CHARTER SEVEN

SIMULATION

Learning objectives
After studying this chapter you should:
● have been introduced to the concept of simulation as decision
making tool.
 understand the meaning, objectives, scope and nature of simulation
model;
 be able to state the basic forms of simulation and its importance in
decision making process;
 identify the variables in simulation and the processes involved in
simulation for decision making;
 be able to construct a simulation model
 understand the use of random numbers to find solution to
simulation problems;
 know what is meant by Monte Carlo Simulation;
 understand the advantages and disadvantages involved in the use of
simulation as a decision making process.

Introduction
Critical decision making is often tied around imitation of reality. Decisions are mainly aligned to
the consequences of previous decisions which are based on those decision variables. Hence an
optimum decision making process is in tandem with development of a model. Models are an
idealized representation of reality. As such, a model once constructed may be used to predict the
consequences of taking alternative actions. Models are developed through experimentation
which allows decision maker to address issues as it relates to needs. The ability to translate
imaginations into reality warrants the development of parameters which begets that act of trials
to arrive at the appropriate model. The act of coupling parameters to formulate the required
model is simply a simulation process. To simulate is to replicate a process in other to develop an
ideal. The bane of first industrial revolution is strongly tied to the quest to replicate methods that
can improve the living standard through the improvement of production processes. The first
industrial revolution took place gradually. In fact, it was a revolution rather than an evolution,
and it is still continuing till date. Coincidentally executives also grow with the rapid revolution.
However, the continuity and gradualness of development, executives could rely on their
judgment and past experience to guide them through new problems. The new problems were
seldom very different from the old and so the executives felt no great need for outside assistance.
Today, many organizations in manufacturing or service sectors have faced dramatic changes in
their business environment (Drury 2004), and many organizations seek to be more expansionist,
entrepreneurial, risk taking and innovative as a conscious move away from inward focused
management techniques (Horgren, et al 2005) which gravitated many problems too complex to
solve using executive analytical solution procedures. In these situations, the only feasible method
of analysis which management may rely on to take decisions may be adoption of simulation
techniques (Forgionne 1996).

SIMULATION DEFINED:
Simulation is simply the act of using model to recreate an actual situation and then studying the
systems characteristics and behaviour by experimenting with the model (Forgionne 1996).
According to Lucy (2002) simulation is defined as the process of experimenting or using a model
and noting the result which. It is a technique used for conducting experiments in situation where
suitable mathematical models do not exist, where the complexity of the mathematical model
cannot be easily handled and where it is impossible or impractical to experiment on a real life
situation (Asaolu and Nasar 2002). Recall that, a model is any representation of reality, which
may be in graphical, physical or mathematical terms (Lucy 2002). In business context, the
processes of experimenting with a model usually consist of inserting different input values and
observing the resulting output values. For example, in a simulation of a queuing situation, the
input values might be the number of arrivals and/or service points and the output values might be
the numbers and/or times in the queue.

Model can be categorized into normative and descriptive models. Normative models are ones
that suggest the best ideal solution to a problem while descriptive models simply describe the
behaviour of a system without suggesting any solution to the problem on board.

The biggest different between simulation models and other models we have studied is in the type
of problem solution generated by the model. Most of the models applicable in quantitative
techniques which includes inventory and linear programming models, resulted in the
identification of an “optimal” or best solution. This quest for optimality is typically observed in
the case of simulation model. The operational mechanics of simulation model is that it tries out
different strategies (Inventory policies, queue disciplines, production schedules) and see how
they interact with uncontrolled variables (demand, traffic flows, machine breakdown) and a
chance is made of a strategy which gives satisfactory (as opposed to optimal) result. (Schneider
and Byers (1979)
THE NATURE OF SIMULATION
Essentially, simulation is a technique for conducting experiment. In this approach, the decision
maker first build a device that imitates (acts like) the real situation. Then by experimenting with
the device, the decision maker can study the characteristics and behaviour of the real situation.
Some simulations use physical devices. For example, an aircraft manufacturer can learn much
about the aerodynamic properties of a new design by imitating (simulating) flight conditions in a
wind stimulant. Analyst can simulate the decision process of actual managers by analyzing the
cases in a course on problems solving. In addition, the government economic model relating to
the gross national product (GNP) to various business indicators may be evaluated through
simulation to determine the economic effects of various changes in the indicators.

Since this chapter introduces a somewhat different way to use quantitative technique in
accounting for decision making. We will refocus our attention here on mathematical simulation
models. Simulation models are usually probabilistic or stochastic in nature. This means that they
are used to describe system under study which try out different strategies (inventory policy,
queue disciplines, production schedules) and see how they interact with uncontrolled variables
(demand, traffic flows machine breakdowns) we then choose a strategy which gives satisfactory
results. Simulation therefore is typically used were analytical techniques are not available or
would be complex which makes model a major concept.

FORMS OF SIMULATION
Forms Description Area
Artificial Programming a computer to imitate Financial analysis
intelligence human thought Management behavior
Business Simulating business operations for Product marketing
operations planning and control purposes Production management
Inventory management Service
system
Financial Management
Corporate Models that link decision making Fire department policy
planning within an organization to conditions Strategic planning
models in the firm’s environment
Heuristic Using step-by-step procedures to Land-use planning
programmin arrive at feasible and satisfactory, Mental health
g though not necessarily optimal Alloy processing
solutions for complex problems Tree farming
 Management A contrived situation that imbeds Marketing
of games participants in a simulated Training
environment where they make Leadership
decisions and analyse results

APPLICATIONS OF SIMULATION TECHNIQUES

Since simulation connotes a process of experimenting on a system through its model and noting
the result that occurs without actually touching the system, then the application of simulation is
broad in nature. Specifically, simulation techniques may be applied in the following areas:
i) Complex queuing problems
ii) Inventory control problem
iii) Product planning problem
iv) Corporate planning and other related areas

Monte Carlo Simulation

Any realistic business problem contains probabilistic or random features, e.g arrivals at a store
may average 80 per day, but the actual arrival patterns is likely to be highly variable; in a
corporate planning exercise forecasts of the likely sales will obviously vary according to
different circumstances, etc. because models must behave like the system under observation, the
model must contain these probabilistic elements. Simulations involving such random elements
are sometimes termed Monte Carlo simulations.
Steps involved in Monte Carlo Simulation
There are five basic steps to following in using Monte Carlo Simulation technique. They are:
1. Set up a probability distribution for important variables (using historical relative
frequencies for each possible variable)
2. Build a cumulative probability distribution for each variable.
3. Establish an interval of random number for each variable from the cumulative probability
distribution.
4. Generate random number.
5. Simulate a series of trials by picking the variable i.e the daily demand falling into the
range of random numbers.

Random Selection
To carry out a realistic simulation process involving probabilistic elements, it is necessary to
avoid bias in the selection of the values which vary. This is done by selecting randomly (using
the term in its statistical sense). This can be done by using one of the following methods:
a.Random number generation by the use of a computer aided process
b. Random number tables. These consist of a table of randomly selected numbers in which
bias does not exist.
c.Lottery selection, e.g. this is done by putting all the numbers in a bag, shake well, then draw
out a number arbitrarily one at a time.
d. Roulette wheel. This is a kind of wheel that is drum shaped. The wheel is spun and a
ball dropped in to select a number (hence the name ‘Monte Carlo simulation’).
e.Dice or cards. These can also be used, although with cards the card drawn should be replaced
and the pack reshuffled before another card is selected.
The repeated random selection of input values and the logging of the resultant outputs is the very
essence of simulation. In this way an understanding is gained of the likely pattern of results so
that a more informed decision can be taken.
Note That; of all the operational simulation, the use of computers which is method (a) above is
by far the most common in the modern day organizational decision making process.

VARIABLES IN SIMULATION MODEL

The fact still remains that an ideal business model usually consists of linked series of equations
and formulae arranged such that they ‘behave’ in a similar manner to the real system being
investigated. A workable formulae and equations in the simulation model uses a number of
factors or variables which can be classified into four groups:
a) Input or exogenous variables
b) Parameters
c) Status variables
d) Output or endogenous variables

Input Variables
These variables are of two types – controlled and non-controlled

Controlled variables: These are the variables that can be controlled by management. Changing
the input values of the controlled values, and noting the charge in the output results, is the prime
activity of simulation. For example, typical controlled variables in an inventory simulation might
be the re-order level and re-order quantity. These could be altered and the effect on the system
outputs noted.

Non-controlled variables: These are input variables which are not under management control.
Typically these are probabilistic or stochastic variables, i.e. they vary but in some uncontrollable,
probabilistic fashion. For example, in a production simulation the number of breakdowns would
be deemed to vary in accordance with a probability distribution derived from records of past
break-down frequencies. In an inventory simulation, demand and lead time would also be
generally classed as non-controlled, probabilistic variables.

Parameters
These are also input variables which, for a given simulation, have a constant value. Parameters
are factors which help to specify the relationships between other types of variables. For example
in a production simulation a parameter (or constant) might be the time taken for routine
maintenance; in an inventory simulation a parameter might be the cost of a stock-out.

Status Variables
In some types of simulation the behaviour of the system (rates, usages, speeds, demand and so
on) varies not only according to individual characteristics but also according to the general state
of the system at various times or seasons. As an example, in a simulation of supermarket demand
and checkout queuing, demand will be probabilistic and variable on any given day but the
general level of demand will be greatly influenced by the day of the week and the season of the
year. Status variables would be required to specify the day(s) and season(s) to be used in a
simulation.
Note: On occasions, status variables and parameters would both be termed just parameters,
although strictly there is a difference between the two concepts.

Output Variables
These are the results of the simulation. They arise from the calculations and tests performed in
the model, the input values of the controlled values, the values derived for the probabilistic
elements and the specified parameters and status values. The output variables must be carefully
chosen to reflect the factors which are critical to the real system being simulated and they must
relate to the objectives of the real system. For example, output variables for an inventory
simulation would typically include:
 Cost of stock holding
 Number of stock outs
 Number of unsatisfied orders
 Number of replenishment orders
 Cost of the re-ordering, and so on.

THE SIMULATION PROCESSES IN QUANTITATIVE TECHNIQUES

Simulation techniques is generally viewed as a systematic process because involves a procedural
step by step implementation. As a result an ideal simulation process can be formulated like a
model in figure X below. This model X indicates the major components of a simulation
processes which must be explicitly explained by the designers to the end users for effective
decision making.

Simulation Process

Define the problem

Develop and validate a

model

Design experiments
Feedback loop

Run simulations

Analyse and interpret

the results
Figure: Simulation Process for Decision Making and Analysis

Defining the Problem:

The first step in simulation is to clearly define the problem including the study’s objectives and
the reasons for using simulation. As part of this phase, management should define both the
attributes of interest and the measures of performance. For example, a bread factory might seek
to configuration the production process and distribution (quantity of product and physical layout
for distribution) that results in the least waste, congestion and lowest production cost. When
simulating different configurations, attributes of interest might include customer waiting time,
idle time of bakery operators, and the time to service customers. In this phase, the decision
maker also should specify the scope of the study and the level of detail needed to obtain the
desired results. Another example is, if a department store like Roban Store, Easter Shop or
Shopright is going to simulate sales patterns, the scope will encompass all departments for every
day of operation. Their objective must incorporate the peak days of their operations in relation to
competitor’s sales, demographic information on consumers, community events, security of
customers and the like. Therefore, a proper problem definition will help managers develop
accurate estimates of the cost and time needed to complete the simulation. In addition, it will
provide guidance for model development, data collection, and the design of simulation
experiments apparatus.

Developing the Model:

The second step in simulation is to develop a model that will achieve the intended results.
Sometimes, the decision maker knows the values of the model’s uncontrollable inputs in which
case we have a deterministic simulation. More often the situation will involve a stochastic or
probabilistic simulation – a case in which the uncontrollable inputs are random variables.
Uncontrollable and controllable inputs can be discrete (have integer outcomes) and can be
described by a count of the number of occurrences. Alternatively, these inputs can be continuous
(divisible into fractional values) and can be measured rather than counted. In its initial form, the
model identifies the key elements of the problem and their interrelationships. This base model’s
parameters are estimated with data gathered from direct observation or historical records. Such
parameters and the assumptions that underlie the model should be validated by the simulation’s
users. If the people that use simulation model have the necessary knowledge and are involved in
model design, then it will facilitate implementation of the later in the process.

The potency of the model can be ascertained when there is an existing system of which a
historical data should be processed through the base simulation model. The results obtained
should be compared with known system performance under identical circumstances. Also, the
and statistical methodologies should be used to determine whether the simulation generates the
same results as the real system. However, if an error is sported, the model should be revised as
needed to eliminate any major discrepancies. But if historical data is unavailable, knowledgeable
individuals (users and other experts) can be asked to identify system performance that would be
reasonable under specified conditions. Simulation results then can be validated against this
“reasonable” performance.
Designing Experiments:
In general, the goal of a simulation study is to learn about a system’s behavior. To achieve this
goal in a timely manner and at a reasonable expense, management must carefully design the
simulation experiment. The experiment must be design in a way that will provide the desired
answers to management’s questions. An important decision is to establish the initial conditions
for the experiment – the assumptions about the state of the system at the start of the simulation.
For example, in the department store situation, should we assume that the store is initially empty,
or should we assume some normal level of activity? The choice of initial conditions can have a
significant effect on the length of time needed for the system to reach a steady state. Along with
initial conditions, decisions must be made about the parameter settings. For example, in the
bread factory situation, what should be the parameters for the time between arrivals of the baked
bread and the service time? Should these parameters be modified by the time of day and day of
the week?

Running the Simulations:

After developing a suitable experimental design, we are ready to actually perform (run) the
simulation. In a deterministic simulation, there will be a single set of values for the
uncontrollable inputs. Since repeat runs with these values will generate identical results,
management need make only one run for each specified policy (set of controllable inputs). In a
probabilistic simulation, uncontrollable inputs will be drawn from a subjective, empirical, or
theoretical distribution (such as the Poisson or normal distribution). Depending on the approach,
such draws may not repeat the same sequence of these inputs. Simulation results then will differ
because of purely random changes in the uncontrollable inputs and because of conscious policy
changes. To isolate the unique effects of the policy changes, the decision maker must also
statistically account for (estimate) the purely random changes. A number of simulation runs for
each specified policy will be necessary to accomplish this task. An important decision is to fix
the length of each simulation run. Often, this length will be stated in terms of the number of
simulation observations. Statistical methodologies should be used to determine the number that
will provide sample statistics within specified maximum errors from the corresponding
population parameters.

