CHAPTER THREE INVENTORY CONTROL

Introduction
The wealth of a nation is measured by its gross national product, which is the
output of goods and services produced in a given time period. Goods are
tangible, physical products that you can see, touch, or feel; services are
intangible products that involve the performance of an act based on knowledge,
skills or capabilities. Manufacturing organizations always transform raw
materials into final products, while service organizations only use materials as
an adjunct to their final products.
It is virtually impossible to find organizations that does not either use,
transform, distribute or sell materials of one kind or another. Business
inventory is spread profusely throughout the economy, predominately in
manufacturing, wholesaling and retailing organizations.
The effective management of materials is crucial to the performance of many
organizations. It can have serious implications for the finance, production and
marketing functions of any organizations. Finance is influenced through
liquidity and return on investment; production through efficiency and cost of
operations; and marketing through sales and customer relations.
Inventory
The control and maintenance of inventory is a problem common to all
organizations in any sector of the economy. The problems of inventory do not
confined themselves to profit-making institutions but likewise are encountered
by social and non-profit institutions. Inventories are common to farms,
manufacturers, wholesalers, retailers, hospitals, churches, prisons, zoos,
universities, and national, state and local governments. Indeed, inventories
also are relevant to the family unit in relation to food, clothing, medicines,
toiletries, and so forth.
The term “inventory” can be used to mean several things, such as:
1. Inventory is the stock on hand of materials at a given time (a tangible
asset which can be seen, measured and counted).
2. Inventory is an itemized list of all physical assets.
3. (As a verb) inventory is to determine the quantity of items on hand.
4. (For financial and accounting records) inventory is the value of the stock
of goods by an organization in a particular time.
In general term “inventory” refers to materials held in an idle or incomplete
state awaiting future sale, use, or transformation or quantity of goods and
materials on hand

Objectives of inventory
In adequate control of inventories can result in both under stocking and
overstocking of items. Under stocking results in missed deliveries, lost sales,
dissatisfaction of customers, and production bottleneck; overstocking
unnecessary ties up funds that might be more productive elsewhere; although
overstocking may appear to be the lesser of the two evils, the price tag for
excessive overstocking can be staggering when inventory holding costs are
high.
Inventory management has two main concerns. One is the level of customer
services that is, to have the right goods, in sufficient quantities, in the right
place, at the right time. The other is the cost of ordering and carrying
inventories.
The overall objective of inventory management is to achieve satisfactory levels
of customer service while keeping inventory costs with in reasonable bounds.
Toward this end, the decision maker tries to achieve a balance in stocking. He
or she must make two fundamental decisions: the timing and size of order (i.e.
when to order and how much to order).
Managers have a number of measures of performance they can use to judge the
effectiveness of inventory management. The most obvious off course, is
customer satisfaction, which they might measure by the number and quantity
of backorders and or customer complains. A widely used measure is inventory
turnover, which is the annual cost of goods sold to average inventory
management. The turnover ratio indicates how many times a year the
inventory is sold. Generally, the higher the ratio, the better, because it implies
more efficient use of inventories
Generally, the objectives of inventory control are:
1. Assurance of having the items needed
Assurance of having the needed items is not limited to projected requirements
only, but also looks into the requirements that may arise from time to time.
These requirements may be a result of the delays in delivery, or items received
but rejected on inspection.
2. Economic buying
Economic buying, in addition to the economic order quantity, considers various
other factors, which influence the overall cost. Economic buying not only
determines the quantity to be procured but also considers the price fluctuation
trend, quantity discounts, and other external factors having an impact on the
price. One of the important objectives of the economic buying is to reduce the
procurement cost to the minimum.
3. Avoiding any likely shortage of materials
4. Avoiding overstocking of materials
5. Reducing inventory carrying costs
6. Providing flexibility for the purchasing department to apply appropriate
purchasing policies such as:
- taking quantity discounts for lower unit prices
- forward buying in case cost is likely to increase
- to adjust quantity to match with economic lot
- to order full track load to reduce transportation cost
- to adjust quantity conforming to standard packaging requirements

FUNCTIONS AND TYPES OF INVENTORIES

a) Functions of inventory
Inventories serve a number of functions. The most important are:
1. To meet anticipated customer demand/to meet variation in product
demand
If the demand of a product is known precisely, it may be possible to produce
the product to exactly meet the demand. Usually, demand is not completely
known and safety or buffer stock must be maintained to absorb variation.
Moreover, inventories are carried to satisfy expected average demand. For
example, stores, supermarkets, shops etc maintain stocks in anticipation of
demand.
2. To smooth production requirements
Firms that experience seasonal pattern in demand often build up inventories
during off-season periods. These inventories are aptly named seasonal
inventories. Companies that sell greeting cards or Christmas tree deal with
seasonal inventories.

