Lecture 17

Operations Management
Dr. Jinil Persis
Assistant Professor
IIM Kozhikode
Inventory
• Inventory
• Stock of any item or resource used in an organisation
• Items that contribute to or become part of the final product
Forecast Actual
• Inventory system Demand Demand
• The set of policies and controls that monitor levels of inventory and
determines what levels should • Reorder point
be maintained?
No inventory,
when stock should =
• Order cycle No stockout
be replenished?
< No Inventory,
how large orders
• Order quantity Stockout
should be?
> Inventory, No
stockout
• Inventory allows us
• To maintain independence of operations
• To meet variation in product demand
• To allow flexibility in production scheduling
• To provide a safeguard for variation in raw material delivery time
• To take advantage of economic purchase order size
• Many other domain specific reasons
Inventory related Cost
• Order cost
• Cost incurred in making a purchase order with the supplier, expediting, record keeping and
receiving in the warehouse.
• Setup cost
• To make a product involves getting material/resources required and setting up the machine,
material handling, documentary tasks etc. Sometimes when a product change happens
changeover cost also will be involved.
• Carrying/holding cost
• Cost incurred in managing, maintaining, handling, insuring, storing goods in warehouse. It
could also include rent, cleaning, repairing and protecting warehouse and environment
maintenance such as heating, cooling, lighting required for certain goods.
• Stockout cost
• Each time we run short of raw materials or spare parts or components or finished goods, cost
is incurred due to waiting time and production disruption, lose in sales, dissatisfied customer
Multi period inventory system
• Two option: fixed order cycle or fixed order quantity
• P system – Fixed order cycle (Periodic review system)
• Q system – Fixed order quantity

Inventory level
Time
Number of orders=D/Q

Q system P system
Order quantity with discount consideration
Annual demand of liquid cleanser in a hospital=816 cases
Range Price ($)
Ordering cost=$12
1-49 20
Carrying cost=$4 per case per year
50-79 18
Find
80-99 17
• Optimal order quantity
100 or more 16
• Total cost

Solution:
2𝐷𝑂
EOQ= √ 𝐻 = SQRT(2*816*12/4) =70 cases
𝑄 𝐷
Total cost(@70)= DC + 2 𝐻 + 𝑄 𝑂 = (18*816)+((70/2)*4)+(816*12/70)=$14968
𝑄 𝐷
Total cost(@80)= DC + 2 𝐻 + 𝑄 𝑂 = (17*816)+((80/2)*4)+(816*12/80)=$14154
𝑄 𝐷
Total cost(@100)= DC + 2 𝐻 + 𝑄 𝑂 = (16*816)+((100/2)*4)+(816*12/100)=$13354
Order quantity with discount consideration
(Contd.) Range
1-499
Price (cents)
90

Annual demand of surge electric = 4000 500-999 85

1000 or more 80
Ordering cost=$30
Annual Carrying cost=40% of purchase price/unit
7000

Find 6000

5000

• Optimal order quantity

Total cost
4000

3000

• Total annual cost 2000

1000
Solution: 0
2𝐷𝑂

650
50
100
150
200
250
300
350
400
450
500
550
600

700
750
800
850
900
950
1000
1050
1100
1150
1200
1250
EOQ1-499= √ = SQRT(2*4000*30/(0.4*.90)) =816
𝐻 Q
2𝐷𝑂
EOQ500-999= √ = SQRT(2*4000*30/(0.4*.85)) =840
𝐻 $90 cents $85 cents $80 cents
2𝐷𝑂
EOQ1000+= √ 𝐻 = SQRT(2*4000*30/(0.4*.80)) =866
𝑄 𝐷
Total cost(840)= DC + 2 𝐻 + 𝑄 𝑂 = (.85*4000)+((840/2)*(0.4*.85))+(4000*30/840)=$3686
𝑄 𝐷
Total cost(1000)= DC + 2 𝐻 + 𝑄 𝑂 = (.80*4000)+((1000/2)*(0.4*0.8))+(4000*30/1000)=$3480
 Demand variation
Icurrent Icurrent
Imax Imax

RoP

Stockouts Lead time

Un Steady demand Steady demand
There is a possibility of stockout Say, Annual demand=12000 units
Icurrent If the demand is steady and the system works for 300 days, daily
Imax demand = 40 units
ҧ = 280 𝑢𝑛𝑖𝑡𝑠
If supply lead time is 7 days, then, RoP = 𝑑𝐿

𝜎𝑑𝐿 − 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑑𝑒𝑚𝑎𝑛𝑑

RoP
Z – Number of standard deviations
𝑑ҧ - Average daily demand
ҧ + 𝑧𝜎𝑑𝐿 L- Lead time (constant)
RoP=𝑑𝐿
Case: If demand and lead time are both
constant
Demand of an item is 2 per day. Delivery carrier takes 7 days to deliver
after an order is made. What should be the reorder point?

