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1
Chapter 6: Inventory Control Models
Textbook: pp. 203-254
2
Learning Objectives
After completing this chapter, students will be able to:
• Understand the importance of inventory control.
• Understand the various types of inventory related
decisions.
• Use the economic order quantity (EOQ) to determine how
much to order.
• Compute the reorder point (ROP) in determining when to
order more inventory.
• Handle inventory problems that allow non-instantaneous
receipt.
• Handle inventory problems that allow quantity discounts.
3
Learning Objectives
After completing this chapter, students will be able to:
• Understand the use of safety stock.
• Compute single period inventory quantities using marginal
analysis.
• Understand the importance of ABC analysis.
• Describe the use of material requirements planning in solving
dependent-demand inventory problems.
• Discuss just-in-time inventory concepts to reduce
inventory levels and costs.
• Discuss enterprise resource planning systems.
4
• Inventory is an expensive and important asset
• Any stored resource used to satisfy a current or
future need
o Raw materials
o Work-in-process
o Finished goods
• Balance high and low inventory levels to minimise
costs
Introduction (1 of 3)
5
• Lower inventory levels
• Can reduce costs
• May result in stockouts (frequent inventory outages)
and dissatisfied customers
• All organisations (banks, hospitals, universities …)
have some type of inventory planning and control
system
• We want to study “how organisations achieve their
objectives by supplying goods/services to their
customers”!
Introduction (2 of 3)
6
Components of Inventory Planning and Control System
Introduction (3 of 3)
manufactured or purchase
from third party
Planning Phase
Feedback L
oop
7
Five uses of inventory:
1. The decoupling function
2. Storing resources
3. Irregular supply and demand
4. Quantity discounts
5. Avoiding stockouts and shortages
• Decoupling Function
o Reduces delays and improves efficiency
o A buffer between stages
Importance of Inventory Control (1 of 3)
8
• Storing resources
o Seasonal products stored to satisfy off-season
demand
o Materials stored as raw materials, work-in-process,
or finished goods
o Labour can be stored as a component of partially
completed subassemblies
• Irregular supply and demand
o Not constant over time
o Inventory used to buffer the variability
Importance of Inventory Control (2 of 3)
9
• Quantity discounts
o Lower prices may be available for larger orders
o Higher storage and holding costs (spoilage,
damaged stock, theft, insurance…)
o By investing in more inventory, you will have less
cash to invest elsewhere!
• Avoiding stockouts and shortages
o Stockouts may result in lost sales
o Dissatisfied customers may choose to buy from
another supplier
o Loss of goodwill
Importance of Inventory Control (3 of 3)
10
Two fundamental decisions:
1. How much to order
2. When to order
Major objective is to minimise total inventory costs:
1. Cost of the items (purchase cost or material cost)
2. Cost of ordering (often involves personnel time)
3. Cost of carrying, or holding, inventory (taxes, insurance,
cost of capital…)
4. Cost of stockouts (lost sales and goodwill that result from
not having the items available for the customers)
Inventory DecisionsEconomic Order Quantity (EOQ)
Reorder Point (ROP)
11
Inventory Cost Factors (1 of 2)
12
• Ordering costs are generally independent of order
quantity
o Many involve personnel time
o The amount of work is the same no matter the size
of the order
• Holding costs generally vary with the amount of
inventory or order size
o Labour, space, and other costs increase with order
size
o Cost of items purchased can vary with quantity
discounts
Inventory Cost Factors (2 of 2)
13
• Economic order quantity (EOQ) model
o One of the oldest and most commonly known
inventory control techniques
o Easy to use
o Several important assumptions limits the
applicability of this model!
• Objective is to minimise total cost of inventory
Economic Order Quantity (EOQ) (1 of 2)
14
Assumptions:
1. Demand is known and constant over time
2. Lead time* is known and constant
3. Receipt of inventory is instantaneous (arrives in one batch, at one
point in time!)
4. Purchase cost (= cost of the inventory!) per unit is constant
throughout the year (Quantity discounts are not possible!)
