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Inventories: Inventory Models Inventory Models
Inventories: Inventory Models Inventory Models
Inventories
An inventory is a stock or store of goods (processing)
Inventory models
Inventory models A significant portion of assets comprises inventories of
g p p
raw materials and finished goods
Practical and economic importance : inventory
Deterministic and control major consideration
Stochastic demand models quantitative analysis /inventory theory
Exists in all sectors of the economy
Construction!
Inventory Models
Inventory decision issues
Demand of various items Inventory models :
Money
Money tied up in the inventory
tied up in the inventory How much should be ordered each time
not producing any return When should the reordering occur
Objective : minimize total variable cost over a
Costs for the care of the stored material : subject
specified time period (assumed to be annual).
to spoilage and obsolescence
The principal factor affecting the solution is the nature
Cost of storage space
of demand:
Insurance expense risk of fire, theft, damage
Insurance expense ‐ risk of fire theft damage Deterministic
Order processing costs Probabilistic
Loss of profit due to stock outs
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Deterministic models
Simplest inventory models
Deterministic Inventory Models Assume:
Items are withdrawn from the inventory at an even rate a,
Items are withdrawn from the inventory at an even rate a
Lots are of a fixed size Q, and lead time is zero or a constant.
Optimal solutions: deterministic model for several
operating assumptions
Safety
stock
Terminologies Inventory Costs
Demand rate (a): constant rate at which the product is withdrawn Ordering (setup) cost (K) ‐‐ salaries and expenses of processing
from inventory (units / time) an order
Lot Size (Q): fixed quantity received at each inventory replenishment
q y y p cost of placing an order, Telephone, Order checking, Labor, Transportation
(units) Holding cost (h)–cost of maintaining inventory in stock
Order level (S): maximum level reached by the inventory is the order Cost of storage, insurance, security costs, warehouse overhead, and other related
level. When backorders are not allowed, this quantity is the same as variable expenses
Q. When backorders are allowed, it is less than Q (units) Purchase cost (c) ‐‐ actual price of the items, unit cost of
Cycle time ( τ): time between consecutive inventory replenishments is purchasing the product
the cycle time. For the models of this section = Q/a. (time)
Cost per time (T): total of all costs related to the inventory system that Backorder (shortage) cost (p)‐‐ costs associated with being out
are affected by the decision under consideration. ($/time) of stock when an item is demanded (including loss of goodwill
Optimal Quantities (Q*, S*, T*): quantities defined above that
l ( * * *) d f d b h and/or income)
and/or income)
maximize profit or minimize cost for a given model are the optimal When a product is needed and the inventory is empty, the
solution demand can either go unfulfilled (lost sale) or be satisfied later
when the product becomes available (backorder). The total
backorder cost is assumed to be proportional to the number of
units backordered and the time the customer must wait.
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Deterministic Models
unavailability /shortage cost
Stock out or depletion cost The different deterministic models:
Shortages may delay work, thereby wasting labor 1. Economic order quantity (EOQ)
Economic order quantity (EOQ)
resources or delaying the completion of the entire
2. EOQ with planned shortages
project
3. EOQ with quantity discounts
Deviations from the schedule may occur during
4. Others
construction
The cost associated with a shortage may also be Demand Models assume that demand is certain and
difficult to assess; constant
If the material used for one activity is not available, it Inventory models:
may be possible to assign workers to other activities and, How much to order To minimize total
depending upon which activities are critical, the project inventory costs
may not be delayed How often to order
1. Economic Order Quantity (EOQ)
The Essence of Demand Models
Optimize the cost tradeoff between holding
costs, which increase with inventory level, and The most basic of the deterministic inventory models
ordering costs, which vary with the frequency of is the economic order quantity (EOQ)
is the economic order quantity (EOQ)
placing orders The variable costs in this model are annual holding
The ideal amount of inventory to order to minimize cost , purchasing cost and annual ordering cost
total inventory costs.
