Inventory Usage Over Time

Inventory Usage Over Time
Usage rate Average

Order inventory
quantity = Q
Inventory level
on hand
(maximum Q
inventory
level) 2
Minimum
inventory
0
Time
Чала Н.Д. Логістичний

менеджмент.
Basic EOQ Model
Important assumptions
1. Demand is known, constant, and
independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided
Minimizing Costs
Objective is to minimize total costs
Total cost of
holding and
setup (order)
Minimum
total cost
Annual cost
Holding cost
Setup (or order)

cost
Optimal order Order quantity
quantity (Q*)
The EOQ Model Annual setup cost =
D
Q
S
Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)
Annual demand Setup or order

=
Number of units in each order cost per order
D
= (S)
Q

D
Q
S
Q
Q = Number of pieces per order Annual holding cost = H
2
Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)
Order quantity
= (Holding cost per unit per year)
2
Q
= (H)
2

D
Q
S
Q
Q = Number of pieces per order Annual holding cost = H
2
Optimal order quantity is found when annual setup cost

equals annual holding cost
D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H

An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year
2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50

An EOQ Example
D = 1,000 units Q* = 200 units
S = $10 per order
Expected Demand D
number of =N= =
orders Order quantity Q*
1,000
N= 200= 5 orders per year

An EOQ Example
S = $10 per order N = 5 orders per year
Number of working
Expected time days per year
between orders = T = N
250
T= 5 = 50 days between orders

An EOQ Example
H = $.50 per unit per year T = 50 days
Total annual cost = Setup cost + Holding cost
D Q
TC = S Q + H 2
1,000 200
TC = ($10) +
200 ($.50)
2
TC = (5)($10) + (100)($.50) = $50 + $50 = $100

Robust Model
 The EOQ model is robust

 It works even if all parameters
and assumptions are not met
 The total cost curve is relatively
flat in the area of the EOQ

An EOQ Example
Management underestimated demand by 50%
D = 1,000 units 1,500 units Q* = 200 units
D Q
TC = S
Q+ H2
1,500 200
TC = ($10) +
200 ($.50) = $75 + $50 = $125
2
Total annual cost increases by only 25%

An EOQ Example
Actual EOQ for new demand is 244.9 units
D = 1,000 units 1,500 units Q* = 244.9 units
D Q
TC = S
Q+ H2
Only 2% less than
1,500 244.9 the total cost of
TC = ($10) + ($.50) $125 when the
244.9 2 order quantity was
200
TC = $61.24 + $61.24 = $122.48

Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells “when” to
order
Demand Lead time for a
ROP = per day new order in days
=dxL
D
d= Number of working days in a year

Reorder Point Curve
Q*
Inventory level (units)

Resupply takes place as order arrives
Slope = units/day = d
ROP
(units)
Time (days)
Figure 12.5
Lead time = L
Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days
D
d= Number of working days in a year
= 8,000/250 = 32 units
ROP = d x L
= 32 units per day x 3 days = 96 units

Production Order Quantity
Model
 Used when inventory builds up
over a period of time after an
order is placed
 Used when units are produced
and sold simultaneously

Model
Part of inventory cycle during
which production (and usage)
is taking place
Inventory level
Demand part of cycle

with no production
Maximum
inventory
t Time

Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days
Annual inventory Holding cost

= (Average inventory level) x
holding cost per unit per year
Annual inventory
= (Maximum inventory level)/2
level
Maximum Total produced during Total used during

= –
inventory level the production run the production run
= pt – dt

Model
t = Length of the production run in days
Maximum Total produced during Total used during

= –
inventory level the production run the production run
= pt – dt
However, Q = total produced = pt ; thus t = Q/p
Maximum Q Q d
inventory level = p –d =Q 1–
p p p
Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p
Model
D = Annual demand
Setup cost = (D/Q)S

Holding cost = 1HQ[1 - (d/p)]
2
(D/Q)S = 1 - (d/p)]
HQ[1
2
2DS
Q =
2
H[1 - (d/p)]
2DS
Q* = H[1 - (d/p)]
p
Example
D = 1,000 units p = 8 units per day
S = $10 d = 4 units per day
H = $0.50 per unit per year
2DS
Q* = H[1 - (d/p)]
2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]
= 282.8 or 283 hubcaps

Model
Note:
D 1,000
d=4= =
Number of days the plant is in operation 250
When annual data are used the equation becomes
2DS
Q* =
annual demand rate
H 1– annual production rate

Quantity Discount Models
 Reduced prices are often available when
larger quantities are purchased
 Trade-off is between reduced product cost
and increased holding cost
Total cost = Setup cost + Holding cost + Product cost
D Q
TC = S
Q+ H +2 PD

A typical quantity discount schedule
Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75
Table 12.2

