CHAPTER 6: INVENTORY ANALYSIS

6.1 Objective

This chapter is the first on inventory. We use it as an introduction to supply chain management
focusing on inventory and its role in business. In a class of 100 minutes without break, we talk about
the general cost and benefits of inventory, the different types of inventory and why they exist.

The focus of the remainder of the chapter/class is then on economies of scale as inventorys first reason of
existence. This should be an easy class to teach.

6.2 Additional Suggested Readings

We assign a short case as supplemental reading for the economies of scale. The case is used to show
simple EOQ calculations and the benefits of centralization. It will also be useful for Chapter 7 to talk
about the benefits of postponement.

Hewlett-Packard: DeskJet Printer Supply Chain (A). Stanford Case 1993. Authors: Laura Kopczak
and Hau L. Lee.

Suggested assignment questions:

1. What factors should be taken into consideration when deciding the batch size of a particular type of
printer shipped to Europe (or any other destination)? What do you think of the fact that inventory
growth had tracked sales growth closely?
2. Assume that each printer costs HP $100 and the fixed cost incurred in each production run (lost
production due to setup) is $1,000. Consider the Option A printers for world wide demand. How
many of these printers should Vancouver produce in each batch?

6.3 Solutions to the Problem Set

Problem 6.1
The data in the question is: flow rate R = 50,000 parts/yr, fixed ordering cost S = $800, purchasing cost C
= $4/part, and cost of capital r = 20%/yr. Thus, the annual unit holding cost is H = rC = $0.8/yr. The
economic order quantity tells us to purchase each time

2RS 2 50,000 800 = 10,000 units.

a) Q =
H 0.8

b) Order R/Q = 5 times per year.

Problem 6.2
BIM Computers: Assume 8 working hours per day.

49
Chapter 6

We know Q = 4 wks supply = 1,600 units; R = 400 units/wk = 20,000 units/yr; purchase cost
per unit C = $1250*80% = $1,000. Thus, holding cost H = rC = 20%/year $1,000 =
$200/yr. Switch over or setup cost S = $2,000 + (1/2hr$1,500/day1day/8hr)= $2,093.75.
Thus, # of setups per year = R/Q = 20,000 units/yr / 1600 units/setup = 12.5 setups/yr. Thus,
Annual setup cost = (R/Q) * S = 12.5 setups/yr $2,093.75/setup = $26,172/yr.
Annual Purchasing Cost = R*C = 20,000 units/yr $1,000/unit = $ 20 M/yr.
Annual Holding Cost = (Q/2) H = 800 $200/yr = $160,000/yr.
Thus, total annual production and inventory cost = $20,186,172.

2 RS 2 20000 2093.75
EOQ = = 647 units.
H 200
number of setups = R/Q = 20,000 /647 = 30.91. Thus, annual setup cost =
30.91setups/yr $2,093.75/setup = $64,718/yr.
annual holding cost = (Q/2) H = 323.5 $200/yr = $64,700/yr (notice that at
optimal EOQ annual holding cost equal setup costs)
annual purchasing cost remains $20M/yr
The resulting annual savings equals $20,186,172 - $20,129,418 = $56,754.

Problem 6.3
Victor's data: flow unit = one dress, flow rate R = 30 units/wk, purchase cost C = $150/unit, order lead
time L = 2 weeks, fixed order cost S = $225, cost of capital r = 20%/yr. Victor currently orders ten weeks
supply at a time, hence Q = 10wks 30 units/wk = 300 units.
a. Costs for Victor's current inventory management:
Annual variable ordering (purchasing) cost = RC = $150/unit 30 units/wk 52 wks/yr
= $234,000/yr.
Annual fixed ordering (setups) cost = (# of orders/yr) S = (R/Q) S = (3052/yr/300) $225
= $1,170/yr.
Annual holding cost = H (Q/2) = (rC) (Q/2) = $30/yr 150 = $4,500/yr.
Total annual costs = $239,670.

b. To minimize costs, Victor should order in batches of

2RS 2 30 52 225
Q* = EOQ = = 153 units.
H 30

Thus, he should place an order for 153 units two weeks before he expects to run out. That is,
whenever current inventory drops to RL = 30 units/wk 2 wks = 60 units, which is the re-
order point.
His annual cost will be

RC + 2RSH 2 30 52 225 30 + $234,000 = $4,589 + $234,000 = $238,589.

