Session 03

Inventory Control Systems

Economic Order Quantity and its variation.

D 0 8 5 4
Supply Chain : Manufacturing and Warehousing

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2
INVENTORY CONTROL SYSTEMS
The fundamental inventory problem can be succinctly
described by two questions :
1. When should an order be placed ?
2. How much should be ordered ?

The complexity of the resulting model depends upon the
assumptions one makes about the various parameters
of the system.
The major distinction is between
a. Inventory Control Subject to Known Demand
b. Inventory Control Subject to Unknown Demand

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3 Source : Production and Operations Analysis 4
th
Edition, Steven Nahmias
McGraw Hill International Edition
Economic Order Quantity and its variation
The EOQ Model ( Economic Order Quantity Model )
is the simplest and most fundamental of all inventory
models.

It describes the most important trade-off between
Fixed Order Costs and Holding Costs.

And is the basis for the analysis of more complex systems.
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4 Source : Production and Operations Analysis 4
th
Edition, Steven Nahmias
McGraw Hill International Edition
Order Quantity
Annual Cost
Order (Setup) Cost Curve
Optimal
Order Quantity (Q*)
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5
The Economic Order Quantity Model
Assumptions:

1. Production is instantaneous. There is no capacity
constraint and the entire lot is produced simultaneously.
2. Delivery is immediate. There is no time lag between
production and availability to satisfy demand.
3. Demand is deterministic. There is no uncertainty about
the quantity or timing of demand.
4. Demand is constant over time. In fact, it can be
represented as a straight line, so that if annual demand is
365 units this translates into a daily demand of one unit.
5 A production run incurs a constant setup cost.
Regardless of the size of the lot or the status of the factory,
the setup cost is the same.
6. Products can be analyzed singly. Either there is only a
single product or conditions exist that ensure reparability of
products.
Notation
D = Demand rate (in units per year).
c = Unit production cost, not counting setup or inventory
costs (in dollars per unit).
A = Constant setup (ordering) cost to produce
(purchase) a lot (in dollars).
h = Holding cost
Q = Lot size (in units); this is the decision variable
The model
Inventory versus time in the EOQ model
The model

Average inventory level:

The holding cost per unit:

The setup cost per unit:

The production cost per unit:
2
Q
=
D
hQ
D
h
Q
2
2
=

=
Q
A
=
c =
Economic Order Quantity
( )
) ( 2
) (
0
2
) (
) cos (
2
) (
3 2
2
2
condition order Second
Q
A
dQ
Q Y d
condition order First
Q
A
D
h
dQ
Q dY
unit per t inventory Total c
Q
A
D
hQ
Q Y
=
= + =
+ + =
Economic order quantity
( )
) (
2
0
2
) (
2
quantity order economic
h
AD
Q
condition order f irst
Q
A
D
h
dQ
Q dY
=
= + =
-
Exercise
Each is invited to analyze the following insights, based on
the EOQ model (20 minutes):

1. There is a tradeoff between lot size and inventory
2. Holding and setup cost are fairly insensitive to lot size
What-if
What-if
EOQ EOQ
Annual demand 12,000 12,000
Cost per unit $6.75 $6.75
Interest rate to hold 20% 20%
Ordering cost $28.00 $28.00
Quantity each order 461 =INT(C5/C10)
Number of orders 26 26
Unit holding cost $1.35 =C6*C7
Annual holding cost $311 =C9*C11/2
Annual ordering cost $728 =C10*C8
Combined cost $1,039 =C12+C13
Annual purchase cost $81,000 =C5*C6
Total cost $82,039 =C14+C15
What-If Analysis
The minimum cost
obtained by using the
economic order
quantity is $952.50, so
increasing the order
quantity by 10% leads
a total cost increase of
only $4.30. Changing
the order quantity by a
small amount has very
little effect on the cost,
because EOQ formula
gives robust solutions.
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Inventory Systems
Single-Period Inventory Model
One time purchasing decision (Example: vendor selling
t-shirts at a football game)
Seeks to balance the costs of inventory overstock and
under stock
Multi-Period Inventory Models
Fixed-Order Quantity Models
Event triggered (Example: running out of stock)
Fixed-Time Period Models
Time triggered (Example: Monthly sales call by sales
representative)
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Single-Period Inventory Model
u o
u
C C
C
P
+
s
sold be unit will y that the Probabilit
estimated under demand of unit per Cost C
estimated over demand of unit per Cost C
: Where
u
o
=
=
=
P
This model states that we should
continue to increase the size of the
inventory so long as the probability
of selling the last unit added is
equal to or greater than the ratio
of: Cu/Co+Cu
Single Period Model Example
Our college basketball team is playing in a tournament
game this weekend. Based on our past experience we
sell on average 2,400 shirts with a standard deviation of
350. We make $10 on every shirt we sell at the game,
but lose $5 on every shirt not sold. How many shirts
should we make for the game?
C
u
=$10 and C
o
= $5; P $10 / ($10 + $5) = .667

