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Tata McGraw

Inventory Control

Chapter 17

• Inventory System Defined• Inventory Costs• Independent vs. Dependent Demand• Single-Period Inventory Model • Multi-Period Inventory Models: Basic

Fixed-Order Quantity Models• Multi-Period Inventory Models: Basic

Fixed-Time Period Model• Miscellaneous Systems and Issues

OBJECTIVES

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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

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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 purchase-order size

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Inventory Costs

• Holding (or carrying) costs– Costs for storage, handling,

insurance, etc• Setup (or production change) costs

– Costs for arranging specific equipment setups, etc

• Ordering costs– Costs of someone placing an order,

etc• Shortage costs

– Costs of canceling an order, etc

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E(1)

Independent vs. Dependent Demand

Independent Demand (Demand for the final end-product or demand not related to other items)

Dependent Demand

(Derived demand items for

component parts,

subassemblies, raw materials,

etc)

Finishedproduct

Component parts

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Inventory Systems

• Single-Period Inventory Model– One time purchasing decision (Example:

vendor selling t-shirts at a football game)– Seeks to balance the costs of inventory

overstock and under stock• 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)

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Single-Period Inventory Model

uo

u

CCCP

sold be unit will y that theProbabilitestimatedunder demand ofunit per Cost C

estimatedover demand ofunit per Cost C:Where

u

o

P

This model states that we should continue to increase the size of the inventory so long as the probability of selling the last unit added is equal to or greater than the ratio of: Cu/Co+Cu

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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

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Multi-Period Models:Fixed-Order Quantity Model Model Assumptions (Part 1)

• Demand for the product is constant and uniform throughout the period

• Lead time (time from ordering to receipt) is constant

• Price per unit of product is constant

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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)

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Basic Fixed-Order Quantity Model and Reorder Point Behavior

R = Reorder pointQ = Economic order quantityL = Lead time

L L

Q QQ

R

Time

Numberof unitson hand

1. You receive an order quantity Q.

2. Your start using them up over time. 3. When you reach down to

a level of inventory of R, you place your next Q sized order.

4. The cycle then repeats.

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Cost Minimization Goal

Ordering Costs

HoldingCosts

Order Quantity (Q)

COST

Annual Cost ofItems (DC)

Total Cost

QOPT

By adding the item, holding, and ordering costs together, we determine the total cost curve, which in turn is used to find the Qopt inventory order point that minimizes total costs

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Basic Fixed-Order Quantity (EOQ) Model Formula

H 2Q + S

QD + DC = TC

Total Annual =Cost

AnnualPurchase

Cost

AnnualOrdering

Cost

AnnualHolding

Cost+ +

TC=Total annual costD =DemandC =Cost per unitQ =Order quantityS =Cost of placing an order or setup costR =Reorder pointL =Lead timeH=Annual holding and storage cost per unit of inventory

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Deriving the EOQ

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

Q = 2DS

H =

2(Annual D em and)(Order or Setup Cost)Annual Holding CostOPT

Reorder point, R = d L_

d = average daily demand (constant) L = Lead time (constant)

_

We also need a reorder point to tell us when to place an order

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EOQ Example (1) Problem Data

Annual Demand = 1,000 unitsDays per year considered in average

daily demand = 365Cost to place an order = $10Holding cost per unit per year = $2.50Lead time = 7 daysCost per unit = $15

Given the information below, what are the EOQ and reorder point?

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EOQ Example (1) Solution

Q = 2DS

H =

2(1,000 )(10)2.50

= 89.443 units or OPT 90 units

d = 1,000 units / year

365 days / year = 2.74 units / day

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

20 units

In summary, you place an optimal order of 90 units. In the course of using the units to meet demand, when you only have 20 units left, place the next order of 90 units.

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EOQ Example (2) Problem Data

Annual Demand = 10,000 unitsDays per year considered in average daily demand = 365Cost to place an order = $10Holding cost per unit per year = 10% of cost per unitLead time = 10 daysCost per unit = $15

Determine the economic order quantity and the reorder point given the following…

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EOQ Example (2) Solution

Q =2DS

H=

2(10,000 )(10)1.50

= 365.148 units, or OPT 366 units

d =10,000 units / year

365 days / year= 27.397 units / day

R = d L = 27.397 units / day (10 days) = 273.97 or _

274 units

Place an order for 366 units. When in the course of using the inventory you are left with only 274 units, place the next order of 366 units.

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Fixed-Time Period Model with Safety Stock Formula

order)on items (includes levelinventory current = I timelead and review over the demand ofdeviation standard =

yprobabilit service specified afor deviations standard ofnumber the= zdemanddaily averageforecast = d

daysin timelead = Lreviewsbetween days ofnumber the= T

ordered be toquantitiy = q:Where

I - Z+ L)+(Td = q

L+T

L+T

q = Average demand + Safety stock – Inventory currently on hand

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Multi-Period Models: Fixed-Time Period Model: Determining the Value of sT+L

T+ L di 1

T+ L

d

T+ L d2

=

Since each day is independent and is constant,

= (T + L)

i

2

• 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

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.

