INVENTORY

MODELS
INVENTORY AND
WAREHOUSE MANAGEMENT
BBMSCM320153
INVENTORY COSTS

 Ordering cost - salaries and expenses of processing an order, Some times considering

the order quantity

 Holding cost - usually a percentage of the value of the item assessed for keeping an item

in inventory (including finance costs, insurance, security costs, item assessed for keeping
an item in inventory, taxes, warehouse overhead, and other related variable expenses)

 Backorder cost - costs associated with being out of stock when an item is demanded

(including lost goodwill)

 Purchase cost - the actual price of the items

 Other costs
INVENTORY MODELS

 The study of inventory models is concerned with two basic

questions:

– How much should be ordered each time

– When should the reordering occur

 The objective is to minimize total variable cost over a specified

time period.
EOQ

What is EOQ?

EOQ = mathematical device for arriving at the purchase

quantity of an item that will minimize the cost.

Total cost = holding costs + ordering costs

EOQ

What is EOQ?

EOQ = mathematical device for arriving at the purchase

quantity of an item that will minimize the cost.

Total cost = holding costs + ordering costs

So…What does that mean?

Basically, EOQ helps you identify the most economical way to

replenish your inventory by showing you the best order quantity.
EOQ SYSTEM

 Behavior of Economic Order Quantity (EOQ) Systems

 Determining Order Quantities

 Determining Order Points

BEHAVIOR OF EOQ SYSTEMS

 As demand for the inventoried item occurs, the inventory level drops.

 When the inventory level drops to a critical point, the order point, the

ordering process is triggered.

 The amount ordered each time an order is placed is fixed or constant.

 When the ordered quantity is received, the inventory level increases.

 An application of this type system is the Inventory Management

*KEY* THE INVENTORY CYCLE
MODEL I. BASIC (EOQ)

 The most basic of the deterministic inventory models is the economic

order quantity (EOQ).

 The variable costs in this model a model are annual holding cost and

annual ordering cost.

 For the EOQ, annual holding and ordering costs are equal
MODEL I: BASIC EOQ - ASSUMPTIONS
 Only one product is involved.

 Annual demand requirements are known.

 Demand is even throughout the year.

 Lead time does not vary.

 Each order is received in a single delivery.

 Acquisition cost is fixed, i.e., no quantity discounts

 No inventory when an order arrives

 Stock-out, customer responsiveness, and other costs are inconsequential

 Annual demand (D), Carrying cost/Holding Cost (Ch ) and Ordering Cost/Set up Cost (Co ) can
ORDER QUANTITY MODEL (EOQ MODEL)
MODEL I: BASIC EOQ - FORMULAS

 Annual carrying cost = (average inventory level) x (carrying cost) = (Q/2)

Ch

 Annual ordering cost = (average number of orders per year) x (ordering

cost) = (D/Q) Co
TOTAL COST
COST MINIMIZATION GOAL
MINIMUM TOTAL COST

 The total cost curve reaches its minimum where the carrying and

ordering costs are equal.

HOW DOES IT WORK?

 Total annual holding cost = (Q/2) Ch •

 Total annual ordering cost = (D/Q) Co

 Total annual stocking cost (TC) = annual carrying cost + annual ordering cost =

(Q/2) Ch + (D/Q) Co

 EOQ: – Set (Q/2) Ch = (D/Q) Co and solve for Q

SOLVE FOR Q ALGEBRAICALLY
DEFINITION OF EOQ COMPONENTS
 Ch = annual holding cost for one unit of inventory

 Ch = VW (Where V = price per unit , W = Inventory Carrying Cost % per unit

 Co = cost of placing an order, regardless of size

 d = demand per period

 D = annual demand

 L = lead time

 Q = Order quantity (this is what we are solving for)

EXAMPLE 1: BASIC EOQ

 Zartex Co. produces fertilizer to sell to wholesalers. One raw material –

calcium nitrate – is purchased from a nearby supplier at $22.50 per ton.

Zartex estimates it will need 5,750,000 tons of calcium nitrate next year.

