INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

INVENTORY MANAGEMENT
1. The Role of Inventory Management
2. The Reasons of Keeping Inventory
3. The Costs of Keeping Inventory
4. Types of Inventory
5. Inventory Valuation

(1)THE ROLE OF INVENTORY MANAGEMENT

 Inventory is a group of materialistic items that a firm keeps to face the
needs of its production system (Inputs & Facilities) and the needs of
its customers.

 Inventory Management works as an automatic system in the firm to

control the appropriate size of inventory. This means to keep the
inventory that can satisfy the needs of the firm, not more / not less.

 We have to distinguish between Inventory Management and

Stocking or Warehousing. Inventory Management is concerned with
the planning and controlling of inventory to decide the its optimal
size, while Stocking or Warehousing is concerned with storage
facilities, its location, areas or spaces, the ways of stocking, the ways
of handling, storage workhorse, and storage bookkeeping.

(2) THE REASONS OF KEEPING INVENTORY

There are many advantages a firm can achieve from keeping
inventory, such as:
1. To be Safe against some types of risks, Including: (a) Increasing demand
because of any reason, (b) Increasing the Lead Time for any reason, (c)
Changing the need for materials from time to time, (d) The urgent or
unexpected demand.

2. To achieve the stability and continuity of the Production and Operation System
through: (a) Flexibility of Production Planning and Scheduling, (b) Balancing
Production Rates during Production Stages, (c) Improving Customers Services.

3. To gain some Economic advantages, such as: (a) Quantity Discount, (b) Price
Fluctuation, (c) Using inventory stages as production process.

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

(3) THE COSTS OF KEEPING INVENTORY

There are some costs or disadvantages of keeping inventory, such as:
1. The risk of losing or damaging inventory, Including: (a) Absoluteness, (b)
Expiring, (c) Fire, (d) Stealing, (d) Price Reduction.

2. The cost of the Lost Opportunity, that means the investment of money in other
activities instead of keeping it in inventory (Sunk Cost).

(4) THE TYPES OF INVENTORY

1. Raw Materials
2. Machines and Equipment
3. Component Parts
4. In-process goods
5. Finished Goods
6. Supplies and Miscellaneous

(5) INVENTORY VALUATION

5/1: Priorities of Inventory Control.
5/2: Inventory Valuation Methods.

(5/1) PRIORITIES OF INVENTORY CONTROL

One of the main roles to set up a good system of inventory control
is to classify the inventory items of the firm according to the type and the
span or the size of control required to those items. There are many
approaches to classify inventory. Each approach has its own advantages,
disadvantages and proper conditions. Among these approaches is “ ABC
Analysis of Inventory”

ABC Analysis of Inventory:

The ABC Analysis of Inventory is a system of classifying
inventory items into 3 groups, A, B, and C that are different in their
importance, where group A is the most important and Group C is the
least one. This system of inventory classifications is appropriate for the
firms that produce for the market in advance according to the expected
demand on their products. The ABC Analysis can be performed using
different ways (Inventory value, inventory suppliers, and inventory
turnover). However, the most common use of. ABC depends upon one
or more of the following variables:

1. Usage average of each item.

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 INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

2. Price average of the item units.

3. Value average of each item.
4. Combining between more than one variable of the mentioned ones.

Whatever the variables used in ABC Analysis, its real value in

inventory control is in its ability to show the importance of each group
of inventory items. For example item A or group A must get the most
care from the management because it is the most important group of the
inventory according to this analysis. Then is group B, and finally group
C that requires the least degree of control. The ABC Analysis of
Inventory can be performed according to the following steps:

1. Calculating the annual value of usage of each inventory item. This is

equal to the annual quantity used multiplied by the unit cost.
2. Arranging inventory items according to their values from the highest
value to the lowest.
3. Calculating the percentage of the value of each item to the total value
of all items.
4. Calculating the accumulative percentage value in front of each item.
This can be done by adding the item’s percentage to the percentages of
all items that above it.
5. Calculating the accumulative percentage of the numeric size of items.
For example, if a firm has 10 inventory, then each size is 10% and the
accumulative percentage of the numeric size of items will be 10%, 20%,
30%,…. 100%.