5. The only variable costs are ordering cost and holding or
carrying cost, and these are constant throughout the year
6. Orders are placed so that stockouts or shortages are avoided
completely
When these assumptions are not met – adjustments to the EOQ
must be made!
Economic Order Quantity (EOQ) (2 of 2)
*Lead time = the time between the placement of the order and
the receipt of the order!
15
Inventory Usage Over Time
e.g. 1,000 bananas
If this amount is 1,000 bananas, all 1,000 bananas arrive at one time when
an order is received. The inventory level jumps from 0 to 1,000 bananas (Q).
Demand is constant over time
inventory drops at a uniform rate!
A new order is placed so that when the inventory level reaches 0, the new order
is received and the inventory level again jumps to Q units (vertical line)!
16
• Annual ordering cost is number of orders per year times cost of
placing each order
• Annual carrying cost is the average inventory times carrying cost
per unit per year
Computing Average Inventory:
Inventory Costs in the EOQ Situation
Blank Blank INVENTORY LEVEL Blank
DAY BEGINNING ENDING AVERAGE
April 1 (order received) 10 8 9
April 2 8 6 7
April 3 6 4 5
April 4 4 2 3
April 5 2 0 1
Maximum level April 1 = 10 units Total of daily averages = 9 + 7 + 5 + 3 + 1 = 25
Number of days = 5 Average inventory level = 25÷5 = 5 units
Average Inventory Level =𝑄
2
Based on our assumptions - if we minimise the sum of the
ordering and carrying costs we are minimising the total costs!
17
Inventory Costs in the EOQ Situation (1 of 3)
Q = number of pieces to orderEOQ = Q* = optimal number of pieces to orderD = annual demand in units for the inventory itemCo = ordering cost of each orderCh = holding or carrying cost per unit per year
Number ofOrdering cost
orders placedper order
cost per year
Ordering costAnnual demand
Number of units per order
in each order
Annual
Ordering
o
DC
Q
18
Inventory Costs in the EOQ Situation (2 of 3)
Q = number of pieces to orderEOQ = Q* = optimal number of pieces to orderD = annual demand in units for the inventory itemCo = ordering cost of each orderCh = holding or carrying cost per unit per year
Carrying costAverage
holding per unitinventory
cost per yea
Annual
Order quantity (Carrying cost per unit per year)
2
r
2
h
QC
19
Total Cost as a Function of Order Quantity:
Inventory Costs in the EOQ Situation (3 of 3)
20
• When the EOQ assumptions are met, total cost is
minimised when:
Annual ordering cost = Annual holding cost
Solving for Q:
Finding the EOQ (1 of 2)
2o h
D QC C
Q
2
2
2
2
2
h o
o
h
o
h
Q C DC
DCQ
C
DCQ
C
21
Equation summary:
Finding the EOQ (2 of 2)
22
• Sells pump housings to other companies
• Reduce inventory costs by finding optimal order quantity
Annual demand = 1,000 units
Ordering cost = $10 per order
Average carrying cost per unit per year = $0.50
Sumco Pump Company (1 of 5)
* 2 2(1,000)(10)40,000 200 units
0.50o
h
DCQ
C
Q = number of pieces to order; D = annual demand in units for theinventory item; Co = ordering cost of each order; Ch = holding or carryingcost per unit per year
optimal number of
units per order
23
The total annual inventory cost is the sum of the
ordering costs and the carrying costs:
Number of orders per year = (D÷Q) = 5
Average inventory (Q÷2) = 100
Sumco Pump Company (2 of 5)
2
1,000 200(10) (0.5)
200 2
$50 + $50 $100
o h
D QTC C C
Q
Q = number of pieces to order; D = annual demand in units for theinventory item; Co = ordering cost of each order; Ch = holding or carryingcost per unit per year
24
Sumco Pump Company (3 of 5)
25
• The total inventory cost can be written to include the
cost of purchased items
o Annual purchase cost is constant at D × C no matter
the order policy, where
C is the purchase cost per unit
D is the annual demand in units
• The average dollar level of inventory
Purchase Cost of Inventory Items (1 of 2)
( )Average dollar level
2
CQ
26
• Inventory carrying cost is often expressed as an
annual percentage of the unit cost or price of the
inventory
• When this is the case, a new variable is introduced:
I = (Annual inventory holding charge as a percentage of
unit price or cost)
Cost of storing inventory for one year = Ch = IC
Thus
Purchase Cost of Inventory Items (2 of 2)
* 2 oDCQ
IC
D = annual demand in units for the inventory itemCo = ordering cost of each orderC = unit price or cost of an inventory item
27
• The EOQ model assumes all input values are know
with certainty and fixed over time!