 Chapter 6

c. Inventory turns = R/I, where average inventory I = Q/2 with cycle stock only.
Current policy: turns = R/(Q/2)=2 R/Q = 2 30units/wk / 300units = 2/10week = 52 2/10
per year = 10.4 times per year.
Proposed policy: Q is roughly halved, so turns roughly double to 20.4 times per year.

Problem 6.4
The retailer: Current fixed costs, S1 = $1000. Current optimal lot size Q1 = 400. New, desired lot size Q2
= 50. We must find the fixed cost S2 at which Q2 is optimal. Since Q1 is optimal for S1, we have

2RS1 2 R 1000
Q1 = 400 = . So, R/H = 160000/2000 = 80.
H H

Now,

2 RS 2
Q2 = 50 = ,
H

or S2 = 502 /(280) = 15.625. So the retailer should try to reduce her fixed costs to $15.625.

Problem 6.5
Major Airlines: This question illustrates the basic tradeoff between fixed and variable costs in a service
industry; thus the concepts of EOQ discussed in class in the context of inventory management are much
more generic.
The process view here is illuminating and it goes as follows: flow unit = one flight attendant (FA). The
process transforms an input (= "un-trained" FA) into an output (= "quitted" FA). The sequence of
activities is: undergo training for 6 weeks, go on vacation for one week, wait in a buffer of "trained, but
not assigned FA" until being assigned, serve as a FA on flights, and finally quit the job.

Untrained R Quitted
FA Training Vacation Pool of Serve on flights FA
trained FAs
T = 6 wks 1 wks ? wks 2 years

The question asks for the tradeoff between training costs (higher class size is preferred) versus 'holding
costs' in the buffer (smaller class size -> fewer attendants waiting in buffer is preferred).
(a)
Flow rate R = 1000 every two years = 500 attendants per year = 10 per week.
Fixed costs of training involves hiring ten instructors and support personnel for 6 weeks.
Thus, fixed costs of training S = 10 ($220+$80) 6 weeks = $18,000 per training session.
Annual holding cost is the cost incurred to hold one flow unit (FA) in the buffer for one year:
H = $500 per month 12 = $6,000 / person / year.
Chapter 6

Thus, Economic Class Size (EOQ) = 54.77 or 55 per class. Thus, we should run R/Q = 500 /
55 = 9.09 classes per year
Per person variable cost of training is the stipend paid for 6 weeks of training + stipend for a
week of vacation = $500/mo. perperson 7 wk 12 mo/yr / 50 wk/yr = $840 per person.
Notice that the annual variable cost is constant $840/person 500 person/yr = $420,000/yr
regardless of the class size.
Total Annual Cost = Fixed Costs of Training + Variable Costs of Training + Holding Costs =
($18,000 9.09) + ($840 500) + (55/2)($6000) = $748,636.36 per year.
Time Between starting consecutive classes (say, T) = Q/R = 5.5 weeks. Thus, we will have
two classes overlap for a 1/2 week (and thus we need two sets of trainers and training class
rooms). The inventory-time diagram looks as follows (assuming for simplicity that we start
the training process at time 0):

I (in training)
110

55

Class 1 Class 2 Class 3

0 6 t (weeks)
5.5

I (on vacation)
Class 1 Class 2 Class 3
55

0 6 7
t (weeks)

I (in buffer)
Class 1 Class 2 Class 3
55

0 6 7 t (weeks)

(b): This part of the question illustrates the following: Often, in reality, people wish to adopt policies
that are simple (e.g., starting training every 6 weeks is simpler than trying to track the exact days to
start training when subsequent trainings start every 5.5 weeks. But what is the implication of
deviation from the optimal? In this case, quite small. This is because the optimal cost structure near
the (optimal) EOQ is quite flat. Thus any solution close to optimality will suffice.
 Chapter 6

If time between classes (T = Q/R ) has to be 6 weeks, then Q = TR = 6 wks 10

attendants/wk = 60 attendants.
Total Cost of this policy = ($18,000)(500/60) + ($840)(500) + (60/2)($6000) = $750,000 per
year.

