Lecture 9

INVENTORY MODELS (Part I)

Deterministic Probabilistic
Model Model
Forecast of Demand

Aggregate Planning

Master Production Schedule

Inventory Control

Operations Scheduling

Vehicle Routing 1
Demand Pattern in Inventory Model
Variation, V = (Standard deviation / Mean) x 100
1) Deterministic + constant (static) with time
 Average monthly demand is approximately constant
and V is reasonably small (< 20%)

2) Deterministic + variable (dynamic) with time

 Average monthly demand varies among different
months but V is reasonably small

3) Probabilistic + stationary over time

 Average monthly demand is approximately constant
and V is high(> 20%)

4) Probabilistic + non-stationary over time

 Average and V vary month to month
2
Deterministic Inventory Models
Economic Order Quantity Model
(EOQ Model)

 How much to order? … Optimum quantity

 When to order? … Optimum reorder point
 What is the total cost?
 What is the average inventory level?
 What is the maximum inventory level?
Types of Inventories

 Raw materials & purchased parts

 Partially completed goods called
work in progress
 Finished-goods inventories
◦ (manufacturing firms)
or merchandise
(retail stores)
Types of Inventories (Cont’d)
 Replacement parts, tools, & supplies
 Goods-in-transit to warehouses or customers
Functions of Inventory
 To meet anticipated demand
 To smooth production requirements
 To decouple operations
 To protect against stock-outs
 To take advantage of order cycles
 To help hedge against price increases
 To permit operations
 To take advantage of quantity discounts
 Objective of Inventory Control

 To achieve satisfactory levels of customer

service while keeping inventory costs
within reasonable bounds
◦ Level of customer service
◦ Costs of ordering and carrying inventory

Inventory turnover is the ratio of

average cost of goods sold to
average inventory investment.
Effective Inventory Management
 A system to keep track of inventory
 A reliable forecast of demand
 Knowledge of lead times
 Reasonable estimates of
◦ Holding costs
◦ Setup costs
◦ Shortage costs
 A classification system
 Key Inventory Terms
Total
Inventory =
Purchase + Setup + Holding + Shortage
cost cost cost cost cost

 Lead time (L): time interval between ordering and

receiving the order
 Holding / carrying costs (h): cost to carry an item in
inventory for a length of time, usually a year
 Ordering / Setup costs (K): fixed cost of ordering
and receiving inventory - bookkeeping expense, order
processing fees, transportation costs, receiving costs, handling costs

 Shortage / Penalty costs (P): costs when demand

exceeds supply
Deterministic Inventory Models
Economic Order Quantity Model (EOQ)

Assumptions
 Single item
 Demand is known and fixed (uniform)
 Deterministic lead time (constant)
 Uniform depletion of the inventory
 The cost parameters, unit cost, holding cost,
and setup cost are known and fixed
 Orders are placed so that stockouts or
shortages are avoided completely
 Inventory Cycle

Profile of Inventory Level Over Time

Q Usage /
Inventory Demand
Level rate, D

Reorder
Point, R

Time
Receive Place Receive Place Receive
order order order order order
Lead time
 EOQ Model

D : Demand rate y: Order quantity

 t0 = y / D : Ordering cycle (time units)

Total cost per unit time (TCU)

= Setup cost + Holding cost per unit time
= (K + h (y/2) t0 )/ t0 = D y
K h
y 2
 EOQ Model
- Cost Minimization Goal
Annual
Cost ($) The Total-Cost Curve is U-Shaped

Slope = 0 TCU
Holding Cost
Minimum
TCU

Setup Cost

QO (optimal order quantity) Order Quantity (Q)

EOQ Model
- Cost Minimization Goal
KD hy
Find Q that minimizes TCU  
y 2
d TCU  h KD 2 KD

 Set  0 or,  2  0 or, y 
d y 2 y h

This order quantity is called Economic Order quantity (EOQ)

and denoted by y *.
2 KD
Hence, EOQ, y *
minimizes TCU.
h

14
 Important Characteristics of the
EOQ Cost Function

• At EOQ, the annual holding cost is the same as annual

ordering / setup cost  Prove!

hy * h 2 KD KDh
Annual holding cost   
2 2 h 2
KD KD KDh
Annual setup cost  *  
y 2 KD 2
h

15
 EOQ Model

 How much to order???

2 KD
Optimum Order Quantity y 
*

OR EOQ h

 When to order???
When the inventory reaches the reorder point: R = LeD

Optimum Inventory Policy for proposed model:

y*
Order y* units every t 0 
*
time units
D
 EOQ Model

L : Lead Time (between placement of an order and its receipt)

Le  L  nt 0
*
Effective Lead Time:

L L
n = (largest integer < * )= *
t0 t0
 EOQ Model - Example
Neon lights on the U of A campus are replaced
at the rate of 100 units per day. The physical
plant orders the neon lights periodically. It costs
$100 to initiate a purchase order. A neon light
kept in storage is estimated to cost about $0.02
per day. The lead time is 12 days. Determine
the optimal inventory policy for ordering the
neon lights.

D= 100 units per day K = $100 per order

h = $0.02 per unit per day L = 12 days
Optimal inventory policy???
 EOQ Model - Example
D= 100 units per day K = $100 per order
h = $0.02 per unit per day L = 12 days

EOQ y 
2*KD = 1000 units neon lights
h
* L
Cycle y = 10 days n= =1
t0 
*
*
Length t0
D
Le  L  nt 0
*
Effective Lead Time = 12 – 1(10) = 2 days

Reorder Point, R = LeD = 2x100 = 200 units

Policy: Order 1000 units whenever inventory level drops to 200 units
 EOQ Model - Example
D= 100 units per day K = $100 per order
h = $0.02 per unit per day L = 12 days

Total cost per day (TCU)

= D y = $20 per day

K h
y 2

Average inventory if costs is minimized

= y* / 2 = 1000 / 2 = 500 units neon lights
Computation of EOQ model

Example – Brewery

 Monthly production of beer = 4 000 hl

 Filling into glass bottles = 25% of production
 Annual holding cost per case = $20
 Setup cost – transportation = $11 000 per order
– other = $1 000 per order
 Lead time = ½ of month

Objective: minimize total cost

Computation of EOQ
Example – Brewery
 Annual demand D = 120 000 cases
 Annual holding cost h = $20 per case
 Setup cost K = $12 000 per order
 Lead time L = 1/2 of month = 1/24 of year

Compute optimal inventory policy.

-EOQ / y*
-Cycle length
-Reorder point
Computation of EOQ
Example – Brewery
Policy I Policy II Policy III
Annual demand D 120 000 120 000 120 000
Order quantity q 10 000 60 000 120 000
Annual unit holding cost h 20 20 20
Average inventory level q/2 5 000 30 000 60 000
Total annual holding cost HC 100 000 600 000 1 200 000
Unit setup cost K 12 000 12 000 12 000
Number of orders Q/q 12 2 1
Total annual setup cost KC 144 000 24 000 12 000
Total annual cost TC 244 000 624 000 1 212 000
Computation of EOQ

Example – Brewery

Inventory Level

Policy I

10 000

0 6 12 Time
Computation of EOQ
Example – Brewery

Inventory
Level Policy II
60 000

0 6 12Time
Computation of EOQ

Example – Brewery
Inventory
Level

120 000
Policy III

0 6 12Time
Computation of EOQ
Example – Brewery Policy I
 Optimum order quantity

2 KD 2(120 000)(12 000)

y 
*
y 
*
 12 000 cases
h 20
 Optimum total annual cost
KD hy TCU  $240 000
TCU  
y 2