Inventory Models

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 Content
 Inventory System Defined
 Inventory Costs
 Economic Order Quantity
 Single-Period Inventory Model
 Multi-Period Inventory Models: Basic Fixed-Order Quantity Models
 Multi-Period Inventory Models: Basic Fixed-Time Period Model
 Price Break Models

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 Inventory System

 Inventory is the stock of any item or resource used in an

organization and can include: raw materials, finished products,
component parts, supplies, and work-in-process

 An inventory system is the set of policies and controls that

monitor levels of inventory and determines what levels should
be maintained, when stock should be replenished, and how large
orders should be

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 Purposes of Inventory

1. To maintain independence of operations

2. To meet variation in product demand

3. To allow flexibility in production scheduling

4. To provide a safeguard for variation in raw material delivery time

5. To take advantage of economic purchase-order size

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 Inventory Costs

 Holding (or carrying) costs

• Costs for storage, handling, insurance, etc
 Setup (or production change) costs
• Costs for arranging specific equipment setups, etc
 Ordering costs
• Costs of someone placing an order, etc
 Shortage costs
• Costs of canceling an order, etc

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 Cost Minimization Goal
By
Byadding
addingthe
theitem,
item,holding,
holding,andandordering
orderingcosts
costs
together,
together,we
wedetermine
determinethe
thetotal
totalcost
costcurve,
curve,which
whichinin
turn
turnis
isused
usedtotofind
findthe
theQQopt inventory order point that
opt inventory order point that
minimizes
minimizestotal
totalcosts
costs

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Order Quantity (Q)
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 Basic Fixed-Order Quantity (EOQ) Model Formula
TC=Total
TC=Totalannualannual
cost
cost
DD=Demand
=Demand
Total Annual Annual Annual CC=Cost
=Costper perunit
unit
Annual = Purchase + Ordering + Holding QQ=Order
=Orderquantity
quantity
Cost Cost Cost Cost Co
Co=Cost
=Costof ofplacing
placing
an
anorder
orderororsetup
setup
cost
cost
RR=Reorder
=Reorderpoint point
LL=Lead
=Leadtimetime
CChh=Annual
=Annualholding
holding
D Q and
andstorage
storagecostcost

TC = DC + Co+ C h
per
perunit
unitof
ofinventory
inventory

Q 2
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 Economic Ordering Quantity (EOQ)

Using
Usingcalculus,
calculus,we
wetake
takethe
thefirst
firstderivative
derivativeofofthe
thetotal
totalcost
costfunction
function
with
withrespect
respectto
toQ,
Q,and
andset
setthe
thederivative
derivative(slope)
(slope)equal
equalto
tozero,
zero,solving
solving
for
forthe
theoptimized
optimized(cost
(costminimized)
minimized)value
valueofofQQopt
opt

2DCo 2(Annual Demand)(Order or Setup Cost)

QOPT = =
Ch Annual Holding Cost

__
RReorder
eorder point,
point, RR == dd LL
We
Wealso
also need
needaa _
reorder
reorderpoint
point to
to d = average daily demand (constant)
tell
tell us
uswhen
when to
to
place L = Lead time (constant)
placean an order
order

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 Inventory Models

 Single-Period Inventory Model

• One time purchasing decision (Example: vendor selling t-
shirts at a game)
• Seeks to balance the costs of inventory overstock and
under stock
 Multi-Period Inventory Models
• Fixed-Order Quantity Models
• Event triggered (Example: running out of stock)

• Fixed-Time Period Models

• Time triggered (Example: Monthly sales call by sales
representative)

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 Single-Period Inventory Model

C
This
Thismodel
modelstates
statesthat
thatwe
weshould
Cuu
should
continue
continuetotoincrease
increasethe
thesize
sizeof
P 
of
P the
theinventory
inventoryso
probability
probabilityof
solong
longas
ofselling
asthe
sellingthe
the
thelast
C
Coo  C
last
Cuu unit
unitadded
than
addedisisequal
thanthe
theratio
equalto
ratioof:
toor
orgreater
of:Cu/Co+Cu
Cu/Co+Cu
greater

Where:
Co Cost per unit of demandoverestimated
Cu Cost per unit of demandunderestimated
P  Probability that theunit willbe sold
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 Single Period Model Example

 Our college Cricket team is playing in a tournament game this

weekend. Based on our past experience we sell on average 2,500
T shirts with a standard deviation of 350. We make Rs 100 on
every T shirt we sell at the game, but lose Rs50 on every T shirt
not sold. How many shirts should we make for the game?
Cu = Rs100 and Co = Rs50; P ≤ 100 / (100 + 50) = .667