Steps in analyzing a quantity discount
1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify,
choose the smallest possible order size
to get the discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total
cost
Total cost curve for discount 2
Total cost
curve for
discount 1
Total cost $
Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a
and must be adjusted upward to 1,000 units at point b
1st price 2nd price

break break
0 1,000 2,000
Figure 12.7
Чала Н.Д. Логістичний Order quantity
Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP
2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)
2(5,000)(49)
(.2)(4.80)
2(5,000)(49)
(.2)(4.75)
Calculate Q* for every discount 2DS
Q* =
IP
2(5,000)(49)
(.2)(5.00)
2(5,000)(49)
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
(.2)(4.75) 2,000 — adjusted
Annual Annual Annual
Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 $25,000 $350 $25,700
700 $350
2 $4.80 $24,000 $480 $24,725
1,000 $245
3 $4.75 $23.750 $950 $24,822.50
2,000 $122.50
Table 12.3
Choose the price and quantity that gives the lowest
total cost
Buy 1,000 units at $4.80 per unit

Probabilistic Models and Safety
Stock
 Used when demand is not constant
or certain
 Use safety stock to achieve a desired
service level and avoid stockouts
ROP = d x L + ss
Annual stockout costs = the sum of the units short x the probability
x the stockout cost/unit
x the number of orders per year

Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year
Number of Units Probability

30 .2
40 .2
ROP 
.3
50
60 .2
70 .1
1.0
Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year
Safety Additional Total

Stock Holding Cost Stockout Cost Cost
(20)($5) = $100 $0
20 $100
(10)($5) = $ 50 (10)(.1)($40)(6) = $240

10 $290
(10)(.2)($40)(6) + (20)(.1)($40)(6) =
$ 0
0 $960 $960
A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames

Probabilistic Demand
Inventory level Minimum demand during lead time

Maximum demand during lead time
Mean demand during lead time

ROP = 350 + safety stock of 16.5 = 366.5
ROP 
Normal distribution probability of
demand during lead time
Expected demand during lead time (350 kits)
Safety stock 16.5 units
0 Lead
time Time
Figure 12.8 Place Receive
Чала Н.Д. Логістичний order order
Use prescribed service levels to set safety
stock when the cost of stockouts cannot be
determined
ROP = demand during lead time + ZsdLT
where Z= number of standard deviations

sdLT = standard deviation of demand
during lead time

Probability of Risk of a stockout

no stockout (5% of area of
95% of the time normal curve)
Mean ROP = ? kits Quantity

demand
350
Safety
stock
0 z
Number of
standard deviations
Probabilistic Example
Average demand = m = 350 kits
Standard deviation of demand during lead time = sdLT = 10 kits
5% stockout policy (service level = 95%)
Using Appendix I, for an area under the curve of 95%, the Z =

1.65
Safety stock = ZsdLT = 1.65(10) = 16.5 kits
Reorder point = expected demand during lead time +

safety stock
= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits

Other Probabilistic Models
When data on demand during lead time is
not available, there are other models
available
1. When demand is variable and lead

time is constant
2. When lead time is variable and
demand is constant
3. When both demand and lead time
are variable

Demand is variable and lead time is constant
ROP = (average daily demand

x lead time in days) + ZsdLT
where sd = standard deviation of demand per day

sdLT = sd lead time

Average daily demand (normally distributed) = 15
Standard deviation = 5
Lead time is constant at 2 days
90% service level desired Z for 90% = 1.28
From Appendix I
ROP = (15 units x 2 days) + ZsdLT

= 30 + 1.28(5)( 2)
= 30 + 9.02 = 39.02 ≈ 39
Safety stock is about 9 iPods
Lead time is variable and demand is constant
ROP = (daily demand x average lead

time in days)
= Z x (daily demand) x sLT
where sLT = standard deviation of lead time in days

Z for 98% = 2.055
Daily demand (constant) = 10 From Appendix I
Average lead time = 6 days
Standard deviation of lead time = sLT = 3
98% service level desired
ROP = (10 units x 6 days) + 2.055(10 units)(3)

= 60 + 61.65 = 121.65
Reorder point is about 122 cameras

Both demand and lead time are variable
ROP = (average daily demand

x average lead time) + ZsdLT
here sd = standard deviation of demand per day

sLT = standard deviation of lead time in days
sdLT = (average lead time x sd2)
+ (average daily demand)2 x sLT2

Average daily demand (normally distributed) = 150
Standard deviation = sd = 16
Average lead time 5 days (normally distributed)
Standard deviation = sLT = 1 day
95% service level desired
Z for 95% = 1.65
From Appendix I
ROP = (150 packs x 5 days) + 1.65sdLT

