What Operations Managers Do?
10 OM Strategy Decisions:
• Design of Goods & Services
• Managing Quality
• Process Strategy
• Location Strategies
• Layout Strategies
• Human Resources
• Supply Chain Management
• Inventory Management
• Scheduling
• Maintenance
10 Decision Areas:
• service & product design
• quality management
• process & capacity design
• location
• layout design
• human resources & job design
• supply chain management
• inventory, MRP, and J-I-T
• intermediate, short-term,
and project scheduling
• maintenance
 Scope of Operations Management

 SYSTEM DESIGN – involves decisions relating

to the system capacity, geographic locations of
facilities, arrangement of departments, layout of
equipment, product or service planning, and
acquisition of equipment.
 SYSTEM OPERATION – involves scheduling,
inventory planning & control, management of
personnel, project management, and quality
assurance
 Introduction to
Inventory Management
 Good inventory management is important for the successful
operation of most businesses and their supply chains
 Operations, marketing and finance have interests in good
inventory management, the importance of which is due to
the ff:
 Inventory is necessary for operations

 Inventory contributes to customer satisfaction

 Inventory is a vital part of business; Inventory

investment is a company’s largest asset (30% of current

assets and 90% of working capital)
 Managerial Performance → ROI = Profit After Tax
Total Assets
 INVENTORY

 Definition: STOCK or STORE of GOODS

 Types of Inventory
1. RM (raw materials and purchased parts)
2. WIP (work-in-process, partially completed
goods)
3. FG (finished-goods inventory)
4. MRO (maintenance/repair/operating supplies)
5. Pipeline Inventory (goods-in-transit to
warehouses or customers)
 FUNCTIONS of INVENTORY
 To meet anticipated demand (walk-ins & provide selection)
 To smooth production requirements (seasonally high demand)
 To decouple production process (buffers vs. m/c breakdowns
or supplies fluctuations)
 To protect against stockouts (delivery delay and variability
increase risk of shortages)
 To take advantage of order cycles (economic lot sizes for
production or periodic ordering for purchases)
 To hedge against inflation and price increases (quantity
discounts)
 To permit operations (production operations are not
instantaneous, need intermediate stocking of RM, WIP, FG)
 OBJECTIVES of
INVENTORY CONTROL
 Inadequate control of inventories result in:
 Under-stocking (missed deliveries, lost sales, dissatisfied
customers, and production bottlenecks
 Overstocking (funds tied-up, high inventory holding costs)
 2 concerns of inventory management
1) level of customer service
2) costs of ordering and carrying inventories
 Overall objective of inventory management
 to achieve a BALANCE in stocking, i.e., achieve
satisfactory levels of customer service while keeping
inventory costs within reasonable bounds
 to make 2 fundamental decisions: TIMING and SIZE of
ORDERS (when to order and how much to order)
 INVENTORY MANAGEMENT
REQUIREMENTS for effective I.M.
 A system to keep track of the inventory on hand and on
order
 A reliable forecast of demand that includes an indication of
possible forecast error
 Knowledge of lead times and lead time variability
 Reasonable estimates of inventory holding costs, ordering
costs, and shortage costs
 A classification system for inventory items
PERFORMANCE MEASURES
 Customer Satisfaction (number and quantity of
backorders and/or customer complaints)
 Inventory Turnover (ratio of goods sold to average
 Inventory Counting Systems
 PERIODIC SYSTEM : a physical count of items in
inventory is made at periodic intervals (e.g. weekly, monthly)
in order to decide how much to order of each item
Advantages:
 Accurate on-hand quantity known (basis for ordering)
 Order for many items results in economies in processing
and shipping orders at the same time
Disadvantages:
 Lack of control between reviews
 Need to protect against shortages between review periods
by carrying extra stock
 Inventory Counting Systems
 PERPETUAL SYSTEM : (continual system) system
that keeps track of removals from inventory continuously,
thus monitoring current levels of each item
Advantages:
 Control provided by continuous monitoring of withdrawals
 Fixed-order quantity is ordered when amount on hand
reaches a pre-determined minimum level
Disadvantages:
 Added cost of record keeping
 Physical count must still be performed (to verify records
because of errors, pilferages)
 Inventory Counting Systems
1. Periodic System
 Supermarkets, discount stores and department stores have always
been major users of periodic counting systems
 Today, most have switched to bar coding
 computerized checkout system
 laser scanning device
 universal product code (UPC) or bar code
2. Perpetual System
 Ranges from very simple to very sophisticated
 A two-bin system is an elementary example:
 Uses two (2) containers for inventory; items are withdrawn from the first
bin until its contents are exhausted
 It is then time to reorder; sometimes an order card is placed at the bottom
of the first bin
 The second bin contains enough stock to satisfy demand until the order is
filled, plus an extra cushion of stock for late delivery or greater usage
 Inventory Counting Systems
1. Perpetual System
 two-bin system (cont’d)
 Advantage : no need to record each withdrawal from inventory
 Disadvantage : reorder card may not be turned in for a variety of reasons
(e.g. misplaced, person responsible forgets to turn it in)
 can be either batch or on-line
 Batch systems
 Inventory records are collected periodically and entered into the
system
 On-Line systems
 Transactions are recorded immediately
 Advantage : they are always up-to-date unlike in batch systems,
a sudden surge in demand could result in reducing the amount of
inventory below the reorder point between periodic read-ins
(frequent batch collections can minimize that problem).
 Inventory Classification System
 Inventory items are not of equal importance in terms of
dollars involved, profit potential, sales or usage volume, or
stockout penalties
 Example : Producer of Electrical Equipment
 Inventory carried includes generators, coils of wire, and