$ Total Costs
Carrying/holding Costs
/
Ordering Costs
Order Quantity (Lot Size)
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EOQ Economic Order Quantity (EOQ)
Demand Assumptions
Order qty, Q rate A known constant demand rate of a unit per unit time
Inventory Level
Order quantity Q arrives when inventory level drops to zero
Purchase cost per unit is constant (no quantity discount)
Delivery time (lead time) is constant
Planned shortages are not permitted
Reorder point R
Reorder point, R
Economic Order Quantity (EOQ) EOQ
The total cost per unit time
Optimum quantity of inventory order Q*, that minimizes T
Cost/unit time = setup cost + purchase cost + holding cost dT/dQ = ‐ak/Q2 + h/2 = 0
Ordering cost per cycle
Ordering cost per cycle = K
K
2ak
Purchase cost per cycle = cQ Q*
h
Holding cost per cycle = hQ2/ 2a Q* 2k
optimal policy
t* cycle time
Total cost per cycle = K + cQ + hQ2/2a a ah
The time between consecutive replenishments of inventory (a Substituting the optimal lot size into the total cost expression
cycle) = Q/a
ahk ahk
Total cost per unit time
Total cost per unit time T* ac 2ahk ac
akk hQ
T= (K + cQ + hQ2/2a)/(Q/a) T ac 2 2
Q 2 At the optimum, the holding cost is equal to the setup cost.
a/Q is the number of orders per unit time. The factor Q/2 is the Optimal policy does not depend on the unit product cost
average inventory level.
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Example 1 2. EOQ with Planned Shortages
A product has a constant demand of 100 units per Inventory shortage (stock out)—demand that cannot be
week. The cost to place an order for inventory met currently because the inventory is depleted
replenishment is $1000. The holding cost for a unit in Shortages occur until a predetermined backorder quantity
inventory is $0.40 per week. No shortages are is reached, at which time the replenishment order arrives
allowed. Find the optimal lot size and the Customers will wait for the product to become available
corresponding cost of maintaining the inventory. again (loss of income, interruption of operation , etc.)
Inventory level to fall below zero rather than to incur large
2 ak 2 x100 x1000
Q* 707 holding costs more economical
holding costs more economical
h 0 .4 Shortage cost : difficult to compute since they are usually
T* 2 ahk 282 .84 $ / week related to 'goodwill'
Q* Note: use of inconsistent
t* 7 .07 weeks time dimensions for the
a
various factors
EOQ with Planned shortage Notation
Assumption p = shortage cost
A known constant demand rate of a unit per unit time S = inventory level just after a batch of Q units is
y j Q
Order quantity Q arrives when inventory level drops added to inventory,
below zero Q ‐ S shortage in inventory just before a batch of Q
Purchase cost per unit is constant (no quantity discount) units is added. a portion of
Delivery time (lead time) is constant the demand is
Planned shortages are permitted backlogged
Back order
Stock‐out
quantity (Q‐S)
period
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Formula Back order inventory model
Production or ordering cost per cycle = K + cQ The factor multiplying h and p are the average on‐
Holding cost per cycle = hS
g p y 2/
/2a hand and back order inventory levels
Shortage cost per cycle = p(Q‐S)2/2a
average
Total cost per cycle T = K + cQ + hs2/2a + p(Q‐S)2/2a on‐hand
inventory level
=S2/2a
The total cost per unit time
Cost/time = setup cost + product cost + holding cost +
Cost/time = setup cost + product cost + holding cost + average
backorder cost Backorder
inventory level
ak hS 2 p Q S 2 = (Q‐S)2/2a
T ac
Q 2Q 2Q
Back order inventory model Formula
Optimal values (S* and Q*) are found by setting dT/dS S *= (2aK/h) * P/(P+h) and
and dT/dQ equal to zero
dT/dS = (hS/Q) – ( p(Q‐S)/Q) = 0 Q* = (2aK/h) * (P+h)/P
dT/dQ = (‐aK/Q2) – (hS2/2Q2) + (P(Q‐S)/Q) –(P(Q‐
The optimal cycle length t* is given by
S)2/(2Q)2)=0
t*= Q* /a
Solving these equations simultaneously leads to
The maximum shortage is Q* ‐ S*
= (2aK/P)
(2aK/P) * h/(P
h/(P+h)
h)
Comparing with no shortage result, the optimal lot
size and cycle times are increased by a factor
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Example 2 3. EOQ with Quantity Discounts
Backorders are allowed in Example 1. The backorder This model incorporates quantity discount prices that
cost is $1 per unit‐week. The optimal policy : depend on the amount ordered (larger quantities)
Discounts affect optimal order quantity
2 ak ph 2 x100 x1000 1 0.4
Q* 836 .7 Variable costs are annual holding, ordering and
h p 0 .4 1
purchase costs
2 ak p 2 x100 x1000 1
S* 597 .6 For the optimal order quantity, the annual holding and
h ph 0 .4 1 0 .4
ordering costs are not necessarily equal.
