Chapter 2: Demand is Varying at an

Approximate Level
¨ Economic order quantity (EOQ): Optimal Order Quantity, Reorder
point.

¨ Safety stock

¨ Discount
 1. Economic Order Quantity
(EOQ) Model - Assumptions
¨ Demand occurs at a known and reasonably constant rate.
¨ The item has a sufficiently long shelf life.
¨ The item is monitored using a continuous review system.
¨ All the cost parameters remain constant forever (over an infinite
time horizon).
¨ A complete order is received in one batch (instantaneously).
 The EOQ Model –
Inventory Profile
The constant environment described by the EOQ assumptions
leads to the following observation:

¨ The optimal EOQ policy consists of same-size orders.

¨ This observation results in the following inventory profile :

 1.1. Cost Equation for the
EOQ Model
¨ Let is the order quantity or lot size

total annual total annual total annual total annual

inventory cost holding cost ordering cost procurement cost
 Costs in the EOQ Model
cost
total cost ost
c
ld ing
ho
al
tot

at the optimal order size

total holding costs and ordering costs
are equal

total ordering cost

Order quantity
 1.2. Sensitivity Analysis in
EOQ Models

cost The curve is reasonably flat around

Deviations from the optimal order size

cause only small increase in the total cost.

Order quantity
 Cycle Time
¨ The cycle time, T, represents the time that elapses between
the placement of orders.

¨ Note, if the cycle time is greater than the shelf life, items will
go bad, and the model must be modified.
 Number of Orders per Year

¨ To find the number of orders per years, take the reciprocal of the cycle time

Example: The demand for a product is 1000 units per year.

The order size is 250 units under an EOQ policy.
¨ How many orders are placed per year? N = 1000/250 = 4 orders.

¨ How often orders need to be placed (what is the cycle time)?

T = 250/1000 = ¼ years. {Note: the four orders are equally spaced}.
 Lead Time and Reorder Point

¨ In reality, lead time L always exists, and must be accounted

for when deciding when to place an order.
¨ The reorder point, R, is the inventory position when an order
is placed.
¨ R is calculated by:

¨ L and D must be expressed in the same time unit.

 Lead Time and Reorder Point –
Graphical demonstration: Short Lead Time

R = Inventory at hand at the beginning of lead time

reorder point

in
ve
nt
or
y
po
sit
io
n
place the order now
 Lead Time and Reorder Point –
Graphical demonstration: Long Lead Time

outstanding
order

place the order now

 2. Safety Stock
¨ Safety stocks act as buffers to handle:

- Higher than average lead time demand.

- Longer than expected lead time.

¨ With the inclusion of safety stock (SS), R is calculated by

¨ The size of the safety stock is based on having a desired service level.
 Safety Stock

reorder point

place the order now

 Safety Stock

reorder point

The safety stock

place the order now prevents excessive
shortages.
 Inventory Costs
Including Safety Stock

total annual total annual total annual total annual safety stock
inventory cost holding cost ordering cost procurement holding cost
cost
ALLEN APPLIANCE COMPANY
(AAC)
¨ AAC wholesales small appliances.
¨ AAC currently orders 600 units of the Citron brand juicer
each time inventory drops to 205 units.
¨ Management wishes to determine an optimal ordering policy
for the Citron brand juicer
ALLEN APPLIANCE COMPANY
(AAC)
Data
¨ Co = $12 ($8 for placing an order) + (20 min. to check)($12 per hr)
¨ C = $10.
¨ H = 14% (10% ann. interest rate) + (4% miscellaneous)
¨ Ch = $1.40 [HC = (14%)($10)]
¨ D = demand information of the last 10 weeks was collected:

Sales of Juicers over the last 10 weeks

Week 1 2 3 4 5
Sales 105 115 125 120 125
Week 6 7 8 9 10
Sales 120 135 115 110 130
ALLEN APPLIANCE COMPANY
(AAC)
Data
¨ The constant demand rate seems to be a good assumption.
¨ Annual demand = (120/week)(52weeks) = 6240 juicers.
 AAC – Solution:
EOQ and Total Variable Cost

¨ Current ordering policy calls for Q = 600 juicers.

TV( 600) = (600/2)($1.40) + (6240 / 600)($12) =$544.8

TV is total variable cost

¨ The EOQ policy calls for orders of size:

TV(327) = (327 / 2)($1.40) + (6240 / 327) ( $12) = $457.89

Savings of 16% is achieved by applying the EOQ solution.

