OPERATIONS MANAGEMENT

Inventory Management
 What Is Inventory?

 Stock of items kept to meet future

demand
 Purpose of inventory management
 how many units to order
 when to order

12-2
 Types of Inventory

 Raw materials
 Purchased parts and supplies
 Work-in-process (partially completed)
products (WIP)
 Items being transported
 Tools and equipment

12-3
 Economic Order Quantity
(EOQ) Models

 EOQ
 optimal order quantity that will
minimize total inventory costs
 Basic EOQ model
 Production quantity model

12-4
 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
 Order quantity is received all at once

12-5
General EOQ Model
Problem 1
ABC corporation has got a demand for particular part at 10,000
units per year. The cost per unit is Rs 2 and its costs Rs 36 to
place an order and to process the delivery. The inventory carrying
cost is estimated at 9% of average inventory investment.
Determine

I. Economic order quantity.

II. Optimum number of orders to be placed per annum.

III. Minimum total cost of inventory per annum.

 Problem 2

A manufacturer has to supply his customers 3600 units of his product

per year Shortages are not permitted. Inventory carrying cost
amounts Rs 1.2 per unit per annum. The set up cost per run is Rs
80. find

(i) Economic order quantity

(ii) Optimum number of orders per annum

(iii) Average annual inventory cost (minimum)

(iv) Optimum period of supply per optimum order.

12-7
 Problem 3

Usha corporation currently practices the following system for the

procurement of an item.

No of orders placed in a year = 8

Ordering cost = 750/ order

Each time order quantity = 250

Carrying cost = 40%

Comment on the ordering policy of the company and estimate the

loss to the company in not practicing scientific inventory policy.

12-8
Problem 4
A pharma company has a demand for 10,00,000 bottles. Each empty bottle
costs the company Rs 1.50. Empty bottles are supplied by M/s Rupa Lass
Ltd. The R.O.L system of stock replenishment is followed. Ordering cost is
Rs. 12.5/order and inventory carrying cost is 25% of cost per bottle. The
demand is constant throughout the year. The lead time is 15 days.
Determine

(a) Economic order quantity

(b) Lead time consumption

(c) Reorder level.

(d) Average inventory

 Model - II
Production Quantity Model
This model is applicable when inventory continuously build up over a
period of time after placing an order or when the units are
manufactured and used (or sold ) at a constant rate. This model is
suitable for the manufacturing environment.

 The item is sold or consumed at the constant demand rate which is

known

 Set up cost is fixed and it does not change with lot size.

 The increase in inventory is not instantaneous but it is gradual

12-10
 Production Quantity Model
(cont.)
Inventory
level

Maximum
Q(1-d/p) inventory
level

Average
Q
(1-d/p) inventory
2 level

0
Begin End Time
order order
Order
receipt receipt
receipt period

Copyright 2006 John Wiley & Sons, Inc. 12-11

 Production Quantity Model
(cont.)
p = production rate d = demand rate

Q
Maximum inventory level = Q - d
p
d
=Q1-
p 2CoD
Qopt = d
Q d Cc 1 - p
Average inventory level = 1-
2 p

CoD CcQ d
TC = + 1- p
Q 2

12-12
 Production Quantity Model:
Example
Cc = $0.75 per yard Co = $150 D = 10,000 yards
d = 10,000/311 = 32.2 yards per day p = 150 yards per day

2CoD 2(150)(10,000)
Qopt = = = 2,256.8 yards
32.2
Cc 1 - d 0.75 1 -
p 150

Co D CcQ d
TC = + 1- p = $1,329
Q 2

Q 2,256.8
Production run = = = 15.05 days per order
p 150

12-13
 Production Quantity Model:
Example (cont.)

D 10,000
Number of production runs = = = 4.43 runs/year
Q 2,256.8

d 32.2
Maximum inventory level = Q 1 - = 2,256.8 1 -
p 150
= 1,772 yards

12-14
 Problem 1

ABC company produces a cable at the rate of 5000 meters

per hour. The cable is used at the rate of 2500
meters/hour. The cost of the cable is Rs 5 per meter.
The inventory carrying cost is 25% and set-up costs are
Rs 4050 per set up. Determine the optimal number of
cycles required in a year for the manufacture of this
cable.
 Problem 2

A contractor undertakes to supply diesel engines to a truck manufacturer at

the rate of 25 per day. He find that the cost of holdings a completed
engine in stock is Rs 16 per month. Production of engines is in batches
and each time a new batch is started, there are set up costs of 10,000 Rs.
How frequently the batches be started and what will be the minimum
average inventory cost and production time if production rate is 40
engines / day

Assume 300 working days in a year.