3. To decouple operations
Historically, manufacturing firms have used inventories as buffer between
successive operations to maintain continuity of production that would
otherwise be disrupted by events such as breakdown of equipment and
accidents that cause a portion of operations to shut down temporarily while the
problem is resolved. The buffer permits other operation to continue
temporarily. Similarly, firms have used buffers of raw materials to maintain
production from disruptions in deliveries from suppliers and finished goods
inventory to buffer sales operation from manufacturing disruptions.
Most recently, companies have taken a closer look at buffer inventories,
recognize the cost and space they require and realizing that finding and
eliminating sources of disruptions can greatly decrease the need for decoupling
operations.
4. To protect against stock outs/to improve customer service
Delayed deliveries and unexpected increase in demand increases the risk of
shortages. Delays can occur because of weather conditions, supplier stock
outs, deliveries of wrong materials, quality problems and so on. The risk of
shortages can be reduced by holding safety stocks, which are stocks in excess
of average demand to compensate for variability demand and lead time.
5. Taking advantage of quantity discounts
The willingness of a firm to take larger inventories of supplies and purchased
parts may gain the firm advantage of lower prices.
6. To take advantage of order cycle
Obviously, there are costs to place an order-labor, phone calls, typing and
postage and so on. Therefore, the larger the size of each order, the fewer the
number of orders, that need to be written. To minimize purchasing and
inventory costs, a firm often buys in quantities that exceed immediate
requirements. This necessitates storing some or the entire purchased amount
for later use. Similarly, it is usually economical to produce in large rather than
smaller quantities. Again, the excess output must be stored for use later. Thus,
inventory storage enables a firm to buy and produce in economic lot sizes
without having to try to much purchases or production with demand
requirements in the short-run. This results in periodic orders, or order cycles.
The resulting stock is known as cycle stock. Order cycles are not always due to
economic lot sizes. In some instances, it is practical or economical to group
orders and/ or to order at fixed intervals.
7. To hedge against contingencies
Occasionally, a firm will suspect that a substantial price increase is about to be
made and purchase larger than normal amounts to avoid the increase. The
ability to store extra goods also allows a firm to take advantage of price
discounts for larger organizations.
8. Speculation: organizations hold inventory in anticipation of price rise in
the future.

b) Types of Inventories
Inventories may be classified in terms of their different uses. They are classified
into two categories. Namely:
A. Direct inventories and
B. Indirect inventories
1. Direct inventories: the inventory of those items which become a component
of finished goods is termed as direct inventories. Direct inventories are
categorized as follows:
A. inventory of raw materials: raw material inventory has been purchased but
not processed, i.e. it requires further processing before they are used in any
assembly or as a finished product. They are a major input and their
shortages can hold up production. They are also useful for seasonal
fluctuations. Changes in production rate and act as buffer between
procurement and manufacturing
B. Work-in-process (progress) (WIP) inventories: these types of inventories
consists of materials actually worked on and inventories lying between
machines or operations. They minimize the production loss, which may
occur due to different production rates at different centers and breakdown
at any center. They also help in replacing wastage and maintaining uniform
production, even though sales may vary. WIP exists because of the time it
takes for a product to be made (called cycle time).
C. finished product inventories: stock of finished goods between production
and marketing is known as finished product inventories, i.e. completed
product awaiting shipment. This type of inventory is essential to assure a
free flow of supply to the consumer, to allow stabilization of the level of
production, and for sales promotion. Finished goods may be inventoried
because future customer demands are unknown.
2. Indirect inventories: Inventory of raw materials that do not form an integral
part of finished products is called indirect inventory. This may include items
such as lubricants, grease, oil, petrol, maintenance materials, etc. these are
also termed as maintenance, repair and operating supplies (WRO) and
consumed in the production process but which do not become parts of the
finished products. Their primary purpose is to keep machinery and process
productive. They exist because the need and timing for maintenance and
repair of some equipment are unknown. Although the demand for MRO
inventories is often a function of maintenance schedules, other unscheduled
MRO demands must be anticipated.

