Chapter 8

Inventory Models

m
 8.1 Overview of Inventory Issues
‡ Proper control of inventory is crucial to the success of an
enterprise.
‡ Typical inventory problems include:
± Basic inventory ± Planned shortage
± Quantity discount ± Periodic review
± Production lot size ± Single period
‡ Inventory models are often used to develop an optimal
inventory policy, consisting of:
± An order quantity, denoted Q.
± A reorder point, denoted R.

 Type of Costs in Inventory Models
‡ Inventory analyses can be thought of as cost-control
techniques.
‡ Categories of costs in inventory models:
± Holding (carrying costs)
± Order/ Setup costs
± Customer satisfaction costs
± Procurement/Manufacturing costs

a
 Type of Costs in Inventory Models
‡ Holding Costs (Carrying costs):
These costs depend on the order size
± Cost of capital
± Storage space rental cost
± Costs of utilities
± Labor Ch = H * C
± Insurance
± Security Ch = Annual holding cost per unit
± Theft and breakage in inventory
± Deterioration or Obsolescence H = Annual holding cost rate
C = Unit cost of an item

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 Type of Costs in Inventory Models
‡ Order/Setup Costs
These costs are independent of the order size.
± Order costs are incurred when purchasing a good
from a supplier. They include costs such as
‡ Telephone
‡ Order checking Co = Order cost
‡ Labor or setup cost
‡ Transportation
± Setup costs are incurred when producing goods for
sale to others. They can include costs of
‡ Cleaning machines
‡ Calibrating equipment
‡ Training staff
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 Type of Costs in Inventory Models
‡ Customer Satisfaction Costs
± Measure the degree to which a
customer is satisfied. Cb = Fixed administrative
± Unsatisfied customers may: costs of an out of stock
‡ Switch to the competition (lost sales). item ($/stockout unit).
‡ Wait until an order is supplied. Cs = Annualized cost of a
± When customers are willing to wait customer awaiting an
there are two types of costs out of stock item
incurred: ($/stockout unit per
year).

V
 Type of Costs in Inventory Models
‡ Procurement/Manufacturing Cost
± Represents the unit purchase cost
(including transportation) in case of a
purchase.
± Unit production cost in case of in-
house manufacturing.

C = Unit purchase or
manufacturing cost.

 Demand in Inventory Models
‡ Demand is a key component affecting an inventory
policy.
‡ Projected demand patterns determine how an
inventory problem is modeled.
‡ Typical demand patterns are:
± Constant over time (deterministic inventory models)
± Changing but known over time (dynamic models)
± Variable (randomly) over time (probabilistic models)

D = Demand rate (usually per year)

÷
 Inventory lassifications

Inventory can be classified in various ways:

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aterials eris
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Non eris
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inis
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Used ty ically by accountants Ite s are classified by Mana e ent of ite s
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t e roduction rocess. ca ital needs. different

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 Review Systems

‡ Two types of review systems are used:

± Continuous review systems.
‡ The system is continuously monitored.
‡ A new order is placed when the inventory reaches a critical
point.
± Periodic review systems.
‡ The inventory position is investigated on a regular basis.
‡ An order is placed only at these times.

m
8.2 Economic Order Quantity Model -
Assumptions
‡ Demand occurs at a known and reasonably
constant rate.
‡ The item has a sufficiently long shelf life.
‡ The item is monitored using a continuous review
system.
‡ All the cost parameters remain constant forever
(over an infinite time horizon).
‡ A complete order is received in one batch.
mm
 The EOQ Model ±
Inventory profile
‡ The constant environment described by the EOQ
assumptions leads to the following observation:

The optimal EOQ policy consists of same-size orders.

Q Q Q
This observation results in the following inventory profile :

m
 Cost Equation for the EOQ Model
Total Annual = Total Annual + Total Annual + Total Annual
Inventory Costs Holding Costs ordering Costs procurement Costs

TC(Q) = (Q/2)Ch + (D/Q)Co + DC

The optimal order Size

Q Q
2D C o Q

Q* =
Ch

ma
 TV(Q) and Q*
TV(Q)
Constructing the total annual variable cost curve
Add the two curves to one another
Total annual holding and

* * o ordering costs
*
* *

Q* Q
The optimal order size mï
Sensitivity Analysis in EOQ models
The curve is reasonably flat around Q*.
Deviations from the optimal order size
cause only small increase in the total cost.

Q* mÄ
 Cycle Time
‡ The cycle time, T, represents the time that
elapses between the placement of orders.

T = Q/D

‡ ote, if the cycle time is greater than the shelf

life, items will go bad, and the model must be
modified.
mV
 umber of Orders per Year

‡ To find the number of orders per years take the

reciprocal of the cycle time

= D/Q

‡ Example: The demand for a product is 1000 units per year.

