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Financial Analysis
Class #18: Inventory Management and Control
Ana Elisa Pereira
October, 2018
Class #18: Inventory Management and Control Financial Analysis
Types of inventories and their importance
• Inventories: link between the production and sale of a product.
• A manufacturing company must maintain a certain amount of
inventory (work-in-process) during production.
• Inventory in transit – that is, between various stages of production –
permits efficient production scheduling and utilization of resources.
I Without it, each stage of production would have to wait for the
preceding stage to complete a unit.
• Raw-materials inventory gives the firm flexibility in its purchasing.
I Without it, the firm must exist on a hand-to-mouth basis.
• Finished-goods inventory allows the firm flexibility in its production
scheduling and in its marketing.
I Production does not need to be geared directly to sales.
I Large inventories allow efficient servicing of customer demands.
⇒ There is an incentive to maintain stocks of all types of inventory.
• In short, a firm with increased inventories is said to be more flexible
Class #18: Inventory Management and Control Financial Analysis
Types of inventories and their importance
• Inventories: link between the production and sale of a product.
• A manufacturing company must maintain a certain amount of
inventory (work-in-process) during production.
• Inventory in transit – that is, between various stages of production –
permits efficient production scheduling and utilization of resources.
I Without it, each stage of production would have to wait for the
preceding stage to complete a unit.
• Raw-materials inventory gives the firm flexibility in its purchasing.
I Without it, the firm must exist on a hand-to-mouth basis.
• Finished-goods inventory allows the firm flexibility in its production
scheduling and in its marketing.
I Production does not need to be geared directly to sales.
I Large inventories allow efficient servicing of customer demands.
⇒ There is an incentive to maintain stocks of all types of inventory.
• In short, a firm with increased inventories is said to be more flexible
Class #18: Inventory Management and Control Financial Analysis
Types of inventories and their importance
• Inventories: link between the production and sale of a product.
• A manufacturing company must maintain a certain amount of
inventory (work-in-process) during production.
• Inventory in transit – that is, between various stages of production –
permits efficient production scheduling and utilization of resources.
I Without it, each stage of production would have to wait for the
preceding stage to complete a unit.
• Raw-materials inventory gives the firm flexibility in its purchasing.
I Without it, the firm must exist on a hand-to-mouth basis.
• Finished-goods inventory allows the firm flexibility in its production
scheduling and in its marketing.
I Production does not need to be geared directly to sales.
I Large inventories allow efficient servicing of customer demands.
⇒ There is an incentive to maintain stocks of all types of inventory.
• In short, a firm with increased inventories is said to be more flexible
Class #18: Inventory Management and Control Financial Analysis
Types of inventories and their importance
• Inventories: link between the production and sale of a product.
• A manufacturing company must maintain a certain amount of
inventory (work-in-process) during production.
• Inventory in transit – that is, between various stages of production –
permits efficient production scheduling and utilization of resources.
I Without it, each stage of production would have to wait for the
preceding stage to complete a unit.
• Raw-materials inventory gives the firm flexibility in its purchasing.
I Without it, the firm must exist on a hand-to-mouth basis.
• Finished-goods inventory allows the firm flexibility in its production
scheduling and in its marketing.
I Production does not need to be geared directly to sales.
I Large inventories allow efficient servicing of customer demands.
⇒ There is an incentive to maintain stocks of all types of inventory.
• In short, a firm with increased inventories is said to be more flexible
Class #18: Inventory Management and Control Financial Analysis
Types of inventories and their importance
• Inventories: link between the production and sale of a product.
• A manufacturing company must maintain a certain amount of
inventory (work-in-process) during production.
• Inventory in transit – that is, between various stages of production –
permits efficient production scheduling and utilization of resources.
I Without it, each stage of production would have to wait for the
preceding stage to complete a unit.
• Raw-materials inventory gives the firm flexibility in its purchasing.
I Without it, the firm must exist on a hand-to-mouth basis.
• Finished-goods inventory allows the firm flexibility in its production
scheduling and in its marketing.
I Production does not need to be geared directly to sales.
I Large inventories allow efficient servicing of customer demands.
⇒ There is an incentive to maintain stocks of all types of inventory.
