CHAPTER 7
Managing
Inventories
Copyright © 2014 McGraw-Hill Higher Education. All rights reserved.
McGraw-Hill/Irwin
Learning Objectives
LO7-1 Define the different types and roles of inventory
LO7-2 Explain the financial impact of inventory
LO7-3 Explain and compute measures of performance
LO7-4 Calculate inventory policy parameters to minimize
total acquisition cost
LO7-5 Determine the cost of a company’s service level
policy
LO7-6 Explain the advantages and disadvantages of
different inventory location strategies
LO7-7 Describe practical techniques for inventory planning
and management
7–2
1
Inventory at PolyCorp
Inventory:
• _______ do I order?
• _________ do I order?
• ________ do I deploy the inventory?
How
much?
LO7‐1
7–3
Types of Inventory
___________: supply of items held to meet demand
Suppliers
Raw Material
Components
MRO
Maintenance, repair &
operating supplies
Work in
Process (WIP)
Finished
Goods (FGI)
Transportation
Distribution
LO7‐1
Customers
7–4
2
Activity
Think of the various stages of inventory
for the following products:
• A piece of furniture
• A pair of shoes
• A grocery product
LO7‐1
7–5
Roles of Inventory
Buffers against
uncertainties:
variation in supply
and demand are
managed with buffer
(safety) stock
Balancing supply
and demand:
decouples
differences in
supply and demand
requirements
LO7‐1
Enabling economies
of buying: price
discounts or
reduced shipping
costs
Roles of
Inventory
Enabling
geographic
specialization:
supply and demand
locations vary
7–6
3
Financial Impact of Inventory
• Opportunity cost
(including cost of
capital)
• Storage and
warehouse
management
• Taxes and
insurance
• Obsolescence,
spoilage, &
shrinkage
• Material handling,
tracking and
management
• Purchased items:
placing and
receiving orders
• Make items:
change-over
between items
• Lost sales or
customer loyalty
• Expediting
• Schedule
disruption
LO7‐2
7–7
Measures of Inventory Performance:
Inventory Turnover
_____________________: ratio of average
inventory on-hand and level of sales
= Cost of goods sold / Average inventory at cost
= Net sales / Average inventory at selling price
= Unit sales / Average inventory in units
With an annual cost of goods sold of $500M and
average inventory of $80M.
Inventory turns = $500/$80 = 6.25 turns
Example 7-2
LO7‐3
7–8
4
Measures of Inventory Performance:
Inventory Turnover – Part II
Advantages of high turn over:
• ‘Fresh’ inventory from high sales
• Reduced risk or mark down from
obsolescence
• Reduced total carrying costs
• Lower asset investment and higher
productivity
Dangers of high turnover:
• Stockouts may mean lower sales
• Increased costs from missing
quantity requirements
• Increased ordering costs
LO7‐3
7–9
Measures of Inventory Performance:
Days, Service Level, Stock outs
• ________________: length of time operations
can be supported with inventory on-hand
Days of supply = Inventory/Daily demand
If inventory is 2M and daily demand is 25,000
day
Example 7-3
Days of supply = 2M/25,000 = 80 days
• ___________: ability to meet customer
demand without a stock out
• ___________: no inventory is available
LO7‐3
7–10
5
Inventory Management Systems
• _________________: demand
is beyond control of the
organization
• _________________: demand
is driven by demand of another
item
LO7‐4
7–11
Continuous Review Model
• _________________: inventory levels are
constantly monitored to determine when
to place a replenishment order
Units in
Inventory
Average
Inventory
Order Point
Time
LO7‐4
Figure 7-1
7–12
6
Total Acquisition Costs
________________________: sum of all relevant
annual inventory costs
– _________________: associated with storing
and assuming risk of having inventory
– _________________: associated with placing
orders and receiving supply
TAC = annual ordering cost + annual carrying cost
LO7‐4
7–13
Total Acquisition Costs
TAC = annual ordering cost + annual carrying cost
= Co (D/Q) + UCi * Q/2
N = D/Q
I = Q/2
Where:
N = orders per year
D = annual demand
Q = order quantity
LO7‐4
I = average inventory level
Co = order cost per order
U = unit cost
Ci = % carrying cost per year
7–14
7
Total Acquisition Costs: Example
If we need 3,000 units per year at a unit price of $20
and we order 500 each time, at a cost of $500 per order
with a carrying cost of 20%, what is the TAC?
N = D/Q = 3000 / 500 = 6 orders per year
I = Q/2 = 500 / 2 = 250 average inventory
TAC = ordering cost + carrying cost
= Co (D/Q) + (UCi )(Q/2)
= $50 (3000/500) + ($20*25%)*(500/2) = $1,300
Where:
N = D/Q
D = 3,000
Q = 500
Co = $50
I = Q/2
Ci = 25%
U = $20
Example 7-4
LO7‐4
7–15
Total Acquisition Costs: Example
If we need 3,000 units per year at a unit price of $20
and we order 200 each time, at a cost of $500 per order
with a carrying cost of 20%, what is the TAC?
N = D/Q = 3000 / 200 = 15 orders per year
I = Q/2 = 200 / 2 = 100 average inventory
TAC = ordering cost + carrying cost
= Co (D/Q) + (UCi )(Q/2)
= $50 (3000/200) + ($20*25%)*(200/2) = $1,150
Where:
N = D/Q
D = 3,000
LO7‐4
Q = 200
Co = $50
I = Q/2
Ci = 25%
U = $20
Example 7-5
7–16
8
Economic Order Quantity (EOQ)
• __________________________________:
minimizes total acquisition costs; point at
which holding and orders costs are equal
• How much to order
D = Annual Demand
Co= Ordering cost
U = Unit cost
Ci = Holding cost
2 DCo
EOQ 
UCi
LO7‐4
7–17
Economic Order Quantity (EOQ)
Carrying + Order
Cost
Carrying Cost
Order Cost
EOQ
LO7‐4
Order Quantity (Q)
7–18
9
Economic Order Quantity (EOQ)
If we need 3,000 units per year at a unit price of
$20, at a cost of $50 per order with a carrying
cost of 20%, what is lowest TAC order quantity?
2 * 3000 * 50
2 DC o
=
EOQ =
20 * 25 %
UC i
= 273 . 86 ⇒ 274
D = 3,000
Co= $50
U = $20
Ci = 25%
Example 7-6
LO7‐4
7–19
Reorder Point – No Uncertainty
• _________________: minimum level of
on-hand inventory that triggers a
replenishment
• When to order
ROP  (d ) t
d = average demand per time period
t = average supply lead time
LO7‐4
7–20
10
Reorder Point – No Uncertainty
If you use 10 units per day, and the lead time for
resupply is 9 days, how low can your inventory
get before placing a new order?
d = 10
t=9
ROP = ( d ) t
= 9 * 10
= 90
Example 7-7
LO7‐4
7–21
EOQ Extensions
Assumptions underlying EOQ:
• No quantity discounts
• No lot size restrictions
• No partial deliveries
• No variability
• No product interactions
LO7‐4
7–22
11
Total Acquisition Costs
D
Q
TAC  Co   UCi   UD
2
Q
Co = Ordering cost
D = Annual demand
Q = Order quantity
U = Unit cost
Ci = Holding cost
LO7‐4
7–23
Total Acquisition Costs
If we need 3,000 units per year at a unit price of
$19, at a cost of $50 per order with a carrying
cost of 20%, what is TAC with a Q=1,000?
D
Q
TAC  Co   UCi   U D
2
Q
 3,000 
 1,000 
 $50
  $19 * 20%
  $19 * 3000
 2 
 1,000 
 $59,050
TAC at unit cost $20 = $61,095, new price saves $2,045
Where: Co = $50
U = $19
LO7‐4
D = 3,000
Ci = 20%
Q = 1,000
Example 7-8
7–24
12
Price Discounts & Lot Sizes
Determining best price break quantity:
Identify price breaks/lot size restrictions
Calculate EOQ for each price/lot size
Evaluate viability of each option
Calculate TAC for each option
Select best TAC option
LO7‐4
7–25
Production Order Quantity
__________________________________:
most economical order quantity when units
become available at rate produced
D = Annual Demand
Co= Ordering cost
Qp
Ci = Holding cost
U = Unit cost
d = daily rate of demand
p = daily rate of production
LO7‐4