Example 1:
Using ABC Analysis of inventory, classify the inventory items of
X firm that deals in 10 items of inventory materials. The firm decided to
make group A = 20%, B = 30% and C = 50%. The following table
reflects the information about these items:

Item 1 2 3 4 5 6 7 8 9 10

Quantity 6 8 12 14 15 10 9 5 4 9
U. Price 12.5 1.25 1.5 0.5 0.6 15 1.5 1 2 0.5

Solution:

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

# Q U.P V 1 2 3 4 5 6
6 12.5 75 150 6 50 50 10 A
2 8 1.25 10 75 1 25 75 20 A
3 12 1.5 18 18 3 6 81 30 B
4 14 0.5 7 13.5 7 4.5 85.5 40 B
5 15 0.6 9 10 2 3.3 88.8 50 B
6 10 15 150 9 5 3 91.8 60 C
7 9 1.5 13.5 8 9 2.7 94.5 70 C
8 5 1 5 7 4 2.3 96.8 80 C
9 4 2 8 5 8 1.7 98.5 90 C
10 9 0.5 4.5 4.5 10 1.5 100 100 C
Total 300 100
Note:
V = Q × U.P
1 is the arrangement of values from the largest to the lowest.
2 is the items number after arrangement.
3 is the item value percentages to the total value.
4 is the accumulative percentage of items values
5 is the item percentage from the total number of items.
6 is the classification.

You can note from the solution that:

1. 75% of the inventory value is coming from 20% of inventory items (2
items from 10).
2. 13.8% of the inventory value is coming from 30% of inventory items (3
items of 10).
3. 11.2% of the inventory value is coming from 50% of inventory items (5
items of 10).

(5/2) INVENTORY VALUATION METHODS

Any firm needs to evaluate its inventory from time to time. For
example when a firm is preparing its annual financial reports, it needs a
method to valuate its inventory to register the inventory value in its
balance sheet. The value of inventory has relationships with the cost of
production, the profits, and the assets of the firms. All those items are
affected by the value of inventory that depends on the method a firm
used to apply in valuation its inventory. There are many methods of
inventory valuation. Among those methods:
 Specific Identification.
 Lower of Market or Cost.
 Average Price (Cost).
 Price Moving Average.
 First in First Out (FIFO)
 Last In First Out (LIFO)

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

In the following parts you can see some examples that explain
these methods.

Specific Identification:
This method can be applied in the case where a firm has inventory
items that can be distinguished according to any base (e. g. type, source,
price…etc). In this case the value of a firm’s inventory is just the sum of
items quantities multiplied by their prices. The following table shows this
case:

Item 1 2 3 4 5 Total
Quantity 6 8 12 14 15
Unit Price 12.5 1.25 1.5 0.5 3
Inv. Value 75 10 18 7 45 155

Lower of Market or Cost:

This method of evaluating inventory depends upon the accounting
principles in evaluating assets according to the their original costs or
market price which one is lower.

Average Price (Cost):

This method utilizes the weighted average of inventory items
quantities multiplied by their prices. The following table shows this case:

Date Information Quantity Unit Price Inv. Value

1/1 Starting Inv. 3000 4.0 12000

2/2 Purchases 5000 4.5 22500
1/3 Purchases 2000 5.0 10000
2/5 Purchases 3000 4.75 14250
TOTAL 13000 58750

Then the weighted Average of inventory price will be:

W.A.I.P. = 58750 ÷ 13000 = 4.52 $/ Unit

If a firm has inventory of 4000 units in the end of the year, then the value
of this inventory will be:

4000 × 4.52 = 18080 $

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

Price (Cost) Moving Average:

This method requires calculating the average (cost) price of the
unit after each process of purchasing or adding to the inventory and using
this average in evaluating all consumptions from inventory until a new
process of purchasing or adding to inventory will happen.

Example 2:
The following table shows information about the inventory of X
firm company, use the Price (Cost) Moving Average Method to evaluate
this inventory.

Date 1/1 15/1 8/2 16/3 11/6 18/8 6/9 5/10 30/12
Inv. In 100 300 150 150
Inv. Out 80 140 130 110 140
U. Price 1.50 1.56 1.60 1.70

Solution:
The following table shows evaluating X firm inventory according
to the Price (Cost) Moving Average Method.

IN OUT BALANCE
Date Q U.P. Value Q U.P. Value Q U.P. Value
1/1 100 1.50 150 100 1.500 150.00
15/1 300 1.56 468 400 1.545 618.00
8/2 80 1.545* 123.60 320 1.545 494.40
16/3 140 1.545 216.60 180 1.545 278.10
11/6 150 1.60 240 330 1.570 518.10
18/8 1.570 204.10 200 1.570 314.00
6/9 1.570 172.70 90 1.570 141.30
15/10 150 1.70 255 240 1.651 396.24
30/12 1.651 231.14 100 1.651 165.10
TOTA 1113 947.84
L
* Note: (100 × 1.50) + (300 × 1.56) = 618
I..P.M.A. = 618 ÷ 400 = 1.545

First in First Out (FIFO):

According to this method a firm consumes the items according to
the date of their arrival starting from the oldest date and ending with the
most recent one. The remaining inventory in this case will be formed
from items purchased in the most recent date.