• In short, a firm with increased inventories is said to be more flexible
Class #18: Inventory Management and Control Financial Analysis
Disadvantages of inventories, Trade off
• The obvious disadvantages are
I costs of holding the inventory, including storage and handling costs
I the required return on capital tied up in inventory.
• An additional disadvantage is the danger of obsolescence.
• Inventories should be increased as long as the resulting savings
exceed the total cost of holding the added inventory.
• This balance depends on the estimates of actual savings, the cost of
carrying additional inventory, and the efficiency of inventory control.
• We now examine principles of inventory control that help achieve an
appropriate balance
Class #18: Inventory Management and Control Financial Analysis
Disadvantages of inventories, Trade off
• The obvious disadvantages are
I costs of holding the inventory, including storage and handling costs
I the required return on capital tied up in inventory.
• An additional disadvantage is the danger of obsolescence.
• Inventories should be increased as long as the resulting savings
exceed the total cost of holding the added inventory.
• This balance depends on the estimates of actual savings, the cost of
carrying additional inventory, and the efficiency of inventory control.
• We now examine principles of inventory control that help achieve an
appropriate balance
Class #18: Inventory Management and Control Financial Analysis
Disadvantages of inventories, Trade off
• The obvious disadvantages are
I costs of holding the inventory, including storage and handling costs
I the required return on capital tied up in inventory.
• An additional disadvantage is the danger of obsolescence.
• Inventories should be increased as long as the resulting savings
exceed the total cost of holding the added inventory.
• This balance depends on the estimates of actual savings, the cost of
carrying additional inventory, and the efficiency of inventory control.
• We now examine principles of inventory control that help achieve an
appropriate balance
Class #18: Inventory Management and Control Financial Analysis
Disadvantages of inventories, Trade off
• The obvious disadvantages are
I costs of holding the inventory, including storage and handling costs
I the required return on capital tied up in inventory.
• An additional disadvantage is the danger of obsolescence.
• Inventories should be increased as long as the resulting savings
exceed the total cost of holding the added inventory.
• This balance depends on the estimates of actual savings, the cost of
carrying additional inventory, and the efficiency of inventory control.
• We now examine principles of inventory control that help achieve an
appropriate balanceClass #18: Inventory Management and Control Financial Analysis
ABC method of inventory control
• Another way to classify inventory is by the dollar value of the firm’s
investment.
• If a firm were to rank inventory items by decreasing value per item,
we might get a cumulative distribution that looks like the figure
below
In this example:
• 15% of the items in inventory (group
A) account for 70% of inventory value.
• The next 30% of the items (group B)
account for 20% of inventory value.
• 55% of the items (group C) explain
only 10% of total inventory value.
Class #18: Inventory Management and Control Financial Analysis
ABC method of inventory control
• When a small proportion of items account for most of the inventory
value, we should devote more attention to controlling those items.
• We may assign them an “A” classification and review these items
more frequently.
• “B” items might be reviewed less often, and “C” items, even less.
• This system is known as the ABC method of inventory control.
• Factors other than dollar value may also need to be considered when
developing a classification plan
I e.g., if something is a critical or bottleneck item, or may soon become
obsolete.
ABC method of inventory control: Method that controls expensive in-
ventory items more closely than less expensive items.
Class #18: Inventory Management and Control Financial Analysis
ABC method of inventory control
• When a small proportion of items account for most of the inventory
value, we should devote more attention to controlling those items.
• We may assign them an “A” classification and review these items
more frequently.
• “B” items might be reviewed less often, and “C” items, even less.
• This system is known as the ABC method of inventory control.
• Factors other than dollar value may also need to be considered when
developing a classification plan
I e.g., if something is a critical or bottleneck item, or may soon become
obsolete.
ABC method of inventory control: Method that controls expensive in-
ventory items more closely than less expensive items.
Class #18: Inventory Management and Control Financial Analysis
ABC method of inventory control
• When a small proportion of items account for most of the inventory
value, we should devote more attention to controlling those items.
• We may assign them an “A” classification and review these items
more frequently.
• “B” items might be reviewed less often, and “C” items, even less.
• This system is known as the ABC method of inventory control.
• Factors other than dollar value may also need to be considered when
developing a classification plan
I e.g., if something is a critical or bottleneck item, or may soon become
obsolete.
