CHAPTER 18
INVENTORY
MANAGEMENT WITH
KNOWN DEMAND
LECTURER: RUSSELL C.CHANG
STUDENT: NGUYEN THI BAO TRAM – DB11G217
Learning Objectives
1. Identify the cost components of inventory models.
2. Describe the basic economic order quantity (EOQ) model.
3. Draw a graph that shows the shape of the pattern of inventory levels over time for this
model.
4. Use a square root formula to obtain the optimal order quantity for this model.
5. Perform sensitivity analysis with this formula to check the effect of inaccuracies in the
estimates of the cost data.
6. Apply the extension of the basic EOQ model where planned shortages are allowed.
7. Apply the extension of the basic EOQ model where quantity discounts are provided for
relatively large order quantities.
8. Apply the extension of the basic EOQ model where inventory is replenished gradually
instead of instantaneously.
Scientific inventory
management
1. Formulate a mathematical model describing the behavior of the inventory system.
2. Seek an optimal inventory policy with respect to this model.
3. Use a computerized information processing system to maintain a record of the current
inventory levels.
4. Using this record of current inventory levels, apply the optimal inventory policy to signal when
and how much to replenish inventory
18.1 A CASE STUDY — THE ATLANTIC
COAST TIRE CORP. (ACT) PROBLEM
Background
- The Atlantic Coast Tire Corporation (ACT): the east coast distributor of Eversafe tires
- To supply 1500 retail stores and auto service stations
- Eversafe sells at a regular rate: 500/month
- Ashley's policy has been to place an order with Eversafe for 1,000 tires as needed every couple
months
- The order is placed just in time to have the delivery arrive as the inventory runs out.
The Cost Components of Maintaining ACT's
Inventory of 185/70 R13 Eversafe Tires
1. Purchase price = $20 per tire
2. Administrative cost for placing an order = $115
the total cost for placing an order is
if 1 tire is ordered: $115 + $20 (1) = $135
if 1,000 tires are ordered: $115 + $20 (1,000) = $20,115
the cost of capital tied up in inventory gives 21 percent per year
3. The annual cost of holding tires in inventory = $4.20 [0.21*$20] times the average number of tires
in inventory throughout the year.
4. The annual cost of being out of stock = $7.50 times the average number of tires short throughout
the year
- Suppose that ACT is out of stock for a total of 30 days (essentially 1/12 of the year).
- The average number of tires short during these 30 days is 120.
- The average number of tires short throughout the year is 120 *1/20=10.
- The annual cost is 10 ($7.50) = $75
18.2 COST COMPONENTS OF
INVENTORY MODELS
Acquisition Cost: The direct cost of acquiring units of a product, either through purchasing or
manufacturing, to replenish inventory
Fixed unit cost: A cost that remains the same regardless of the decisions made
Quantity discounts: Reductions in the unit acquisition cost of a product that are offered for
ordering a relatively large quantity
Cost Component 1: The direct cost of replenishing inventory,
whether through purchasing or manufacturing of the product.
Notation: c = unit acquisition cost.
ACT Example: c = $20 per tire
Setup Cost
incur by initiating the replenishment
Cost Component 2: The setup cost to initiate the replenishing
of inventory, whether through purchasing or manufacturing of
the product.
Notation: K = setup cost.
ACT Example: K = $115
Holding Cost
incur when units are placed into inventory
Cost Component 3: The cost of holding units in inventory.
Notation: h = annual holding cost per unit held
= unit holding cost.
ACT Example: h = $4.20
Shortage Cost
need to withdraw units from inventory but not available
Cost Component 4: The cost of having a shortage of units, i.e.,
of needing units from inventory when there are none there.
Notation: p = annual shortage cost per unit short
= unit shortage cost.
ACT Example: p = $7.50
Combining These Cost
Components
Inventory policy
- Annual acquisition cost = c times number of units added to inventory per year.
- Annual setup cost = K times number of setups per year.
- Annual holding cost = h times average number of units in inventory
throughout a year.
- Annual shortage cost = p times average number of units short throughout a year
- TC = total inventory cost per year = sum of the above four annual costs
-Fixed cost: A cost that remains the same regardless of the decisions made
-Variable costs: A cost that is affected by the decisions made.
