Operations Management: Sustainability

and Supply Chain Management

Fourth Canadian Edition

Chapter 12
Inventory Management

Copyright © 2023 Pearson Canada Inc. 12 - 1

Outline

• Global Company Profile: Inventory Management

Provides Competitive Advantage at Amazon.com
• The Importance of Inventory
• Managing Inventory
• Inventory Models
• Inventory Models for Independent Demand
• Probabilistic Models and Safety Stock
• Single-Period Model
• Fixed-Period (P) Systems

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Learning Objectives (1 of 2)

When you complete this chapter, you should be

able to:
1. Conduct an ABC analysis
2. Explain and use cycle counting
3. Explain and use the EOQ model for independent
inventory demand
4. Compute a reorder point, and explain safety stock

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Learning Objectives (2 of 2)

When you complete this chapter, you should be

able to:
5. Apply the production order quantity model
6. Explain and use the quantity discount model
7. Understand service levels and probabilistic inventory
models

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Global Company Profile: Inventory Management
Provides Competitive Advantage at Amazon.com
(1 of 3)

• Amazon.com started as a “virtual” retailer – no

inventory, no warehouses, no overhead; just
computers taking orders to be filled by others
• Growth has forced Amazon.com to become a world
leader in warehousing and inventory management

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Global Company Profile: Inventory Management
Provides Competitive Advantage at Amazon.com
(2 of 3)

1. Each order is assigned by computer to the closest

distribution centre that has the product(s)
2. A “flow meister” at each distribution centre assigns
work crews
3. Lights indicate products that are to be picked and
the light is reset
4. Items are placed in crates on a conveyor, bar code
scanners scan each item 15 times to virtually
eliminate errors

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Global Company Profile: Inventory Management
Provides Competitive Advantage at Amazon.com
(3 of 3)

5. Crates arrive at central point where items are boxed

and labelled with new bar code
6. Gift wrapping is done by hand at 30 packages per
hour
7. Completed boxes are packed, taped, weighed and
labelled before leaving warehouse in a truck
8. Order arrives at customer within 2–3 days

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Inventory Management

• Inventory refers to stocks of goods and materials that are

maintained for many purposes, the most common being to
satisfy normal demand patterns.

• The objective of inventory management is to strike a

balance between inventory investment and customer
service

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Importance of Inventory

• One of the most expensive assets of many companies

representing as much as 50% of total invested capital
• Operations managers must balance inventory investment
and customer service level. A firm can reduce costs by
reducing inventory. On the other hand, production may
stop and customers become dissatisfied when an item is
out of stock.
• Operations managers must balance inventory
investment and customer service

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Functions of Inventory

1. To decouple or separate various parts of the

production process
2. To decouple the firm from fluctuations in demand
and provide a stock of goods that will provide a
selection for customers
3. To take advantage of quantity discounts
4. To hedge against inflation

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Types of Inventory

• Raw material
– Purchased but not processed
• Work-in-process
– Undergone some change but not completed
– A function of cycle time for a product
• Maintenance/repair/operating (MRO)
– Necessary to keep machinery and processes
productive
• Finished goods
– Completed product awaiting shipment

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Types of Inventory

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The Material Flow Cycle

Figure 12.1 The Material Flow Cycle Most of the time that work is in process (95% of the flow time) is not productive time.

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Managing Inventory

1. How inventory items can be classified

2. How accurate inventory records can be maintained

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ABC Analysis (1 of 6)
LO1: Conduct an ABC analysis

• Divides inventory into three classes based on annual

dollar volume
– Class A - high annual dollar volume
– Class B - medium annual dollar volume
– Class C - low annual dollar volume
• Used to establish policies that focus on the few critical
parts and not the many trivial ones

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ABC Analysis (2 of 6)

ABC Calculation
(1) (2) (3) (4) (5) (6) (7)

Percentage Percentage
Item of Number Annual Annual of Annual
Stock of Items Volume × Unit = Dollar Dollar
Number Stocked (Units) Cost Volume Volume Class
1,000 $ 90.00 $ 90,000 72% A
20%
500 154.00 77,000 A
1,550 17.00 26,350 B
30% 350 42.86 15,001 23% B
1,000 12.50 12,500 B

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ABC Analysis (3 of 6)

ABC Calculation (continued)

(1) (2) (3) (4) (5) (6) (7)
Percentage Percentage
Item of Number Annual Annual of Annual
Stock of Items Volume × Unit = Dollar Dollar
Number Stocked (Units) Cost Volume Volume Class
600 14.17 8,502 C
2,000 0.60 1,200 C
50% 100 8.50 850 5% C
1,200 0.42 504 C
250 0,60 150 C
8,550 $232,057 100.0%

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ABC Analysis (4 of 6)

Figure 12.2 Graphic Representation of ABC Analysis

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ABC Analysis (5 of 6)

