Chapter 10

Independent Demand Inventory Systems

Skip: Developing Optimal Safety Stock Levels with

Payoff Tables
Rules of Thumb in Setting Order Points

Payoff Tables: A Retailing Stocking Decision

10-0
Why Holding Inventory is Important

• Inventory can be a strategic tool

• Helps level capacity
• Uncouples production stages
• Increases flexibility
• Provides cheaper ordering policies

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 Two Types of Inventory Systems

• Fixed Order Quantity System -

When the Order Point (OP) is reached, we
put an order. Also known as the 2 bin
system.

• Fixed Order Period System -

Reviews the inventory level at “fixed time
intervals.” Order enough materials to bring
the inventory to a predetermined level.

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 Inventory Models for the Fixed Order
Quantity System

• Economic Order Quantity Model (EOQ)

• EOQ for Production Lots

• EOQ with Quantity Discounts

• Models with uncertain demand during lead

time

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 Economic Order Quantity (EOQ)
Let D - annual demand (units/year)
Q - order quantity (units)
C - carrying cost ($/unit/year)
S - ordering cost ($/order)
TSC = Total Annual Stocking cost ($)
LT = lead time (days)

How much to order? EOQ = 2 DS / C

LT × D
When do we order? OP =
No . days per year
EOQ D
How much will it cost? TSC = C + S
2 EOQ

What is the maximum Inventory Level? I max = EOQ

What is the average Inventory level? I ave = EOQ 10-6

2
 Economic Order Quantity

Inventory
Level
EOQ

OP
↔ ↔
TIME
LT LT
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 Economic Order Quantity

2. The Greenmore Lawn Products Company produces lawn

fertilizer. One raw material--ammonium nitrate--is purchased
in large quantities in the making of fertilizer. 2,500,000 tons
of ammonium nitrate are forecast to be required next year to
support production. If ammonium nitrate costs $122.50 per
ton, carrying cost is 35 percent of acquisition cost, and
ordering cost is $1,595 per order:
a. In what quantities should Greenmore buy ammonium
nitrate?
b. What annual stocking costs will be incurred if
ammonium nitrate is ordered at the EOQ?
c. How many orders per year must Greenmore place
for ammonium nitrate?
d. How much time will elapse between orders.
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 EOQ for Production Lots

In addition to notations in EOQ,

Let d = daily demand (units per day)

= D / no. of days per year
p = daily production (units per day)

How much to produce? EOQ = (2DS / C)[p / (p - d)]

When do we setup the machine? OP = LT x d

EOQ
How much will it cost? TSC = [(p - d) / p]C + (D / EOQ)S
2

What is the maximum inventory level?

What is the average inventory level? Iave = Imax / 2

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 EOQ for Production Lots
Inventory
Level
Imax

OP

↔
Time
LT
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 EOQ for Production Lots

6. The production rate of final assembly is 800 compact

discs per day. After the compact discs are assembled,
they go directly to finished-goods inventory.
Customer demand averages 400 compact discs per
day and about 50,000 compact discs per year. If it
costs $500 to set up the assembly line for the compact
disks and $1.00 per compact disc per year to carry
them in inventory:
a. How many compact discs should be in a
production lot at final assembly?
b. What is the TSC at the EOQ?

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 EOQ with Quantity Discount
Additional Notations:

Let i - annual carrying rate (fraction)

aC - with acquisition cost ($ per unit)
TMC - Total Annual Material Cost ($)

C = i(aC)

Example: Assume an annual inventory carrying rate of

20% and acquisition cost of $5 per unit, find the
carrying cost per unit per year.