Example 3:

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

The following table shows information about the inventory of X

firm company, use the FIFO method to evaluate this inventory.
Date 1/1 15/1 8/2 16/3 11/6 18/8 6/9 5/10 30/12
Inv. In 100 300 150 150
Inv. Out 80 140 130 110 140
U. Price 1.50 1.56 1.60 1.70

Solution:
The following table shows evaluating X firm inventory according
FIFO Method.

IN OUT BALANCE
Date Q U.P. Value Q U.P. Value Q U.P. Value
1/1 100 1.50 150 100 1.500 150.00
15/1 300 1.56 468 400 618.00
100 1.500 150.00
300 1.56 468.00
8/2 80 1.500 120 320 498.00
20 1.500 30.00
300 1.56 468.00
16/3 140 217.20 180 1.56 280.80
20 1.500 30.00
120 1.56 187.20
11/6 150 1.60 240 330 520.80
180 1.56 280.80
150 1.60 240.00
18/8 130 1.56 202.80 200 318.00
50 1.56 78.00
150 1.60 240.00
6/9 110 174.00 90 1.60 144.00
50 1.56 78.00
60 1.60 96.00
15/10 150 1.70 255 240 399.00
90 1.60 144.00
150 1.70 255.00
30/12 140 229.00 100 1.70 170.0
90 1.60 144.00
50 1.70 85.00

Last in First Out (LIFO):

According to this method a firm consumes the items according to
the date of their arrival starting from the Newest date and ending with the
Oldest one. The remaining inventory in this case will be formed from
items purchased in the oldest date.

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

Example 4:
The following table shows information about the inventory of X
firm company, use the LIFO method to evaluate this inventory.

Date 1/1 15/1 8/2 16/3 11/6 18/8 6/9 5/10 30/12
Inv. In 100 300 150 150
Inv. Out 80 140 130 110 140
U. Price 1.50 1.56 1.60 1.70

Solution:
The following table shows evaluating X firm inventory according
LIFO Method.

IN OUT BALANCE
Date Q U.P. Value Q U.P. Value Q U.P. Value
1/1 100 1.50 150 100 1.50 150.00
15/1 300 1.56 468 400 618.00
100 1.50 150.00
300 1.56 468.00
8/2 80 1.56 124.80 320 493.20
100 1.50 150.00
220 1.56 343.20
16/3 140 1.56 218.40 180 274.80
100 1.50 150.00
80 1.56 124.80
11/6 150 1.60 240 330 514.80
100 1.50 150.00
80 1.56 124.80
150 1.60 240.00
18/8 130 1.60 208.00 200 306.80
100 1.50 150.00
80 1.56 124.80
20 1.60 32.00
6/9 110 171.80 90 1.50 135.00
20 1.60 32.00
80 1.56 124.80
10 1.50 15.00
15/10 150 1.70 255 240 390.00
90 1.50 135.00
150 1.70 255.00
30/12 140 1.70 238.00 100 152.00
90 1.50 135.00
10 1.70 17.00

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

Note that the selected method of inventory valuation will affect

cost, profit, and value of the end of the year inventory. This effect
depends also on the trend of prices. The following table shows this issue.
PRICES ARE GOING UP PRICES ARE GOING UP
COST PROFIT INVIN COST PROFIT INVIN
FIFO METHOD Reduced Increased Increased Increased Reduced Reduced
LIFO METHOD Increased Reduced Reduced Reduced Increased Increased

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

INVENTORY PLANNING AND CONTROL

Inventory Planning and Control deals with some decisions related
to determining the optimal size of inventory the firm must keep. The
decision of keeping inventory usually connected with three impacts on
inventory costs: (1) Increasing some costs, (2) Decreasing some other
costs, (3) Fluctuating some other costs. The following table may
summarize the problem of the Inventory Planning and Control with the
first two groups of costs, the third group is analyzed after that:

THE COSTS OF INVENTORY

INVENTORY BALANCE NO INVENTORY

INCREASING COSTS DECREASING COSTS
1. The cost of invested capital (Cost of 1. The cost of order set up
the lost opportunity)
2. The cost of storage facilities. 2. The cost of producing and/or
purchasing
3. Taxes and insurance
4. The cost of: lost, old, damages ...
etc.

However, there is a third group of inventory costs, calls

Fluctuating or Uncertain Costs. This group of costs includes the costs
that are completely unknown because of the uncertainty in the
surrounding conditions. In some conditions these costs will be benefits to
the firm, while in others will be disadvantages. The main two examples
of these costs are related to changing prices of items purchased and
quantity discount. The changing of future prices of inventory items is
uncertain, and its result not stable but depends on the firm’s inventory
conditions. The following diagram may represent this case.

