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Module 3: Deterministic Inventory Models

Lecture 3.2: EOQ Extensions

IEE 534: Supply Chain Modeling & Analysis

Prof. Esma S. Gel

Recall…
• In the last lecture, we have learned how to calculate
the EOQ for a setting with zero lead time
• We learned how to write the total cost per unit time
function, and optimize it with respect to the ordering
quantity, Q r <latexit sha1_base64="Njl1mNydArirbbo5fY4Jy2umL20=">AAACA3icbVDLSgNBEJz1GeNr1ZteBoMgHsJuUPSgENCD4CUB84BsDLOT2WTI7MOZXiEsC178FS8eFPHqT3jzb5wke9DEgoaiqpvuLjcSXIFlfRtz8wuLS8u5lfzq2vrGprm1XVdhLCmr0VCEsukSxQQPWA04CNaMJCO+K1jDHVyO/MYDk4qHwS0MI9b2SS/gHqcEtNQxd6t3R/gCO+peQuJ4ktCkdHOVJv007ZgFq2iNgWeJnZECylDpmF9ON6SxzwKggijVsq0I2gmRwKlgad6JFYsIHZAea2kaEJ+pdjL+IcUHWuliL5S6AsBj9fdEQnylhr6rO30CfTXtjcT/vFYM3lk74UEUAwvoZJEXCwwhHgWCu1wyCmKoCaGS61sx7RMdBOjY8joEe/rlWVIvFe2TolU9LpTPszhyaA/to0Nko1NURteogmqIokf0jF7Rm/FkvBjvxsekdc7IZnbQHxifPyCilzI=</latexit>

2KD
Q⇤ =
h
• We learned how to calculate the optimal total cost per
unit time, C(Q*)
<latexit sha1_base64="PbfMcMOuu8LnVlxlfZHAmUc6MbY=">AAAB/nicbVDLSgNBEOyNrxhfq+LJy2AQokLYDYpehEByELwkYB6QrGF2MkmGzD6cmRXCEvBXvHhQxKvf4c2/cZLsQRMLGoqqbrq73JAzqSzr20gtLa+srqXXMxubW9s75u5eXQaRILRGAh6Iposl5cynNcUUp81QUOy5nDbcYWniNx6pkCzw79QopI6H+z7rMYKVljrmQSlXvT89uW7LB6Hiwm15MD4j5Y6ZtfLWFGiR2AnJQoJKx/xqdwMSedRXhGMpW7YVKifGQjHC6TjTjiQNMRniPm1p6mOPSieenj9Gx1rpol4gdPkKTdXfEzH2pBx5ru70sBrIeW8i/ue1ItW7cmLmh5GiPpkt6kUcqQBNskBdJihRfKQJJoLpWxEZYIGJ0olldAj2/MuLpF7I2xd5q3qeLRaTONJwCEeQAxsuoQg3UIEaEIjhGV7hzXgyXox342PWmjKSmX34A+PzBw06lEI=</latexit>

p
C(Q⇤ ) = 2KDh + cD

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Basic EOQ Model: Insights

The simple EOQ model provides two important insights:
1. An optimal policy balances inventory holding cost per unit
time with setup cost per unit time.
As Q ­ inventory holding costs per unit time ­
setup costs per unit time ¯
2. Total inventory cost per unit time is insensitive to order
quantities around the neighborhood of EOQ

Optimal Cost per Unit Time

• Changes in order quantities have a relatively small
impact on the cost per unit time, around the EOQ value
Total Annual Cost (setup+holding+purchase)

250

200
$/year

150

Q* =3870, cost/yr=$81.75
100

50
0 2000 4000 6000 8000 10 000
Ordering Quantity, Q

Objectives
• By the end of this lecture, you will be prepared to:
• Calculate the EOQ inventory ordering policy for cases with
positive and known lead times
• Calculate the Economic Production Lotsize (EPL) for settings
with fixed setup costs

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Basic EOQ Model: Sensitivity

How much does the C(Q) change when we use a
suboptimal ordering quantity?
• The term is the same under the two ordering quantities
à omitted from this calculation
<latexit sha1_base64="yQfki/MiWfIGTLrMwCT+TThU0AA=">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</latexit>

KD hQ r r
Q + 2 1 2KD Q h
p = +
2KDh 2Q k 2 2KD
✓ ◆
Q⇤ Q 1 Q⇤ Q
= + = + ⇤
2Q 2Q⇤ 2 Q Q
• In the following, let b =Q/Q*. Then, from the above equation

Sensitivity Analysis
b 0.5 0.8 0.9 1 1.1 1.2 1.5 2
Ratio 1.25 1.025 1.0056 1 1.0045 1.0167 1.0833 1.25

What does this imply?

