Inventory Control

Selected Slides from Jacobs et al, 9th Edition

Operations and Supply Management
Chapter 17
Edited, Annotated and Supplemented by
Peter Jurkat
 17-2

Inventory System

• Inventory is the stock of any item or resource

used in an organization and can include: raw
materials, finished products, component
parts, supplies, and work-in-process
• An inventory system is the set of policies and
controls that monitor levels of inventory and
determines what levels should be maintained,
when stock should be replenished, and how
large orders should be
 Inventory
Purposes Costs
1. To maintain independence of • Holding (or carrying)
operations costs
2. To meet variation in product – Costs for storage, handling,
insurance, etc
demand • Setup (or production
3. To allow flexibility in change) costs
production scheduling – Costs for arranging specific
equipment setups, etc
4. To provide a safeguard for • Ordering costs
variation in raw material – Costs of someone placing an
delivery time order, etc
5. To take advantage of • Shortage costs
– Costs of canceling an order,
economic purchase-order size etc
 17-4

Independent vs. Dependent Demand

Independent Demand (Demand for the final end-product or

demand not related to other items)

Finished
product
Dependent Demand
(Derived demand
items for
component parts,
E(1 subassemblies,
) raw materials, etc)

Component parts
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 17-6

Inventory Systems
• Single-Period Inventory Model
– One time purchasing decision (Example: vendor
selling t-shirts at a football game, air line flight,
seasonal fashion items)
– Seeks to balance the costs of inventory overstock
and under stock lost revenue
• Multi-Period Inventory Models
– Fixed-Order Quantity Models
• Event triggered (Example: running out of stock)

– Fixed-Time Period Models

• Time triggered (Example: Monthly sales call by
sales representative)
 17-7

Single-Period Inventory Model

Optimal stocking level is number where expected benefit of carrying

item is less than expected cost of that item. => PC o ≤ (1- P)Cu
This
Thismodel
modelstates
statesthat
thatwe
we
CCuu should
shouldcontinue
continueto toincrease
increase
P 
P the
thesize
sizeofofthe
theinventory
inventorysoso

C
Coo  C
Cuu
long
longas
selling
asthe
sellingthe
theprobability
probabilityof
thelast
lastunit
of
unitadded
addedisis
equal
equalto toororgreater
greaterthan
thanthe
the
ratio
ratioof:
of:Cu/Co+Cu
Cu/Co+Cu
 17-8

Single Period Model Example

• Our college basketball team is playing in a

tournament game this weekend. Based on our past
experience we sell on average 2,400 shirts with a
standard deviation of 350. We make $10 on every
shirt we sell at the game, but lose $5 on every shirt
not sold. How many shirts should we make for the game?
Cu = $10 and Co = $5; P ≤ $10 / ($10 + $5) = .667

Z.667 = .432 (use NORMSDIST(.667) or Appendix E)

therefore we need 2,400 + .432(350) = 2,551 shirts
 17-9

Multiperiod Inventory Systems

 17-10

Preset:
reorder
period T &
required
Preset: order quantity Q inventory
& reorder level R level M
Simplest Fixed Order Quantity Model
• Demand for the product • Inventory holding cost is
is constant and uniform based on average
throughout the period inventory

• Lead time (time from • Ordering or setup costs

ordering to receipt) is are constant
constant
• All demands for the
• Price per unit of product product will be satisfied
is constant (No back orders are
allowed)
 17-12

Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 2)

• 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)
 17-13

Basic Fixed-Order Quantity Model and Reorder Point Behavior

1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
L L
2. Your start using
them up over time. 3. When you reach down to
Time a level of inventory of R,
R = Reorder point
Q = Economic order quantity you place your next Q
L = Lead time sized order.
 17-14
Basic Fixed-Order Quantity (EOQ) Model Formula
TC=Total
TC=Totalannual
annualcost
cost
Total Annual Annual Annual DD==Annual
AnnualDemand
Demand
Annual = Purchase + Ordering + Holding CC=Cost
=Costper
perunit
unit
Cost Cost Cost Cost QQ=Order
=Orderquantity
quantity
SS=Cost
=Costofofplacing
placingan
an
D
D Q
Q order
orderororsetup
setupcost
cost
TC
TC == DC
DC ++ SS++ H H RR=Reorder
=Reorderpoint
point