• Values are estimated or may change
• Sensitivity analysis determines the effects of these
changes
• Because the EOQ is a square root, changes in the
inputs (D; Co; Ch) result in relatively minor changes
in the order quantity
Sensitivity Analysis with the EOQ Model (1 of 2)
* 2EOQ o
h
DCQ
C
28
Sumco Pump example:
If we increase Co from $10 to $40
In general, the EOQ changes by the square root of the
change to any of the inputs!
Sensitivity Analysis with the EOQ Model (2 of 2)
2(1,000)(10)EOQ 200 units
0.50
2(1,000)(40)EOQ 400 units
0.50
* 2EOQ o
h
DCQ
C
29
• Next decision is “When to order”
• The time between placing an order and its receipt is
called the lead time (L) or delivery time
• “On hand” and “on order” inventory must be
available to meet demand during lead the total of
these is called “inventory position”
• Generally the “when to order” decision is usually
expressed in terms of a reorder point (ROP; inventory
position at which an order should be placed)
Reorder Point: Determining When To Order
ROP (Demand per day) (Lead time for a new order in days)
d L
30
D = Annual demand = 8,000
d = Daily demand = 40 units
L = Delivery in 3 working days
An order for the EOQ (400) is placed when the inventory
reaches 120 units
The order arrives 3 days later just as the inventory is
depleted to 0!
Procomp’s Computer Chips (1 of 2)
ROP 40 units per day 3 days
120 units
d L
d = Demand per day
L = Lead time for a new order in days
31
Reorder Point Graphs
Time between placing an order and its receipt is called lead time (L)
Q = 400
d = 40 units
L = Delivery in 3 working days
ROP = d * L = 120
ROP < Q 120 < 400
120
400
3 days
120 = 120 + 0
New order placed
when inventory = 120
32
Annual demand = 8,000
Daily demand = 40 units
Delivery in three twelve working days
Suppose the lead time for Procomp Computer Chips was
12 days instead of 3 days. How would this affect the
“reorder point”?
Procomp’s Computer Chips (2 of 2)
33
Annual demand = 8,000
Daily demand = 40 units
Delivery in three twelve working days
New order placed when inventory = 80 and one order is
in transit!
Procomp’s Computer Chips (2 of 2)
34
Reorder Point Graphs
Time between placing an order and its receipt is called lead time (L)
Q = 400
d = 40 units
L = Delivery in 12 working days
ROP = d * L = 480
ROP > Q 480 > 400
80
400
12 days
480 = 80 + 400
New order placed
when inventory = 80
and one order is in
transit!
35
Reorder Point Graphs
Time between placing an order and its receipt is called lead time (L)
Q = 400
d = 40 units
L = Delivery in 12 working days
ROP = d * L = 480
ROP < Q 480 < 400
Q = 400
d = 40 units
L = Delivery in 3 working days
ROP = d * L = 120
ROP < Q 120 < 400
400
400
3 days
12 days
36
• When a firm receives its inventory over a period of
time, a new model is needed that does not require the
“instantaneous inventory receipt assumption”!
• This new model is applicable when inventory
continuously flows or builds up over a period of
time after an order has been placed or when units
are produced and sold simultaneously.
