DETERMINISTIC EOQ MODEL

Dr. Muhammad Shafiq

Assistant Professor, Industrial Engineering and Management,

Institute of Quality and Technology Management (IQTM),
1 University of the Punjab, Lahore, Pakistan.
CONTENTS
 Introduction
 GENERAL INVENTORY MODEL
 DETERMINISTIC EOQ MODEL
 Actual demand vs. Expected demand
 ROP and Safety stock
 DYNAMIC EOQ MODELS
General dynamic programming algorithm

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WHAT IS INVENTORY?

Inventory is the raw materials, component

parts, work-in-process, or finished products
that are held at a location in the supply chain.

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WHY DO WE CARE?
At the macro level:

Inventory is one of the biggest corporate assets ($).

Investment in inventory is currently over $1.25

Trillion (U.S. Department of Commerce).
This figure accounts for almost 25% of GNP.

Enormous potential for efficiency increase by

controlling inventories
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WHY DO WE CARE?
At the firm level:
 Sales growth: right inventory at the right place at the right
time
 Cost reduction: less money tied up in inventory, inventory
management, obsolescence

Higher profit

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WHAT DO YOU CONSIDER?

 Cost of not having it.

 Cost of going to the grocery or gas station (time,
money), cost of drawing money.
 Cost of holding and storing, lost interest.
 Price discounts.
 How much you consume.
 Some safety against uncertainty.

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COSTS OF INVENTORY
 Physical holding costs:
 out of pocket expenses for storing inventory (insurance,
security, warehouse rental, cooling)
 All costs that may be entailed before you sell it
(obsolescence, spoilage, rework...)
 Opportunity cost of inventory: foregone return on
the funds invested.
 Operational costs:
 Delay in detection of quality problems.
 Delay the introduction of new products.
 Increase throughput times.

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BENEFITS OF INVENTORY

• Hedge against uncertain demand

• Hedge against uncertain supply
• Economize on ordering costs
• Smoothing

To summarize, we build and keep inventory in

order to match supply and demand in the most
cost effective way.

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MODELING INVENTORY IN A
SUPPLY CHAIN…

Supplier
Retail
Warehouse

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DIFFERENT TYPES OF INVENTORY
MODELS

1. Multi-period model
• Repeat business, multiple orders
2. Single period models
• Single selling season, single order

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MULTIPERIOD MODEL

orders

On-hand
inventory
Supply

 Key questions: • Ordering costs

 How often to review? • Holding costs
 When to place an order?
 How much to order?
 How much stock to keep?
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1. GENERAL INVENTORY MODEL

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2. THE ECONOMIC ORDER
QUANTITY (MULTIPERIOD MODEL)

Supplier Retailer Demand

• Demand is known and deterministic: D units/year

• We have a known ordering cost, S, and immediate replenishment
• Annual holding cost of average inventory is H per unit
• Purchasing cost C per unit

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ASSUMPTIONS OF BASIC EOQ
MODEL

Demand is deterministic and occurs at a

constant rate.
If an order of any size (say, q units) is placed, an
ordering and setup cost K is incurred.
The lead time for each order is zero.
No shortages are allowed.
The cost per unit-year of holding inventory is h.

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Inventory Costs
 Holding (or carrying) costs

 Setup (or production change) costs

 Ordering costs.

 Shortage costs.

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Inventory Systems

 Rules to manage inventory, specifically:

 timing (when to order)
 sizing (how much to order)
 Continuous Review or Fixed-Order Quantity Models
(Q)
 Event triggered (Example: running out of stock)
 Periodic Review or Fixed-Time Period Models (P)
 Time triggered (Example: Monthly sales call by sales
representative)

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Comparison of Periodic and
Continuous Review Systems

Periodic Review Continuous Review

 Fixed order intervals  Varying order intervals
 Variable order sizes  Fixed order sizes (Q)
 Convenient to administer  Allows individual review
frequencies
 Inventory position only  Possible quantity discounts
required at review
 Lower, less-expensive safety
stocks

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 Inventory costs

 C = Unit cost or production cost: the additional

cost for each unit purchased or produced.
 H = Holding costs: cost of keeping items in
inventory(cost of lost capital, taxes and insurance
for storage, breakage, etc., handling and storing)
 S = Setup or ordering costs: a fixed cost incurred
every time you place an order or a batch is
produced.

