MA4850 Supply Chain &

Logistics Management

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 Lesson Overview
T1 Introduction T4 Warehousing, Packaging & Material Handling

T2.1 Forecasting Time Series T5.1 Transportation

T2.2 Forecasting Causal Models

T5.2 Transportation Costs & Logistics Network
T3.1 Inventory Management Introduction
T6.1 Supply Chain & Contracting
T3.2 EOQ Models
T6.2 Supply Chain & Product Architecture
T3.3 Newsvendor Model
T7 Global Supply Chain & Logistics
T3.4 QR Model

T3.5 Base Stock Policy T8 Supply Chain & Risk Management

T3.6 Inventory Management & Accounting T9 Information Technology

MA4850: Supply Chain & Logistics Management 2

 Topic 3.2
Inventory Management –
EOQ Models

MA4850: Supply Chain & Logistics Management 3

 Learning Objectives
By the end of this course, you should be able to:
• Define the types of inventory
• Describe EOQ
• Apply EOQ

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 Inventory Models
• Economic ordering quantity (EOQ)
• Newsvendor model
• Continuously reviewed models
• Periodically reviewed models

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 Types of Inventory
• Cycle stock (or base stock) is inventory used in between order
arrivals.
• Transit stock represents the amount of inventory typically in transit
between facilities or on order but not received.
• Safety stock is the inventory used to buffer against uncertainty in
demand and lead time.

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 Average Inventory
Quantity / Dollars

Cycle stock

Average inventory

Safety stock
Inventory in transit

Time
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 Inventory Control Decisions
• When should we order?
− Re-order point
− Ordering frequency
• How many should we order each time?
− Order quantity
• How much safety stock should we keep?
− Demand uncertainty
− Lead time uncertainty
• …

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 Economic Order Quantity (EOQ)
Scenario fixed ordering cost: e.g. 10 orders = 1 dollars/
order; 100 orders = 0.5 dollar/order

Order Quantity

Manufacturer Retailer

• A single product • No delivery lead time • Demand rate is constant

• Production is instantaneous • There is a fixed ordering cost
• There is inventory holding cost
• No backorders allowed

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 EOQ
Notations

𝐷 Demand rate (unit/year)

𝐹 Fixed ordering cost (dollar/order)
𝑐 Unit product value (or cost) (dollars/unit)
ℎ Inventory carrying cost rate (percentage/year)
𝑄 Order quantity

𝑄 Cycle length (year)

𝑇= 𝐷

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 EOQ
Inventory Level

Inventory level
Slope: −𝑫
Q

0 T 2T 3T Time

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 EOQ Demands are the same

Order Frequency vs. Order Size

Order size smaller,
Fixed ordering cost is higher.
Inventory cost is lower.

𝑄1

𝑇1 2𝑇1 3𝑇1 4𝑇1 ⋯ 8𝑇1

𝑄2

𝑇2 2𝑇2 3𝑇22
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 EOQ
Relevant Costs

Q
  h c
dollars/year
Inventory holding costs
2
D
Ordering cost  Q F
 

D Q
Total inventory related costs C Q      F     h  c
Q 2

 Note 1: production cost is a constant

 Note 2: all costs are annual based

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 EOQ
Cost Curves

Costs
Total Cost
Inventory Holding Cost

Ordering Cost
Production Cost

Q* Lot size Q

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 EOQ
The Optimal Order Quantity
• First order condition
dC Q  DF hc
 2  0
dQ Q 2
2 DF 2F
 Q*   T* 
hc Dhc
C Q *   2hcDF
• Second order condition
d 2C Q  2 DF
 3 0
dQ 2 Q

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 Sensitivity Analysis
• The assumptions of EOQ models are quite strong.
• How bad would it be if:
− I get the demand wrong?
− I use a different order quantity Q’?
− I get my cost parameters wrong?
− …

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 EOQ Sensitivity : 𝑸
If we order 𝑄 ′ instead of 𝑄 ∗ :
FD chQ 
C  Q   
Q  2

C (Q  )  2hcDF

C Q  FD chQ  1 FD Q  ch
   
C (Q  ) Q  2chFD 2 2chFD 
Q 2ch 2 2 FD

2 FD
 C  Q  1  Q  Q  
Q      
ch 

C (Q ) 2  Q Q 

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 EOQ Sensitivity
𝑸 (Graphical Illustration)

Total cost ratio vs. Order quantity ratio

2.76
2.56
Relatively better to order more than to order less
2.36
2.16
C(Q’)/C(Q*)

1.96
1.76
1.56 EOQ very robust to order quantity Q
1.36
1.16
0.96
0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8
Q’/Q*

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 EOQ Sensitivity
𝑫, 𝒄, 𝒉 𝒂𝒏𝒅 𝑭
If we thought the demand is 𝐷′ instead of the true demand 𝐷:

2 FD  Q D
Q   *
ch Q D

C  D 1  D D 
    
C  D  
2  D D 

 The relationship also holds true for 𝐹, 𝑐, 𝑎𝑛𝑑 ℎ.

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 EOQ Sensitivity
𝑫, 𝒄, 𝒉, 𝑭 (Graphical Illustration)

Total cost ratio as function of Demand and Quantity ratio

2.76
2.56
EOQ is even more robust to changes in D, c, h, and F
2.36
Total cost ratio

2.16
1.96
D’/D*
1.76
1.56 Q’/Q*
1.36
1.16
0.96
0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8
Variable ratio (D, c, h, F)

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 EOQ
Extensions
• Lead time : 0 L
• Production rate : infinite finite
• Demand : deterministic stochastic
• Product : single multiple
• …

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 EOQ Extension
Constant Lead Time
Inventory level

Q
Q Q

Reorder point:
DL

0 Q/D 2Q/D Time

Lead time: L

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 EOQ Extension
Finite Production Rate
if R < D, means production
Inventory level R: Constant production rate rate is lesser than demand,
will have backlog
R>D

Max on-hand
Inventory: H
Slope: −𝑫

Slope: R-D

𝑇1 𝑇2 𝑇1 : Production uptime Time

Cycle time: T 𝑇2 : Production downtime
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 EOQ Extension
Finite Production Rate

Total quantity of Q Q
Q  D * T  R * T1  T  , T1 
production/demand in each cycle D R

Maximum inventory on-hand H   R  D  * T1  ( R  D)*

Q
R

 Q 1 D
R 
D H
C (Q )    * F  
 D
 Q 1 D
 R   * h * c
*h*c   * F   
Q  2  Q 2
Inventory-related cost  
D Q

   * F    * h * c, where h  1  D h
Q 2 R 
2DF
Economic order quantity Q* 
hc

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 Summary
• A simple and general approach to solving ordering quantity
• Despite strong assumptions, EOQ model captures the fundamental
trade-offs:
• Fixed ordering costs
• Inventory carrying costs
• Yield results to make optimal decision mathematically

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Thank you

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