Q 22
LL=Lead
=Leadtime
Q
time
H=Annual
H=Annualholding
holdingand
and
storage
storagecost
costper
perunit
unit
Inventory cost is TC - DC of
ofinventory
inventory
D/Q is number of orders per year Solve for Q which
Q/2 is average inventory per order period yields minimum cost
Also need average daily demand to calculate lead time 2DS
_ Q EOQ =
d = average daily demand (constant) H
L = Lead time (constant)
_
_
R
Reo rder
eord er ppoint,
oint, R
R == ddLL
 17-15

Cost Minimization Goal

By
Byadding
addingthe
theitem,
item,holding,
holding,and
andordering
orderingcosts
coststogether,
together,wewe
determine
determinethe thetotal
totalcost
costcurve,
curve,which
whichin
inturn
turnisisused
usedto
tofind
findthe
the
QQopt inventory order point that minimizes total costs
opt inventory order point that minimizes total costs

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Order Quantity (Q)
 17-16
EOQ Example (1) Problem Data
Given
Giventhe
theinformation
informationbelow,
below,what
whatare
arethe
theEOQ
EOQand
andreorder
reorder
point?
point?
Annual Demand = 1,000 units
Days per year considered in average
daily demand = 365
Cost to place an order = $10 Lead time = 7 days
Holding cost per unit per year = $2.50 Cost per unit = $15
2DS
2DS = 2(1,000
2(1,000 )(10)
)(10) = 89.443 units or 90 units
Q
QOPT =
OPT = H = 2.50 = 89.443 units or 90 units
H 2.50
1,000
1,000 units
units// year
year = 2.74 units / day
dd == = 2.74 units / day
365
365days
days// year
year
__
Reorder
Reorder point,
point, RR == dd LL== 2.74units
2.74units//day
day(7days)
(7days)==19.18
19.18 or
or 20
20 units
units

See Ch17_Inventory_Control.xls!Example 17.2

 17-17
Safety Stock

Continuous check
for reorder point

Periodic
check
 17-18

Fixed-Time Period Model with Safety Stock Formula

qq==Average
Averagedemand
demand++Safety
Safetystock
stock––Inventory
Inventorycurrently
currentlyon
onhand
hand
qq==dd(T L)++ZZTT++LL--II
(T++L)

Where
Where::
qq==quantitiy
quantitiyto
tobe
beordered
ordered
TT==the
thenumber
numberofofdays
daysbetween
betweenreviews
reviews
LL==lead
leadtime
timein
indays
days
dd==forecast
forecast average
averagedaily
dailydemand
demand
zz==the
thenumber
numberofofstandard
standarddeviations
deviationsfor
foraaspecified
specifiedservice
serviceprobabilit
probabilityy
T + L ==standard
standarddeviation
deviationofofdemand
demandover
overthe
thereview
reviewand
andlead
leadtime
time
T +L
II==current
currentinventory
inventorylevel
level(includes
(includesitems
itemson
onorder)
order)
 17-19

Multi-Period Models: Fixed-Time Period Model:

Determining the Value of T+L

   
T+
T+LL 22
T+T+LL == 
i i 11
ddi
i

Since
Sinceeach
eachday
dayisisindependent anddd isisconstant,
independentand constant,
T+T+LL == (T + L) 22
(T + L)dd

• The standard deviation of a sequence

of random events equals the square
root of the sum of the variances
 17-20

Example of the Fixed-Time Period Model

Given
Given the
the information
information below,
below, how
how many
many units
units
should
should be
be ordered?
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.
 17-21

Example of the Fixed-Time Period Model: Solution (Part 1)