miscellaneous nuts and bolts among other items in stock

 Unrealistic to devote equal attention to each of these items

 Instead, a more reasonable approach would be to allocate

control efforts according to the relative importance of

various items in inventory
 A-B-C approach classifies inventory items according to some measure of
importance, usually dollar usage (i.e. dollar value per unit multiplied by
annual usage rate), and allocating control efforts accordingly
 Inventory Classification System
 ABC Analysis divides on-hand inventory into three (3)
classifications on the basis of annual dollar value
 It is an inventory application of the Pareto principle which states that there are
a “critical few and trivial man.”
 Idea is to establish inventory policies that focus resources on the few critical
inventory parts and not the many trivial ones.
 It is not realistic to monitor inexpensive items with the same intensity as very
expensive items
 ABC Classification
 Annual dollar volume = annual demand x cost per unit
 Typically three (3) classes of items are used: A (very important), B
(moderately important), and C (least important)
 The actual number of categories may vary from organization to organization,
depending on the extent to which a firm wants to differentiate control efforts.
 Inventory Classification System
 ABC Classification
 Class A items generally account for about only 15% to
20% of the number of items in inventory but represent
70% to 80% of the total dollar usage
 Class C items may represent only 5% to 10% of the
annual dollar volume but about 55% to 60% of the total
inventory items
 Class B items are those inventory items with medium
annual dollar volume, about 15% to 20% of the total value
representing about 30% of the the number of inventory
items
 Percentages vary from firm to firm, but in most instances a
relatively small number of items will account for a large
share of the value or cost associated with an inventory
 Inventory Classification System
 ABC Classification
 Class A items should receive a close attention through
frequent reviews of amounts on hand and control over
withdrawals
 Class C items should receive only loose control (two-bin
system, bulk orders)
 Class B items should have controls that lie between A & C
 Note that Class C items are not necessarily unimportant;
incurring a stockout of C items such as the nuts and bolts
used to assemble manufactured goods can result in a costly
shutdown of an assembly line (due to low annual dollar
volume, larger orders or ordering in advance will help
without incurring much additional cost)
 Inventory Classification System
Example No.1
Annual
Annual Unit Dollar
Item x =
Demand Cost Value
1 1,000 $4,300 $4,300,000
Class A
2 5,000 720 3,600,000
3 1,900 500 950,000
4 1,000 710 710,000
5 2,500 250 625,000 Class B
6 2,500 192 480,000
7 400 200 80,000
8 500 100 50,000
9 200 210 42,000
Class C
10 1,000 35 35,000
11 3,000 10 30,000
12 9,000 3 27,000
 Inventory Classification System
Example No.2
Item % of No. Annual Annual Percent of
Stock Of Items Volume x Unit Dollar Annual $
=
Number Stocked (Units) Cost Value Volume Class
# 10286 1,000 $90.00 $90,000 38.8%
20% 72% A
# 11526 500 154.00 77,000 33.2%