INDEPENDENT VERSUS DEPENDENT DEMAND

INVENTORY

To choose appropriate inventory control system, inventory manager need to

know the different types of inventories. Historically, inventories are classified in
to independent and dependent demand inventories.
In independent demand inventories the demand for various items is unrelated
to each other and therefore needed quantities of each must be determined
separately. In dependent demand the need for any one item is a direct result of
the need for other items, usually a higher level item of which it is part.
In concept, dependent demand is a relatively straightforward computational
problem. Needed quantities of a dependent demand item are simply computed,
based on the number needed in each higher level item where it is used. For
example, if an automobile company plans to produce 500 automobiles per day,
then obviously it will need 2,000 wheels and tires (plus spares). The number of
wheels and tires needed is dependent on the production levels and not derived
separately.

INVENTORY COSTS

The objectives inventory management is to have the appropriate amounts of

materials in the right place, at the right time and at low cost. Inventory costs
are associated with operation of an inventory system and result from action or
lack of action on the part of management in establishing the system. They are
the basic economic parameters to any inventory decision model and the more
relevant ones to most systems are itemized as follows:
1. Purchase cost
2. Order/setup cost
3. Holding cost
4. Stock out cost

The purchase cost: is the unit price if it is obtained from an external source,
or the unit production cost if it is produced internally. The unit cost should
always be taken as the cost of the item as it is placed in inventory. For
purchased items, it is the purchase price plus any freight cost. For
manufactured items, the unit cost includes direct labor, direct materials and
factory overhead. The purchase cost is modified for different quantity levels
when a supplier offers quantity discounts.

The order/setup cost: originates form the expenses of issuing a purchase

order to an outside supplier or from internal production setup costs. This cost
is usually assumed to vary directly with the number of orders or setups placed
and not at all with the size of the order. The order cost includes such items as
making requisitions, analyzing vendors, writing PO, receiving materials,
inspecting materials, following up orders and doing the processing necessary to
complete the transaction. The setup cost comprises the costs changing over the
production process to produce the ordered item. It usually includes the shop
order, scheduling the work, preproduction setup, expediting and quality
acceptance.

The holding/carrying cost: includes the cost associated with investing in

inventory and maintaining the physical investment in storage. It incorporates
such items as capitals, taxes, insurance, handling, storage, shrinkage,
obsolescence and deterioration. Capital cost reflects lost earning power or
opportunity cost. If the funds were invested elsewhere, a return on the
investment would be expected. Capital cost is a charge that accounts for this
un-received return. Many states treat inventories as taxable property; so the
more you have, the higher the taxes. Insurance coverage requirements are
dependent on the amount to be replaced if property is destroyed. Insurance
premiums vary with the size of the inventory investment. Obsolescence is the
risk that an item will lose value because of shifts in styles or customer
preference. Shrinkage is the decrease in inventory quantities over time from
loss or theft. Deterioration means a change in properties due to age or
environmental degradation. Many items are age-controlled and must be sold or
used before an expiration date (e.g. food items, photographic materials, and
pharmaceuticals). The usual simplifying assumption made in inventory
management is that holding costs are proportional to the size of the inventory
investment.

Sock out/depletion cost: is the economic consequence of an external or an

internal shortage. An external shortage occurs when a customer’s order is not
filled; an internal shortage occurs when an order of a group or department
within the organization is not filled. External shortages can incur backorder
costs, present profit loss (potential sale) and future profit loss (good will
erosion). Internal shortages can result in lost production (idle resources) and a
delay in a completion date. The extent of the cost depends on the reaction of
the customer to the out-of-stock condition. If demand occurs for an item put of
stock, the economic loss depends on whether the shortage is backordered,
satisfied by substitution of another item, or canceled. In the one situation, the
sale is not lost but delayed a few days in shipment. The stock out cost can vary
considerably from item to item, depending on customer response or internal
practice. It can be extremely high if the missing item forces a production to
shut down or causes a customer to go elsewhere in the future.
Therefore, an effective inventory management should minimize inventory costs.
INVENTORY SYSTEM

An important aspect of inventory management is that items held in inventory

are not of equal importance in terms of dollars invested, profit potential, sales
or usage volume or stockout penalties. For instance, a producer of electrical
equipment might have electric generators, coils of fire, and miscellaneous nuts
and bolts among the items carried in inventory. It would be unrealistic to
devote equal attention to each of these items. Instead, a more reasonable
approach would be to allocate control efforts according to the relative
importance of various items in inventory.

