Inventory Management

BBA Program.
Mahbub Parvez, Faculty of Business & Entrepreneuship. DIU

Inventory is a stock of items kept by an organization to meet internal or external customer demand. The purpose of
inventory management is to determine the amount of inventory to keep in stock –how much to order and when to
replenish or order.

Nature of Inventory Problem:

The nature of the inventory problem consists of repeatedly placing and receiving orders of given sizes at set
intervals. From this stand point an inventory policy answers the following two questions.

1. How much to order?

2. When to order?

How much to order determines the Economic Order Quantity (EOQ) model by minimizing the cost.

When to order highly connected and represents ordering and placing time.

When to order includes: 1. Periodic order / review (discrete)

2. Continuous order / review.

If the system requires periodic review (e.g every week or month) the time for receiving a new order coincides with the
start of each period.

Alternately if the system is based on continuous review, new orders are placed when the inventory level drops to a
pre specified level, called the reorder point.

The deterministic model of inventory are of two types: 1. Static, which have constant demand over time.
2. Dynamic, in which the demand varies.

Inventory cost:

Total Inventory Cost = Purchasing cost + Setup cost + Holding cost + Shortage cost

All cost must be expressed in terms of the desired order quantity and the time between orders.

Purchasing cost: The price per unit of the item. It may be constant, or it may be offered at a discount that
depends on the size of the order.

Setup cost: Represents the fixed charge incurred when and order is placed. This is independent of the size of
the order.

Holding Cost: Represents the cost of maintaining the inventory in stock. It includes storage, interest on capital,
maintenance and handling.

Shortage Cost: Shortage cost is penalty incurred when we run out of stock.

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Inventory Management
BBA Program.
Mahbub Parvez, Faculty of Business & Entrepreneuship. DIU

EOQ model with static demand:

The simplest of the inventory model involves constant rate demand with instantaneous order replacement and no
shortage.
y = Order Quantity (number of units)
D= Demand rate (units per unit time)
t0 = Ordering cycle length (time units)

Inventory
level Points in time at which orders are received.

Reorder
Point

Average Inventory
= y/ 2

to = y / D L L
Time

An order of size y units is placed and received instantaneously when the inventory level is zero. And the
demand rate is constant.

The ordering cycle for this pattern is to = y/D time units.

The average inventory level is y/2 units

There are two cost parameters

K = Setup cost associated with the placement of an order.

h = Holding cost (dollars per inventory unit per unit time)

So, the total cost per unit time

TCU (y) = Setup cost per unit time + Holding cost per unit time

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Inventory Management
BBA Program.
Mahbub Parvez, Faculty of Business & Entrepreneuship. DIU

To find the optimum value of y (minimizing y) set first derivative equal to 0.

The condition is also sufficient because TCU(y) is convex. The solution of the equation yields the EOQ y* as

y* =

i.e. Order y* = units every t0* = y* / D time units.

Example:1 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 between placing and receiving an order is 12 days. Determine the optimal
inventory policy for ordering the neon light.

Solution: We have D = 100 units / day

K = $ 100 per order
h =$0.02 per unit / day
L = 12 days

Optimum order quantity y* = = neon light

The associated cycle length is t0* = y* / D = 1000 / 100 = 10 days

Since L = 12 > t0* = 10 days , we have to fine the effective lead time Le .

Where Le = L – nt0* Consider n = ( Largest integer) ≤

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Inventory Management
BBA Program.
Mahbub Parvez, Faculty of Business & Entrepreneuship. DIU

= 12 – (1)10 = Largest integer ≤

= 2 days =1

The reorder point thus occurs when the inventory level drops to L eD = 2 x 100 = 200 units.

So, the inventory policy for ordering the neon light is order 1000 units whenever the inventory level drops to
200 units.

Also, the daily inventory cost associated with the proposed inventory policy is

TCU (y) = KD / y + h (y / 2)
= (100 x 100) / 1000 + .02 ( 1000 / 2)
= 10 + 10 = $ 20 per day.

Q: 1 A company stocks an item that is consumed at the rate of 50 units per day. It costs the company $ 20 each
time an order is placed. An inventory unit held in stock for a week will cost $ 0.35.
a. Determine the optimum inventory policy, assuming a lead time of 1 week.
b. Determine the optimum number of orders per year (365 days)
[ Ans: a. Order 200 units when ever inventory drops to 150 units. TCU (y) = $ 10 / day. ]

Q: 2 In each of the following cases, no shortage is allowed and the lead time between placing and receiving an
order is 30 days. Determine the optimal inventory policy and the associated cost per day.
a. K = $ 100, h = $ 0.05, D = 30 units per day, Also L = 30 [Ans: Order 346.5 units when ever inventory
drops to 207 units. TCU = 17.32 per day]

b. K = $ 50, h = $ 0.05, D = 30 units per day, L = 30 [ Ans: Order 245 units when ever inventory
drops to165 units. TCU = $12.246 per day]

c. K = $ 100, h = $ 0.01, D = 40 units per day, L = 30 [ Ans: Order 894 units when ever inventory
drops to 305 units; TCU = $ 8.94 per day]

d. K = $100, h = $0.04, D = 20 units, L = 30 [ Ans: Order 316 units when ever inventory drops
to 284 units. TCU = $12.65 per day]

# The EOQ Model with Non instantaneous Receipt

The non instantaneous receipt model is an inventory system in which an order is received gradually, as inventory is
depleted.

