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Prof. Kishore Kumar Mahato- VIT University
Inventory
Types of Inventory
• WIP
• raw materials
• finished goods
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Prof. Kishore Kumar Mahato- VIT University
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Prof. Kishore Kumar Mahato- VIT University
Inventory Functionality and Definitions
Inventory management involves risk which varies depending upon a firms position in the
distribution channel .
The typical measures of inventory exposure are time duration, depth, and width of
commitment.
1. Manufacturer
For a manufacturer inventory risk is long term. Its begin with raw material and components
parts purchase, include work-in-process, and ends with finished goods.
In addition finished goods are often placed in warehouses in anticipation of customer demand.
In some situation, manufactures are requested to consign inventory to customer facilities.
Although a manufacturer, typically has a narrower product line than a retailer or wholesaler,
the manufacturers inventory commitment is deep and of long duration.
Order costs
• Fixed
• Variable
Holding Costs
• Insurance
• Maintenance and Handling
• Taxes
• Opportunity Costs
• Obsolescence
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The Inventory Cycle
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Prof. Kishore Kumar Mahato- VIT University
Inventory Analysis Methods
ABC Analysis
This analysis categorizes items based on their annual consumption value. Sometimes, Inventory
Managers can Use Pareto’s Principle for classification.
Pareto’s Principle classifies the important items in a certain group that usually constitute a small
portion of the total items in the group. Then, the majority of the items, as a whole, will seem to
be of minor significance.
Here is how ABC Analysis looks like:
A: 10% of total inventories contributing to 70% of total consumption
value.
B: 20% of total inventories, which account for about 20% of the total
consumption value.
C: 70% of total inventories, which account for only 10% of the total
consumption value.
This can then be further supplemented by XYZ Analysis, which helps forecast the difficulty of
selling a particular item. X is used as a symbol for those that are easier to sell, whereas Z classifies
the most difficult items to sell
F stands for Fast moving, S for Slow moving and N for Nonmoving items.
VED Analysis
This is an analysis whose classification is dependent on the user’s experience and perception.
This analysis classifies inventory according to the relative importance of certain items to other items, like in
spare parts. In VED Analysis, the items are classified into three categories which are:
SDE Analysis
This analysis classifies inventory based on how freely available an item or
scarce an item is, or the length of its lead time. This is how the inventory is
classified:
Lot, or batch size: quantity that a supply chain stage either produces or orders
at a given time.
Cycle inventory is held primarily to take advantage of economies of scale in
the supply chain and reduce cost within a supply chain.
Cycle inventory: average inventory that builds up in the supply chain because
a supply chain stage either produces or purchases in lots that are larger than
those demanded by the customer
Q = lot or batch size of an order
D = demand per unit time
Ideally, cycle inventory decisions should consider costs across the entire supply chain, but in
practice, each stage generally makes its own supply chain decisions. This increases total cycle
inventory and total costs in the supply chain
• Therefore, cycle inventory adds 5 days to the time a unit spends in the supply chain
• Lower cycle inventory is better because:
• Average flow time is lower. The larger the cycle inventory, the longer is the lag time between
when a product is produced and when it is sold. A lower level of cycle inventory is always
desirable, because long time lags leave a firm vulnerable to demand changes in the marketplace.
• Working capital requirements are lower
• Lower inventory holding costs
If
Q = 1000 units
D =100 units/day
Cycle Inventory = ?
Average flow time = ?
𝑸
𝑪𝒚𝒄𝒍𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 =
Assume holding cost of one bottle = 0.50 paise
𝟐 Then for 5 days => Holding Cost = 0.50 x 5 = 2.50
Cycle inventory =
Rupees
1000
= 500 = Average Inventory level from cycle
2
inventory If your Profit = 4 Rs. Per bottle
𝑸
Then if a bottle is stored and sold after 5 days
𝟐𝑫
( Rs. 4.00 – Rs. 2.50 = Rs.1.50)
The primary role of cycle inventory is to allow different stages to purchase products in lot sizes that minimize the
sum of material, ordering, and holding costs.
Ideally cycle inventory decisions should consider costs across the entire supply chain, but in practice, each stage
generally makes its own supply chain decisions – increases total cycle inventory and total costs in the supply chain
decisions – increases total cycle inventory and total costs in the supply chain
For example, apparel is shipped from Asia to North America in full container loads to reduce the
transportation cost per unit.
Similarly, an integrated steel mill produces hundreds of tons of steel per lot to spread that high cost of
setup over a large batch. To understand how the supply chain achieves these economies of scale, we first
identify supply chain costs that are influenced by lot size.