ABC classification of Inventory systems

The A-B-C approach classifies inventory items according to some measure of
importance, usually annual dollar usage (i.e., dollar value per unit multiplied
by annual usage rate) and then allocates control efforts accordingly. Typically,
three classes of items are used: A (very important), B (moderately important)
and C (least important). However, the actual number of categories may vary
from organization to organization, depending on the extent to which a firm
wants to differentiate control efforts. With three classes of items, A items
generally account for about 15 to 20 percent of the number of different items in
inventory but about 70 to 80 percent of the dollar usage. At the other end of
the case, C items might account for about 50 to 60 percent of the number of
different items but only about 5 to 10 percent of the dollar usage of an
inventory. These percentages vary from firm to firm, but in most instances a
relatively small number of items will account for a large share of the value or
cost associated with inventory and these items should receive a relatively
greater share of control efforts. For instance, A items should receive close
attention through frequent reviews of amounts on hand and control over
withdrawals. The C items should receive only loose control and the B items
should have controls that lie between the two extremes.

Note that C items are not necessarily unimportant; incurring a stockout of C

items such as nuts and bolts used to assemble manufactured good can result
in a costly shutdown of an assembly line. However, due to the low annual
dollar volume of C items, there may not be much additional cost incurred by
ordering quantities of these items, or ordering a bit easier.

Classify the inventory items as A, B, or C based on annual dollar value, given

the following information.
 Item Annual demand X Annual dollar
Unit cost value
1 1000 $4300 $4,300,000
2 5000 720 3,600,000
3 1900 500 950,000
4 1000 710 710,000
5 2500 250 625,000
6 2500 192 480,000
7 400 200 80,000
8 500 100 50,000
9 200 210 42,000
10 1000 35 35,000
11 3000 10 30,000
12 9000 3 27,000
Total
$10,929,000

The first two items have a relatively high annual dollar value (72 percent of the
total value, 17 percent of number of different items), so it seems reasonable to
classify them as A items. The next four items appear to have moderate annual
dollar values (25 percent of total value, 33 percent of number of different items)
and should be classified as B items. The remainder are C items, based on their
relatively low dollar value (3 percent of total value, 50 percent of number of
different items).

ECONOMIC ORDER QUANTITY MODEL (HOW MUCH TO ORDER)

EOQ: the ideal order size: is the size of an order for goods that minimizes the
sum of shipping, handling and carrying costs. The question of how much to
order is frequently determined by using an economic order quantity (EOQ)
model. It identifies the optimal quantity by minimizing the sum of certain
annual costs that vary with order size. Three order size models are described
here:
- The economic order quantity model
- The economic order quantity model with non-instantaneous
delivery
- The quantity discount model
In short, economic order quantity is the size that minimizes total cost.

Basic economic order quantity (EOQ) model

The basic EOQ model is the simplest of the three models. It is used to identify
the order size that will minimize the sum of the annual costs of holding
inventory and ordering inventory. The unit purchase price of items in inventory
is not generally included in the total cost because the unit cost is independent
of the order size unless quantity discounts are provided by suppliers. If holding
costs are specified as a percentage of unit cost, then unit cost is indirectly
included in the total cost as a part of holding costs.
The basic model involves a number of assumptions and they are:
- Only one product is involved.
- Annual demand requirements are known.
- Demand is spread evenly throughout the year so that the demand
rate is reasonably constant.
- Lead time does not vary.
- Each order is received in a single delivery.
- There are no quantity discounts.
Inventory ordering and usage occur in cycles. A cycle begins with receipt of an
order of Q units, which are then withdrawn at a constant rate over time. When
the quantity on hand is just sufficient to satisfy demand during lead time, an
order of Q units is submitted to the supplier. Because it is assumed that both
the usage rate and the lead time do not vary, the order will be received at the
precise instant that the inventory on hand falls to zero. The orders are timed to
avoid both excess and stock outs (i.e. running out of stock).
The optimal order quantity reflects a trade-off between carrying and ordering
costs: as order size varies, one type of cost will increase while the other
decreases. Foe example, if the order size is relatively small, the average
inventory will be low, resulting in low carrying costs. However, a small order
size will necessitate frequent orders, which will drive up annual ordering costs.
Conversely, ordering large quantities at infrequent intervals can hold down
annual ordering costs, but that would result in higher average inventory levels
and therefore increased carrying costs.