 The annual carrying cost for this material is 40% of the acquisition cost,

and the ordering cost is $595.

EXAMPLE 1: BASIC EOQ

 What is the most economical order quantity?

SOLUTION FOR EXAMPLE 1 : BASIC EOQ

 Annual holding cost =

Ch = VW (V = price per unit = $ 22.50, W = Inventory Carrying Cost

% = 40%)

 Co = cost of placing an order, regardless of size = $595

 D = annual demand = 5,750,000 Ton/Year

 Q = Order quantity (this is what we are solving for)

SOLUTION FOR EXAMPLE 1 : BASIC EOQ
SOLUTION FOR EXAMPLE 1 : BASIC EOQ
EXAMPLE 2: BART’S BAROMETER BUSINESS

 Economic Order Quantity Model

 Bart's Barometer Business (BBB) is a retail outlet which deals exclusively with

weather equipment. Currently BBB is trying to decide o decide on an inventory and

reorder policy for home barometers.
 Barometers cost BBB $50 each and demand is about 500 per year distributed evenly throughout

the year.

 Reordering costs are $80 per order and holding costs are figured at 20% of the cost of the item.

 BBB is open 300 days a year (6 days a week and closed two weeks in August). Lead time is 60

working days.
EXAMPLE 2: BART’S BAROMETER BUSINESS

 Optimal Reorder Quantity

Q * = 2DCo /Ch = 2(500)(80)/10 = 89.44 » 90

 Optimal Reorder Point

Lead time is T = 60 days and daily demand is d = 500/300 or1.667.

Thus the reorder point r = (1.667)(60) = 100.

Bart should reorder 90 barometers when his inventory position reaches 100
EXAMPLE 2: BART’S BAROMETER BUSINESS

 Number of Orders Per Year

Number of reorder times per year = (500/90) = 5.56 or once or once every
(300/5.56) (300/5.56) = 54 working days (about every 9 weeks).
EXAMPLE 2: BART’S BAROMETER BUSINESS
CLASSROOM EXERCISE TUTORIAL 1

 An industrial machine tool manufacturer supplies replacement parts from its inventory.

 For a particular part, the annual demand is expected to be 4800 units.

 Machine Machine setup costs are $40, ts are $40,

 Carrying costs are 25% percent per year, and part is valued in inventory at $100 each.

 Calculate the economic order quantity and the optimal time between orders.

 D = annual rate of demand or requirement for period (units) = 4800

 Co = cost of placing an order or set up cost ($ per order) = $40

 V = Cost of one unit of inventory ($ per unit) = $100

 W = carrying cost per dollar value of inventory per year = 25%

CLASSROOM EXERCISE TUTORIAL 1I

 Assume you have a product with the following parameters:

– Annual Demand (D)= 360 units

– Holding cost per year (VW)= $1.00 per unit

– Order cost (Co ) = $100 per order

 What is the EOQ for this product?

 Assuming a 300-day work year, how many orders should be processed per year?

 What is the expected time between orders?

 What is the total cost for the inventory policy used?

 MODEL II. ECONOMIC PRODUCTION LOT SIZE
Assumptions

 Demand occurs at a constant rate of D items per year

 Constant Supply Rate

 Production rate is P items per year (and P >D)

 Set-up cost: $Co per run

 Holding cost: $Ch per item in inventory per year

 Purchase cost per unit is constant (no quantity discount).

 Set-up time (lead time) is constant.

