Chapter VI.

Inventory Models

1. Simple EOQ Model

2. Production Run Model
3. Quantity Discount Model
4. Safety Stock
Inventory, or stock, is held by just about every type of organization from the local
corner shop which has extra supplies in the back room through to the large multinational.
Inventory refers to goods or materials held by an organization for future
use and might include raw materials, parts from suppliers and semi-finished products as well
as finished goods awaiting sale or shipment. Keeping inventory can be
very expensive for organizations but, on the other hand, running out of stock can be
just as problematic so there is little surprise that inventory models are an important
area for management science.

Every organization holds inventory in one form or another. Managing this inventory
effectively has attracted considerable attention from management scientists and in this
section some of the key principles involved were outlined
 Principles of Inventory Management

Having the right levels of inventory, or stock, is critical for many organizations. Too
much inventory makes costs escalate. Too little inventory and sales and production
may suffer.

Inventory models are used by managers faced with the dual problems of
maintaining sufficient inventories, or stock, to meet demand for goods and, at the
same time, incurring the lowest possible inventory costs.
Inventory Counting Systems
Methods used to track the quantity of goods on hand are:
Periodic inventory systems – relies upon an occasional physical
count of the inventory to determine the ending inventory balance and the
cost of goods sold. Periodic inventory accounting systems are normally better
suited to small businesses where you can visually review it without any
particular need for more detailed inventory records.
Perpetual inventory systems - keeps continual track of inventory
balances with updates made automatically whenever a product is received
or sold. Perpetual inventory system is vastly superior to the periodic
inventory system and is well suited for businesses with high sales volume
and multiple retail outlets (like grocery stores or pharmacies) need perpetual
inventory systems.
Inventory Costs
There are typically three critical costs involved in inventory management.

• The first of these, holding costs, refers to the costs incurred in carrying a given level of
inventory for a period of time.
• The second type of cost involved in inventory management is ordering cost.
Ordering costs are those costs involved in actually placing an order and receiving of
inventory. Such costs are usually fixed regardless of the actual amount ordered and are
usually expressed as a cost per order placed.
• The third type of cost is known as the stockout cost. This is the cost involved when
customer demand cannot be met because of insufficient inventory. In the medium to long
term such costs may also involve loss of customer goodwill, loss of future sales and loss of
future profit – although these are notoriously difficult to quantify accurately.
The prime purpose of effective inventory management is to
minimize these costs by determining the optimum amount of
inventory that should be held and ordered and when inventory
should be ordered
Economic Order Quantity (EOQ) Model
 Optimum amount of an item that should be ordered at
any given point in time, such that the total annual cost of
carrying and ordering that item is minimized. Simply put
– how much product should you purchase to maintain a
cost- efficient supply chain?
 Basic Assumptions:
 Demand is known and constant
 Lead time is known and constant
 Recipient of inventory is instantaneous
 Quantity discounts are not possible
 There must be a single product involved
Economic Order Quantity (EOQ) Model
• When you order inventory, let’s say you started your own business, and you need to buy
some inventory, you need to know precisely how much inventory you want to buy,
because you don’t want to buy too much or too little.
• If you buy too little, then you could have a thing called stockout.
• If you buy too many, then you could have spoilage.

• ORDERING COSTS: The costs which are associated with the purchase or order of
materials. Ex. Transportation costs
• CARRYING COSTS: The cost for holding inventories in store. Example; cost of storage,
insurance costs, etc.
DEVELOPING THE EOQ
Annual Carrying Cost =

Where:
Q = order quantity in units
H = holding (carrying) cost per unit

Annual Ordering Cost =

Where:
D = demand, usually in units per year
S = set up (ordering) costs
Q = order quantity in units

Total Annual Cost (TC) = +

Optimum/Economic Order Quantity (Qₒ) =

Example 1:

The local distributor of Philippine made furniture plan to sell 540

rattan chairs of a certain design. Annual carrying costs is ₱150 per
unit and ordering cost is ₱1,450. The distributor operates 288 days
a year.

a. Determine the EOQ.

b. Find how many times per year does the store reorder.
c. Find the length of an order cycle.
d. Calculate the total annual cost if the EOQ quantity is ordered.
Solution:
a) (Qₒ) =

b)=

c) = x number of working days

Reorder Point (ROP) in EOQ
Now that we know how much to order, we want to address
the question of when to order. To answer this question, we
need to introduce the concept of inventory position. The
inventory position is defined as the amount of inventory on
hand plus the amount of inventory on order. The when-to-
order decision is expressed in terms of a reorder point – the
inventory position at which a new order should be placed.
ROP quantity when demand and lead time to receive an
order are constant is equal to the amount demanded during
lead time:

Where:
d = demand rate (per day or week)
LT = lead time in days or weeks
Example 2:
An ePaint Internet store is open 250 days per year. If
annual demand is 15,000 gallons of Aerosol paint and the
lead time to receive an order is 10 days, determine the
reorder point for the paint.
calculate:
Demand (d)
Lead Time (LT) =
SOLUTION:
Demand (d) = 15,000 gallons/year or 15,000 250 = 60 gallons/day
Lead Time (LT) = 10 days

gallons
• The ePaint Internet store guarantees a 10 day delivery. If we assume that the store operates
250 days per year, the annual demand of 15,000 gallons implies a daily demand of 60 gallons.

