Inventory

Control Models
 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.
 Use of Safety Stock

Safety stock is extra stock kept on hand. It helps in avoiding stock outs.
When the EOQ assumptions are met, it is possible to schedule orders to arrive so that stock-outs are
completely avoided. However, if the demand or the lead time is uncertain, the exact demand during the lead
time (which is the ROP in the EOQ situation) will not be known with certainty. Therefore, to prevent stock
outs, it is necessary to carry additional inventory called safety stock.

When demand is unusually high during the lead time, you dip into the safety stock in-stead of encountering a
stock out. Thus, the main purpose of safety stock is to avoid stock outs when the demand is higher than
expected. Its use is shown in Figure 6.7. Note that although stock outs can often be avoided by using safety
stock, there is still a chance that they may occur. The demand may be so high that all the safety stock is used
up, and thus there is still a stock out.
One of the best ways to implement a safety stock policy is to adjust the reorder point. In
the EOQ situation where the demand and lead time are constant, the reorder point is simply
the amount of inventory that would be used during the lead time (i.e., the daily demand
times the lead time in days). This is assumed to be known with certainty, so there is no
need to place an order when the inventory position is more than this. However, when the
daily demand or the lead time fluctuates and is uncertain, the exact amount of inventory
that will be used during the lead time is uncertain. The average inventory usage during the
lead time should be computed, and some safety stock should be added to this to avoid stock
outs. The reorder point becomes
ROP = 1Average demand during lead time2 + 1Safety stock2
ROP = 1Average demand during lead time2 + SS
where:
SS = safety stock
 Safety stock is included in the ROP.
How to determine the correct amount of safety stock is the only remaining question.
How is the optimum stock level determined?

However, a more general approach is to determine what service level is desired and then find the safety stock level that
would accomplish this. A prudent manager will look at the holding cost and the stock out cost to help determine an
appropriate service level. A service level indicates what percentage of the time customer demand is met. In other words,
the service level is the percentage of time that stock outs are avoided. Thus,
Service level = 1 - Probability of a stock out
or
Probability of a stock out = 1 - Service level

Once the desired service level is established, the amount of safety stock to carry can be found using the probability
distribution of demand during the lead time.
SAFETY STOCK WITH THE NORMAL DISTRIBUTION Equation 6-15 provides the general formula for
determining the reorder point. When demand during the lead time is normally distributed, the reorder point becomes

ROP = 1Average demand during lead time2 +

where
Z = number of standard deviations for a given service level
= standard deviation of demand during the lead time

Thus, the amount of safety stock is simply . The following example looks at how to determine the appropriate
safety stock level when demand during the lead time is normally distributed and the mean and standard deviation are
known.
 CALCULATING LEAD TIME DEMAND
AND STANDARD DEVIATION
If the mean and standard deviation of demand during the lead time are not known, they must be calculated from
historical demand and lead time data. Once these are found, Equation 6-16 can be used to find the safety stock
and reorder point. Throughout this section, we assume that lead time is in days, although the same procedure
can be applied to weeks, months, or any other time period. We will also assume that if demand fluctuates, the
distribution of demand each day is identical to and independent of demand on other days. If both daily demand
and lead time fluctuate, they are also assumed to be independent.
Safety Stock and the Normal Distribution
There are three situations to consider. In each of the following ROP formulas, the average demand during the lead time
is the first term and the safety stock ( )is the
second term.
1. Demand is variable but lead time is constant:
CALCULATING ANNUAL HOLDING COST WITH SAFETY STOCK When the EOQ assumptions of constant
demand and constant lead time are met, the average inventory is Q>2, and the annual holding cost is (Q/2)C h. When
safety stock is carried because demand fluctuates, the holding cost for this safety stock is added to the holding cost of the
regular inventory to get the total annual holding cost.
Total annual holding cost = Holding cost of regular inventory + Holding cost of safety stock
 Single-Period Inventory Models

A decision-making approach using marginal profit and marginal loss is called marginal analysis. Marginal profit
(MP) is the additional profit achieved if one additional unit is stocked and sold. Marginal loss (ML) is the loss that
occurs when an additional unit is stocked but cannot be sold.
When there are a manageable number of alternatives and states of nature and we know the probabilities for each
state of nature, marginal analysis with discrete distributions can be used.

When there are a very large number of possible alternatives and states of nature and the probability distribution of
the states of nature can be described with a normal distribution, marginal analysis with the normal distribution is
appropriate.
 Marginal Analysis with Discrete Distributions
Finding the inventory level with the lowest cost is not difficult when we follow the marginal analysis procedure. This
approach says that we would stock an additional unit only if the expected marginal profit for that unit equals or
exceeds the expected marginal loss. This relationship is expressed symbolically as follows:
P = probability that demand will be greater than or equal to a given supply (or the probability of selling at least one
additional unit)
1 - P = probability that demand will be less than a given supply (or the probability that one additional unit will not
sell)
The expected marginal profit is found by multiplying the probability that a given unit will be sold by the marginal
profit, P(MP). Similarly, the expected marginal loss is the probability of not selling the unit multiplied by the marginal
loss, or (1 - P)(ML).
The optimal decision rule is to stock the additional unit if P(MP) 1 –P)ML
With some basic mathematical manipulations, we can determine the level of P for which this relationship holds:

In other words, as long as the probability of selling one more unit (P) is greater than or equal to ML/(MP + ML), we
would stock the additional unit.
Marginal Analysis with the Normal Distribution

When product demand or sales follow a normal distribution, which is a common business situation, marginal analysis
with the normal distribution can be applied. First, we need to find four values:

Once these quantities are known, the process of finding the best stocking policy is somewhat similar to marginal analysis
with discrete distributions. We let X* = optimal stocking level.
 ABC Analysis
The purpose of ABC analysis is to divide all of a company’s inventory items into three groups (group A, group B, and
group C) based on the overall inventory value of the items. 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. A
brief description of each group follows, with general guidelines as to how to categorize items.
Dependent Demand: The Case for Material Requirements
Planning
In all the inventory models discussed earlier, we assume that the demand for one item is independent of the demand for other items. products
and compute the requirements for component parts.

