Practice Set 7 Inventory Management
PART I. Qualitative questions
Question 1
What are some of the main reasons for companies to carry inventory?
(a) Inventory is required or unavoidable. In certain industries, it is required by regulations. One
example would be the amount of cash reserve in banks required by the governments.
(b) Inventory supports business operations. It can relieve the pressure of the production system by
decoupling the dependency of various stations in a process, as a result, this increases the flexibility of
the productions and decrease the numbers of setup needed.
(c) Inventory is kept for the unexpected events in a business. For smooth business operations,
businesses often need to keep a certain amount of inventory for the unexpected events like the delay in
delivery of materials.
(d) Inventory is also kept to take the advantage of economic benefits. Because every order incurs a
cost, therefore, the larger of the quantity we order, the less frequent we need to order over a period of
times. This is also known as the economies of scales.
Question 2
List the three types of costs related to inventory.
Holding cost or carrying cost is the cost associated with having inventory in stock, it is the most
significant one in a business because it includes inventory service cost, inventory risk cost, cost of
capital, and the opportunity cost.
Shortage cost is the cost associated with stock out and backlog orders. Other than loss of sales and
profits, it also results in non-monetary impacts like customer dissatisfaction.
Ordering cost is the cost incurred every time when replenishing the inventory from the suppliers. It
includes supplier selection cost and sometimes, the process may involve competitive bidding. We
usually consider ordering cost a fixed cost as it doesn’t vary much with the order quantity.
PART II. Quantitative questions
Question 3 (EOQ model with probabilistic demand)
Daily demand for a certain product is normally distributed with a mean of 60 and standard deviation
of 7. The source of supply is reliable and maintains a constant lead time of six days. The cost of
placing the order is $10 and annual holding costs are $0.50 per unit. There are no stock out costs, and
unfilled orders are filled as soon as the order arrives. Assume sales occur over the entire 365 days of
the year. Find the order quantity and reorder point to satisfy a 95 percent probability of not stocking
out during the lead time. Assume there are 365 working days.
Given: d = 60 units/day; S = $10/order; H = 0.5/unit/year
Once you’ve identified the right numbers, remember to match the units (i.e. day/month/year, etc.). In
this case, we need to calculate the average annual demand in order to match it with the annual
holding cost.
Average annual demand = 60(365) = 21,900
EOQ = !2𝐷𝑆/𝐻 = !2(21900)(10) / 0.5 ≈ 936 units
Given L = 6 days
From the mean and standard deviation of daily demand, we can estimate the mean and standard
deviation of lead time demand as follows:
Average lead time demand = d L = 60(6) = 360; Lead time standard deviation = !d√𝐿 = 7 (√6 ) =
17.1464
A 95% probability of not stocking out during the lead time = service level, we use 0.95 to find the z-
value from the normal distribution table, which is 1.645.
R = d L + z !L = 360 + 1.645 (17.1464) = 388.21 ≈ 388 units
Question 4 (EOQ model with probabilistic demand)
Sarah’s Muffler Shop has one standard muffler that fits a large variety of cars. Sarah wishes to
establish a reorder point system to manage inventory of this standard muffler. Use the following
information to determine the best order size and the reorder point:
Annual demand 3,500 mufflers
Standard deviation of daily demand 6 mufflers per working day
Item cost $30 per muffler
Annual holding cost 25% of item value
Ordering cost $50 per order
Service probability 90%
Lead time 2 working days
Working days 300 per year
Given: D = 3,500 mufflers/year; S = $50/order; H = $30(25%) = $7.5/muffler/year
EOQ = !2𝐷𝑆/𝐻 = !2(3500)(50) / 7.5 ≈ 216 mufflers
L = 2 working days
Given a 90% service level, z-value = 1.28
R = d L + z !L = (3500/300)(2) + 1.28(6√2) = 23.33 + 10.86 = 34.19 ≈ 34 mufflers
Question 5 (EOQ model with probabilistic demand)
A distributor of large appliances needs to determine the order quantities and reorder points for the
various products it carries. The following data refer to a specific refrigerator in its product line:
Cost to place an order $100
Holding cost 20 percent of product cost per year
Cost of refrigerator $500 each
Annual demand 500 refrigerators
Standard deviation during lead time 5 refrigerators
Lead time 7 days
Consider an even daily demand and a 365-working day year.
a) What is the economic order quantity?
