Objectives

• Understand the costs that are relevant in

deciding how much to order at one time
• Explain the assumptions used in deriving the
economic order quantity and calculate an
economic order quantity using the standard EOQ
formula
• Explain the concept of an order point
• Understand the reasons for carrying safety stock
Order
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 Objectives
• Describe the idea of service level and the factors
influencing it
• Explain the two-bin system and the perpetual inventory
system
• Understand the use of the periodic review system
• Recognize the purpose of auditing inventory records
• Explain the cycle counting process

Order
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Order Quantity
• Costs that are relevant in deciding how much
to order
• Economic order quantity (EOQ) formula
• Order point
• Safety stock
• Service level

Order
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Order Qty (continued)
• Two-bin and perpetual inventory systems
• The periodic review system
• Auditing inventory records
• Cycle counting process

Order
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 How Much to Order at One
Time

• Management will want to

– Minimize sum of all costs involved
– Maximize customer service
• Management has to make decision rules
• Methods of deciding how much to order at one
time:
– Lot-for-lot
– Fixed order quantity
– Economic order quantity Order
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Lot-for-Lot
• Only required amount is ordered
• No unused lot-size inventory is created
• Is used
– For dependent demand items
– For expensive components (A items)
– In a Just-in-Time (JIT) environment

Order
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Fixed Order Quantity
• Specific amount is ordered each time an order
is placed
• Is quick and simple
• Is often made on the basis of what seems
reasonable
• Does not always produce the best results

Order
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 Economic Order Quantity
Assumes that
• Demand is relatively constant and known
• Items are produced or purchased in lots or batches
• Order preparation costs, inventory carrying costs,
and lead times are constant and known
• Replacement occurs all at once

Order
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 Economic Order Quantity

Weekly demand = 100 units; order quantity is 200 units

Order quantity 200
Average lot size inventory = = = 100 units
2 2
Annual demand
Number of orders per year =
Order quantity

100 x 52
= Order
= 26 orders per year
200 Qty…
Reprinted with permission, J.R. Tony Arnold, Introduction to Materials Management, second edition, Prentice-Hall, 199
 Order Quantity
If the order quantity (Q) increases,
 Annual cost of ordering decreases
 Annual cost of carrying increases
We want an order quantity where the sum of these two
costs is a minimum

Annual demand
Annual cost of ordering = x cost of ordering
Q

Q Order
Annual cost of carrying = xunit cost x cost of carrying
2 Qty…
Economic Order Quantity

Order
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Reprinted with permission, J.R. Tony Arnold, Introduction to Materials Management, second edition, Prentice-Hal
Economic Order Quantity Formula

2AS
EOQ =
ic
Where
A = Annual usage in units
S = Ordering cost in dollars
i = Annual inventory carrying cost as a decima
c = Unit cost
Order
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 Economic Order Quantity Formula
For example, if
A = 1,000 units
S = $20 per order
i = 20% = .2
c = $5 per unit
2 x 1,000 units x $20
EOQ = = 200 units
0.2 x $5
Order
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Problem 7.1
A = 100,000 units
S = $32 per order
i = 20% = .20
c = $8 per unit

2AS
EOQ =
ic

Order
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How to Reduce Lot Size

2AS
EOQ =
ic

What can be controlled—

• Annual demand?
• Cost of carrying inventory?
• Unit cost?
• Ordering cost?
Order
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When to Place an Order
• If an order is placed late, there is the possibility
of a stock out
• If an order is placed early, there will be extra
inventory and cost
• A system is needed to tell when to order
• Common systems include
– Order point system
– Periodic review system
– MRP Order
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 Order Point System

• Order point = demand during lead time + safety stock

• OP = DDLT + SS
Order
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Reprinted with permission, J.R. Tony Arnold, Introduction to Materials Management, second edition, Prentice-Hal
 Order Point Formula—Example
Demand = 100 units per week
Lead time = 4 weeks
Safety stock = 100 units
OP = DDLT + SS
= 100 (4) + 100
= 500
Place an order when 500 units are on hand

Order
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 Order Point
• Order quantities are usually fixed

