.65)(30)(3) 300 148.5 448.5 yd
Reorder Point Variable Demand and Lead Time

When both demand and lead time are variable:
2
2 2
R d L Z ( d ) L ( L) d
where:
d average daily demand
L average lead time
2
2 2
( d ) L ( L) d standard deviation of demand during lead time
2
2 2
Z ( d ) L ( L) d safety stock
Reorder Point Variable Demand and Lead Time

Example
Carpet Discount Store:
d 30 yd per day
d 5 yd per day
L 10 days
L 3 days
Z 1.65 for 95% service level
2
2 2
R d L Z ( d ) L ( L ) d
(30)(10) (1.65) (5)(5)(10) (3)(3)(30)(30)
300 150.8
450.8 yds
Bell Computers produces and stocks computer printers in its finished- goods
warehouse. These DDLT (demand during lead time) historical data are believed to be
representative of future demand for one printer model.
Actual DDLT
Frequency
Actual DDLT
Frequency
0-29
0
70-79
.25
30-39
.1
80-89
.1
40-49
.1
90-99
.05
50-59
.15
100-109
.05
60-69
.2
110-120
0
Solve:
1. If at least a 90 percent service level is to be provided for these printers: what is the order
point? What is the safety stock?
2. If the DDLT for the printer is actually normally distributed with a mean of 65 and a
standard deviation of 10 and a 90 percent service level is to be provided for these printers:
what is the order point? What is the safety stock?
3. If the lead time for these printers is so stable that the lead time can be assumed to be a
constant 6.5 days, the demand per day is normally distributed with a mean of 10 and a standard
deviation of 2, and at least a 90 percent service level is to be provided for these printers: what
is the order point? What is the safety stock? (Z (90%) =1.29).
Problem
Grey Wolf Lodge is a popular 500-room hotel in the North
Woods. Managers need to keep close tabs on all room service
items, including a special pine-scented bar soap. The daily
demand for the soap is 275 bars, with a standard deviation of
30 bars. Ordering cost is $10 and the inventory holding cost is
$0.30/bar/year. The lead time from the supplier is 5 days, with
a standard deviation of 1 day. The lodge is open 365 days a
year.
a. What is the economic order quantity for the bar of soap?
b. What should the reorder point be for the bar of soap if management
wants to have a 99 percent cycle-service level?
c. What is the total annual cost for the bar of soap, assuming a Q system
will be used?
Solved Problem
SOLUTION
a. We have D = (275)(365) = 100,375 bars of soap; S = $10; and H
= $0.30. The EOQ for the bar of soap is
2(100,375)($10)
2DS
EOQ =
=
$0.30
H
=
6,691,666.7 = 2,586.83 or 2,587 bars
Solved Problem
b. We have d = 275 bars/day, d = 30 bars, L = 5
days, and LT = 1 day.
dLT =
Ld2 + d2LT2 =
(5)(30)2 + (275)2(1)2 = 283.06 bars
Consult the body of the Normal Distribution appendix

for 0.9900. The closest value is 0.9901, which
corresponds to a z value of 2.33. We calculate the safety
stock and reorder point as follows:
(2.33)(283.06) = 659.53 or 660 bars
Safety stock = zdLT =
y stock = (275)(5) + 660 = 2,035 bars
Solved Problem
c. The total annual cost for the Q system is
Q
D
C = (H) +
(S) + (H)(Safety stock)
2
Q
2,587
100,375
C=
($0.30) +
($10) + ($0.30)(660) = $974.05
2
2,587
Order Quantity for a

Periodic Inventory System
Q = d(tb + L) + zd
tb + L - I
where
d
tb
L
d
zd
= average demand rate

= the fixed time between orders
= lead time
= standard deviation of demand
tb + L = safety stock
I = inventory level
13-109
Periodic Inventory System
13-110
Fixed-Period Model With

Variable Demand
d
d
tb
L
I
z
= 6 packages per day

= 1.2 packages
= 60 days
= 5 days
= 8 packages
= 1.65 (for a 95% service level)
Q = d(tb + L) + zd
tb + L - I
= (6)(60 + 5) + (1.65)(1.2)
60 + 5 - 8
= 397.96 packages
13-111
Fixed-Period Model with Excel
Formula for order

size, Q, in cell D10
13-112
Period order quantity (POQ)

POQ=EOQ/average weekly usage
Average weekly usage=Demand/weekly no. of order
Planned order receipt=sum of demand in POQ
Example-POQ
Given EOQ=250 units
Week
Net
10
requir 0
ement
Planne
d
order
50 150
10
Tot
al
75
200
55
80
150
30
890

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Inventory Management

Copyright 2011 John Wiley & Sons, Inc.

Copyright 2011 John Wiley & Sons, Inc.

Copyright 2011 John Wiley & Sons, Inc.

Two Forms of Demand

Copyright 2011 John Wiley & Sons, Inc.

Copyright 2011 John Wiley & Sons, Inc.

Pareto in Inventory Mgt

Inaccurate stock records

Root cause each and categorise

Inaccurate goods receipt recording due to lack of training

Number of reported errors or complaints

Group by root cause and sum the scores

Copyright 2011 John Wiley & Sons, Inc.

ABC Classification: Class Assignment

Copyright 2011 John Wiley & Sons, Inc.

HML(High, medium, low): Based on unit price of

FSN(Fast moving, slow moving and non

Copyright 2011 John Wiley & Sons, Inc.

Copyright 2011 John Wiley & Sons, Inc.

Managing inventory :Unsuccessfully

Copyright 2011 John Wiley & Sons, Inc.

Type of Inventory Costs

Copyright 2011 John Wiley & Sons, Inc.

Types of Inventory Costs

Storage space rental cost

Copyright 2011 John Wiley & Sons, Inc.

Types of Inventory Costs

Types of Inventory Costs

Inventory Control Systems

Periodic system (fixed-time-period)

Copyright 2011 John Wiley & Sons, Inc.

Inventory Control Systems

osition = On-hand inventory + Scheduled receipts

Selecting the Reorder Point

Decision: Place no new order

Placing a New Order

(25)(4) = 100 cases

Periodic Review System (P)

No constraints are placed on lot size

Order is placed to bring the inventory position up

Periodic Review System (P)

How Much to Order in a P System

That is, 405 sets must be ordered to bring the inventory

Inventory Replenishment policy

Up-to fixed level inventory(R,S):

Copyright 2011 John Wiley & Sons, Inc.

Economic Order Quantity

Basic EOQ model

Copyright 2011 John Wiley & Sons, Inc.

Assumptions of Basic EOQ Model

Copyright 2011 John Wiley & Sons, Inc.

Inventory Order Cycle

Copyright 2011 John Wiley & Sons, Inc.

EOQ Cost Model

Annual ordering cost =

Copyright 2011 John Wiley & Sons, Inc.

EOQ Cost Model

Copyright 2011 John Wiley & Sons, Inc.

EOQ Cost Model

Copyright 2011 John Wiley & Sons, Inc.

Cc = $0.75 per gallon

Qopt = 2,000 gallons