ABC method of inventory control: Method that controls expensive in-
ventory items more closely than less expensive items.
Class #18: Inventory Management and Control Financial Analysis
ABC method of inventory control
• When a small proportion of items account for most of the inventory
value, we should devote more attention to controlling those items.
• We may assign them an “A” classification and review these items
more frequently.
• “B” items might be reviewed less often, and “C” items, even less.
• This system is known as the ABC method of inventory control.
• Factors other than dollar value may also need to be considered when
developing a classification plan
I e.g., if something is a critical or bottleneck item, or may soon become
obsolete.
ABC method of inventory control: Method that controls expensive in-
ventory items more closely than less expensive items.
Class #18: Inventory Management and Control Financial Analysis
ABC method of inventory control
• When a small proportion of items account for most of the inventory
value, we should devote more attention to controlling those items.
• We may assign them an “A” classification and review these items
more frequently.
• “B” items might be reviewed less often, and “C” items, even less.
• This system is known as the ABC method of inventory control.
• Factors other than dollar value may also need to be considered when
developing a classification plan
I e.g., if something is a critical or bottleneck item, or may soon become
obsolete.
ABC method of inventory control: Method that controls expensive in-
ventory items more closely than less expensive items.
Class #18: Inventory Management and Control Financial Analysis
Economic Order Quantity
Economic order quantity (EOQ): The quantity of an inventory item to
order so that total inventory costs are minimized over the firm’s planning
period.
– How much should we order?
– The EOQ amount
• We must determine the optimal order quantity for a particular item
of inventory
I given its forecast usage, ordering cost, and carrying cost.
• Ordering can mean either the purchase of the item or its production.
• Assume for the moment that the usage of a particular item of
inventory is known with certainty.
Class #18: Inventory Management and Control Financial Analysis
Economic Order Quantity
Economic order quantity (EOQ): The quantity of an inventory item to
order so that total inventory costs are minimized over the firm’s planning
period.
– How much should we order?
– The EOQ amount
• We must determine the optimal order quantity for a particular item
of inventory
I given its forecast usage, ordering cost, and carrying cost.
• Ordering can mean either the purchase of the item or its production.
• Assume for the moment that the usage of a particular item of
inventory is known with certainty.
Class #18: Inventory Management and Control Financial Analysis
Economic Order Quantity
• This usage is at a steady rate throughout the period being analyzed.
I If usage is 2,600 items in six months, 100 items are used each week.
• Assume that ordering costs per order, O, are constant regardless of
the size of order.
I costs of placing an order, receiving and checking the goods once they
arrive, etc
I The total ordering cost is the cost per order times the number of
orders for the period.
• Assume the carrying costs per unit of inventory are constant
regardless of the number of units and through time.
I carrying costs per unit, C, capture the cost of inventory storage,
handling, and insurance, plus the required return on the investment in
inventory.
I The total carrying cost for a period is the carrying cost per unit times
the average number of units of inventory for the period.
Class #18: Inventory Management and Control Financial Analysis
Economic Order Quantity
• This usage is at a steady rate throughout the period being analyzed.
I If usage is 2,600 items in six months, 100 items are used each week.
• Assume that ordering costs per order, O, are constant regardless of
the size of order.
I costs of placing an order, receiving and checking the goods once they
arrive, etc
I The total ordering cost is the cost per order times the number of
orders for the period.
• Assume the carrying costs per unit of inventory are constant
regardless of the number of units and through time.
I carrying costs per unit, C, capture the cost of inventory storage,
handling, and insurance, plus the required return on the investment in
inventory.
I The total carrying cost for a period is the carrying cost per unit times
the average number of units of inventory for the period.
Class #18: Inventory Management and Control Financial Analysis
Economic Order Quantity
• This usage is at a steady rate throughout the period being analyzed.
I If usage is 2,600 items in six months, 100 items are used each week.
• Assume that ordering costs per order, O, are constant regardless of
the size of order.
I costs of placing an order, receiving and checking the goods once they
arrive, etc
I The total ordering cost is the cost per order times the number of
orders for the period.
• Assume the carrying costs per unit of inventory are constant
regardless of the number of units and through time.
I carrying costs perunit, C, capture the cost of inventory storage,
handling, and insurance, plus the required return on the investment in
inventory.