= (150 x 5) + 1.65 (5 days x 162) + (1502 x 12)
= 750 + 1.65(154) = 1,004 packs

Single Period Model
• Only one order is placed for a product
• Units have little or no value at the end of the sales
period
Cs = Cost of shortage = Sales price/unit – Cost/unit

Co = Cost of overage = Cost/unit – Salvage value
Cs
Service level =
Cs + Co

Single Period Example
Average demand =  = 120 papers/day
Standard deviation =  = 15 papers
Cs = cost of shortage = $1.25 - $.70 = $.55
Co = cost of overage = $.70 - $.30 = $.40
Cs
Service level =
Cs + Co
.55 Service
level
= .55 + .40 57.8%
= .55 = .578
.95  = 120
Optimal stocking level
Single Period Example
From Appendix I, for the area .578, Z  .20
The optimal stocking level
= 120 copies + (.20)()

= 120 + (.20)(15) = 120 + 3 = 123 papers
The stockout risk = 1 – service level
= 1 – .578 = .422 = 42.2%

Fixed-Period (P) Systems
 Orders placed at the end of a fixed period
 Inventory counted only at end of period
 Order brings inventory up to target level
 Only relevant costs are ordering and holding

 Lead times are known and constant
 Items are independent from one another

Fixed-Period (P) Systems
Target quantity (T)
Q4
On-hand inventory Q2
Q1 P
Q3
Time
Fixed-Period (P) Example
3 jackets are back ordered No jackets are in stock
It is time to place an order Target value = 50
Order amount (Q) = Target (T) - On-

hand inventory - Earlier orders not yet
received + Back orders
Q = 50 - 0 - 0 + 3 = 53 jackets

Fixed-Period Systems
 Inventory is only counted at each

review period
 May be scheduled at convenient times
 Appropriate in routine situations
 May result in stockouts between
periods
 May require increased safety stock

Inventory Counting Systems
• Periodic System
Physical count of items made at periodic intervals
• Perpetual Inventory System
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item
12-52 Чала Н.Д. Логістичний менеджмент.

Inventory Counting Systems
(Cont’d)
• Two-Bin System - Two containers of inventory;
reorder when the first is empty
• Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached
214800 232087768

Key Inventory Terms
• Lead time: time interval between ordering and
receiving the order
• Holding (carrying) costs: cost to carry an item in
inventory for a length of time, usually a year
• Ordering costs: costs of ordering and receiving
inventory
• Shortage costs: costs when demand exceeds
supply

Cycle Counting
• A physical count of items in inventory
• Cycle counting management
• How much accuracy is needed?
• When should cycle counting be performed?
• Who should do it?

Economic Order Quantity Models
• Economic order quantity (EOQ) model
• The order size that minimizes total annual cost
• Economic production model
• Quantity discount model

Assumptions of EOQ Model
• Only one product is involved
• Annual demand requirements known
• Demand is even throughout the year
• Lead time does not vary
• Each order is received in a single delivery
• There are no quantity discounts

The Inventory Cycle
Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand
Reorder
point
Time
Receive Place Receive Place Receive
order order order order order
Lead time
Total Cost
Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q

Cost Minimization Goal
The Total-Cost Curve is U-Shaped

Q D
Annual Cost TC  H  S
2 Q
Ordering Costs
Order Quantity
QO (optimal order quantity)
(Q)

Deriving the EOQ
Using calculus, we take the derivative of the total

cost function and set the derivative (slope) equal to
zero and solve for Q.
2DS 2(Annual Demand )(Order or Setup Cost )

Q OPT = =
H Annual Holding Cost

Minimum Total Cost
The total cost curve reaches its minimum where
the carrying and ordering costs are equal.
Q = DS
H
2 Q

Economic Production Quantity (EPQ)
• Production done in batches or lots
• Capacity to produce a part exceeds the part’s
usage or demand rate
• Assumptions of EPQ are similar to EOQ except
orders are received incrementally during
production

Economic Production Quantity Assumptions
• Only one item is involved
• Annual demand is known
• Usage rate is constant
• Usage occurs continually
• Production rate is constant
• Lead time does not vary
• No quantity discounts

Economic Run Size
2DS p
Q0 
H p u

Total Costs with Purchasing Cost
Annual Annual Purchasing

+
TC = carrying + ordering cost
cost cost
Q + DS + PD
TC = H
2 Q

Total Costs with PD
Figure 12.7
Cost
Adding Purchasing cost TC with PD
doesn’t change EOQ
TC without PD
PD
0 EOQ Quantity
Total Cost with Constant Carrying Costs
TCa
Total Cost TCb

Decreasing
TCc Price
CC a,b,c
OC
EOQ Quantity
When to Reorder with EOQ
Ordering
• Reorder Point - When the quantity on hand of an
item drops to this amount, the item is reordered
• Safety Stock - Stock that is held in excess of
expected demand due to variable demand rate
and/or lead time.
• Service Level - Probability that demand will not
exceed supply during lead time.

