Operations Research Models and Methods

Paul A. Jensen and Jonathan F. Bard

Inventory Theory.S2
The Deterministic Model
An abstraction to the chaotic behavior of Fig. 2 is to assume that items are withdrawn from the
inventory at an even rate a, lots are of a fixed size Q, and lead time is zero or a constant. The
resulting behavior of the inventory is shown in Fig. 4. We use this deterministic model of the
system to explain some of the notation associated with inventory. Because of its simplicity, we
are able to find optimum solutions to the deterministic model for several operating assumptions.

Inventory Level
s+Q

0
0 Q/a 2Q/a 3Q/a 4Q/a 5Q/a 6Q/a Time

Figure 4. The inventory pattern eliminating uncertainty.

Notation
This section lists the factors that are important in making decisions related to
inventories and establishes some of the notation that is used in this section.
Dimensional analysis is sometimes useful for modeling inventory systems, so we
provide the dimensions of each factor. Additional model dependent notation is
introduced later.
• Ordering Cost (c(z)): This is the cost of placing an order to an outside
supplier or releasing a production order to a manufacturing shop. The amount
ordered is z . c(z) is often a nonlinear function. The dimension of ordering
cost is ($).
• Setup Cost (K): A common assumption is that the ordering cost consists of a
fixed cost, that is independent of the amount ordered, and a variable cost that
depends on the amount ordered. The fixed cost is called the setup cost. ($).
• Product Cost (c): This is the unit cost of purchasing the product as part of an
order. If the cost is independent of the amount ordered, the total cost is cz,
where c is the unit cost and z is the amount ordered. Alternatively, the
product cost may be a decreasing function of the amount ordered. ($/unit).

9/9/01 Inventory Theory

 Inventory Theory 2

• Holding Cost (h): This is the cost of holding an item in inventory for some
given unit of time. It usually includes the lost investment income caused by
having the asset tied up in inventory. This is not a real cash flow, but it is an
important component of the cost of inventory. If c is the unit cost of the
product, this component of the cost is c , where is the discount or interest
rate. The holding cost may also include the cost of storage, insurance, and
other factors that are proportional to the amount stored in inventory. ($/unit-
time).
• Shortage Cost (p): When a customer seeks the product and finds the
inventory empty, the demand can either go unfulfilled or be satisfied later
when the product becomes available. The former case is called a lost sale, and
the latter is called a backorder. Although lost sales are often important in
inventory analysis, they are not considered in this section, so no notation is
assigned to it. The total backorder cost is assumed to be proportional to the
number of units backordered and the time the customer must wait. The
constant of proportionality is p, the per unit backorder cost per unit of time.
($/unit-time).
• Demand Rate (a): This is the constant rate at which the product is withdrawn
from inventory. (units / time).
• Lot Size (Q): This is the fixed quantity received at each inventory
replenishment. (units).
• Order Level (S): The maximum level reached by the inventory is the order
level. When backorders are not allowed, this quantity is the same as Q. When
backorders are allowed, it is less than Q. (units)
• Cycle Time ( ): The time between consecutive inventory replenishments is
the cycle time. For the models of this section = Q/a. (time)
• Cost per Time (T): This is the total of all costs related to the inventory system
that are affected by the decision under consideration. ($/time)
• Optimum Quantities (Q*, S*, *, T*): The quantities defined above that
maximize profit or minimize cost for a given model are the optimum solution.

Lot Size Model with no Shortages

The assumptions of the model are described in part by Fig. 5, which shows a plot
of inventory level as a function of time.
 Inventory Theory 3

Figure 5. Lot size model with no shortages

The inventory level ranges between 0 and the amount Q. The fact that it never
goes below 0 indicates that no shortages are allowed. Periodically an order is
placed for replenishment of the inventory. The order quantity is Q. The arrival of
the order is assumed to occur instantaneously, causing the inventory level to shoot
from 0 to the amount Q. Between orders the inventory decreases at a constant
rate a. The time between orders is called the cycle time, , and is the time re-
quired to use up the amount of the order quantity, or Q/a.
The total cost expressed per unit time is

Cost/unit time = Setup cost + Product cost + Holding cost

aK hQ
T = Q + ac + 2 . (3)

a
In this expression, Q is the number of orders per unit time.