Given: D = 500 refrigerators/year; S = $100/order; H = $500(20%) =
$100/refrigerator/year
EOQ = !2𝐷𝑆/𝐻 = !2(500)(100) / 100 ≈ 32 refrigerators
b) If the distributor wants a 97 percent service probability, what reorder point, R, should be
used?
Given a 97% service level, z-value = 1.88
R = d L + z !L = (500/365)(7) + 1.88(5) = 9.59 + 9.4 = 18.99 ≈ 19 refrigerators
*here standard deviation during lead time (!L) is already given as 5, there’s no need to compute by hand
Question 6 (Cost calculation)
Items purchased from a vendor cost $20 each, and the forecast for next year’s demand is 1,000 units.
If it costs $5 every time and order is placed for more units and the storage cost is $4 per unit per year,
what quantity should be ordered each time?
a) What is the total ordering cost for a year?
Given: D = 1,000 units/year; S = $5/order; H = $4/unit/year
EOQ = !2𝐷𝑆/𝐻 = !2(1000)(5) / 4 = 50 units
Total annual ordering cost = S (D/Q) = 5(1000/50) = $100
b) What is the total holding cost for a year?
Total annual holding cost = H (Q/2) = 4(50/2) = $100
Once again, total holding cost and ordering cost should be the same when the company is
ordering the optimal economic quantity.
Question 7 (EOQ model with probabilistic demand)
Given the following information, formulate an inventory management system. The item is demanded
50 weeks a year.
Item cost $10.00
Order cost $250.00
Annual holding cost (%) 33% of item cost
Annual demand 25,750
Weekly demand 515 per week
Standard deviation of weekly demand 25 per week
Lead time 1 week
Service probability 95%
a) State the order quantity and reorder point.
Given: D = 25750 units/year; S = $250/order; H = $10(33%) = $3.3/unit/year
Q = !2𝐷𝑆/𝐻 = !2(25750)(250) / 3.3 ≈ 1975 units
L = 1 week
Given a 95% service level, z-value = 1.645
R = d L + z !L = 515(1) + 1.645(25√1) = 515 + 41.125 = 556.125 ≈ 556 units
b) Determine the annual holding and ordering costs
Total annual ordering cost = S (D/Q) = 250 (25750/1975) =$3,259.12
Total annual holding cost = H (Q/2) = 3.3 (1975/2) = $3,259.12
Once again, total storage cost and ordering cost should be the same when the company is
ordering the optimal economic quantity.
Question 8 (EOQ model - frequency)
Campus Publishing prints textbooks written by faculty and distribute around the world. The Business
English book is particularly popular and has annual sales of 100,000 copies per year. Printing each
copy of the book costs $60. The author is encouraged to come up with revisions (i.e., new editions) to
cater to consumer needs. Each revision will require $250,000 for a new typeset of the book. After a
new edition is released, its sales value is discounted at a rate of $2 every 3 months which means every
three months, the value drops by $2. How frequently should new editions be published?
Given: D = 100,000 copies/ year; S = $250,000/revision, H = $2(12/3) = $8/year
Note: For H, we can find that within a year the total drop in value is 2+2+2+2 = $8. Because a book
is not sold, there is a loss of $2 every three months, then in a year the total loss of holding the
inventory becomes $2 x 4 = $8.
$60 is a variable cost, EOQ model focuses on the fixed cost per batch order
Sales of each edition: Q = !2𝐷𝑆/𝐻 = !2(100000)(250000) / 8 ≈ 79,057 copies
Time between editions: T = Q/D = 79057 / 100000 ≈ 0.79 year ≈ 9.5 months
Question 9 (Safety stock)
Annual demand for a product is 13,000 units; weekly demand is 250 units with a standard deviation of
40 units. The cost of placing an order is $100, and the time from ordering to receipt is four weeks.
The annual inventory carrying cost is $0.65 per unit.
a) To provide a 98 percent service level, what must the reorder point be?
Given: D = 13,000/year (i.e., d = 250/week); L = 4 weeks
Given a 98% service level, z-value = 2.05
R = dL + z !L = 250(4) + 2.05(40 √4) = 1164 units
b) Suppose the production manager is told to reduce the safety stock of this item by 100 units. If
this is done, what will the new service level be?