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Inventory Management
BBA Program.
Mahbub Parvez, Faculty of Business & Entrepreneuship. DIU

In the basic EOQ Model, average inventory was half the maximum inventory level or y/2, but in this model variation
the maximum inventory level is not simply y; it is an amount somewhat lower than y, adjusted for the fact the order
quantity is depleted during the order receipt period.

In order to determine the average inventory level, we define the following parameters unique to this model.

P= Daily rate at which the order is received over time (production rate)
d= Daily rate at which inventory is demanded.

As we know no shortages are possible. The demand cannot exceed production rate. i.e p≥ d

The time required to receive and order is the order quantity divided by the rate at which the order is received or y/p.
For example if the order size is 100 units and the production received in 5 days. The amount of inventory that will be
depleted or used up during this time period is determined by multiplying by the demand rate: y/p(d)

For example, if it takes 5 days to receive the order and during this time inventory is depleted at the rate of 2 units per
day, then 10 units are used. As a result, the maximum amount of inventory on hand is the order size minus the
amount depleted during the receipt period, computed as

Maximum inventory level =

Hence average inventory level =

Total holding cost =

TCU =
Solving this function for the optimal value of y

Example: 2 The 1-75 Carpet Discount store in North Georgia stocks carpet in its warehouse and sells it through
an adjoining showroom. The store keeps several brands and styles of carpet in stock; however, its biggest seller is
super shag carpet. The store wants to determine the optimal order size and total inventory cost for this brand of
carpet given an estimated annual demand of 10,000 yards of carpet, and annual carrying cost of 0.75 per yard and
an ordering cost of $150. The store like to know the number of orders that will made annually and time between
orders, given that the store is open every day except Sunday. Thanksgiving Day and Christmas day (which is not a
Sunday)

Solution: Demand D = 10,000 yards / year

Holding Cost h = 0.75/year
Ordering Cost K = 150/ order

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Inventory Management
BBA Program.
Mahbub Parvez, Faculty of Business & Entrepreneuship. DIU

The optimum order qty

Time between orders

Given that the store is open 311 days annually (365- 52 Sundays – Thanks giving and Christmas)

Hence to = 0.2 x 311 = 62.2 storedays

No. of orders

TCU

Example: 3 (Quantity Discount with constant carrying cost)

Comptek Computers wants to reduce a large stock of PCs it is discontinuing. It has offered the university bookstore
at Tech a quantity discount pricing schedule as follows:

Quantity Price
1-49 $1400
50-89 $1100
90+ $900
The annual carrying cost for the bookstore for a PC is $190, the ordering cost is $2500 and annual
demand for this particular model is estimated to be 200 units. The bookstore wants to determine if it
should take advantage of this discount or order the basic EOQ order size.

Solution: K =2500
D =200 units / year
h =109/ year

The order size is eligible for the first discount $1100. Therefore, this price is used to compute total cost
TCU

Since there is a discount for a larger order size than 50 units. This total cost of 233784 must be compared with total
cost with an order of 90 and discounted price of $900

TCU

Since the total cost is lower, the maximum discount price should be taken and 90 units should be ordered.

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Inventory Management
BBA Program.
Mahbub Parvez, Faculty of Business & Entrepreneuship. DIU
Example: 4 The 1-75 Outlet has its own manufacturing facility in which it produces super shag carpet. The
ordering cost k is $cost of setting up the production process to make super shag carpet. Recall that h = $0.75 per
yard and D= 10,000 yards per year. The manufacturing facility operates the same days the store is open( i.e 311
days) and produces 150 yards of carpet per day. Determining the optimal order size, total inventory cost, the length
of time to receive an order, the number of orders per year and the maximum inventory level.

Solution: K =150/order
D =10000/year
h =0.75/ yard/ year
d = 10000/ 311 = 32.2 yards / day
p = 150 yards per day

The optimum order qty

= 1329.27

The length of time to receive an order for this type of manufacturing operation is commonly called the length of the
production run.
Production run

Given that the store is open 311 days annually (365- 52 Sundays – Thanks giving and Christmas)

No. of orders per year

Maximum Inventory level

Exercise: Taylor, p-483, No. 10-1, 10-3, 10-4, 10-6, 10-7, 10-9, 10-20, 10-25

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