I The total carrying cost for a period is the carrying cost per unit times
the average number of units of inventory for the period.
Class #18: Inventory Management and Control Financial Analysis
Economic Order Quantity
• In addition, we assume that inventory orders are filled when needed
I out-of-stock items can be replaced immediately ⇒ no need to
maintain a safety stock.
• Steady rate of inventory usage + no safety stock ⇒ average
inventory (in units) can be expressed as
Average inventory = Q/2
where Q is the quantity ordered and is assumed to be constant for
the planning period.
• When a zero level of inventory is reached, a new order of Q items
arrives.
Class #18: Inventory Management and Control Financial Analysis
Economic Order Quantity
• In addition, we assume that inventory orders are filled when needed
I out-of-stock items can be replaced immediately ⇒ no need to
maintain a safety stock.
• Steady rate of inventory usage + no safety stock ⇒ average
inventory (in units) can be expressed as
Average inventory = Q/2
where Q is the quantity ordered and is assumed to be constant for
the planning period.
• When a zero level of inventory is reached, a new order of Q items
arrives.
Class #18: Inventory Management and Control Financial Analysis
Economic Order Quantity
• In addition, we assume that inventory orders are filled when needed
I out-of-stock items can be replaced immediately ⇒ no need to
maintain a safety stock.
• Steady rate of inventory usage + no safety stock ⇒ average
inventory (in units) can be expressed as
Average inventory = Q/2
where Q is the quantity ordered and is assumed to be constant for
the planning period.
• When a zero level of inventory is reached, a new order of Q items
arrives.
Class #18: Inventory Management and Control Financial Analysis
Economic Order Quantity
Class #18: Inventory Management and Control Financial Analysis
Total inventory costs
• Carrying cost of inventory is C × (Q/2)
I average number of units of inventory times carrying cost per unit
• The total number of orders over a period = S/Q
I where S is the total usage (in units) of an item of inventory in the
period
• Consequently, total inventory costs are:
Total inventory cost (T) = C(Q/2)︸ ︷︷ ︸
carrying costs
+ O(S/Q)︸ ︷︷ ︸
ordering costs
�
�
�
�
• Trade-off:
I ↑ order quantity, Q, ↑ total carrying costs, but ↓ total ordering
costs.
I In words, there is a trade-off between the economies of increased
order size and the added cost of carrying additional inventory.
Class #18: Inventory Management and Control Financial Analysis
Total inventory costs
• Carrying cost of inventory is C × (Q/2)
I average number of units of inventory times carrying cost per unit
• The total number of orders over a period = S/Q
I where S is the total usage (in units) of an item of inventory in the
period
• Consequently, total inventory costs are:
Total inventory cost (T) = C(Q/2)︸ ︷︷ ︸
carrying costs
+ O(S/Q)︸ ︷︷ ︸
ordering costs
�
�
�
�
• Trade-off:
I ↑ order quantity, Q, ↑ total carrying costs, but ↓ total ordering
costs.
I In words, there is a trade-off between the economies of increased
order size and the added cost of carrying additional inventory.
Class #18: Inventory Management and Control Financial Analysis
Total inventory costs
• Carrying cost of inventory is C × (Q/2)
I average number of units of inventory times carrying cost per unit
• The total number of orders over a period = S/Q
I where S is the total usage (in units) of an item of inventory in the
period
• Consequently, total inventory costs are:
Total inventory cost (T) = C(Q/2)︸ ︷︷ ︸
carrying costs
+ O(S/Q)︸ ︷︷ ︸
ordering costs
�
�
�
�
• Trade-off:
I ↑ order quantity, Q, ↑ total carrying costs, but ↓ total ordering
costs.
I In words, there is a trade-off between the economies of increased
order size and the added cost of carrying additional inventory.
Class #18: Inventory Management and Control Financial Analysis
Total inventory costs
• Carrying cost of inventory is C × (Q/2)
I average number of units of inventory times carrying cost per unit
• The total number of orders over a period = S/Q
I where S is the total usage (in units) of an item of inventory in the
period
• Consequently, total inventory costs are:
Total inventory cost (T) = C(Q/2)︸ ︷︷ ︸
carrying costs
+ O(S/Q)︸ ︷︷ ︸
ordering costs
�
�
�
�
• Trade-off:
I ↑ order quantity, Q, ↑ total carrying costs, but ↓ total ordering
costs.