Z
.667
= .432 (use NORMSDIST(.667)
therefore we need 2,400 + .432(350) = 2,551 shirts

Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 1)
Demand for the product is constant and uniform
throughout the period
Lead time (time from ordering to receipt) is
constant
Price per unit of product is constant
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Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 2)
Inventory holding cost is based on average inventory
Ordering or setup costs are constant
All demands for the product will be satisfied (No back
orders are allowed)
Basic Fixed-Order Quantity Model and Reorder Point Behavior
R = Reorder point
Q = Economic order quantity
L = Lead time
L
L
Q Q Q
R
Time
Number
of units
on hand
1. You receive an order quantity Q.
2. Your start using
them up over time.
3. When you reach down to
a level of inventory of R,
you place your next Q
sized order.
4. The cycle then repeats.
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Cost Minimization Goal
Ordering Costs
Holding
Costs
Order Quantity (Q)
C
O
S
T
Annual Cost of
Items (DC)
Total Cost
Q
OPT
By adding the item, holding, and ordering costs together, we
determine the total cost curve, which in turn is used to find the Q
opt

inventory order point that minimizes total costs
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Basic Fixed-Order Quantity (EOQ) Model Formula
H
2
Q
+ S
Q
D
+ DC = TC
Total
Annual =
Cost
Annual
Purchase
Cost
Annual
Ordering
Cost
Annual
Holding
Cost
+ +
TC=Total annual
cost
D =Demand
C =Cost per unit
Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
L =Lead time
H=Annual holding
and storage cost
per unit of inventory
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Deriving the EOQ
Using calculus, we take the first derivative of the total cost function with
respect to Q, and set the derivative (slope) equal to zero, solving for the
optimized (cost minimized) value of Q
opt

Q =
2DS
H
=
2(Annual Demand)(Order or Setup Cost)
Annual Holding Cost
OPT
Reorder point, R = d L
_
d = average daily demand (constant)
L = Lead time (constant)
_
We also need a
reorder point to tell us
when to place an
order
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EOQ Example (1) Problem Data
Annual Demand = 1,000 units
Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
Given the information below, what are the EOQ and
reorder point?
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EOQ Example (1) Solution
Q =
2DS
H
=
2(1,000 )(10)
2.50
= 89.443 units or
OPT
90 units
d =
1,000 units / year
365 days / year
= 2.74 units / day
Reorder point, R = d L = 2.74units / day (7days) = 19.18 or
_
20 units
In summary, you place an optimal order of 90 units. In the
course of using the units to meet demand, when you only have
20 units left, place the next order of 90 units.
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EOQ Example (2) Problem Data
Annual Demand = 10,000 units
Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost per
unit
Lead time = 10 days
Cost per unit = $15
Determine the economic order quantity
and the reorder point given the following
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EOQ Example (2) Solution
Q =
2DS
H
=
2(10,000 )(10)
1.50
= 365.148 units, or
OPT
366 units
d =
10,000 units / year
365 days / year
= 27.397 units / day
R = d L = 27.397 units / day (10 days) = 273.97 or
_
274 units
Place an order for 366 units. When in the course of using the
inventory you are left with only 274 units, place the next order of 366
units.
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Fixed-Time Period Model with Safety Stock Formula
order) on items (includes level inventory current = I
time lead and review over the demand of deviation standard =
y probabilit service specified a for deviations standard of number the = z
demand daily average forecast = d
days in time lead = L
reviews between days of number the = T
ordered be to quantitiy = q
: Where
I - Z + L) + (T d = q
L + T
L + T
o
o
q = Average demand + Safety stock Inventory currently on hand
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Multi-Period Models: Fixed-Time Period Model:
Determining the Value of o
T+L
( )
o o
o
o o
T+L d
i 1
T+L
d
T+L d
2
=
Since each day is independent and is constant,
= (T+ L)
i
2
=