Prices & Inventory HIGH SIZE OF LOW SIZE OF

INVENTORY INVENTORY
INCREASING PRICES GOOD (BENEFITS) BAD (COSTS)
DECREASING PRICES BAD (COSTS) GOOD (BENEFITS)

Similar results may accompany the decision of accepting or

refusing the supplier’s Quantity Discount. The following table shows
this case.

Purchase a small quantity and sacrifice Purchase a high quantity and get the
the quantity discount offered quantity discount offered

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

LOW INVENTORY COST HIGH INVENTORY COST

From the previous discussion of inventory cost behavior, we can
see that the most important question in Inventory Planning and Control is
the issue of the optimal size of inventory a firm must keep. There are
many models to solve this problem; The following diagram represents
the inventory models in different situations:

INVENTORY PLANNING & CONTROL MODELS

STATE
OF
DEMAND

FIXED RANDOM
DEMAND DEMAND

FIXED FIXED Demand

QUANTITYMO TIME Marginal
DELS MODELS Analysis

Expected
Economic Economic
Profits
Quantity Production
Model
Model Run (EPR)

One
One Product
Product Model
Model

Many
Many Products
Products Model
Model

Many
Models that will be focused upon.
Process
Model

Each model in the graph has its assumptions and conditions.

Because of time constraints, in this lecture we will concentrate on the
following models:

 The Economic Quantity Model.

 Economic Production Run Models (One and Many Products

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

 Random Demand Models (Marginal Analysis and Expected Profits Models)

(1) THE ECONOMIC QUANTITY MODEL (EQM)

In this model the Optimal Size of Inventory is gained when the

Cost of Storage equals the Cost of Order. This model based on some
assumptions, we have to be aware before applying the model to make
inventory decision. These assumptions are:

1. The Demand is fixed and certain.

2. The Lead Time is Fixed and Certain.
3. Each inventory item is independent from other items and requires a separate
application of the model.
4. The Economic Quantity determined by the model arrives to the store on time
and as a whole.
5. Purchasing Cost per unit, Ordering Cost per order, and Storage Cost per unit
are fixed and known.

As we said in this model:

Q is optimal (Q*) When:

STORAGE COST (S) = ORDERING COST (O)

ORDERING COST:
Assuming that the total demand on a firm’s product is fixed and
known, we can show that ordering cost increases with the decrease of
quantify size that a firm orders each time, and hence the increase of the
numbers of orders. The following 2 graphs show this relationship.

O.C. O.C.

C
O
S
T

Size of order Number of orders

STORAGE COST:
Assuming that the total demand on a firm’s product is fixed and
known, we can show that storage cost decreases with the decrease of
quantify size that a firm orders each time.. The following 2 graphs show
this relationship.

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

S.C.

C
O
S
T
S.C.

Size of order Number of orders

Combining the 4 graph together, we can determine the optimal size

of a firm inventory.

T.C. T.C.

O.C S.C. S.C O.C.

C
O
S
T

Q* Q*

Size of order Number of orders

SOLVING THE MODEL BY FORMULA:

Ordering Cost (O) equals the number of orders required to face the
demand, (assuming that each order equals the Economic Quantity)
multiplies by the cost of each order. Assuming that inventory
consumption is fixed, Storage Cost (S) is the Average Consumption
multiplies by the Storage Cost per unit. Given the following:

C = Total Costs B = Storage Cost per Unit

O = Total Order Cost D = Demand
S = Total Storage Cost Q* = Economic Quantity.
A = Order Cost per Unit

Then:

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

C = C* IF O = S

D Q*
 A  B
Q* 2

DA Q * B

Q* 2

Q* 2 B = 2 DA

Dividing both sides by B, then:

2 DA
Q *2 
B

Taking the square root of both sides, then:

2 DA
Q* 
B

Note: We can deal with B as an absolute cost or as a percent of the value

of the average inventory or of the unit price.

Example 5:

Given that:
D = 1800 tons / year Price = 20 $ / unit and B = 20% of price
A = 100 $ / order No. of working days = 300 days / year
B = 4 $ / unit L = Lead Time = 15 days

Solution:
1) How much inventory should the firm keep?

2  1800  100 360000

Q*    90000  300unit / order
4 4

2) When we should order?

D 1800
The No. of orders =   6orders / year
Q* 300

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

300
Time between each 2 orders =  50days
6
3) The Dally Consumption Rate of Inventory

300
  6units / day
50

4) Reorder Point (R):

R = The Dally Consumption of Inventory  Lead Time (L)

R= 6 units / day  15 days = 90 units

or R = 15 days

The flowing graph summarize the behavioral model of the

inventory of the previous example.