Under these circumstances, the daily demand rate (d)
must be taken into account.
EOQ Without Instantaneous Receipt
37
• Production run model: This graph shows inventory
levels as a function of time. Model especially suited to
the production environment!
Inventory Control and the Production Process:
EOQ Without Instantaneous Receipt
Units are produced and sold simultaneously!
38
• In the production process, instead of having an
ordering cost, there will be a setup cost
Cost of setting up the production facility to manufacture
the desired product!
• Salaries and wages of employees responsible for
setting up the equipment
• Engineering and design costs of making the setup
• Paperwork, supplies, utilities …
Annual Carrying Cost for Production Run
Model (1 of 3)
39
• So how can we derive the optimal production quantity?
• We need to set our “setup costs” equal to “carrying
costs” and then solve for the “order quantity”.
• Let’s start by developing the expression for carrying
cost!
Annual Carrying Cost for Production Run
Model (1 of 3)
40
• As with the EOQ model, the carrying costs of the
production run model are based on the average
inventory, and the average inventory is one-half the
maximum inventory level.
Model variables:
Q = number of pieces per order (production run)
Cs = setup cost
Ch = holding or carrying cost per unit per year
p = daily production rate
d = daily demand rate
t = length of production run in days
Annual Carrying Cost for Production Run
Model (1 of 3)
41
• Maximum inventory level =
(Total produced during the production run)
− (Total used during production run) =
= (Daily production rate)(Number of days production)
− (Daily demand)(Number of days production) =
= (pt) − (dt)
Since Total produced = Q = pt and
Maximum inventory level =
Annual Carrying Cost for Production Run
Model (2 of 3)
= Q
tp
– – 1–Q Q d
pt dt p d Qp p p
p = daily production rated = daily demand ratet = length of production run in days
42
Average inventory is one-half the maximum:
and
Annual Carrying Cost for Production Run
Model (3 of 3)
Average inventory 1–2
Q d
p
Annual holding cost 1–2
h
Q dC
p
43
When a product is produced over time, setup cost
replaces ordering cost:
and
Both of these are independent of the size of the order
and the size of the production run! This cost is simply
the number of orders (or production runs) times the
ordering cost (setup cost).
Annual Setup Cost for Production Run Model
Q = number of orders or production run; Cs = setup cost; D = annual demand rate
44
• Set setup costs equal to holding costs and solve for
the optimal order quantity
o Annual holding cost = Annual setup cost
Solving for Q, we get the optimal production quantity Q*
Determining the Optimal Production Quantity
45
Equation summary:
Production Run Model
*
Annual holding cost 1 – 2
Annual setup cost
2Optimal production quantity
1 –
h
s
s
h
Q dC
p
DC
Q
DCQ
dC
p
46
Brown Manufacturing produces commercial refrigeration units in
batches. The firm’s estimated demand for the year is 10,000
units. It costs about $100 to set up the manufacturing process,
and the carrying cost is about 50 cents per unit per year. When
the production process has been set up, 80 refrigeration units
can be manufactured daily. The demand during the production
period has traditionally been 60 units each day. Brown operates
its refrigeration unit production area 167 days per year.
How many units should Brown produce in each batch?
How long should the production part of the cycle last?
Brown Manufacturing (1 of 4)*
Annual holding cost 1 – 2
Annual setup cost
2Optimal production quantity
1 –
h
s
s
h
Q dC
p
DC
Q
DCQ
dC
p
47
Produces commercial refrigeration units in batches:
Annual demand = D = 10,000 units
Setup cost = Cs = $100
Carrying cost = Ch = $0.50 per unit per year
Daily production rate = p = 80 units daily
Daily demand rate = d = 60 units daily
1. How many units should Brown produce in each batch?
2. How long should the production part of the cycle last?
Brown Manufacturing (1 of 4)*
Annual holding cost 1 – 2
Annual setup cost
2Optimal production quantity
1 –
h
s
s
h
Q dC
p
DC
Q
DCQ
dC
p
48
1.