Thus, the ideal solution is an order size that causes neither a few very large
orders nor many small orders, but one that lies somewhere in between. The
exact amount to order will depend on the relative magnitudes of carrying and
ordering costs.

Annual carrying cost is computed by multiplying the average amount of

inventory on hand by the cost to carry one unit for one year (even though any
given unit would not be held for a year). The average inventory is simply half of
the order quantity: the amount on hand decreases steadily from Q units to
zero, for an average of (Q+0)/2, or Q/2. Using the symbol H to represent the
average annual carrying cost per unit, the total annual carrying cost is
Annual carrying cost= Q H
2
Where Q= order quantity in units
H= holding (carrying) cost per unit per year

Carrying cost is thus a linear function of Q: carrying costs increase or decrease

in direct proportion to changes in the order quantity Q.
On the other hand, annual ordering cost will decrease as order size increases,
because for a given annual demand, the larger the order size, the fewer the
number of orders needed. For instance, if annual demand is 24,000 units and
the order size is 2,000 units per order, there must be 12 orders over the year.
But if Q = 4,000 units, only six orders will be needed; if Q = 6,000 units, only
four orders will be needed. In general, the number of orders per year will be
D/Q, where D = Annual Demand and Q = Order size. Unlike carrying costs,
ordering costs are relatively insensitive to order size; regardless of the amount
of an order, certain activities must be done, such as determining how much is
needed, periodically evaluating sources of supply and preparing the purchase
order. Hence, there is a fixed ordering cost. Annual ordering cost is a function
of the orders per year and the ordering cost per order.

Annual ordering cost = D S

Q

Where D = demand, in units per year

S = ordering cost per year

Because the number of orders per year, D/Q, decreases as Q increases,

annual ordering cost is inversely related to order size.

The total annual cost associated with carrying and ordering inventory, when Q
units are ordered each time, is

TC = Annual carrying cost + Annual ordering cost

= Q H + D S ------------------------------------------------ 1
2 Q

An expression for the optimal order quantity, Qopt, can be obtained using
calculus:

TC = PD + Q H + D S
2 Q
dTC = dQ H + d(D/Q)S = H/S – DS/Q²
dQ 2
Solving for Q: 0 = H/2 – DS/Q², So Q² = 2DS and Q = √2DS
H H
Qopt = √2DS -------------------------------------------------- 2
H
Thus, given annual demand, the ordering cost per order, and annual carrying
cost per unit, one can compute the optimal (economic) order quantity. The
minimum total cost is then found by substituting Qopt for Q in formula 1.

The length of an order cycle (i.e. the time between orders) is

 Length of order cycle = Qopt (year) ------------------------------------ 3
D

Example 1: Jimma University uses approximately 32,000 reams of paper

annually. The papers are used at a steady rate during the 240 days a year that
the plant operates. Annual holding cost is Br.1.25 per ream and ordering cost
is Br.20 per order. Determine:
a. What is the EOQ?
b. How many times per year does the store reorder?
c. What is the length of an order cycle?
d. What is the total cost if the EOQ quantity is ordered?

Given: D = 32,000 reams per year

H = Br. 1.25 per unit per year
S = Br. 20

a. Qopt = √2DS = √2 (32,000) 20 = √1024000 = 1011.93 or 1012 reams.

H 1.25

b. Numbers of orders per year: D/Qopt = 32,000/1012 = 31.62

c. Length of order cycle: Qopt/D = 1012 tires/32,000 tires/year = 1/43 of a

year, which is 1/43 x 240 = 7.59 or approximately eight workdays.

d. TC = Carrying cost + Ordering cost

= (Qopt/2) H + (D/Qopt) S
= (1011.93/2) 1.25 + (32,000/1011.93) 20
= Br. 632.5 + 632.5
= Br. 1265
Note that the ordering and carrying costs are equal at the EOQ.