Analyzing and interpreting the Results:

In every experiment, analysis is crucial. The final step in the simulation process is to analyze
and interpret the results. Analysis largely involves comparing the simulated outcomes from the
specified policies. In probabilistic simulation, there will be a distribution of outcomes for each
specified policy. Descriptive statistics (such as the mean and standard deviation) then will be
needed to measure the outcomes expected values and where possible ranges over which the
actual values may fall. Also, statistical methodologies should be used to determine whether
observed outcome differences are due to policy changes or chance. In most cases, the results of
the analysis provided the decision maker with information sufficient to select the best policy
among those examined (which is not necessarily the optimal problem solution). Sometimes, the
analysis suggests that further evaluation is needed before a conclusion can be reached. Such
evaluation may require management to redefine the problem and then repeat the rest of the
simulation process (as indicated by the feedback loop in Figure 17.1).
CONSTRUCTION OF A SIMULATION MODEL
The application of Quantitative Techniques in decision making is highly hinged on model
formulation. Simulation as a decision making apparatus under the auspices of quantitative
techniques is an anchor link in predictive decision making process. Therefore the success of
simulation exercise is highly related to it exhibiting a predictive quality which is the onus of an
ideal model. In the construction of a simulation model, due care is fully exercised in order to
achieve the optimum result it is meant for.

Some broad guidelines for constructing a simulation model are given below: these will be found
useful for dealing with examination questions but in this area especially, practice is vital.
Step 1: Identify the objective(s) of the simulation.
A detailed listing of the results expected from the simulation will help to clarify
step 5 – the output variables.
Step 2: Identify the input variables. Distinguish between controlled and non-controlled
variables.
Step 3: Where necessary determine the probability distribution for the non-controlled
variables.
Step 4: Identify any parameters and status variables
Step 5: Identify the output variables
Step 6: Determine the logic of the model

This is the heart of the simulation construction. The key questions are: how are the input
variables changed into output results? What formulae/decision rules are required? How will the
probabilistic elements be dealt with? How should the results be presented? To illustrate these
steps a simple problem follows together with a solution using the six step approach given above.

Note: To show the stages clearly within the constraints of a printed format the example that
follows has been carried out manually. In practice, a computer would be used for simulations
with either a specialized program or, for small simulations, a spreadsheet package such as Excel
or Lotus 1.2.3. It will be noted how the table layouts that follow naturally transform into the cells
of a spreadsheet. The model logic of step 6 above is the stage where the programming of the
spreadsheet cells takes place and the necessary formulae are entered in the cells.

FACTORS THAT MAY CAUSE SIMULATION MODEL FAILURE

The fact still remain that the primary aim of engaging in simulation process is not just model
formulation but to serve as a parameter for achievement of an organizational goal. This is
because simulation model is not a goal but a means of achieving a goal. As such the ability of the
simulation process to provide the plate form for aiding optimum decision making process is the
core basis for adopting simulation as a quantitative techniques tool for organizational decision
making process. Simulation in itself is not a cure it all apparatus but a well guided system that
depends on the input variable to achieve the anticipated result. Therefore, there are factors that
may contribute to the failure of a simulation process to achieve the required goals. These factors
are:
i) Setting unachievable objectives: The failure of management to critically define an
achievable objective constitutes a major cause for simulation model failure. This is
 because objective function remains the key element for which any simulation process
is expected to produce a model required to address decision making process.
ii) Use of incompetent personnel: The simulation process will always generate poor
decision making for prediction of outcome when the personnel teams are not
knowledgeable enough on the crux of the problem. For instance, when the simulation
model developers are not in consonance with the implementers of the model, the
result is bound to fail because of knowledge gap. More so when an incompetent team
that lack professionalism and expertise formulate a model, the simulation process is
bound to fail.
iii) Lack of collaboration: One of the basic characteristics of quantitative techniques is
team work. A simulation process that lacks collaboration among all the interest
parties is designed to fail. This is because a synergic relationship must exist between
the management team, program developer and end user in order to generate the
variable that will make up the objective function to be tackled.
iv) Model complexity: The intent behind the design of a model is to simplify the
complexity of an existing system. As such, any simulation model that is shroud in too
much technicalities will be complex for end users to implement which negates the
primary aim of the simulation model. Likewise, any simulation model that is not
structured to accommodate the appropriate design details that is consistent with the
available data and resources will also fail.
v) High running cost: A simulation model with high running cost is quite unsustainable
for any organization to operate. This is because the prime aim of opting for the
simulation model is to reduce operational cost through optimum decision making.
Therefore any simulation model that increase the running cost as a result of huge
financial commitment, prolonged delay, end users dissatisfaction, incompatible team
or difficulty in model interpretation is bound to fail.
vi) Lack of validation parameter: Validation parameter is a process of comparing a
designed model with the actual system it replicates. In other words, validation simply
means the pedestal of an ideal model which makes it a representative the real system.
The ability of a simulation process to pass through validation means that the process
is verifiable which means comparability of the simulation model with the real system.
However, a simulation model that cannot be validated cannot equally be verifiable.
This means that such simulation model will fail.

A simple inventory simulation

Example 1
A wholesaler stocks an item for which demand is uncertain. He wishes to assess two re-ordering
policies i.e order 10 units at a reorder level of 10, or order 15 units at a reorder level of 15 units,
to see which is most economical over a 10 day period.
The following information is available:

Demand per day (units) Probability

4 0.10
5 0.15
 6 0.25
7 0.30
8 0.20
If the carrying costs is ₦15 per unit per day. Ordering costs ₦50 per order. Loss of goodwill for
each unit out of stock ₦30 and the lead time 3 days while the opening Stock 17 units. Suppose
the probability distribution is to be based on the following random numbers
41 92 05 44 66 07 00 00 14 62
20 07 95 05 79 95 64 26 06 48
Run the simulation bearing in mind that the reorder level is physical stock plus any
replenishment orders outstanding.

Solution
Step 1: Objectives of simulation
To simulate the behaviour of two ordering policies – order 15 units at reorder level of 15
units and order 10 units at reorder level of 10 units and adopt the cheaper policy.

Step 2: Identify the input variables.

Controlled variables:
Order quantity
Reorder level
Non-Controlled variable:
Probabilistic demand

Step 3: Determine probability distribution.

The random numbers are allocated to the demand as follows

Demand Probability Cumulative Random

probability numbers
4 10% 10% 00 - 09
5 15% 25% 10 - 24
6 25% 50% 25 – 49
7 30% 80% 50 – 79
8 20% 100% 80 – 99
The two random number sequences supplied can then be used for the two runs of the simulation
with each pair of digits used to select a demand. For example, for the 15 order quantity
simulation, the first two digits, 41, give a Day 1 demand of 6 units. The next two digits, 92, give
a Day 2 demand of 8 units and so on.

Step 4: Identify Parameters and Status Variables

Parameters
Opening Stock17 units
Carrying costs N15 per unit per day
Ordering costs N50 per order
Loss of goodwill N30
Lead time 3 days.
There are no status variables in this simple example.

Step 5: Identify the output variables

The main output variable is Total Cost. However ancillary output variables which arise from the
simulation include:
 Number of orders placed
 Number of stock outs
 Cost of stock outs
 Total carrying cost
 Total order cost,

Step 6: Determine model logic.

In this simple example the logic and rules required are nothing more than the basics of inventory
control thus:

Reorder level = Physical stock + Replenishment Orders outstanding

Closing stock = Opening stock – Demand
Carrying cost per day = Stock x N15 per unit
Goodwill costs = Stock shortfall x N30 per unit
Total cost = Goodwill costs + carrying costs + ordering costs.

The information, values and rules are then used to simulate the two ordering policies. The results
of these simulations are shown in the schedules in the table below from which it will be seen that
the simulation shows that the ‘order 15’ policy is more economical over the 10days simulated. It
must be emphasized that in practice the simulations would be carried out over many more cycles
than 10 days in order to obtain a truly representative picture.

Day Opening Demand Closing Order Carrying Stock out Total

stock stock costs costs costs costs
₦ ₦ ₦ ₦
1 17 6 11 50 165 215
2 11 8 3 45 45
3 3 4 - - 30 30
4 +15 6 9 50 135 185
5 9 7 2 30 30
6 2 4 - - 60 60
7 +15 4 11 50 165 215
8 11 4 7 105 105
9 7 5 2 30 30
 10 +15 + 2 7 10 50 150 200
200 825 90 1,115
Results of simulation using order quantity and re-order level of 15 units. Figure above

Notes on the Figure above

 The daily demand is found by using the random numbers in the example (i.e 41, 92, 05, etc.)
and determining the demand from the probability allocation in Step 3 above. Thus 41 is in the
25-49 group and corresponds to a demand of 6, 92 is in the 80-9 group corresponding to a
demand of 8 and so on.
 An order for 15 is placed whenever physical stock and replenishment orders outstanding ≤ 15.
This occurs on Days 1, 4, 7 and 10.

Result of simulation using order quantity and re-order level of 10 units

Day Opening Demand Closing Order Carrying Stock out Total
stock stock costs costs costs costs
₦ ₦ ₦ ₦
1 17 5 12 180 180
2 12 4 8 50 120 170
3 8 8 - - - -
4 - 5 - - 150 150
5 +10 7 3 50 45 95
6 3 8 - - 150 150
7 - 7 - - 210 210
8 +10 6 4 50 60 110
9 4 4 - - -
10 - 6 - - 180 180
150 405 690 1,245

USE OF RANDOM NUMBERS IN SIMULATION MODELS

Since simulation models are typically stochastic, we need a technique for generation uncertain
events from a probability distribution. The most common way to do this is to use random
numbers.

Example: The Obiagu Liquor carries a wide variety of wines. One leading seller is in Enugu.
Obiagu has observed the following pattern for weekly demand.

Demand (in bottles) Relative

Per week X Frequency of Occurrence
10 .12
11 .25
12 .33
13 .12
14 .12
 15 .06
1.00
As we can note from the above data, Obiagu observes a variety of different demand levels for
this product. If we were to include the demand for this product in a model of Obiagu’s inventory
problem, we would need a mechanism to represent the various levels of demand. Now let us
introduce a second approach, the use of random numbers. If we had a random, event generating
device (such as a large Roulette-type wheel) which would come up ten to 12 percent of the time,
eleven to 25 percent of the time, etc., it would be simple to represent the various levels of
demand. One would simply spin the wheel and use the resulting demand level as an input into
the model. Through the use of random numbers one can, in fact, accomplish this result. Random
numbers are a set of numeric values which occur with equal likelihood and without discernible
patterns. Random numbers can be created by the use of a computer program; tables of random
numbers also exist. A portion of a random number table is shown in the table below.

Random number table

03689 33090 43465 96789 56688 32389 77206 06534 10558 14478
43367 46409 44751 73410 35138 24910 70748 57336 56043 68550
45357 52080 62670 73877 20604 40408 98060 96733 65094 80335
62683 03171 77109 92515 78041 27590 42651 00254 73179 10159
04841 40918 69047 68986 08150 87984 08887 76083 37702 28523
85963 06992 65321 43521 46393 40491 06028 43865 58190 28142
03720 78942 61990 90812 98452 74098 69738 83272 39212 42817
10159 85560 35619 58248 65498 77977 02896 45198 10655 13973
80162 35686 57877 19552 63931 44171 40879 94532 17828 31848
74388 92906 65829 24572 79417 38460 96294 79201 47755 90980
12660 09571 29743 45447 64063 46295 44191 53957 62393 42229
81852 60620 87757 72165 23875 87844 84038 04994 93466 27418
03068 61317 65305 64944 27319 55263 84514 38374 11657 67723
29623 58530 17274 16908 39253 37595 57497 74780 88624 93333
30520 50588 51231 83816 01075 33098 81308 59036 49152 86262
93694 02984 91350 33929 41724 32403 42566 14232 55085 65628
86736 40641 37958 25415 19922 65966 98044 39583 26828 50919
28141 15630 37675 52545 24813 22075 05142 15374 84533 12933
79804 05165 21620 98400 55290 71877 60052 46320 79055 45913
From Buffa, E.S. and J.S. Dyer, Management Science/Operations Research:
Model Formulation and Solution Method, Copyright @ 1977 by John Wiley &
Sons, Inc. Reprinted by permission.
We can now use this table of random numbers to generate or simulate weekly demand for
Obiagu liquor. First we form the cumulative distribution of the probabilities or relative
frequencies for the variable under study. We then assign a set of random numbers to each
possible demand level according to its relative likelihood of occurrence. The reason for
establishing the cumulative distribution is that it aids in the assignment of random numbers to the
demand levels. The table shows the random number assignment scheme for the demand of
Chico.
Table showing Assignment scheme for Obiagu Liquor
Demand X Relative Cumulative Assignment of Random
 Frequency Frequency Numbers
10 .12 .12 01-12
11 .25 .37 13-37
12 .33 .70 38-70
13 .12 .82 71-82
14 .12 .94 83-94
15 .06 1.00 95-99, 00
Notice how we have assigned these values. Demand level 10 has a relative likelihood of
occurrence of .12, thus we must assign 12 percent of our random numbers this level. As the
relative likelihood’s are carried to two decimal places, we need two-digit random numbers for
this example. Therefore, we assign the random numbers 01 through 12 to this we have already
used numbers 01-12 for the first level, we now assign 13 through 37 to 11. We proceed in the
same manner for each of the remaining classes. The cumulative frequencies aid this process. For
each class, we assign 13 through 37 to this second class. This represents 25 unique random
numbers assigned to demand level of 11. we proceed in the same manner for each of the
remaining classes. The cumulative frequencies aid this process. For each class, we assign random
numbers up to and including the value corresponding to the upper limit of the cumulative
distribution (for this purpose, we ignore the decimal point). We then proceed to assign numbers
to the next class, starting with one number greater than the upper limit of the previous class. This
continues until the last class. In this class the upper bound to the cumulative distribution will be
1.00. Since we are using two-digit random numbers to represent achieve the full allocation of
values to this class, we also assign the number 00 (corresponding to the value of 1.00) here.
Problems Obiagu has also observed the following demand pattern for an Ogbete Dealer, another
local favorite.
(a) (b)
Demand Relative Cumulative Assigned
per week Frequency Frequency Random Numbers
0 .10
1 .12
2 .14
3 .30
4 .20
5 .14
1.00
(a) Formulate the appropriate cumulative frequencies for this problem.
(b) Using the approach covered in this section, assign random numbers to each of the
demand levels.