• Other criteria than annual dollar volume may be used

– Anticipated engineering changes
– Delivery problems
– Quality problems
– High unit cost

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ABC Analysis (6 of 6)

• Policies employed may include

– More emphasis on supplier development for A items
– Tighter physical inventory control for A items
– More care in forecasting A items

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Record Accuracy

• Accurate records are a critical ingredient in

production and inventory systems
• Allows organization to focus on what is
needed
• Necessary to make precise decisions about
ordering, scheduling, and shipping
• Incoming and outgoing record
keeping must be accurate
• Stockrooms should be secure
Two-bin(box) system
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Cycle Counting
LO2: Explain and use cycle counting

• Items are counted and records updated on a periodic

basis
• Often used with ABC analysis to determine cycle
• Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and corrected
5. Maintains accurate inventory records

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Control of Service Inventories

• Can be a critical component of profitability

• Losses may come from shrinkage or pilferage
• Applicable techniques include
1. Good personnel selection, training, and discipline
2. Tight control on incoming shipments
3. Effective control on all goods leaving
facility

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Inventory in the Firm

• Batching Economies or Cycle Stocks

– Arises from three sources.
 Procurement
 Production
 Transportation

• Uncertainty and Safety Stocks

– All organizations are faced with uncertainty.
– On the demand side, there is usually uncertainty in
how much customers will buy and when they will buy it.

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 Inventory in the Firm, continued

• Uncertainty and Safety Stocks, continued

– On the supply side, there might be uncertainty about
obtaining what is needed from suppliers and how long
it will take for the fulfillment of the order.
• Time/In-Transit and Work-in-Process Stocks
– The time associated with transportation means that
even while goods are in motion, an inventory cost is
associated with the time period. The longer the time,
the higher the cost.

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 Inventory in the Firm, continued

• Time/In-Transit and Work-in-Process Stocks,

continued
– WIP inventories, associated with manufacturing, can be
significant while the length of time the inventory sits in
a manufacturing facility waiting and should be carefully
evaluated in relationship to scheduling techniques and
the actual manufacturing/assembly technology.
• Seasonal Stocks
– Seasonality can occur in the supply of raw materials, in
the demand for finished product, or in both.
– Those faced with seasonality issues are constantly
challenged when determining how much inventory to
accumulate.

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 Inventory in the Firm, continued

• Seasonal Stocks, continued

– Seasonality can impact transportation.
• Anticipatory Stocks
– A fifth reason to hold inventory arises when an
organization anticipates that an unusual event might
occur that will negatively impact its source of supply.
• The Importance of Inventory in Other Functional
Areas
– Logistics interfaces with an organization’s other
functional areas.
 Marketing
 Manufacturing
 Finance
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Inventory Models - DEMAND

• In general, the demand for items in inventory is either

dependent or independent.
• Independent demand - the demand for item is
independent of the demand for any other item in
inventory - items are final products demanded by external
customers.
• Dependent demand - the demand for item is
dependent upon the demand for some other item in
the inventory - items are typically component parts or
materials used in the process of producing a final product.

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Holding, Ordering, and Setup Costs

• Holding costs - the costs of holding or “carrying”

inventory over time
• Ordering costs - the costs of placing an order and
receiving goods
• Setup costs - cost to prepare a machine or process
for manufacturing an order

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Inventory Models for Independent
Demand
Need to determine when and how much to order
1. Basic economic order quantity
2. Production order quantity
3. Quantity discount model

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Basic EOQ Model
LO3: Explain and use the EOQ model for independent inventory
demand

Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided

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Inventory Usage Over Time

Figure 12.3 Inventory Usage Over Time

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Minimizing Costs
• Objective is to minimize total costs

Figure 12.4 (c)

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The EOQ Model (1 of 3)

Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

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The EOQ Model (2 of 3)

Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

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The EOQ Model (3 of 3)

Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Optimal order quantity is found when annual setup cost equals annual
holding cost

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 An EOQ Example

Determine optimal number of items to order

D = 1,000 units
S = $10 per order
H = $0.50 per unit per year

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 An EOQ Example
Determine expected number of orders per year
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected Demand
number of = N = =
orders Order quantity

1,000
N= = 5 orders per year
200

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 An EOQ Example
Company has a 250 day working year, determine
optimal time period between orders
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year

Expected Number of working days per year

time between = T =
orders Expected number of orders

250
T= = 50 days between orders
5

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 An EOQ Example
Determine the total annual inventory cost
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year T = 50 days

Total Annual Inventory Cost = Setup Cost + Holding Cost

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 The EOQ Model

When including actual cost of material P (price)

Total Annual Cost = Setup Cost + Holding Cost + Product Cost

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Reorder Points
LO4: Compute a reorder point, and explain safety stock

• EOQ answers the “how much” question

• The reorder point (ROP) tells “when” to order

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Reorder Point Curve

Figure 12.5 The Reorder Point (ROP) Q* is the optimum order quantity, and lead time represents the time between placing and
receiving an order.