Carrying cost is sometimes stated as a percentage of the purchase price of an

item rather than as a dollar amount per unit. In this case, it requires
converting percentage into a dollar amount and use EOQ formula to calculate.

Example 2: XYZ Company purchases 3600 computers a year at Br. 6000

each. Ordering costs are Br. 50, and annual carrying costs are 20 percent of
the purchase price. Compute the optimal quantity and the total annual cost of
ordering and carrying the inventory.

Given: D = 3600 computers per year

S = Br. 50
H = .20 x 6000 = 1200
 Qopt = √2 (3600) 50 = √300 = 17.3 computers
1200
TC = Carrying cost + Ordering cost
= (Qopt/2) H + (D/Qopt) S
= (17.3/2) 1200 + (3600/17.3) 50
= 10392.3 + 10392.3
= Br. 20784.6
NB: Holding and ordering costs and annual demand are typically estimated
values rather than values that can be precisely determined. Holding costs are
sometimes designated rather than computed by managers. Consequently, the
EOQ should be regarded as an approximate quantity rather than an exact
quantity.
Exercise 1: A large law firm uses an average of 40 packages of copier paper a
day. The firm operates 260 days a year. Storage and handling costs for the
paper are $3 a year per pack and it costs approximately $6 to order and receive
a shipment of paper.
a. What order size would minimize total annual ordering and carrying costs?
b. Compute the total annual cost using order size from part a.
c. Are annual ordering and carrying costs always equal at the EOQ?

The EOQ with non-instantaneous receipt

This model is also called Incremental replenishment or Economic Production
Run Quantity. A variation of the basic EOQ model from the EOQ with non-
instantaneous receipt is the receipt of items all at once. In the EOQ model the
assumption that orders are received all at once is relaxed. The order quantity is
received gradually overtime, and the inventory level is depleted at the same
time it is being replenished. This situation also occurs when orders are
delivered gradually overtime or when the firm is both the producer and user.

If usage and production (delivery) rates are equal, there will no be inventory
buildup, because all output will be used immediately and the issue of lot size
(order size) doesn’t come up. For this model, the production rate must exceed
the demand (usage) rate, or P > D, where P = production rate and D = demand
or usage rate.

TC = carrying cost + Setup cost

= (Imax) H + (D/Qopt) S
2
Where: Imax = Maximum inventory

Economic run quantity is: Qopt = √2DS x √ p nn

H p–d
Where:
p = production or delivery rate
 d = usage rate
The cycle time (the time between orders or between the beginnings of runs) for
the economic run size models is a function of the run size and usage (demand
rate):
Cycle time = Qopt
d
Similarly, the run size (the production phase of the cycle) is a function of the
run size and the production rate:
Run size = Qopt
p
The maximum inventory levels: Imax = Qopt (p-d)
p
The average inventory levels: I average = Imax
2
Example 3: Ethiopian Airlines produce sub components at a rate of 300 per
day. And it uses these subcomponents at a rate of 12,500 per year of 250
working days. Holding costs are $2 per item per year and setup costs are $30
per order.
a. What is the Optimal run size?
b. What is the total cost for carrying and setup cost?
c. What is the cycle time for the optimal run size?
d. What is the run time?

Solution
Given: p = 300
D = 12,500
S = 30
H=2
u = annual demand/working days = 12,500/250 = 50

a. Qopt = √2DS X √ p n= √ 2 (12,500)30 x √ 300 = √375000 x √1.2

H p-d 2 300-50

Qopt = 670.82 or 671

b. TC = Carrying cost + setup cost

= (Imax) H + (D/Qopt) S
2
Thus, first determine Imax:
Imax = Qopt (p-d) = 670.82 (300-50) = 559.02 or 559
P 300
TC = 559 (2) + 12,500 (30)
2 670.82
= 559 +559
 TC = 1118
Note again the equality of costs (set up and carrying costs) at the EOQ.

c. Cycle time = Qopt/d = 559/50 = 11.18 days

Thus, a run of subcomponents will be made every eleven days.

d. Run time = Qopt/p = 559/ 300 = 1.86 days or approximately 2 days

Thus, each run will require two days to complete.