Recall safety stock = z !L
Target safety stock = 2.05(80) – 100 = 64
Hence,
z (80) = 64
z = 0.8
Check the normal distribution table, a z-value of 0.8 corresponds to a probability of 0.7881.
The new service level would be about 79% (rounded).
Question 10 (Safety stock)
Consider a retailer who plans to expand his business in a new city. He can choose to build a flagship
store to serve the entire city; or he can build 2 regional branch stores, each serving its own region.
Weekly demand in region 1 is normally distributed with mean 2,000 and standard deviation 400.
Weekly demand in region 2 is normally distributed with mean 800 and standard deviation 100. The
lead time for both regions is 2 weeks. Assume a target service level of 95%.
a) How much safety stock will the retailer have to hold if he builds 2 regional stores?
Given a 95% service level, z-value = 1.645
Safety stock in regional store 1 = 1.645 (400√2 ) ≈ 930.55
Safety stock in regional store 2 = 1.645 (100√2) ≈ 232.64
Total safety stock = 930.6 + 232.6 = 1163.2 ≈ 1163
b) How does the safety stock requirement change if the retailer uses a central flagship store?
When one central flagship store is built, the parameters for regional store 1 and 2 are
combined into a new set of parameters.
Specifically, we’re interested in the standard deviation as it affects the safety stock:
Meanwhile, a centralised flagship store can help reduce the total standard deviation among
different regions.
Combined standard deviation would be √4006 + 1006 ≈ 412.31
Safety stock at centralized flagship store = 1.645(412.31√2) = 959.19 ≈ 959
The total safety stock requirement would be reduced by 1163 – 959 = 204.
Question 11 (EPQ model)
Arthur Meiners is the production manager of WheelRite, a small producer of metal parts. WheelRite
supplies CalTex, a larger assembly company, with 10,000 wheel bearings each year. This order has
been stable for some time. Set up cost for WheelRite is $40, and holding cost is $0.6 per wheel
bearing per year. WheelRite can produce 500 wheel bearings per day. CalTex is a just-in-time
manufacturer and requires that 50 bearings be shipped to it each business day.
a) What is the optimum production quantity?
Given: D = 10,000 bearings/ year (d = 50 bearings/day);
p = 500 bearings/day;
S = $40/ production run;
H = $0.6/ bearing/ year;
Q* = !2𝐷𝑆/𝐻(1 − 𝐷/𝑃) = !2 (10000)(40) / 0.6(1 − 10000/100000) ≈ 1217 units
b) What is the maximum number of wheel bearings that will be in inventory at WheelRite?
Imax = Q* (1 – d/p) = 1217 (1 – 50/500) = 1095.3 ≈ 1095 bearings
c) How many production runs of wheel bearings will WheelRite have in a year?
D/ Q* = 10000 / 1217 = 8.22 ≈ 8 production runs in a year
d) What is the total setup + holding cost for WheelRite?
Total annual setup cost = S (D / Q*) = 40 (10000 / 1217) ≈ $329
Total annual holding cost = H (Imax / 2) = 0.6(1095/2) ≈ $329
Total setup + holding cost for WheelRite would be about $658.
Question 12 (EPQ model)
Race One Motors is an Indonesian car manufacturer. At its largest manufacturing facility, in Jakarta,
the company produces subcomponents at a rate of 300 per day, and it uses these subcomponents at a
rate of 12,500 per year (of 250 working days). Holding costs are $2 per item per year, and setup costs
are $30 per production run.
a) What is the economic production quantity?
Given: D = 12,500 items/ year (d = 50 items/ day);
P = 75,000 items/ year (p = 300 items/ day);
S = $30/production run;
H = $2/item/year;
Q* = !2𝐷𝑆/𝐻(1 − 𝑑/𝑝) = !2(12500)(30) / 2(1 − 50/300) ≈ 671 items
b) How many production runs per year will be made?
D / Q* = 12500 / 671 = 18.63 ≈ 19 production runs in a year
c) What will be the maximum inventory level?
Imax = Q* (1 – d/p) = 671 (1 – 50/300) = 559 items
d) What is the annual cost of ordering and holding inventory?
Total annual setup cost = S (D / Q*) = 30 (12500/671) ≈ $559
Total annual holding cost = H ( Imax / 2 ) = 2 (559/2) ≈ $559
Total setup + holding cost for Race One Motors would be $1118.