Brown Manufacturing (2 of 4)
*
*
2
1 –
2 10,000 100
600.5 1 –
80
2,000,00016,000,000
10.54
4,000 units
s
h
DCQ
dC
p
Q
49
1. 2.
Brown Manufacturing (2 of 4)
Annual demand = D = 10,000 units
Setup cost = Cs = $100
Carrying cost = Ch = $0.50 per unit per year
Daily production rate = p = 80 units daily
Daily demand rate = d = 60 units daily
*
*
2
1 –
2 10,000 100
600.5 1 –
80
2,000,00016,000,000
10.54
4,000 units
s
h
DCQ
dC
p
Q
Quantity produced
in each batch
Daily production
rate
50
If Q* = 4,000 units and we know that 80 units can be produced
daily, the length of each production cycle will be days. When
Brown decides to produce refrigeration units, the equipment will
be set up to manufacture the units for a 50-day time span.
The number of production runs per year will be
D/Q = 10,000/4,000 = 2.5.
The average number of production runs per year is 2.5.
There will be 3 production runs in one year with some inventory
carried to the next year
Therefore only 2 production runs are needed in the second year.
Brown Manufacturing (1 of 4)
51
In developing the EOQ model, we assumed that quantity
discounts were not available.
However, many companies do offer quantity discounts.
If such a discount is possible, but all of the other EOQ
assumptions are met, it is possible to find the quantity
that minimises the total inventory cost by using the EOQ
model and making some adjustments!
Quantity Discount Models (1 of 7)
52
• When quantity discounts are available the basic EOQ
model is adjusted by adding in the “purchase or
materials cost” (Logic they change based on order
quantity!):
Total cost = Material cost + Ordering cost + Holding cost
Where D = annual demand in units
Co = ordering cost of each order
C = cost per unit
Ch = holding or carrying cost per unit per year
Quantity Discount Models (2 of 7)
Total cost + + 2
o h
D QDC C C
Q
Q = number of orders or production run
53
Quantity Discount Models (3 of 7)
Holding cost per unit is based on cost per unit (C), so
Ch = IC
Where I = holding cost as a percentage of the unit cost (C)
54
You are now offered following discounts by your supplier:
Will buying at the lowest unit cost
result in lowest total cost?
Overall our objective is to minimise the total cost!
Quantity Discount Models (4 of 7)
55
• Overall our objective is to minimise the total cost.
• Because the unit cost (4.75) for the third discount is
lowest, we might be tempted to order 2,000 units or more
to take advantage of the lower material cost.
• Placing an order for that quantity with the greatest discount
cost might not minimise the total inventory cost.
• As the discount quantity goes up, the material cost goes
down, but the carrying cost increases because the orders
are large.
• Key trade-off when considering quantity discounts is
between the reduced material cost and the increased
carrying cost!
Quantity Discount Models (5 of 7)
56
Total Cost (TC) Curve for the Quantity Discount Model
Quantity Discount Models (6 of 7)
57
Steps in the process:
1. For each discount price (C), compute
2. If EOQ < Minimum for discount, adjust the quantity to Q
= Minimum for discount
3. For each EOQ or adjusted Q, compute
4. Choose the lowest-cost quantity
Quantity Discount Models (7 of 7)
2EOQ oDC
IC
Total cost + + 2
o h
D QDC C C
Q
58
Brass Department Store stocks toy race cars. Recently,
the store was given a quantity discount schedule for the
cars. The ordering cost is $49 per order, the annual
demand is 5,000 race cars, and the inventory carrying
charge as a percentage of cost, I, is 20%.
Discount schedule:
What order quantity will minimise the total inventory cost?