T+T+LL == (T L) ==
(T++ L) dd
22
 30 10  44  == 25.298
30++10
22
25.298

The
The value
value for
for “z”
“z” isis found
found by
by using
using the
the Excel
Excel
NORMSINV
NORMSINV function,function, or or as
as wewe will
will do
do here,
here, using
using
Appendix
Appendix D. D. ByBy adding
adding 0.5 0.5 to
to all
all the
thevalues
values in
in
Appendix
Appendix D D and
and finding
finding thethe value
value in in the
the table
table that
that
comes
comes closest
closest to
to the
the service
service probability,
probability,the the“z”
“z”
value
value can
can be
be read
read by by adding
addingthe thecolumn
column heading
heading
label
label to
to the
the row
row label.
label.
So,
So,by
byadding
adding0.5
0.5to
tothe
thevalue
valuefrom
fromAppendix
AppendixDDof of0.4599,
0.4599,
we
wehave
haveaaprobability
probabilityofof0.9599,
0.9599,which
whichisisgiven
givenby
byaazz==1.75
1.75
 17-22

Example of the Fixed-Time Period Model: Solution (Part 2)

qq==dd(T L)++ZZTT++LL --II

(T++L)

qq==20(30
20(30++10)
10)++(1.75)(25.
(1.75)(25.298)
298)--200
200

80044.272
qq==800 44.272--200
200==644.272,
644.272,or
or645
645units
units
So,
So, to
to satisfy
satisfy 96
96 percent
percent of
of the
the demand,
demand,
you
you should
should place
place an
an order
order of
of 645
645 units
units at
at
this
this review
review period
period
See Ch17_Inventory_Control.xls!Example17.5
 17-23

Multi-Period Models: Fixed-Time Period Model:

Determining the Value of sT+L

   
T+
T+LL 22
T+T+LL == 
i i 11
ddi
i

Since
Sinceeach
eachday
dayisisindependent anddd isisconstant,
independentand constant,
T+T+LL == (T + L) 22
(T + L)dd

• The standard deviation of a sequence

of random events equals the square
root of the sum of the variances
 17-24

Example of the Fixed-Time Period Model

Given
Given the
the information
information below,
below, how
how many
many units
units
should
should be
be ordered?
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.
 17-25

Example of the Fixed-Time Period Model: Solution (Part 1)

T+T+LL == (T L) ==
(T++ L) dd
22
 30 10  44  == 25.298
30++10
22
25.298

The
The value
value for
for “z”
“z” isis found
found by
by using
using the
the Excel
Excel
NORMSINV
NORMSINV function,function, or or as
as wewe will
will do
do here,
here, using
using
Appendix
Appendix D. D. ByBy adding
adding 0.5 0.5 to
to all
all the
thevalues
values in
in
Appendix
Appendix D D and
and finding
finding thethe value
value in in the
the table
table that
that
comes
comes closest
closest to
to the
the service
service probability,
probability,the the“z”
“z”
value
value can
can be
be read
read by by adding
addingthe thecolumn
column heading
heading
label
label to
to the
the row
row label.
label.
So,
So,by
byadding
adding0.5
0.5to
tothe
thevalue
valuefrom
fromAppendix
AppendixDDof of0.4599,
0.4599,
we
wehave
haveaaprobability
probabilityofof0.9599,
0.9599,which
whichisisgiven
givenby
byaazz==1.75
1.75
 17-26

Example of the Fixed-Time Period Model: Solution (Part 2)

qq==dd(T L)++ZZTT++LL --II

(T++L)

qq==20(30
20(30++10)
10)++(1.75)(25.
(1.75)(25.298)
298)--200
200

80044.272
qq==800 44.272--200
200==644.272,
644.272,or
or645
645units
units

So,
So, to
to satisfy
satisfy 96
96 percent
percent of
of the
the demand,
demand,
you
you should
should place
place an
an order
order of
of 645
645 units
units at
at
this
this review
review period
period
 17-27

Price-Break Example Solution (Part 1)

Since
Sincethe
thefeasible
feasiblesolution
solutionoccurred
occurredin inthe
thefirst
firstprice-break,
price-break,itit
means
meansthat
thatall
allthe
theother
othertrue
trueQQopt values occur at the
opt values occur at the
beginnings
beginningsofofeach
eachprice-break
price-breakinterval.
interval. Why?
Why?