The order size is 250 units under an EOQ policy.
‡ How many orders are placed per year? = 1000/250 = 4 orders.
‡ How often orders need to be placed (what is the cycle time)?
T = 250/1000 = ¼ years. { ote: the four orders are equally spaced}.
m
 Lead Time and the Reorder Point

‡ In reality lead time always exists, and must be

accounted for when deciding when to place an
order.
‡ The reorder point, R, is the inventory position
when an order is placed.
‡ R is calculated by
R=LD

L and D must be expressed in the same time unit.

m÷
 Lead Time and the Reorder Point ±
Graphical demonstration: Short Lead Time

Reorder
Point

Place the order L

now
R = Inventory at hand at the beginning of lead time mÖ
 Lead Time and the Reorder Point ±
Graphical demonstration: Long Lead Time
Outstanding order R = inventory at hand
at the beginning of lead time +
one outstanding order
= demand during lead time
Inventory
at = LD
hand


Place the order L
now
 Safety stock
‡ Safety stocks act as buffers to handle:
± Higher than average lead time demand.
± Longer than expected lead time.
‡ With the inclusion of safety stock (SS), R is calculated by

R = LD + SS

‡ The size of the safety stock is based on having a desired

service level.
m
 Safety stock
Planned
situation
Actual
Reorder situation
Point

Place the order L

now
R = LD 
 Safety stock
Actual
situation
Reorder
Point ?

LD
SS=Safety stock

Place the order L

now The safety stock
prevents excessive
R = LD + SS shortages. a
 Inventory Costs
Including safety stock

Total Annual = Total Annual + Total Annual + Total Annual

Inventory Costs Holding Costs ordering Costs procurement Costs

TC(Q) = (Q/2)Ch + (D/Q)Co + DC + ChSS

Safety stock
holding cost

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 ALLE APPLIA CE COMPA Y (AAC)

‡ AAC wholesales small appliances.

‡ AAC currently orders 600 units of the Citron brand
juicer each time inventory drops to 205 units.
‡ Management wishes to determine an optimal
ordering policy for the Citron brand juicer

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 ALLE APPLIA CE COMPA Y (AAC)
‡ D t
± C =$ ($ f pl ing n d ) + ( min. t )($ p )
± C =$ . [HC = ( %)($ )]
± C =$ .
± H = % ( % nn. int t t ) + ( % mi ll n )
± D = d m nd inf m ti n f t l t ll t d:

l fJ i t l t
3
l
7 9
l 3 3
V
 ALLE APPLIA CE COMPA Y (AAC)

‡ Data
± The constant demand rate seems to be a good
assumption.
± Annual demand = (120/week)(52weeks) = 6240 juicers.


 AAC ± Solution:
EOQ and Total Variable Cost

‡ Current ordering policy calls for Q = 600 juicers.

TV( 600) = (600 h 2)($1.40) + (6240 h 600)($12) = $544.80

‡ The EOQ policy calls for orders of size

Savings of 16%


2(6240)(12)
*
Q= = 2 .065 2
1.40

TV( 2 ) = ( 2 h 2)($1.40) + (6240 h 2 ) ( $12) = $45 .8

÷
 AAC ± Solution:
Reorder Point and Total Cost

‡ Under the current ordering policy AAC holds 1 units safety

stock (how come? Observe):

‡ AAC is open 5 day a week.

± The average daily demand = 120/week)/5 = 24 juicers.
± Lead time is 8 days. Lead time demand is (8)(24) = 1 2 juicers.
± Reorder point without Safety stock = LD = 1 2.
± Current policy: R = 205.
± Safety stock = 205 ± 1 2 = 1 .

‡ For safety stock of 1 juicers the total cost is

TC( 2 ) = 45 .8 + 6240($10) + (1 )($1.40) = $62,8 6.0
TV( 2 ) + Procurement + Safety stock
cost holding cost Ö
 AAC ± Solution:
Sensitivity of the EOQ Results

‡ Changing the order size

± Suppose juicers must be ordered in increments of 100 (order 00 or 400)
± AAC will order Q = 00 juicers in each order.
± There will be a total variable cost increase of $1. 1.
± This is less than 0.5% increase in variable costs.

‡ Changes in input parameters

± Suppose there is a 20% increase in demand. D= 500 juicers.
± The new optimal order quantity is Q* = 5 . Only 0.4%
± The new variable total cost = TV( 5 ) = $502
increase
± If AAC still orders Q = 2 , its total variable costs becomes

TV( 2 ) = ( 2 â2)($1.40) + ( 500â 2 )($12) = $504.1

a
 AAC ± Solution:
Cycle Time

‡ For an order size of 2 juicers we have:

± T = ( 2 â 6240) = 0.0524 year.