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Total costs of carrying inventory
 Assumptions
 demand is constant and uniform throughout the period for
your products (5 cases per day)
 Price per unit is constant for the period ($16/case)
 Inventory holding cost is based on an average cost.
 Total Inventory Policy Cost annually
= annual purchase cost
+ annual order cost
+ annual holding cost

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 Cost Minimization Goal

C
O Total Cost
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Order Quantity (Q)

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

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 Total cost of Inventory Policy

 = annual purchase cost (annual demand * Cost/item)

+ annual order cost (annual # orders * Cost to order)
+ annual holding cost (average units held*cost to carry one unit)

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 Total Inventory Cost Equation

D Q
TC  D * C  S  H
Q 2
D = yearly demand of units
C = cost of each unit
Q = quantity ordered
S = cost to place order
H = average yearly holding cost for each unit
= storage+interest*C
D/Q = number of orders per year
Q/2 = average inventory held during a given period
assuming with start with Q and drop to zero
before next order arrives (cycle inventory).
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Deriving the EOQ :
Economic Order Quantity

 Using calculus, we take the derivative of the total cost

function and set the derivative (slope) equal to zero

2DS 2(Annual Demand)(Order or Setup Cost)

Q  EOQ = =
H Annual Holding Cost

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 EOQ Model--Basic Fixed-Order
Quantity Model (Q)

Number
of units
on hand Q Q Q

R
L L

Time
R = Reorder point
Q = Economic order quantity
L = Lead time

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WHAT IS THE OPTIMAL QUANTITY
TO ORDER?

Total Cost = Purchasing Cost + Ordering Cost + Inventory Cost

Purchasing Cost = (total units) x (cost per unit)

Ordering Cost = (number of orders) x (cost per order)

Inventory Cost = (average inventory) x (holding cost)

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 FINDING THE OPTIMAL QUANTITY
TO ORDER…
Let’s say we decide to order in batches of Q…
Inventory position Number of D
periods will be Q

The average
inventory for
each period is…
Period over which demand for Q has occurred Time
Q
2
Total Time
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FINDING THE OPTIMAL QUANTITY
TO ORDER…

Purchasing cost = D x C

D
Ordering cost = x S
Q

Q
Inventory cost = x H
2

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SO WHAT IS THE TOTAL COST?

D Q
TC = D C + S + H
Q 2

In order now to find the optimal quantity we need to

optimize the total cost with respect to the decision
variable (the variable we control)

Which one is
the decision
variable?

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WHAT IS THE MAIN INSIGHT FROM
EOQ?
There is a tradeoff between holding costs and ordering costs

Total cost

Cost
Holding costs

Ordering costs
Order
Quantity (Q*)
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EXAMPLE:

Assume a car dealer that faces demand for 5,000 cars per year, and
that it costs $15,000 to have the cars shipped to the dealership.
Holding cost is estimated at $500 per car per year. How many
times should the dealer order, and what should be the order size?

What if the lead time to receive cars is 10 days?

(when should you place your order?)

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Economic Order Quantity - EOQ
2SD 2(15,000 )(5,000 )
Q* = Q 
*
 548
H 500

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43
EXAMPLE (CONTINUED)…
What if the lead time to receive cars is 10 days?
(when should you place your order?)

Since D is given in years, first convert: 10 days = 10/365yrs

10 10
R = D = 5000 = 137
365 365

So, when the number of cars on the lot reaches 137,

order 548 more cars.

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EXAMPLE (CONTINUED)…
What if the lead time to receive cars is 10 days?
(when should you place your order?)

Since D is given in years, first convert: 10 days = 10/365yrs

10 10
R = D = 5000 = 137
365 365

So, when the number of cars on the lot reaches 137,

order 548 more cars.

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 But demand is rarely predictable!

Inventory
Level

Order
Quantity

ROP = ???
Demand???