I In words, there is a trade-off between the economies of increased
order size and the added cost of carrying additional inventory.
Class #18: Inventory Management and Control Financial Analysis
Optimal Order Quantity
The optimal quantity of an inventory item is the quantity Q∗ that mini-
mizes total inventory costs over our planning period.
• Deriving our expression for the total cost with respect to Q, we have
∂T
∂Q =
C
2 − OSQ
−2 = 0⇒ Q∗ =
√
2OS
C
• Checking the second order condition:
∂2T
∂Q2 = 2OSQ
−3 > 0
• This is indeed a minimum, so Q∗is the Economic Order Quantity
Class #18: Inventory Management and Control Financial Analysis
Optimal Order Quantity
The optimal quantity of an inventory item is the quantity Q∗ that mini-
mizes total inventory costs over our planning period.
• Deriving our expression for the total cost with respect to Q, we have
∂T
∂Q =
C
2 − OSQ
−2 = 0⇒ Q∗ =
√
2OS
C
• Checking the second order condition:
∂2T
∂Q2 = 2OSQ
−3 > 0
• This is indeed a minimum, so Q∗is the Economic Order Quantity
Class #18: Inventory Management and Control Financial Analysis
Optimal Order Quantity
The optimal quantity of an inventory item is the quantity Q∗ that mini-
mizes total inventory costs over our planning period.
• Deriving our expression for the total cost with respect to Q, we have
∂T
∂Q =
C
2 − OSQ
−2 = 0⇒ Q∗ =
√
2OS
C
• Checking the second order condition:
∂2T
∂Q2 = 2OSQ
−3 > 0
• This is indeed a minimum, so Q∗is the Economic Order Quantity
Class #18: Inventory Management and Control Financial Analysis
To illustrate...
• Suppose that
I usage of an inventory item is 2,000 during a 100-day planning period
I ordering costs are $100 per order
I carrying costs are $10 per unit per 100 days.
• The EOQ amount is then
Q∗ =
√
2 (100) (2000)
10 = 200 units
• The firm would order (2,000/200) = 10 times during the period
(every 10 days)
Class #18: Inventory Management and Control Financial Analysis
Intuition
Q
Costs
Ordering costs
Carrying costs
Total costs
Q∗
Total inventory cost (T) = C(Q/2)︸ ︷︷ ︸
carrying costs
+ O(S/Q)︸ ︷︷ ︸
ordering costs
• T declines at first as the fixed costs of ordering are incurred less often as
fewer but larger orders are placed.
• T begins to rise when the decrease in ordering costs is more than offset by
the additional carrying costs of maintaining a larger inventory.
• Point Q∗ minimizes the total cost of inventory.
Class #18: Inventory Management and Control Financial Analysis
Order Point: When to Order?
• In addition to knowing how much, the firm also needs to know when
to order.
• “When” here means the quantity to which inventory must fall in
order to signal a reorder of the EOQ amount.
• So far, we have assumed that inventory can be ordered and received
without delay.
• Usually there is a time lapse between placement of a purchase order
and receipt of the inventory
I This lead time must be considered.
Class #18: Inventory Management and Control Financial Analysis
Order Point: When to Order?
• In addition to knowing how much, the firm also needs to know when
to order.
• “When” here means the quantity to which inventory must fall in
order to signal a reorder of the EOQ amount.
• So far, we have assumed that inventory can be ordered and received
without delay.
• Usually there is a time lapse between placement of a purchase order
and receipt of theinventory
I This lead time must be considered.
Class #18: Inventory Management and Control Financial Analysis
Order Point: When to Order?
• Suppose that demand for inventory is known with certainty...
• but that it takes 5 days from placement to receipt of an order.
• We found that the EOQ for our example firm was 200 units,
resulting in an order being placed every 10 days.
• This firm had a zero lead time and a daily usage of 20 units.
• If usage remains at a steady rate, the firm would now need to order
5 days before it ran out of stock, or at 100 units of stock on hand.
• If there is no need for safety stock, the order point is expressed as
Order point (OP) = Lead time × Daily usage
• In our example,
5 days × 20 units per day = 100 units
• When the new order is received 5 days later, the firm will just have
exhausted its existing stock.