Solution
(a) (b)
Cumulative Assigned
Frequency Random Numbers
.10 01-10
.22 11-22
.36 23-36
.66 37-66
 .66 67-86
.86 87-99, 00
1.00

Now that we have developed the assignment scheme, how do we use this information? When
using a random number table, we simply go to some point in the table and then proceed through
the table in a logical sequence selecting random numbers within our pre-specified range. Each
random number is then compared to the assigned values and a corresponding level of the
variable of interest is selected.
For the Obiagu Liquor example, we need to select two-digit random numbers. Start with the
value in the upper left-hand corner of the random numbers in the table which gives us the first
value of 03689. Since we need only two-digit numbers let’s use the first two numbers, 03. Using
this value, we would see that the number 03 would “generate” a demand level of 10 bottles. If we
were to require a second value for demand in our analysis, we would need to select another
random number from the table. Generally, one uses the next value from some logical sequence.
For this example, we will use the first two digits of the numbers in table and proceed from row to
row. The second random number in the table is 43367. Using the value 43 as our random
number, we would have the demand level of 12 as our second observation. We would proceed in
this manner until we had selected enough observations to satisfy the purpose of our study. If we
take a sample of 10 observations we would get the results listed below.

Randomly Selected
Observation Random Number Demand – Level
1 03 10
2 43 12
3 45 12
4 62 12
5 04 10
6 85 14
7 03 10
8 10 10
9 80 13
10 74 13

Of course, if we were using a computerized simulation model, we would want to generate

weekly demand levels for a two or three year period rather than just ten weeks. Our sample is
very small but it does demonstrate the use of random numbers in simulating stochastic events.

Further example of simulation

A common application of simulation is to examine the behaviour of queues in circumstances
where the use of queuing formulae is not possible. The following example is typical.

Example
A filling station is being planned and it is required to know how many attendants will be needed
to maximize earnings. From traffic studies it has been forecasted that customers will arrive in
accordance with the following table:
 Probability of 0 customers arriving in any minute 0.72
Probability of 1 customers arriving in any minute 0.24
Probability of 2 customers arriving in any minute 0.03
Probability of 3 customers arriving in any minute 0.01
From past experience, it has been estimated that service times vary according to the following
table
Service time in 1 2 3 4 5 6 7 8 9 10 11 12 min
Probability 0.16 0.13 0.12 0.10 0.09 0.08 0.07 0.06 0.05 0.05 0.05 0.04
If there are more than two customers waiting, in addition to those being serviced, new arrivals
drive away and the sale is lost. If a petrol pump attendant is paid₦40 per 8 hour per day and the
average contribution per customer is estimated to be ₦4. How many pump attendants are
needed?
Solution
Step 1: Objectives of simulation: To find the number of attendants to maximize earnings
Step 2: Input variables
Controlled: Number of attendants
Non-Controlled: a) Customer arrival rate
a) Service time
Step 3: Probability distribution
As previously, a random number table is used and an extract is made from the table.
The arrival pattern estimated is reproduced below with random numbers assigned.
Random nos
Assigned
Probability of 0 customers arriving in any minute = 0.72 01-72
Probability of 1 customers arriving in any minute = 0.24 73-96
Probability of 2 customers arriving in any minute = 0.03 97-99
Probability of 3 customers arriving in any minute = 0.01 00
Similarly for the service pattern we assign the random numbers thus:
Service time per 1 2 3 4 5 6 7 8 9 10 11 12
minute
Likelihood 0.16 0.13 0.12 0.10 0.09 0.08 0.08 0.06 0.05 0.05 0.05 0.04
Random number 01-16 17- 29 30-41 42- 51 52-60 61-68 69- 75 76-81 82-86 87-91 92-96 97-00
assigned
The random number table is read in any direction in groups of two digits and, according to the
digits, the appropriate arrival pattern or service time is selected. For example, assume that for the
arrival pattern the table is read from left to right starting from the first row.

Minute No. Random digits from table No of arrivals

1 50 0
2 53 0
3 22 0
4 54 0
5 96 1
6 95 1
7 65 0
8 24 0
9 14 0
 10 57 0
11 73 1
12 54 0
13 77 1
14 69 0
15 52 0
16 21 0
17 49 0
etc. 0
Table 2
Selecting on this basis over say, a week’s operations, will result in a random selection reflecting
the estimated probabilities.
Step 4: Parameters
Attendant cost N40 per day
Average contribution per customer N4
Step 5: Output variables
Average contributions per day
Attendant costs per day
No. of unsatisfied customers
Step 6: Logic of simulation
In this case the logic is shown using a flowchart Figure below and the results of the simulation
would be entered on a simple worksheet

Sta

Randomly
selected no of
arrivals in any
minute

Yes No
Is
attendant
Randomly
select service Queu 1 or 2
time e

>2 Driven on

Add 1 to
‘drive on’
counter
Add £4 to
contribution
counter Driven on

Has
cost/contributio
n pattern
emerged? Continue
simulation
A flow chat representation of Simulation logic

The results of such a simulation could be entered on a simple worksheet as follows:

Minute No. of Queue Attendant Attendant Contributio No. of
arrivals length n earned unsatisfied
customers
1
2
3
4
5
6
7
8
etc

Carrying out the simulation

Now that the objectives, variables, logic and so on have been established the simulation is
carried out for a number of iterations each representing 1 minutes operations; first with 1
attendant, then 2 attendants, then 3 and so on until a cost/contribution pattern emerges.

As the flowchart, the figure above, is worked through every minute, the number of arrivals
would be randomly selected as shown in the table.
It will be apparent that such a simulation is simple to set up and use but becomes very tedious
indeed to repeat for hundreds of iterations.

Results of simulation
The above simulation has been worked through for several days’ operation with 1,2,3 and 4
attendants and the results obtained are tabulated below:
No. of Average Attendant(s) cost Average no. of
attendants contribution per per day vehicles/day driving
day on
₦ ₦
1 312 40 81
2 520 80 29
 3 576 120 16
4 600 160 2

From the table it will be seen that there is little difference in net profit per day between 2, 3 and 4
attendants, although there is of course a substantial difference in the average number of vehicles
driving on. The results of a simulation do not necessarily indicate an optimal solution but provide
more information upon which a reasoned decision can be taken.

Computers and Simulation

To carry out any sort of realistic simulation, the use of a computer becomes a necessity. This is
not because of any great complexity, but merely because of the large number of times that one
has to work through the model. In the above example a computer was used to establish the table
of results, but it did nothing more than could have been achieved using the model flowchart and
the worksheets and a lot of patience. Because of the importance of computers in simulation,
special simulation languages have been developed to facilitate the program writing and the use of
the model. The GPSS (General Purpose Systems Simulator) exists for most computer systems. In
addition there is the universal availability of spreadsheet programs that are able to carry out
many types of practical simulations.

Further illustration
Olijo Nig. Ltd is a mono-product company: and the daily demand for this product varies.
Observed daily demand had the following probability distribution:
Demand per day Probability
34 0.05
35 0.08
36 0.14
37 0.16
38 0.20
39 0.22
40 0.04
41 0.05
42 0.06

You are required to simulate demand for a 15 day period if random numbers are generated to be
107437313119007174604721296802

Solution:
Allocate random numbers on the basis of percentage probabilities, so that 100 random numbers
in the range 00-99, will be allocated to various possible outcomes.
 Cumulative Random Nos.
Demand per day Probability Probability Allocated
34 0.05 0.05 00-04
35 0.08 0.13 05-04

36 0.14 0.27 13-26

37 0.16 0.043 27-42

38 0.20 0.63 43-62

39 0.22 0.85 63-84

40 0.04 0.89 85-88

41 0.05 0.94 89-93

42 0.06 1.00 94-99

Simulate demand for a 15 day period

Day Random Numbers Demand Units

1 10 35
2 74 39
3 37 37
4 31 37
5 31 37
6 19 36
7 00 34
8 71 39
9 74 39
10 60 38
11 47 38
12 21 36
13 29 37
14 68 39
15 02 34
Illustration: 2
Oliefi Aaron Stores Nig. Ltd. deals in a perishable commodity for which the daily supply and
demand are subject to random variation and cannot be forecasted. The records maintained over
the previous 350 revealed the following pattern:

Kilograms available for Purchase Number of Days

0 35
1 70
2 105
3 105
4 35
350
The potential demand over the same period revealed no seasonal variations and had the
following pattern:
Kilograms available for Purchase Number of Days
0 52½
1 70
3 105
4 87½
5 35
350
One kilogram of the commodity cost ₦24 and sells for ₦36. if is unsold at the end of the day its
scrap value is nil. If there is unsatisfied demand on any day, it means a loss of goodwill etc of ₦6
per kilogram.
You are required to prepare simulation for the first seven days given a series of random number
table as follows; 57,34,23,70,97,51,48,36,81,32,09,31,64,49.

Solution:
(a). Allocate random numbers as follows:
No of kilogram Probability Cumulative Allocation of
available of probability Random Nos.
purchase
1 0.10 0.10 00.09
2 0.20 0.30 10-09
3 0.30 0.60 30-59
4 0.30 0.90 60-89
5 0.10 1.00 90-99

No of kilogram Probability Cumulative Allocation of

available demanded probability Random Nos.
1 0.15 0.15 00.14
2 0.20 0.30 15-34
3 0.30 0.65 35-64
4 0.25 0.90 65-89
 5 0.10 1.00 90-99

(b). Random number should now be read in pairs and used to determine the levels of supply
and demand for each day in the simulated period of activity.
Day Purchase Kilogram Demand Kilogram Unsatisfied Waste
random No purchased Random Demanded Demanded
No
1 57 3 34 2 - 1
2 23 2 70 4 2 -
3 97 5 51 3 - 2
4 48 3 36 3 - -
5 81 4 32 2 1 -
6 09 1 31 3 - 1
7 64 4 49 3 - 1
22 19 3 6
Parameters are:
Cost per kilogram N24
Sales value per kg N36
Loss of goodwill N6

Determination of profit: N
Sales revenue N36 [19-3] 576
Less Cost
Purchase cost [24 x 22] 528
Goodwill [6 x 3] 18 546
30_

Illustration 3
A Management Accountant of a firm considered the under-listed variables as significant to his
routine analysis of income statement:
(i) Direct labour cost
(ii) Direct material cost
(iii) Sales revenue

Using the data collected over the last two years, and taking into account likely changes in the
level of operation during the next few months, the following distributions have been estimated
for the monthly income and expenditure in each of these categories.

Direct labour cost Probability

N’000
10-12 0.3
 12-14 0.5
14-16 0.2
Direct material cost Probability
N’000
6-8 0.2
8-10 0.3
10-12 0.3
12-14 0.2
Sales revenue Probability
N’000
30-34 0.1
34-38 03
38-42 0.4
42-46 0.2

Additional information:
[a] Other expenditure items which amounted to N14,000 per month are to be regarded as
fixed.
[b] All cash receipts and payments are assumed to be independent and occur the end of the
month.
[c] Random numbers are given as follows:
Direct labour cost: 279298
Direct material cost: 4 4 1 0 3 4
Sales revenue: 066802
You are required to simulate 6 months’ income statement for the firm.

Solution
To perform the simulation, random number ranges must be allocated to the three
distributions based on the probabilities given in each. The mid-points are used as representative
figure for each class interval.

Direct labour cost:

Mid-point Probability Cumulative Random Number
Probability
11 0.3 0.3 0-2
13 0.5 0.8 3-7
15 0.2 1.0 8-9

Raw material cost:

Mid-point Probability Cumulative Random Number
Probability
7 0.2 0.2 0-1
9 0.3 0.5 2-4
 11 0.3 0.8 5-7
13 0.2 1.0 8-9

Mid-point Probability Cumulative Random Number

Probability
32 0.1 0.1 0-0
36 0.3 0.4 1-3
40 0.4 0.8 4-7
44 0.2 1.0 8-9

Month S/R Cash D/L Cash R/m Cash Fixed Net

Random Flow Cost Flow Cost Flow Cost Profit
No Random Random
No No
N’000 N’000 N’000 N’000 N’000
1 0 32 2 (11) 4 (9) (14) (2)
2 6 40 7 (13) 4 (9) (14) 4
3 6 40 9 (15) 1 (7) (14) 4
4 8 44 2 (11) 0 (7) (14) 12
5 0 32 9 (15) 3 (9) (14) (6)
6 2 36 8 (15) 4 (9) (14) (2)
Total profit 10

Example
Ejikemeuwa Enterprise, as a motor spare parts trader wishes to determine the levels of stock it
should carry for the items in its range. Demand is not certain and there is a lead – time for stock
replenishment for one item. The following information is obtained from his trading activities.
Demand Probability
(Units per day)
3 0.10
4 0.25
5 0.25
6 0.30
7 0.10

Carrying costs [per unit per day]…………………………N2

Ordering costs [per order]………………………….N50
Lead time for replenishment [in days]. 3
Stock on hand at the beginning of the simulation exercise was 21 units.
You are required to:

Carryout a simulation run over a period of ten days with the objective of evaluating the following
rule;
Order 15 units when present inventory plus any outstanding order falls below 15 units.
Random numbers to be employed are 0911518665712996.
 Your calculation should include the total cost of operating this inventory rule for eight
days.

Solution to illustration 4
Demand per Probability Cumulative Allocation of
day probability Random Nos.
3 0.10 0.10 00.09
4 0.25 0.35 10-34
5 0.25 0.60 35-59
6 0.30 0.90 60-89
7 0.10 1.00 90-99

Day Stock Random Demand Stock Order Holding Total

b/f Units No. Units c/f Cost Cost Cost
Units N N N
1 21 09 3 18 - 36 36
2 18 11 4 14* 50 28 78
3 14 51 5 9 - 18 18
4 9 86 6 3 - 6 6
5 3 + 15 65 6 12* 50 24 74
6 12 71 6 6 - 12 12
7 6 29 4 2 - 4 4
8 2 + 15 96 7 8* 50 16 66
150 144 294
*Indicates re-ordering at the start of the day.

Advantages of simulation
b) Simulation can be applied in areas where analytical techniques are not available or
would be too complex.
c) The constructing the simulation model inevitably must involve management and this
may enable a deeper insight into obtaining the actual problem of resource utilization.
d) A well constructed simulation model does enable the results of various policies and
decisions to be examined without any irreversible commitments being made
e) Simulation is cheaper and less risky because it does not lead to alteration of the real
system.