Place Receive Time

46 order Lead Time order
 Actual Demand < Expected Demand
Inventory
Level

Order
Quantity
Lead Time Demand X

ROP

Inventory at time of receipt

Lead Time Time

Place Receive
order order
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If Actual Demand > Expected, we Stock Out
Order
Quantity

Stockout
Point
Inventory

Time

Lead Time Unfilled demand

Place Receive
48 order order
 If ROP = expected demand, service level is
50%. Inventory left 50% of the time, stock
outs 50% of the time.
Inventory
Level

Order
Quantity
ROP = Expected Demand

Uncertain Demand
Average

Time
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 To reduce stockouts we add safety stock
Inventory
Level

Order Quantity
ROP = Q = EOQ
Safety
Stock + Expected
Expected LT Demand
LT
Demand Safety Stock
Lead Time Time

Place Receive
50 order order
 Decide what Service Level you want to provide
(Service level = probability of NOT stocking out)

Service level Probability

of stock-out

Safety
Stock

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 Safety stock =
(safety factor z)(std deviation in LT demand)

Service level Probability

of stock-out

Safety
Stock
Read z from Normal table for a given service level
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 Caution: Std deviation in LT demand

Variance over multiple periods = the sum of

the variances of each period (assuming
independence)

Standard deviation over multiple periods is

the square root of the sum of the variances,
not the sum of the standard deviations!!!

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 Average Inventory =
(Order Qty)/2 + Safety Stock
Inventory
Level

Order
Quantity

EOQ/2
Average
Inventory

Safety Stock (SS)

Lead Time Time

Place Receive
54 order order
 HOW TO FIND ROP & Q
2SD
1. Order quantity Q= EOQ 
H
2. To find ROP, determine the service level (i.e., the
probability of NOT stocking out.)
 Find the safety factor from a z-table or from the graph.
 Find std deviation in LT demand: square root law.
std dev in LT demand  ( std dev in daily demand ) days in LT
 LT   D LT
 Safety stock is given by:
SS = (safety factor)(std dev in LT demand)
 Reorder point is: ROP = Expected LT demand + SS
3. Average Inventory is: SS + EOQ/2
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EXAMPLE (CONTINUED)…

Assume a car dealer that faces demand for 5,000 cars per year, and
that it costs $15,000 to have the cars shipped to the dealership.
Holding cost is estimated at $500 per car per year. How many
times should the dealer order, and what should be the order size?

Now if the lead time is 10 days and the expected yearly demand
is 5000. You estimate the standard deviation of daily demand
demand to be d = 6. When should you re-order if you want to
be 95% sure you don’t run out of cars?

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EXAMPLE (CONTINUED)…
Back to the car lot… recall that the lead time is 10 days
and the expected yearly demand is 5000. You estimate the
standard deviation of daily demand demand to be d = 6.
When should you re-order if you want to be 95% sure you
don’t run out of cars?
Since the expected yearly demand is 5000, the expected
demand over the lead time is 5000(10/365) = 137. The z-
value corresponding to a service level of 0.95 is 1.65. So
ROP  137  1.65 10(36) 168

Order 548 cars when the inventory level drops to 168.

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3. DYNAMIC EOQ MODELS
( GENERAL DYNAMIC PROGRAMMING ALGORITHM)

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3. DYNAMIC EOQ MODELS
( GENERAL DYNAMIC PROGRAMMING ALGORITHM)

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3. DYNAMIC EOQ MODELS
( GENERAL DYNAMIC PROGRAMMING ALGORITHM)

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3. DYNAMIC EOQ MODELS
( GENERAL DYNAMIC PROGRAMMING ALGORITHM)

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EXAMPLE

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EXAMPLE

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EXAMPLE

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EXAMPLE

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Production Planning Model: EPQ Model

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 Quantity Discounts : Example

ZORIC buys screwed bolts in bulk quantities from 21st century Manufacturing
company. This manufacturing company offers quantity discounts to customers who
make procurements in large quantities. The discount schedule is as under;

Order Quantity Price/unit(P)

