Summer Class | Management Science

INTEGER PROGRAMMING
Real Life Application:
Formulation and Solution Techniques for Integer Programming Problems  Airline Crew Scheduling
 Facility Location
Integer Programming (IP) is a type of mathematical optimization or operations research where some  Sudoku Puzzle
or all of the variables are restricted to be integers. It is a special case of linear programming (LP),
where the solutions are not just real numbers but integers. In summary, Branch and Bound systematically navigates complex integer programming problems,
ensuring optimal solutions are found efficiently through a structured approach of branching, bound -
ing, and systematic search. Its goal is to find the optimal solution while minimizing the number of
Components
subproblems explored.
1. Decision Variables: These are the variables that will be determined by solving the IP problem. Solving the Integer Programming Model:
In IP, these values are required to take integer values.
Step-by-Step Approach Using Branch and Bound Method:
For example, if we’re planning production levels, our decision variables could be the number of
 Initialization: Start with no projects selected, initial benefit = 0 Budget = 100,000
units of each product to produce.
 Branching: The decision tree starts by exploring whether each project should be included or ex-
cluded
Let's denote:
 Branch 1 (Project A, B, C)
x as the number of units of product 1,
(ABC) Cost 20,000 + 50,000 + 40,000 = 110,000 exceeds budget
y as the number of units of product 2
(ABC) Benefits 50 + 60 + 80 = 190
 Branch 2 (Project C, D, E)
2. Objective Function: This is the function that needs to be maximized or minimized. It is a linear
(CDE) Cost 40,000 + 30,000 + 10,000 = 80,000
function of the decision variables.
(CDE) Benefits 80 + 70 + 30 = 180
 Branch 3 (Project A, B, E)
For example, if our goal is to maximize profit, our objective function might look like this:
(ABE) Cost 20,000 + 50,000 + 10,000 = 80,000
(ABE) Benefits 50 + 60 + 30 = 140
Maximize z = 40x + 30y
Therefore, Branch 2 is the combination of Project A, Project B, and Project E provides the maximum
3. Constraints: These are the restrictions or limitations on the decision variables. They are ex-
benefit of 180 within the $100,000 budget. This selection ensures that the organization gets the high-
pressed as linear inequalities or equalities.
est possible benefit without exceeding the budget constraint.
For example, if there are limitations on production time, the constraints might be:
Application Integer Programming to Project Selection
2x + y ≤ 100 (hours in manufacturing),
x + 2y ≤ 80 (hours in packaging), Overview
x ≥ 0, y ≥ 0. (non-negativity).
Integer Programming (IP) helps in deciding which projects to undertake from a list of potential
Types of Integer Programming projects, considering constraints like budget, resources, and interdependencies. The goal is to maxi-
mize the overall benefit or minimize the cost.
1. Pure Integer Programming: All decision variables are required to be integers.
Scenario: An organization needs to select a set of projects to undertake from a list, given a limited
2. Mixed-Integer Programming (MIP): Only some of the decision variables are required to be
budget and the goal of maximizing the overall benefit. Each project has an associated cost and ex -
integers, while others can be non-integer.
pected benefit. The organization must decide which projects to fund, considering budget constraints.
3. Binary Integer Programming: The decision variables are restricted to be binary (0 or 1).
Given Data:
Example of an Integer Programming Problem Statement:
 Total Budget: 100,000
A company manufactures two products, P1 and P2. Each product requires different amounts of time
Projects:
in manufacturing and packaging departments. The company wants to maximize its profit while con -
sidering the constraints on the available time in each department.  Project A: Cost = 20,000, Benefit = 50 points
 Project B: Cost = 50,000, Benefit = 60 points
Pure Integer Programming  Project C: Cost = 40,000, Benefit = 80 points
 Project D: Cost = 30,000, Benefit = 70 points
A jewelry shop in the city specializes in ornaments and the manager has planned to limit the use of  Project E: Cost = 10,000, Benefit = 30 points
diamonds in the artistic configuration of diamond rings, diamond earrings, and diamond necklaces.
The three items require the following specifications: Application Integer Programming to Scheduling