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

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

T+ L d2 2 = (T + L) = 30 + 10 4 = 25.298

The value for “z” is found by using the Excel NORMSINV function, or as we will do here, using Appendix D. By adding 0.5 to all the values in Appendix D and finding the value in the table that comes closest to the service probability, the “z” value can be read by adding the column heading label to the row label.

So, by adding 0.5 to the value from Appendix D of 0.4599, we have a probability of 0.9599, which is given by a z = 1.75

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

or 644.272, = 200 - 44.272 800 = q

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

I - Z+ L)+(Td = q L+T

units 645

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

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Price-Break Model Formula

Cost Holding AnnualCost) Setupor der Demand)(Or 2(Annual =

iC2DS = QOPT

Based on the same assumptions as the EOQ model, the price-break model has a similar Qopt formula:

i = percentage of unit cost attributed to carrying inventoryC = cost per unit

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

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Price-Break Example Problem Data (Part 1)

A company has a chance to reduce their inventory ordering costs by placing larger quantity orders using the price-break order quantity schedule below. What should their optimal order quantity be if this company purchases this single inventory item with an e-mail ordering cost of $4, a carrying cost rate of 2% of the inventory cost of the item, and an annual demand of 10,000 units?

Order Quantity(units) Price/unit($)0 to 2,499 $1.202,500 to 3,999 1.004,000 or more .98

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Price-Break Example Solution (Part 2)

units 1,826 = 0.02(1.20)

4)2(10,000)( = iC

2DS = QOPT

Annual Demand (D)= 10,000 unitsCost to place an order (S)= $4

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

units 2,000 = 0.02(1.00)

4)2(10,000)( = iC

2DS = QOPT

units 2,020 = 0.02(0.98)

4)2(10,000)( = iC

2DS = QOPT

Carrying cost % of total cost (i)= 2%Cost per unit (C) = $1.20, $1.00, $0.98

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

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

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Price-Break Example Solution (Part 3)

Since the feasible solution occurred in the first price-break, it means that all the other true Qopt values occur at the beginnings of each price-break interval. Why?

0 1826 2500 4000 Order Quantity

Total annual costs So the candidates

for the price-breaks are 1826, 2500, and 4000 units

Because the total annual cost function is a “u” shaped function

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Price-Break Example Solution (Part 4)

iC 2Q + S

QD + DC = TC

Next, we plug the true Qopt values into the total cost annual cost function to determine the total cost under each price-break

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

Finally, we select the least costly Qopt, which is this problem occurs in the 4000 & more interval. In summary, our optimal order quantity is 4000 units

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Maximum Inventory Level, M

Miscellaneous Systems:Optional Replenishment System

MActual Inventory Level, I

q = M - I

I

Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.

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Miscellaneous Systems:Bin Systems

Two-Bin System

Full Empty

Order One Bin ofInventory

One-Bin System

Periodic Check

Order Enough toRefill Bin

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ABC Classification System

• Items kept in inventory are not of equal importance in terms of:

– dollars invested

– profit potential

– sales or usage volume

– stock-out penalties

0

3060

30

60

AB

C

% of $ Value

% of Use

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 65% are the “C” items

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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

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Question Bowl

Which of the following is a reason why firms keep a supply of inventory?

a. To maintain independence of operations

b. To meet variation in product demandc. To allow flexibility in production

schedulingd. To take advantage of economic

purchase order size e. All of the above

Answer: e. All of the above (Also can include to provide a safeguard for variation in raw material delivery time.)

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Question Bowl

An Inventory System should include policies that are related to which of the following?

a. How large inventory purchase orders should be

b. Monitoring levels of inventoryc. Stating when stock should be

replenishedd. All of the abovee. None of the above

Answer: d. All of the above

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Question Bowl

Which of the following is an Inventory Cost item that is related to the managerial and clerical costs to prepare a purchase or production order?

a. Holding costsb. Setup costsc. Carrying costsd. Shortage costse. None of the above

Answer: e. None of the above (Correct answer is Ordering Costs.)

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Question Bowl

Which of the following is considered a Independent Demand inventory item?

a. Bolts to a automobile manufacturer

b. Timber to a home builderc. Windows to a home builderd. Containers of milk to a grocery

storee. None of the above

Answer: d. Containers of milk to a grocery store

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Question Bowl

If you are marketing a more expensive independent demand inventory item, which inventory model should you use?

a. Fixed-time period modelb. Fixed-order quantity modelc. Periodic systemd. Periodic review systeme. P-model

Answer: b. Fixed-order quantity model

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Question Bowl

If the annual demand for an inventory item is 5,000 units, the ordering costs are $100 per order, and the cost of holding a unit is stock for a year is $10, which of the following is approximately the Qopt?

a. 5,000 unitsb. $5,000c. 500 unitsd. 316 unitse. None of the above

Answer: d. 316 units (Sqrt[(2x1000x100)/10=316.2277)

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Question Bowl

The basic logic behind the ABC Classification system for inventory management is which of the following?

a. Two-bin logicb. One-bin logicc. Pareto principled. All of the abovee. None of the above

Answer: c. Pareto principle

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Question Bowl

A physical inventory-taking technique in which inventory is counted frequently rather than once or twice a year is which of the following?

a. Cycle countingb. Mathematical programmingc. Pareto principled. ABC classificatione. Stockkeeping unit (SKU)

Answer: a. Cycle counting

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End of Chapter 17

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