-TVC = total variable inventory cost per year= sum of the variable annual costs
-Estimating the cost: estimate relevant the costs K set up cost, h holding cost, p shortage cost
18.3 THE BASIC ECONOMIC
ORDER QUANTITY (EOQ) MODEL
D = annual demand rate = number of units being withdrawn from inventory per year
Ex: ACT’s Customers purchase approximately 500 of its Eversafe tires of the 185/70 R13 size each month
D = 12 (500) = 6,000 tires sold per year
The Assumptions of the Model
Assumptions
1. A constant demand rate.
2. The order quantity to replenish inventory arrives all at once just when desired.
3. Planned shortages are not allowed
Ex: - Eversafe ships the tires on a truck.
- The tires arrive all at once.
- Eversafe ships the tires on a truck. Thus, the tires arrive all at once.
Lead time: The amount of time between the placement of an order and its receipt.
Reorder point: The inventory level at which the order is placed.
Reorder point = (daily demand) x (lead time)
Ex: Since ACT has 250 working days per year, its daily demand is
Daily demand = D/250 days = 6,000 tires sold per year/250 working days per year
= 24 tires sold per day
Reorder point = (24 tires/day) (9 days)
= 216 tires
Reorder point: 216 tires
Just in time for the
delivery=0
Lead time for the
delivery=9 working days
During each two-month
inventory cycle
A Broader Perspective of the
Model
Ex: ACT sold exactly 24 tires each and every working day
- Continuous-review system: An inventory system whose current inventory level is monitored on
a continuous basis.
- Periodic-review system: a system whose inventory level is only checked periodically
- Continuous-review inventory model: the kind of inventory system assumed by the EOQ model
- the inventory level will drop to 0 at the same instant that a delivery occurs
The Objective of the Model
Q = order quantity
- Minimize TVC = total variable
inventory cost per year
- TVC = annual setup cost + annual
holding cost
- Annual setup cost = K times number
of setups per year,
- Annual holding cost = h times
average inventory level
- K = setup cost each time an order
occurs,
- H = unit holding cost.
Ex:
- currently the number of setups (order placements) per year: 6
- the average inventory level: 500
- K setup cost each time an order occurs = $115
- h setup cost each time an order occurs = $4.20
- TVC = annual setup cost + annual holding cost
TVC = 6K + 500 h
= 6 ($115) + 500 ($4.20)
= $2,790
18.4 THE OPTIMAL INVENTORY
POLICY FOR THE BASIC EOQ
MODEL
Analysis of the ACT Problem
- Figure 18.4 A spreadsheet formulation of the basic EOQ model for the ACT problem when using
the current order quantity of Q = 1,000
- Figure 18.5 A data table for the ACT problem that shows the variable costs that would be
incurred with various order quantities.
- Figure 18.6 The results obtained by applying the Excel Solver to the spreadsheet model in
Figure 18.4.
The Square Root Formula for the
Optimal Order Quantity
Number of setups per year = annual demand rate/ order quantity
= D/Q
Average inventory level = (maximum level + minimum level)/2
=
TVC (Total Variable Cost) = annual setup cost + annual holding cost
=K
Annual holding cost = Annual setup cost.
This yields the following formula for Q*:
D = annual demand rate, K = setup cost,
h = unit holding cost)
Applying the Square Root
Formula to ACT’s Problem
he ACT data needed for the square root formula are
D = 6,000
K = $115
h = $4.20
current policy of ordering 1,000 tires each time, it is most economical
to order 573 tires each time instead. Although this increases the annual number of setups to place
orders from the current 6 to
D = 6,000
K = $115
h = $4.20,
total variable cost per year from the
current $2,790 to TVC = $115 (10.47) +
$4.20 (286.5) = $2407.
14% reduction (TVC from 2790 to 2407)
K = $115 Sensitivity Analysis
h = $4.20
these estimates could be off by as much as 10% in either direction
Range of possible values
Setup cost $103.50 to $126.50
Unit holding cost: $3.78 to $4.62
sensitivity analysis to see how sensitive the original solution of Q* = 573 tires is to changes in the original estimates to other possible values in
these ranges:
1. How much can the optimal order quantity Q* change from 573 if the true values of these
costs lie elsewhere in these ranges?
2. If the true values do lie elsewhere, but Q = 573 is used as the order quantity anyway
(since the true values are not known), how much can the resulting total variable cost
(TVC) exceed the value of TVC when using the order quantity Q* that would be optimal
for the true values of the costs?
18.5 THE EOQ MODEL WITH
PLANNED SHORTAGES
inventory shortage: stockout
Backorders: fill the demand later when the inventory can \be replenished
(hereeeeeeeeeeeeeeeeeeeeeeeeeeeee)
The Assumptions of the Model
Assumptions
1. A constant demand rate.
2. The order quantity to replenish inventory arrives all at once just when desired.
3. Planned shortages are allowed. When a shortage occurs, the affected customers will wait for
the product to become available again. Their backorders are filled immediately when the order
quantity arrives to replenish inventory.
