The Basic Economic Order Quantity (EOQ) Model

The economic order quantity (EOQ) model is one of the oldest and most commonly known inven-

tory-control techniques. This technique is relatively easy to use but is based on several assumptions:

1. Demand is known, constant, and independent.

2. Lead time-that is, the time between placement and receipt of the order-is known and constant

3. Receipt of inventory is instantaneous and complete. In other words, the inventory from an order
arrives in one batch at one time.

4. Quantity discounts are not possible.

5. The only variable costs are the cost of setting up or placing an order (setup cost) and the cost of
holding or storing inventory over time (holding or carrying cost). These costs were discussed in the
previous section.

6. Stockouts (shortages) can be completely avoided if orders are placed at the right time.

Minimizing Costs

The objective of most inventory models is to minimize total costs. With the assumptions just given,

significant costs are setup (or ordering) cost and holding (or carrying) cost. All other costs, such as

the cost of the inventory itself, are constant. Thus, if we minimize the sum of setup and holding

costs, we will also be minimizing total costs.

Reorder Points

Now that we have decided how much to order, we will look at the second inventory question, whan

to order. Simple inventory models assume that receipt of an order is instantaneous. In other worrls

they assume (I) that a firm will place an order when the inventory level for that particular item

reaches zero, and (2) that it will receive the ordered items immediately. However, the time berween

placement and receipt of an order, called lead time, or delivery time. can be as short as a few hours

or as long as months. Thus, the when-to-order decision is usually expressed in terms of a reorder

point (ROP).

Production Order Quantity Model

This model is anplicable under two situations: (1) when inventory continuously flows or builds up over a
penod of ime after an order has been placed or (2) when units are produced and sold simultane

oeshy Under these circumstances, we take into account daily production (or inventory-flow) rate

and daily demand rate. Figure 12.6 shows inventory levels as a function of time.

Because his model is especially suitable for the production environment, it is commonly called the

arodaction order quantity model It is useful when inventory continuOusly builds up over time and tra-

daomal coooc Order qoantity assumptions are valid. We derive this model by setting ordering or setup

aas cqual to olding costs and solving for optimal order size.

Quantity Discount Models

To increase sales, many companies offer quantity discounts to their customers. A quantity discount

is simply a reduced price (P) for an item when it is purchased in larger quantities. It is not uncom-

mon to have a discount schedule with several discounts for large orders.

PROBABILISTIC MODELS WITH CONSTANT LEAD TIME

All of the inventory models We have discussed so far make the assumption that demand for a prod-

uct is constant and certain. We now relax this assumption. The following inventory models apply

when product demand is not known but can be specified by means of a probability distribution.

These types of models are called probabilistic models

FIXED-PERIOD (P) SYSTEMS

The inventory models that we have considered so far are fixed-quantity, or Q systems. That is, the same

fixed amount is added to inventory every time an order for an item is placed. We saw that orders are

event-triggered. When inventory decreases to the reorder point (ROP), a new order for Q units is placed.

To use the fixed-quantity model, inventory must be continuously monitored. This is called a

perpetual inventory system. Every time an item is added to or withdrawn from inventory, records

must be updated to make sure the ROP has not been reached.
In a fixed-period, or P system, on the other hand, inventory is ordered at the end of a given

period. Then, and only then, is on-hand inventory counted. Only the amount necessary to bring total

inventory up to a prespecified target level is ordered.