12-16
 Problem 2

An automobile manufacturing company is purchasing an item from outside

suppliers. Demand is 10,000 units per annum. Cost of the item is Rs 5 per unit
and procurement cost is estimated to be Rs 100 per order. Cost of carrying
inventory is 25%. If the consumption rate is constant determine EOQ.

In the above problem, if the company decides to manufacture the above item
with an equipment which produce 100 units per day. The cost of units thus
produced is Rs 3.5 per unit set up cost is Rs 150.

How your answer is changed in the second case.

 Q.1
Annual demand for an item is 4800 units. Ordering cost is
Rs. 500/ order. Inventory carrying cost is 24% of the
purchase price per unit, per year. The price breaks are
given as follows.
Quantity Price (Rs)/ unit
0≤Q1<1200 10
1200 ≤ Q2<2000 9
2000 ≤ Q3 8
Find
(a) Optimal order quantity
(b) If the ordering cost is changed to Rs. 300 per order, find
the optimal order quantity

12-18
Q.2

A manufacturing company requires special

gears at the rate of 300 numbers per year.
Each gear costs Rs. 36. The procurement
cost and inventory carrying costs are
estimated at Rs. 30 and 20% respectively. If
the supplier offers a discount of Rs.2 per
gear on an order of 200 or above, will it be
advisable to avail the discount? What should
be the order quantity?
 Q.3
The annual demand for a machine component is
24,000 units. The carrying cost is Rs 0.40 unit/year,
the ordering cost is Rs 20 per order and the shortage
cost is Rs10 unit/year. Find the values of the
following
(i) Economic order quantity
(ii)Maximum inventory
(iii)Maximum shortage
(iv)Cycle time
(v)Inventory period (t1)
(vi)Shortage period (t2)
12-20
Q.4
The demand for an item is 18,000 per year.
Production rate is 3000 units/month. The carrying
cost is Rs 0.15 unit/month and the setup cost is
Rs.500 per setup. The shortage cost is Rs.20 per
unit per year. Find the following parameters
(i)Economic Batch Quantity
(ii)Maximum Inventory
(iii)Maximum stock out
(iv)Cycle time
 Two Forms of Demand
 Dependent
 Demand for items used to produce
final products
 Tires stored at a Goodyear plant are
an example of a dependent demand
item
 Independent
 Demand for items used by external
customers
 Cars, appliances, computers, and
houses are examples of independent
demand inventory

12-22
 Inventory and Quality
Management

 Customers usually perceive quality

service as availability of goods they want
when they want them
 Inventory must be sufficient to provide
high-quality customer service in TQM

12-23
 Inventory Costs

 Carrying cost
 cost of holding an item in inventory
 Ordering cost
 cost of replenishing inventory
 Shortage cost
 temporary or permanent loss of sales
when demand cannot be met

12-24
 Inventory Control Systems

 Continuous system (fixed-

order-quantity)
 constant amount ordered
when inventory declines to
predetermined level
 Periodic system (fixed-time-
period)
 order placed for variable
amount after fixed passage of
time

Copyright 2006 John Wiley & Sons, Inc. 12-25

 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

12-26
ABC Classification: Example
PART UNIT COST ANNUAL USAGE
1 $ 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120

12-27
 ABC Classification:
Example (cont.)
TOTAL % OF TOTAL % OF TOTAL
PART PART
VALUE UNIT
VALUECOSTQUANTITY
ANNUAL USAGE
% CUMMULATIVE
9 1
$30,600 $ 60
35.9 6.0 90 6.0
8 16,000
2 18.7
350 5.0 11.0
2 14,000 16.4 4.0
A40 15.0
3 30 130
1 5,400 6.3 9.0 24.0
4 4
4,800 5.680 6.0 B60 30.0
3 5
3,900 4.630 10.0 100 40.0
% OF TOTAL % OF TOTAL
6 6
3,600
CLASS ITEMS20
4.2 18.0
VALUE 180QUANTITY
58.0
5 3,000
7 3.510 13.0 170 71.0
10 2,400
A 9, 8,2.8
2 12.0
71.0 C 83.0
8 320 50 15.0
7 1,700
B 1, 4,2.0
3 17.0
16.5 100.0
25.0
9
C 5107
6, 5, 10, 12.5 60 60.0
$85,400
10 20 120
Example 10.1

