MD 021 - Management and Operations

Inventory Management
Introduction
Economic Order Quantity (EOQ) Model
Economic Production Quantity Model
Quantity Discounts Model
Reorder Point (Q System)
Shortages and Service Levels
Single Period Model

Definition of Independent Demand Inventory

Independent demand inventory consists of items for which demand is influenced
by market conditions and is not related to production decisions for any other
item held in stock.
Contrast this with dependent demand inventory, consisting of items required as
components or inputs to a product or service. We will talk about managing
dependent demand inventory in manufacturing using a material requirements
planning (MRP) system.

Types of Inventory

Cycle inventory

Safety stock

Anticipation inventory

Pipeline inventory

Managing Independent Demand Inventory

Managing independent demand inventory involves answering two questions:

How much to order?

When to order?

Five Assumptions of EOQ

Demand is known and constant

Whole lots

Only two relevant costs

Item independence

Certainty in lead time and supply

Total Annual Relevant Cost

a. Annual holding cost
Annual holding cost =

Q
(H)
2

b. Annual ordering cost

Annual ordering cost =

D
(S)
Q

c. Total annual relevant cost:

c

Q
D
( H ) (S )
2
Q

Derivation of Economic Order Quantity (EOQ) and Time Between Orders

(TBO)
Total annual relevant cost: C =

Q
D
( H) (S)
2
Q

Take the first derivative of cost with respect to quality:

Setting

dC
0
dQ

and solving for Q:

Time between orders:

TBOEOQ

EOQ

2 DS
H

EOQ
D

dC H
D

2 (S )
dQ
2 Q

Overland Motors Example

Overland Motors uses 25,000 gear assemblies each year (i.e. 52
weeks) and purchases them at $3.40 per unit. It costs $50 to
process and receive each order, and it costs $1.10 to hold one unit
in inventory for a whole year. Assume demand is constant.
Ralph U. Reddie has been ordering 1,000 gear assemblies at a
time, but can adjust his order quantity if it will lower costs.
a. What is the annual cost of the current policy of using a 1,000unit lot size?

b. What is the order quantity that minimizes cost?

c. What is the time between orders for the quantity in part b?

d. If the lead time is two weeks, what is the reorder point, R?

Economic Production Quantity

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1. Maximum Cycle Inventory

I max

Q
pd
( p d ) Q(
)
p
p

2. Total cost = Annual holding cost + Annual ordering

or setup cost
c

I max
D
Q pd
D
( H ) (S ) (
)( H ) ( S )
2
Q
2
p
Q

3. Economic Production Lot Size (ELS)

ELS

2DS
H

p
pd

Economic Production Quantity Example

A domestic automobile manufacturer schedules 12 twoperson teams to assemble 4.6 liter DOHC V-8 engines per
work day. Each team can assemble five engines per day.
The automobile final assembly line creates an annual
demand for the DOHC engine at 10,080 units per year. The
engine and automobile assembly plants operate six days per
week, 48 weeks per year. The engine assembly line also
produces SOHC V-8 engines. The cost to switch the
production line from one type of engine to the other is
$100,000. It costs $2,000 to store one DOHC V-8 for one
year.
a. What is the economic lot size?

b. How long is the production run?

c. What is the average quantity in inventory?

d. What are the total annual relevant costs?

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Quantity Discounts

In the case of quantity discounts (price incentives to purchase large quantities),

the price, P, is relevant to the calculation of total annual cost (since the price is
no longer fixed).
Total cost = Annual holding cost + Annual ordering cost + Annual cost of
materials
C

Q
D
( H ) ( S ) PD
2
Q

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Quantity Discounts
Two-Step Procedure

Step 1: Beginning with lowest price, calculate the

EOQ for each price level until a feasible
EOQ is found. It is feasible if it lies in the
range corresponding to its price.
Step 2: If the first feasible EOQ found is for the
lowest price level, this quantity is best.
Otherwise, calculate the total cost for the
first feasible EOQ and for the larger price
break quantity at each lower price level. The
quantity with the lowest total cost is optimal.