• Order point is determined by the average demand during

the lead time

• Intervals between replenishments are not constant

Order quantity
• Average inventory  + safety stock
2

• Order point = Demand during lead time + safety stock

Order
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 Problem
The lead time for a particular SKU is four weeks, the
average demand is 200 units per week, and safety stock is
set at one week’s demand. The order quantity is 2,000
units. Calculate the order point.
Demand = 200 units per week
Safety stock = 200 units
Order quantity = 2,000 units
Lead time = 4 weeks
Order point = DDLT + SS = + =
Order
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 Safety Stock
• Safety stock is used to prevent a stock out
• The amount of safety stock carried depends on
– Variability of demand during the lead time
– Frequency of ordering
– Desired service level
– Length of the lead time
– Ability to forecast and control lead times

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 Service Levels
The cost of carrying safety stock plus the cost of a stockout
should be a minimum
Costs of a stockout:
• Cost of backorder
• Cost of lost sales
• Cost of lost customers
All are difficult to calculate
Management should state the number of stockouts per
year that is tolerable Order
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 Determining When to Order
Two basic systems:
• Two-bin system
• Perpetual inventory record system

Order
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 Perpetual Inventory Record

Order quantity = 500 units

426254 Screw Order point = 100 units
On On
Date Order Received Issued Hand Allocated Available
01 500 500
02 500 400 100
03 500 500 100
04 400 100 0 100
05 500 600 600

Order
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 Periodic Review System
The quantity of an item on hand is determined a
fixed intervals and an order is placed
 Review intervals are fixed
 Order quantities vary

Order
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reprinted with permission, J.R. Tony Arnold, Introduction to Materials Management, second edition, Prentice-H
 Periodic Review System
The quantity on hand plus the quantity ordered must last until the
next shipment is received.
Target level = Demand during the lead time
+ Demand during the review period
+ Safety stock
T = D (R + L) + SS
Where:
T = Target level
D = Demand per unit of time
R = Review period
L = Lead time
Order quantity = Target level – quantity on hand
= T–I Order
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 Periodic Review Example
D = Demand per working day = 300 ÷ 5 = 60/day
R = Review period = 20 days
L = Lead time = 2 days
SS = Safety stock = 3 days’ supply = 180 units
I = Inventory on hand = 260 units
T = Target level = D (R + L) + SS
= 60 (20 + 2) + 180 = 1,500 units
Order quantity = T–I
= 1,500 – 260 = 1,240 units
Order
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 Periodic Review System
Used where:
• There are many small issues from inventory,
and posting transactions is expensive
• Many different items are ordered from one
source
• Ordering costs are small

Order
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 Auditing Inventory Records
Two basic methods
 Periodic (usually annual) counts of all items
 Cycle (usually daily) counts of selected items

Order
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 Periodic Inventory Audit
• Primary purpose is to verify the financial value of the
inventory
• Production is disrupted while inventory takes place
• Labor and paperwork are expensive
• Accuracy is poor
– People taking the inventory are usually inexperienced
and error prone

Order
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 Cycle Counting
• Inventory is counted continually throughout
the year
• Some items are counted each day
• All items are counted a predetermined
number of times a year depending on their
importance
• Cycle counting uses trained and dedicated
personnel Order
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 Cycle Counting
Purpose: To identify items in error and
eliminate causes of error
Advantages
 Timely detection and correction of
problems
 Little or no loss of production
 Identification and elimination of causes of
error

Order
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 Count Frequency Process
• Classify items by their importance into A, B,
and C categories

• Establish rules for count frequency of each

classification

• Establish count schedule

Order
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 Count Frequency Schedule Example

Number of Count Number of

Classification Items Frequency Counts
A 2,000 12 24,000
B 3,000 4 12,000
C 5,000 2 10,000
Total counts 46,000
Workdays per year 250
Counts per day 184

Order
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 Problem

Number of Count Number of

Classification Items Frequency Counts
A 1,100 12
B 1,650 4
C 2,250 2
Total counts
Workdays per year 250
Counts per day

Order
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 Problem
A = 12,000 units
S = $20
i = 25% = .25
c = $7.50
2AS 2 x 12,000 units x $20
EOQ = = = 506 units
ic .25 x $7.50

Annual demand 12,000

Orders per year = = = 23.7
Order quantity 506
Order
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