= 0.0524(52)(5) = 14 days.
working days per week

± This is useful information because:

‡ Shelf life may be a problem.
‡ Coordinating orders with other items might be desirable.
am
 AAC ± Excel Spreadsheet

=1/E11 =SQRT(2*$B$10*$
Copy to cell H12 B$14/$B$1 )

=$B$15*$B$10+$B$16- =E10/B10
I T(($B$15*$B$10+$B$16)/E10)*E10 Copy to cell
Copy to cell H1 H11

=(E10/2)*$B$1 +($B$10/E10)*$B$14
=$B$10*$B$11+E14+$B$1 *B16
Copy to cell H14 a
Copy to Cell H15
Service Levels and
Safety Stocks

aa
 8. Determining Safety Stock Levels

‡ Businesses incorporate safety stock requirements

when determining reorder points.
‡ A possible approach to determining safety stock
levels is by specifying desired service level .

aï
 Two Types of Service Level
Service levels can be viewed in two ways.

‡ The cycle service level ‡ The unit service level

± The probability of not
incurring a stockout during
an inventory cycle.
± Applied when the likelihood
of a stockout, and not its
magnitude, is important for
the firm.
± The percentage of demands
that are filled without
incurring any delay.
± Applied when the percentage
of unsatisfied demand
should be under control.
aÄ
 The Cycle Service Level Approach
‡ In many cases short run demand is variable even
though long run demand is assumed constant.

‡ Therefore, stockout events during lead time may

occur unexpectedly in each cycle.

‡ Stockouts occur only if demand during lead time is

greater than the reorder point.
aV
 The Cycle Service Level Approach
‡ To determine the reorder point we need to know:
± The lead time demand distribution.
± The required service level.

‡ In many cases lead time demand is approximately

normally distributed. For the normal distribution case
the reorder point is calculated by

R = ˜L + z
L 1± = service level
a
The Cycle Service Level Approach

Service level = P(DL>R) =

P(DL<R) =
1±

˜=1 2 R

P(DL> R) = P(Z > (R ± ˜L)/
L) = . Since

P(Z > Z ) = , we have Z = (R ± ˜L)/
L,
which gives«
R = ˜L + z
L
a÷
 AAC -
Cycle Service Level Approach
‡ Assume that lead time demand is normally
distributed.
‡ Estimation of the normal distribution parameters:

± Estimation of the mean weekly demand =

ten weeks average demand = 120 juicers per week.

± Estimation of the variance of the weekly demand =

Sample variance = 8 . juicers2.
aÖ
 AAC -
Cycle Service Level Approach
‡ To find ˜Land
L the parameters ˜ (per week) and

(per week) must be adjusted since the lead time is
longer than one week.

± Lead time is 8 days =(8h5) weeks = 1.6 weeks.

‡ Estimates for the lead time mean demand and

variance of demand
˜L
(1.6)(120) = 1 2;
2L
(1.6)(8 . ) = 1 ï.
 AAC -
Service Level for a given Reorder Point

‡ Let us use the current reorder point of 205 juicers.

205 = 1 2 + z (11.55) ƒ z = 1.1 1 .

‡ From the normal distribution table we have that a reorder

point of 205 juicers results in an 8 % cycle service level.

ïm
 AAC ±
Reorder Point for a given Service Level

‡ Management wants to improve the cycle service

level to %.
‡ The z value corresponding to 1% right hand tail is
2. .
R = 1 2 + 2. (11.55) = 21 juicers.

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 AAC ±
Acceptable umber of Stockouts per Year

‡ AAC is willing to run out of stock an average of at

most one cycle per year with an order quantity of
2 juicers.

‡ What is the equivalent service level for this

strategy?

ïa
 AAC ±
Acceptable umber of Stockouts per Year

‡ There will be an average of

6240âa2 = 1 .08 lead times per year.
‡ The likelihood of stockouts = 1/1 = 0.0524.
‡ This translates into a service level of 4. 6%

ïï
 The Unit Service Level Approach

‡ When lead time demand follows a normal distribution

service level can be calculated as follows:
± Determine the value of z that satisfy the equation

L(z) = Q* â
L

± Solve for R using the equation

R = ˜L + z
L

ïÄ
 AAC ±
Cycle Service Level (Excel spreadsheet)

= ORMI V(B ,B5,B6)

= ORMDIST(B8,B5,B6,TRUE)

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 Discussion

‡ Pilih persoalan inventory yang paling saudara

kenal.
‡ Rancang sistem inventory yang sesuai
‡ Dengan asumsi-asumsi tertentu, tentukan kuantitas
pemesanan yang optimal
‡ Lakukan analisis !