The standard deviation of a sequence of random

events equals the square root of the sum of the
variances
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Example of the Fixed-Time Period Model
Average daily demand for a product is 20
units. The review period is 30 days, and lead
time is 10 days. Management has set a policy
of satisfying 96 percent of demand from items
in stock. At the beginning of the review period
there are 200 units in inventory. The daily
demand standard deviation is 4 units.
Given the information below, how many units should be
ordered?
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Example of the Fixed-Time Period Model: Solution (Part 1)
( )( ) o o
T+ L d
2
2
= (T + L) = 30 + 10 4 = 25.298
The value for z is found by using the Excel NORMSINV
function, or as we will do here, using Appendix D. By
adding 0.5 to all the values in Appendix D and finding the
value in the table that comes closest to the service
probability, the z value can be read by adding the column
heading label to the row label.
So, by adding 0.5 to the value from Appendix D of 0.4599,
we have a probability of 0.9599, which is given by a z = 1.75
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Example of the Fixed-Time Period Model: Solution (Part 2)
or 644.272, = 200 - 44.272 800 = q
200 - 298) (1.75)(25. + 10) + 20(30 = q
I - Z + L) + (T d = q
L + T
units 645 +
o
So, to satisfy 96 percent of the demand, you should
place an order of 645 units at this review period
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Price-Break Model Formula
Cost Holding Annual
Cost) Setup or der Demand)(Or 2(Annual
=
iC
2DS
= Q
OPT
Based on the same assumptions as the EOQ model, the price-
break model has a similar Q
opt
formula:
i = percentage of unit cost attributed to carrying inventory
C = cost per unit
Since C changes for each price-break, the formula above will
have to be used with each price-break cost value
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Price-Break Example Problem Data
(Part 1)
A company has a chance to reduce their inventory ordering costs by placing
larger quantity orders using the price-break order quantity schedule below.
What should their optimal order quantity be if this company purchases this
single inventory item with an e-mail ordering cost of $4, a carrying cost rate
of 2% of the inventory cost of the item, and an annual demand of 10,000
units?
Order Quantity(units) Price/unit($)
0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
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Price-Break Example Solution (Part 2)
units 1,826 =
0.02(1.20)
4) 2(10,000)(
=
iC
2DS
= Q
OPT
Annual Demand (D)= 10,000 units
Cost to place an order (S)= $4
First, plug data into formula for each price-break value of C
units 2,000 =
0.02(1.00)
4) 2(10,000)(
=
iC
2DS
= Q
OPT
units 2,020 =
0.02(0.98)
4) 2(10,000)(
=
iC
2DS
= Q
OPT
Carrying cost % of total cost (i)= 2%
Cost per unit (C) = $1.20, $1.00, $0.98
Interval from 0 to 2499, the
Q
opt
value is feasible
Interval from 2500-3999, the
Q
opt
value is not feasible
Interval from 4000 & more, the
Q
opt
value is not feasible
Next, determine if the computed Q
opt
values are feasible or not
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Price-Break Example Solution (Part 3)
Since the feasible solution occurred in the first price-break, it
means that all the other true Q
opt
values occur at the beginnings of
each price-break interval. Why?
0 1826 2500 4000 Order Quantity
Total
annual
costs
So the candidates
for the price-
breaks are 1826,
2500, and 4000
units
Because the total annual cost function is
a u shaped function
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Price-Break Example Solution (Part 4)
iC
2
Q
+ S
Q
D
+ DC = TC
Next, we plug the true Q
opt
values into the total cost annual cost
function to determine the total cost under each price-break
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
= $12,043.82
TC(2500-3999)= $10,041
TC(4000&more)= $9,949.20
Finally, we select the least costly Q
opt
, which is this problem occurs
in the 4000 & more interval. In summary, our optimal order quantity
is 4000 units
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Maximum Inventory Level, M
Miscellaneous Systems:
Optional Replenishment System
M
Actual Inventory Level, I
q = M - I
I
Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.
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Miscellaneous Systems:
Bin Systems
Two-Bin System
Full Empty
Order One Bin of
Inventory
One-Bin System
Periodic Check
Order Enough to
Refill Bin
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ABC Classification System
Items kept in inventory are not of equal importance in
terms of:
dollars invested
profit potential
sales or usage volume
stock-out penalties
0
30
60
30
60
A
B
C
% of
$ Value
% of
Use
So, identify inventory items based on percentage of total dollar value,
where A items are roughly top 15 %, B items as next 35 %, and
the lower 65% are the C items
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Inventory Accuracy and Cycle Counting
Inventory accuracy refers to how well the
inventory records agree with physical count
Cycle Counting is a physical inventory-taking
technique in which inventory is counted on a
frequent basis rather than once or twice a year