Exercise 1: A company is about to begin production of a new product. The

manager of the department that will produce one of the components for the
product wants to know how often the machine used to produce the item will be
available for other work. The machine will produce the item at a rate of 200
units a day. Eighty units will be used daily in assembling the final product.
Assembly will take place five days a week, 50 weeks a year. The manager
estimates that it will take almost a full day to get the machine ready for a
production run, at a cost of $60. Inventory holding costs will be $2 per unit a
year. Determine:
A. What run quantity should be used to minimize total annual cost?
B. What is the length of a production run in days?
C. During production, at what rate will inventory build up?
D. Compute the maximum inventory level.
E. It the manager wants to run another job between runs of this item, and
needs a minimum of 10 days per cycle for the other work, will there be
enough time?

Quantity Discounts
Quantity discounts are price reduction for large orders offered to customers to
induce them to buy in large quantities. Most vendors, in attempting to keep
their best customers happy, will provide inducements to large purchasers of
their products. To increases sales, many companies offer quantity discounts
to their customers.

Quantity discount is simply a reduced price for an item whenever it is

purchased in large quantity. Here, the buyer’s goal is to select the order
quantity that will minimize total cost, where total cost is the sum of carrying
cost, ordering cost, and purchase cost:

TC = Q H + D S + PD
2 Q
Note that in basic EOQ model, determination of order size does not involve
the purchase cost because price per unit is the same for all order sizes and
thus has no impact on the optimal order size.
 However, when a price discount is available, it is associated with a specific
order size, which may be different from the optimal order size and the
customer must evaluate the trade-off between possibly higher carrying costs
with the quantity discounts versus EOQ cost. As a result, the purchase price
does have an impact on the order size decision when a discount is available.

The procedures for determining the overall EOQ differs slightly depending on
the following two cases:
1. when carrying cost is constant
2. when carrying cost is expressed as a percentage of purchase price
A. when carrying costs are constant, the procedure is as follows:
1. Compute the common EOQ.
2. Only one of the unit prices will have the EOQ in its feasible range
since the ranges do not overlap. Identify the range.
I. If the feasible EOQ is in lower price range, that is the optimal
order quantity.
II. If the feasible EOQ is in any other range, compute the total
costs for the EOQ and for the price break of all lower unit costs.
Compare the total costs; the quantity (EOQ or price break) that
yields the lower total cost is the optimal order quantity.
Exercise 1: A company will begin stocking remote control devices. Expected
monthly demand is 800 units. The controllers can be purchased from either
supplier A or supplier B. their price lists are as follows:

Supplier A Supplier B
Quantity Unit price Quantity Unit price
1 – 199 $ 4.00 1 -149 $ 4.10
200 – 399 3.80 150 – 349 3.90
4000 + 3.60 350 + 3.70
Ordering cost is $40 per order and annual carrying cost is $6.00 per unit.
a. Which supplier should be used?
b. What order quantity is optimal if the intent is to minimize total annual
costs?

B. When carrying costs are expressed as a percentage of price, determine

the best purchase quantity with the following procedure:
1. Beginning with the lowest unit price, compute the EOQs for each
price until you find a feasible EOQ (i.e. until an EOQ falls in the
quantity range for its price).
2. If the EOQ for the lowest unit price is feasible, it is the optimal
order quantity. If the EOQ is not feasible in the lowest price range,
compare the total cost at the price break for all lower prices with
 the total cost of the largest feasible EOQ. The quantity that yields
the lowest total cost is the optimum.
Exercise 1: A manufacturer of exercise equipment purchases the pulley
section of the equipment from a supplier who lists these: less than 1,000, $5
each; 1000 to 3999, $4.95 each; 4000 to 5999, $ 4.90 each; and 6000 or more,
$ 4.85 each. Ordering costs are $50 per order, annual carrying costs are 40
percent of purchase price and annual usage is 4900 pulleys. Determine the
order quantity that will minimize total cost and total annual cost.

