INVENTORY MANAGEMENT

What is Inventory Management?

●​ The core of operational management activity
●​ A system of keeping track of items in inventory, and the making of decisions about
how much and where to order.

Requirements for effective Inventory Management

1.​ A system to keep track of the inventory on hand and on order.
2.​ A reliable forecast of demand that includes an indication of possible forecast
error.
3.​ Knowledge of lead times and lead time variability.
4.​ Reasonable estimates of inventory holding costs, ordering costs, and shortage
costs.​
5.​ A classification system for inventory items.

Functions of Inventory
1.​ To meet anticipated customer demand.
2.​ To smooth production requirements.
3.​ To decouple operations.
4.​ To protect against stockouts.
5.​ To take advantages of order cycles.
6.​ To hedge against price increases.
7.​ To permit operations
8.​ To take advantage of quality discounts.

Inventory management has two main concerns. One is the level of customer service,
that is, to have the right goods, in sufficient quantities, in the right place, at the right
time. The other is the costs of ordering and carrying inventories.

- the overall objective of inventory management is to achieve satisfactory levels of

customer service while keeping inventory costs within reasonable bounds.

Inventory Model: EOQ

Economic order quantity (EOQ)

EOQ models identify the optimal order quantity by minimizing the sum of certain annual
costs that vary with order size.

Assumptions of the basic EOQ model:

1.​ Only one product is involved.
2.​ Annual demand requirements are known.
3.​ Demand is spread evenly throughout the year so that the demand rate is reasonable
constant
4.​ Lead time does not vary.
5.​ Each order is received in a single delivery.
6.​ There are no quantity discounts.
Formulas

𝐷 𝐷 𝑄
Ordering Costs = 𝑄
𝑆 Total Annual Costs = 𝑄
𝑆 + 2
𝐻

𝑄 𝐷
Holding Costs = 2
𝐻 N= 𝑄

𝑁𝑜. 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

EOQ =
2𝑥𝐷𝑥𝑆 T= 𝑁
ℎ

Where:
S - Ordering or setup cost
H - Holding Cost
Q - Optimum Demand
D - Demand (annual)
N - Expected number of orders
T - Expected time between order

Problem 1: annual demand - 1,000 units; setup/ordering cost - P10/order; holding cost -
P50/unit per year

Ordering Costs =
1,000
10 = 𝑃500 Total Annual Costs =
20
𝐷 𝑄
𝑄
𝑆 + 2
𝐻 = 𝑃500 + 𝑃500 = 𝑃1, 000
20
Holding Costs = 2
𝑃50 = 𝑃500
1,000
N= 20
= 500
2𝑥1,000𝑥𝑃10
EOQ = 𝑃50
= 20 𝑢𝑛𝑖𝑡𝑠 𝑁𝑜. 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
T= 𝑁

Problem 2: 250-day working year and wants to find the number of orders and expected time
between orders

1,000
N= 20
= 50 𝑜𝑟𝑑𝑒𝑟𝑠/𝑦𝑟

250 𝑑𝑎𝑦𝑠
T= 50
= 5 𝑑𝑎𝑦𝑠 𝑖𝑛𝑡𝑒𝑟𝑣𝑎𝑙
DECISION TREES

●​ Pay-off Tables - shows expected pay-offs for each alternatives

●​ EMV Criterion - Expected Monetary Value: usually given by top-level managements
■​ may be from person hired for such purpose, or
■​ benchmarking
●​ Decisions under uncertainty:
a.​ Maximin - alternative with best of the worst (choose the best among the
worst)
b.​ Maximax - best possible pay-off
c.​ Laplace - one with best average pay-off
d.​ Minimax Regret - least worst regrets

PROBLEM
Pay-off Table EMV

Problem 1: New Bridge No New Bridge NB 0.60

NNB 0.40
A (small) 1,000,000 14,000,000 100%
B (medium) 2,000,000 10,000,000

C (large) 4,000,000 6,000,000

a)​ Maximin
Worst: New Bridge (has the least pay-offs)
A ​ ​ 1M
B​ ​ 2M
C​ ​ 4M

b)​ Maximax
Best: No New Bridge (has greater pay-offs)
A ​ 14M
B​ ​ 10M
C​ 6M

c)​ Laplace
A [(1M + 14M) / 2] = 7.5M
B [(2M + 10M) / 2] = 6M
C [(4M + 6M) / 2] = 5M
 d)​ Minimax Regret

New Bridge No New Bridge Best Among

A 4M - 1M = 3M 14M - 14M = 0 3M

B 4M - 2M = 2M 14M - 10M = 4M 4M

C 4M - 4M = 0 14M - 6M = 8M 8M

Step 1: Per column, choose the basis (maximin) which is the highest. Use it to get its
difference in each amount.
Step 2: In the third column, choose among the differences per row the highest.
Step 3: Among the amounts in the third column, choose the lowest possible amount
since we are trying to determine the “regret”.

