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Economic Order Quantity

Inventory models/techniques

ECONOMIC ORDER QUANTITY

REORDER POINT SUBSYSTEM

STOCK-LEVEL SUBSYSTEM
Introduction
• EOQ, or Economic Order Quantity, is
defined as the optimal quantity of orders
that minimizes total variable costs required
to order and hold inventory.
• The EOQ tool can be used to model the
amount of inventory that we should order
each month.
How EOQ Works

The Principles Behind EOQ: The Total Cost


Curve

& 
Assumptions
• Demand is known and consumption rate is
constant.
• Unit purchase rate is constant irrespective of
quantity purchased.
• Whole order quantity arrives at one time.
• Material is available in plenty.
• Basic costs like ordering cost and inventory
carrying cost are fairly accurate.
Methods and Models
• There are three methods of finding E.O.Q.
– Graphical method
– Algebraic method
– Tabular method

• The various EOQ models are:


– Simple/ Classical model
– Model with shortages
– Model with price breaks
– Reorder point with probabilistic demand
The Principles Behind EOQ:
The Holding Costs
• Keeping inventory on hand
• Interest
• Insurance
• Taxes
• Theft
• Obsolescence
• Storage Costs
The Principles Behind EOQ:
The Procurement Costs

• Primarily the labor costs associated with


processing the order
• Ordering and requisition
• A portion of the freight if the amounts vary
according to the size of the order
• Receiving, inspecting, stocking
• Invoice processing
Basic Formulae
Q* Optimal Order Quantity
D Annual demand quantity of the product
P Purchase cost per unit
C/Co Fixed cost per order (not per unit, in addition to unit cost)
H/Cc Annual holding cost per unit (also known as carrying cost)
(warehouse space, refrigeration, insurance, etc. usually not
related to the unit cost)
Purchase This is the variable cost of goods: purchase unit P×D
cost price × annual demand quantity.
Ordering This is the cost of placing orders: each order C × D/Q
cost has a fixed cost C, and we need to order D/Q
times per year.
Holding cost The average quantity in stock (between fully H × Q/2
replenished and empty) is Q/2, and cost of
holding it is H.
Model with Price Breaks
• Total Inventory Cost = ordering cost + holding
cost
• C= Co D + CcQ
• Q 2
Example
• Site Name – Treedom Park
• Location – Alandi, Pune.
• Built up area – 200000 sq. ft.
• 4 buildings, G + 7, residential buildings.
Annual Demand (D) 25000 bags of cement
Classical
Purchase Price(P)
Model
Rs. 210 / bag

Ordering Cost (Co) Rs. 200 per order

Holding Cost (cc) Rs 40 per unit per year

EOQ (Q*) √(2 X Co X D) / Cc 500


No. of orders (n) D / Q* 50

Optimal Cycle Time (T) Q/D 500/25000=0.02

Ordering Cost (D x Co) / Q 10000


Holding Cost (Q x Cc) / 2 10000
Purchase Cost DxP 5250000
Total Cost (TC) H.C + O.C + P.C 5270000
Model with Price Breaks
D Demand 25000 units
Co Ordering Cost 200 Rs / order
Cc Holding Cost 20% of purchase price

Lot Size Unit Price Cc


1 to 199 250 50
200 to 399 225 45
400 and above 210 42

EOQ for lot size 400 and above Q1 487.94


EOQ for lot size 200 to 399 Q2 471.4
EOQ for lot size 1 to 199 Q3 447.21
Model with Price Breaks
Holding Cost Ordering Cost Purchase Price
Q1 10247.16 10246.74 5250000.00
Q2 10606.70 10606.50 5625000.00
Q3 11180.43 11180.25 6250000.00