Solution:
RoP=Demand during lead time = 2*7 = 14 units

Case: If demand and lead time are both constant, RoP= demand during lead time
Case: Demand is variable and lead time is constant
Expected demand during lead time is known
RoP=expected demand during lead time + Safety stock
Where Safety stock = 𝑍𝜎𝑑𝐿𝑇 , 𝜎𝑑𝐿𝑇 -standard deviation of lead time demand
and Z – number of standard deviations

Example
Demand of a construction supply from the historical records during lead time turned out to be N(50,5) tons. If
the manager is not willing to accept stockout risk not more than 3%, then,
• What should be the safety stock?
• What will be the reorder point?

Solution:
SS= 𝑧𝜎𝑑𝐿 =1.88*5=9.4 tons (Z=NORM.S.INV(0.97))
RoP=Expected demand during lead time + safety stock = 50+9.4=59.4 tons
Case: Demand is variable and Lead time is
constant (Contd.) Here, Demand on each day during LT
ҧ + SS
RoP = 𝑑LT
is independent
where 𝑑ҧ is average daily/weekly demand, LT- lead time If two random variables X and Y are
Safety stock = 𝑍𝜎𝑑𝐿𝑇 =Z σ𝐿𝑇 2 independent ,
𝑖=1 𝜎𝑑 = 𝑍𝜎𝑑 𝐿𝑇
𝜎𝑑 = 𝑆𝐷 𝑜𝑓 𝑤𝑒𝑒𝑘𝑙𝑦 𝑜𝑟 𝑑𝑎𝑖𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑

Example:
A restaurant uses an average of 50 jars of sauce per week normally distributed with SD=3 jars. Delivery Lead
time of an order is 2 weeks. The manager is not willing to accept not more than 10% risk of stockout.
Determine reorder point.

Solution:
SS= 𝑧𝜎𝐿 =1.28* σ𝐿𝑇 2
𝑖=1 𝜎𝑑 = 1.28∗ 3 𝐿𝑇=5.4 jars (Z=NORM.S.INV(0.90))
RoP=Expected Demand during lead time + safety stock = (50*2)+5.4=105.4 jars = 106 jars
Case: Demand is steady and Lead time is
variable
• If only lead time is variable, then If X is a random variable and a is a constant,
Safety stock = 𝑍𝜎𝑑𝐿𝑇 =𝑍𝑑𝜎𝐿𝑇 Standard deviation of aX= 𝑎𝜎𝑋
𝜎𝐿𝑇 = 𝑆𝐷 𝑜𝑓 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑑𝑎𝑦𝑠/𝑤𝑒𝑒𝑘𝑠
RoP = 𝑑𝐿𝑇+ SS where 𝑑 is daily/weekly demand,
𝐿𝑇 - average lead time in days/week
Example:
A hotel uses 600 bars of soap each day and this tends to be fairly constant. Lead time of soap delivery is
normally distributed with mean 6 days and SD 2 days. A service level of 90% is desired.

Solution:
d=600
LT=N(6,2) days
Z=1.28 (=NORM.S.INV(0.9))
SS =𝑍𝑑𝜎𝐿𝑇 = 1.28 ∗ 600 ∗ 2 = 1536 𝑢𝑛𝑖𝑡𝑠
RoP=(600*6)+1536=5136 units
Case: Both demand and lead time are variables
• If both demand and lead time are variables, then, RoP = 𝑑ҧ 𝐿𝑇+SS
Safety stock = 𝑍𝜎𝑑𝐿𝑇 = 𝑍 𝐿𝑇𝜎𝑑2 + 𝑑ҧ 2 𝜎𝐿𝑇
2

𝑤ℎ𝑒𝑟𝑒, 𝜎𝑑 = 𝑆𝐷 𝑜𝑓 𝑤𝑒𝑒𝑘𝑙𝑦 𝑜𝑟 𝑑𝑎𝑖𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑,

𝜎𝐿𝑇 = 𝑆𝐷 𝑜𝑓 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑑𝑎𝑦𝑠/𝑤𝑒𝑒𝑘𝑠
Example:
A hotel replaces broken glasses at a rate of 25 per day. This follows a normal distribution with SD 3 glasses
per day. Supplier takes a lead time normally distributed with an average of 10 days and SD of 2 days.
What should be RoP to achieve a service level of 95%.
Solution:
d=600
LT=N(6,2) days
Z=1.64 (=NORM.S.INV(0.95))
SS =𝑍𝑑𝜎𝐿𝑇 = 𝑍 𝐿𝑇𝜎𝑑2 + 𝑑ҧ 2 𝜎𝐿𝑇
2
= 1.64*sqrt((10*3*3)+(25*25*2*2))= 83.46
RoP=(25*10)+84=334 units