Disadvantages of simulation
Even though records has shown that simulation is easily workable and applicable, the following
disadvantages are experienced in its application
a) Simulation may still be complex to those not conversant with it application. It
therefore requires a substantial amount of managerial and technical time.
b) Practical simulation inevitably requires the use of computers. Although there is near
universal ownership of machines, a considerable amount of additional expertise is
required to obtain worthwhile results from simulation exercises. This expertise is not
always available.
c) Simulations do not produce optimal results. The manager makes the decision after
testing a number of alternative policies. There is always the possibility that the
optimum policy is not selected.
CHARPTER EIGHT
Inventory Management

Learning objectives
After studying this chapter you should:
● understand the meaning of inventory;
 be able to classify the distinction between inventory and stock ;
 state the reason for maintaining inventory;
 be able to understand the classification of inventory;
 understand the meaning of inventory control and inventory
management;
 determine the importance of inventory control and inventory
management;
 be able to compare inventory control to inventory management;
 understand the terminologies and methods of computing costs that
are associated to inventory control and management;
 be able to formulate an inventory control model;
 know the various types of inventory control system, their merits
and demerits;
 understand the basic terminologies involved in the computation of
various stock levels;
 master the computation process involved in determination of stock
levels in inventory control and management;
 be able to draw and interpret a graphical presentation of a
computed stock level;
 know the meaning of economic order quantity (EOQ) and the
associated assumptions;
 understand the methods of computing and determining the value of
EOQ;
 know the meaning of safety stock and methods of its
determination.
Introduction
“Sorry, we’re out of that item.” How often have you heard that during shopping trips?

“After our sojourn in this world, all mortal will appear before the creator of mankind to give
account of our selves” this assertion from the bible clearly means that something somewhere in
us is keeping records or taking inventory of our deeds and activities in this world. One may
attribute the inbuilt device taking inventory of our actions to be our conscience or any other thing
you may think of. Standing on this platform, one might arguable say that the word inventory
means so many things to so many people and may be ascribed as a generic concept which is also
as old as mankind. Basically, the concept inventory cuts across so many disciplines as such may
have diverse definition depending on the perspective from which it is viewed. Mirroring it from
the Quantitative Techniques perspective, the word inventory may simply be adjudged as any
kind of resource that has economic value kept securely for future use.

Globally, most organizations budget billions of financial resources in inventories. The main
reason is to sustain a balance between the inflow and outflow of goods that are useable but are
currently in an idle state. Inventories can be thought of as water tanks: there may be a constant
inflow of water that is pumped into the tank by a pump, while the outflow is low at night, high in
the morning (when people get up, take a shower, etc), it then decreases significantly until the
demand again increases in the evening (when people come home, do laundry, etc), just to fall off
again for the night. Other, popular, examples include grocery stores whose inventories consist of
various foodstuffs awaiting sale to its customers. Here, the delivery of the goods is in bulk
whenever a delivery truck arrives, while the demand is unknown and erratic. In the case of
hospitals, they have in stock medical supplies, bed linen and drugs. Again, the demand for these
items is uncertain and may differ widely from one day to the next. All these instances have a few
basic features in common. They have a supply, a demand, and some costs to obtain, keep, and
dispose of inventories. An inventory as a resource may be classified into three categories: (i)
physical resources such as raw material, semi-finished goods or finished goods.(ii) human
resources such as unused labour (manpower) and (iii) financial resources such as working
capital.

The real essence of maintaining inventory as a resource is to provide desirable services to

customers and to achieve optimum sales target through uninterrupted production line and supply
chain. As such, it is pertinent to balance the inventory management policies by adopting an
optimum inventory model that can ensure minimum total cost of inventory

Inventory Defined
An inventory simply means an idle stock of item for future use. It may be regarded as any kind
of resources that has economic value and is maintained to fulfill the present and future needs of
an organization. An inventory consists of usable but idle resources such as men, machine,
material or money that are stored or reserved as a stock in hand for smooth and efficient running
of future affairs of an organization at the minimum cost of funds. The key issues in inventory are
the quantity (how much) and the timing (when) of the order. Inventory represents a current
asset since a company typically intends to sell its finished goods within a short amount of time,
typically a year. Inventory has to be physically counted or measured before it can be put on a
statement of financial position (balance sheet).

In accounting and managerial decision making processes the term inventory is most times
assumed to mean the same thing as stock or asset. Granted that they are interrelated but there still
exist a thin line dividing them conceptually.
Asset
An asset is a resource with an economic worth that is owned or controlled by a person, a
company or a nation for deriving short-term and long-term future benefits. Assets have a broad
scope because they remain in the business for both long-term (Fixed Assets) and short-term
(Current Assets). Assets can be in the tangible or intangible form, as such all inventories are part
of the asset but not all assets are inventories. In simple terms assets are the organization owns
while inventories are what the organization sells. The major difference between assets and
inventory are significantly noticeable in the fact that assets are long-term investments that are
difficult to sell, necessitate maintenance and stands beneficial to the organization in the present,
future or prospective whereas inventories are only held for a limited time and are quickly sold. A
good contrast in this two terms lies on the fact that any trade or Production Company’s inventory
is a valuable asset that require optimum inventory control and management through a workable
inventory model.

Inventory
An Inventory is finished products as well as the raw materials used to make the products. For
instant, the machinery used to produce the products and the building in which the products are
made. In other words, anything that goes into producing the items sold by your business is part
of its inventory.

Stock
Stock is the finished product that is sold by the business. In some cases, stock is also raw
materials, if the business also sells those products to its customers. For example, a car
dealership’s stock includes cars, but also can include tires, engine parts or other car accessories.

The Differences between Inventory and Stock

While stock deals with products that are sold as part of the business’s daily operation, inventory
includes sale products and the goods and materials used to produce them. For example, the cars,
car parts and accessories are sold during normal business practices, but the machines that run
diagnostic tests on cars or the car lot itself are not. Inventory takes in account all of the assets a
business uses to produce the goods it sells and determines the sale price for the stock. The stock
determines the amount of revenue a business generates and the more stocks that is sold, the
higher the revenues.

For accounting purposes, counting inventory items is done generally once a year, but for stock,
the numbers are tracked daily. This is mostly because inventory is replenished as needed to
ensure there is an adequate stock for the business to keep its doors open. It is usually not
necessary to count the number of tires a car dealership has daily, but it is very important to know
how many cars are left on the lot. Also, although the sale of assets can create in infusion of cash
into the business, this money is not considered revenue. Only the sale of the stock itself is
included in the revenue total.

However, an inventory problem is said to exist if either the resources are subjected to control or
if there is at least one such cost that decreases as inventory increases. It is the problems that are
associated to inventory management that culminated to the formulation of an inventory model
which the core objective is to minimize total (actual or expected) cost. An inventory model may
be of independent demand or dependent demand. In an independent demand model, the demand
for an item is isolated or independent of the demands for other items in inventory. Example is
finished goods that can stand alone for its utility. In a dependent demand model, the demand for
an item is reliant on another item or dependent upon the demand for other items in the inventory.
Example is assembling components that must be used conjointly with others to achieve the
desired purpose.

REASONS FOR MAINTAINING INVENTORY

The overall reason why organization hold and maintain inventory is because it is practically
impossible to keep stock adequate enough to meet the optimum desired needs at any point in
time. There is no doubt that virtually every organization must maintain inventory directly or
indirectly to ensure smooth running of its operations. For many organizations, inventories
represent a major capital cost, in some cases the dominant cost, so that the management of this
capital becomes of the utmost importance. This is because inventory, no business activities can
be performed. Organizations therefore maintain inventory because of the following reasons:
i) Smooth running of the organization:
Inventory helps in the smooth running and efficient running of an organization by
facilitating the decoupling of the production line for optimum performance
ii) Provision of uninterrupted services:
Inventory facilitates the provision of uninterrupted services to customer or vendor at a
short notice.
iii) Promotion of customer retention and goodwill.
Maintenance of inventory promotes customer’s satisfaction, facilitates customer
retention capacity and bursts the organization’s goodwill because there will always by
goods available and prompt delivery.
iv) Benefits of Bulk Purchase:
Inventory maintenance makes the organization to benefit enormously from economics
of scale associated to bulk purchase in term of discount, transshipment benefits, less
clerical and documentary cost.
v) Cost Reduction:
Maintaining inventory makes organizations to reduce costs that may be associated to
machine setup, movement of raw materials from one location to another and general
production cost.

CLASSIFICATION OF INVENTORIES
When considering the inventories, we need to distinguish different classes of items that are kept
in stock. In practice, it turns out that about 10% of the items that are kept in stock usually
account for something in the order of 60% of the value of all inventories. Such items are
therefore of prime concern to the company, and the stock of these items will need close attention.
These most important items are usually referred to as “A items” in the ABC classification system
developed by the General Electric Company in the 1950s. The items next in line are the B items,
which are of intermediate importance. Inventories may therefore be classified according to the
role they play as an organization stock which may be a direct or indirect role during
manufacturing. Simply put inventories are categorically classified as direct and indirect
inventories.

1. The Direct Inventories

These are inventories or items that are used precisely and purely for the production of required
products. Direct inventories are further segregated as raw materials, work in process, finished
goods, maintenance and scrap inventories.

i) Raw material inventories:

The raw materials inventories are the materials used directly in the manufacturing of product
and can be identified on the product.
ii) Work-in -process inventories or in the process inventories:
These are inventories that are semi-finished. These inventories are not in a complete form and
lack proper classification as a finished item because they are at various stages of production.
This type of inventory is usually accumulated between operations or facilities as it is still
undergoing transformation and should be avoided because it accumulates unnecessary cost if
allowed to stay longer in that state.
iii) Finished goods inventories: These are completed inventory ready for dispatch or utility for
purpose it is meant for. This class of inventory is usually regarded as stock keep to ensure
adequate and steady supply to customers and in some cases ensure stabilization of the
production line by eliminating breakage as a result of stock-out in the course of
manufacturing.
iv) Spare parts inventories or MRO (maintenance, repair and operating) Inventories.
These are inventories that are kept as consumable in the course of production. It is natural
that finished products sold to the customer may get damaged, deteriorated or deplete in the
course of usage. As such organizations keep inventories as backup in terms of spare parts for
maintenance, repair or as a support utility for continuous operations.
v) Scrap or waste inventory:
These are miscellaneous inventories considered by the organization as a waste, obsolete or
scrap product but may be of financial value if it is sold to other users it may be beneficial to
as raw material. They are considered as inventory because organization stocks them where
they are valued and disposed off from time to time.

2. Indirect Inventories
This is a class of inventory that comprise of stock items that are necessary for the manufacturing
of goods but are not a direct component of such goods. They are ancillary goods that cannot be
assigned to a specific unit in the final goods. Inventories or materials like oils, grease, lubricants,
cotton waste and such other materials are required during the production process. But we cannot
identify them on the product. Indirect inventories may be segregated according to its utility in
production process thus:

i) Fluctuation or Buffer Inventories:

These inventories are maintained to safeguard the fluctuation in demand and non-delivery of
material in time due to extended lead-time. These inventories are generally regarded as Safety
stock or reserves to cushion to effect of unexpected fluctuation in demand, disruptions in
production process or breakdown of transportation system. Fluctuation inventories absorb the
effect of changing demand and lead-time failure.
ii) Anticipation inventory:
These are inventories held by an organization to meet the expected change in demand. When
there is an indication that the demand for company’s product is going to be increased in the
coming season, a large stock of material is stored in anticipation. Sometimes in anticipation of
raising material prices, the material is stocked to abate the negative effect of rising material
price on the production cost.
iii) Lot size inventory or Cycle inventories:
Lot size refers to the quantity of an item ordered for delivery on a specific date or
manufactured in a single production run. Lot size or cycle inventory refers to the total
quantity of a product ordered for manufacturing. This situation happens in batch production
system where products are produced in economic batch quantities. The materials for the
production are procured in quantities larger than the economic quantities to meet the
fluctuation in demand which leads to stocking of excess materials.
iv) Transit or Pipeline Inventories:
In transit inventory, also called transportation inventory or goods in transit; it is any good
shipped by a seller but not yet received by a buyer. These items are considered to be part of
the shipper's inventory during their transit up until the recipient has paid for them. Since the
movement of item cannot be instantaneous, optimal inventory level is required for shipping
of inventory items to distribution centres and customers from production centres. The
amounts of transit or pipeline inventory depend on the time required for shipping and the
nature of the demand.
v) Decoupling inventories:
This is a class of indirect inventory maintained and used when a product manufacturer set
aside extra raw materials or work in progress items for all or some stages in a production
line, so that a low-stock situation or breakdown at one stage doesn't slow or stop operations.
Basically, these inventories are stocked in the manufacturing plant as a precaution, in case
the semi finished from one machine does not come to the next machine, the decoupling stock
is used to continue a production process without interruption.

The essence of classifying inventory is to establish the inventory control measure that will ensure
a workable optimum balance for ideal decision making in an organization.

Inventory Control Defined

Inventory control also called stock control or warehouse management is process that involves the
daily activity of managing stock within the warehouse or warehouses spread over other locations.
It comprises management of items from the time you have them in stock to their final destination
(ideally to customers) or disposal (not ideal). Inventory control activities include receiving,
storing and transferring stock, as well as tracking and fulfilling orders and returns. It also
involves the act of monitoring the movement, usage, and storage of stock. Specifically, Inventory
control means managing your inventory levels to ensure that you are keeping the optimal amount of
each product. In organization, proper inventory control can keep track of your purchase orders and
keep a functional supply chain. The goal of inventory control therefore is to maximize profits with
minimum inventory investment, without impacting customer satisfaction levels. A cursory look
at inventory control indicates that it is a complex chain of operations that oversees products
storage, replenishment, classification, warehousing, turnover and tracking. Inventory control is
obviously a multi-functional and multi-dimensional process.

In organization, the warehouse inventory control involves the following processes:

i) Barcode scanner integration.

ii) Reorder reports and adjustments.

iii) Product details, histories, and locations.
iv) Comprehensive inventory lists and counts.
v) Variants handling, bundles segregation and kitting of associate products.
vi) Harmonizing the stock on hand with sales orders and purchase orders.
Inventory Control System:
An inventory control system is a technology solution that manages and tracks a company's goods
through the supply chain. This technology will integrate and manage purchasing, shipping,
receiving, warehousing, and returns into a single system. It also manages the day-to-day stock
and warehouse activities. The best systems are able to scale as you add more products and
facilities. They are customizable and integrate with ERP systems. The best inventory control
system will automate a lot of manual processes. It will provide an accurate picture of what
inventory you have, where it is, and when you need to reorder to keep your stock at optimal
levels.

