CHAPTER 4

INVENTORY
MODEL
 INVENTORY
MODELS FOR
PURCHASING
 This chapter discusses the importance of inventory and
illustrates the inventory models that materials managers
can use in determining inventory policy for items that are
purchased by their organizations. The purchased items may
be sold as they are if the firm is engaged in trading. Or, the
purchased items may be raw materials, parts, or
components that are used to manufacture the firms’
products. Purchased items also include office supplies, fuel,
and other materials that are used by the organizations in the
conduct of their business.
WHAT IS
INVENTORY?
 Inventory is any stored economic resources
for immediate or near future use. In
manufacturing firms, examples of these are: raw
materials, work-in-progress, finished goods,
spare parts, components, and supplies. Other
examples are merchandise in stores, blood in
blood banks, unused spaces in a building, and
many others.
 OBJECTIVES
At the end of the chapter, students would be able to do the
following:
• Enumerate the different purposes and costs in keeping inventory;
• Define some inventory terms;
• Derive the optimal order quantity, inventory costs and others;
• Determine when to place an order;
• Determine how much to order when quantity discounts are
offered; and
• Know what items in the inventory need to be monitored closely.
 PURPOSES OF INVENTORY
• To facilitate manufacturing process
• To take advantage of abundant supply
• To hedge against inflation
• To beat irregular supply and demand
• To enjoy quantity discount
• To avoid stock out and shortages
• Buying/producing in batches
• Allowing organization to cope with perishable materials
 COST OF KEEPING
INVENTORY
• Opportunity Cost
• Loss due to obsolescence
• Loss due to Product deterioration
• Operational Cost
 INVENTORY SYSTEM TERMS
• Item Cost (P). • Depletion.
• Ordering Cost (O). • Surplus.
• Holding or Carrying Cost • Shortage.
(H). • Lead Time.
• Shortage or Stock Out Cost. • Reorder Point
• Inventory Level. • Cycle (C)
• Demand.
 INVENTORY CONTROL
TECHNIQUES
1. Economic Order Quantity
2. Reorder Point
3. ABC Analysis
4. Quantity Discount Analysis
 THE ECONOMIC
ORDER QUANTITY
(EOQ)
 EOQ is one of the oldest and most
common known inventory control
techniques. This techniques is simple, with
the following important assumptions:
• Demand is known
• Lead time is also known
• Order arrives in one batch, at one point in time.
• No quantity discount are availed.
• Ordering cost and holding cost are the only relevant costs.
• If orders are placed on time, there will be no stock outs or
shortages.
• EOQ application is per item.
 The EOQ model derives the optimal order quantity Q*
using the formula:
Q* =
Where:
D = annual demand
O = ordering cost
H = average annual holding cost
Optimal Number of Orders made in a Year (Y*) where
Y* = D/Q*
Optimal Cycle (C*) where
C* = Q*/d
C* = WD/Y*
Optimal Annual Ordering Cost (AOC*) where
AOC* = (D/Q*)(O)
Optimal Annual Holding Cost (AHC*) where
AHC* = (Q*/2)(H)
Optimal Total Inventory Cost (TIC*) where
TIC* = AOC* + AHC*
TIC* = (D/Q*)(O) + (Q*/2)(H)
Optimal Maximum Inventory Level (Imax*) where
Imax* = Q*
Optimal Average Inventory Level (Iavg*) where
Iavg* = Q*/2
Example:
A firm, Ayala Company heard about the EOQ
model and would like to determine the optimal
order quantity that will reduce its annual
inventory cost. Given its annual demand of
1,000 units, ordering cost of P10 per order, and
average holding cost per unit per year of P0.50,
derive Q*, Y*, C*, AOC*, AHC*, TIC*, Imax*, and
Iavg*.
Q* = = = 200 units
Y* = D/Q* = 1,000/200 = 5 orders per year
C* = WD/Y* = 365/5 = 73 days
AOC* = (D/Q*)(O) = (1,000/200) (10) = P50
AHC* = (Q*/2)(H) = (200/2) (0.50) = P50
TIC* = AOC* + AHC* = P50 + P50 = P100
Imax* = Q* = 200 units
Iavg* = Q*/2 = 200/2 = 100 units
THE REORDER
POINT
(ROP)
 The ROP is that particular point in the inventory
level when order is placed. The ROP is a function of
demand and lead time, and for as long as these are given
time period, a firm that adheres to the ROP technique
does not incur shortage or surplus. The ROP is given as:
ROP = d x L
Where:
d = daily demand
L = Lead Time
CASE 1: WHEN LEAD TIME IS
SHORTER THAN CYCLE (L <
C).
Refer back to the Ayala Company problem.
Suppose, lead time is 10 days, what is the ROP
of the firm?
ROP = d x L = 2.74 x 10 = 27 units
CASE 2: WHEN LEAD TIME IS
LONGER THAN CYCLE (L >
C).
Refer again to the Ayala Company problem.
Suppose L is 90 days instead of 10 days, what is
ROP?
Adjustment: Subtract C from L (90 – 73 = 17).
Adjusted ROP = d x L = 2.74 x 17 = 47 units
 CASE 3: WHEN L IS MUCH
LONGER.
Refer again to Ayala Company problem,
Suppose that L is much longer, say 180 days,
what is ROP?
Solution:
Adjustment 1: 180 – 73 = 107
Adjustment 2: 107 – 73 = 34
Adjusted ROP = 2.74 x 34 = 93 units
QUANTITY
DISCOUNT
ANALYSIS
 To increase sales and reduce cost, many
companies offered quantity discounts. A
quantity discount is a reduction from the
price of the item to entice customers to
buy in large volume.
 TC = Product Cost + Annual Ordering Cost + Annual Holding
Cost
= DP + +
Where:
D = annual demand
P = product price
Q = order quantity
O = ordering cost
H = average holding cost
Example:
Toy Kingdom sells yo-yos which has an annual
demand of 4,000 units. Recently, it has been offered
quantity discount as shown in the schedule below. The
ordering cost is P80 per order and the average inventory
holding cost is estimated to be 20 percent of the product
cost. Should Toy Kingdom take the offer?
QUANTITY PRICE
1 to 999 P5.00
1,000 to 1,999 P4.75
2,000 and above P4.50
 STEP 1.
FOR EACH PRICE LEVEL,
DERIVE Q* USING THE EOQ
FORMULA: (ANSWER ARE
ROUNDED OFF TO WHOLE
NUMBERS)
Q1* = = = 800 units
Q2* = = = 821 units
Q3* = = = 843 units
 STEP 2.
FIND IF THE DERIVED Q*S
QUALIFIED FOR THE
DISCOUNT. IF NOT ADJUST THE
ORDER QUANTITY UPWARD TO
THE LOWEST QUANTITY THAT
QUALIFIES FOR THE DISCOUNT
EACH PRICE LEVEL.
At P1 = P5.00, Q* = 800 units
QUALIFIED. Order Q* = 800 Units
At P2 = P4.75, Q* = 821 units
NOT QUALIFIED, Order Q* = 1,000 units
At P3 = P4.50, Q* = 843 units
NOT QUALIFIED, Order Q* = 2,000 units
 STEP 3.
COMPUTE THE TOTAL COST
FOR EVERY Q DETERMINED
IN STEP 2 USING THE
EQUATION,
TC = Product Cost + Annual Ordering Cost + Annual Holding Cost
At Q* = 800 units P = P5.00 O = P80 H = P1.00