T * 239 .04 $ / weekk
Q*
t* 8.37 weeks
a
Note : cost of operation has decreased, backorder level is 239
during each cycle
EOQ with Quantity Discounts EOQ with Quantity Discounts
Assumptions Assume : N different prices: c1, c2, …, cN with the
A known constant demand rate of a unit per unit time . prices decreasing with the index
Order quantity Q arrives when inventory level drops to The quantity level at which the kth price becomes
zero. effective is qk, with q1 equal zero
Purchase cost per unit is not constant (quantity Define q(N+1) equal to infinity, indicating that the
discount). price cN holds for any amount greater than qN
Delivery time (lead time) is constant
Since the price decreases as quantity increases the
Planned shortages are not permitted
Planned shortages are not permitted
values of qk increase with the index k
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EOQ with Quantity Discounts EOQ with Quantity Discounts
Note the optimal order quantity for the no backorder Optimal Order Quantity (Q** )
1. Find the price level for which Q* lies within the quantity
case is not affected by the product price, c range (the last of the conditions above is true). Let this be
range (the last of the conditions above is true). Let this be
Optimal order quantity for each price range has to be level n*. Compute the total cost for this lot size
computed aK hQ*
Tn* acn*
2ak *
Optimal lot size Q* Q* Q 2
h 2. For each level k > n*, compute the total cost Tk for the lot
size Qk* *
Find for each k the value of Qk * such that aK hQ
Tk * ack k
Qk 2
if Q* > qk+1 then Qk * = qk+1
3. Let k* be the level that has the smallest value of Tk. The
If Q* < qk then Qk *= qk optimal lot size Q** is the lot size giving the least total cost
If qk < Q* < qk+1 then Qk* = Q* as calculated in Steps 1 and 2
Example 3 Solution
For Example 1, assume quantity discounts: N= 3
For an amount purchased from 0 to 500 units, the unit q1
1 = 0 and c1 = 100
price is $100 q2 = 500 and c2 = 90 2ak
Q*
For orders at or above 500 but less than 1000, the unit q3 = 1000 and c3 = 85 h
price is $90. This price applies to all units purchased q4 = ∞
For orders at or greater than 1000 units, the unit price is
Neglecting the quantity ranges, the optimal lot size is
$85
707 regardless of price
This quantity falls in the second price range
All lower ranges are then excluded
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Solution Deterministic models
Compare the cost at Q = 707 and c2 = 90, with the cost at Q = Simple cases are considered
1000 and c3 = 85
The model can be varied in a number of important
p
K
aK hQ*
For the cost c2 : Tn* *
acn* aspects. For example, non‐instantaneous
Q 2
T2 = $9282 (for Q2 * = 707 and c2 = 90)
replenishment rate, multiple products, and constraints
* on maximum inventory are easily incorporated
aK hQ
For the cost c3 : Tk *
ack k Lot size formulas derived are based on a number of
Qk 2
T3 = $8,800 (for Q3 = 1000 and c3 = 85). assumptions
Difficult to accurately estimate the parameters used in
Optimal policy is to order 1000 for each replenishment. The
cycle time associated with this policy is 10 weeks. the formulas
Introduction
Uncertainty plays a role in most inventory
Stochastic Inventory Models management
Stochastic nature of demand/demand is unknown
Random Variable for Demand (x): a random variable
Single‐ and multi‐period models
(demand) for a given period of time
Mathematical derivations: determine optimal policies
in terms of probability distribution
Modeling : which distribution to use for demand
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PDF Expected Shortage and Excess
Assumption : individual demand events occur independently Consider: relationship of demand and inventory level
Poisson distribution when the expected demand in a time during some time period:
interval is small and the normal distribution when the expected
interval is small and the normal distribution when the expected
demand is large Demand < initial inventory level (excess)
Let a be the average demand rate. For an interval of time t the Demand > initial inventory level (shortage)
expected demand is at, the PDF
P( x)
at e
x at Assume :
inventory level is a positive value z
x!