Class #18: Inventory Management and Control Financial Analysis
Order Point: When to Order?
• Suppose that demand for inventory is known with certainty...
• but that it takes 5 days from placement to receipt of an order.
• We found that the EOQ for our example firm was 200 units,
resulting in an order being placed every 10 days.
• This firm had a zero lead time and a daily usage of 20 units.
• If usage remains at a steady rate, the firm would now need to order
5 days before it ran out of stock, or at 100 units of stock on hand.
• If there is no need for safety stock, the order point is expressed as
Order point (OP) = Lead time × Daily usage
• In our example,
5 days × 20 units per day = 100 units
• When the new order is received 5 days later, the firm will just have
exhausted its existing stock.
Class #18: Inventory Management and Control Financial Analysis
Order Point: When to Order?
• Suppose that demand for inventory is known with certainty...
• but that it takes 5 days from placement to receipt of an order.
• We found that the EOQ for our example firm was 200 units,
resulting in an order being placed every 10 days.
• This firm had a zero lead time and a daily usage of 20 units.
• If usage remains at a steady rate, the firm would now need to order
5 days before it ran out of stock, or at 100 units of stock on hand.
• If there is no need for safety stock, the order point is expressed as
Order point (OP) = Lead time × Daily usage
• In our example,
5 days × 20 units per day = 100 units
• When the new order is received 5 days later, the firm will just have
exhausted its existing stock.
Class #18: Inventory Management and Control Financial Analysis
Order Point: When to Order?
• Suppose that demand for inventory is known with certainty...
• but that it takes 5 days from placement to receipt of an order.
• We found that the EOQ for our example firm was 200 units,
resulting in an order being placed every 10 days.
• This firm had a zero lead time and a daily usage of 20 units.
• If usage remains at a steady rate, the firm would now need to order
5 days before it ran out of stock, or at 100 units of stock on hand.
• If there is no need for safety stock, the order point is expressed as
Order point (OP) = Lead time × Daily usage
• In our example,
5 days × 20 units per day = 100 units
• When the new order is received 5 days later, the firm will just have
exhausted its existing stock.
Class #18: Inventory Management and Control Financial Analysis
Summing up...
Lead time: The length of time between the placement of an order for an
inventory item and when the item is received in inventory.
Order point: The quantity to which inventory must fall in order to signal
that an order must be placed to replenish an item.
Class #18: Inventory Management and Control Financial Analysis
Order Point
Class #18: Inventory Management and Control Financial Analysis
Safety Stock
• In practice, the usage of inventory is generally not known with
certainty
I usually, it fluctuates during a given period of time.
• Typically, the demand for finished-goods inventory is subject to the
greatest uncertainty.
• The lead time required to receive delivery of inventory is also usually
subject to some variation.
• Owing to these fluctuations, it is not usually feasible to allow
expected inventory to fall to zero before a new order is anticipated.
I A safety stock is advisable.
Class #18: Inventory Management and Control Financial Analysis
Safety Stock
• In practice, the usage of inventory is generally not known with
certainty
I usually, it fluctuates during a given period of time.
• Typically, the demand for finished-goods inventory is subject to the
greatest uncertainty.
• The lead time required to receive delivery of inventory is also usually
subject to some variation.
• Owing to these fluctuations, it is not usually feasible to allow
expected inventory to fall to zero before a new order is anticipated.
I A safety stock is advisable.
Class #18: Inventory Management and Control Financial Analysis
Safety Stock
• In practice, the usage of inventory is generally not known with
certainty
I usually, it fluctuates during a given period of time.
• Typically, the demand for finished-goods inventory is subject to the
greatest uncertainty.
• The lead time required to receive delivery of inventory is also usually
subject to some variation.
• Owing to these fluctuations, it is not usually feasible to allow
expected inventory to fall to zero before a new order is anticipated.
I A safety stock is advisable.
Class #18: Inventory Management and Control Financial Analysis
Safety Stock
Safety stock: Inventory stock held in reserve as a cushion against uncer-
tain demand (or usage) and replenishment lead time.
• What would happen if the firm had: a safety stock of 100 units,
expected demand of 200 units every 10 days, expected lead time of
5 days?