Diamond Integer programming is a mathematical optimization technique where some or all of the decision
Ornament
½ Carat ¼ Carat variables are required to be integers commonly used when the decision variables represent discrete
Ring 4 6 choices, such as yes/no decisions, assignments, or counts of items. It is widely used in scheduling
Earring (Pair) 3 5 problems to ensure optimal allocation of resources and time.
Necklace 10 9
Availability 150 160
The Process of Formulating an Integer Linear Programming Problem
The jeweler does not want to configure the diamond into more than 50 items. The per unit profit for
1. Identify the decision variables
the rings is Rs. 1500, for earrings is Rs. 2400, and for necklace is Rs. 3600. Formulate the problem as
Decision Variables: The decision variables are the variables that will decide my output.
an ILP model for maximizing the profit.
2. Write the objective function
 Decision Variables: Let x1 = Number of diamond rings, x2 = Number of pair of earrings, x3 =
Objective function: It is defined as the objective of making decisions.
Number of necklaces
3. Mention the constraints
 Objective Function: Maximize Z = 1500x1 + 2400x2 + 3600x3
Constraints: Equations or inequalities that represent the limitations and requirements of the
Subject to: 4x1 + 3x2 + 10x3 ≤ 150 (½ Carat Diamond)
problem.
6x1 + 5x2 + 9x3 ≤ 160 (¼ Carat Diamond)
x1 + x2 + x3 ≤ 50 (Total Number of Items)
4. Explicitly state the non-negativity restriction
With x1, x2, x3 ≥ 0; x1, x2, x3 are integers
Non-negativity Restriction: For all linear programs, the decision variables should always take
non-negative values.
Branch and Bound Method
Work- Scheduling Problem: Characteristic
Branch and Bound (B&B) is a powerful method for solving Integer Programming problems by sys-
tematically exploring and pruning the solution space to ensure optimal solutions are found efficiently
A decision maker wants to satisfy work requirements with minimum cost.
even in complex combinatorial environments.
Example: Post Office Problem
Here’s a concise breakdown of its key steps and advantages:
1. Problem Formulation: Define the integer programming problem with an objective function and
A post office requires different numbers of full-time employees on different days of the week. The
linear constraints.
number of full-time employees required on each day is given in Table 4. Union rule sates that each
2. Relaxation to LP: Relaxing integer constraints in an IP problem to solve a simpler LP problem
full-time employee must work five consecutive days and then receive two days off. For example, an
provides bounds on the optimal objective value and initial feasible solutions for further algo-
employee who works Monday to Friday must be off at Saturday and Sunday. The post office wants to
rithm exploration.
meet its daily requirements using only full-time employees. Formulate the LP that the post office can
3. Branching: Divide the problem into smaller subproblems.
use to minimize the number of full-time employees who must be hired.
4. Bounding: Calculate bounds for each subproblem to determine if further exploration is needed.
5. Searching: Recursively explore subproblems, pruning branches where lower bounds exceed
Table 4
current feasible solutions. Requirements for Post Office
6. Pruning: Discard subproblems that cannot yield better solutions than the current best. Day Number of Full-time Employees Required
1 = Monday 17
Advantages: 2 = Tuesday 13
 Optimality: Guarantees globally optimal solutions. 3 = Wednesday 15
 Efficiency: Handles large solution spaces by pruning unpromising branches. 4 = Thursday 19
 Flexibility: Incorporates various techniques for enhanced performance. 5 = Friday 14
Summer Class | Management Science
6 = Saturday 16
7 = Sunday 11 Project Resource Required Profitt
P1 2 $10
A Wrong Formulation P2 3 $15
P3 4 $20
Minimize z = x1 + x2 + x3 + x4 + x5 + x6 + x7
s.t. x1 ≥ 17 Integer Programming Formulation
x2 ≥ 13
x3 ≥ 15 Decision Variables
x4 ≥ 19
x5 ≥ 14
Let xi be a binary decision variable that indicates whether project i is selected (1) or not (0):
x6 ≥ 16
x7 ≥ 11
xi ≥ 0 I = 1, 2, …, 7)  x1: 1 if the project is selected, 0 otherwise.
Illustration: A Wrong Definition of X  x2: 1 if the project is selected, 0 otherwise.
 x3: 1 if the project is selected, 0 otherwise.
MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY SATURDAY SUNDAY