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Reorder Point Example

Demand = 8,000 iPods per year

250 working day year
Lead time for orders is 3 working days, may take 4

D
d=
Number of working days in a year
d (daily demand) = 8,000/250 = 32 units

ROP = d x L
= 32 units per day x 3 days = 96 units
= 32 units per day x 4 days = 128 units

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Quantity Discount Models
LO6: Explain and use the quantity discount model
• Reduced prices are often available when larger quantities
are purchased
• Trade-off is between reduced product cost and increased
holding cost

Total cost = Setup cost + Holding cost + Product cost

where Q = Quantity ordered

D = Annual demand in units
S = Ordering or setup cost per order
P = Price per unit
H =Holding cost per unit per year
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Quantity Discount Model
Wohl’s Discount Store stocks toy race cars. Recently, the store has been given
a quantity discount schedule for these cars. This quantity schedule was shown
in Table 12.2. Thus, the normal cost for the toy race cars is $5.00. For orders
between 1000 and 1999 units, the unit cost drops to $4.80; for orders of 2000
or more units, the unit cost is only $4.75. Furthermore, ordering cost is $49.00
per order, annual demand is 5000 race cars, and inventory carrying charge, as
a percentage of cost, I, is 20%, or 0.2. What order quantity will minimize the
total inventory cost?

TABLE 12.2 A Quantity Discount Schedule

DISCOUNT DISCOUNT
NUMBER DISCOUNT QUANTITY DISCOUNT (%) PRICE (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75

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Quantity Discount Models

Steps in analyzing a quantity discount

1. For each discount, calculate a value for optimal order
size Q*
2. If Q* for a discount doesn’t qualify, choose the smallest
possible order size to get the discount, For example, if
Q* for discount 2 in Table 12.2 were 500 units, you would
adjust this value up to 1000 units.
3. Compute the total cost for each Q* or adjusted value
from Step 2
4. Select the Q* that gives the lowest total cost

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Quantity Discount Models

Total cost curve for discount 2

Total cost
curve for
discount 1
Total cost $

Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a and
must be adjusted upward to 1,000 units at point b

1st price 2nd price

break break

0 1,000 2,000
Order quantity
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Quantity Discount Example
Total Demand is 5000 toy cars
Calculate Q* for every discount

2(5000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5000)(49)
Q2* = = 714 cars/order
(.2)(4.80)

2(5000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
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Quantity Discount Example

Total Demand is 5000 toy cars

Calculate Q* for every discount
2(5000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5000)(49)
Q2* = = 714 cars/order
(.2)(4.80) 1000 — adjusted
2(5000)(49)
Q3* = = 718 cars/order
(.2)(4.75) 2000 — adjusted
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Quantity Discount Example

TABLE Total Cost Computations for Wohl’s Discount Store

ANNUAL ANNUAL ANNUAL
DISCOUNT UNIT ORDER PRODUCT ORDERING HOLDING
NUMBER PRICE QUANTITY COST COST COST TOTAL

1 $5.00 700 $25,000 $350 $350

$25,700

2 $4.80 1,000 $24,000 $245 $480

$24,725

3 $4.75 2,000 $23,750 $950

$122.50 $24,822.50
Choose the price and quantity that gives the lowest total cost
Buy 1000 units at $4.80 per unit

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Quantity Discount Models

LEARNING EXERCISE : Wohl’s has just been offered a third

price break. If it orders 2500 or more cars at a time, the unit
cost drops to $4.60. What is the optimal order quantity now?

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Probabilistic Models and
Safety Stock
▶ Used when demand is not constant or certain
▶ Use safety stock to achieve a desired service
level and avoid stockouts

ROP = d x L + ss

Annual stockout costs = the sum of the units short x

the probability x the stockout cost/unit
x the number of orders per year

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Safety Stock Example

David Rivera Optical has determined that its reorder point for eyeglass frames is
50 (d X L) units. Its carrying cost per frame per year is $5, and stockout (or lost
sale) cost is $40 per frame. The store has experienced the following probability
distribution for inventory demand during the lead time (reorder period). The
optimum number of orders per year is 6.
ROP = 50 units Stockout cost = $40 per items
Orders per year = 6 Holding cost = $5 per item per year
NUMBER OF UNITS PROBABILITY
30 .2
40 .2
ROP  50 .3
60 .2
70 .1
1.0
How much safety stock should David Rivera keep on hand?
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Safety Stock Example

ROP = 50 units Stockout cost = $40 per item

Orders per year = 6 Holding cost = $5 per item per year

We begin by looking at zero safety stock.