• We know that the optimal ordering quantity, EOQ is
<latexit sha1_base64="AD2dSg0HWZqTS5xm9zsQvrlEgUc=">AAACAXicbVBNS8NAEJ34WetX1IvgJVgE8VCSouhBoaAHwUsL9gOaWjbbTbt0s4m7G6GEePGvePGgiFf/hTf/jds2B219MPB4b4aZeV7EqFS2/W3MzS8sLi3nVvKra+sbm+bWdl2GscCkhkMWiqaHJGGUk5qiipFmJAgKPEYa3uBy5DceiJA05LdqGJF2gHqc+hQjpaWOuVu9O7pw5b1QiesLhJPSzVWa9NO0Yxbsoj2GNUucjBQgQ6VjfrndEMcB4QozJGXLsSPVTpBQFDOS5t1YkgjhAeqRlqYcBUS2k/EHqXWgla7lh0IXV9ZY/T2RoEDKYeDpzgCpvpz2RuJ/XitW/lk7oTyKFeF4ssiPmaVCaxSH1aWCYMWGmiAsqL7Vwn2kg1A6tLwOwZl+eZbUS0XnpGhXjwvl8yyOHOzBPhyCA6dQhmuoQA0wPMIzvMKb8WS8GO/Gx6R1zshmduAPjM8fbgCW3g==</latexit>

r
2KD
Q⇤ =
h
• Accordingly, the optimal reorder interval is
<latexit sha1_base64="isrWbcPX6h1zpoQxzfX8q4c0I8U=">AAACAXicbVDLSgNBEOz1GeNr1YvgZTAI4iHsBkUPCgE9CF4i5AXZGGYns8mQ2Yczs0JY1ou/4sWDIl79C2/+jZNkD5pY0FBUddPd5UacSWVZ38bc/MLi0nJuJb+6tr6xaW5t12UYC0JrJOShaLpYUs4CWlNMcdqMBMW+y2nDHVyO/MYDFZKFQVUNI9r2cS9gHiNYaalj7lbvji4ceS9U4ngCk6R0kyZX/TTtmAWraI2BZomdkQJkqHTML6cbktingSIcS9myrUi1EywUI5ymeSeWNMJkgHu0pWmAfSrbyfiDFB1opYu8UOgKFBqrvycS7Es59F3d6WPVl9PeSPzPa8XKO2snLIhiRQMyWeTFHKkQjeJAXSYoUXyoCSaC6VsR6WMdhNKh5XUI9vTLs6ReKtonRev2uFA+z+LIwR7swyHYcApluIYK1IDAIzzDK7wZT8aL8W58TFrnjGxmB/7A+PwBc0GW4Q==</latexit>

r
⇤ 2K
T =
Dh
• But what if T* happens to be an “inconvenient”
number?
• The above sensitivity analysis indicates that we can
adjust the reorder interval to a reasonable value
without much penalty in the cost function…

Positive lead times

• The zero lead time assumption, along with
deterministic demand means that it is optimal to put in
orders when inventory hits zero

• Now suppose that lead time is not zero, but a positive,

known duration…

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Extension: Known, Constant Lead Times

The basic EOQ model can be extended to the case of
known and constant lead times.
• We can calculate the reorder point at which an order needs to
be initiated.

Lead time of
4 months
Source: Nahmias

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Extension: Known, Constant Lead Times

• When there is a positive lead time, calculate the EOQ
as before
• Identify the REORDER LEVEL that will trigger an
order of size Q*
• Calculate the reorder interval
à 1.24 years in example
• For an order to arrive when inventory hits zero, we
need to initiate an order 4 months prior to the point
that inventory hits zero
à Order Q*=3870 when inventory hits R=1040

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Extension: Known, Constant Lead Times

• What do we do when the lead time is LONGER than
the optimal reorder interval, T*
• For example, what would we need to do if the lead
time is 2 years in the above example?