The average price paid per unit purchased is a key cost in the lot-sizing decision. A buyer may increase the
lot size if this action results in a reduction in the price paid per unit purchased.
For example, if the jeans manufacturer charges $20 per pair for orders under 500 pairs of jeans and $18 per
pair for larger orders, the store manager at Jean-Mart gets the lower price by ordering in lots of at least 500
pairs of jeans. The price paid per unit is referred to as the material cost and is denoted by C. It is measured
in dollars per unit. In many practical situations, material cost displays economies of scale - increasing lot
size decreases material cost.
Holding cost is the cost of carrying one unit in inventory for a specified period of time, usually one year. It is
a combination of the cost of capital, the cost of physically storing the inventory, and the cost that results from
the product becoming obsolete. The holding cost is denoted by H and is measured in dollars per unit per year.
It may also be obtained as a fraction, of the unit cost of the product. Given a unit cost of C, the holding cost
H is given by
H = hC....................................................(2)
Any stage of the supply chain exploits economies of scale in its replenishment decisions
in the following three typical situations:
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Prof. Kishore Kumar Mahato- VIT University
ESTIMATING CYCLE INVENTORY-RELATED COSTS IN PRACTICE
When setting cycle inventory levels in practice, a common hurdle is estimating the ordering
and holding costs. Given the robustness of cycle inventory models, it is better to get a good
approximation quickly rather than spend a lot of time trying to estimate costs exactly.
Our goal is to identify incremental costs that change with the lot-sizing decision. We can
ignore costs that are unchanged with a change in lot size. For example, if a factory is running at
50 percent of capacity and all labor is full time and not earning overtime, it can be argued that
the incremental setup cost for labor is zero. Reducing the lot size in this case will not have any
impact on setup cost until either labor is fully utilized (and earning overtime) or machines are
fully utilized (with a resulting loss in production capacity).
Where,
E = amount of equity
D = amount of debt
Rf = risk-free rate of return (which is usually in the mid-single digits) β =
the firm’s beta, a measure of volatility of stock price
MRP = market risk premium (which is around the high single digits)
Rb = rate at which the firm can borrow money (related to its debt rating)
t = tax rate
Dr. Kishore Kumar Mahato, SMEC, VIT
VELLORE
• Obsolescence (or spoilage) cost: The obsolescence cost estimates the rate at which the value of the
stored product drops because its market value or quality falls. This cost can range dramatically, from
rates of many-thousand percent to virtually zero, depending on
the type of product. Perishable products have high obsolescence rates. Even nonperishables can have
high obsolescence rates if they have short life cycles. A product with a life cycle of six months has an
effective obsolescence cost of 200 percent. At the other end of the spectrum are products such as crude
oil that take a long time to spoil or become obsolete. For such products, a low obsolescence rate may be
applied.
• Handling cost: Handling cost should include only incremental receiving and storage costs that vary
with the quantity of product received. Quantity-independent handling costs that vary with the number of
orders should be included in the order cost. The quantity dependent handling cost often does not change
if quantity varies within a range. If the quantity is within this range (e.g., the range of inventory a crew
of four people can unload per period of time), incremental handling cost added to the holding cost is
zero. If the quantity handled requires more people, an incremental handling cost is added to the holding
cost.
• Miscellaneous costs: The final component of holding cost deals with a number of other
relatively small costs. These costs include theft, security, damage, tax, and additional insurance
charges that are incurred. Once again, it is important to estimate the incremental change in these
costs on changing cycle inventory.
To better understand the trade-offs discussed in this section, consider a situation that often arises in daily life the
purchase of groceries and other household products. These may be purchased at a nearby convenience store or
at a Costco (a large warehouse club selling consumer goods), which is generally located much farther away.
The fixed cost of going shopping is the time it takes to go to either location. This fixed cost is much lower for
the nearby convenience store.
Prices, however, are higher at the local convenience store. Taking the fixed cost into account, we tend to tailor
our lot size decision accordingly. When we need only a small quantity, we go to the nearby convenience store
because the benefit of a low fixed cost outweighs the cost of higher prices at the convenience store. When we
are buying a large quantity, however, we go to Costco, where the lower prices over the larger quantity
purchased more than make up for the higher fixed cost.
In this section, we focus on the situation in which a fixed cost associated with placing, receiving, and
transporting an order is incurred for each order. A purchasing manager wants to minimize the total cost of
satisfying demand and must therefore make the appropriate cost tradeoffs when making the lot-sizing
decision. We start by considering the lot-sizing decision for a single product.
Assume that HP does not offer any discounts, and each unit costs $C no matter how large an order is.
