Fall – 2018 – Chapter 4: Inventory Planning and Control

Independent Versus Dependent Demand Inventory

Two general categories of Demand Inventory: Independent and dependent 

  • Dependent demand- represented by an item whose demand is linked directly to the demand or production level of another item
    • Typically used in manufacturing- For example: tires for a bicycle, quantity of tires is dependent on number of bicycles produced
    • Material requirement planning (MRP) systems are planning mechanisms used to determine dependent demand requirements  
  • Independent demand- refers to inventory requirements for finished goods
    • Product ready for consumer to purchase and use

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Channels of Distribution:

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4 Major Types of Inventory Image result for inventory

  1. Raw materials and components- purchased from an outside company or are used to make components
  2. Work in process (WIP)- materials/parts that have been partially formed from raw materials but are not yet finished goods 
  3. Finished goods- Products that are ready to be shipped directly to customers (including wholesalers or retailers)
  4. Maintenance, repair, and operations (MRO)- items that a business needs to operate 

Costs of Inventory

As inventory makes its way from raw materials to finished goods, value and cost increase. Inventory shows up on financial balance sheets in addition to income statements in the form of holding or carrying costs.

Carrying or Holding Costs

Whether inventory is purchased or produced, costs are involved in the acquisition and holding of inventory. Components of holding costs are as follows…

  • Capital or opportunity cost- Interest rates range from 5-25%- Money is borrowed or capital from internal sources ($$$)
  • Physical space occupied by the inventory- Interest rates range from 3-10%- Includes building rent or depreciation, utility costs, insurance, taxes and so on
  • Handling of inventory- Interest rates range from 4-10%- Includes labor costs such as receiving, warehousing, and security and material handling costs
  • Pilferage, scrap, deterioration, and obsolescence- Interest rates rang from 2-5%- the longer inventory sits around, higher the chances something bad happens to it 
Ordering Costs

When ordering additional inventory, two types of cost are involved (which many companies tend to ignore):

  • Fixed Cost- costs that incur no matter what
  • Variable Cost- associated with purchase orders, such as preparing an order request, creating purchase order itself, reviewing inventory levels, etc.
Setup Costs

If you manufacture a product (not a retailer or wholesaler), there are costs associated with changing production over. This is also known as ‘setup costs’. It includes labor, parts and downtime.

Total Cost Minimized

The goal is to minimize total costs. Graphically this occurs at the intersection of holding costs and setup costs. Holding costs and setup costs are inverse, resulting in a tradeoff between the two of them. At the point that those costs intersect is where total costs are minimized. This is calculated by the Economic Order Quantity (EOQ) inventory model.

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The Economic Order Quantity Model –

Answers the Question: How much we need?

Economic order quantity (EOQ)- the order quantity that minimizes total inventory costs by optimizing the tradeoffs between holding and ordering costs. Assumptions of EOQ are as follows…

  • The ordering cost is constant
  • The rate of demand is known and spread evenly
  • The lead time is known and fixed
  • The purchase price of the item is constant
  • The replenishment is made instantaneously, and the entire order is delivered at one time

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3 Types of EOQ Models

  • Basic or Simple Model- already discussed 
  • Production Order Quantity Model- this model assumes that no materials produced are used immediately, resulting in decreasing holding costs. This model takes into account daily production and demand rates. 
  • Quantity Discount Model- this model factors in pricing discounts based on reaching certain minimum purchase quantities. This then compares the effect of buying more than is needed but with a lower price, which may offset the impact on holding costs. 
Basic EOQ Calculation


  • Q= Optimal number of pieces per order (EOQ)
  • D= Annual demand in units for the inventory item
  • S= Setup or ordering cost for each order
  • H= Holding or carrying cost per unit per year

Then you can solve for

  • Annual setup costs: (D/Q)*S
  • Annual holding cost: (Q/2)*H
  • Total Annual cost: (D/Q)*S + (Q/2)*H
  • Economic Order Quantity = square root of 2DS/H

Reorder Point (ROP) Models:

  • Answers the question: When to replenish?
  • Two general approaches: Fixed Quantity Model (Q) and Fixed Period (P) Model
Fixed-Quantity Model

Demand per day * Lead time for a new order- For example: 10 units per day * 3 day lead time = 30 unit ROP

Safety stock

Generally is added on to ROP calculation- ROP= d*LT+ss

  • Probabilistic Safety Stock: Use a confidence level to meet a certain level of variability in demand

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  • Rules of Thumb Safety Stock Calculations
    • Half lead time- divide safety stock by 2
    • Maximum sales less average sales- provides coverage on the upside for the occasional large oversell
    • Statistical safety stock converted to days- uses the safety stock probabilistic models’ unit calculation converted to a days of supply inventory target
Fixed-Period Model

The use of periods of supply targets can be advantageous when you tend to have seasonality with your products, which is one of the main features of Fixed-Period, or P, model. Inventory is continuously monitored.