Because
Becausethe
thetotal
totalannual
annualcost
costfunction
functionisisaa“u”
“u”
Total shaped
shapedfunction
function
annual
costs Price2 < Price1
Price1 Price3 < Price2

So
Sothe
thecandidates
candidates
for
forthe
theprice-breaks
price-breaks
are
areEOQ
EOQ11,Q
,Q22and
andQQ33
units
units
0 EOQ1 Q2 Q3 Order Quantity
 17-28

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 2DS 2(10,000)(4)

value is feasible Q OPT = = = 1,826 units
iC 0.02(1.20)
Interval from 2500-3999, the Qopt 2DS 2(10,000)(4)
value is not feasible
Q OPT = = = 2,000 units
iC 0.02(1.00)
Interval from 4000 & more, the 2DS 2(10,000)(4)
Qopt value is not feasible Q OPT = = = 2,020 units
iC 0.02(0.98)
 17-29

Price-Break Example Solution (Part 3)

Since
Sincethe
thefeasible
feasiblesolution
solutionoccurred
occurredin inthe
thefirst
firstprice-break,
price-break,itit
means
meansthat
thatall
allthe
theother
othertrue
trueQQopt values occur at the
opt values occur at the
beginnings
beginningsofofeach
eachprice-break
price-breakinterval.
interval. Why?
Why?

Because
Becausethe
thetotal
totalannual
annualcost
costfunction
functionisisaa“u”
“u”
Total shaped
shapedfunction
function
annual
costs So
Sothe
thecandidates
candidates
for
forthe
theprice-breaks
price-breaks
are
are1826,
1826,2500,
2500,and
and
4000
4000units
units

0 1826 2500 4000 Order Quantity

 17-30

Price-Break Example Solution (Part 4)

Next,
Next,we
weplug
plugthe
thetrue
trueQQopt values into the total cost annual cost
opt values into the total cost annual cost
function
functionto
todetermine
determinethe
thetotal
totalcost
costunder
undereach
eachprice-break
price-break

D
D Q
Q iC
TC = DC +
TC = DC + S
S++ iC
Q
Q 2
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,
Finally,we
weselect
selectthe
theleast
leastcostly
costlyQQopt , which is this problem
opt, which is this problem
occurs
occursininthe
the4000
4000&&more
moreinterval.
interval. In
Insummary,
summary,our ouroptimal
optimal
order
orderquantity
quantityisis4000
4000units
units
 17-31

ABC Classification System

• Items kept in inventory are not of equal

importance in terms of:
– 60
dollars invested % of
$ Value 30 A
– profit potential 0 B
– C
sales or usage volume % of 30
Use 60
– stock-out penalties

So, identify inventory items based on percentage of total dollar

value, where “A” items are roughly top 15 % (or 75% of dollar
value), “B” items as next 35 % (or 20% of dollar value), and the
remaining are the “C” items

See ABC-Classification.xls
 17-32

Inventory Accuracy and Cycle Counting

• Inventory accuracy refers to how

well the inventory records agree
with physical count
• Cycle Counting is a physical
inventory-taking technique in which
inventory is counted on a frequent
basis rather than once or twice a
year
 Overall Inventory Measures
• Regardless of ordering strategy, some
common measures used to evaluate
inventories are:
– Average inventory value = (Q/2 + SS)C
– Inventory turn over
= cost of goods sold/average inventory value
= DC/(Q/2 + SS)C = D/(Q/2 + SS)
– For Fixed-Time Period Model Q = dT
– Are high turnovers better than low?