2 DC o
 d
Ci U 1  
p

7–26
13
Production Order Quantity
Qp= EOQ
D = 500,000
Co= $2,000
Ci = 25%
U = $10
d = 2,000
p = 5,000
Example 7-9
Qp 

2 DC o
 d
Ci U 1  
p

2 * 500,000 * $2,000
 2,000 
25% * $101 

 5,000 
 36,514.84  36,515
7–27
LO7‐4
Demand During Lead Time
Variation can occur in both demand rates
and lead times
2
 ddlt  t  d  t2
2
d
 ddlt = standard deviation of demand during lead time
t = average lead time
 d = standard deviation of demand
d = average demand
 t = standard deviation of lead time
LO7‐4
7–28
14
Demand During Lead Time
Average demand is 10 units day with standard
deviation of 1.5, and lead time of 10 days with
standard deviation of 2.5 days
2
 ddlt  t d2  d  t2
 9(1.52 )  10 2 (2.52 )
t = 10 days
 d = 1.5 units
 25.4 units
d = 10 per day
 t = 2.5 days
Example 7-7
LO7‐4
7–29
Determining Service Levels
__________________________________:
determining the acceptable stock out risk
level
ddlt
SS  z 
SS = Safety stock
z = standard deviations needed for service level
 ddlt = standard deviation of demand during lead time
LO7‐5
7–30
15
Determining Service Levels
Standard deviation of demand during lead time is
25.4 units, acceptable stock out level is 5% (95%
service level). From the z table = 1.65
SS  z  ddlt
 1 .65 * 25 .4
 42 units
Safety stock carrying cost:
$19 * 42 units * 20% = $159.60 year
Example 7-11
LO7‐5
7–31
Economic Order Quantity (EOQ)
LO7‐5
7–32
16
Revisiting ROP and Average
Inventory
Considering uncertainty
ROP = Reorder point
d = average lead time
t = average demand
SS = Safety stock
Q = order quantity