1 2 3 4 5 6
Q* = 300 --------------------------------------------------------------------------------

200

100
R --------------------------------------------------------------------------------

35 85 135 185 285

50 100 150 200 300

time

Solving The Model By Table:

You can solve the previous example using table method as
following (Also, See the graph after the table):

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

(1) (2) (3) (4) (5) (6)

No. of Q Aver. Inv. S.C. O.C. T.C.
Orders (D ÷ (1)) (Q ÷ 2) ((3) × B) ((1) × A) ((4) + (5))
1 1800 900 3600 100 3700
2 900 450 1800 200 2000
3 600 300 1200 300 1500
4 450 225 900 400 1300
5 360 180 720 500 1220
6* 300 * 150 * 600 * 600 * 1200 *
7 257 129 514 700 1214
8 225 112.5 450 800 1250
9 200 100 400 900 1300
10 180 90 360 1000 1360
* Optimal

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

THE IMPACT OF PRICE DISCOUNT EQ

Firms used to promote their products selling by giving quantity
price discount. The more the quantity you purchase, the less the price of
purchases you get. However, although it seems good to purchase more
quantities to get price reduction, but the cost of inventory may get higher.
In such a case the purchasing manager must compare between the benefit
from getting the price discount and the increase in Inventory cost to
make the decision. To make such decision follow these steps:

1. Calculate the Total Cost according to the optimal quantity resulted

from the model of the Economic Quantity. The total cost equals:
Ordering Cost, Storage Cost, and Purchasing Cost.
2. Calculate the Total Cost in case of getting the quantity discount by
purchasing the smallest quantity that enable you to get the discount.
3. Compare the 2 total cost and select the lower one.

Example 6:
The yearly demand of purchases in X firm is 18000 units. The
ordering cost is 20$ per order, and the storage cost is 2$ per unit. If the
price per unit is 10$ and the supplier offered the following quantity
discount what is the right size of purchases of this firm.

IF YOU PURCHASE YOU WILL GET DISCOUNT

1800 units to less than 3000 units 2%
3000 units to less than 6000 units 3%
6000 units or more 4%

Solution:
1. Calculate the Economic Quantity (Q*) and the Total Cost of this
quantity.

2 DA
Q* 
B

2  18000  20 720000
Q*    360000  600
2 2

18000 600
T .C.  (  20)  (  2)  (18000  10)  600  600  180000  181200 &
600 2

2. Calculate the Total Cost of purchasing the quantity of 1800 units and
getting discount of 2%.

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

18000 18000
T .C.  (  20)  (  2)  18000  9.8)  200  1800  176400  178400$ .
1800 2

3. Calculate the Total Cost of purchasing the quantity of 3000 units and
getting discount of 3%.

18000 3000
T .C  (  20)  (  2)  (18000  9.7)  120  3000  174600  177720$
3000 2

4. Calculate the Total Cost of purchasing the quantity of 6000 units and
getting discount of 4%.

18000 6000
T .C.  (  20)  (  2)  (18000  9.6)  60  6000  172800  178860$
6000 2

5. Now compare the 4 total costs and select the minimum total cost as a
base of your decision.

# Cases Total Cost

*
1 Purchase Q of 600 units (No discount) 181200$
2 Purchase Q of 1800 units (2% discount) 178400$
3 Purchase Q of 3000 units (3% discount) 177720$ *
4 Purchase Q of 6000 units (4% discount) 178860$

From the analysis you can see that the firm should purchase its needs
in 6 orders, each order is 3000 units instead of the economic quantity,
and it will save in this case 3480$ (181200$ – 177720$)

Example 7:
The yearly demand of purchases in X firm is 1800 units. The
ordering cost is 100$ per order, and the storage cost is 10% of unit price
(or the value of average inventory. The supplier offered the following
quantity discount. What is the right size of purchases of this firm.

IF YOU UNIT
PURCHASE PRICE
> 300 units 12.00 $
300 : > 500 10.00 $
500 : > 800 09.00 $
800 : > 1200 08.50 $
1200 : > 1800 08.25 $
1800 or more 08.15 $

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

Solution:
1) Calculate the Economic Quantity (Q*) for each unit price given in
the table using the following Economic Quantity Formula:.

2 DA
Q* 
B%  Pr ice

For example Q* at the price of 12 $ will be:

2  1800  100
Q12*   548units
0.10  12

2) Find which calculated quantity does locate within the range of

discount.
3) Calculate the total cost of the calculated quantity that is located
within the range of discount.
For example the total cost at the price of 9 $ per unit will be:

1800 632
T .C.9  (  100)  ((  (0.10  9))  (1800  9)  284.8  284.8  16200  16769.2$
632 2

4) Calculate the total costs of each case the firm will purchase larger
quantities to get less prices.
5) Compare the total cost that you calculated in (3) with each total
cost you calculated in (4) and select the quantity that minimizes
the total cost. The following table shows those optimal quantities.
The following table summarizes the results.