Problem 6.6

Fixed cost of filling an ATM m/c, S = $100.

To estimate demand, observe that the average size of each transaction = $80. With 150 transactions per
week, annual demand R is estimated to be = 1505280 = 624,000.

With cost of money of 10%, unit holding cost, H = $0.10 / year

Then, the economic quantity to place in the ATM machine is given by the EOQ formula:

2R S 2 624000 100
Q= = = 35, 327
H 0.1
The number of times the ATM needs to be filled = R/Q = 624000/35327 = 17.66 per year.
Problem 6.7
The annual demand, R = 150,000 lbs/yr. The purchase price per lb is $1.50. However the shipping cost
exhibits a quantity discount model. The holding cost per year is then 15% of the sum of the purchase and
shipping cost. The administrative costs of placing an order = $50/order.
(a) In addition, rental cost of the forklift truck adds to the fixed cost giving a total fixed cost, S =
50+350 = $400/order. We can use a spreadsheet model as shown in Table TN 6.1. The optimal
order quantity = 22,000 lbs with an annual cost of $249,916.77.
(b) If GC buys a forklift and builds a new ramp, then the per-transaction fixed cost will simply be the
administrative cost of $50 per order. The economic order quantity and annual operating costs of
this option is shown in Table TN 6.2. The economic order quantity is 15000 lbs. with an annual
operating cost = $246,833.75. The annual savings = 249,916.77 - 246,833.75 = $3,083.02. The
net present value of cost savings (over 5 years) with cost of capital of 15% = $10,334.76.
Assuming a useful life of 5 years for the forklift and ramp, an investment of less than $10,334
generates a positive NPV.
Problem 6.8
Changeover time = 4hrs resulting in a fixed cost, S = 4 250 = $1,000.
Annual demand, R = 1000/mo 12 = 12,000 units / yr.
Unit cost, C = 100
Holding cost = $25 / unit / yr.
a) The optimal production batch size is
Chapter 6

2RS 2 12000 1000

Q 980
H 25
b) To reduce batch size by a factor of 4, the setup cost needs to be reduced by a factor of (4)2 = 16.
That is, S should reduce to 1000/16 = $62.5. This reduction can be achieved by reducing the
changeover time or the cost per unit time during changeovers.
Problem 6.9
a) From the EOQ formula, observe that the order quantity is proportional to the square root of
annual demand (R). Since cycle inventory is half of the order quantity, it too is proportional to R.
Since HP motors has a higher R, the cycle inventory for HP motors is also higher.

b) Average time spent by a motor T = Icycle / R. Since Icycle is proportional to R , T is proportional

to 1/ R . Therefore time spent by a HP motor is less than the time spent by an LP motor.
Problem 6.10
Each retail outlet faces an annual demand, R = 4000/wk 50 = 200,000 per year. The unit cost of the
item, C = $200 / unit. The fixed order cost, S = $900. The unit holding cost per year, H = 20 % 200 =
$40 / unit / year.
a) The optimal order quantity for each outlet

2RS 2 200000 900

Q 3000
H 40
with a cycle inventory of 1500 units. The total cycle inventory across all four outlets equals 6000
units.
b) With centralization of purchasing the fixed order cost, S = $1800. The centralized order quantity
is then,