Brass Department Store (1 of 6)
59
Toy race cars:
Quantity discounts available
Step 1 – Compute EOQs for each discount
Brass Department Store (2 of 6)
60
Total Cost (TC) Curve for the Quantity Discount Model
Quantity Discount Models (6 of 7)
61
Step 2 – If EOQ < Minimum for discount, adjust the
quantity to Q = Minimum for discount
Brass Department Store (3 of 6)
2EOQ oDC
IC
62
Step 2 – If EOQ < Minimum for discount, adjust the
quantity to Q = Minimum for discount
• The EOQ for discount 1 is allowable
• The EOQs for discounts 2 and 3 are outside the
allowable range, adjust to the possible quantity closest
to the EOQ
Q1 = 700
Q2 = 1,000
Q3 = 2,000
Brass Department Store (3 of 6)
63
Step 3 – Compute total cost for each quantity
Total Cost Computations for Brass Department Store:
Step 4 – Choose the alternative with the lowest total cost
Brass Department Store (4 of 6)
64
Step 3 – Compute total cost for each quantity
Total Cost Computations for Brass Department Store:
Step 4 – Choose the alternative with the lowest total cost
Brass Department Store (4 of 6)
65
Reorder Point Graphs
Time between placing an order and its receipt is called lead time (L)
400
400
3 days
12 days
• When the EOQ assumptions
are met, it is possible to
schedule orders to arrive so
that stockouts are completely
avoided!
• If the demand or the lead
time is uncertain, the exact
demand during the lead time
(ROP in the EOQ situation)
will not be known with
certainty!
• Therefore, to prevent
stockouts, it is necessary to
carry additional inventory
called safety stock.
66
• If demand or the lead time are uncertain, the exact
ROP will not be known with certainty!
• To prevent stockouts, it is necessary to carry additional
inventory called safety stock.
• Can be implemented by adjusting the Reorder Point
(ROP)
ROP = (Average demand during lead time) + Safety stock
ROP = (Average demand during lead time) + SS
where SS = safety stock
Use of Safety Stock (1 of 4)
67
Use of Safety Stock (2 of 4)
• When demand is
unusually high during
the lead time, you dip into
the safety stock instead of
encountering a stockout!
• The main purpose of
safety stock is to avoid
stockouts when the
demand is higher than
expected.
68
• Objective is to choose a safety stock amount the
minimises total holding and stockout costs
• If variation in demand and holding and stockout costs
are known, payoff/cost tables could be used to
determine safety stock
• More general approach is to choose a desired service
level based on satisfying customer demand
Use of Safety Stock (3 of 4)
69
• Set safety stock to achieve a desired service level
Service level = 1 − Probability of a stockout
or
Probability of a stockout = 1 − Service level
Use of Safety Stock (4 of 4)
70
ROP = (Average demand during lead time) + ZσdLT
where
Z = number of standard deviations for a given service level
σdLT = standard deviation of demand during the lead time
Thus Safety stock = ZσdLT
Safety Stock with the Normal Distribution
71
• Item A3378 has normally distributed demand during
lead time
Mean = 350 units, standard deviation = 10
• Stockouts should occur only 5% of the time
Hinsdale Company (1 of 8) --- Safety Stock and
the Normal Distribution
μ = Mean demand = 350
σdLT = Standard deviation = 10
X= Mean demand + Safety stock
SS= Safety stock = X − μ = Zσ
XZ
72
From Appendix A we find Z = 1.65
ROP = (Average demand during lead time) + ZsdLT
= 350 + 1.65(10)
= 350 + 16.5 = 366.5 units (or about 367 units)
Hinsdale Company (2 of 8)
SSX
73
Three situations to consider:
o Demand is variable but lead time is constant
o Demand is constant but lead time is variable
o Both demand and lead time are variable
Calculating Lead Time Demand and Standard
Deviation (1 of 4)
74
1. Demand is variable but lead time is constant
where
Calculating Lead Time Demand and Standard
Deviation (2 of 4)
ROP ddL Z L
average daily demand
standard deviation of daily demand
lead time in days
d
d
L
75
2. Demand is constant but lead time is variable