IF YOU UNIT QUATITY TOTAL

PURCHASE PRICE Q* Q* : D. R. PURCHASED COST
> 300 units 12.00 $ 845 Q* > D. R.
300 : > 500 10.00 $ 600 Q* > D. R.
500 : > 800 09.00 $ 632 Q* in D. R. 632 16769.2 $
800 : > 1200 08.50 $ 650 *
Q < D. R. 800 15865.0 $
1200 : > 1800 08.25 $ 661 *
Q < D. R. 1200 15495.0 $ *
1800 or more 08.15 $ 665 *
Q < D. R. 1800 15503.5 $
*
Q is the economic quantity at the given price.
Q* : D. R. is relationship between the economic quantity and the range of discount.
* Is the optimal total cost resulted from purchasing the optimal quantity.
Students can perform calculations of the table as an assignment.

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

(2) ECONOMIC PRODUCTION RUN (EPR) MODELS

In many cases firms may produced their needs from some

requirements by themselves instead of purchasing those requirements
from the outsiders. In such cases we can use the Economic Production
Run (EPR) Models to make decisions about inventory. These types of
inventory models have the same assumptions of EQ Models in addition
to the following assumptions:

1. The Rate of Production (P) of a firm is higher than its Rate of

Consumption (C), and hence the inventory of that firm is
accumulated gradually by the difference between the two rates (P –
C). The inventory will increase with the continuation of production
process and it starts in declination after finishing the specific
production run until it goes to zero, where the firm starts to produce
the second production run.
2. In the case of this model a firm is a producer and a consumer in the
same time, hence the inventory average is calculated as the half of
the inventory maximum limit, not the half of the quantity. The
inventory maximum limit is calculated on the base of the time period
of producing the production run (T) multiply by the difference
between the production rate and the consumption rate, i.e. (P – C).

From the previous graph, you can see that Economic Production
run can be classified into three groups as the following:

 Economic Production Run for One Product.

 Economic Production Run for Many Products.
 Economic Production Run for Many Production Processes.

As mentioned before, we will focus on the first two model.

Economic Production Run (One Product):

From the assumptions of the model just mentioned we can see that
the maximum limit of inventory is the difference between the production
rate (P) and the consumption rate (C) multiply by the time period of
producing the production run, i.e.:

Maxinv  (P  C ) T

And the average inventory is the half of the maximum inventory, hence

(P  C ) T
Averageinv 
2

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

In addition to these symbols, If we refer to the quantity or the size

of a production run by the letter (R), for the total demand by the letter
(D), the preparation cost per run by the letter (B) ,and the storage cost by
the letter (S), then we can get the optimal size of the run R* when The
Cost of Preparing a Production Run = The Cost of Storage, I.e. when:

D (P  C )T
B  S
R 2

DB TS (P  C )

R 2

Because the time of a production run (T) is equal to (R ÷ P), then:

DB RS (P  C )

R 2P

Then via cross multiplication, we can get:

R 2S (P  C )  2DBP

Dividing both sides by S (P – C), we get:

2DBP
R2 
S (P  C )

Taking the square root of booth sides, we get:

2DBP
R
S (P  C )

The following table and the two graphs reflect the relationships
between the quantity or the size of a production run and the some costs.

Size Size of Number of Size Cost Cost

of Production Production of of of
Case Demand Run Runs Inventory Inventory Preparation

1 Fixed Large Few Large High Low

2 Fixed Small Many Small Low High

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

T.C. T.C.

B S B S.

C
O
S
T

R* R*

Size of Run Number of Runs

Example 8:
The production rate of a product in the X firm is 960 per day. The
firm distributes its product in the market 240 units per day. To prepare
the production system to produce a production run, it costs the firm 45 $.
If the firm work 200 days each year, and the storage cost is 1 $ per unit
and each unit requires 5 $ extra costs of materials, wages…etc. What is
the optimal size of the production run of this firm, and what is its total
cost in this case.

Solution:
In this case the yearly demand on the product of X firm is 48000
units (240 units × 200) days. Applying the formula of the optimal size of
a production run, we get:

2DBP
R* 
S (P  C )

2  48000  45  960
R*   5760000  2400units
1(960  240)

The Total Cost in this case will be: (Production cost + Preparation
Cost + Storage Cost), and if we let (O) represents the production cost
per unit, then we get:

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

D R * (P  C )
TotalCost  (D O )  (  B )  S
R* 2P
48000 24000  (960  240)  1
TotalCost  (48000  5)  (  45)  ( )
2400 2  960

 240000  900  900

 241800$

We can calculate extra information to help management to

rationalize its efforts, among those: Time that is required to produce the
production run (T), the period between starting producing a production
run and the starting of the second run (H), and the maximum size of
inventory (MaxInv) as the following:

R * 2400
T    2.5days
P 960

R * 2400
H    10days
C 240

R* 2400
MaxInv   (P  C )   (960  240)  1800units
P 690

Example 9: (Solve by your self)

The production rate of a product in the X firm is 100 units per day.
The firm distributes its product in the market 1200 units per year. The
consumption rate of this product is 60 units. To prepare the production
system to produce a production run, it costs the firm 15 $ and the storage
cost is 1 $ per unit and each unit requires 5 $ cost of production What is
the optimal size of the production run of this firm, and what is its total
cost in this case. (Calculate all other information you can get from the
data).