 Planned shortages are not permitted

EPQ MODEL
MODEL II. ECONOMIC PRODUCTION LOT SIZE

 Formulas

 d= daily demand rate

 p= daily production

 t = number of days for production run

 Since we assume p will be larger than d, the daily inventory build up rate

during the production phase is = (p-d) t

MODEL II. ECONOMIC PRODUCTION LOT SIZE

• Now if we know that we are producing a production lot of Q units at a daily

production rate of p units, then Q = pt, hence – t = Q/p
• Thus maximum Inventory
• = (p-d)t
• = (p-d) (Q/p)
• = (1 – d/p)Q
MODEL II. ECONOMIC PRODUCTION LOT SIZE

• Thus
– Average Inventory = ½ (1 – d/p)Q
– If Annual per unit Holding Cost is Ch
– Then Annual Holding Cost = ½ (1-d/p)Q*Ch,
– If the annual Demand is D and set up cost is Co
– Annual Set up cost = D/Q C0
• Total Cost = ½ (1-d/p)QCh, + D/Q C0
MODEL II. ECONOMIC PRODUCTION LOT SIZE

• Suppose that production facility operates 250 days a year, then we can
get daily demand d ( d = D/250 )
• Now lets assume that Annual Production is P,
• Then P = 250p,
• Thus p = P/250
• Thus d/p = (D/250) / (P/250) = D/P
• Hence we can now write the TC Total Cost = ½ (1-D/P)Q Ch, + D/Q C
MODEL II. ECONOMIC PRODUCTION LOT SIZE

• Formulas
• Optimal production lot-size: Q *2 = 2DCo /[(1-D/P )Ch ]
• Number of production runs per year: D/Q *
• Time between set-ups (cycle time): Q */D years
• Total annual cost: [(1/2)(1-D/P )Q *Ch ] + [DCo /Q *]
(holding + ordering)
EXAMPLE 1: EOQ FOR PRODUCTION LOTS

 Highland Electric Co. buys coal from Cedar Creek Coal Co. to generate
electricity. CCCC can supply coal at the rate of 3,500 tons per day for
$10.50 per ton. HEC uses the coal at a rate of 800 tons per day and
operates 365 days per year
EXAMPLE 1: EOQ FOR PRODUCTION LOTS

 HEC’s annual carrying cost for coal is 20% of the acquisition cost, and
the ordering cost is $5,000.
 What is the economical production lot size?
 What is HEC’s maximum inventory level for coal?
EXAMPLE 1: EOQ FOR PRODUCTION LOTS
EXAMPLE 1: EOQ FOR PRODUCTION LOTS
EXAMPLE 1: EOQ FOR PRODUCTION LOTS
EXAMPLE 2: NON-SLIP TILE CO

 Economic Production Lot Size Model

Non-Slip Tile Company (NST) has been using production runs of 100,000 tiles, 10
times per year to meet the demand of 1,000,000 tiles annually. The set-up cost is
$5,000 per run and holding cost is estimated at 10% of the manufacturing cost of
$1 per tile. The production capacity of the machine is 500,000 tiles per month.
The factory is open 365 days per year.
Total Annual Variable Cost
Optimal Production Lot Size
Number of Production Runs Per Year
Idle Time Between Production Runs
EXAMPLE 2: NON-SLIP TILE CO

 Total Annual Variable Cost Model

This is an economic production lot size problem with
D = 1,000,000, P = 6,000,000, Ch = .10, Co = 5,000
TC = (Holding Costs) + (Set-Up Costs)
= [Ch (Q/2)(1 - D/P )] + [DCo /Q]
= .04167Q + 5,000,000,000/Q
EXAMPLE 2: NON-SLIP TILE CO

 Optimal Production Lot Size

Q * = 2DCo /[(1 -D/P )Ch ]
= 2(1,000,000)(5,000) /[(.1)(1 - 1/6)]
= 346,410
 Number of Production Runs Per Year
The number of runs per year = D/Q *
= 2.89 times per year.
EXAMPLE 2: NON-SLIP TILE CO

 Total Annual Variable Cost

How much is NST losing annually by using their present production

schedule?

 Optimal TC = .04167(346,410) + 5,000,000,000/346,410 = $28,868

 Current TC = .04167(100,000) + 5,000,000,000/100,000 = $54,167

 Difference = 54,167 - 28,868 = $25,299

EXAMPLE 2: NON-SLIP TILE CO

 Idle Time Between Production Runs

 There are 2.89 cycles per year.

 Thus, each cycle lasts (365/2.89) = 126.3 = 126.3 days.