12-28
 Inventory Order Cycle
Order quantity, Q
Demand
rate
Inventory Level

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
placed receipt placed receipt

12-29
 EOQ Cost Model
Co - cost of placing order D - annual demand
Cc - annual per-unit carrying cost Q - order quantity

Co D
Annual ordering cost =
Q
CcQ
Annual carrying cost =
2
CoD CcQ
Total cost = +
Q 2

12-30
 EOQ Cost Model

Deriving Qopt Proving equality of

costs at optimal point
Co D CcQ
TC = +
Q 2 Co D CcQ
=
∂ TC CoD C Q 2
= + c
∂Q Q2 2 2CoD
Q = 2
C0 D Cc Cc
0= +
Q2 2
2CoD
2CoD Qopt =
Qopt = Cc
Cc

12-31
 EOQ Cost Model (cont.)
Annual
cost ($) Total Cost
Slope = 0

CcQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost =
Q

Optimal order Order Quantity, Q

Qopt

12-32
 EOQ Example
Cc = $0.75 per yard Co = $150 D = 10,000 yards

2CoD CoD CcQ

Qopt = TCmin = +
Cc Q 2
2(150)(10,000) (150)(10,000) (0.75)(2,000)
Qopt = TCmin = +
(0.75) 2,000 2

Qopt = 2,000 yards TCmin = $750 + $750 = $1,500

Orders per year = D/Qopt Order cycle time = 311 days/(D/Qopt )

= 10,000/2,000 = 311/5
= 5 orders/year = 62.2 store days
12-33
Quantity Discounts

Price per unit decreases as order

quantity increases

CoD CcQ
TC = + + PD
Q 2
where

P = per unit price of the item

D = annual demand

12-34
 Quantity Discount Model (cont.)
ORDER SIZE PRICE
0 - 99 $10 TC = ($10 )
100 – 199 8 (d1)
200+ 6 (d2)
TC (d1 = $8 )

TC (d2 = $6 )
Inventory cost ($)

Carrying cost

Ordering cost

Q(d1 ) = 100 Qopt Q(d2 ) = 200

12-35
 Quantity Discount: Example
QUANTITY PRICE
Co = $2,500
1 - 49 $1,400
Cc = $190 per computer
50 - 89 1,100
D = 200
90+ 900

2 Co D 2(2500)(200)
Qopt = = = 72.5 PCs
Cc 190

For Q = 72.5
CoD CcQopt
TC = + + PD = $233,784
Qopt 2

For Q = 90
Co D CcQ
TC = + + PD = $194,105
Q 2
12-36
 Reorder Point
Level of inventory at which a new order
is placed

R = dL
where
d = demand rate per period
L = lead time

12-37
 Reorder Point: Example

Demand = 10,000 yards/year

Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154
yards/day
Lead time = L = 10 days

R = dL = (32.154)(10) = 321.54 yards

12-38
 Safety Stocks
 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

12-39
 Variable Demand with
a Reorder Point
Q
Inventory level

Reorder
point, R

0
LT LT
Time

12-40
 Reorder Point with
a Safety Stock
Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Time
12-41
 Reorder Point With
Variable Demand

R = dL + zσ d L
where
d = average daily demand
L = lead time
σ d = the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
probability
zσ d L = safety stock

12-42
 Reorder Point for
a Service Level
Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
zσ d L

dL R
Demand
Copyright 2006 John Wiley & Sons, Inc. 12-43
 Reorder Point for
Variable Demand
The carpet store wants a reorder point with a 95%
service level and a 5% stockout probability
d = 30 yards per day
L = 10 days
σ d = 5 yards per day

For a 95% service level, z = 1.65

R = dL + z σ d L Safety stock = z σ d L
= 30(10) + (1.65)(5)( 10) = (1.65)(5)( 10)
= 326.1 yards = 26.1 yards

12-44
 Order Quantity for a
Periodic Inventory System

Q = d(tb + L) + zσ d tb + L - I

where
d = average demand rate
tb = the fixed time between orders
L = lead time
σ d = standard deviation of demand

zσ d tb + L = safety stock
I = inventory level
12-45
Fixed-Period Model with
Variable Demand
d = 6 bottles per day
σ d = 1.2 bottles
tb = 60 days
L = 5 days
I = 8 bottles
z = 1.65 (for a 95% service level)

Q = d(tb + L) + zσ d tb + L - I
= (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8
= 397.96 bottles
12-46
Copyright 2006 John Wiley & Sons, Inc.
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or damages caused by the use of these 12-47