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Quantity Discounts Example

Order Quantity
0-99
100 or more

Price Per Unit

$50
$45

If the ordering cost is $16 per order, annual holding

cost is 20 percent of the per unit purchase price, and
annual demand is 1,800 items, what is the best order
quantity?
Step 1.

Step 2.

EOQ45.00

EOQ50.00

C76

C100

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Reorder Point (Q System)

A continuous review (Q) system tracks the remaining inventory of an item each
time a withdrawal is made, to determine if it is time to reorder.
Decision rule: Whenever a withdrawal brings the inventory down to the reorder
point (R), place an order for Q (fixed) units.

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Reorder Point
Demand pattern
Known and
constant
Known and
constant
Variable, normally
distributed,
known
Variable, normally
distributed,
known
Known and
constant

Lead time for

ordering
None

ROP
ROP = 0

Known and constant

ROP =

d LT

Known and constant

ROP =

d LT z dLT

Known and constant

ROP =

d LT z LT d

Variable, normally
distributed,
known
unknown

ROP =

d LT zd LT

dLT

Uncertain, discrete
probability
distribution

LT

Determine ROP for a given service level

based on the cumulative probabilities of
demand during lead time.

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Shortage and Service Levels

Expected Shortage per order cycle:
E (n) = E (z)
dLT

E(z) = standardization parameter obtained from

Table 11.3.
dLT

= standard deviation of lead time demand

Expected shortage per year:

E (N) = E (n)

D
Q

Annual Service Level:

SLannual 1

E(N )
E ( z ) dLT
1
D
Q

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Q System Example
You are reviewing the companys current inventory policies for its
continuous review system (Q system), and began by checking out
the current policies for a sample of items. The characteristics of
one item are:
Average demand = 10 units/wk (assume 52 weeks per year)
Ordering and setup cost (S) = $45/order
Holding cost (H) = $12/unit/year
Average lead time (L) = 3 weeks
Standard deviation of demand during lead time = 17 units
Service-level = 70%
a) What is the EOQ for this item?

b) What is the desired safety stock?

c) What is the desired reorder point R?

d) What is the decision rule for replenishing inventory?

e) What is the expected shortage per year?

If instead of the above situation, suppose the lead time is known

and constant at 3 weeks and the standard deviation of demand
during lead time is unknown. However, we do know the standard
deviation of weekly demand to be 8 units. How do your answers
change?

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Cycle-Service Level with Discrete Distribution

Set R so that the probabilities of demand at or below its level
total the desired cycle-service level.
To find safety stock, subtract expected demand during lead time
from R.
Application:
The demand during lead time distribution is shown below, along
with possible R values and their corresponding cycle-service
levels.
Demand
Level
0
50
100
150
200
250

Probability
0.30
0.20
0.20
0.15
0.10
0.05

R
0
50
100
150
200
250

Cycle-Service
Level (%)

a. What reorder point R would result in a 95% cycle-service level?

b. How much safety stock is provided with this policy?

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Single Period (Newsvendor) Model

Used to handle ordering of perishables and items that
have a limited useful life.
shortage costs = unrealized profit per unit
excess costs = the unit cost less the salvage value
1. Calculate the shortage and excess costs:
C shortage C s Revenue per unit - Cost per unit
Cexcess Ce Original cost per unit - Salvage value per unit

2. Calculate the service level (SL), which is the

probability that demand will not exceed the
stocking level:
SL =

Cs
C s Ce

3. Determine the optimal stocking level, S o , using the

service level and demand distribution information.
So

= Mean demand + zSL*demand

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Example of the Newsvendor Model

The concession manager for the college football stadium
must decide how many hot dogs to order for the next game.
Each hot dog is sold for $2.25 and makes a profit of $0.75.
Hot dogs left over after the game are sold to the student
cafeteria for $0.50 each. Based on previous games, the
demand is normally distributed with an average of 2000 hot
dogs sold per game and a standard deviation of 400. Find
the optimal stocking level for hot dogs.

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