• We now have:
Order point (OP) = (Average lead time × Average daily usage) + Safety stock
• With a safety stock of 100 units, the order point must be set at (5
days × 20 units) + 100 units = 200 units
• Notice we are now talking about expected values, not constant
values!
Class #18: Inventory Management and Control Financial Analysis
Safety Stock
Safety stock: Inventory stock held in reserve as a cushion against uncer-
tain demand (or usage) and replenishment lead time.
• What would happen if the firm had: a safety stock of 100 units,
expected demand of 200 units every 10 days, expected lead time of
5 days?
• We now have:
Order point (OP) = (Average lead time × Average daily usage) + Safety stock
• With a safety stock of 100 units, the order point must be set at (5
days × 20 units) + 100 units = 200 units
• Notice we are now talking about expected values, not constant
values!
Class #18: Inventory Management and Control Financial Analysis
Safety Stock
Safety stock: Inventory stock held in reserve as a cushion against uncer-
tain demand (or usage) and replenishment lead time.
• What would happen if the firm had: a safety stock of 100 units,
expected demand of 200 units every 10 days, expected lead time of
5 days?
• We now have:
Order point (OP) = (Average lead time × Average daily usage) + Safety stock
• With a safety stock of 100 units, the order point must be set at (5
days × 20 units) + 100 units = 200 units
• Notice we are now talking about expected values, not constant
values!
Class #18: Inventory Management and Control Financial Analysis
Safety Stock
Safety stock: Inventory stock held in reserve as a cushion against uncer-
tain demand (or usage) and replenishment lead time.
• What would happen if the firm had: a safety stock of 100 units,
expected demand of 200 units every 10 days, expected lead time of
5 days?
• We now have:
Order point (OP) = (Average lead time × Average daily usage) + Safety stock
• With a safety stock of 100 units, the order point must be set at (5
days × 20 units) + 100 units = 200 units
• Notice we are now talking about expected values, not constant
values!
Class #18: Inventory Management and Control Financial Analysis
Safety StockClass #18: Inventory Management and Control Financial Analysis
Illustrating the importance of safety stock
• Frame B: illustrates actual experience for our hypothetical firm.
• First segment: actual usage is somewhat less than expected
I slope of the line is less than that for the expected demand in frame A.
• At the order point (200 remaining units), an order is placed for 200
units of additional inventory.
• Instead of taking the expected 5 days for the inventory to be
replenished, it takes only 4 days.
• Second segment of usage is much greater than expected.
I as a result, inventory is rapidly used up
• At 200 units of remaining inventory, an order is again placed, but it
takes 6 days for it to be received.
• Third segment: usage is about the same as expected
I the slopes of the expected and actual usage lines are about the same.
• Because inventory was so low at the end of the previous segment of
usage, an order is placed almost immediately.
Class #18: Inventory Management and Control Financial Analysis
The Amount of Safety Stock
• Proper amount of safety stock to keep depends on several factors:
1. The greater the uncertainty associated with forecast demand for
inventory, the greater the safety stock the firm will wish to carry.
2. The greater the uncertainty of lead time to replenish stock, the
more safety stock the firm will wish to maintain.
3. Another factor influencing the safety stock decision is the cost of
running out of inventory.
I cost of being out of raw-materials and in-transit inventories is a delay
in production.
I cost of running out of finished goods comes from lost sales and
customer dissatisfaction.
4. The final factor is the cost of carrying additional inventory.
I If it was zero, a firm could maintain whatever safety stock was
necessary to avoid all possibility of running out of inventory.
Ultimately, the question reduces to the probability of inventory stockout
that management is willing to tolerate.
Class #18: Inventory Management and Control Financial Analysis
The Amount of Safety Stock
• Proper amount of safety stock to keep depends on several factors:
1. The greater the uncertainty associated with forecast demand for
inventory, the greater the safety stock the firm will wish to carry.
2. The greater the uncertainty of lead time to replenish stock, the
more safety stock the firm will wish to maintain.
3. Another factor influencing the safety stock decision is the cost of
running out of inventory.
I cost of being out of raw-materials and in-transit inventories is a delay
in production.
I cost of running out of finished goods comes from lost sales and
customer dissatisfaction.