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8.4 EOQ Models with Quantity Discounts

‡ Quantity Discounts are Common Practice in Business

± By offering discounts buyers are encouraged to increase
their order sizes, thus reducing the seller¶s holding costs.

± Quantity discounts reflect the savings inherent in large

orders.

± With quantity discounts sellers can reward their biggest customers

without violating the Robinson - Patman Act.

ï÷
 8.4 EOQ Models with Quantity Discounts
‡ Quantity Discount Schedule
± This is a list of per unit discounts and their corresponding
purchase volumes.
± ormally, the price per unit declines as the order quantity
increases.
± The order quantity at which the unit price changes is called a
break point.
± There are two main discount plans:
‡ All unit schedules - the price paid for all the units purchased is based on
the total purchase.
‡ Incremental schedules - The price discount is based only on the
additional units ordered beyond each break point. ïÖ
 All Units Discount Schedule
‡ To determine the optimal order quantity, the total
purchase cost must be included

TC(Q) = (Qâ2)Ch + (DâQ)Co + DCi + ChSS

Ci represents the unit cost at the ith pricing level.

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 AAC - All Units Quantity Discounts
‡ AAC is offering all units quantity discounts to its
customers.
‡ Data
˜Quantity



Discount
  
c ul
mm


 m
m

 
 


 
 



m
m


 

2 
 

Äm
Should AAC increase its regular order of
a2 juicers, to take advantage of the discount?

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 AAC ± All units discount procedure

± Step 1: Find the optimal order Qi* for each discount level ³i´.
Use the formula Q *  ( 2 Co ) / Ch
± Step 2: For each discount level ³i´ modify Q i* as follows
‡ If Qi* is lower than the smallest quantity that qualifies for the i th
discount, increase Qi* to that level.
‡ If Qi* is greater than the largest quantity that qualifies for the ith
discount, eliminate this level from further consideration.
± Step a: Substitute the modified Q*i value in the total cost
formula TC(Q*i ).
± Step 4: Select the Q i * that minimizes TC(Q i*)
Äa
 AAC ± All units discount procedure
Step 1: Find the optimal order quantity Qi* for each
discount level ³i´ based on the EOQ formula

o est cost order si e per discount level

iscount Qualifyin rice
level order per unit Q*
1 1
1 1

1
2

Äï
 AAC ± All Units Discount Procedure
± Step 2 : Modify Q i *
$10/unit
$ . 5/unit $ .50
Q1* Q2Q* *
aa6
a
1 2 a00 aa1 5 600
Modified
Modified Q*
Q* dd tot
tot oo tt
QQ ified
ified i i ee Modified
Modified otot
de
de pe
pe itit Q*
Q* Q*
Q* oo tt
22 ****
**** ****
****
22 22

2 22 ÄÄ
 AA ± A it Di o t o ed e
± Step 2 : Modify Q i *
$ / it * Q*Q *
* Q * $
* QQ * *
* Q
Q Q
Q 2 Q *

2
Modified
Modified Q*
Q* dd tot
tot oo tt
QQ ified
ified i i ee Modified
Modified otot
de
de pe
pe itit Q*
Q* Q*
Q* oo tt
22 ****
**** ****
****
22 22

22 ÄV
 AAC ± All Units Discount Procedure
± Step a: Substitute Q I * in the total cost function
odified
odified Q*
Q* and
and total
total ost
ost
Qualified
Qualified rice
rice odified
odified Total
Total
rder
rder per
per nitnit Q*
Q* Q*
Q* ost
ost
1-2
1-2 10.00
10.00 a00
a00 ****
**** ****
****
a00-5
a00-5 .5
. 5 aa1
aa1 aa1
aa1 61,2
61,2 2.1a
2.1a
600-
600- .50
.50 aa6
aa6 600
600 55 ,80a.80
,80a.80
1000-4
1000-4 .40
.40 aa
aa 1000
1000 55 ,a88.88
,a88.88
2 5000
5000 .00
.00 a45
a45 5000
5000 55 ,a24.
,a24. 88
± Step 4 AAC should order 5000 juicers
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 AAC ± All Units Discount Excel Worksheet
m

 

 


 

 
 

 

Annual Demand, D = 6240.00 Order quantity, Q* = 5000
Per Unit Cost, C = 10.00 Cycle Time (in years), T = 0.801282051
Annual Holding Cost Rate, H = 0.14 # of Cycles Per Year, N = 1.248
Annual Holding Cost Per Unit, Ch = 1.40 Reorder Point, R = 205.0000
Order Cost, Co = 12.00 Total Annual Cost, TC(Q*) = 59341.36
Lead Time (in years), L = 0.03077
Safety Stock, SS = 13.00

 m

4
   
  
      
0 1 10.00 327 62876.09 327
1 300 9.75 331 61309.88 331
2 600 9.50 336 59821.09 600
3 1000 9.40 337 59405.99 1000
4 5000 9.00 345 59341.36 5000
5
6
7
8
Ä÷
 8.4 Production Lot Size Model -
Assumptions
‡ Demand rate is constant.
‡ Production rate is larger than demand rate.
‡ The production lot is not received instantaneously (at an
infinite rate), because production rate is finite.