ROP  d x t  SS
average inventry 
Q
 SS
2
ROP  (10 * 9)  42  132 units
 1000 
average inventory  
  42  542
 2 
Example 7-12
LO7‐5
7–33
Periodic Review Model
__________________________________: fixed
time between inventory review, on-hand level is
unknown during this uncertainty period
UP  OI  t
UP = Uncertainty period
OI = Order interval
t = average lead time
d = average lead time
z = standard deviations needed for service level
Q  d(UP)  z ddup  A
 ddup= standard deviation of demand during the uncertainty period
A = inventory on hand
LO7‐4
7–34
17
Periodic Review Model
Orders are placed every 30 days and average lead
time is 9 days. Standard deviation of demand is
1.5 units.
UP = Uncertainty period
OI = 30 days
t = 9 days
σd = 1.5 units
UP  OI  t
 30  9  39 days
 ddup  (UP) d2
 (39)(1.52 )  9.37
Example 7-13
LO7‐4
7–35
Periodic Review Model
There are currently 105 units in stock
UP = 39 days
OI = 30 days
t = 9 days
d = 10 units
z = 95% = 1.65
 ddup= 9.37
A = 105
Q  d(UP)  z ddup  A
 10(39) 1.65(9.37) 105
 390 16 105
 301units
Example 7-14
LO7‐4
7–36
18
Single Period Inventory Model
• __________________________________: items
are ordered once, and have little left over value
(newsvendor problem)
• __________________________________:
probability of meeting demand
C stockout  Unit selling price  Unit cos t
Coverstock  Unit cos t  Disposal cos t  Salvage cos t
1  TSL Cstockout   TSL Coverstock 
TSL 
LO7‐4
C stockout
C stockout  Coverstock
7–37
Single Period Inventory Model
Units cost $10 and sell for $30, unsold units have
no value, and no disposal or salvage value
C stockout  Unit selling price  Unit cos t
C overstock  Unit cos t  Disposal cos t  Salvage cos t
TSL 
C stockout
C stockout  C overstock
Cso  $30  $10  $20
Cos  $10  0  0  $10
TSL 
LO7‐4
$20
 .667
$20  $10
Example 7-15
7–38
19
Impact of Location on Inventory
__________________________________:
estimation of impact of changing the number of
locations on inventory
SS n 
Nn
Ne
 SS e
SS n = safety stock of the new number of locations
N n = total number of new locations
N e = number of existing locations
SS e = system safety stock for existing locations
LO7‐6
7–39
Impact of Location on Inventory
A single warehouse currently has 1,000 units of
safety stock. How much is needed if a second
warehouse is added?
SS n = safety stock of the new number of locations
Nn = 2
Ne = 1
SS n 
SS e = 1000
Nn
Ne
 SS e
2
x1000
1
Example 7-16
 1,410

LO7‐6
7–40
20
Inventory and Locations
LO7‐6
7–41
Managing Inventory
• ___________________: reducing lot sizes
• ___________________: using ABC
analysis and reducing lead time
• ___________________: balance inventory,
lead time and service levels
• _________________________________:
matching management system to specific
items
LO7‐6
7–42
21
Managing Inventory:
ABC Analysis
• ______________: ranking inventory by
importance
• ________________: small percentage of items
have a large impact on sales, profit or costs
LO7‐6
7–43
Inventory Information Systems and
Accuracy
• Global Trade Item Number
(GTIN): identification system
for finished goods sold to
Identification
consumers
Systems
• Part Number: unique identifier
used by a specific firm
Inventory
Record
Accuracy
LO7‐7
• Cycle Counting: inventory is
physically counted on a routine
schedule
7–44
22
Managing Inventory Across the
Supply Chain
___________________: variation increases
upstream in the supply chain (from consumer to
manufacturers)
LO7‐7
7–45
Managing Inventory Across the
Supply Chain
• ___________________________: the vendor is
responsible for managing inventory for the
customer
–Vendor monitors and replenishes inventory balances
–Customer saves holding costs
–Vendor has higher visibility of inventory usage
• ______________________________________:
supply chain partners sharing information
LO7‐7
7–46
23
Managing Inventories Summary
1. There are multiple types of inventory
2. Inventory fulfills multiple roles
3. Inventory is an asset, and has multiple costs
4. An inventory policy determines how much and when
to order
5. Continuous systems monitor on-hand levels
6. Safety stock levels are linked with service levels
7. Periodic systems count inventory at specific
intervals
8. Number of storage locations impact inventory levels
9. Managers should work to reduce inventory levels
7–47
24