Z.667 = .432 (use NORMSDIST(.667) or Appendix E)

therefore we need 2,500 + .432(350) = 2,651 shirts

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 Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions

 Demand for the product is constant and uniform

throughout the period

 Lead time (time from ordering to receipt) is

constant

 Price per unit of product is constant

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 Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions

 Inventory holding cost is based on average inventory

 Ordering or setup costs are constant

 All demands for the product will be satisfied (No back

orders are allowed)

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 Fixed Order Model

Quant Quant Quant

ity, ity, ity,
Q Q Q

T T
T
i i
i
m m
m
e e
e
L L
L

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 Basic Fixed-Order Quantity Model and Reorder Point Behavior

1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
L L
2. Your start using
them up over time. 3. When you reach down to
Time a level of inventory of R,
R = Reorder point
Q = Economic order quantity you place your next Q
L = Lead time sized order.
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 EOQ Example (1) Problem Data

Given
Giventhe
theinformation
informationbelow,
below,what
whatare
arethe
theEOQ
EOQand
andreorder
reorderpoint?
point?

Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = Rs10
Holding cost per unit per year = Rs2.50
Lead time = 7 days
Cost per unit = Rs15

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 EOQ Example (1) Solution

2DCo 2(1,000 )( 10)

Q OPT = = = 89.443 un its or 90 units
Ch 2.50

1,000
1,000 units
units // year
year = 2.74 units / day
dd == = 2.74 units / day
365 days / year
365 days / year

__
Reorder
Reorderpoint,
point, RR == dd LL== 2.74units
2.74units//day
day(7days)
(7days)==19.18
19.18 or
or 20
20 units
units

In
Insummary,
summary,youyouplace
placeananoptimal
optimalorder
orderof
of90
90units.
units. In
In
the
thecourse
courseof
ofusing
usingthe
theunits
unitsto
tomeet
meetdemand,
demand,when
when
you
youonly
onlyhave
have2020units
unitsleft,
left,place
placethe
thenext
nextorder
orderof
of9090
units.
units.

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 Fixed Period Model

Quantity, Quantity, Quantity,

Q1 Q2 Q3

Fixed Time
Fixed Time Fixed Time

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 EOQ Example (2) Problem Data

Determine
Determine thethe economic
economic order
order quantity
quantity
and
and the
the reorder
reorder point
point given
given the
the following…
following…

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = Rs10
Holding cost per unit per year = 10% of cost
per unit
Lead time = 10 days
Cost per unit = Rs15

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 EOQ Example (2) Solution

2DCo 2(10,000 ) (10)

Q OPT = = = 365.148 un its, or 366 units
Ch 1.50

10,000
10,000 units
units// year
year = 27.397 units / day
dd == = 27.397 units / day
365 days / year
365 days / year

__
RR == dd LL== 27.397
27.397 units
units//day
day (10
(10 days)
days)== 273.97
273.97 or
or 274
274 units
units

Place
Placean
anorder
orderfor
for366
366units.
units. When
Whenin inthe
thecourse
courseofof
using
usingthe
theinventory
inventoryyou
youare
are left
left with
withonly
only274
274units,
units,
place
placethe
thenext
next order
orderofof366
366units.
units.

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 Fixed-Time Period Model with Safety Stock Formula

qq==Average
Averagedemand
demand++Safety
Safetystock
stock––Inventory
Inventorycurrently
currentlyon
onhand
hand

qq==dd(T L)++ZZTT++LL--II
(T++L)

Where
Where::
qq==quantitiy
quantitiyto
tobe
beordered
ordered
TT==the
thenumber
numberof ofdays
daysbetween
betweenreviews
reviews
LL==lead
leadtime
timeinindays
days
dd==forecast
forecast average
averagedaily
dailydemand
demand
zz==the
thenumber
numberofofstandard
standarddeviations
deviationsfor
foraaspecified
specifiedservice
serviceprobabilit
probabilityy
T + L ==standard
standarddeviation
deviationof
ofdemand
demandover
overthe
thereview
reviewand
andlead
leadtime
time
T +L
II==current
currentinventory
inventorylevel
level(includes
(includesitems
itemson
onorder)
order)

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 Multi-Period Models: Fixed-Time Period Model:
Determining the Value of T+L

   
T+
T+LL 22
T+T+LL == 
i i 11
ddi
i

Since
Sinceeach
eachday
dayisisindependent anddd isisconstant,
independentand constant,
T+T+LL == (T + L) 22
(T + L)dd
 The standard deviation of a sequence of random
events equals the square root of the sum of the
variances

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 Example of the Fixed-Time Period Model

Given
Giventhe
theinformation
informationbelow,
below,how
howmany
manyunits
unitsshould
shouldbe
beordered?
ordered?