‡ There is only one product to be scheduled.

‡ The rest of the EOQ assumptions stay in place.

ÄÖ
 Production Lot Size Model ±
Inventory profile

‡ The optimal production lot size policy orders the

same amount each time.
‡ This observation results in the inventory profile
below:

V
 Production Lot Size Model ±
Understanding the inventory profile
The production increases the
inventory at a rate of P.
Demand accumulation
during production run = DT1
Maximum inventory Maximum inventory = (P ± D)T1
= (P ± D)(Q/P) = Q(1 ± D/P)
Production
The inventory increases Lot Size = Q = PT1
at a net rate of P - D T1
Demand accumulation
Production
during production run
time
The demand decreases the
inventory at a rate of D.
Vm
 Production Lot Size Model ±
Total Variable Cost

‡ The parameters of the total variable costs function are

similar to those used in the EOQ model.

‡ Instead of ordering cost, we have here a fixed setup

cost per production run (Co).

‡ In addition, we need to incorporate the annual

production rate (P) in the model.
V
 Production Lot Size Model ±
Total Variable Cost
TV(Q) = (Qâ2)(1 - DâP)Ch + (DâQ)Co

P is the annual production rate

The average inventory

The Optimal Order Size

*
2DCo
Q = C (1-D/P)
h

Va
 Production Lot Size Model ±
Useful relationships

‡ Cycle time T = Q h D.

‡ Length of a production run T1 = Q h P.

‡ Time when machines are not busy producing the

product T2 = T - T1 = Q(1hD - 1hP).

‡ Average inventory = (Qh2)(1-DhP).

Vï
 FARAH COSMETICS COMPA Y

‡ Farah needs to determine optimal production lot

size for its most popular shade of lipstick.
‡ Data
‡ The factory operates  days a week, 24 hours a day.
‡ Production rate is 1000 tubes per hour.
‡ It takes a0 minutes to prepare the machinery for production.
‡ It costs $150 to setup the line.
‡ Demand is 80 dozen tubes per week.
‡ Unit production cost is $.50
‡ Annual holding cost rate is 40%.
VÄ
 FARAH COSMETICS COMPA Y ±
Solution
Dozens
‡ Input for the total variable cost function
D = 61a,200 per year [( 80 dozen/week (12)â ](a65)

Ch = 0.4(0.5) = $0.20 per tube per year.

Co = $150

P = (1000)(24)(a65) = 8,60,000 per year.

VV
 FARAH COSMETICS COMPA Y ±
Solution
‡ Current Policy
Currently, Farah produces in lots of 84,000 tubes.

T = (84,000 tubes per run)â(61a,200 tubes per year)= 0.1a years

(about 50 days).

T1 = (84,000 tubes per lot)â(8,60,000 tubes per year)= 0.00 6 years

(about a.5 days).

T2 = 0.1a - 0.00 6 = 0.124 years (about 46.5 days).

TV(Q = 84,000) = (84,000â2) {1-(61a,200â8,60,000)}(0.2)

+ 61a,200â84,000)(150) = $8 0.
V
 FARAH COSMETICS COMPA Y ±
Solution
‡ The Optimal Policy
The optimal order size
Using the input data we find

2(61a,200)(150)
Q* = = a1,4
(0.2)(1-61a,200/860,000)

TV(Q* = a1,4 ) = (a1,4 h2) [1-(61a,200h8,60,000)](0.2) +

(61a,200ha1,4 )(150) = $5,850.
V÷
 FARAH COSMETICS COMPA Y ±
Production Lot Size Template (Excel)

VÖ
 8.5 Planned Shortage Model

‡ When an item is out of stock, customers may:

± Go somewhere else (lost sales).
± Place their order and wait (backordering).

‡ In this model we consider the backordering case.

‡ All the other EOQ assumptions are in place.


 Planned Shortage Model ±
the Total Variable Cost Equation
‡ The parameters of the total variable costs function are
similar to those used in the EOQ model.