The Key features of an inventory control system include:

i) Inventory Tracking: These are inventory control systems that report inventory quantities,
product details and storage locations.
ii) Check-In/Check-Out: The inventory control system tracks stock transfers and the
movement of orders and returns.
iii) Real-Time Updates: The inventory control system watches stock status, minute-by-minute.
iv) Notifications: The system warns about low stock, expiring items and overstocked items and
reorders stock to maintain proper inventory.
v) Audits and Reports: The system engages in the process of stock Audit by tracking patterns
and reports the results for evaluation.

IMPORTANCE OF INVENTORY CONTROL

The importance of inventory control needs not to be over emphasized because it is the life wire
of any organization. The fact remains that when you get inventory control right, you reduce
costs, free up capital, improve warehousing and keep customers happy. Here are a few
importance of inventory control in any business organization.
i) Keeps Stock Counts Accurate:
Inventory control provides an accurate reflection of all units on hand. The best way to do this is
by using a digital inventory system that electronically scans in barcodes of both new inventory
and the retrieval of each unit picked in an order. This way real-time inventory stock level can be
reported on at any time.
ii) Helps you make the right inventory management decisions:
Inventory control is more than just tracking inventory. It also takes inventory turnover into
account, or how quickly inventory is sold and replaced in a specific time period. Sales are never
going to be 100% linear, so you must continuously measure changes over time to adjust the rate
and quantities at which you replenish.
iii) Helps in the harmonization of inventory control Activities:
Inventory control helps connect the upstream activities of purchasing and manufacturing to the
downstream activities of sales and product demand to prevent bottlenecks, speed up processes,
identify slow-moving or obsolete items, and even help evaluate suppliers.
iv) Eliminates write-offs:
Inventory control directly affects inventory accounting, which measures the changes in the value
of physical inventory and costs of goods sold over time. Proper inventory control
prevents inventory write-offs for inventory that no longer has value by reducing waste, making it
easy to calculate inventory value, and helping your bottom line by only carrying inventory that
you need.
v) Ensures retention of enough units to fulfill orders
Proper inventory stock control is aimed at holding the least amount of inventory in the
warehouse(s), yet enough to keep up with demand. This unit accounts for safety stock, as the last
resort required to fulfill orders late or to keep customers waiting satisfied.

Inventory Management Defined

Inventory management refers to the process of ordering, storing, using, and selling a company's
inventory. This includes the management of raw materials, components, and finished products,
as well as warehousing and processing of such items. Inventory management refers to the act of
managing order processing, manufacturing, storage, and selling raw materials and finished
goods. It ensures the right type of goods reach the right place in the right quantity at the right
time and at the right price. Thus, it maintains the product availability at warehouses, retailers,
and distributors. It is also an approach for keeping track of the flow of inventory. It starts right
from the procurement of goods and its warehousing and continues to the outflow of the raw
material or stock to reach the manufacturing units or to the market, respectively. When the goods
arrive at the premises, inventory management ensures receiving, counting, sorting, arrangement,
storage and maintenance of these items, i.e. stock, raw material, components, tools, etc,
efficiently. Inventory management, on the other hand, is a broader term that covers how you
obtain, store, and profit from raw materials and finished goods alike. The right stock, at the right
levels, in the right place, at the right time, at the right cost.

Importance of Inventory Management

The two main benefits of inventory management are that it ensures you’re able to fulfill
incoming or open orders and raises profits. However, inventory management is beneficial to
organizations in the following ways
i) Saves Money:
Understanding stock trends means you see how much of and where you have something in stock
so you’re better able to use the stock you have. This also allows you to keep less stock at each
location (store, warehouse), as you’re able to pull from anywhere to fulfill orders. All of these
decreases costs tied up in inventory and decreases the amount of stock that goes unsold before
they are obsolete.

ii) Improves Cash Flow:

With proper inventory management money can only be spent on inventory that sells. This
process makes cash to always circulate through the business and not tied in the inventory.
iii) Satisfies Customers:
Effective inventory management leads to customer retention. This because one quality
organization must possess to develop loyal customers is ensuring they receive the items they
want without waiting.
iv) Balance of Inventory
An Effective inventory management enables businesses to balance the amount of inventory
they have coming in and going out. The better a business controls its inventory, the more
money it can save in business operations.
v) Inventory control data Source
Inventory management uses a variety of data to keep track of the goods which is a good data
source for inventory control mechanism. The data are generated as they move through the
process, including lot numbers, serial numbers, cost of goods, quantity of goods and the dates
when they move through the process.

Inventory Management System

An inventory management system is the combination of technology (hardware and software) and
processes and procedures that oversee the monitoring and maintenance of stocked products,
whether those products are company assets, raw materials and supplies, or finished products
ready to be sent to vendors or end consumers. It may be referred to as a process by which you
track your goods throughout your entire supply chain, from purchasing to production to end
sales. An inventory management system enables a company to maintain a centralized record of
every asset and item in the control of the organization, providing a single source of truth for the
location of every item, vendor and supplier information, specifications, and the total number of a
particular item currently in stock.
Because inventory often consists of movable assets, inventory management systems are critical
for keeping tabs on current stock levels and understanding what items move quickly and which
items are more slow-moving, which in turn enables organizations to determine when it’s time to
reorder with greater accuracy.

An effective inventory management system is an integral part of supply chain management

(SCM). It plays a crucial role in overseeing purchases of production components from suppliers
and fulfilling customer orders. Companies with multiple warehouses and multiple selling
channels use ERP to coordinate their inventory management systems. ERP generates real-time
product, cost, supply, and demand information so companies do not need to keep as much
inventory on-hand, can better meet customer demand and plan for market fluctuations.

A complete inventory management system consists of:

 i) A system for identifying every inventory item and its associated information, such as
barcode labels or asset tags.
ii) Hardware tools for reading barcode labels, such as handheld barcode scanners or smart
phones with barcode scanning apps.
iii) Inventory management software, which provides a central database and point of reference
for all inventory, coupled with the ability to analyze data, generate reports, forecast future
demand, and more.
iv) Processes and policies for labeling, documentation, and reporting. This should include
an automated inventory management technique such as Just in Time, ABC Analysis,
First-In First-Out (FIFO), Stock Review, or another proven methodology.
v) People who are trained to follow and implement these policies and processes.

Key features of an inventory management system include:

i) Item Master: Traces inventory by size, color, lot, serial number, bundle or kit.
ii) Order Management: Provides a view into the complete order and fulfillment
process.
iii) Inventory Traceability: Tracks lots or serial numbers from end to end, from raw
materials to production to distribution.
iv) Inventory Auditing: Enables both physical counts and cycle inventory.
v) Reporting: Watches and reports on inventory trends.
vi) Demand Planning: Helps you predict product demand, so you order the right amount
of stock.
vii) Inventory Forecasting: Predicts how much you will sell based on past trends and
historical data.
viii) Inventory Control: Uses a big-picture analysis to manage the end-to-end process
and warehouse layout.
ix) Inventory Optimization: Maintains the right stock and quantities at the lowest
carrying costs, so you never have too much or too little.

BENEFITS OF ADOPTING INVENTORY CONTROL SYSTEM

An inventory management system enables seamless communication and tracking of products
across the globe. The majority of businesses today are selling through multiple channels, such as
online, in-store and through third-party retailers. Additionally, many businesses store their
inventory across multiple warehouses, and all of this adds complexity to managing inventory
efficiently and effectively. Inventory management system is a viable integrated system that gives
visibility to track inventory across multiple locations and enables organizations to use your
inventory more effectively and keep less inventory on hand. There are therefore many benefits of
adopting inventory control system in the activities of organization. Listed below are some of the
benefits thus:
i) Improved cash flow.
ii) Better reporting and forecasting capabilities.
iii) Reduction in storage costs (overhead).
iv) Reduced labor costs.
v) Reduction in dead stock.
vi) Better organization.
vii) Enhanced transparency.
 viii) Improved supplier, vendor, and partner relationships

INVENTORY CONTROL AND INVENTORY MANAGEMENT COMPARED

Keeping control of stock so as to hold the least amount of inventory in a warehouse makes for
easier organization, lower holding costs, better cash flow, and more space within your
warehouses. In most cases inventory control can sometimes be synonymic to inventory
management, as both inventory management and inventory control help to keep business
financially sustainable and meet customer demand. Even though they appear as the same concept
and many view it as though they are, but in the context of Quantitative techniques their
differences are obvious.

DIFFERENCES BETWEEN INVENTORY CONTROL AND INVENTORY

MANAGEMENT
Let's look at this symbolically - your warehouse is the body, your Inventory Control is the arms
and legs - they do all the hard and physical labour. Your Inventory Management is the brain
which processes all the data from your inventory control and turns that data into valuable
insights to enable you to make critical business decisions. These two areas are co-dependent. At
first glance, inventory control and inventory management seem similar. After all, they both cover
similar bases revolving around the question, “How much stock should I order?” That is why
most times these two terms are often used interchangeably without recourse to the fact that they
actually deal with different aspects of inventory optimization and serves different business
objectives. The differences are as stated below:
i) In simple terms inventory control = the management of inventory already in the possession of
a company while inventory management = inventory control plus forecasting and planning
for future inventory requirement, managing purchase and supply activities, storage and
protection against damage or loss while in transit or in the store.
ii) Inventory control is responsible for the movement of inventory within warehouse. With stock
control, you track which goods or materials you have and in which quantities. You also track
the condition and status of items. By contrast, inventory management encompasses the entire
process of forecasting demand, ordering and managing stock on hand. This practice looks to
the future to see what customers will want to purchase and places orders accordingly.
iii) Inventory control is focused more at the operations-level and very involved in warehouse
system management, from scanning in new items in real-time on the warehouse floor to
preparing units for kitting and assembly while inventory management is the high level
oversight of inventory, from raw materials to stocked goods which includes ordering
and restocking inventory, strategically selecting locations and facilities to store
product, inventory forecasting, and more.
iv) Inventory Control is the supervision of non-capitalized assets (inventory) and stock items
whereas Inventory Management is the strategy for balancing the amount of working capital
that is tied up in inventory with service-level goals across multiple stock-keeping units
(SKU’s). Inventory Management ensures that you always have the right quantity of the right
product at the right time and in the right location.

Similarities of Inventory Control and Inventory Management

Generally speaking, inventory control is one part of inventory management whose goal is to
maximize profits with minimum inventory investment, without impacting customer satisfaction
levels. Both inventory control and inventory management track and manage stock. Inventory
control is a part of the overall inventory management process and tracks daily trends for each
item. Inventory management follows broader trends over longer periods. Both practices use
mobile devices to for barcodes and radio frequency identification (RFID) scans for precise, real-
time updates. If a question is asked “Which Do You Take Care of First: Inventory Control or
Inventory Management?” Some experts believe that successful stock management starts with
good stock control. They suggest you begin by understanding which stock is in your warehouse
and its condition. Next, review strategic topics, such as warehouse location and layout, forecasts
and seasonality. Finally, adjust stock types, quantities and order cycles to meet changes in
demand, suppliers and events. According to other experts, the real profit comes once you
understand where your business is going from an inventory standpoint. To them, inventory
management must come before inventory control. This simply means that the inventory
management and inventory control are both systems and tools to manage stock. Both inventory
management and control may use a separate solution for each task but ideally, communicate and
interface with each other in terms of optimum stock maintenance.

COSTS ASSOCIATED WITH INVENTORY CONTROL

Cost is universal a concept that is usually attributed to the act of spending resources in order to
acquire something. The cost of something is the amount of money that is needed in order to buy,
do, or make it. Cost may be defined as the value of economic resources used in the production of
goods and services. In organizations, the maintenance of inventory is not without an associated
cost. These costs are usually prevalent and noticeable in either incremental or declining form.
The kind of costs experienced in a bid to maintain a particular level of inventory in organization
is generally regarded as Relevant Costs. They are considered as relevant costs because they play
an important role in the analysis of an inventory control system. In inventory control relevant
cost are classified four categories as follows:
i) Purchase Costs
ii) Inventory Carrying or Stock holding Costs
iii) Ordering or Set-up or Procurement Costs
iv) Stock-out or Shortage or Customer Service Costs

a) Purchase Costs:
Purchase cost is the total cost for the items acquired (purchased) including shipping, taxes,
overhead and other charges. It consists of actual price paid for the procurement of as current
assets delivered as inventories at their current position and value. Purchase cost may be
constant or vary with the quantity of purchase. If the purchase cost is constant, it does not
affect the inventory control decisions but if otherwise it varies as a result of discount, change
in order or other externalities the purchase cost influences the inventory control policies.
The purchase cost can be determined thus:
i) In a Deterministic Condition:
Purchase cost = (Price per unit) × (Demand per unit time)
PC = XD
where PC = Purchase cost, X = Price per unit and D = Demand per unit time.
ii) In a Probabilistic Condition:
This is a situation where the price break of fluctuate as a result of quantity discount as a
result of bulk purchase, customer loyalty or rebate.
The Purchase cost = Price per unit when order size or rebate is Q × Demand per unit time.
PC = XQ.D
where PC = Purchase cost, X = Price per unit, Q = Size of order and D = Demand per unit
time.

b) CARRYING OR INVENTORY HOLDING OR STOCK HOLDING COST:

These costs are also known as storage costs. It is the amount of money incurred or
accumulated over a period of time for the storage, security and maintenance of the stock in
the organization’s facilities or warehouse(s). The major reasons for holding or carrying stock
are as follows:
i) To ensure that sufficient goods are available to meet the anticipated demand.
ii) To absorb variations in demand and ensure steady production process.
iii) To provide buffer between production process.
iv) To take advantage of bulk purchasing discount.
v) To absorb seasonal fluctuation in usage and demand.
vi) To enable production process to run smoothly and efficiently.
The carrying cost or inventory holding costs naturally vary directly with the size of the inventory
as well as the time period the items are stored in the warehouse. Depending on the nature of the
inventory, the following costs are peculiar to the inventory control mechanism of carrying costs:
i) Cost of capital tied up in the form of bank interest on money borrowed for acquisition
of the inventory:
ii) Storage charges (rent, lighting, heating, refrigeration, air-conditioning, storage space
iii) Staff payment for personnel handling the inventory control equipment and running
cost of warehouse maintenance.
iv) Handling cost associated to documentation and movement of stock.
v) Auditing procedures, stock taking or perpetual inventory cost.
vi) Insurance, taxes, security and preventive maintenance charges
vii) Deterioration, depreciation and obsolesce costs.
viii) Pilferage, pest damage, loss or thief cost.
ix) Record keeping, administrative and inspection costs.
Carrying cost can be determined by three different ways:
i) Carrying Cost = (Cost of carrying one unit of an item in the inventory for a given
length of time usually one year) × (Average number of an item carried in the
inventory for a given length of time,
ii) Carrying Cost = (Cost of carrying one Naira worth of inventory for one year) ×
(Naira value of units carried).
iii) Expression of carrying cost either as percentage per unit time.(Example, 20% per
year) or in terms of monetary value per unit per unit time ( example,
₦5000/unit/year).