 The time to produce 346,410 per run = (346,410/6,000,000)365 =

21.1 days.

 Thus, the machine is idle for 126.3 - 21.1 = 105.2 days between runs.
EXAMPLE 2: NON-SLIP TILE CO

 Maximum Inventory

Current Policy

 maximum inventory = (1-D/P )Q * = (1-1/6)100,000 )100,000 » 83,333

Optimal Policy

 maximum inventory = (1-1/6)346,410 = 288,675.

PROBLEM 3
PROBLEM 3
PROBLEM 3
TUTORIAL – EPQ MODEL_1
EPL Computer produces its multimedia notebook computer on a production line that has an
annual capacity of 16,000 units. EPL Computer estimates the annual demand for this model is
6000 units. The cost to set up the production lie is $2345, and the annual holding and the annual
holding cost is $ 20 is per unit. Current practice calls for production runs of 500 notebook
computers each month

 What is the Optimum production lot Size

 How many production runs should be made each year?

 What is recommended cycle time?

 Would you recommend changing the current production lot size from the monthly 500 unit

production runs to EPQ? Why or why not? If yes, is there any savings of your recommendation,
if so what is it?
 TUTORIAL_2

• A five days lead time is schedule and set up a production run and 250
working days
 Find the recommended production lot size
 Total annual cost
 Re-order point
 Cycle length
MODEL III. EOQ WITH PLANNED SHORTAGES
 Shortage or stock-out is a demand that cannot be supplied.

 Shortage are undesirable and should be avoided if possible

 However, there are situations shortage is desirable from economic point of view

- If the value of the of the inventory per unit is high, and hence holding is high
 This model consider back-order cost

 Assumptions

– Demand occurs at a constant rate of D items per year.

– Ordering cost: $Co per order.

– Holding cost: $Ch per item in inventory per year.

– Backorder cost: $Cb per item backordered per year.

– Purchase cost per unit is constant (no quantity discount).

– Set-up time (lead time) is constant.

– Planned shortages are permitted (backordered demand units are withdrawn from a replenishment order
MODEL III. EOQ WITH PLANNED SHORTAGES

 With the EOQ with planned shortages model, a replenishment order does not
arrive at or before the inventory position drops to zero.
 Shortages occur until a predetermined backorder quantity is reached; at
which time the replenishment order arrives.
 The variable costs in this model are annual holding, backorder, and ordering.

 For the optimal order and backorder quantity combination, the sum of the
annual holding and backordering costs equals the annual ordering cost.
INVENTORY LEVELS FOR PLANNED SHORTAGES MODEL
MODEL III. EOQ WITH PLANNED SHORTAGES

 Average
Inventory =

 Now we can find other ways of expressing t1 and T, since we know

maximum inventory is Q-S and d represents the constant daily
demand
MODEL III. EOQ WITH PLANNED SHORTAGES

 Since Q units are order each cycle, the length of a cycle (T)
must be

 Replacing these 2 in Average Inventory

 Now we can define inventory using only 2 variables

MODEL III. EOQ WITH PLANNED SHORTAGES

 Annual Number of Orders = D/Q

 Average Backorders =
 So, when we let the maximum No of backorders reach an amount of S
at a daily rate of d, the length of the backorder portion of the
inventory cycle is

 Average Backorders =
MODEL III. EOQ WITH PLANNED SHORTAGES
 Ordering cost: $Co per order.

 Holding cost: $Ch per item in inventory per year.

 Backorder cost: $Cb per item backordered per year

 TC = Inventory Holding Cost + Ordering Cost + Ordering cost

MODEL III. EOQ WITH PLANNED SHORTAGES - EXAMPLE
 Suppose that the HRCC company has a product which the assumption of the
inventory model with backorders are valid. Information obtained by the company is
as follows;
 D = 2000 units per year

 I= 20% from unit cost

 V=$50 per Unit

 Co=$25 per order

 The company is considering the possibility of allowing some backorders to occur for
the product. The backorder cost is estimated to be $30 per unit per year. Working
Days per year is 250.
 What is Q* and S*.