‡ In addition, we need to incorporate the shortage costs in

the model.
± Backorder cost per unit per year (loss of goodwill cost) - Cs.
‡ Reflects future reduction in profitability.
‡ Can be estimated from market surveys and focus groups.
± Backorder administrative cost per unit - Cb
‡ Reflects additional work needed to take care of the backorder.
m
 Planned Shortage Model ±
the Total Variable Cost Equation
‡ The Annual holding cost =
Ch[T1âT](Average inventory) =
Ch[T1âT] (Q-S)â2

‡ The Annual shortage cost =

Cb(number of backorders per year) +
Cs(T2âT)(Average number of backorders).
T1 T2
‡ To calculate the annual holding cost and
shortage cost we need to find T
± The proportion of time inventory is carried, (T1/T)
± The proportion of time demand is backordered, (T2/T).

 Finding T1/ T and T2/ T

Average inventory = (Q - S) / 2
Q-S Proportion of time
inventory exists
Q = T1âT

Q = (Q - S) / Q

T1 T2 T1
Proportion of time
T shortage exists
S T S = T2âT
=S/Q
Average shortage = S / 2 a
 Planned Shortage Model ±
The Total Variable Cost Equation

‡ Annual holding cost:

Ch[T1âT](Q-S)â2 = Ch[(Q-S) âQ](Q-S)â2
= Ch(Q-S)2â2Q

‡ Annual shortage cost:

Cb(Units in short per year) +
Cs[T2âT](Average number of backorders) =
Cb(S)(DâQ) + CsS2/2Q

ï
 Planned Shortage Model ±
The Total Variable Cost Equation
± The total annual variable cost equation

(Q -S)2 D (C + SC ;  S2
TV(Q,S) = Ch + o b CS
2Q Q 2Q
Holding Ordering Time independent Time dependent
costs costs backorder costs backorder costs
± The optimal solution to this problem is obtained under the
following conditions
‡ Cs > 0 ;

‡ Cb < \/ 2CoCh / D
Ä
 Planned Shortage Model ±
The Optimal Inventory Policy
The Optimal Order Size
2DCo Ch + Cs (DCb)2
Q* = Ch
x
Cs
i
ChCs
The Optimal Backorder level
Q * C - DC
* h b
S= C +C
h s
Reorder Point
R = L D - S*
V
 SCA LO PLUMBI G CORPORATIO

‡ Scanlon distributes a portable sauna from Sweden.

‡ Data
± A sauna costs Scanlon $2400.
± Annual holding cost per unit $525.
± Fixed ordering cost $1250 (fairly high, due to costly transportation).
± Lead time is 4 weeks.
± Demand is 15 saunas per week on the average.


 SCA LO PLUMBI G CORPORATIO
± Backorder costs
‡ Scanlon estimates a $20 goodwill cost for each week a
customer who orders a sauna has to wait for delivery.
‡ Administrative backordrer cost is $10.

‡ Management wishes to know:

± The optimal order quantity.
± The optimal number of backorders.
÷
 SCA LO PLUMBI G ±
Solution

‡ Input for the total variable cost function

± D = 80 saunas [(15)(52)]

± Co = $1,250
± Ch = $525
± Cs = $1,040
± Cb = $10

Ö
 SCA LO PLUMBI G ±
Solution
‡ The optimal policy

2(80)(1250) 525+1040 (80)(10)2

Q* = 525
x
1040
i (525)(1040)
4

(4)(525) — (80)(10)
S*= 525 + 1040

20

R = (4 / 52)(80) i 20 = 40
÷
 SCA LO PLUMBI G ±
Spreadsheet Solution

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 8. Review Systems ± Continuous
Review
‡ (R, Q) Policies
± The EOQ, production lot size, and planned shortage
models assume that
‡ inventory levels are continuously monitored
‡ Items are sold one at a time.

÷
 8. Review Systems ± Continuous
Review
‡ (R, Q) Policies
± The above models call for order point (R) order
quantity (Q) inventory policies.
± Such policies can be implemented by
‡ A point-of-sale computerized system.
‡ The two-bin system.

÷a
 Continuous Review Systems

‡ (R, M) policies
± When items are not necessarily sold one at a time, the
reorder point might be missed, and out of stock
situations might occur more frequently.

± The order to level (R, M) policy may be implemented in

this situation.

֕
 Continuous Review Systems

‡ (R,M) policies
± The R, M policy replenishes inventory up to a pre-
determined level M.

± Order Q = Q* + (R ± I) = (M ± SS) + (R ± I) each

time the inventory falls to the reorder point R or below.
(Order size may vary from one cycle to another).
ր
 Periodic Review Systems

‡ It may be difficult or impossible to adopt a

continuous review system, because of:
± The high price of a computerized system.
± Lack of space to adopt the two-bin system.
± Operations inefficiency when ordering different items from
the same vendor separately.
‡ The periodic review system may be found more suitable
for these situations.