 AAC – Solution:
Reorder Point and Total Cost

¨ Under the current ordering policy AAC holds 13 units safety stock (how come?
Observe):
¨ AAC is open 5 day a week.
- The average daily demand = (120/week)/5 = 24 juicers.
- Lead time is 8 days. Lead time demand is (8)(24) = 192 juicers.
- Reorder point without Safety stock = LD = 192.
- Current policy: R = 205.
- Safety stock = 205 – 192 = 13.
¨ For safety stock of 13 juicers the total cost is
TC(327) = 457.89 + 6240($10) + (13)($1.40) = $62,876.09
TV(327) + procurement cost + safety stock holding cost
 AAC – Solution:
Sensitivity of the EOQ Results
Changing the order size
¨ Suppose juicers must be ordered in increments of 100 (order 300 or 400)
¨ AAC will order Q = 300 juicers in each order.
¨ There will be a total variable cost increase of $1.71.
¨ This is less than 0.5% increase in variable costs.

Changes in input parameters

¨ Suppose there is a 20% increase in demand. D=7500 juicers.
¨ The new optimal order quantity is Q* = 359.
¨ The new variable total cost = TV(359) = $502
¨ If AAC still orders Q = 327, its total variable costs becomes
TV(327) = (327/2)($1.40) + (7500/327)($12) = $504.13 → only increase 0.4%
 AAC – Solution: Cycle Time

¨ For an order size of 327 juicers we have:

T = (327/ 6240) = 0.0524 year.

= 0.0524(52)(5) = 14 days.

working days per week

¨ This is useful information because:

- Shelf life may be a problem.

- Coordinating orders with other items might be desirable.

AAC – Excel Spreadsheet
 3. EOQ Models with
Quantity Discounts
Quantity Discounts are Common Practice in Business
¨ By offering discounts buyers are encouraged to increase
their order sizes, thus reducing the seller’s holding costs.
¨ Quantity discounts reflect the savings inherent in large
orders.
¨ With quantity discounts sellers can reward their biggest
customers.
 EOQ Models with
Quantity Discounts
Quantity Discount Schedule

¨ This is a list of per unit discounts and their corresponding purchase volumes.

¨ Normally, the price per unit declines as the order quantity increases.

¨ The order quantity at which the unit price changes is called a break point.

¨ There are two main discount plans:

- All unit schedules - the price paid for all the units purchased is based on the
total purchase.
- Incremental schedules - The price discount is based only on the additional
units ordered beyond each break point.
 All Units Discount Schedule

¨ To determine the optimal order quantity, the total purchase

cost must be included

¨ Ci represents the unit cost at the i th pricing level.

 AAC - All Units
Quantity Discounts
¨ AAC is offering all units quantity discounts to its customers.
¨ Data
Quantity Discount Schedule
1-299 $10.00
300-599 $9.75
600-999 $9.40
1000-4999 $9.50
5000 $9.00

Should AAC increase its regular order of

327 juicers, to take advantage of the discount?
 AAC – All units
discount procedure
¨ Step 1: Find the optimal order Qi* for each discount level “i” by using the formula

¨ Step 2: For each discount level “i” modify Qi* as follows

- If Q* < qi, then Qi* = qi.

- If qi  Q* < qi+1, then Qi* = Q*

- If qi+1  Q*, eliminate this level from further consideration.

¨ Step 3: Substitute the modified Qi* value in the total cost formula TC(Qi*).

¨ Step 4: Select the Qi* that minimizes TC(Qi*)

 AAC – All units
discount procedure
¨ Step 1: Find the optimal order Q i* for each discount level “i”
by using the formula

Lowest cost order size per discount level

Discount Qualifying Price
level order per unit Q*
0 1-299 10.00 327
1 300-599 9.75 331
2 600-999 9.50 337
3 1000-4999 9.40 336
4 5000 9.00 345
 AAC – All units
discount procedure
¨ Step 2:

Lowest cost order size per discount level

Discount Qualifying Price
level order per unit Q* Qi *
0 1-299 10.00 327 ****
1 300-599 9.75 331 331
2 600-999 9.50 337 600
3 1000-4999 9.40 336 1000
4 5000 9.00 345 5000
 AAC – All units
discount procedure
¨ Step 3: Substitute the modified Q i* value in the total cost
formula TC(Qi*).

Modified Q* and total Cost

Qualified Price Modified Total

Q* Qi *
Urder per Unit Cost
1-299 10.00 300 **** ***

300-599 9.75 331 331 $61,309.88

600-999 9.50 336 600 $59,192.71
1000-4999 9.40 337 1000 $60,037.17
$59,341.36
5000 9.00 345 5000
 AAC – All units
discount procedure
¨ Step 4: AAC should order 600 juicers as it results in the
minimum total annual cost

Modified Q* and total Cost

Qualified Price Modified Total

Q*
Urder per Unit Q* Cost
1-299 10.00 300 **** ****
300-599 9.75 331 331 $61,309.88
600-999 9.50 336 600 $59,192.71
1000-4999 9.40 337 1000 $60,037.17
$59,341.36
5000 9.00 345 5000
AAC – All Units Discount Excel
Worksheet