DAVIS
F O U R T H
E D I T I O N
AQUILANO
CHASE
chapter 16
Inventory Systems for
Independent Demand
© The McGraw-Hill Companies, Inc., 2003
PowerPoint
Presentation
by
Charlie
Cook
Chapter Objectives
• Introduce the different types of inventories that exist in
a company and provide a rationale for why companies
maintain inventories.
• Identify the various costs associated with carrying and
maintaining inventories.
• Define the classical inventory models and the
conditions necessary for them to be applicable.
• Show how economic order quantity is calculated for
each of the different inventory models.
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
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Chapter Objectives (cont’d)
• Introduce the single-period inventory model and the
concept of yield management with respect to service
operations.
• Present some of the current inventory management
trends and issues that exist in companies today.
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Managerial Issues
• Inventory is no longer viewed as an asset
• Product life cycles are becoming shorter
increasing the likelihood of product
obsolescence.
• Inventory concealing other problems.
• The high costs of inventory storage.
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Definition of Inventory
• Inventory
–The stock of any item or resource used in an
organization, includes raw materials, finished
goods, and work-in-process.
• Inventory Management System
–The set of policies and controls that monitors
levels of inventory and determines:
• What levels should be maintained.
• When stock should be replenished.
• How large orders should be.
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Types of Inventory
• Raw Materials
–Vendor-supplied items that have not had any
labor added by the firm receiving the items.
• Finished Goods
–Completed products that are still in the
possession of the firm that manufactured them.
• Work-in-Process (WIP)
–Items that have been partially processed but are
still incomplete.
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Reason for Maintaining Inventory
• To protect against uncertainty:
–Shortages of raw materials.
–Work-in-process variations.
–Changes in demand for finished products.
• To support a strategic plan
–As a cyclic demand buffer for a level-output
strategy.
• To take advantage of economies of scale
–Large quantity purchases reduce the average
total unit costs related to fixed ordering, setup
costs, and transportation costs.
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Inventory Costs
• Holding and Carrying Costs
–Storage costs (facility, insurance, taxes, utilities)
–Capital costs (opportunity costs)
–Obsolescence/shrinkage costs (depreciated
value)
• Setup or Ordering Costs
• Shortage (or Stockout) Costs
• Purchase Costs
• Transportation Costs
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Independent versus Dependent Demand
• Independent Demand
–The demand that pertains to the requirements
for end products (external market demand).
• Dependent Demand
–The requirements for components that are
directly dependent on the demand for the end
products in which they are used.
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Types of Inventory Systems
• Fixed-Order Quantity
–A system where the order quantity remains
constant but the time between orders varies.
• Preferred for important or expensive items
because average inventory is lower.
• Provides a quicker response to stockouts
• Is more expensive to maintain due to inventory
record-keeping costs.
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Types of Inventory Systems
• Fixed-Time Period
–A system where the time period between orders
remains constant but the order quantity varies.
• Has larger average inventory to prevent stockouts.
• Useful when purchasing multiple items from one
vendor to save on costs.
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Comparison of
Fixed-Order
Quantity and
Fixed-Time Period
Reordering
Inventory Systems
Exhibit 16.1
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Basic Inventory Models
• Fixed-Order-Quantity Model Assumptions:
–Demand for the product is known, constant, and
uniform throughout the period.
–Lead time (L), which is the time from ordering to
receipt, is constant.
–Price per unit of product is constant (no quantity
discounts).
–Ordering or setup costs are constant
–All demands for the product are known with
certainty, no back orders or stockouts.
–There is no interaction with other products.
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Basic Fixed-Order Quantity Model
Exhibit 16.2
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Fixed-Order-Quantity Model
Total annual cost =
Annual purchase cost + Annual ordering cost + Annual holding cost
D
Q
TC  DC  S  H
Q
2
TC
D
C
Q
=
=
=
=
Total Annual Cost
Annual demand in units
Cost per unit
Quantity to be order (the optimum is termed
the economic order quantity—EOQ)
S = Setup or ordering cost
H = Annual holding cost per unit
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Annual Product Cost, Based on Size of Order
Exhibit 16.3
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Fixed-Order-Quantity Model (cont’d)
• Economic Order Quantity
–The optimal quantity to order taking into
consideration both the cost to carry inventory
and the cost to order the item.