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Extension: Finite Production Rate

• The basic EOQ model can be extended to the case of
finite production rate
• We can calculate the optimal production lot size when
costs for setting up production exists…

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Extension: Finite Production Rate

Inventory
I(t) Slope = P
<latexit sha1_base64="ysRDycV/DcQrwEpzv2iWIguG0y0=">AAAB+XicbVBNS8NAEN34WetX1KOXYBG8WBJR9CIU9OCxov2ANpTNdtIu3WzC7qRYQv+JFw+KePWfePPfuG1z0NYHA4/3ZpiZFySCa3Tdb2tpeWV1bb2wUdzc2t7Ztff26zpOFYMai0WsmgHVILiEGnIU0EwU0CgQ0AgGNxO/MQSleSwfcZSAH9Ge5CFnFI3Use02whNmDyJOYHxdPb3t2CW37E7hLBIvJyWSo9qxv9rdmKURSGSCat3y3AT9jCrkTMC42E41JJQNaA9ahkoagfaz6eVj59goXSeMlSmJzlT9PZHRSOtRFJjOiGJfz3sT8T+vlWJ45WdcJimCZLNFYSocjJ1JDE6XK2AoRoZQpri51WF9qihDE1bRhODNv7xI6mdl76Ls3p+XKpU8jgI5JEfkhHjkklTIHamSGmFkSJ7JK3mzMuvFerc+Zq1LVj5zQP7A+vwBRNuTZw==</latexit>

T1=Q/P T2 time
T1 is the length of
T=Q/D each production run

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Economic Production Lot Size, EPL

• The total cost function can be written as
D
<latexit sha1_base64="KBrFlNa/WItj0LPKQUMvMY7Kfac=">AAACGXicbZDLSsNAFIYn9VbrLerSzWARWoolKYpuhEK7ENw0YC/QhjKZTtqhkwszE6GEvIYbX8WNC0Vc6sq3cdpkoa0HBj7+/xzOnN8JGRXSML613Nr6xuZWfruws7u3f6AfHnVEEHFM2jhgAe85SBBGfdKWVDLSCzlBnsNI15k25n73gXBBA/9ezkJie2jsU5diJJU01I1GySrfDFyOcHzXTGIrqeBmZZIKVsk8T0k5raScxLVkqBeNqrEouApmBkWQVWuofw5GAY484kvMkBB90wilHSMuKWYkKQwiQUKEp2hM+gp95BFhx4vLEnimlBF0A66eL+FC/T0RI0+ImeeoTg/JiVj25uJ/Xj+S7rUdUz+MJPFxusiNGJQBnMcER5QTLNlMAcKcqr9CPEEqCqnCLKgQzOWTV6FTq5qXVcO6KNbrWRx5cAJOQQmY4ArUwS1ogTbA4BE8g1fwpj1pL9q79pG25rRs5hj8Ke3rB5Vbn3I=</latexit>

KD Q(1 P)
C(Q) = + cD + h
Q 2
• Since the function is convex, taking the derivative wrt
Q and equating to zero gives
KD h D
<latexit sha1_base64="1I7accx2fvNPGA/z184HtDtHHOE=">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</latexit>

C 0 (Q⇤ ) = + (1 ) = 0 ()
Q2 2 P
<latexit sha1_base64="ipbEeCHnbaFeuTYlzzZlH9CFYOk=">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</latexit>

s
2KD
EPL =
h 1 DP

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EPL Example
A manufacturing firm produces and item on a
production line, which is also used to manufacture
other items. Each time the firm sets up for production of
this item, they incur a cost of $450.

The annual demand for the item is 4,000 units. In

comparison, the production rate is 6,000 units per year.
Holding costs for the item can be estimates at an
annual rate of 25%, and the production cost of the item
is estimated as $15 per unit.

Calculate the optimal lot size that the firm should use to
produce the item on this shared production line.

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EPL Example

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EPL Example-Continued
Now suppose that the manufacturing firm received an
offer from an off-shore company to manufacture the
items. That is, the firm would be buying the items from
this company, at a slightly higher cost of $20, but this will
enable them to use the production line for a new product
on their production line.
The off-shore company is charging a fixed cost of $1000
per order.

Should the firm buy the item from the off-shore company,
or continue to manufacture the item in-house?

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EPL Example – buy or manufacture?

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Time to reflect…

This Photo by Unknown Author is licensed under CC BY-SA-NC

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