SAFETY ADDITIONAL TOTAL
STOCK HOLDING COST STOCKOUT COST COST

20 (20)($5) = $0
$100 $100
(10)($5) = $
10 50 (10)(.1)($40)(6) = $240 $290
(10)(.2)($40)(6) + (20)(.1)($40)(6) =
0 $ 0
$960 $960

70-50 Probability of 70 unit demand

60-50 Probability of 60 unit demand
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Safety Stock Example

ROP = 50 units Stockout cost = $40 per item

Orders per year = 6 Holding cost = $5 per item per year

SAFETY ADDITIONAL TOTAL

STOCK HOLDING COST STOCKOUT COST COST
(20)($5) =
20 $0
$100 $100
(10)($5) = $
10 (10)(.1)($40)(6) = $240
50 $290

0 $ 0 (10)(.2)($40)(6) + (20)(.1)($40)(6) =
$960 $960

The safety stock with the lowest total cost is 20 items.

Therefore, this safety stock changes ROP = 50+20=70 items.

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Fixed-Period (P) Systems (1 of 2)

• Orders placed at the end of a fixed period

• Inventory counted only at end of period
• Order brings inventory up to target level
– Only relevant costs are ordering and holding
– Lead times are known and constant
– Items are independent from one another

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Fixed-Period (P) Systems (2 of 2)

Figure 12.9 Inventory Level in a Fixed-Period (P) System Various amounts (Q1, Q2, Q3, etc.) are ordered at regular time
intervals (P) based on the quantity necessary to bring inventory up to the target quantity (T).

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Fixed-Period Systems

• Inventory is only counted at each review period

• May be scheduled at convenient times
• Appropriate in routine situations
• May result in stockouts between periods
• May require increased safety stock

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Inventory Management:
Special Concerns

▶ Dead inventory (dead stock)

▶ Is a fourth category, D, to ABC analysis where D stands
for either “dogs” or dead inventory (dead stock)
▶ Refers to product for which there is no sales during a
12-month period.

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Inventory Management:
Special Concerns

• Inventory Turnover
– Number of times that inventory is sold in a
one-year period. (Compare with competitors
or benchmarked companies)

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Inventory Turnover Example

▶ Donny's Furniture Company sells industrial furniture for

office buildings. During the current year, Donny reported
cost of goods sold on its income statement of $1,000,000.
Donny's beginning inventory was $3,000,000 and its
ending inventory was $4,000,000. Donny's turnover is
calculated like this:

▶ As you can see, Donny's turnover is .29. This means that Donny only sold
roughly a third of its inventory during the year. It also implies that it would take
Donny approximately 3 years to sell his entire inventory or complete one turn.
In other words, Danny does not have very good inventory control.
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Inventory Management:
Special Concerns
• Complementary Products
– Inventories that can be used or distributed together, i.e.
razor blades and razors.

• Substitute Products
– Products that can fill the same
need or want as another product.
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 Contemporary Approaches to
Managing Inventory
▶ Lean Manufacturing
▶ Just-in-time (JIT)
 Seeks to minimize inventory by reducing (or
eliminating) safety stock while having the
required amount of materials arrive at the
production location at the exact time they are
needed

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Active Learning

What is the LEAN approach to

INVENTORY management?

5 minutes online research.

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 Contemporary Approaches to Managing
Inventory
▶ Vendor-Managed Inventory (VMI)
▶ Size and timing of replenishment orders are the
responsibility of the manufacturer or distributor
▶ Allows manufacturers to have access to a
distributor’s or retailer’s sales and inventory data
▶ Benefits include reduced inventories, fewer
stockouts and improved customer retention

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Contemporary Approaches to Managing
Inventory

• Vendor-Managed Inventory (VMI)

– The basic principles:
 The supplier and its customer agree on which products are to
be managed using in the customer’s distribution centers.
 An agreement is made on reorder points and economic order
quantities for each of these products.
 As these products are shipped from the customer’s distribution
center, the customer notifies the supplier, by SKU, of the
volumes shipped on a real-time basis.

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Discussion Questions
▶ Describe the four types of inventory.
▶ What is the purpose of the ABC classification system?
▶ Identify and explain the types of costs that are involved in
an inventory system.
▶ Explain the major assumptions of the basic EOQ model.
▶ What is the relationship of the economic order quantity to
demand? To the holding cost? To the setup cost?
▶ What is meant by "service level"?
▶ Describe the difference between a fixed-quantity (Q) and
a fixed-period (P) inventory system
▶ What is "safety stock"? What does safety stock provide
safety against?
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Summary

• Inventory represents a major investment for many

firms
• There are four types of inventories:
– Raw material and purchased components
– Work-in-process
– Maintenance, repair, and operating (RMO)
– Finished goods
• There are many methodologies for calculating the
best “Just-in-time” inventory requirements
• Mathematical techniques including the use of Excel
and other software is frequently used
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