The holding cost is thus given by H = hC (using Equation 2). The model is developed using the
following basic assumptions:
�
� ………………………. (3)
Number of orders per year =
�
�
Given a lot size of Q, we have an average inventory of Q/2. The annual holding cost is thus the cost of
holding Q/2 units in inventory for one year and is given as
Figure 1 shows the variation in different costs as the lot size is changed. Observe that the annual
holding cost increases with an increase in lot size. In contrast, the annual ordering cost declines
with an increase in lot size. The material cost is independent of lot size because we have assumed
the price to be fixed. The total annual cost thus first declines and then increases with an
increase in lot size.
… …………………. (5)
For this formula, it is important to use the same time units for the holding cost rate h and the demand D.
With each lot or batch of size Q*, the cycle inventory in the system is given by Q*/2. The flow time
spent by each unit in the system is given by Q*/(2D). As the optimal lot size increases, so does the cycle
inventory and the flow time. The optimal ordering frequency is given by n*, where
… …………………………..(6)
In Example 1 we illustrate the EOQ formula and the procedure to make lot-sizing
decisions.
Solution:
In this case the store manager has the following inputs
Annual demand, D = 1,000 x 12 = 12,000 units
Order cost per lot, S = $4,000
Unit cost per computer, C = $500
Holding cost per year as a fraction of unit cost, h = 0.2
Using the EOQ formula (equation 5), the optimal lot size is
Key Point
Total ordering and holding costs are relatively stable around the economic order quantity. A
firm is often better served by ordering a convenient lot size close to the EOQ rather than the
precise EOQ.
Key Point
If demand increases by a factor of k, the optimal lot size increases by a factor of . The
number of orders placed per year should also increase by a factor of . Flow time attributed to
cycle inventory should decrease by a factor of .
Let us return to the situation in which monthly demand for the Deskpro model is 1,000
computers. Now assume that the manager would like to reduce the lot size to Q = 200 units
to reduce flow time. If this lot size is decreased without any other change, we have
From the history recorded in Table 1, it is observed that stockouts occurred on 2 of 30 total days. Since sales never exceed 10
units per day, no possibility of stockout exists on the first 5 days of the replenishment cycle. Stockouts were possible on days 6
through 10 based on the remote possibility that demand during the first 5 days of the cycle averaged 10 units per day and no
inventory was carried over from the previous period. Since during the three performance cycles 10 units were sold on only one
occasion, it is apparent that the real risk of stockout occurs only during the last few days of the performance cycle, and then only
when sales exceed the average by a substantial margin.
It should be apparent that the risk of stockouts created by variations in sales is limited to a short
time and includes a small percentage of total sales. Although the sales analysis presented in
Table 10-8 helps achieve an understanding of the opportunity, the appropriate course of action is
still not clear. Statistical probability can be used to assist management in planning safety stock.
The following discussion applies statistical techniques to the demand uncertainty problem.
The probability of occurrences assumes a pattern around a measure of central tendency, which is
the average value of all occurrences. While a number of frequency distributions can be used in
inventory control, the most basic is the normal distribution.
A normal distribution is characterized by a symmetrical bell-shaped curve, illustrated in Figure
above. The essential characteristic of a normal distribution is that the three measures of central
tendency have equal value. The mean (average) value, the medium (middle) observation, and the
mode (most frequently observed) value are all the same. When these three measures are nearly
identical, the frequency distribution is normal.
The above example illustrates in table 3 shows, how statistical probability can assist with the
quantification of demand uncertainty, but demand conditions are not the only source of uncertainty.
Performance cycles can also vary.
Dr. Kishore Kumar Mahato, SMEC, VIT
VELLORE
Performance Cycle Uncertainty
Performance cycle uncertainty means that inventory policy cannot assume consistent
delivery.
The planner should expect that actual performance cycle experience will cluster near
the average and be skewed in excess of the planned duration. If performance cycle
uncertainty is not evaluated statistically, the most common practice is to base safety
stock requirements on the planned replenishment time.
However, if there is substantial variation in the performance cycle, a formal
evaluation is desirable.
Where,
σc = Standard deviation of combined probabilities;
T = Average performance cycle time;
St = Standard deviation of the performance cycle;
D = Average daily sales; and
Ss = Standard deviation of daily sales.
This formulation estimates the convoluted or combined standard deviation of T days with an average
demand of D per day when the individual standard deviations are Ss and St respectively. The average
for the combined distribution is the product of T and D, or 50.00 (10.00 x 5.00).