Average daily demand for a product is 20 units. The review

period is 30 days, and lead time is 10 days. Management has
set a policy of satisfying 96 percent of demand from items in
stock. At the beginning of the review period there are 200
units in inventory. The daily demand standard deviation is 4
units.

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 Example of the Fixed-Time Period Model: Solution (Part 1)

T+T+LL == (T L) ==
(T++ L) dd
22
 30 10  44  == 25.298
30++10
22
25.298

The value for “z” is found by using the Excel NORMSINV

function. By adding 0.5 to all the values in Z table and finding the
value in the table that comes closest to the service probability, the
“z” value can be read by adding the column heading label to the
row label.

So, by adding 0.5 to the value from Z Table of 0.4599, we have a

probability of 0.9599, which is given by a z = 1.75

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 Example of the Fixed-Time Period Model: Solution (Part 2)

q = d(T + L) + Z  T + L - I

q = 20(30 + 10) + (1.75)(25.298) - 200

q = 800  44.272 - 200 = 644.272, or 645 units

So, to satisfy 96 percent of the demand, you should place an

order of 645 units at this review period

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 Price-Break Model Formula

Based on the same assumptions as the EOQ model, the price-

break model has a similar Qopt formula:

2DCo 2(Annual Demand)(Order or Setup Cost)

QOPT = =
iC Annual Holding Cost

i = percentage of unit cost attributed to carrying inventory

C = cost per unit

Since “C” changes for each price-break, the formula above will
have to be used with each price-break cost value

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 Price-Break Example Problem Data

AAcompany
companyhas hasaachance
chancetotoreduce
reducetheir
theirinventory
inventoryordering
orderingcosts
costsby by
placing
placinglarger
largerquantity
quantityorders
ordersusing
usingthe
theprice-break
price-breakorder
orderquantity
quantity
schedule
schedulebelow.
below. What
Whatshould
shouldtheir
theiroptimal
optimalorder
orderquantity
quantitybebeififthis
this
company
companypurchases
purchasesthis
thissingle
singleinventory
inventoryitem
itemwith
withan
ane-mail
e-mailordering
ordering
cost
costof
ofRs4,
Rs4,aacarrying
carryingcost
costrate
rateof
of2%
2%ofofthe
theinventory
inventorycost
costof
ofthe
theitem,
item,
and
andan
anannual
annualdemand
demandof of10,000
10,000units?
units?

Order Quantity(units) Price/unit(Rs)

0 to 2,499 Rs1.20
2,500 to 3,999 1.00
4,000 or more .98

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 Price-Break Example Solution

First, plug data into formula for each price-break value of “C”

Annual Demand (D)= 10,000 unitsCarrying cost % of total cost (i)= 2%

Cost to place an order (Co)= Rs4 Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 2499, the 2DCo 2(10,000)( 4)

Qopt value is feasible Q OPT = = = 1,826 units
iC 0.02(1.20)
Interval from 2500-3999, 2DCo 2(10,000)( 4)
the Qopt value is not Q OPT = = = 2,000 units
iC 0.02(1.00)
feasible
Interval from 4000 & more, 2DCo 2(10,000)( 4)
the Qopt value is not Q OPT = = = 2,020 units
iC 0.02(0.98)
feasible
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 Price-Break Example Solution

Since
Sincethe
thefeasible
feasiblesolution
solutionoccurred
occurredininthe
thefirst
firstprice-
price-
break,
break,ititmeans
meansthat
thatall
allthe
theother
othertrue
trueQQopt values occur at
opt values occur at
the
thebeginnings
beginningsof ofeach
eachprice-break
price-breakinterval.
interval. Why?
Why?

Because
Becausethe
thetotal
totalannual
annualcost
costfunction
functionis
isaa
Total “u”
“u”shaped
shapedfunction
function
annual
costs So
Sothe
thecandidates
candidates
for
forthe
theprice-
price-
breaks
breaksare
are1826,
1826,
2500,
2500,and
and4000
4000
units
units
0 1826 2500 4000 Order Quantity
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 Price-Break Example Solution

Next, we plug the true Qopt values into the total cost annual cost
function to determine the total cost under each price-break
D Q
TC = DC + Co + iC
Q 2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
==Rs12,043.82
Rs12,043.82
TC(2500-3999)=
TC(2500-3999)=Rs10,041
Rs10,041
TC(4000&more)=
TC(4000&more)=Rs9,949.20
Rs9,949.20
Finally, we select the least costly Qopt, which is this problem occurs in
the 4000 & more interval. In summary, our optimal order quantity is
4000 units

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End of Chapter

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