–Minimizes total inventory cost
2 DS
EOQ 
H
Fundamentals of Operations Management 4e
D = Annual demand in units
S = Setup or ordering cost
H = Annual holding cost per unit
© The McGraw-Hill Companies, Inc., 2003
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Fixed-Order-Quantity Model (cont’d)
• Reorder Point
–The point in time by which stock must be
ordered to replenish inventory before a stockout
occurs.
R  dL
R  Reorder point
d  Average demand per time period (constant)
L  Number of time periods between placing order and delivery
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Basic Inventory Models
• Fixed Order Quantity Model with Usage
–Considers a supplier that will provide an order
quantity over a period of time rather than all at
once.
TC  DC  D Q S  I max 2H
I max   p  d Q p 
d
p
(p - d)
(Q/p)
= the constant demand rate for the item in production
= production rate of the process
= inventory that accumulates each time period
= number of time periods required to fill the order
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Basic Inventory Models (cont’d)
• Fixed Order Quantity Model with Usage
(cont’d)

D
p  d QH
TC  DC  S 
Q
2p
2 DS
p
EOQ 

H p d
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Fixed Order Quantity Model with
Usage during Production Time
Exhibit 16.4
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Basic Inventory Models (cont’d)
• Fixed-Time-Period Model
–Inventory is counted at fixed intervals.
–Ceiling (par) inventory is established.
–Safety stock level is established.
–Order quantity to return inventory to ceiling
level varies based on on-hand inventory less
safety stock at time inventory is counted.
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Fixed-Time Period Inventory Model
Exhibit 16.5
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Basic Inventory Models (cont’d)
• Quantity-Discount Model
–Addresses price discounts associated with
minimum order quantities.
–Two types of quantity discounts
• Incremental discounts which apply increasing
discounted unit prices as orders reach or exceed
certain quantity levels of units.
• In the all-units approach, discounts are applied to
all units with the unit cost determined by the size
of the purchase order.
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Total Cost Curves for a
Quantity-Discount Model
Exhibit 16.6
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Total Cost Calculations in a
Quantity-Discount Model
Exhibit 16.7
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Inventories and Service Levels
• Determining Safety Stock Levels
–Variation in product demand.
–Variability in the lead time required to replenish
the item.
–The desired level of service that the company
wants to provide its customers.
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The Impact of Variation, Lead Time, and Service Level
on the Amount of Safety Stock (SS) Required
Exhibit 16.8
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Economic Order Quantity Models in
Relation to the Real World
• Costs are difficult to measure.
• Demand is not constant.
• Lack of focus on lot sizing and inventory
control.
• Need to focus on reducing setup costs to
reduce EOQs and total costs.
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Effect of Reduced Setup Costs
on Order Size and Total Costs
Exhibit 16.9
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Perishable Inventory
• Single-Period Inventory Model
–Product is only viable for sale during a single
time period.
–Demand for the product is highly variable, but
follows a known probability distribution.
–The scrap value of the product or the value of
the product after the time period has elapsed is
less than the initial cost of the product.
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Inventory Management in Services
• Yield Management or Revenue Management
–Goal is maximizing capacity utilization by selling
all of a service capacity for some price that
exceeds the service’s variable costs per unit of
service.
–A large proportion of capacity is sold in advance
for reduced prices; some capacity is held for
last-minute customers willing to pay full prices.
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Additional Issues in
Inventory Management
• Determining Realistic Costs
–Accounting data is usually expressed in
averages; marginal costs are needed to
determine proper lot sizes.
–Carrying and ordering costs are not constant.
–Some costs (e.g., obsolescence) are subjective.
• Inventory Accuracy
–Shrinkage, misidentification, and misplaced
items create inventory inaccuracies.
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Cost to Place Orders versus the Number
of Orders Placed: Linear Assumption and
Normal Reality
Exhibit 16.10
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ABC Inventory Planning
• ABC Analysis
–A method for grouping items by dollar volume to
identify those items to be monitored closely.
–Follows the Pareto principle.
–“A” items: high dollar volume (15%)
–“B” items: moderate dollar volume (35%)
–“C” items: low dollar volume (50%)
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Annual Usage of Inventory by Value
Exhibit 16.11
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ABC Grouping of Inventory Items
Exhibit 16.12
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Current Trends in
Inventory Management
• Inventory is a liability, not an asset.
• Average amount of inventory relative to annual
sales is decreasing.
• Firms are focusing on reducing setup and
order costs, resulting in smaller economic
order quantities.
• Firms are working more closely with vendors
to reduce product throughput times and,
consequently, lead times.
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