Objective Function

Maximize the total profit:

Maximize 10x1 + 15x2 + 20x3
x1 = 2 x2 = 3 x3 = 4 x4 = 4 x5 = 4 x6 = 2 x7 = 1
Constraints
x1 = number of employees working on day 1
1. Resource Constraint: The total resources used by the selected projects should not exceed the
Although you only have 4 employees, the sum = 20
available resource (7):
Illustration: A Correct Definition of X
2x1 + 3x2 +4x3 ≤ 7
MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY SATURDAY SUNDAY
2. Binary Constraints: Each project can either be selected or not:

x1, x2, x3 ϵ {0, 1}

x1 = 2 x2 = 1 x3 = 1 x4 = 0 x5 = 0 x6 = 0 x7 = 0 Integer Programming Model

x1 = number of employees working on day 1 Putting it all together, we have the following integer programming model:
Now, you have 4 employees and the sum equals = 4
Maximize 10x1 + 15x2 + 20x3
Decision Variables and Objective Functions Subject to 2x1 + 3x2 + 4x3 ≤ 7
 Decision Variables x1, x2, x3 ϵ {0, 1}
xi = number of employees beginning work on day i
Solution Interpretation
 Objective Functions
Minimize = x1 + x2 + … x6 + x7 Assuming we solved this problem using an integer programming solver, let’s say we get the follow-
ing solution:
Constraints
 x1 = 1
s.t. x1 + x4 + x5 + x6 + x7 ≥ 17 (Monday Constraint)
 x2 = 1
x1 + x2 + x5 + x6 + x7 ≥ 13 (Tuesday Constraint)
 x3 = 0
x1 + x2
x3 + + x6 + x7 ≥ 15 (Wednesday Constraint)
+ x1 + x2
x3 + x4 + x7 ≥ 19 (Thursday Constraint)
+ x1 + x2
x3 + x4 + x5 ≥ 14 (Friday Constrain) This means that the optimal solution is to select projects P1 and P2, which uses 2 + 3 = 5 resources
+ x2
x3 + x4 + x5 + x6 ≥ 16 (Saturday Constraint) and provides a total profit of 10 + 15 = 25.
x3 + x4 + x5 + x6 + x7 ≥ 11 (Sunday Constraint)

Formulation: Post Office Problem Conclusion

Minimize z = x1 + x2 + x3 + x4 + x5 + x6 + x7 Integer programming provides a powerful tool for tackling scheduling problems in management sci-
s.t. x1 + x4 + x5 + x6 + x7 ≥ 17 (Monday Constraint) ence. By formulating the scheduling as a linear programming problem, we are able to determine the
x1 + x2 + x5 + x6 + x7 ≥ 13 (Tuesday Constraint) best possible outcome for many constraints such as the number of resources, the number of shifts,
x1 + x2 + x3 + x6 + x7 ≥ 15 (Wednesday Constraint)
week-off for each resource, allocating resources based on budget or workload and so on.
x1 + x2 + x3 + x4 + x7 ≥ 19 (Thursday Constraint)
x1 + x2 + x3 + x4 + x5 ≥ 14 (Friday Constrain)
DECISION ANALYSIS
x2 + x3 + x4 + x5 + x6 ≥ 16 (Saturday Constraint)
x3 + x4 + x5 + x6 + x7 ≥ 11 (Sunday Constraint)
xi ≥ 0 (i = 1, 2, …, 7) (Sign Constraint) Decision Making