Total Cost for Q3 6272360.68


Total Cost for Q2 5646213.20
Total Cost for Q1(400 and above) 5270493.90

Optimal order quantity in this case is 400 units or above


Model with shortages
• Assumption of Back-ordering, shortages are
deliberately planned to occur.
• It may be advisable on economic
considerations, specially when the value of the
item in question is very high with consequent
high holding cost.
• Setting off the cost of shortages against the
saving in the holding cost.
Model with Shortages
Q* EOQ
M Max. Inventory Level
T1 Inventory Period
T2 Shortage Period
T Cycle Time
Cs Shortage Cost
Tc Total Cost
• Annual ordering cost = D/Q * A
• Since the maximum inventory, M, is Q-S.
Thus,
• Total Cost = Ordering Cost + Holding Cost +
Shortage Cost
• Total cost expression would be as follows:
T = D/Q*Co+(Q-S)2Cc/2Q+Cs*S2/2Q
EOQ = √[(2 x Co X D)/Cc] x [(Cs + Cc)/Cs]
T (Q*) = √[2 x D x Co x Cc] x [Cs/(Cs + Cc)]
• Step – I
• To identify EOQ
Step- II
To identify Optimal level of Shortages,
S* = EOQ * (Cc / Cc+Cs)
Step-III
To identify Maximum Inventory level
M= Q-S
Step – IV
Identify Total Cost
Re-order point subsystem
• Determine the re-order point : It is a point such
that the stock in hand would be just sufficient to
meet the demand during lead time.
• O.P(shortage)
• = Optimal Shortage level – Consumption during
lead time
Model With Shortages example
D Demand 25000
Cp Purchase price 210
Co Ordering Cost 200
Cc Holding Cost 40
Cs Shortage Cost 75
REORDER POINT SUBSYSTEM
• Reorder point: The inventory level at which an order should be
placed to replenish the inventory.

• It depends on:
 Inventory required during lead time.
 Minimum level of inventory held to prevent shortage
i.e. Reorder Point = Normal consumption during lead time + Safety
stock

21
Reorder Point (ROP)

ROP = d x L
Example
Arena company Buys pumps from a
manufacturer and sells to retailers

D = 1000 pumps annually


• Assume lead time, L = 3 business days
• Assume 250 business days per year
• Then daily demand,
d = 1000 pumps/250 days = 4 pumps per day

ROP = (4 pumps per day) x (3 days)


= 12 pumps
Use of Safety Stock
Determining safety stock
• The inventory model discussed so far are all
based on the twin common assumptions of
constant and known demand for the item and
lead time. Becoz of these assumptions these
models are called deterministic.
• We shall now consider the situations in which
the demand and/or lead time are not known
with certainty and they need not be constant.
• They shall be taken as random variables,
capable of assuming varying values whose
probability distributions may be known.
• In deterministic models, the stock replenished
as soon as the stock reaches the point of
exhaustion, due to the assumptions underlying
them.
• Under such idealistic situations, there is no
need to maintain any extra stock because the
supplies would reach the moment the stock
level reduces zero and there would be no stock
outs(unless they are intentionally allowed to
occur). However, when the demand is variable
and so is lead time, there is a need to provide
for the safety or buffer stocks
• In order to meet either or both the
contingencies, viz. that the demand rate during
the lead time is in excess of what was
expected/forecasted and that the delivery of
goods is delayed.
• The safety stock is and important constituent in
re-order point.
Determination of safety stock
• The analysis would be done under each of the
two conditions, first, when the safety stock
costs are known and second when they are not
known.
• Example when stock out costs are known.
Example: M/s Sunderesh Ltd. manufactures steel nuts and bolts. The
probability distributions of the daily usage rate of the raw material
(steel) and the lead time are given below:

29
Reorder Point with Probabilistic Demand
Demand 1500
Cc Rs 150 per order
Co Rs 300
Cp Rs 6000 per unit
Cs Rs 50

Demand Occurrence Probability 80 90 100 110 120 130


/Frequency
80 4 0.04 0 150 300 450 600 750
90 6 0.06 50 0 150 300 450 600
100 80 0.8 100 50 0 150 300 450
110 5 0.05 150 100 50 0 150 300
120 3 0.03 200 150 100 50 0 150
130 2 0.02 250 200 150 100 50 0
100 1.00 101.5 59.5 29.5 159.5 299.5 445.5

Optimum
Reorder Point with Probabilistic Demand
• Expected DDLT
(80x4)+(90x6)+(100x80)+(110x5)+(120x3)+(130x2)
100
= 100.3
Order point = DDLT+ Safety stock
Safety stock = O.P(maximum DDLT)-(Average EDDLT)
• Optimal Safety Stock
100 – 100.3 = –0.3 items