Example
Suppose the average stock during a year is valued at ₦200,000, and the inventory carrying
cost for the year is valued at 20% . How much should be paid by the management annually.
 Solution
Stock value = ₦20,000
% cost of carrying inventory = 20%
20
∴ Amount paid annual for carrying cost = 20000 × = ₦4,000
100

c) Ordering or Set-up or Procurement Costs

Ordering cost otherwise known as set-up cost or procurement cost is the charge incurred
when an order is placed for acquisition of stock that will be placed in the warehouse(s). It is a
fixed cost that is directly associated with placing an order or setting up machinery before
starting production. Specifically, when an item is produced in-house, the ordering cost is
referred as set-up cost, which includes both cost associated to paper work and any other
physical preparations. Ordering or setup cost is independent of the size of the order or
production rather it varies with the number of orders placed during a given period of time. In
inventory control system, increasing the order quantity reduces the setup cost associated with
a given demand but will in reverse increase the average inventory level and the cost of tied
capital. However, reducing the order size increases the frequency of ordering which increases
the associate setup cost. In finding a quantitative solution to inventory control, the actual
costs that is directly related to ordering costs are:
i) Transportation costs
ii) Administrative and clerical cost associated to the purchase of items.
iii) Tooling costs for items manufactured internally.
iv) Accounting and inventory receivable and related payment cost or charges.
v) Inspections and documentation costs related to batching, sorting and specified storing.
vi) Requisition cost of handling of invoices.
vii) Overhead cost of mailing, telephone calls,

Generally the ordering cost can be determined in the inventory control thus:
Ordering cost = (Cost per order or per set-up) × (Number of orders or set-ups placed in the
planning period)

d) Stock-out or Shortage or Customer Service Costs:

Stock-out otherwise known as shortage or customer service cost is a type of inventory control
and management costs associated with the lost opportunity caused by the exhaustion of the
inventory in the warehouse or store. It is a cost incurred when an organization run out of
stock. It may be viewed as the cost accruable to the organization as a result of lost income
and an unforeseen expense associated with a shortage of inventory. This type of cost is
unanticipated because the exhaustion of inventory could be a result of various factors. The
most notable amongst them is defective stock replenishment practices which lead to stock
out. A stock-out is a situation where an item that is regularly commercialized at a point of
sale or production and occupies a specific place on the shelves or store is not available to the
consumer or production chain at the moment of purchase or need for production. Stock-outs
could prove to be very costly for the companies. The subtle responses could be postponement
of purchase, disruption of production process or idling of the machines and manpower. The
 more disastrous ones are the lost sales, cancellation of order, consumer’s frustration which
may lead to switch of stores or even purchase of substitute items (brands). Another effect of
stock-out cost is noticeable in the loss of goodwill. Goodwill is considered an intangible asset
and it reflects the value of a company’s brand name, solid customer base, good customer
relations, good employee relations, and any patents or proprietary technology. The loss of
goodwill leads to revenue drop which is an associated cost to the organization.

Inventory stock-out cost can be measured by assessing the level of customer services or
production order achieved in relation to meeting up with product demand. Due stock-out is
an unpredictable and dynamic in nature, it can be estimated through the formula below:

Stock-out cost = (Cost of being short one unit) × (Average number of units short). However,
the average number (Av) of units short can be calculated thus:

{ Minimum shortage }+ {Maximum shortage }

Av no of units short ¿ × {Period of shortage}
2

INVENTORY MODEL
Inventory model is a systematic process that deals with the determination of the level of material
an organization must maintain to ensure a smooth all round operations in the organization.
Inventory model is the actual basis for decision making in the area of balancing the cost of
capital resulting from holding stock too much stock against the penalty cost emanating from
inventory shortage. The nature of inventory model is to a large extent determined by the nature
of demand affecting it. This is because demand for products or materials may be deterministic or
probabilistic. However, in real life scenario demand is usually probabilistic in nature. In the case
of modeling most deterministic demand are approximated to make it acceptable for decision
making process in an organization. The effect of approximation made the inventory model to be
a complex issue, as such made it impossible to develop an inventory model that are generalized
to cover all possible situation in inventory management and control problems. However, the
bottom line is that all inventory models seek three basic results to problems:
i) How much to order
ii) When to order (Produce or purchase)
iii) How much safety stock should be kept
i) How much to order: This is a pertinent question in drawing inventory model because it
requires a concise and well articulated answer. This query (How much to order) specifically
seeks to know and address issues associated to the order size, acquisition cost and other
logistics. This is to enable the inventory control policy to accommodate the related
consequences of order placement with regards to its impact on the carrying cost. Carrying cost
being the storage cost is a direct recipient of the level of order placed. Naturally large order
implies expectation of high inventories which translate to high cost of acquisition and carrying
cost. In inventory control and management order placement must be based on demand in both
production line and sales points to avoid over stocking which increases the carrying cost.
ii) When to order: This is a systematic method of balancing the period of ordering (either
externally or internally) and replenishment which is equated to the rate of demand. This
simply means a conscious obedience to the concept of lead time associated to each item. Lead
time may be defined as the time interval between the placement of an order for an item and its
 receipt as a stock in the warehouse. When to order regulates the reorder level which is the
level of stock at which a further replenishment order should be placed.
iii) How much safety stock should be kept: Safety stock is an extra quantity of a product which
is stored in the warehouse to prevent an out-of-stock situation. It serves as insurance against
fluctuations in demand. In organization’s inventory control policy, the demand characteristic
remains a parameter that cannot be easily quantified or tracked as a determinant factor for the
quantity of stock to be kept for eventuality or contingency. This is because organization
battle most at times with the cost of overstocking items in the mist of striving to avoid item’s
stock-out. Organizations may therefore, workup safety stock by relying on the demand
forecast generated through extrapolating the past demand history.

The basic formula for answering the above two question to a reasonable extent is by the careful
application of cost minimization inventory cost function otherwise known as total inventory cost:

Total Purchase Setup Holding Shortage

Inventory cost = +¿ +¿ +¿
Cost Cost Cost Cost

Alternatively, one can adopt computerized method in find solution to the total inventory cost as
against the stated manual method which is tedious, complex and time consuming. The utilization
of computer software like; Excel spreadsheet, Solver and AMPL model (AMPL/Excel/TORA
programs) makes the computation of inventory problems easier, faster, accurate, reliable and
dependable in decision making process.

However, finding solutions to inventory problem through the application of manual or

computerized process is still subject to the variations attributable to whether the demand for an
item is deterministic or probabilistic. Either way, the demand may or may not vary with time.
For example, an increase in the consumption of soft drinks and beer in the southern Nigeria is in
most cases a function of time of the year usually Christmas or festivity period. Also a noticeable
increase in the demand for potable water is function of time of the year usually during dry
season. A cursory look at the demand pattern may show variations attributable to time period
considerable but these variations can be approximated to an acceptable value in order to arrive at
an acceptable data for decision making.

Generally, the demand pattern in an inventory model may be classified into four types which are
dependent on the availability of data that represent the future demand. They are:
i) Deterministic and constant (static) demand pattern with time.
ii) Deterministic and variable (dynamic) demand pattern with time.
iii) Probabilistic and stationary demand pattern over time.
iv) Probabilistic and non-stationary demand pattern over time.
In real world application, the potency of an inventory model is based on the ability to strike a
balance between simple (deterministic) and complex (probabilistic) model. This because it will
not be ideal to apply a simplistic model that does not reflect reality, or a complex model that is
analytically problematic to proffer solution for a decision making challenges.
Therefore, the adoption of approximation of demand techniques remains paramount for
generating the values needed in determining the solution to inventory problems as stated below:
To determine the mean and standard deviation of consumption for a specific period say a month.

Standard deviation
The Coefficient of variation V = ×100.
mean

The assumptions guiding the application of the above formula are:

i) If the average monthly demand is “approximately” constant for all months and V is
reasonably small (< 20%), then the demand may be considered deterministic and
constant with its value equal to the average of all monthly demands
ii) If the average monthly demand varies appreciably among the different months but V
remains reasonably small, then the demand is considered deterministic but variable.
iii) If in the case of i) above V is high (> 20%) but approximately constant, then the
demand is probabilistic and stationary.
iv) When the mean and coefficient of variation vary appreciably over time then the
demand is probabilistic and non-stationary.
This assumptions justify to a large extent the main reason organizations maintain inventory.

Types of Inventory Control System

There are several types of inventory management systems that organizations use. The adoption
of a particular inventory control system depends on the nature of inventory and the
organization’s policy. However, the three major examples of inventory systems are:
i) Re-order level or Re-order Point inventory system.
ii) Periodic inventory system and
iii) Perpetual inventory system.
iv)
A. The re-order level or reorder point (ROP) inventory system: This is the minimum inventory or
stock level for a specific product that triggers the reordering of more inventories when reached. It is a
minimum amount of an item which a firm holds in stock, such that, when stock falls to this
amount, the item must be reordered. The under listed is the characteristics of a re-order level
inventory system.
i) A predetermined re-order level is set for each item in the system
ii) When the stock level falls to the re-order level, a replenishment order is issued
iii) The replenishment order is invariably the EOQ

Advantages of a Re-order Level System or Re-order Point System

i) This system is appropriate for organization dealing on widely differing types of
inventories.
ii) The system facilitates an automatic generation of a replenishment order at the
appropriate time by comparing the stock level against re-order level.
iii) This system is responsive to the effect of inflation on demand characteristics.
iv) It ensures a higher service level, either with external or internal customers.
v) It avoids delays or bottlenecks throughout the supply chain by getting items promptly.
vi) It reduces inventory cost by optimizing inventory space.
vii) It makes staff to save time by focusing on value-added activities.
Disadvantages of Using Re-order Level or Re-order Point System
i) It is not the appropriate tool for calculating the economic order quantity in a situation
of varying demand and ordering cost. The information generated will be inaccurate.
ii) It is not capable of handling multiple re-order level in a situation where many items in
the inventory reach re-order level at the same time.
iii) The items cannot be grouped and ordered at a time since the reorder points occur
irregularly.

A. Periodic Review Inventory Control System

This is otherwise called the constant cycle system. It is a classic inventory system where the
inventory level is reviewed at a regular time intervals (e.g., once a week), whereupon the
decision is made as to how much to order to bring the inventory level up to a given amount. The
characteristics of periodic review system are:
i) Stock level for all parts are reviewed at fixed interval
ii) The inventory replenishment order is issued where necessary.
iii) The quantity of replenishment order is not in line with the calculated EOQ
iv) The replenishment order quantity is what brings the stock to the predetermined level.
v) The periodic review tends to stimulate the order of variable quantities at fixed
intervals.

Advantages of Periodic Review inventory System

i) There is room for obtaining large quantity discount when a range of items are
ordered.
ii) The economies of scale are enjoyed in placing order by spreading the purchase order
equitably.
iii) The entire stock items are reviewed periodically to root out spoilage, damaged,
obsolete and non moving items.
iv) It leads to a proactive production planning and efficient production process.
v) It reduces cost of set-up and eliminates cost inherent in idle time of machine and
personnel.
vi) It promotes adequate production control.

Disadvantages of Periodic Review Inventory System

i) This system is better suited for small businesses with fewer goods or slow-moving
goods with less variety as such it may be difficult to apply in large inventory system.
ii) Since the update of the periodic inventory system can only happen after a specific
interval, tracking a fast-moving commodity could be hard.
iii) Unknown Stock Levels. When using lean manufacturing methods it is important to
know what is in stock at every point in the production process. ...

Continuous review systems

generally order the same quantity of items in each order. The order frequency varies in
continuous systems because the inventory is monitored and orders are placed when items
reach a particular level. With periodic review systems, products are ordered at the same time
each period.

COMPUTATION OF STOCK LEVELS

The terminologies below clearly explained the various stock levels which are inherent in
inventory control and management. The management of any organization must therefore use it a
yard-stick in determining the state of items in their store. In the computation of stock level, the
following criteria must be given due considerations:
i) The demand or consumption of the item (material, component, stock)
ii) The lead time
iii) The data reliability (dependability upon the generated data) and
iv) The economic order quantity or re-order quantity.

INVENTORY CONTROL TERMINOLOGY

These are basic terms associated to computation of time, items and costs involved in
organization’s inventory control and management.
i) Lead time or Procurement time: This is the period of time between placements of
an order internally or externally and the time of replenishment usually expressed in
days, weeks or months. The goods are certified as being procured only when they are
available for us.
ii) Demand: This is the quantity of goods required for production, units of item required
over a period of time. The size of demand may be deterministic or probabilistic.
Demand is expressed as a rate or size which determines the demand pattern.
iii) Economic Ordering Quantity (EOQ): Economic Order Quantity (EOQ), also
known as Economic Purchase Quantity (EPQ) or Economic Batch Quantity (EBQ) is
the order quantity that minimizes the total holding costs and ordering
costs in inventory management. It is also a calculated ordering quantity which
minimizes the balances of costs between inventory holding costs and re-orders costs.
iv) Physical Stock: This also called actual inventory. This is the number of items that are
actually present and available in a organization’s warehouse.
v) Free Stock: This is a stock that is paid for in full and is not pledged in any way as
collateral. Free stock is determined by adding physical stock to outstanding
replenishment order less unfulfilled requirements.
vi) Safety Stock: This is also called buffer stock or minimum stock. This is a
contingency stock kept as stock allowance to cover forecast errors in lead time,
demand level or demand time.
vii) Maximum Stock: This is the maximum stock level tagged as a not-to-exceed amount
used for inventory planning. This stock level is based on a calculation of the cost of
storage, standard order quantities, and the risk of inventory becoming obsolete or
spoiling with the passage of time. This stock level warn management about slow
moving stock, low demand of material, low material utilization which may lead to
over stocking.
viii) Minimum level: This is the lowest level of the stock that is established by
management. It is arrived at after considering the lead time and the demand for the
items. This is the red button at which management must take action to replenish stock
of fact the consequences of stock out problems. This level should not be ignored by
management but take decisive action to ensure replenishment.
 ix) Re-order level: This is that inventory level at which an entity should issue a purchase
order to replenish the amount on hand. When calculated correctly, the reorder level
should result in replenishment inventory arriving just as the existing inventory
quantity has declined to zero.
x) Re-order Quantity: This is the magnitude or the number of units to be ordered in a
new purchase order for the fresh supply of a particular inventory item. In some
inventory control system, this is the EOQ but in some other systems a different value
is used.