4. The final factor is the cost of carrying additional inventory.
I If it was zero, a firm could maintain whatever safety stock was
necessary to avoid all possibility of running out of inventory.
Ultimately, the question reduces to the probability of inventory stockout
that management is willing to tolerate.
Class #18: Inventory Management and Control Financial Analysis
The Amount of Safety Stock
• Proper amount of safety stock to keep depends on several factors:
1. The greater the uncertainty associated with forecast demand for
inventory, the greater the safety stock the firm will wish to carry.
2. The greater the uncertainty of lead time to replenish stock, the
more safety stock the firm will wish to maintain.
3. Another factor influencing the safety stock decision is the cost of
running out of inventory.
I cost of being out of raw-materials and in-transit inventories is a delay
in production.
I cost of running out of finished goods comes from lost sales and
customer dissatisfaction.
4. The final factor is the cost of carrying additional inventory.
I If it was zero, a firm could maintain whatever safety stock was
necessary to avoid all possibility of running out of inventory.
Ultimately, the question reduces to the probability of inventory stockout
that management is willing to tolerate.
Class #18: Inventory Management and Control Financial Analysis
The Amount of Safety Stock
• Proper amount of safety stock to keep depends on several factors:
1. The greater the uncertainty associated with forecast demand for
inventory, the greater the safety stock the firm will wish to carry.
2. The greater the uncertainty of lead time to replenish stock, the
more safety stock the firm will wish to maintain.
3. Another factor influencing the safety stock decision is the cost of
running out of inventory.
I cost of being out of raw-materials and in-transit inventories is a delay
in production.
I cost of running out of finished goods comes from lost sales and
customer dissatisfaction.
4. The final factor is the cost of carrying additional inventory.
I If it was zero, a firm could maintain whatever safety stock was
necessary to avoid all possibility of running out of inventory.
Ultimately, the question reduces to the probability of inventory stockout
that management is willing to tolerate.
Class #18: Inventory Management and Control Financial Analysis
The Amount of Safety Stock
• Proper amount of safety stock to keep depends on several factors:
1. The greater the uncertainty associated with forecast demand for
inventory, the greater the safety stock the firm will wish to carry.
2. The greater the uncertainty of lead time to replenish stock, the
more safety stock the firm will wish to maintain.
3. Another factor influencing the safety stock decision is the cost of
running out of inventory.
I cost of being out of raw-materials and in-transit inventories is a delay
in production.
I cost of running out of finished goods comes from lost sales and
customer dissatisfaction.
4. The final factor is the cost of carrying additional inventory.
I If it was zero, a firm could maintain whatever safety stock was
necessary to avoid all possibility of running out of inventory.
Ultimately, the question reduces to the probability of inventory stockout
that management is willing to tolerate.
Class #18: Inventory Management and Control Financial Analysis
Problem 1
Vostick Filter Company is a distributor of air filters to retail stores. It
buys its filters from several manufacturers. Filters are ordered in lot sizes
of 1,000, and each order costs $40 to place. Demand from retail stores is
20,000 filters per month, and carrying cost is $0.10 a filter per month.
1. What is the optimal order quantity with respect to lots (that is,
what multiple of 1,000 units should be ordered)?
2. What would be the optimal order quantity if the carrying cost were
cut in half to $0.05 a filter per month?
3. What would be the optimal order quantity if ordering costs were
reduced to $10 per order?
Class #18: Inventory Management and Control Financial Analysis
Problem 2
A college bookstore is attempting to determine the optimal order
quantity for a popular book on psychology. The store sells 5,000 copies
of this book a year at a retail price of $12.50, and the cost to the store is
20 percent less, which represents the discount from the publisher. The
store figures that it costs $1 per year to carry a book in inventory and
$100 to prepare an order for new books.
1. Determine the total inventory costs associated with ordering 1, 2, 5,
10, and 20 times a year.
2. Determine the economic order quantity.
3. What implicit assumptions are being made about the annual sales
rate?
4. Determine the order point considering that the bookstore likes to
keep a safety stock of 200 books and the lead time is 10 days.
Class #18: Inventory Management and Control Financial Analysis
Referências
• Van Horne & Wachowicz (2009) - Chapter 10
Class #18: Inventory Management and Control Financial Analysis