Demand is a random variable x with pdf, f(x), and
When at is large the Poisson distribution can be approximated
with a normal distribution with mean and standard deviation CDF F(x)
CDF, F(x)
Other distributions can be assumed for demand
Probability of shortage and excess Probability of shortage and excess
probability of a shortage, Ps, and the probability of The expected excess can be expressed also:
excess, Pe:
For discrete distributions, sums replace the integrals
in the above equation
Items shortage:
Expected shortage and expected excess
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Single‐period model
Single Period Model with No Setup Cost
Computer that will be obsolete before the next order Consider an inventory situation:
Perishable product The items are purchased for a cost c per unit and sold for a price
Seasonal products such as bathing suits, winter coats, etc. b per unit
b per unit.
If an item remains unsold at the end of the period, it has a
Newspaper and magazine salvage value of a.
Etc.. If the demand is not satisfied during the interval, there is a cost
of d per unit of shortage. Stockout cost: d = b ‐ c
The demand during the period is a random variable x with given
pdf and CDF.
The problem is to determine the number of items to purchase.
We call this the order level, S, because the purchase brings the
inventory to level S
Assume there is no cost for placing the order for the items
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Profit Expected profit
If the demand is less than S, revenue is obtained only Taking the expectation over all values of the random
for the number sold, x, Salvage is obtained for the variable, the expected profit is
unsold amount S – x
If the demand is greater than S, revenue is obtained
only for the number sold, S. shortage cost of d is Simplifying the above eqn.
p y g q
expended for each item short,
Optimal order level Cost expression
Optimal order level The result can be expressed in terms of the purchasing
cost, c, a holding cost h, and a shortage cost p,
The CDF of the optimal order level, S*
The two solutions are equivalent if:
q
h = –a negative of the salvage value
p = b + d lost revenue + shortage cost
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Cost expression Example: Newsboy Problem
If the demand has a normal distribution with mean m A newsboy who must purchase a quantity of newspapers for the
day's sale.
and standard deviation s, the expected profit is easily The purchase cost of the papers is $0.10 and they are sold to
The purchase cost of the papers is $0.10 and they are sold to
evaluated for any given order level. customers for a price of $0.25.
Papers unsold at the end of the day are returned to the
The order level in terms m and s publisher for $0.02.
The optimality condition becomes: The boy does not like to disappoint his customers (who might
turn elsewhere for supply), so he estimates a "good will" cost of
$0.15 for each customer who is not be satisfied if the supply of
papers runs out.
The boy has kept a record of sales and shortages, and estimates
The boy has kept a record of sales and shortages and estimates
that the mean demand during the day is 250 and the standard
deviation is 50.
A normal distribution is assumed. How many papers should he
purchase?
Solution
single‐period problem because today's newspapers
will be obsolete tomorrow
a = 0.02, the salvage value of a newspaper,
b = 0.25, the selling price of each paper,
c = 0.10, the purchase cost of each paper,
d = 0.15, the penalty cost for a shortage.
Calculate F(S*)
From table K*= 0.805
S* = 0.805(50)+250 =290.2 = 291
From previous eqns.
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