• So, we expect (10 days)(60 gallons per day) = 600 gallons of Aerosol paint to be sold during
the 10 days it takes a new order.

• In inventory terminology, the ten-day delivery period is referred to as the lead time for a new
order, and the 600 gallons demand anticipated during this period is referred to as the lead-time
demand.

• So the customer should order a new shipment of Aerosol paint from ePaint when the inventory
reaches 600 gallons.

• For inventory systems using the constant demand rate assumption and a fixed lead time, the
reorder point is the same as the lead-time demand.
Production Run Model
• A production run is a quantity of units that are produced contiguously
by a production line.
• It is common for a factory to produce one type of item until desired
levels of inventory are achieved.
• This process of producing units for a period of time is known as a
production run. Production runs to replenish inventory are made at
regular intervals.
• During a production run, the production of items is continuous and at
a constant rate.
Examples:
Batch Production
• A bakery does a production run of 14 batches of cookies each morning. Each
batch is 1200 cookies. When the production run is complete, machines undergo a
changeover for a production run of bread.
Mass Production
• A luggage company sells 1000 units of a small tote bag each month. They
produce this in a production run of 10,000 units. These units then sit in
inventory until they are sold. The production run of 10,000 units produces
10 month supply but only takes 4 days to complete. When the production run
is completed the production line undergoes changeover for a production run of a
different luggage model.
Example 3:
A toy manufacturer uses 63,000 rubber wheels per year for its
popular convertible series. The firm makes its own wheels which it can
produce at a rate of 500 per day. The toy convertibles are assembled
uniformly over the entire year. Carrying cost is ₱20 per wheel a year. Set
up cost for a production run of wheels is ₱2,500. The firm operates 315
days per year. Determine the:
a) Optimal run size
b) Minimum total annual cost for carrying and set up
c) Cycle Time for the optimal run size
d) Run Time
Solution:
D = (DEMAND)
S = (SET UP/ORDERING COST)
H = (HOLDING/CARRYING COST)
P = (PRODUCTION/DELIVERY RATE)
U = (USAGE RATE)
Solution:
D = 63,000 wheels per year (DEMAND)
S = 2,500 per order (SET UP/ORDERING COST)
H = 20 per unit per year (HOLDING/CARRYING COST)
P = 500 wheels per day (PRODUCTION/DELIVERY RATE)
U = 63,000 wheels per 315 days or 200 wheels per day
(63,000/315)
(USAGE RATE)
The Role of Inventory
• Organizations hold inventory for a number of reasons, one of which is being able
to meet customer demand for a product or service where that demand has a
degree of uncertainty.
• If a large retail organization such as Gap knew for certain that an item in its new
fashion range would sell exactly 40 000 units then it would know exactly how many
units to orders from its suppliers.
• However, because demand will not be known for certain, no matter how good our
forecasting, the company will hold additional amounts of inventory known as
buffer or safety stocks in case customer demand is higher than expected.
• If it doesn’t hold such buffer stocks then the company may well lose sales if
demand is higher than expected as customers may not be prepared to wait until
new stock arrives in the stores.
• A second role of inventory is to help organizations cope with
seasonal or cyclical
demand for items.

• A third role of inventory is to help organizations reduce, or

manage, risk

• A fourth important role of inventory is to take advantage of price discounts. A

supplier may be willing to offer a large discount if we purchase in bulk, allowing
us
to pass low prices on to customers and increase market share and customer
loyalty.
Quantity Discount Model
• Quantity discounts are price reductions for large orders
offered to customers to induce them to buy in large
quantities.
• The buyer’s goal with quantity discounts is to select the
order quantity that will minimize the total cost, where the
total cost is the sum of carrying cost, ordering cost, and
purchasing (i.e., product) cost.
To solve for the overall EOQ when carrying costs are constant.

1. Compute for the common EOQ

2. Only one of the unit prices will have the EOQ in its feasible range since
ranges do not overlap. Identify the range.

a. If the feasible EOQ is on the lowest price range, that is the optimal
order quantity.

b. If the feasible EOQ is in any other range, compute the total cost for
the EOQ and for the price breaks of all lower unit cost. The quantity
that yields the lowest total cost is the optimal order quantity.