where
Calculating Lead Time Demand and Standard
Deviation (3 of 4)
ROP LdL Z d
average lead time
standard deviation of lead time
daily demand
L
L
d
76
3. Both demand and lead time are variable
• The most general case
• Can be simplified to the earlier equations
Calculating Lead Time Demand and Standard
Deviation (4 of 4)
2 2 2ROP d LdL Z L d
77
• Determine safety stock for three other items
• For SKU F5402,
• Desired service level = 97%
o For a 97% service level, Z = 1.88
Hinsdale Company (3 of 8)
= 15, = 3, = 4dd L
ROP
15(4) + 1.88(3 4) 15(4) + 1.88(6)
60 + 11.28 71.28
ddL Z L
78
• For SKU B7319,
• Desired service level = 98%
o For a 98% service level, Z = 2.05
Hinsdale Company (4 of 8)
= 25, = 6, = 3Ld L
ROP
25(6) + 2.05(25)(3) 150 + 2.05(75)
150 + 153.75 303.75
LdL Z d
79
• For SKU F9004,
• Desired service level = 94%
o For a 94% service level, Z = 1.55
Hinsdale Company (5 of 8)
= 20, = 4, = 5, = 2d Ld L
2 2 2
2 2 2
ROP
(20)(5) + 1.55 5(4) + (20) (2)
100 + 1.55 1680
100 + 1.55(40.99) 100 + 63.53 163.53
d LdL Z L d
80
• As service levels increase
o Safety stock increases at an increasing rate
• As safety stock increases
o Annual holding costs increase
Service Levels, Safety Stock, and Holding
Costs
81
Safety Stock for SKU A3378 at Different Service Levels:
Hinsdale Company (6 of 8)
82
Under standard assumptions of EOQ
o Average inventory = Q÷2
o Annual holding cost = (Q÷2)Ch
With safety stock
Calculating Annual Holding Cost with Safety
Stock
Holding cost ofTotal annual Holding cost of
regularholding cost safety stock
inventory
THC (SS)2
h h
QC C where THC = total annual holding cost
Q = order quantity
Ch = holding cost per unit per year
SS = safety stock
83
Service Level Versus Annual Carrying Costs:
Hinsdale Company (7 of 8)
84
• The purpose is to divide the inventory into three
groups (A, B, and C) based on the overall inventory
value of the items
• Group A items account for the major portion of
inventory costs (high price!)
o Typically 70% of the dollar value but only 10% of the
quantity of items
o Great care should be taken in forecasting the demand
and developing good inventory management policies for
this group!
o Mistakes can be expensive!
ABC Analysis (1 of 5)
A prudent manager should spend more time managing those items
representing the greatest dollar inventory cost because this is where
the greatest potential savings are.
85
• Group B items are more moderately priced
o Items represent about 20% of the company’s
business in dollars, and about 20% of the items in
inventory
o Not appropriate to spend as much time developing
optimal inventory policies for this group as with the A
group since inventory costs are much lower!
o Moderate levels of control!
ABC Analysis (2 of 5)
86
• Group C items are very low cost but high volume
o These items may constitute only 10% of the company’s
business in dollars, but they may consist of 70% of the
items in inventory.
o It is not cost effective to spend a lot of time managing
these items!
o For the group C items, the company should develop a
very simple inventory policy, and this may include a
relatively large safety stock.
o Since the items cost very little, the holding cost
associated with a large safety stock will also be very
low.
ABC Analysis (3 of 5)
87
• More care should be taken in determining the safety
stock with the higher priced group B items.
• For the very expensive group A items, the cost of
carrying the inventory is so high, it is beneficial to
carefully analyse the demand for these so that safety
stock is at an appropriate level!
• Otherwise, the company may have exceedingly high
holding costs for the group A items.
ABC Analysis (4 of 5)
88
Summary of ABC Analysis:
ABC Analysis (5 of 5)
89
• End of chapter self-test 1-14
(pp. 243-244)
Compile all answers into one
document and submit at the
beginning of the next lecture!
On the top of the document,
write your Pinyin-Name and
Student ID.
• Please read Chapter 11!
Homework --- Chapter 6