÷V
 Periodic Review Systems

‡ Under this system the inventory position for each

item is observed periodically.

‡ Orders for different items can be better

coordinated periodically.

÷
 Periodic Review Systems
± (T,M) Policies
‡ In a replenishment cycle policy (T, M), the inventory
position is reviewed every T time units.
‡ An order is placed to bring the inventory level back up
to a maximum inventory level M.
‡ M is determined by
± Forecasting the number of units demanded during the
review period T.
± Adding the desired safety stock to the forecasted demand.

÷÷
 Periodic Review Systems

‡ Calculation of the replenishment level and order

size

M = TD + SS
T =Review period
L = Lead time Q = M + LD ± 6
SS= Safety stock
Q = Inventory position
D = Annual demand
I = Inventory position ÷Ö
 AAC operates a (T, M) policy

‡ Every three weeks AAC receives deliveries of

different products from Citron.
‡ Lead time is eight days for ordering Citron¶s
juicers.
‡ AAC is now reviewing its juicer inventory and
finds 210 in stock.
‡ How many juicers should AAC order for a safety
stock of a0 juicers?
Ö
 AAC operates a (T, M) policy ± Solution

‡ Data
± Review period T = a weeks = a/52 = .056 years,
± Lead time = L = 8 days = 8/260 = .0a0 years,
± Demand D = 6240 juicers per year,
AAC operates
± Safety stock SS = a0 juicers, 260 days a year.
± Inventory position I = 210 juicers (5)(52) = 260.

Öm
 AAC operates a (T, M) policy ± Solution

‡ Review period demand = TD = ( a/52)(6240) = a60

juicers,

‡ M = TD + SS = a60 + a0 = a0 juicers,

‡ Q = M + LD ±
= a0 + .0a0(6240) - 210 = a2

juicers.

Ö
 AAC operates a (T, M) policy ± Solution
Replenishment level
Order Order M = maximum inventory

Inventory position
Inventory position

SS SS SS

Review L Review L
point T point

otice: I + Q is designed to satisfy the demand within an interval of T + L.

To obtain the replenishment level add SS to I + Q.
Öa
 8.8 Single Period Inventory Model -
Assumptions
‡ Demand is stochastic ‡ At the end of each
with a known distribution. period, unsold inventory
‡ Shelf life of the item is is disposed of for some
limited. salvage.
‡ Inventory is saleable only ‡ The salvage value is less
within a single time than the cost per item.
period. ‡ Unsatisfied demand may
‡ Inventory is delivered result in shortage costs.
only once during a time
period.
Öï
 The Expected Profit Function

‡ To find an optimal order quantity we need to balance the

expected cost of over-ordering and under ordering.

Expected Profit = 
x
(Profit when Demand=X)Prob(Demand=X)

‡ The expected profit is a function of the order size, the random

demand, and the various costs.

ÖÄ
 The Expected Profit Function
± Developing an expression for EP(Q)
‡ otation
p = per unit selling price of the good.
c = per unit cost of the good.
s = per unit salvage value of unsold good.
K = fixed purchasing costs
Q = order quantity.
EP(Q) = Expected Profit if Q units are ordered.

‡ Scenarios
± Demand X is less than the order quantity (X < Q).
± Demand X is greater than or equal to the order quantity (X 2Q.
ÖV
 The Expected Profit Function
‡ Scenario 1: Demand X is less than the units
stocked, Q.
Profit = pX + s(Q - X) - cQ - K
‡ Scenario 2: Demand X is greater than or equal to the
units stocked.
Profit = pQ - g(X - Q) - cQ - K

EP(Q) = [pX+s(Q - X) - cQ - K]P(X) + [pQ - g(X - Q) - cQ - K]P(X)

X| Q X2 Q

Ö
 The Optimal Solution
± To maximize the expected profit order Q*

‡ For the discrete demand case take the smallest value of Q*

that satisfies the condition

P(D w Q*) 2 (p - c + g)â(p - s + g)

‡ For the continuous demand case find the Q* that solves

F(Q*) = (p - c + g) â(p - s + g)
Ö÷
 THE SE TI EL EWSPAPER
‡ Management at Sentinel wishes to know how
many newspapers to put in a new vending
machine.
Demand distribution is
‡ Data discrete uniform between
± Unit selling price is $0.a0 a0 and 4 newspapers.
± Unit production cost is $0.a8.
± Advertising revenue is $0.18 per newspaper.
± Unsold newspaper can be recycled and net $0.01.
± Unsatisfied demand costs $0.10 per newspaper.
± Filling a vending machine costs $1.20.
ÖÖ
 SE TI EL - Solution