Q
The factor 2 is the average inventory level.
Setting to zero the derivative of T with respect to Q we obtain
dT aK h
dQ = – Q2 + 2 = 0.
Solving for the optimum policy,

2aK
Q* = h , (4)

Q*
and * = a . (5)
 Inventory Theory 4

Substituting the optimum lot size into the total cost expression, Eq. 3, and pre-
serving the breakdown between the cost components we see that

ahK ahK
T* = 2 + ac + 2 = ac + 2ahK . (6)
At the optimum, the holding cost is equal to the setup cost. We see that optimum
inventory cost is a concave function of product flow through the inventory (a),
indicating that there is an economy of scale associated with the flow through
inventory. For this model, the optimum policy does not depend on the unit
product cost. The optimum lot size increases with increasing setup cost and flow
rate and decreases with increasing holding cost.

Example 1
A product has a constant demand of 100 units per week. The cost to place an
order for inventory replenishment is $1000. The holding cost for a unit in
inventory is $0.40 per week. No shortages are allowed. Find the optimum lot
size and the corresponding cost of maintaining the inventory. The optimum lot
size from Eq. 4 is

2(100)(1000)
Q* = 0.4 = 707.
The total cost of operating the inventory from Eq. 6 is
T* = $282.84 per week.
From Q* and Eq. 5, we compute the cycle time,
t* = 7.07 weeks.
The unit cost of the product was not given in this problem because it is
irrelevant to the determination of the optimum lot size. The product cost is,
therefore, not included in T*.
Although these results are easy to apply, a frequent mistake is to use
inconsistent time dimensions for the various factors. Demand may be measured
in units per week, while holding cost may be measured in dollars per year. The
results do not depend on the time dimension that is used; however, it is necessary
that demand be translated to an annual basis or holding cost translated to a weekly
basis.

Shortages Backordered

A deterministic model considered in this section allows shortages to be

backordered. This situation is illustrated in Fig. 6. In this model the inventory
level decreases below the 0 level. This implies that a portion of the demand is
backlogged. The maximum inventory level is S and occurs when the order
arrives. The maximum backorder level is Q-S. A backorder is represented in the
figure by a negative inventory level.
 Inventory Theory 5

Figure 6 Lot-size model with shortages allowed

The total cost per unit time is

Cost/time = Setup cost + Product cost + Holding cost + Backorder cost

aK hS2 p(Q - S)2
T = Q + ac + 2Q + 2Q (7)

The factor multiplying h in this expression is the average on-hand

inventory level. This is the positive part of the inventory curve shown in Fig. 6.
Since all cycles are the same, the average on-hand inventory computed for the
first cycle is the same as for all time. We see the first cycle in Fig. 7.

S On-Hand
Area
Backorder
Area

S-Q

Fig. 7. The first cycle of the lot size with backorders model

Defining O(t) as the on-hand inventory level and O as the average on-hand
inventory
 Inventory Theory 6

⌠O(t)dt = (1/ )[On -hand Area]

O = (1/ )⌡
0

a S2 S2
= (Q )(2a ) = 2Q

Similarly the factor multiplying p is the average backorder level, B , where

(Q - S)2
B = (1/ )[Backorder Area] = 2Q .
Setting to zero the partial derivatives of T with respect to Q and S
yields

2aK p
S* = h p+h, (8)

2aK p+h
Q* = h p , (9)

Q*
and * = a. . (10)

Comparing these results to the no shortage case, we see that the optimum lot size
and the cycle times are increased by the factor
[(p + h)/h]1/2.
The ratio between the order level and the lot size depends only on the relative
values of holding and backorder cost.

ph
S*/Q*= p + h (11)

This factor is 1/2 when the two costs are equal, indicating that the inventory is in
a shortage position one half of the time.

Example 2
We continue Example 1, but now we allow backorders. The backorder cost is $1
per unit-week. The optimum policy for this situation is found with Eq. 8, 9 and
10.

2(100)(1000) 1
S* = 0.4 1 + 0.4 = 597.61

2(100)(1000) 1 + 0.4
Q* = 0.4 1 = 836.66
 Inventory Theory 7

836.66
t* = 100 = 8.36 weeks.