Application Integer Programming to Allocation It is the process of making choices by identifying a decision, gathering information, and assessing al-
ternative resolutions.
Resources Allocation is a fundamental application of Integer Programming (IP) that involves assign-
ing resources to tasks, activities, or projects in a way that optimizes a specific objective function. (In  Decision analysis is a systematic, quantitative, and visual approach to addressing and evaluating
other words, allocation problems aim to distribute resources efficiently among different entities to the important choices that businesses sometimes face
meet specific requirements or goals.)  Identifying and assessing all aspects of a decision, and taking actions based on the decision that
produces the most favorable outcome.
1. Resource Optimization: Integer programming allows businesses to optimize the allocation of  Involves using analytical tools to make a decision that results in the best possible outcome for
limited resources, such as manpower, budget, or inventory. By formulating the problem as an in- you, the decision-maker.
teger programming model, decision-makers can determine the most efficient distribution of re-
sources to maximize productivity and minimize costs. Decision Making Under Uncertainty

2. Constraints and Objectives: Integer programming takes into account both constraints and ob- Decision-Making Approaches:
jectives in resource allocation. Constraints can include factors like capacity limitations, budget 1. Maximax Approach (Optimistic)
constraints, or regulatory requirements. Objectives may involve maximizing profit, minimizing 2. Maximin Approach (Conservative or Pessimistic)
waste, or achieving a specific performance metric. By incorporating these factors into the model, 3. Minimax Regret Approach
businesses can make informed decisions that align with their goals. 4. Laplace Approach (Equally Likely)
5. Hurwicz Approach (Realism)
3. Decision Variables: Integer programming involves defining decision variables that represent the
allocation of resources. These variables are typically binary (0 or 1), indicating whether a re-
Payoff Table/Decision Table
source is allocated or not. By assigning appropriate values to these variables, businesses can de-
termine the optimal allocation strategy.
The Bini Company must make a decision in the midst of uncertainty. They are struggling to choose
By incorporating these perspectives and insights, integer programming in resource allocation pro- between bonds, stocks, and mutual funds as investments. They take into account the growing, stable,
vides businesses with a powerful tool to optimize their decision-making processes and achieve effi- or declining as economic conditions.
cient resource utilization.
Let A1 = Bonds Decision Alterna- States of Nature
A2 = Stocks tives S1 S2 S3
Resource Allocation Problem A3 = Mutual Funds
A1 30 15 65
S1 = Growing
S2 = Stable A2 75 20 35
Statement A3 25 45 50
S3 = Declining

A company has 3 projects (P1, P2, P3) to which it can allocate a limited number of resources. Each
Maximax Approach (Optimistic)
project requires a certain number of resources and provides a certain profit. The company has 7 re -
sources available. The goal is to maximize the total profit while ensuring that the resource allocation
constraints are satisfied.  Maximizes the maximum profit
Summer Class | Management Science
 The decision maker wants to achieve the largest possible profit  Specific
 Measurable
Procedure:  Achievable
1. Locate the maximum payoff value.  Relevant
2. From among the maximums, choose the highest value.  Time-Bound
3. The decision alternative corresponding to the highest value will be the decision.  3 Different Dimensions
 Technical Decision Criteria
States of Nature  Economic Decision Criteria
Decision Alternatives
Growing Stable Declining  Relationship Decision Criteria
Bonds 30 15 65
Stocks 75 20 35 Decision Trees
Mutual Funds 25 45 50
 Mathematical models used to weigh out decisions based on the probability, expected value, and
1. Maximum payoff values corresponding to Bonds = 65
net gain.
Maximum payoff values corresponding to Stocks = 75
 The 4 Step Approach to Decision Trees
Maximum payoff values corresponding to Mutual Funds = 50
 Identify the Options
2. From among the maximum payoff of the alternatives, choose the highest value maximum payoff
 Add Possible Outcomes
value among the three which is 75
 Add Associated Costs, Outcome Probabilities and Financial Results
3. The alternative corresponding to the highest value 75 is Stock, will be the decision.
 Calculate the Expected Values and Net Gains