The Formulae for the Computation of different stock levels

The formulae for the computation of different stock levels in the inventory control systems are as
stated below:
i) Re-order Level = Maximum usage × Maximum Re-order Period.

ii) Minimum Stock Level = Re-order level +¿ (average usage × average re-order
period).

Note: a. Average lead time (re-order period) is usually given but where it is not
given, it is calculated as:
Maximum ℜ−order period+ Minimum ℜ−order period
2
b. Suppose, the averages re-order period is given and one of Maximum or minimum
re-order period is not given, you can work out the one given. For instance, if
maximum re-order period is given alongside the average re-order period then:
Maximum ℜ−order Period+ Minimum ℜ−order period
Average re-order period = (
2
∴ Minimum re-order period = 2(average re-order period) – (Maximum re-order
period)

iii) Maximum stock = Re-order +¿ Re-order – (Minimum usage × Minimum re-order

period
level level quantity

Minimum stock level+ Maximum stock level

iv) Average Stock level =
2

Example
Suppose Jinkpatta Investment, has draw the following data from his inventory control items
Normal (Average) usage 500 per day
Minimum usage 20 per day
Maximum usage 600 per day
Lead time 20- 25 days
EOQ (known) 1000.
From the above data determine the various control levels in the inventory controls.

Solution:
 i) The re-order level = Maximum usage × maximum lead time
= 600 unit × 25 days
= 15,000 units
ii) Minimum Level = Re-order level – Average usage × Average lead time
= 15,000 – (500 × 22.5)
= 15,000 – 11,250
= 3,750 units
iii) Maximum Level = Re-order level +¿ EOQ – Minimum usage in minimum lead time
= 15,000 +¿ 1000 – (20 × 20)
= 16,000 – 400
= 15,600 units.

Example
SOMINWA Global is a manufacturing industry that uses 100,000 units of raw material per
annum. The business operates for 400 days and the lead time is 5 to 10 days. The Economic
other quantity is 610 unit while the carrying cost for inventory per unit is ₦100 and the ordering
cost per unit is ₦40. The records of previous years indicated the under listed usage pattern of
materials in the industry:
Lead time usage: 700 750 600 680 720 800 500
Quantity used: 50 60 45 52 62 55 40
You are required to determine the various control levels.

Solution
i) First determine the average usage thus
Average usage Probability (Qt ÷ Expected value
No of days (Usage × Prob)

700 50÷ 400 = 0.125 87.5

750 60÷ 400 = 0.15 112.5

600 45÷ 400 = 0.1125 67.5

680 52÷ 400 = 0.13 88.4

720 62÷ 400 = 0.155 111.6

800 55÷ 400 = 0.1375 110

500 40÷ 400 = 0.1 50

 Average usage 627.5

ii) Find the other key variables:

a. Maximum usage = 800
b. Minimum usage = 500
c. Average usage = 627.5
d. Lead time = 5 – 10 days
e. Average lead time 7.5 days
iii) Find the solutions:
i) Re-order level = maximum usage × maximum lead time
= 800 × 10
= 8,000 units
ii) Minimum level = Re-order level – (Average usage × average lead time)
= 8,000 – (627.5 × 7.5)
= 8,000 – 4,706.25
= 3,293.75 units
iv) Maximum level = Re-order level +¿ EOQ – Minimum usage in minimum lead time
= 8,000 +¿ 610 – (500 × 5)
= 8,610 – 2,500
= 6,110 units.

Graphical Presentation of Computed different Stock levels

The figures computed for different stock levels can be presented graphically for easy inventory
control and management. An observation and interpretation of the graph exhibits the
relationships among various stock levels which sends a signal to the management for necessary
action.

Example:
In Jimkpata Construction Company recorded the following for the building material BM 101 for
the past six months.
Normal (average) usage = 300 units per day
Minimum usage = 240 units per day
Maximum usage = 360 units per day
Lead time (Re-order period):
= Maximum = 50 days
= Minimum = 40 days
Economic order quantity (EOQ) = 25,000 units

You are required to compute and present graphically the stock levels to enable the inventory
control of the building material BM101. Address specifically the following:
i) Re-order level.
ii) Minimum Stock level
iii) Maximum Stock level
 iv) Average stock level
v) Graphical Presentation of the above.

Solution:
Re-order level = Maximum usage × Maximum lead time
= 360 × 50
= 18.000 units
Minimum stock level = Re-order level – (Ave usage × Ave lead time)
50+40
= 18,000 – (300 × )
2
= 18,000 – (300 × 45)
= 18,000 – 13,500
= 4,500 units.

Maximum stock level = Re-order level +¿ EOQ – (minimum usage × minimum lead time)
= 18,000 +¿ 25,000 – (240 × 40)
= 43,000 – 9.600
= 33,400 units.

Minimum stock level+ Maximum stock level

Average stock level =
2
4,500+33,400
= 2
37900
= 2
= 18,950 units

Graphical Presentation
Units

33,400
Max level

18,000
Re-order
Level

4,500
Min level Safety Stock
Time Period
(weekly or monthly usage)
Fig X Graphical Presentation of Stock Levels
Economic Order Quantity
Economic order quantity is simply defined as the optimal replenishment order size (lot size) of
inventory item(s) that achieves the optimal total (or variable) inventory cost during the given
period of time. It is an order quantity that minimizes the total average inventory cost.

Brief History of Economic Order Quantity

The concept of economic order quantity was first developed by Ford W. Harris in 1913. The idea
behind the concept is that the management is confronted with a set of opposing costs like
ordering cost and inventory carrying costs. As the lot size ‘q’ increases, the carrying cost ‘C1’
also increases while the ordering cost ‘C3’ decreases and vice versa. Hence, Economic Ordering
Quantity (EOQ) is that size of order that minimizes the total annual (or desired time period) cost
of carrying inventory and cost of ordering under the assumed conditions of certainty and known
annual demand.

SYMBOLS USED IN DETERMININIG ECONOMIC ORDER QUANTITY

Q* = EOQ i.e the optimum number of units per order
Cp = Cost of an item purchased (₦ per unit)
C0 = Ordering cost (set up cost) per order (₦ per order)
Cc = Carrying cost per unit per annum = Cp × R = (₦ per item per unit of time)
R = Rate i.e cost of carrying on naira worth of inventory expressed in percentage per unit of time
D = Demand per annum
Cs = Stock out cost (shortage cost per unit per time)
Pr = Production rate per annum
Tc = Total cost i.e total inventory cost
t = Reorder cycle (time period)
n = number of order per unit of time
ROL = Reorder level
TVC = Total variable inventory cost

Determination of Economic Order Quantity

1. The Use of Trial and Error Method
The formulation of economic order quantity formulae can be done through the follow steps:
i) Select the number of possible lot sizes to purchase.
ii) Determine total cost for each lot size chosen.
iii) Calculate and select the order quantity that minimizes total cost.

The above steps are applied by first of all considering the Average inventory concept. This is
because the inventory carrying cost which is the cost of holding the inventory in the stock cannot
be calculated day to day as and when the inventory level goes on decreasing due to consumption
or increases due to replenishment. For example, let us say the rent for the warehouse is ₦50,000
and we have an inventory worth ₦1,000,000. Due to daily demand or periodical demand the
level may vary and it is practically difficult to calculate the rent depending on the level of
inventory of the day. Hence adoption average inventory concept to solve the possible ambiguity.
This means that at the beginning of the cycle the level of inventory is worth ₦1,000,000 and at
the end of the cycle, the level is zero. Hence we can take the average of this two i.e. (0 +
1,000,000) / 2 = 500,000. Let us take a simple example and see how this will work out.
FEFE industries use 50,000 units of materials for production at a unit price of ₦10. The ordering
cost is ₦150 per order and the carrying cost is 15% of the average inventory cost. Use the trial
and error method to determine the economic order quantity if the order quantities for the year is
1000, 2000, 3000, 4,000, 5,000 and 6,000.

I II III IV V VI
Order Quantity Av no Average Carrying Ordering Total Cost
of order Inventory Cost Cost ₦
p.a ₦ ₦
50000 Col . I Col.III × 1.5 Col.II × 150 Col.IV +¿ Col V
col . I 2
1000 50 500 750 7500 8250
2000 25 1000 1500 3750 5250
3000 17 1500 2250 2550 4800
4000 13 2000 3000 1950 4950
5000 10 2500 3750 1500 5250
6000 8 3000 4500 1200 5700
A cursory look at the last column indicates that the total cost goes on reducing and reaches the
minimum of ₦4800 and then it increases again. Also a look at the order quantity or lot size
shows that it goes on increasing with a corresponding increase in the carrying cost while the
ordering cost goes on decreasing. An observation reveals that the optimal order quantity of about
3200 units and optima number of orders is 17 units for the year. Also, the optimal order quantity
of 3200 units, both ordering cost and inventory costs are same (a point of intersect). Hence we
can say that the optimal order quantity occurs when ordering cost is equal to the inventory
carrying cost. The disadvantage of adopting the trial and error method lies on the fact that it is
difficult to get the data for the exact quantity which makes it difficult to determine the values
where the ordering cost and inventory carrying costs are equal. Hence it is better to go for
mathematical approach.

This above computation using trial and error can also be expressed mathematically and illustrate
by the graph below:

Costs

9000

8000

7000 Total cost

6000

Q
5000 Carrying cost = C
2 c
 4000

3000

2000 Total variable cost

D
1000 Ordering cost = C
Q 0

Order Size
1000 2000 3000 4000 5000 6000 7000 8000
EOQ

ECONOMIC ORDER QUANTITY ASSUMPTIONS

In order to apply the concept of economic order quantity in solving inventory management and
control problems, the following assumptions must be adhered to:
i) The inventory system should involve one type of item or product.
ii) The demand must be known, constant and resupplied or replenishment is
instantaneous.
iii) The carrying cost is known and constant.
iv) The ordering cost is known and constant.
v) The purchase price, reorder cost is known and constant.
vi) Stock out or shortages are not allowed.
vii) The lead time is constant and known.

THE ECONOMIC ORDER QUANTITY FORMULAE

1. When the order is external and order quantity is received instantaneously.
Inventory management and control is not an easy task but the use of economic order quantity
where the order is external and order quantity is received instantaneously is the simplest
inventory model. This because the model assumes that the demand is fixed, known and no
shortages are allowed which makes the stock-out cost to be infinite. The carrying cost (C c) is
assumed to be proportional to amount of inventory as well as the time (t o) the inventory is held.
Therefore, the inventory manager is tasked to critically determine the frequency of order
placement and the number of units to be ordered.
Suppose orders are placed at time intervals t at a uniform rate of goods R per unit time, then the
quantity q = Rt must be ordered. Since the time of stocking is small then the figure below
expresses the model.

Inventory
Level
a q q
 b c Time
t t t
T

Figure x representing the EOQ inventory model with uniform demand and infinite
Replenishment Rate

1 2 1
From the model above it will be observed that Rt. Dt = Rt = qt = Area of inventory triangle
2 2
abc.
1
From the model, the carrying cost or cost of holding inventory during a time t = CCRt 2
2
The ordering cost = CO
1
The total cost during time t = CCRt 2 + CO
2
1 C
Average total cost per unit time = Ct = CCRt + o
2 t
To find the value of t differentiate the above equation with respect to t.
δC (t) 1
δt 2
C
= CCRt −¿ o = 0 which gives t =
t √
2C o
Cc R
The average total cost C(t) is minimum for optimal time interval
t0 =
√ 2C o
Cc R
The optimal quantity q0 to be ordered during each order =
q0 = Rt0 =
√2C o.R
Cc
here the R =
q
t

The resulting minimum average cost per unit time =

1
Ct(q) = CCR
1
2 √
2C o
Cc R
1
+ CO C R
√
2C
= √ C C R + √2 √ C c C o R = √ 2C c C o R
√2 c o
∴ The minimum average cost per unit time (Ct) = √ 2C c C o R
However when the cost of item is included the above formulae changes to √ 2C c C o R + CR
Where C is the cost per unit of the item purchased.

Example
Ugomsinachukwu Enterprises supplies 24,000 units of a product per annum to her customers.
The demand for her product is known and the shortage cost is assumed to be infinite. The
carrying cost of the product is ₦20 per unit per month and the ordering cost is ₦400 per order.
You are required to determine the following:
i) The optimum lot size (q)
ii) The optimum scheduling period and
iii) The minimum average cost per unit time.

Solution
24,000
The supply rate R = = 2000 units/ month
12
Cc = ₦20 per unit per month
Co = ₦400 per order
Solving by using the values above:
i) q=
√ 2C o.R
Cc √
= 2 × 400 ×2000 = 282.84 ≅ 283 units
20

ii)

iii)
t0 =
√ 2C o
Cc R
2C C
√
= 2 × 400 = 0.14 month between orders
20 × 2000
(Ct) = √ c o R = √ 2× 20 ×12 ×400 ×(2000 ×12) = ₦67,882.25 per year.

Note that, the economic order quantity formulae can be arrived at through a derivation by using
variables as stated below:
Let D = annual demand of an item
Q = order quantity
Co = cost of ordering
Cc = carrying cost.