1 < Q < 1000 $ 5.00
1000 <= Q <2000 4.80
Q >= 2000 4.75

ZORIC’s Inventory Manager Zhufaar wants to make decision on order size (Q) so as
to minimize his inventory as well as purchase cost of screwed bolts. He estimates that
annual demand of the screwed bolts will be 5000. Each order will cost him $49. The
inventory carrying cost rate is estimated to be 20%.
In case inventory carrying cost rate turns out to be 10%, what Zhufaar will do?
 Quantity Discounts : Example Solution

Let’s denote three discount slabs as under;

Discount No Order Quantity Price/unit(P)
1 1 < Q < 1000 $ 5.00
2 1000 <= Q <2000 4.80
3 Q >= 2000 4.75

For each discount schedule corresponding EOQ’s will be

2 DC0 2( 5000)( 49 )
Q*j   Q*j 
( 0.20 )( Pj )
IPj

Q1*= 700 Q2* = 714.43 Q3*=718.18

 Quantity Discounts : Example Solution

Q1*= 700 Q2* = 714.43 Q3*=718.18

Fitting the EOQ’s in corresponding slab;

Discount No Order Quantity EOQ Adjusted Q
1 1 < Q < 1000 700 700
2 1000 <= Q <2000 714.43 1000
3 Q >= 2000 718.18 2000

Total cost/year = Total Purchase Price of Screwed Bolts + Ordering

cost per year + inventory holding cost per year

DCo Q j
Ct ( Q j )  Pj D   IPj
Mathematically; Qj 2
(5000)(49) Q j ( 0.20 )Pj
Ct ( Q j )  Pj ( 5000)  
Qj 2
For I = 20%, least cost order size = 1000 with Discount
schedule # 2
For I = 10%, least cost order size = 2000 with Discount
schedule # 3
EOQ APPLICATION
 ARMEDI Business keeps a large stock of items in different parts
of the country. The pressure vessel division of the company has a
sizable store in their office building. The store keeps 20 different
items. Annual demand data of these items along with item
purchase cost is tabulated ( and presented on next slide). The
company follows the following ordering policy;
 “If annual demand of an item > 10,000; make 2 orders per year;
otherwise make one order”
 What is the total inventory cost of 20-item store?
 10000

P
EOQ APPLICATION
 Arian Muth is manager of the pressure-vessels store. He was
horrified to see 20 Million $ figure.
 He approached Judy Brian in the department for help. Judy was
Inventory Consultant in the organization. The Consultant
advised him to apply EOQ methodology.
 How much Arian Muth will be able to save in inventory
costs if he applies EOQ methodology?
Store Space Required under current ordering policy
 Arian Muth was hesitant to apply EOQ-based strategy; as
the number of orders per year was going to increase at a
drastic rate.
 Arian expressed his reservations about EOQ solutions to
Judy. Judy asked him to calculate the present space
requirements for 20-items
 Arian collected information about space requirements (in
CFT) for all 20-items (shown in next slide).

 Based on his present ordering policy, how much space is

being utilized by these 20 items in the stores.
10000
Store Space Required under EOQ policy
 Arian Muth got terrified to see this horrendous figure of
17037557 cubic feet (CFT) being currently utilized for storing
those 20-items.
 Arian spoke to Judy again telling this huge amount of space
required to store these 20-items
 Judy advised him to make storage space requirement calculations
using EOQ approach.

 Based on EOQ policy, how much space is being saved?

 How much Dollars required for making
purchases

 Inventory consultant Judy wanted to convince store manager Arian on

another very beneficial aspect of EOQ policy.
 Judy asked Arian Muth to compare the dollars required to invest at
the time of placing orders for both policies.
 Dollars invested at the time of placing order is equal to

20
 Pj Q j
where, Pj = purchase price of jth item

j 1 Qj = order size of jth item

 Compare the Dollars requirement for both policies?

 EOQ Challenges

 Arian Muth was finally convinced that EOQ is highly valuable

tool for inventory control.

 His main concern was high values of frequent ordering activity as a

result of EOQ implementation.

 Judy advised him to make his case before Director

of Pressure-Vessels cell. In cooperation with
Director Purchases, Arian was able to activate
Purchase department to adapt to this frequent
ordering requirements to implement the new
inventory control strategy.
 ANY QUESTION??

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