Maximin Approach (Pessimistic)

Highest Pay ₱80,000

 Maximizes the minimum payoff
 The decision maker attempts to maximize the minimum profit P = 0.4
Firm A
Procedure:
Cost = ₱15,000 Lowest Pay ₱40,000
1. Locate the minimum payoff values.
2. From among the minimums, choose the maximum. P = 0.6
3. The decision alternative corresponding to the highest value will be the decision.
Accounting Highest Pay ₱70,000
States of Nature Firm Firm C
Decision Alternatives
Growing Stable Declining P = 0.3
Bonds 30 15 65 Cost = ₱12,000
Stocks 75 20 35
Mutual Funds 25 45 50 Lowest Pay ₱50,000

P = 0.7
1. Minimum payoff values corresponding to Bonds = 15
Minimum payoff values corresponding to Stocks = 20 To do nothing
Minimum payoff values corresponding to Mutual Funds = 25
2. From among the minimum payoff of the alternatives, choose the highest value minimum payoff
value among the three which is 25
FIRM A FIRM C
3. The alternative corresponding to the highest value 25 is Mutual Funds, will be the decision.
Cost of Option ₱15,000 ₱12,000
Probability of Highest Pay 0.4 0.3
Minimax Regret Approach Probability of Lowest Pay 0.6 0.7
Result of Highest Pay ₱80,000 ₱70,000
 Minimizes the minimum regrets Result of Lowest Pay ₱40,000 ₱50,000
 The decision maker chooses the alternative with the minimum of all maximum regrets across all Expected Value Success ₱32,000 ₱21,000
alternatives. Expected Valur Failure ₱24,000 ₱35,000
 Regret = Opportunity Cost Net Gain ₱41,000 ₱44,000
 Regret = Best payoff - Payoff received Expected Value = Financial Result * Probability
Net Gain = Sum of all Expected Value per outcome - Costs

Procedure:
1. Convert conditional profit matrix to regret matrix. Expected Value
2. Find the maximum values corresponding to each act.
3. From among the averages, choose the minimum value.  Describes the long-term average level of a random variable based on its probability distribution.
4. The alternative corresponding to the minimum value will be the decision.  EV of a stock or other investment is an important consideration and is used in scenario analyses.
 Modern portfolio theory uses EV in conjunction with an investment's risk (standard deviation) to
Regret Table/Opportunity Cost Table come up with optimized portfolios.
 EV can help investors size up whether an investment's risk is worth the potential reward.
States of Nature  Expected value refers to the anticipated value of an asset in the future. The EV of a random vari -
Decision Alternatives able gives a measure of the center of the distribution of the variable. The EV is essentially the
Growing Stable Declining
Bonds 45 30 0 long-term average value of the variable.
Stocks 0 25 30
Mutual Funds 50 0 15 Example Problem:

Laplace Approach (Equally Likely) A company plans to invest in a particular construction project. There is a 35% chance that it will lose
$30,000, a 40% chance that it will break even, and a 25% chance that it will make a profit of $55,000.
 Maximizes the average payoff How much can the company expect to make or lose on this project?
 Average Payoff = (P1 + P2 + P3) ÷ 3
Solution:
Procedure:
Outcome (Amount of Profit or Loss) Probability
1. Find the average payoff values corresponding to each alternative.
-$30,000 35% = 0.35
2. From among the averages, choose the maximum value.
$0 40% = .040
3. The decision alternative corresponding to the maximum value will be the decision.
$55,000 25% = 0.25
EV = ΣP(Xi) × Xi
1. Average payoff values corresponding to Bonds = 36.67
Average payoff values corresponding to Stocks = 43.33 EV = −$30,000(0.35) + $0(0.40) + $55,000(0.25) = $3,250
Average payoff values corresponding to Mutual Funds = 40
2. From among the average payoff of the alternatives, choose the maximum value minimum payoff
Sensitivity Analysis
value among the three which is 43.33
3. The alternative corresponding to the highest value 43.33 is Stocks, will be the decision.
 In decision making under uncertainty, sensitivity analysis helps assess how variations in input
parameters impact the outcomes of a model or decision. It identifies which factors have the most
Hurwicz Approach (Realism)
significant influence and provides insights for robust decision-making.
 Sensitivity analysis is a crucial component of decision making under uncertainty. It helps us un-
 Finds a compromise between the best and the worst payoff.
derstand how sensitive our decisions are to changes in input parameters or assumptions.
 The decision maker chooses the alternative with the best weighted average payoff based on the
coefficient of realism α, 0 ≤ α ≤ 1.
Risk Assessment
 For each decision alternative, the approach is to multiply the best payoff.
 Weighted outcome = α (best payoff) + (1-α) (worst payoff)
 Risk assessment is a crucial component of decision analysis. It helps identify, analyze, and prior-
 α close to 1 = optimism
itize potential risks associated with a decision. By systematically evaluating these risks, deci-
 α close to 0 = pessimism
sion-makers can make more informed choices that consider both the potential benefits and draw-
backs of different courses of action.
Decision Criteria  To this day, these ideas are still considered the building blocks of businesses, risk analysis or as -
sessment is a proven way of identifying and assessing factors that could hinder nor negatively
 Set of guidelines or requirements essential for decision-making. affect the success of a business or project.
 Good decision criteria: S.M.A.R.T.
Summer Class | Management Science
 Applying this knowledge will help the decision makers in the company/business make rational
decisions given any situations.

Identify choices

Request a risk Identify prefer- Start scoping the risk

assessment
assessment ences

Identify infor-
mation

INVENTORY MANAGEMENT

Inventory management is an approach for keeping track of the flow of inventory. It starts right from Inventory Management Process: Five Key Stages
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. The process can be carried out The inventory management process involves tracking and controlling stock as it moves from your
manually or by using an automated system. suppliers to your warehouse to your customers. There are five main stages to follow:

 Inventory management is a systematic approach to sourcing, storing, and selling inventory — 1. Purchasing: This can mean buying raw materials to turn into products, or buying products to
both raw materials (components) and finished goods (products). sell on with no assembly required.
2. Production: Making your finished product from its constituent parts. Not every company will
 In business terms, inventory management means the right stock, at the right levels, in the right get involved in manufacturing — wholesalers, for instance, might skip this step entirely.
place, at the right time, and at the right cost as well as price. 3. Holding stock: Storing your raw materials before they’re manufactured (if required), and your
finished goods before they’re sold.
 Inventory management is how you track and control your business’ inventory as it is bought, 4. Sales: Getting your stock into customers’ hands, and taking payment.
manufactured, stored, and used. It governs the entire flow of goods — from purchasing right 5. Reporting: Businesses need to know how much it is selling, and how much money it makes on
through to sale — ensuring that you always have the right quantities of the right item in the right each sale.
location at the right time.
Objectives of Inventory Management
Inventory
 Preventing Dead Stock or Perishability
Inventory is defined as a stock of items kept on hand by an organization to use to meet customer de- With an optimal inventory level, the chances of wastage in the form of goods spoilage or dead
mand. It means the goods that your company handles with the intention of selling. It might be raw stock.
materials that you buy and turn into something entirely new, or it might be a bulk product that you
break down into its constituent parts and sell separately.  Optimizing Storage Cost
It reduces the chances of maintaining excessive stock, even if the requirements are predeter -
MAINTENANCE/REPAIR/
RAW MATERIAL WORK-IN PROCESS OPERATING SUPPLIES
FINISHED GOODS mined, which ultimately cuts down on the unnecessary warehousing costs.