Determinants of the Reorder Point
• The rate of demand
• The lead time
• Demand and/or lead time variability
• Stockout risk (safety stock)

Safety Stock
Figure 12.12
Quantity
Maximum probable demand
during lead time
Expected demand
during lead time
ROP
Safety stock reduces risk of Safety stock

stockout during lead time LT Time

Reorder Point
Figure 12.13
The ROP based on a normal

Distribution of lead time demand
Service level
Risk of
a stockout
Probability of
no stockout
ROP Quantity
Expected
demand Safety
stock
0 z z-scale

Fixed-Order-Interval Model
• Orders are placed at fixed time intervals
• Order quantity for next interval?
• Suppliers might encourage fixed intervals
• May require only periodic checks of inventory
levels
• Risk of stockout
• Fill rate – the percentage of demand filled by the
stock on hand

Fixed-Interval Benefits
• Tight control of inventory items

• Items from same supplier may yield savings in:
• Ordering
• Packing
• Shipping costs
• May be practical when inventories cannot be
closely monitored

Fixed-Interval Disadvantages
• Requires a larger safety stock
• Increases carrying cost
• Costs of periodic reviews

Single Period Model
• Single period model: model for ordering of
perishables and other items with limited useful
lives
• Shortage cost: generally the unrealized profits per
unit
• Excess cost: difference between purchase cost and
salvage value of items left over at the end of a
period

Single Period Model
• Continuous stocking levels
• Identifies optimal stocking levels
• Optimal stocking level balances unit shortage and
excess cost
• Discrete stocking levels
• Service levels are discrete rather than continuous
• Desired service level is equaled or exceeded

Optimal Stocking Level
Cs Cs = Shortage cost per unit
Service level =
Cs + Ce Ce = Excess cost per unit
Ce Cs
Service Level
Quantity
So
Balance point

Example 15
• Ce = $0.20 per unit
• Cs = $0.60 per unit
• Service level = Cs/(Cs+Ce) = .6/(.6+.2)
• Service level =Ce.75 Cs
Service Level = 75%
Quantity
Stockout risk = 1.00 – 0.75 = 0.25


Inventory Usage Over Time

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Inventory Usage Over Time

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Inventory Usage Over Time

Usage rate Average

Чала Н.Д. Логістичний

Setup (or order)

Q = Number of pieces per order

Annual setup cost = (Number of orders placed per year)

Annual demand Setup or order

Чала Н.Д. Логістичний

Annual holding cost = (Average inventory level)

Чала Н.Д. Логістичний

Optimal order quantity is found when annual setup cost

Чала Н.Д. Логістичний

Чала Н.Д. Логістичний

Чала Н.Д. Логістичний

Чала Н.Д. Логістичний

Total annual cost = Setup cost + Holding cost

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

Чала Н.Д. Логістичний

 The EOQ model is robust

Чала Н.Д. Логістичний

Total annual cost increases by only 25%

Чала Н.Д. Логістичний

Чала Н.Д. Логістичний

Чала Н.Д. Логістичний

Inventory level (units)

= 32 units per day x 3 days = 96 units

Чала Н.Д. Логістичний

Чала Н.Д. Логістичний

Demand part of cycle

Чала Н.Д. Логістичний

Annual inventory Holding cost

Maximum Total produced during Total used during

Чала Н.Д. Логістичний

Maximum Total produced during Total used during

Maximum inventory level Q d

Setup cost = (D/Q)S

= 282.8 or 283 hubcaps

Чала Н.Д. Логістичний

When annual data are used the equation becomes

Чала Н.Д. Логістичний

Total cost = Setup cost + Holding cost + Product cost

Чала Н.Д. Логістичний

3 2,000 and over 5 $4.75

Чала Н.Д. Логістичний

Total cost curve for discount 3

1st price 2nd price

Чала Н.Д. Логістичний

Чала Н.Д. Логістичний

Number of Units Probability

Safety Additional Total

(10)($5) = $ 50 (10)(.1)($40)(6) = $240

A safety stock of 20 frames gives the lowest total cost

Чала Н.Д. Логістичний

Inventory level Minimum demand during lead time

Mean demand during lead time

Safety stock 16.5 units

ROP = demand during lead time + ZsdLT

where Z= number of standard deviations

Чала Н.Д. Логістичний

Probability of Risk of a stockout

Mean ROP = ? kits Quantity

Using Appendix I, for an area under the curve of 95%, the Z =

Safety stock = ZsdLT = 1.65(10) = 16.5 kits