Q
The average stock =
2
Q
Total annual carrying cost or stock holding cost = Cc
2
D
Determination of number of orders per annum =
Q
D
Annual ordering cost = C
Q o
Q D
The total cost = carrying cost plus ordering cost = Cc +¿ Co
2 Q
However, to determine the EOQ which is the point where the total cost (Tc) is at a minimum, the
differentiation method is applied. Hence differentiate the total cost (Tc) with respect to Quantity
(Q).
dTc Cc DC o
= −¿ 2
dQ 2 Q
dTc Cc DC o
and when dQ = 0 costs are at a minimum i.e 0 = 2 −¿ 2
Q
DC o Cc
To find Q 2 =
Q 2
2DCo = Q2Cc
 DC o
Q2 =
Cc

∴ Q = EOQ =
√ 2 D .C o
Cc
this formulae means

√2 × Annula demand × ordering cost

carrying cost
This formulae is generally called Wilson or Harris lot size formulae or square root formulae.

Example:

2. EOQ where the items are manufactured internally and there is non-instantaneous
Replenishment.

Stock level

t1 and t2 are the period over

which replenishments are made

Time
t1 t2

Figure X Stock levels showing non-instantaneous Replenishment

The formulae for Economic order quantity with gradual replenishment is as stated below:
Demand D = R × t × number of batches. Where R = rate or cost of purchase and t = lead
time
D
D=R×t×
Q
Q
And t =
R
t(R−D)
The average stock = substituting for t
2
Q D
(R−D) Q(1− )
The average stock = R or R
2 2
D
Q(1− )Cc
Total annual stock holding cost = R
2

√
2D.Co
Therefore the EOQ with gradual replacement = D
C c (1− )
R
Example:
Emilichoma industries used 30,000 units of a manufacturing item per annum which cost ₦3,000
each unit. Suppose an internal replenishment rate amounted to 60,000 units per annum at an
ordering cost of ₦1,000 per order and the carrying costs are 20 percent of the purchase cost.
Determine the economic order quantity where gradual replenishment is allowed.

Solution:

√
2D.Co
Using the formulae EOQ with gradual replacement = D
C c (1− )
R
Where Demand D = 30,000 units
Ordering cost Co = ₦1,000
Carrying cost Cc = 20% of ₦3,000 = ₦600
Rate of replenishment R = 60,000
Substituting the values thus

√
2 ×30,000 × 1,000
EOQ with gradual replacement = 30,000
600(1− )
60,000
=
√
60,000,000
600 (1−0.5)
=
√
60,000,000
600(0.5)
= 200,000 units

3. EOQ where stock out are Permitted:

As earlier mentioned stock out is a situation that affects the well being of the organization
negatively. In most cases, stock out costs are difficult to quantify and it is to avoid the
cost associated to stock out that makes organizations to strive to maintain an optimum
stock level. However, if the values for the cost of stock out are known through normal
distribution and forecast, then it can be included in the data for the determination of
economic order quantity. The formulae for the economic order quantity where stock out
is permitted is as follows:

Stock level

x + in-stock zone

Q
_ Out of stock
y zone

To derive the EOQ with stock out formulae is as stated below:

 x
Let the proportion of time in the in-stock =
Q
y
The proportion of time in the out of stock =
Q
1
The average stock is therefore the minimum level.
2
1 x
The carrying cost in relation to in-stock zone = x Cc
2 Q
1 y
The stock-out cost in relation to stock out zone = y Cs
2 Q
DC o 1 x 1 y
Hence, the total cost = + x Cc + y Cs
Q 2 Q 2 Q
1 2 1 2
DC o x Cc (Q−x ) C s
Substituting for y in the equation above = + 2 + 2
Q
Q Q
This equation shows the total cost function. However to determine the minimum value we
differentiate in relation to zero thus:
∂ Tc x C c ( Q−x ) C c
= –
∂x Q Q

( )
1 2 1 2
∂ Tc −DC o x Cc Q (Q−x ) C c − (Q−x)
= −¿ 2 + 2 Cs
∂Q Q
2
2 2
Q Q
Relating to zero we have:
1
(x Cc – (Q – x) Cs) = 0
Q

Cs
∴ x=Q
C c +C s
1 1 −1 2 2
−¿ 2 (DCo + x 2Cc (Q −x ) Cs = 0
Q 2 2
2
2DC o x Cc
Q2 = + + x2
Cs Cs
2DC o C +C
Q2 = +x2 c s
Cs Cs
Cs
To substitute for x when it is = Q
C c +C s
2
2DC o Q Cs
Q2 = +
Cs Cc +C s

∴ Q2 1−( Cs
C c+C s) =
2DC o
Cs
 (
Q2 1−
Cc
C c+C s
= )
2DC o
Cs
2 D C o(C c+C s )
Q2 =
C c Cs

∴Q=
√2 D .C o
Cc
×
Cs √
C c+ C s

The above is the formulae for determining the EOQ where stock out are Permitted

Example
FOCUS Enterprises is a dealer on pharmaceutical products and the following data reflects the
position of a particular product in their inventory system.
Annual demand = 200,000 units
Ordering cost = ₦20 per unit per order
Purchase price = ₦40 per unit
Carrying cost = 20 percent of the inventory value per annum
Suppose a provision of 25 percent of the purchase price of the inventory is made available for the
stock-out cost. Determine the economic order quantity where stock-out is allowed.

Solution:
Let Annual demand be D = 200,000
Ordering cost be Co= ₦20 per order
Purchase cost be Pc = ₦40 per unit.
Carrying cost be Cc = 20% of ₦40 = ₦8 per unit per annum
Stock-out cost be Cs = 25% of ₦40 = ₦10 per unit per annum.
Using the EOQ formulae for stock-out allowance thus:

EOQ =
√ 2 D .C o
Cc
×
√
C c+ C s
Cs
=
√ 2 ×200,000 × 20 ×
8 √ 8+10
10
=

√ √
= 8,000,000 × 18 = √ 1,000,000 × √ 1.8
8 10

= 1000 × 1.3416 = 1,341. 64

∴ EOQ ≅ 1,342 units

4. Economic Order Quantity (EOQ) where Discount is obtainable

In the real world scenario, customer or producer obtain a given quantity materials or items in
order to enjoy some form of discount. In a case where quantity discount or price break are
offered for large order quantity, the price P of the product will depend upon order quantity. In
determining the economic order quantity, compare the various associated costs of each
succeeding discount point with the normal EOQ and select the value that represent the best
quantity to order. Therefore, the model P should be considered in determining the total cost. The
equation for determining the total cost Tc where a discount is allowed is as follows:
Tc = annual carrying cost + annual ordering cost + annual acquisition cost.
 i) For instantaneous delivery, the Total cost (Tc) is given by
Tc = ( ) ( )
Q
2
Cc +
Q
2
Co + (D)P
Where D = Demand
The EOQ formulae is

EOQ = q =
√
2 D .C o
Cc
which is the normal formulae.

ii) For gradual delivery, the total cost Tc is given by

Tc = ( )[(
Q P−d
2 p )] ( )
Cc +
D
Q
Co + (D)P

The EOQ =
√[( 2 D .C o
Co )] [ p
( p−R ) ]
Where P = unit per time period or production rate per unit time.
R = rate of demand per unit time.
Example
Moretillmore Enterprises purchases 5000 paints per year for use. Each order costs ₦700. The
inventory holding cost is 25% of the unit price. The supplier has provided the following price
list:
Order Quantity Price Per unit (P)
0 to 499 ₦500
500 to 649 ₦450
650 + ₦420
Assuming instantaneous delivery, find:
a. The optimal order quantity (EOQ)
b. The optimal total cost
c. The number of orders per year
d. Time between orders

Solution
Given that D = 5000, Co = 700 per unit and Cc = 0.25(P)

EOQ when P = (500) =

√2 D .C o
Cc
=
√
2 ×5000 × 700
0.25 × 500
=
√
7,000,000
125
= √ 56,000 = 236.64 units

EOQ when P = (450) =

√ 2 D .C o
Cc
=
√
2 ×5000 × 700
0.25 × 450
=
√
7,000,000
112.5
= √ 62,222.22 = 249.44 units

EOQ when P = (42.50) =

units
√
2 D .C o
Cc
=
√
2 ×5000 × 700
0.25 × 420.50
=
√
7,000,000
105.125
= √ 66,587.40 = 256.68

Examine the various EOQ obtained using:

Tc = ( ) ( )
Q
2
Cc +
Q
2
Co + (D)P
 Tc (500) = ( 236.64
2 )
(0.25 × 500) + (
236.64 )
5,000
700 + (5000)(500)
= (118.32)(125) + (21.129)(700) + (5000)(500)
= 14,790 + 14,790.4 + 2,500,000
= ₦2,529, 580.40
Tc(450) = ( )
500
2
(0.25 × 450) + (5,000
500 )
700 + (5000)(450)
= (250)(112.50) + (10)(700) + (5000)(450)
= 28,125 + 7000 + 2,250,000
= ₦2,285,125.0
Tc(650) = ( )
650
2
(0.25 × 420) + (5,000
650 )
700 + (5000)(420)
= (325)(105) + (7.6923)(700) + (5000)(420)
= 34125 + 5384.61 + 2,100,000
= ₦2,139,509.61
A look at the various total cost indicates that the lowest total cost is ₦2,139,509.61
corresponding to the unit price of ₦420. Therefore
a. The optimal order quantity (EOQ) = 650 units
b. Optimum total cost (Tc) = ₦2,139,509.61
D 5000
c. The number of order per year = = = 7.69 ≅ 8 units
EOQ 650
EOQ 650
d. The time between orders = = = 0.12 per year ≅ 44 days
D 5000

SAFETY STOCK IN INVENTORY CONTROL

Safety stock otherwise known as buffer stock or cushion stock may be defined as the stock
maintained in an organization that is aimed at absorbing the variability in both stock demand and
lead time. It is an extra inventory provisions made by an organization to carry extra stock in
order to guard against issues of stock-out. Safety stock may simply be viewed as the extra stock
in excess of the lead time demand that stand as a protection against possible stock out. Safety
stock is an inventory management and control strategy that organization adopted with caution
because of the following reasons:
a. To check mate the cost implication of carrying the inventory (carrying cost).
b. To avoid the issue of over stocking, wastes and losses.
c. Safety stock is assessed to minimize the cost of stock out and other related costs.
d. To reduce the occurrence of disservice, idle time and loss of goodwill.

DETERMINATION OF SAFETY STOCK

The value of safety stock is judiciously determined by balancing the stock holding cost with the
stock out cost. The amount of safety stock is the level where the total costs associated with safety
stock are at a minimum. The value of safety stock is considered optimum at a level where the
safety stock holding cost plus the stock out cost is lowest. Hence, the simple method for
determining the safety stock is the application of estimation method thus:
Estimate the maximum lead time and the normal lead time for the inventory requirement. Hence,
Safety stock = (maximum lead time demand – normal (average) lead time demand ) × average
demand.
Example
Fechukwu Enterprises recorded an average consumption 4000 units of a production material and
the average lead time for the material is two months. Suppose the maximum material is observed
to be 4500 units per month and the maximum lead time is three months. Determine the safety
stock for the material.

Solution
Using the Cost estimation method thus
The optimum safety stock = (maximum lead time demand – normal or average lead time
demand) × average demand.
Where maximum consumption (demand) = 4,500 unit
Maximum lead time = 3 months
Average consumption (demand) = 4,000
Average (normal) lead time = 2 months
Therefore safety stock = 3 × 4,500 – 2 × 4,000 = 13,500 – 8,000 = 5,500 units.

Determination of safety stock using Cost Tabulation method

Example:
Chukwuebuka Fortune Construction Company used a raw material which costs ₦1000 per unit
and the average demand for the material per annum is 2,000. Suppose the EOQ of the material
has been computed to be 400 units, the carrying cost is pegged at 20% per annum and the stock
out cost is estimated to be ₦500 per item that are unavailable. If the demand and lead time vary
accordingly while the records shows that the usage over the 40 lead-times are as stated below:
(i) (ii) (iii)
Usage in lead number of times Probability
time recorded ii/ 40
15 - 19 3 0.08
20 - 24 9 0.23
25 - 29 7 0.18
30 - 34 5 0.13
35 - 39 6 0.15
40 - 44 4 0.10
45 - 49 6 0.15
40 1:00

Required: Determine the safety stock using the above information from the records of
Chukwuebuka Fortune Construction Company.

Solution:
From the information given the solution will be provided through the following steps.
Step 1. Use the midpoint of each group of the usage to determine the average usage.

x t tx
17 3 51
22 9 198
 27 7 189
32 5 160
37 6 222
42 4 168
47 6 282
40 1,270
1,270
The average usage = = 31.75
40
Step 2. Determine the carrying cost and stock out cost using various re-order levels.
A B C D E F G H
Re-order Safety Stock Carrying Possible Prob No of Shortage Total
Levels cost shortage orders cost cost

(A -31.75)
(Mid-point)
(B × ₦200) (x – A) Given ( )
2000
400
(D ×
₦500
E × F ×
(C + G)
35 3.25 650 2 0.15 5 750
7 0.10 5 1,750
12 0.15 5 4,500 7,650
40 8.25 1,650 2 0.10 5 500
7 0.15 5 2,625 4,800
45 13.25 2,650 2 0.15 5 750 4,400
The computation from the above table indicated that the optimum re-order level is 45 units
which permit a safety stock of 13.25 which is 13 units approx with an average demand lead time
of 31.75.

Example
In Chukwudi Kpom Kwem Enterprises, the records reveal the following distribution for lead
time and daily demand during lead time.
Lead time distribution
Lead time (days): 0 1 2 3 4 5 6 7 8 9 10
Frequency :0 0 1 2 3 4 4 3 2 2 1

Demand rate distribution

Demand/day (units): 0 1 2 3 4 5 6 7
Frequency : 3 5 4 5 2 3 2 1
You are required to determine the Safety stock using the above information.

Solution
Step 1. Compute in a tabular form in order to determine the average lead time
A B Col(A) × Col (B)
Lead time Frequency
1 0 0
2 1 2
3 2 6
4 3 12
5 4 20
6 4 24
 7 3 21
8 2 16
9 2 18
10 1 10
22 129
129
Average lead time = = 5.86
22
Step 2. Compute in a tabular form in order to determine the average demand rate.
A B Col(A) × Col (B)
Demand Frequency
0 3 0
1 5 5
2 4 8
3 5 15
4 2 8
5 3 15
6 2 12
7 1 7
25 70
70
Average demand rate = = 2.8
25
∴ Average lead time demand = 5.56 × 2.8 = 16.4 units
Maximum lead time demand = maximum lead time × maximum demand rate
= 10 × 7 = 70 units
Hence the safety stock = maximum lead time – average lead time demand
= 70 – 16.4 = 53.6 ≅ 54 units.