Economic Production Run Model (Many Products):

In most cases firms produce many types of product and they need
to know the optimal size of the production run for each product in
addition to any related information. The same ideas of the previous
model are applicable here with some small adjustments.
Example 10:
The following table reflects some information about the
production of X firm (with the same symbols of the formula).

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

D B S P C
Prod.
AA 7000 63.5 1.6 80 60
BB 12000 160 1.4 100 85
CC 9000 125 0.5 90 70
DD 8000 85 1.2 60 50
EE 15000 150 2.0 120 105

Solution:
1. Prepare the following table using the same symbols of the EPR
formula:

D B S P C (P  C )  B  S
Prod. P
AA 7000 63.5 1.6 80 60 (20 × 7000 × 1.6) ÷ 80 = 2800
BB 12000 160 1.4 100 85 (15 × 12000 × 1.4) ÷ 100 = 2520
CC 9000 125 0.5 90 70 (20 × 9000 × 0.5) ÷ 90 = 1000
DD 8000 85 1.2 60 50 (10 × 8000 × 1.2) ÷ 60 = 1600
EE 15000 150 2.0 120 105 (15 × 15000 × 2.0) ÷ 120 = 3750
583.5 TOTAL 11760

2. Calculate the Optimal Number of the Production (NofR * ) using

the following formula:

TOTAL
NofR * 
2  totalofB

11670
NofR *   10Runs
2  583.5

3. Prepare the following table to reflect the Optimal Size of each

production run (R*), the time period to produce each run (T), the
gap between starting a run and starting another run (H), and the
maximum inventory from each run (MaxInv).

R* T H MaxInv
Prod. (D ÷ NofR*) (R* ÷ P) (R* ÷ C) (P-C) × ((R* ÷ P)
AA 700 8.75 11.67 175
BB 1200 12.00 14.12 180
CC 900 10.00 12.86 200
DD 800 13.33 16.00 133.3
EE 1500 12.50 14.29 187.5

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

(4) RANDOM DEMAND MODELS

Random, unstable, or unfixed demand models are generally

applicable on the cases of some special products. The analysis in this
case may be called: Random Demand Analysis, The Probabilistic
Demand Analysis, or The Newsboy Problem. There are many situations
where we can need this type of analysis. The following are some of those
cases:

1. When the demand on the product dose not represent a continues

phenomenon. For example when the demand is connected with a specific
day (the demand on news papers or strawberries) or the demand is
connected to a special occasion (the demand on Christmas trees or roses).
2. the demand is unstable or changing dramatically from time to time, or what
we call the seasonal demand (the demand on schools’ uniforms, stationary
goods, or closes of pilgrims).
3. when the life of a product is very short as a result perish or Absoluteness
(meets, fishes, diary products).

In such cases firms’ failure to determine their needs from the required
items (inventory) may take one (and only one of an item) of the two
following forms.

 The inventory will be higher than the demand or the need of the
firm. In this case the firm may enforced to sell the extra items as a
scrap and achieves some losses.
 The inventory will be less than the demand or the need of the firm.
In this case, although the firm dose not achieve losses but it loose the
opportunity to achieve profits as a result of not facing the demand or
the missed sales opportunities (the cost of ending or consuming
inventory).

In the following parts focuses will be given to two of the random

demand models:

 Marginal Analysis Model

 Expected Profits Model.

Marginal Analysis Model:

This model handles the random demand problem using some of
statistical and economic concepts. The starting point for a reader to
understand the model is to keep in mind the following rules:

1. the total sum of the probabilities of mutually exclusive events is 1.

For example the sum the probability of selling a product and the

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

probability of not selling that product is 1 (100%). If we refer to the

probability of selling the product by (P), then the probability of not
selling that product will be (1-P).
2. It is necessary to continue inventorying extra units from an
inventory item or product until its achieved marginal profits are
greater than its marginal loses. such cases firms’ failure to
determine their needs from the required items (inventory) may take
one (and only one of an item) of the two following forms.
3. Marginal change is the change in the dependent variable because of
the change in the independent variable by one unit. While the
Marginal Profit (M) of a product is the difference between product
selling price and product production or purchasing cost, the
Marginal Loss (L) of a product is the defiance between the product
production or purchasing cost and its price when it was sold as
scrap or garbage.
4. The expected profit of selling a unit is equal to the multiplication
result of a unit profit by its selling probability, and the expected loss
of a unit is equal to the multiplication result of a unit loss by its not
selling probability.