2 RS 2 800000 1800
Q 8485
H 40
and a cycle inventory of 4242.5 units.

6.4 Test Bank

Usually, tests will combine concepts from Chapters 6 and 7. Therefore, refer to questions for Chapter
7 that include concepts from Chapter 6.We list here a few questions that exclusively rely on concepts
in Chapter 6.
[1] Complete Computer (CC) is a retailer of computer equipment in Minneapolis with four retail
outlets. Currently each outlet manages its ordering independently. Demand at each retail outlet
averages 4,000 units per week. Each unit costs $200 and CC has a holding cost of 20%. The fixed
cost of each order (administrative + transportation) is $900. Assume 50 weeks in a year.
 Chapter 6

(a) Given that each outlet orders independently and gets its own delivery, the optimal order size
at each outlet is (5 points) [SHOW WORK]
(i) 424
(ii) 3,000; EOQ = sqrt (2RS/H) = sqrt (2*4000*50*900/40) = 3000
(iii) 6,000
(iv) 42,426
(v) None of the above

(b) CC is thinking of centralizing purchasing (for all four outlets). In this setting, CC will place a
single order (for all outlets) with the supplier. The supplier will deliver the order on a
common truck to a transit point. Since individual requirements are identical across outlets, the
total order is split equally and shipped to the retailers from this transit point. This entire
operation has increased the fixed cost of placing an order to $1,800. If CC manages ordering
optimally in the new setting, average inventory in the CC system (across all four outlets) can
be expected to (5 points)
(i) Increase
(ii) Decrease
(iii) Remain unchanged

Give arguments for your answer:

In the decentralized system, cycle stock per outlet = 3000/2 = 1500. Total cycle stock = 1500*4 =
6000. In the centralized system, Demand increases by a factor of 4 over a single outlet. Fixed costs
increase by a factor of 2. So EOQ will increase by a factor of sqrt (42) = sqrt (8) = 2.83. So cycle
stock = 2.83 (3000/2) = 4245 < 6000.
Students may work out the EOQ all over again by the original formula and do the comparison. Either
approach is fine.
Chapter 6

Table TN 6.1: Problem 6.7 (with use of rental forklift)

S 400 per order
R 150000 lbs / yr
(h+r) 15.00% % per year
purchase
price 1.5 per lb.

Order Shipping Total holding Number Annual Average Annual Annual Total
size (Q ) cost per variable cost
of orders order Cycle holding procurement Annual
pound cost = pound
purchase per year (R/Q ) cost Inventory cost cost costs TC
cost + (H ) (S R/Q ) (Q/2 ) (H Q/2 ) (C R )
shipping
(C )

8000 0.17 1.67 0.2505 18.75 7500.00 4000 1002 250500 259,002.00
9000 0.17 1.67 0.2505 16.67 6666.67 4500 1127.25 250500 258,293.92
10000 0.15 1.65 0.2475 15.00 6000.00 5000 1237.5 247500 254,737.50
11000 0.15 1.65 0.2475 13.64 5454.55 5500 1361.25 247500 254,315.80
12000 0.15 1.65 0.2475 12.50 5000.00 6000 1485 247500 253,985.00
13000 0.15 1.65 0.2475 11.54 4615.38 6500 1608.75 247500 253,724.13
14000 0.15 1.65 0.2475 10.71 4285.71 7000 1732.5 247500 253,518.21
15000 0.13 1.63 0.2445 10.00 4000.00 7500 1833.75 244500 250,333.75
16000 0.13 1.63 0.2445 9.38 3750.00 8000 1956 244500 250,206.00
17000 0.13 1.63 0.2445 8.82 3529.41 8500 2078.25 244500 250,107.66
18000 0.13 1.63 0.2445 8.33 3333.33 9000 2200.5 244500 250,033.83
19000 0.13 1.63 0.2445 7.89 3157.89 9500 2322.75 244500 249,980.64
20000 0.13 1.63 0.2445 7.50 3000.00 10000 2445 244500 249,945.00
20500 0.13 1.63 0.2445 7.32 2926.83 10250 2506.125 244500 249,932.95
21000 0.13 1.63 0.2445 7.14 2857.14 10500 2567.25 244500 249,924.39
21500 0.13 1.63 0.2445 6.98 2790.70 10750 2628.375 244500 249,919.07
22000 0.13 1.63 0.2445 6.82 2727.27 11000 2689.5 244500 249,916.77
22500 0.13 1.63 0.2445 6.67 2666.67 11250 2750.625 244500 249,917.29
23000 0.13 1.63 0.2445 6.52 2608.70 11500 2811.75 244500 249,920.45
23500 0.13 1.63 0.2445 6.38 2553.19 11750 2872.875 244500 249,926.07
24000 0.13 1.63 0.2445 6.25 2500.00 12000 2934 244500 249,934.00
24500 0.13 1.63 0.2445 6.12 2448.98 12250 2995.125 244500 249,944.10
25000 0.13 1.63 0.2445 6.00 2400.00 12500 3056.25 244500 249,956.25
25500 0.13 1.63 0.2445 5.88 2352.94 12750 3117.375 244500 249,970.32
 Chapter 6