As with the inventory models discussed previously, the major questions that must be answered are how much to order and when to order. But
with dependent demand, inventory scheduling and planning can be very complex indeed. In these situations, material requirements planning
(MRP) can be employed effectively. Some of the benefits of MRP follow:
1. Increased customer service and satisfaction
2. Reduced inventory costs
3. Better inventory planning and scheduling
4. Higher total sales
5. Faster response to market changes and shifts
6. Reduced inventory levels without reduced customer service
Although most MRP systems are computerized, the analysis is straightforward and similar from one computerized system to the next. Here is
the typical procedure.
 Material Structure Tree
 We begin by developing a bill of materials (BOM). The BOM identifies the components, describes them, and
indicates the number required in the production of one unit of the final product. From the BOM, we develop a
material structure tree.

 The structure tree has three levels: 0, 1, and 2. Items above any level are called parents, and items below any level
are called components.
 Parents and components are identified in the material structure tree.
 The material structure tree shows how many units are needed at every level of production.
Let’s say that demand for product A is 50 units. Each unit of A requires 2 units of B and 3 units of C. Now, each unit of B
requires 2 units of D and 3 units of E. Furthermore, each unit of C requires 1 unit of E and 2 units of F. Thus, the demand
for B, C, D, E, and F is completely dependent on the demand for A. Given this information, a material structure tree can be
developed for the related inventory items.
After the material structure tree has been developed, the number of units of each item required to satisfy demand can be
determined. This information can be displayed as follows:

Part B: 2 * number of A>s = 2 * 50 = 100

Part C: 3 * number of A>s = 3 * 50 = 150
Part D: 2 * number of B>s = 2 * 100 = 200
Part E: 3 * number of B>s + 1 * number of C>s = 3 * 100 + 1 * 150 = 450
Part F: 2 * number of C>s = 2 * 150 = 300
Thus, for 50 units of A we need 100 units of B, 150 units of C, 200 units of D, 450 units of E, and 300 units of F. Of
course, the numbers in this table could have been determined directly from the material structure tree by multiplying
the numbers along the branches times the demand for A, which is 50 units for this problem. For example, the number
of units of D needed is simply 2 * 2 * 50 = 200 units.
Gross and Net Material Requirements Plans

 Once the materials structure tree has been developed, we

construct a gross material requirements plan. This is a
time schedule that shows when an item must be ordered
from suppliers when there is no inventory on hand or
when the production of an item must be started in order
to satisfy the demand for the finished product at a
particular date.
 Use on-hand inventory to compute net requirements.
 Just-In-Time Inventory Control
With JIT, inventory arrives just before it is needed.

With this approach, inventory arrives just in time to be used during the
manufacturing process to produce subparts, assemblies, or finished goods. One technique of implementing JIT
is a manual procedure called kanban. Kanban in Japanese means “card.” With a dual-card kanban system, there
is a conveyance kanban, or C-kanban, and a production kanban, or P-kanban. The kanban system is very simple.
 Four Steps of Kanban
Arrow 1: As shown in Figure 6.16, full containers along with their C-kanban card are taken from the storage
area to a user area, typically on a manufacturing line (see arrow 1).
Arrow 2: During the manufacturing process, parts in the container are used up by the user. When the container
is empty, the empty container along with the same C-kanban card is taken back to the storage area (depicted by
arrow number 2). Here the user picks up a new full container, detaches the P-kanban card from it, attaches his or
her C-kanban card to it, and returns with it to the user area (depicted by arrow number 1 again).
Arrow 3: This detached P-kanban card is attached to an empty container in the storage area and then—and only
thenis the empty container taken back to the upstream producer area (depicted by arrow number 3).

Arrow 4: This empty container is then refilled with parts and taken with its P-kanban card
back to the storage area (depicted by arrow number 4). This kanban process continuously cycles throughout the
day. Kanban is sometimes known as a “pull” production system.
 Enterprise Resource Planning
Over the years, MRP has evolved to include not only the materials required in production but also the labor
hours, material cost, and other resources related to production. When approached in this fashion, the term MRP
II is often used, and the word resource replaces the word requirements. As this concept evolved and
sophisticated computer software programs were developed, these systems were called enterprise resource
planning (ERP) systems.
The objective of an ERP system is to reduce costs by integrating all of the operations of a firm. This starts with
the supplier of the materials needed and flows through the organization to include invoicing the customer for the
final product. Data are entered once into a database, and then these data can be quickly and easily accessed by
anyone in the organization. This benefits not only the functions related to planning and managing inventory but
also other business processes such as accounting, finance, and human resources.
The benefits of a well-developed ERP system are reduced transaction costs and increased speed and accuracy of
information. However, there are drawbacks as well. The software is expensive to buy and costly to customize.
The implementation of an ERP system may require a company to change its normal operations, and employees
are often resistant to change. Also, training employees on the use of the new software can be expensive.
There are many ERP systems available. The most common ones include SAP, Oracle, and PeopleSoft. Even
small systems can cost hundreds of thousands of dollars. The larger systems can cost hundreds of millions of
dollars.