Marginal Model of Inventory Analysis stats that a firm must

continue increasing its inventory of an item or a product as long as the
expected profits of this product is greater than its expected losses. A firm
must stop increasing its inventory when the expected profits are equal to
the expected. Given that (M) is the marginal profit, (L) is the marginal
loss, and (P) is the probability of the event, then P × M or (PM) is the
expected profit and P × L or (PL) is the expected loss. From the
statement of the model we can state the following:

P  M  L  (1  P )
PM  L  (1  P )
PM  L  PL
PM  PL  L
dividing both sides by (M + L), then
L
P
M L

This means that the probability to sell the stored item is equal to
the marginal loss divided by the deference between the marginal profit
and the marginal loss. Hence a firm continues to add additional units to
its inventory as long as the probability to sell this unit is greater than the
probability calculated by the last mentioned formula.
Example 11:
A newsboy used to buy a dally newspaper with 2 $ and sell it in
the same day of purchasing by 6 $. If he failed to sell it, he would sell it

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

in the second day as a garbage to a factory of recycling with 1 $. Keeping

a record about his activity for 200 days, he registered the following table:

Sold Quantity 50 51 52 53 Total days

For how many days 20 70 80 30 200

What the optimal quantity of the newspaper the newsboy must purchase?

Solution:
1. using the information in the table prepare a new table that contains
the probabilities of selling each quantity (number of days the
quantity was sold divided by the total days) and the accumulative
probabilities (the probability to sell the quantity or more). The
table can take this form:

Sold Quantity 50 51 52 53 Total days

For how many days 20 70 80 30 200
Probability 0.10 0.35 0.40 0.15 1
Accumulative Prob. @ 1 0.90 0.55 0.15
@ The probability of selling the mentioned quantity or more.

1. Applying the mentioned formulas, we can see that the profit is

equal to 4 $ per issue (6 $ the selling price – 2 $ the purchasing
price), and the loss is 1 $ (2 $ the purchasing price – 1 $ the price
of selling the issue as garbage). Hence:

L
P
M L

1
P  0.20
1 4

2. Look in the row of accumulative probabilities and find the first

probability that is greater than the probability calculated by the
mentioned formula (i. e. 0.55). Hence the newsboy must purchase
52 issues every day.

Expected Profits Model:

This model uses the same ideas of the marginal analysis depending
upon the Expected Value Concept and the ability of a decision maker to
carry risk. For the previous example, we can help the decision maker by
preparing The Total Conditional Profits Matrix as in the following
table:

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

Expected Risk Risk

Profit Condi. Matrix Value D. Taker D. Avoider D.
Maker Maker Maker
s
Demand 50 51 52 53
P 0.10 0.35 0.40 0.15 E.V. Max M Min M
50 200 200 200 200 200.00 200.00 200.00*
51 199 204 204 204 203.50 204.00 199.00
52 198 203 208 208 205.25* 208.00 198.00
53 197 202 207 212 205.00 212.00* 197.00
Quantity 52 53 50
*

From the table we can see that:

 if the newsboy is a risk taker, the optimal decision is to purchase 53 issues
per day looking for the maximum profit (212.00 $).
 if the newsboy is a risk avoider, the optimal decision is to purchase the
minimum quantity 50 issues per day looking for the minimum profit (200.00
$).
 if the newsboy is in the meddle between risk taking and risk avoiding or
oriented by the expected value, the optimal decision is to purchase 52 issues
per day looking for the largest expected profit (205.25 $). However the
nature of the decision maker is a variable that is effected by many natural,
educational, and cultural factors that beyond this type of lecture.

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INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

APPENDIX

THE IMPACT OF PURCHASING

ON PROFITS

STRATEGY STRATEGY
B A
Rationalizing Increasing THIS
Purchasing Sales by 5% YEAR DATA
Cost by 5%
2000000 2100000 2000000 SALES
COSTS:
988000 1092000 1040000 Materials
560000 588000 560000 Wages
200000 210000 200000 Others
1748000 1890000 1800000 Total Costs
252000 210000 200000 Profit

Profit is Profit is Strategy

increased by increased by Impact
25% from the 5% from the
previous year previous year

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 INVENTORY MANAGEMENT Abdelnasser M. Ali. Ph.D.

THE IMPACT OF PURCHASING

ON PROFITS

Costs & C.
Increasing Firm’s
Satisfaction
Profitability Needs

Keep Production Scientific

Running Management
Control
Right Quantity Planning
Control
Right Quality Organizing
Control
Right Source Directing
Control
Right Time Controlling
Control
Right Price

Right Service

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