TC1 =
= 20,000 + 400 + 400
= P20,800.00
 
 
TC = Product Cost + Annual Ordering Cost + Annual Holding
Cost
At Q* = 1,000 units P = P4.75 O = P80 H = P0.95

TC2
= 19,000 + 320 + 475
= P19,795.00
TC = Product Cost + Annual Ordering Cost + Annual Holding Cost
At Q* = 2,000 units P = P4.50 O = P80 H = P0.90

TC3 =
= 18,000 + 160 + 900
= P19,060.00
 STEP 4.
CHOOSES THAT ORDER
QUANTITY WITH THE
LOWEST TOTAL INVENTORY
COST.
Lowest total inventory cost is
P19,060 at Q = 2,000 units.
THE ABC
ANALYSIS
The ABC analysis recognizes the fact that
some inventory items need to be closely
monitored than the others, thus the very
core of the analysis is the classification of
all the items purchased by the organization
and lumping them into three groups: Group
A, Group B, and Group C.
Group A
The items in this group are considered as
critical to the operation of the organization,
hence, their inventory must be carefully
monitored. These items comprise only about 10
percent of all the inventory items but they
typically make up over 70 percent of the
company’s business in monetary terms.
Group B
The items in this group are not so
critical. Items in B group represent about
20 [percent of the company’s business in
monetary terms and comprises about 20
percent of all the items in the inventory.
Group C
The items in this group are not critical to
the operation of the organization. These
items represent about 10 percent of the
company’s business in monetary terms and
comprise 70 percent of the items in the
inventory
Example:
Forever is not Enough Fruit Store has
1,300 assorted items in the inventory
amounting to P23,000,000. In
general, determine the number of
items and the value of these items in
each group.
Solutions:
Number of Items
Group A: 1,300 (10%) = 130
Group B: 1,300 (20%) = 260
Group C: 1,300 (70%) = 910
Total = 1,300
Solutions:
Monetary Value
Group A: 23,000,000 (70%) = P16,100,000
Group B: 23,000,000 (20%) = P4,600,000
Group C: 23,000,000 (10%) = P2,300,000
Total = P23,000,000