Chapter 12 – Independent Demand
Inventory Management
Operations Management
by
R. Dan Reid & Nada R. Sanders
2nd Edition © Wiley 2005
PowerPoint Presentation by R.B. Clough - UNH
Overview of Management 326
Operations and Operations Strategy
Designing an Operations System
Managing an Operations System
Done
Done
We are here
Types of Inventory
Inventory Management Objectives



Maintain good customer service
Keep costs as low as possible, consistent with the
desired level of customer service
Minimize inventory investment
Relevant Inventory Costs
in Inventory Management
Measurable Cost of Inventory =
Item
Costs
+
Holding
Costs
+
Order Costs for
purchased items
OR
Setup Costs for
items made by
your company
+
Shortage costs:
Administrative
& transportation
costs related to
back orders
Shortages and back orders result in lost sales and
lost goodwill. These costs are hard to measure.
Item Costs

Item costs



For purchased items, the item cost is the
purchase price, plus shipping
For work in process, the item cost is the
cost of materials and labor used in the item
For finished goods, the item cost is the
cost of goods sold.
Inventory Holding Costs


Inventory holding costs include capital costs,
storage costs, and risk costs
Capital costs:



If inventory is financed with borrowed money, the
capital cost is the interest rate paid
If inventory is financed from retained earnings,
the capital cost is the opportunity cost of not
putting the money into other investments
Storage costs: the costs of space, people, and
equipment used in inventory storage
Inventory Holding Costs (2)


Risk costs: cost of taxes and insurance
on inventory, damage, obsolescence,
and theft
Inventory holding costs are usually
computed as a percentage of item costs
Ordering and Setup Costs


For purchased items, ordering costs are
the fixed costs associated with placing
an order with a supplier
For items made internally, setup costs
are used instead of order costs
Shortage Costs


Administrative and transportation costs
related to back orders
Lost good will and lost sales due to
product shortages – hard to measure
Dependent Demand



Demand for raw materials, component parts,
and subassemblies used to make a finished
product
Both the amount of demand and the date
required depend on the production schedule
Control systems for dependent demand



Material Requirement Planning (MRP)
Enterprise Resource Planning (ERP)
Just-in-Time
Independent Demand


Any demand that is not dependent is
called independent demand
Examples of independent demand:
finished goods, retail inventories,
distributor inventories, fuels, repair
parts; maintenance, repair, and
operating (MRO) supplies
Inventory Management Policies

An inventory management policy should
determine


How much to order
When to order
Ways to Compute
Optimal Order Quantities

Economic Order Quantity (EOQ)


Used to compute optimal order quantity for
independent demand items
Economic Production Quantity (EPQ)


Order can be delivered in small batches
Often used to determine lot size for parts in
manufacturing (dependent demand)
EOQ Overview



Objective: Minimize the total annual cost (TC) of
placing orders and carrying inventory
Given:
 D = Annual demand (may have to compute from
daily, weekly, or monthly demand)
 S = Cost of placing 1 order
 H = Annual cost of holding 1 unit in inventory
Compute:
 Q = order quantity (amount to order) that
minimizes TC
Economic Order Quantity

EOQ Assumptions:






Demand is known & constant no safety stock is required
Lead time is known & constant
No quantity discounts are
available
Ordering (or setup) costs are
constant
All demand is satisfied (no
shortages)
The order quantity arrives in a
single shipment
Total Cost Function




Annual cost of placing orders =
(cost of 1 order)x(orders per year) = (D/Q)S
Average inventory = (Q+0)/2 = Q/2
Annual cost of holding inventory =
(average inventory)x(annual cost of holding 1 unit in
inventory)
= (Q/2)H
Compute: TC = (D/Q)S + (Q/2)H
Total Annual Inventory Cost with EOQ Model

Total annual cost= annual ordering cost + annual
holding costs
 D Q
TC Q   S   H; and Q 
Q  2 
2DS
H
EOQ Example: A computer company has annual demand of
10,000. They want to determine EOQ for circuit boards which
have an annual holding cost (H) of $6 per unit, and an ordering
cost (S) of $75. Calculate TC and the reorder point (R) if the
purchasing lead time is 5 days.

EOQ (Q)
Q

2DS

H
2 * 10,000 * $75
 500 units
$6
Reorder Point (R)
R  Daily Demand x Lead Time 

10,000
* 5 days  200 units
250 days
Total Inventory Cost (TC)
 10,000 
 500 
TC  
$75



$6  $1500  $1500  $3000
 500 
 2 
Reorder Point
for Constant Demand


Objective: Compute a reorder point, R, to meet
demand during purchasing lead time.
Given:




L = purchasing lead time = time between order placement
and order receipt (may have to convert units, such as
converting weeks to days)
d = daily demand (may have to compute from annual,
monthly or weekly demand).
Compute: R = dL
Note: If N = number of business days per year, then
d = (D/N) and D = dN.
Economic Production Quantity (EPQ)

Same assumptions as the EOQ except: inventory
arrives in increments & is drawn down as it arrives
EPQ Equations

Total cost:
TC EPQ

Maximum inventory:



 D   I MAX 
  S  
H
Q   2

d=avg. daily demand rate
p=daily production rate
Calculating EPQ
I MAX

d
 Q 1  
p

EPQ 
2DS

d

H
1


p


Safety Stock and Service Levels

If demand or lead time is uncertain,
safety stock can be added to
improve order-cycle service levels



R = dL +SS
Where SS =zσdL, and Z is the
number of standard deviations
and σdL is standard deviation of
the demand during lead time
Order-cycle service level
 The probability that demand
during lead time will not exceed
on-hand inventory
 A 95% service level (stockout
risk of 5%) has a Z=1.645
Justifying Smaller Order Quantities
in Manufacturing

JIT or “Lean Systems” recommends reducing order quantities to
the lowest practical levels
EPQ 


2DS

d
H
1  p 



Reduce Q by reducing setup time, which also reduces setup cost.
Reducing Q reduces IMAX and TCQ.
I MAX

d
 Q 1  
p

TC EPQ
 D   I MAX 
  S  
H
Q   2