‡ Input to the optimal order quantity formula

p = 0.a0
c = 0.20 [0.a8-0.18]
s = 0.01
g = 0.10 p+ g - c
The probability of the optimal service level =
p+ g - s
K = 1.20
0.a0 + 0.10 - 0.20 = 0.51a
=
0.a0 + 0.10 - 0.01
m
 SE TI EL ± Solution
Finding the optimal order quantity Q*
1.0

P(D w a) = 0.50

P(D w 40) = 0.55
0.51a

0.55
0.50
Q* = 40

m m
a0 a 40 4
SE TI EL ± Spreadsheet Solution

=(B5+B8-B6)/(B5+B8-B)

=(E6-B10+1)/(B11-B10+1)

=ROU DUP(B10+E5*(B11-
10),0)

m 
 WE DELL¶S BAKERY
‡ Management in Wendell¶s wishes to determine
the number of donuts to prepare for sale, on
weekday evenings
Demand is normally distributed
‡ Data with a mean of 120, and a
± Unit cost is $0.15. standard deviation of 20 donuts.
± Unit selling price is $0.a5.
± Unsold donuts are donated to charity for a tax credit
of $0.05 per donut.
± Customer goodwill cost is $0.25.
± Operating costs are $15 per evening.
m a
 WE DELL¶S BAKERY - Solution

‡ Input to the optimal order quantity formula

p = $0.a5
c = $0.15
s = $0.05
g = $0.25 p+ g - c
The optimal service level = p+ g - s
K = $15.00
0.a5+ 0.25 - 0.15 = 0.8182
=
0.a5+0.25 - 0.05

m ï
 WE DELL¶S BAKERY - Solution
Finding the optimal order quantity
‡ From the relationship F(Q*) = 0.8182 we find the
corresponding z value.
‡ From the standard normal table we have z = 0.a186.
‡ The optimal order quantity is calculated by

Q* = ˜ + z
.8182

˜=120 Q*

‡ For Wendell¶s Q* = 120 + (0.a186)(20)  1a8

m Ä
 WE DELL¶S BAKERY - Solution
Calculating the expected profit
‡ For the normal distribution
EP(Q*) = (p - s) ˜ - (c - s)Q* - (p + g - s) (
)L[(Q* - ˜ ) h
 - K

L [(Q* - ˜ ) /
 is obtained from the partial expected value

table.
‡ For Wendell¶s
EP(1a8) = (0.a5 - 0.05)(120) - (0.15 - 0.05)(1a8) - (0.a5 + 0.25
- 0.05)x(20)L[(1a8 - 120) / 20] - 15 = $6.10
L(0.) = 0.1004 m V
 WE DELL¶S BAKERY -
Spreadsheet Solution

= ORMI V(E5,
B10,B11) =(B5+B8-
B6)/(B5+B8-B)

=(B5-B)*B10-(B6-B)*E6-(B5+B8-B)*B11*(EXP(-
(((E6-B10)/B11)^2)/2)/((2*PI())^0.5)-((E6-B10)/B11)*(1-
ORMSDIST((E6-B10)/B11)))-B
m 
 WE DELL¶S ±
The commission strategy
‡ When commission replaces fixed wages«
± Compare the maximum expected profit of two strategies:
‡ $0.1a commission paid per donut sold,
‡ $15 fixed wage per evening (calculated before).
± Calculate first the optimal quantity for the alternative
policy.
± Check the expected difference in pay for the operator.

m ÷
 WE DELL¶S ±
The commission strategy - Solution
‡ The unit selling price changes to
c = 0.a5 - 0.1a = $0.22

‡ The optimal order:

F(Q*) = (0.22 + 0.25 - 0.15) / (0.22 + 0.25 - 0.05)= 0.616.

‡ Z = .1
Q* = ˜ + z
= 120 + (0.1)(20)
1a4 donuts.

m Ö
 WE DELL¶S ±
The commission strategy - Solution

‡ Will the bakery¶s expected profit increase?

EP(1a4) = (0.22 - 0.05)(20) - (0.15 - 0.05)(1a4) - (0.22 +
0.25 - 0.05)x(20)L[(1a4 - 120) / 20] = $5.80 < 6.10

‡ The bakery should not proceed with the alternative

plan.

mm
 WE DELL¶S ±
The commission strategy - Solution

‡ Comments
± The operator expected compensation will increase,
but not as much as the bakery¶s expected loss.
± An increase in the mean sales is probable when the
commission compensation plan is implemented. This
may change the analysis results.

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