 Maintaining Sufficient Stock

Having proper inventory management, the shortage of raw material or goods will be avoided be-
cause of its constant supply.

 Reducing the Inventories’ Cost Value

When there is a constant purchase of goods or stock, the organization can ask for discounts and
other benefits to decrease the purchase price.
Roles of Inventory
 Enhancing Cash Flow
Inventory has a significant impact on the cash flow of the company. With effective inventory
Anticipation Stock
management, the organization can ensure sufficient liquid cash to enhance its operational effi -
 Stock built in anticipation of demand or price change
ciency. (It’s talking about maximization of profit).
 Production capacity cannot meet demand at the time that occurs
Inventory Models
Cycle Stock
 Stock created due to cyclic nature of replenishment
Inventory models are mathematical frameworks used by businesses to determine the optimal quantity
 Exists due to economies of scale in replenishment (e.g., a fixed cost in placing an order)
and timing for stock reordering to minimize costs and meet demand. They aid in balancing ordering,
 When we reduce time between orders, cycle stock goes down
holding, and stockout costs to achieve efficient inventory management.
Safety Stock
Classifications of Inventory Models
 A level of extra stock that is maintained to mitigate risk of stockouts caused by uncertainties in
supply and demand.
Deterministic Model
 Permit business operations to proceed according to their plans
A deterministic model is a method based on the assumption that all parameters and variables associ -
Demand
ated with an inventory stock are known and that there is no uncertainty associated with demand and
replenishment of inventory stock.
Inventory exists for the purpose of meeting the demand of customers.
Examples of deterministic models:
 Dependent demand items are used internally to produce a final product.  Basic economic order quantity model (EOQ model)
 Independent demand items are final products demanded by an external customer.  EOQ model with backorders allowed (with planned shortages)
 Economic production lot size model
Inventory Cost  EOQ model with quantity discounts

 Carrying costs are the costs of holding items in storage. Economic Order Quantity Models
 Ordering costs are the costs associated with replenishing the stock of inventory being held.
 Shortage costs also referred to as stockout costs, occur when customer demand cannot be met The most widely used and traditional means for determining how much to order in a continuous sys -
because of insufficient inventory on hand. tem is the economic order quantity (EOQ) model, also referred to as the economic lot size model.

Flow of Inventory The function of the EOQ model is to determine the optimal order size that minimizes total inventory
costs. There are several variations of the EOQ model, depending on the assumptions made about the
inventory system.

 Basic EOQ model

 EOQ with non-instantaneous receipt
 EOQ model with shortages

Basic Economic Order Quantity Model

The simplest form of the economic order quantity model on which all other model versions are based
is called the basic EOQ model. It is essentially a single formula for determining the optimal order
size that minimizes the sum of carrying costs and ordering costs. The model formula is derived under
a set of simplifying and restrictive assumptions, as follows:
Summer Class | Management Science

 Demand is known with certainty and is relatively constant over time. Cost Model with Cost Model
 No shortages are allowed.
 Lead time for the receipt of orders is constant.
 The order quantity is received all at once.

Annual Carrying Cost = Cc(Q/2)

Annual Ordering Cost = Co(D/Q)
Total Inventory Cost = TC = Cc(Q/2) + Co(D/Q)
Optimal Order Quantity =

Total Minimum Cost =

Noninstantaneous Replenishment

A variation of the basic EOQ model is achieved when the assumption that orders are received all at The individual cost functions are provided as follows, where S equals the shortage level and Cs
once is relaxed. This version of the EOQ model is known as the noninstantaneous receipt model, also equals the annual per-unit cost of shortages:
referred to as the gradual usage, or production lot size, model. occurs when production is not instanta-
neous and inventory is replenished gradually rather than in lots.

p = daily rate at which the order is received over time, also known as the production rate
d = the daily rate at which inventory is demanded