Thus, given a frequency distribution of daily sales from O to 10 units per day and a range in
replenishment cycle duration of 6 to 14 days, 13 units (1 standard deviation multiplied by 13 units) of
safety stock is required to protect 84.14 percent of all performance cycles. To protect at the 97.72
percent level, a 26-unit safety stock is necessary. These levels assume a one-tail distribution since it is
not necessary to protect against lead time demand below average.
Where,
SL = The stockout magnitude (the product availability level);
f(k) = A function of the normal loss curve which provides the area in a right tail
of a normal distribution;
σc = The combined standard deviation considering both demand and
replenishment cycle uncertainty; and
Q = The replenishment order quantity.
Where,
The safety stock required to provide a 99 percent product fill rate when the order quantity is 300 units is
approximately 5 units. Table 8 shows how the calculated safety stock and average inventory levels vary
for other order quantities. An increased order size can be used to compensate for decreasing the safety
stock levels, or vice versa. The existence of such a trade-off implies that there is a combination of
replenishment order quantities that will result in desired customer service at the minimum cost.
ROP = D x T + SS,
Where,
Since inventory counts occur periodically, any item could fall below the desired
reorder point prior to the review period. Therefore, the assumption is made that
the inventory will fall below ideal reorder status prior to the periodic count
approximately one-half of the review times. Assuming a review period of 7 days
and using conditions similar to those of the perpetual example, the ROP then
would be as follows:
ROP = D(T + P/2) + SS
= 20(10 + 7/2) + 0 = 20(10 + 3.5) = 270 units.
The average inventory formulation for the case of periodic review is:
Iavg = Q/2 + (P x D)/2 + SS,
where,
Iavg = Average inventory in units;
Q = Order quantity in units;
P = Review period in days;
D = Average daily demand in units;
SS = Safety stock in units.
The final assumption characteristic of reactive inventory systems is that performance cycle length cannot be
correlated with demand. The assumption is necessary to develop an accurate approximation of the variance of the
demand over the performance cycle. For many situations higher demand levels create longer replenishment
performance cycles since they also increase the demands on inventory and transportation resources. This implies
that periods of high demand should not necessarily correspond to extended performance cycles caused by
stockouts or limited product availability.
Operationally, most inventory managers limit the impact of such limitations through the skillful use of manual
overrides. However, these overrides often lead to ineffective inventory decisions since the resulting plan is based
on inconsistent rules and managerial policy.
Replenishment programs are designed to streamline the flow of goods within the
distribution channel.
There are several specific techniques for collaborative replenishment, all of which build on
the common denominator of rapidly replenishing inventory according to actual sales
experience.
The intent is to reduce reliance on forecasting when and where inventory will need to be
positioned to meet consumer or end-user demand and instead allow suppliers to respond to
demand on a just-in-time basis.
Effective collaborative replenishment programs require extensive cooperation and
information sharing among distribution channel participants.
Specific techniques for automatic replenishment include quick response, continuous
replenishment, vendor managed inventory, and profile replenishment.
1. Product/Market Classification
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Prof. Kishore Kumar Mahato- VIT University
Measuring product availability
Product availability: a firm’s ability to fill a customer order out of available inventory
Stockout: a customer order arrives when a product is not available
Product fill rate (fr): fraction of demand that is satisfied from product in inventory
Order fill rate (OFR): fraction of orders that are filled from available inventory
Cycle service level (CSL): fraction of replenishment cycles that end with all customer demand met
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Prof. Kishore Kumar Mahato- VIT University
Replenishment policies
Replenishment policy: decisions regarding when to reorder and how much to reorder
Continuous review: inventory is continuously monitored and an order of size Q is placed when the inventory
level reaches the reorder point ROP
Periodic review: inventory is checked at regular (periodic) intervals and an order is placed to raise the
inventory to a specified threshold (the “order-up-to” level).
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Prof. Kishore Kumar Mahato- VIT University
Continuous review policy: Safety Inventory and Cycle Service Level
𝑅𝑂𝑃 = 𝐷𝐿 + 𝑠𝑠
𝐶𝑆𝐿 = 𝐶𝑦𝑐𝑙𝑒
𝑆𝑒𝑟𝑣𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙
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Prof. Kishore Kumar Mahato- VIT University
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑄
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = + 𝑠𝑠
2
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Prof. Kishore Kumar Mahato- VIT University
𝐷𝐿 = 𝐷𝐿 =(2500)(2) = 5000
Solve
Give
n:
𝑅𝑂𝑃 = 𝐷𝐿 + 𝑠𝑠
𝐷 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 =
2500/week
𝜎𝐷= Standard deviation of the demand per period =
𝑆𝑆 = 𝑅𝑂𝑃 − 𝐷𝐿 = 6000 − 5000
= 1000
500
𝐿 = 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑓𝑜𝑟 𝑟𝑒𝑝𝑙𝑒𝑛𝑖𝑠ℎ𝑚𝑒𝑛𝑡 =
2 weeks Q = 10000
𝑅𝑂𝑃 = 𝑅𝑒𝑜𝑟𝑑𝑒𝑟 𝑝𝑜𝑖𝑛𝑡 =6000
𝑄 10000
𝑫𝑳= Mean demand during lead time 𝐶𝑦𝑐𝑙𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
= 2
2
=?