  • Distribution Requirements Planning (DRP)- tool which enables the user to set inventory control parameters (safety stock for example) to calculate the time-phased inventory requirements

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Single-Period Model

A model used by companies that order seasonal or one-time items. The product typically has no value after the time it is needed. There are costs associated with ordering too much/little, so getting the order right is crucial.

  • Cost of a shortage: (sales price/unit-cost/unit)
  • Cost of an overage: (cost/unit-scrap value/unit

One is then able to determine a service level (probability of not stocking out) by dividing the cost of shortage by combining cost of shortage and overage. The calculated service level can then determine a reorder quantity using the same method as figure 4.5.

The ABC Method of Inventory Planning and Control

ABC analysis- a method used in many inventory systems to stratify or classify items. ABC analysis is based on the Pareto principle (80/20 rule), which states a relatively few number of products generate a large percentage of sales.

Realities of ABC Classification
  • It’s not always based on volume of a product. It’s best to uses sales units. 
  • It’s not always the 80/20 rule. The cut offs for A, B, and C are somewhat subjective.
  • A is not always an A- At multiple locations, different products may be more popular/bring higher revenue
  • History or forecast can be used for ABC Analysis
Other Uses for ABC Classification
  • SKU rationalization- Used to determine candidates for discounted, scrapped, written off or sold at large discount candidates
  • Quality control- Used to analyze quality issues where resources are limited and there are a variety of issues that need to be resolved.
    Image result for abc method of inventory controlImage result for 80/20 rule inventory

Inventory Control and Accuracy

  • Businesses use software to keep perpetual count of inventory in their factory, warehouse, or store. These counts can be inaccurate due to inadequate procedures, lost paperwork, and lack of training. Therefore, physical counts are conducted to verify inventory and determine if large discrepancies exist. 
  • To insure accuracy, companies perform physical inventory counts, where everything stops for 2-3 days, while employees go out and count the inventory performing a blind check. (they are unaware of the actual inventory count)
Cycle Counting
Uses ABC codes to determine when items should be counted and what the target level of accuracy should be. For example, higher-volume/profit A items should be cycled more often and with extremely high accuracy targets. 

Benefits of cycle counting:

  • Less disruptive to daily operations because it is performed during regular hours with business as usual
  • Provides an ongoing measure of inventory accuracy and procedure execution (requiring less safety stock as a result)
  • Accuracy issues are corrected on a timelier basic then an annual physical inventory
  • Tailored to focus on items with higher value, higher movement volume, or that are critical to business processes
  • Trained cycle counters perform the work and usually report to an inventory control manager
  • Root cause analysis is used to ensure that once counts are corrected in the system, they don’t keep occurring. One method is to determine the cause of discrepancy and then take counts daily for that item until there are no issues.

Key Metrics

A number of metrics are important to inventory, but the most commonly used it inventory turnover.

Inventory turnover

  • Reflects the velocity at which inventory is flowing trough your business
  • Both used as a budgetary and planning target and benchmark against best-in-class companies for all forms of inventory
  • Inventory Turnover= Cost of goods sold/Current inventory investment
    • Current investment can be current on-hand inventory or the average of several periods (Beginning inventory + ending inventory)/2
  • High inventory turnover reflects fast moving inventory, which leads to lower holding or carrying cost

Inventory Planning and Control Technology


Inventory control software is usually included in an accounting system or ERP software system as a basic function (although it can be licensed as a standalone system as well)

  • Tracks orders, receipts, shrinkage, allocation, and shipment of products
  • Produces reports such as current inventory balance, out-of-stock products, and inventory transactions

Distribution Requirements Planning Software

Distribution Requirements Planning (DRP) software is more geared to business that have to manage a network of distribution centers

  • Compares future demand versus available inventory to predict future shortages and schedules planned replenishment orders based on user set criteria.
  • DRP is hierarchical- net requirements can be summarized up the supply chain to the plant level to create the master production schedule (MPS), which can then be exploded with a bill of materials (BOM) to generate requirements for raw materials and components

Many inventory systems have barcode or radio frequency identification (RFID) functionality to scan items that are received, picked or transferred.

  • Technology can be used to automate a variety of functions (cycle counting for example)
  • Examples of equipment- barcode scanners, radio frequency tags and readers, mobile handheld computers, and barcode labelers and printers

Presentation Link

  • https://docs.google.com/presentation/d/1w18UVuZ6M5kM1nfpF1wn8wKBsVFSXbJBRGfFkjPrv4c/edit?usp=sharing

Video Links

  • Inventory Control- ABC Analysis: https://www.youtube.com/watch?v=qLGC_hlzu6A
  • Inventory Control for Components- Dependent Demand: https://www.youtube.com/watch?v=F530N76KNYs
  • Inventory Turnover Radio: https://youtu.be/7L9-9rl6g6g

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