Table TN 6.2: Problem 6.7 (without use of rental forklift)

S 50 per order
R 150000 lbs / yr
(h+r) 15.00% % per year
purchase
price 1.5 per lb.
Order Shipping Total holding Number Annual Average Annual Annual Total
size (Q) cost per variable cost of orders order cost Cycle holding procurement Annual costs
pound cost = pound (R/Q) (SxR/Q) Inventory cost cost (CxR) TC
purchase per year (Q/2) (HxQ/2)
cost + (H)
shipping
(C)
6000 0.17 1.67 0.2505 25.00 1250.00 3000 751.5 250500 252,501.50
6500 0.17 1.67 0.2505 23.08 1153.85 3250 814.125 250500 252,467.97
7000 0.17 1.67 0.2505 21.43 1071.43 3500 876.75 250500 252,448.18
7500 0.17 1.67 0.2505 20.00 1000.00 3750 939.375 250500 252,439.38
8000 0.17 1.67 0.2505 18.75 937.50 4000 1002 250500 252,439.50
8500 0.17 1.67 0.2505 17.65 882.35 4250 1064.625 250500 252,446.98
9000 0.17 1.67 0.2505 16.67 833.33 4500 1127.25 250500 252,460.58
9500 0.17 1.67 0.2505 15.79 789.47 4750 1189.875 250500 252,479.35
10000 0.15 1.65 0.2475 15.00 750.00 5000 1237.5 247500 249,487.50
10500 0.15 1.65 0.2475 14.29 714.29 5250 1299.375 247500 249,513.66
11000 0.15 1.65 0.2475 13.64 681.82 5500 1361.25 247500 249,543.07
11500 0.15 1.65 0.2475 13.04 652.17 5750 1423.125 247500 249,575.30
12000 0.15 1.65 0.2475 12.50 625.00 6000 1485 247500 249,610.00
12500 0.15 1.65 0.2475 12.00 600.00 6250 1546.875 247500 249,646.88
13000 0.15 1.65 0.2475 11.54 576.92 6500 1608.75 247500 249,685.67
13500 0.15 1.65 0.2475 11.11 555.56 6750 1670.625 247500 249,726.18
14000 0.15 1.65 0.2475 10.71 535.71 7000 1732.5 247500 249,768.21
14500 0.15 1.65 0.2475 10.34 517.24 7250 1794.375 247500 249,811.62
15000 0.13 1.63 0.2445 10.00 500.00 7500 1833.75 244500 246,833.75
15500 0.13 1.63 0.2445 9.68 483.87 7750 1894.875 244500 246,878.75
16000 0.13 1.63 0.2445 9.38 468.75 8000 1956 244500 246,924.75
16500 0.13 1.63 0.2445 9.09 454.55 8250 2017.125 244500 246,971.67
17000 0.13 1.63 0.2445 8.82 441.18 8500 2078.25 244500 247,019.43
17500 0.13 1.63 0.2445 8.57 428.57 8750 2139.375 244500 247,067.95