C = (.2) (5) = $1/unit-year

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 EOQ with Quantity Discount

Steps:
1. Compute EOQ of each sales price

2. Determine which EOQ is within the quantity range

for its price

3. Compute the TMC for the feasible EOQ and the TMCs
of quantities with lower sales prices

4. The quantity with the lowest TMC is the order

quantity

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 EOQ with Quantity Discount

9. A building supply wholesaler sells windows. One

popular window, part number 3060 BDP, is estimated
to have a demand of 50,000 next year. It costs the
warehouse $200 to place and receive an order, and
carrying costs are 30 percent of acquisition cost.
The supplier quotes these prices on this window:

Q ac
1-999 $41.60
1,000+1,999 40.95
2,000+ 40.92
a. What is the warehouse’s EOQ?
b. What is the minimum TMC?
c. How much time will elapse between orders?
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 Uncertain Demand During Lead Time
Case 1: Setting Safety Stock at Service Levels for a Discrete DDLT

13. A maintenance department at a chemical plant needs to plan

inventories for a frequently used maintenance product, a 6691
roller bearing unit. Under consideration is the order point for
this item and the appropriate level of safety stock. Average
demand per week is 15.4 seals, and average lead time is 5.1
weeks. These data on usage of this bearing are retrieved from
the computer:

Actual DDLT Occurrences Actual DDLT Occurences

60-79 7 100-109 3
80-89 9 110-119 2
90-99 5 120-129 1

a. Compute the order point using the 90 percent service

level.
b. What safety stock is provided with your answer to part a?
 Uncertain Demand During Lead Time

Case 2: Setting Safety Stock at Service Levels for

DDLT that is Normally Distributed

14. If EDDLT = 55.5 units, σ DDLT = 12.5 units,

DDLT is normally distributed, and service level
is 95 percent:
a. What is the order point?
b. What is the safety stock level?

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Case 3: Setting Safety Stock Levels at Service
Levels for Constant Lead Time and Normally
Distributed Demand per Day.

15. The E-Z Mony Loan Company is a feeder operation servicing

local Detroit industrial workers. It must periodically go to banks
to trade loan paper for cash to use for short-term loans. E-Z
wishes to know at what minimum level of cash inventory it
should initiate order procedures for more cash from the banks.
Mr. Slick, the president of E-Z believes that the actual DDLT is
really normally distributed with a mean of $725,000 and a
standard deviation of $166,208. If Mr. Slick specifies a service
level of 85 percent:

a. What is the order point?

b. What is the safety stock level?

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 Fixed Order Period System
In addition to previous notations;

T = Time between orders in fraction of a year

What is the time between reviews?

T = 2S / DC
How much to order at the time of review?

Order Quantity = Upper inventory target

- Inventory level + EDDLT

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 Fixed Order Period System

22. An office supply warehouse is reviewing its ordering policies

for its inventory items. The warehouse takes periodic inventory
counts of its stock and places orders for materials needed. One
of its items is a desk calendar, stock number 2436B. Inventory
counts were taken today, and the inventory level was 3,395 of
the 2436B calendar. The upper inventory target is 10,000, and
EDDLT is 1,000. Annual demand in the region is approximately
100,000 ordering cost is $200 per order, acquisition cost is
$3.95, and carrying cost is 35 percent of acquisition cost.

a. When should the physical inventory count be taken

next?

b. How many calendars should be ordered today?

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 Other Inventory Models
Newsboy Model Using Marginal Analysis

Let MLC - marginal cost of an excess unit

MSC - marginal cost of a unit shortage
P -probability of needing the nth unit
(1-p) - probability of not needing the nth unit

Expected cost of an excess unit = expected cost of a

unit shortage

(1 - P )MLC = P ( MSC )

MLC
P =
MSC + MLC
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 Newsboy Problem

24. Big Store sells A60 Strongcharge automobile batteries. Batteries

are ordered weekly for delivery on Monday morning. The sales
price for an A60 is $65, and its cost for Big Store is $45. If too
many batteries are ordered and stock must be carried over the
weekend, corporate headquarters charges Big Store $15 per
battery for increased insurance, finance, and warehouse
occupation costs. If Big Store is out of stock, it forgoes the
profits from missed sales. How many A60 batteries should Big
Store order each week if the weekly sales pattern is as shown
below?

No. of Batteries Demanded Probability

20 .2
30 .3
40 .4
45 .1

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Percent of Total
ABC Classification of Materials
Dollar Value in
Inventory
100
C
90
B
80
70
60

50

40
A
30

20

10

0
0 10 20 30 40 50 60 70 80 90 100
Total Percent of Materials in Inventory
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