MODEL III. EOQ WITH PLANNED SHORTAGES - EXAMPLE

 If the system is implemented the system will operate with following

properties
• Maximum Inventory = Q – S = 115.47 S = 115.47 – 28.87 = 86.6
Units Cycle
• Time = T = (Q/D) x 250 = 115.47/2000 x 250 = 14.43 working
days
MODEL III. EOQ WITH PLANNED SHORTAGES - EXAMPLE

 Annual Cost
MODEL IV: EOQ
WITH QUANTITY
DISCOUNTS/
MODEL IV: EOQ WITH QUANTITY DISCOUNTS

 Lower unit price on larger quantities ordered.

 This is presented as a price or discount schedule,

Ex-Certain unit price over a certain order quantity range

 This model differs from Model I because the acquisition
cost (ac) may vary with the quantity ordered, i.e., it is not
necessarily constant
MODEL IV: EOQ WITH QUANTITY DISCOUNTS
 The EOQ with quantity discounts model is applicable where a supplier

offers a lower purchase cost when an item is ordered in larger quantities.

 This model's variable costs are annual holding, ordering and purchase

costs.

 For the optimal order quantity, the annual holding and ordering costs are

not necessarily equal

MODEL IV: EOQ WITH QUANTITY DISCOUNTS
Under this condition, acquisition cost becomes an

incremental cost and must be considered in the

determination of the EOQ
MODEL IV: EOQ WITH QUANTITY DISCOUNTS

 Assumptions

 Demand occurs at a constant rate of D items per year.

 Ordering Cost is $Co per order.

 Holding Cost is $Ch

 Purchase Cost is $C1 per item if the quantity ordered is between 0 and x1 , $C2 if the

order quantity is between x1 and x2 , etc.

 Delivery time (lead time) is constant.

 Planned shortages are not permitted.

MODEL IV: EOQ WITH QUANTITY DISCOUNTS

 Formulas

– Optimal order quantity: the procedure for determining Q * will be

demonstrated

– Number of orders per year: D/Q*

– Total annual cost: [(1/2)Q *Ch ] + [DCo /Q *] + DC (holding + ordering +

purchase)
CALCULATION PROCESS

 Holding Cost rate is 20% of the acquisition

 Ordering Cost is $49 per order

 Annual Demand is 5000 units

 What order Q should we select??

CALCULATION PROCESS

 Step 1 – For each discount category compute a

Q* using the EOQ Formula based on the unit cost

associated with the discount Category
CALCULATION PROCESS
 Step 2 – For the Q* that is too small to qualify for the

assumed discount price, adjust the order quantity upward

to the nearest order quantity that will allow the price
discount

– Q*2=1000

– Q*3=2500

 Now we have to do an analysis of total cost.

CALCULATION PROCESS

 Step 3 – For each order quantity computer the total annual cost. The Q yielding the

minimum TC is the optimal Order quantity

EXAMPLE: EOQ WITH QUANTITY DISCOUNTS

 A-1 Auto Parts has a regional tyre warehouse in Atlanta. One

popular tyre, the XRX75, has estimated demand of 25,000

next year. It costs A-1 $100 to place an order for the tyres,
and the annual carrying cost is 30% of the acquisition cost.
The supplier quotes these prices for the tire:
EXAMPLE: EOQ WITH QUANTITY DISCOUNTS
EXAMPLE

 EOQ with Quantity Discounts Model Nick's Camera Shop carries Zodiac instant
print film. The film normally costs Nick $3.20 per roll, and he sells it for $5.25.
Zodiac film has a shelf life of 18 months. Nick's average sales are 21 rolls per
week. His annual inventory holding cost rate is 25% and it costs Nick $20 to place
an order with Zodiac. If Zodiac offers a 7% discount on orders of 400 rolls or
more, a 10% discount for 900 rolls or more, and a 15% discount for 2000 rolls or
more, determine Nick's optimal order quantity.
Thank you..