When to reorder with EOQ ordering

EOQ models answer the question of how much to order, but not the
question of when to reorder. Reorder point identify the reorder point (ROP)
in terms of a quantity. It occurs the quantity on hand drops to a
predetermined amount. That amount generally includes expected demand
during lead time and perhaps an extra cushion of stock, which serves to
reduce the probability of experiencing a stock out during lead time. Note
that order to know the reorder point has been reached; a perpetual
inventory system is required.

ROP is when the quantity on hand of an item drops to this amount, the item
is reordered. The basic concern of the manager is to place an order when
the amount of inventory on hand is sufficient to satisfy demand during lead
time.
There are four determinants of the reorder point quantity:
1. The rate of demand (usually based on a forecast)
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stock out risk acceptable to management.
If demand and lead time are both constant, the reorder point is simply
ROP = d x LT
Where, d – demand rate (units per day or week)
LT – lead time in days or weeks
NB Demand and lead time have the same time units.

Example: Soosen takes two-a-day vitamins, which are delivered to his home by
a Mike seven days after an order is called in. at what point should Soosen
reorder?
Solution
Given Usage rate = 2 vitamins a days
Lead time = 7 days
ROP = Uage rate x Lad time
= 2 vitamins per day x 7 days = 14 vitamins

Vary in demand and lead time

When variability is present in demand or lead time, it creates the possibility
that actual demand will exceed expected demand. Consequently, it becomes
necessary to carry additional inventory called safety stock, to reduce the risk of
running out of inventory (a stock out) during lead time. The reorder point then
increases by the amount of the safety stock. Safety stock is a stock that is held
in excess of expected demand due to variable demand rate and/or lead time.
ROP = Expected demand + Safety Stock
during lead time
Example: If expected demand during lead time is 100 units and the desired
amount of safety stock is 10 units, the ROP = 110 units.
Note that stock out protection is needed only during lead time. If there is a
sudden surge at any point during the cycle, this will trigger another order.
Once that order is received, the danger of an imminent stock out is negligible.

Service level: is a probability that demand will not exceed supply during lead
time. The customers’ service level increases as the risk of stock out decreases.
Order cycle service level: is the probability that demand will not exceed
supply during lead time (i.e. the amount of stock on hand will be sufficient to
meet demand). E.g. A service level of 95% implies a probability of 95% that
demand will not exceed supply during lead time.
The risk of stock out is the complement of service level; a customer service level
of 95% implies a stock out of 5%. That is

Service level = 100% - stock out risk

The amount of safety that is appropriate for a given situation depends on the
following factors:
1. The average demand rate and average lead time.
2. Demand and lead time variability.
3. The desired service level.
For a given order cycle service level, the greater the variability in either demand
rate or lead time, the greater the amount of safety stock that will be needed to
achieve that service level. Similarly, for a given amount of variation in demand
rate or lead time, achieving an increase in the service level will require
increasing the amount of safety stock. Selection of a service level may reflect
stock out costs (e.g. lost sales, customer dissatisfaction) or it might simply be a
policy variable (e.g. the manager wants to achieve a specified service level for a
certain item).

Several models can be used when variability is present. The first model can be
used if an estimate of expected demand during lead time and its standard
deviation are available. The formula is:
ROP = Expected demand + zσdLT
during lead time
Where, z = number of standard deviations
σdLT = standard deviation of lead time demand
This model generally assumes that any variability in demand rate or lead time
can be adequately described by a normal distribution. The value of z used in a
particular instance depends on the stock out risks that the manager is willing
to accept. Generally, the smaller the risk the manager is willing to accept, the
greater the value of z.

If variability exists in demand or lead time or both, one of the following

formulas can be used:
1. If only demand is variable, then σdLT = z√LT x σd, and the reorder point
is:
ROP = d x LT x z√LT x σd
Where, d = Average daily or weekly demand
σd = standard deviation of demand per day or week
LT = lead time in days or week
Example: see your exercise book.

2. If only lead time is variable, then σdLT = dσLT and the reorder point is:

ROP = d x LT + zdσLT
Where, d = daily or weekly demand
LT = Average lead time in days or weeks
σLT = standard deviation of lead time in days or weeks
Example 2: See your exercise book.

3. If both demand and lead time are variable, then σdLT = √LTσ 2d + d2σLT2
and the reorder point is:
ROP = d x LT + z √LTσ2d + d2σ2LT
NB: Each of these models assume that demand and lead time are
independent.