S = maximum shortage (units
backordered)
the inventory level is allowed to
go down to -S, at which point an
order quantity Q arrives.
S units
out of the Q are used to fill the
backorders, so the maximum
inventory level is Q - S
Figure 18.8 The pattern of inventory levels over time assumed by the EOQ model with planned shortages, where
both the order quantity Q and the maximum shortage S are the decision variables
The Objective of the Model
Minimize TVC = total variable inventory cost per year
TVC = annual setup cost + annual holding cost + annual shortage cost
The Optimal Inventory Policy
Application to the ACT Case
Study
K = $115, h = $4.20, p = $7.5
Q* = 716 tires (order quantity)
S* = 257 tires (maximum shortage)
Q* - S* = 459 tires (maximum inventory level)
The resulting total variable inventory cost per year is
TVC = $1,928.
The value of S* also leads to identifying the reorder point for this inventory policy.
Reorder point = –S* + (daily demand) (lead time)
= –257 tires + (24 tires/day) (9 days)
= –41 tires
Figure 18.9
The results obtained for the ACT problem by applying either of the Excel
templates (Solver version or analytical version) for the EOQ model with
planned shortages.
Application to the ACT Case
Study
Figure 18.9 The results obtained for the ACT problem by applying either of the Excel templates
(Solver version or analytical version) for the EOQ model with planned shortages
Table 18.1 Comparison of the Basic EOQ
Model and the EOQ Model with Planned
Shortages for the ACT Problem
18.6 THE EOQ MODEL WITH
QUANTITY DISCOUNTS
Quantity Discounts
Cost Analysis
TVC = annual acquisition cost + annual setup cost + annual holding cost
c = unit acquisition cost (as given in Table 18.2)
D = annual demand rate = 6,000,
K = setup cost = $115,
Q = order quantity (the decision variable),
h = unit holding cost.
I = inventory holding cost rate = 0.21.
h = Ic = 0.21 c.
Table 18.4 A Cost Comparison of the Best
Order Quantities for the Respective
Discount Categories
Figure 18.11 The application of the Excel template (analytical) for the EOQ model with quantity
discounts to the ACT problem.
18.7 THE EOQ MODEL WITH
GRADUAL REPLENISHMENT
- The order quantity to replenish arrives all at once just when desired.
- Production lot size: the number of units produced during a production time.
- Assumptions
- 1. A constant demand rate.
- 2. A production run is scheduled to begin each time the inventory level drops to 0, and this
- production replenishes inventory at a constant rate throughout the duration of the run.
- 3. Planned shortages are not allowed.
Figure 18.12 The pattern of inventory levels over time — rising during a production run and
dropping afterward — for the EOQ model with gradual replenishment.
An Example — the SOCA
Problem
Current Inventory Policy
1. Daily demand rate = 1,000 speakers per day.
2. Daily production rate = 3,000 speakers per day (when producing).
3. The production facilities get set up to start a production run each time the inventory levelis
scheduled to drop to 0.
4. Each production run produces 30,000 speakers over a period of 10 working days, so another
20 working days elapse before the next production run is needed.
Maximum inventory level = production lot size minus demand during production run
= 30,000 speakers – (10 days) (1,000 speakers/day)
= 30,000 speakers – 10,000 speakers
= 20,000 speakers.
Average inventory level = ½ (maximum inventory level)
= 10,000 speakers.
SOCA's costs associated with this inventory policy are summarized below.
c = unit production cost = $12 per speaker produced,
K = setup cost for a production run = $12,000,
h = unit holding cost = $3.60 per speaker in inventory per year.
With 250 working days per year, the number of speakers needed per year is
D = annual demand rate = (1,000 speakers/day) (250 days) = 250,000 speakers.
the annual cost of producing these speakers= ($12/speaker) (250,000 speakers) = $3 million
The Optimal Inventory Policy for This Model
SOCA's optimal production lot size can be obtained directly from a square root formula that is similar
to the one for the basic EOQ model.
R = (daily production rate) (number of working days per year)
= (3,000) (250)
= 750,000.
The Optimal Inventory Policy for
This Model
Figure 18.13 The results obtained for the SOCA problem by applying either of the Excel
templates (Solver version or analytical version) for the EOQ model with gradual replenishment
THANK YOU