Again neglecting the product cost, we find from Eq. 7

T* = $239.04 per week.

The cost of operation has decreased since we have removed the prohibition
against backorders. There backorder level is 239 during each cycle.

Quantity Discounts

The third deterministic model considered incorporates quantity discount prices

that depend on the amount ordered. For this model no shortages are allowed, so
the inventory pattern appears as in Fig. 5. The discounts will affect the optimum
order quantity. For this model we assume there are N different prices: c1, c2, …,
cN, with the prices decreasing with the index. The quantity level at which the kth
price becomes effective is qk, with q1 equal zero. For purposes of analysis define
q(N+1) equal to infinity, indicating that the price cN holds for any amount greater
than qN. Since the price decreases as quantity increases the values of qk increase
with the index k.
To determine the optimum policy for this model we observe that the
optimum order quantity for the no backorder case is not affected by the product
price, c. The value of Qk* would be the same for all price levels if not for the
ranges of order size over which the prices are effective. Therefore we compute
the optimum lot size Q* using the parameters of the problem.

2aK
Q* = h . (12)
We then find the optimum order quantity for each price range.
Find for each k the value of Qk* such that
if Q* > qk+1 then Qk* = qk+1,
if Q* < qk then Qk*= qk,
if qk ≤ Q* < qk+1 then Qk* = Q*
Optimum Order Quantity (Q** )
a. Find the price level for which Q* lies within the quantity range (the last of the
conditions above is true). Let this be level n*. Compute the total cost for this
lot size
aK hQ*
Tn* = Q* + acn* + 2 . (13)
 Inventory Theory 8

b. For each level k > n*, compute the total cost Tk for the lot size Qk*.

aK hQk*
Tk = Q * + ack + 2 (14)
k
c. Let k* be the level that has the smallest value of Tk . The optimum lot size
Q** is the lot size giving the least total cost as calculated in steps b and c.

Example 3
We return to the situation of Example 1, but now assume quantity discounts. The
company from which the inventory is purchased hopes to increase sales by
offering a break on the price of the product for larger orders. For an amount
purchased from 0 to 500 units, the unit price is $100. For orders at or above 500
but less than 1000, the unit price is $90. This price applies to all units purchased.
For orders at or greater than 1000 units, the unit price is $85.
From this data we establish that N = 3. Also
q1 = 0 and c1 = 100,
q2 = 500 and c2 = 90,
q3 = 1000 and c3 = 85,
q4 = ∞.
Neglecting the quantity ranges, from Eq. 12 we find the optimum lot size is 707
regardless of price. We observe that this quantity falls in the second price range.
All lower ranges are then excluded. We must then compare the cost at Q = 707
and c2 = 90, with the cost at Q = 1000 and c3 = 85. For the cost c2 we use Eq.
13.
T2 = $9,282 (for Q2* = 707 and c2 = 90)
For the cost c3 we use Eq. 14.
T3 = $8,800 (for Q3* = 1000 and c3 = 85).
Comparing the two costs, we find the optimum policy is to order 1000 for each
replenishment. The cycle time associated with this policy is 10 weeks.

Modeling

The inventory analyst has three principal tasks: constructing the mathematical
model, specifying the values of the model parameters, and finding the optimum
solution. This section has presented only the simplest cases, with the model
specified as the total cost function. The model can be varied in a number of
important aspects. For example, non instantaneous replenishment rate, multiple
products, and constraints on maximum inventory are easily incorporated.
 Inventory Theory 9

Deterministic models will most often describe a nonlinear total cost

function with only a few variables. The tools of calculus sometimes can often be
used find the optimum solution. Some assumptions, however, lead to complex
optimization problems requiring nonlinear programming or other numerical
methods.
The classic lot size formulas derived in this section are based on a
number of assumptions that are usually not satisfied in practice. In addition it is
often difficult to accurately estimate the parameters used in the formulas. With
the admitted difficulties of inaccurate assumptions and parameter estimation, one
might question whether the lot size formulas should be used at all. We should
point out that whether or not the formulas are used, lot size decisions are
frequently required. However abstract the models are, they do recognize
important relationships between the various cost factors and the lot size, and they
do provide answers to lot sizing questions.