𝒔𝒔 = 𝑺𝒂𝒇𝒆𝒕𝒚 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
=? Cycle inventory = ? 2
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
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= 5000
Average inventory = ? = 5000 + 1000 =
𝝈𝑳= Standard deviation of the demand lead time 6000
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Prof. Kishore Kumar Mahato- VIT University
Solve
Given:
𝐷 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐷𝐿 = 𝐷𝐿 =(12000)(1.5) = 18000
𝑅𝑂𝑃 = 𝐷𝐿 + 𝑠𝑠
12000/month
𝜎𝐷= Standard deviation of the demand per period =
𝑆𝑆 = 𝑅𝑂𝑃 − 𝐷𝐿
2500
𝐿 = 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑓𝑜𝑟 𝑟𝑒𝑝𝑙𝑒𝑛𝑖𝑠ℎ𝑚𝑒𝑛𝑡 =
1.5 months Q = 24000
𝑅𝑂𝑃 = 𝑅𝑒𝑜𝑟𝑑𝑒𝑟 𝑝𝑜𝑖𝑛𝑡 =19000 𝑆𝑆 = 19000 − 18000 = 1000
𝒔𝒔 = 𝑺𝒂𝒇𝒆𝒕𝒚 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 =?
𝝈𝑳= Standard deviation of the demand lead time =?
𝜎𝐿 = 𝐿𝜎𝐷 = 1. = 3062
5
Comment on the replenishment policy of the
(2500)
firm
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Prof. Kishore Kumar Mahato- VIT University
Multi-Echelon Inventory Optimization and Planning
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Prof. Kishore Kumar Mahato- VIT University
Multi-Echelon Inventory Optimization and Planning
This method combines inventory optimization (how much stock to keep at each distribution level) and multi-
echelon planning (deciding where to keep inventory at each distribution).
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Prof. Kishore Kumar Mahato- VIT University
Discussion Questions
1. Consider an IKEA manufacturer that is deciding on the size of its replenishment order from one of Europe’s leading
wholesalers for wood-based goods, the JAF Group. What costs should be taken into account when making this
decision?
2. Discuss how various costs for the IKEA manufacturer in Question 1 change as it decreases the lot size ordered from
the JAF Group.
3. As demand from the IKEA manufacturer in Question 1 grows, how would you expect the cycle inventory measured
in days of inventory to change? Explain.
4. Assume an IKEA manager from Question 1 wants to decrease the lot size without increasing the costs she incurs.
What would she need to do to achieve her goal?
5. “Though owned by different parties, members of the supply chain should coordinate with each other instead of
pursuing their own objectives.” Do you agree? Explain.
6. Do you think integer replenishment policies should be synchronized in multi-echelon supply chains? Explain.
7. Why is it appropriate to include only the incremental cost when estimating the holding and order cost for a firm?
© VIT University 2025
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References
• Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance. Boston, MA: Irwin McGraw-Hill, 2000.
• Lee, Hau L., and Corey Billington. “Managing Supply Chain Inventories: Pitfalls and Opportunities.” Sloan Management
Review (Spring 1992): 65–73.
• Maxwell, William L., and John A. Muckstadt. “Establishing Consistent and Realistic Reorder Intervals in
Production- Distribution Systems.” Operations Research (1985): 33, 1316 –1341.
• Munson, Charles L., Jianli Hu, and Meir J. Rosenblatt. “Teaching the Costs of Uncoordinated Supply Chains.” Interfaces
(2003): 33, 24 –39.
• Roundy, Robin. “A 98%-Effective Lot-Sizing Rule for a Multi-Product, Multi-Stage Production Inventory System.”
Mathematics of Operations Research (1986): 11, 699–727.
• Silver, Edward A., David Pyke, and Rein Petersen. Inventory Management and Production Planning and Scheduling. New
York: Wiley, 1998.
• Zipkin, Paul H. Foundations of Inventory Management. Boston, MA: Irwin McGraw-Hill, 2000.
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