Decision Tree

Review (Practice Problem)

Alternatives Low Moderate High

Small Facility 70M 70M 70M

Medium 67M 72M 72M

Large 56M 62M 76M

A) Maximin
Worst: Low (has the least pay-offs)
​ Small Facility​​ 70M
​ Medium​ ​ 67M
​ Large​ ​ ​ 56M

B) Maximax
​ Best: High (has the greatest pay-offs)
​ Small Facility​ ​ 70M
​ Medium​ ​ 72M
​ Large​ ​ ​ 76M
C) Laplace
​ Small Facility (70M + 70M + 70M) / 3 =​ ​ 70M
​ Medium (67M + 72M + 72M) / 3 =​ ​ 70.33M
​ Large (56M + 62M + 76M) / 3 =​ ​ 64.67M

D) Minimax Regret

Small Facility Medium Large Best Among

A 70M - 70M = 0 72M - 70M = 2M 76M - 70M = 6M 6M

B 70M - 67M = 3M 72M - 72M = 0 76M - 72M = 4M 4M

C 70M - 56M = 14M 72M - 62M = 10M 76M - 76M = 0 14M

Step 1: Per column, choose the basis (maximin) which is the highest. Use it to get its
difference in each amount.
Step 2: In the third column, choose among the differences per row the highest.
Step 3: Among the amounts in the third column, choose the lowest possible amount since
we are trying to determine the “regret”.

ABC ANALYSIS

●​ Method for dividing on-hand inventory into 3 classifications based on volume.

○​ A-B-C approach: classifies inventory items according to some measure of
importance, usually annual dollar value, and then allocates control efforts
accordingly.
●​ A(important),
●​ B(moderately important), and
●​ C(least important).
○​ Managers use the ABC concept in many different settings to improve
operations. One key use occurs in customer service, where a manager can
focus attention on the most important aspects of customer service by
categorizing different aspects as very important, important, not very important.
○​ ABC concept can also be used toward inventory using cycle counting which is
a physical count of items in inventory.

●​ Application of the “Pareto Principle”

○​ By Vilfredo Pareto, an Italian economist
○​ There are a “critical few and trivial many”
○​ Establish inventory policies that focus resources on the few critical inventory
parts and not the many trivial ones.
●​ Class A: ​ 70 - 80% (annual dollar value is high)
Class B: ​ 15 - 25%
Class C: ​ 5% (ADV is low)
Total: ​ ​ 100%

Example:
 Item Annual Value Unit Cost
XX1 1200 5.80
B66 1110 5.40
3CPO 896 1.10
33CP 1104 7.50
R2D2 1110 2.00
RMS 961 2.20

Step 1: Identify the Annual Dollar Value (ADV) by multiplying annual value with unit cost.
Step 2: Arrange from highest to lowest ADV.
Step 3: Trial and error computation - classify into the 3 classes.

33CP​ ​ ​ 1104 x 7.50 = 8,280

XX1​ ​ ​ 1200 x 5.80 = 6,960
B66​ ​ ​ 1110 x 5.40 = 5,994
R2D2​ ​ ​ 1110 x 2.00 = 2,220
RMS​ ​ ​ 961 x 2.20 = 2,114.2
3CPO​ ​ ​ 896 x 1.10 = 985.6
Total​ ​ ​ ​ 26,553.8

3CPO​ ​ ​ 985.6 / 26,553.8 = 3.71%​ -> Class C

R2D2, RMS​ ​ 2,220 + 2,114.2 / 26,553.8 = 16.32%​​ -> Class B
33CP, XX1, B66 ​ 8,280 + 6,960 + 5,994 / 26,553.8 = 79.97%​ ​ -> Class A