Production Length = Q/p

Maximum Inventory Level = Q - (Q/p) d
= Q (1 - d/p)
Average Inventory Level = Sample Problem:

We will now assume that the I-75 Carpet Discount Store allows shortages and the shortage cost, C s, is
$2 per yard per year. All other costs and demand remain the same (C c = $0.75, Co = $150, and D =
10,000 yd.). What are the optimal order size and shortage level and total minimum annual inventory
cost?
Total Carrying Cost =
Formula:

Total Annual Inventory Cost =

Optimal Order Size =

Case in Point: Manufacturing brown

 Produces commercial refrigeration units in batches
 Annual demand = D = 10,000 units
 Setup cost = Co = $100 Classifications of Inventory Models
 Carrying cost = Cc = $0.50 per unit per year
 Daily production rate = p = 80 units daily Stochastic Model/Probability Model
 Daily demand rate = d = 60 units daily
This is a model based on probability that helps predict future events while taking into account ran-
1. How many units should Brown produce in each batch? domness and variables that can occur. Probabilistic modeling looks at different options that can take
2. How long should the production part of the cycle last? place in the future by calculating random options into the equation.

Economic Order Quantity with Shortage Examples of Probability Models:

 Probabilistic model with continuous demand
 Single-period decision model

Probabilistic Model

Practice:

Lead time is 5 days and daily demand is 100 units per day.

Answer:

ROP = D X LT
ROP = 100 X 5
ROP = 500

Single-Period Decision Model

Summer Class | Management Science

This is used when a product has a limited shelf life or a single selling season, such as newspapers,
flowers, or seasonal clothing. The goal is to order the optimal quantity that maximizes the expected
profit, while minimizing the risk of overstocking or understocking.

Example: Weekly Magazine

At the start of each week, a news stall stocks 40 copies of Global update, a weekly magazine. The
stall owner pays P30 per copy to the distributor and sells it for P60. Each unsold copy at the end of
the week can be disposed for P10 later. The demand for magazine is given in the distribution:

Period Demand 46 47 48 49 50 51 52 53 54 55
Probability 0.05 0.05 0.05 0.05 0.1 0.1 0.15 0.2 0.15 0.1
Cumm Prob 0.05 0.1 0.15 0.2 0.3 0.4 0.55 0.75 0.9 1

1. What is the current service level?

2. What is the optimal service level?
3. What is the optimal quantity stock?

Inventory Control System

An inventory system is a structure for controlling the level of inventory by determining how much to
order (the level of replenishment) and when to order. There are two basic types of inventory systems:
a continuous (or fixed–order quantity) system and a periodic (or fixed time period) system.

Perpetual System

A continuous inventory system, also known as a perpetual or fixed-order quantity system, maintains a
continuous record of the inventory level for each item.

Periodic System

A periodic inventory system, also known as a fixed-time period or periodic review system, counts in-
ventory at specific intervals like weekly or monthly.

Inventory Optimization

The process of strategically managing and controlling stock levels in order to maximize efficiency,
minimize costs, and meet customer demand Objective is to minimize costs and maximize perfor-
mance, productivity, efficiency, and improve customer service.

Techniques:
1. ABC Analysis – one of the most commonly used methods for inventory optimization.
2. JIT Inventory – products are ordered and delivered just before they are needed.

Sample Problem (JIT Inventory)

Scenario:

A small manufacturing company produces widgets. The company uses a Just-In Time (JIT) inventory
management system to ensure they have the right amount of materials on hand to meet daily produc-
tion needs without holding excess inventory.

Here are the details:

 Annual Demand for widgets: 10,000 units
 Number of Working Days per Year: 250 days
 Lead Time (time from placing an order to receiving materials): 2 days
 Safety Stock: 50 units (extra inventory to cover unexpected demand or delays)

Questions:
1. What is the daily demand for widgets?
2. What is the reorder point for the company?