# 12760 1,550 17.00 26,350 11.3%

# 10867 30% 350 42.86 15,001 6.4% 23% B
# 10500 1,000 12.50 12,500 5.4%

# 12572 600 14.17 8,502 3.7%

# 14075 2,000 0.60 1,200 .5%
# 01036 50% 100 8.50 850 .4% 5% C
# 01307 1,200 0.42 504 .2%
# 10572 250 0.60 150 .1%
10 items $232,057
 Record Accuracy
 Good inventory policies are meaningless if management does
not know what inventory is on hand.
 Accuracy of records is a critical ingredient in production and
inventory systems
 Record accuracy allows organizations to focus on those items
that are needed, rather than settling for being sure that “some of
everything” is in inventory
 Only when an organization can determine accurately what it has
on hand can it make precise decisions about
a) ordering b) scheduling c) shipping
 To ensure accuracy,
 Incoming & outgoing record keeping must be good
 Stockroom security must also be good
 Record Accuracy
 A well-organized stockroom will have
 Limited access
 Good housekeeping
 Storage areas that hold fixed amounts of inventory
 Bins, shelf space, and parts that are labeled accurately
 Cycle Counting
 Records must still be verified through a continuing audit
(cycle count)
 Is a continuing reconciliation of inventory with inventory
records
 Is a physical count of items in inventory, the purpose of
which is to reduce discrepancies between records and
actual quantity
 Record Accuracy
 Cycle Counting
 Procedures:
1) Items are counted
2) Records are verified
3) Inaccuracies are periodically documented
4) Cause of inaccuracies is traced
5) Appropriate remedial action is taken to ensure integrity
of the inventory system
 Cycle counting uses ABC classification as a guide:
• A items will be counted frequently perhaps once a month
• B items will be counted less frequently, perhaps once a quarter
• C items will be counted perhaps once every 6 months
 Example : Cycle Counting
Cole’s Trucks, Inc., a builder of high-quality refuse trucks, has about 5,000
items in its inventory. After hiring Matt Jones, a bright young industrial
engineering student, for the summer, the firm determined that it has 500 A
items, 1,750 B items, and 2,750 C items. Company policy is to count A items
every month (every 20 working days), all B items every quarter (every 60
working days), and all C items every 6 months (every 120 working days).
How many items should be counted each day?

SOLUTION:
Item Number of Item
Class Quantity Cycle Counting Policy Counted per Day
A 500 Each month (20 working days) 500 / 20 = 25/day
B 1,750 Each quarter (60 working days) 1,750 / 60 = 29/day
C 2,750 Every 6 months (120 working days) 2,750 / 120 =
Seventy-seven items are counted each day ← 23/day
 Demand Forecasts and
Lead-Time Information
 Inventories are used to satisfy demand requirements, so it is
essential to have reliable estimates of the amount and timing of
demand.
 It is also essential to know how long it will take orders to be
delivered or the leadtime (the time between submitting an order
and receiving it)
 Managers need to know the extent of variability of demand and
leadtime
 The greater the potential variability, the greater the need for additional
stock to reduce the risk of a shortage between deliveries.
 Thus, there is a crucial link between forecasting and inventory
management
 Point-of-sale (POS) systems electronically record actual sales. Knowledge of actual sales
can greatly enhance forecasting and inventory management. Real time information on
actual demand enables management to make necessary changes to restocking decisions.
 Cost Information

 Three (3) basic information are associated

with inventories, namely:
1. Holding Cost
2. Ordering Cost
Set-Up Cost
 Shortage Cost
 Holding Cost
 Holding or carrying costs are the costs associated with
holding or “carrying” inventory over time, usually a year
 Relates to physically having items in storage, and therefore
include interest, insurance, taxes, depreciation, obsolescence,
deterioration, spoilage, pilferage, breakage, and warehousing
costs (heat, light, rent, security); also include opportunity costs
associated with funds tied up
 Is stated in 2 ways:
 Percentage of unit price ) usually ranging from 20%
 Dollar amount per unit ) to 40% of the item’s VALUE
 Ordering Cost
 Is the cost of ordering and receiving inventory
 Varies with the actual placement of an order
 Is the cost of the ordering process that includes
determining how much is needed, preparing invoices,
shipping costs, inspecting goods upon arrival for
quality and quantity, and moving the goods to
temporary storage
 Is generally expressed as a fixed dollar amount per
order, regardless of order size (or quantity ordered)
 Set-Up Cost

 When orders are being manufactured by the firm

itself instead of ordering it from a supplier, the cost
of machine set-up is the cost to prepare a machine
or process (time in preparing equipment for the job
by adjusting the machine, changing cutting tools,
etc.) for manufacturing an orders
 Is analogous to ordering cost, i.e., it is expressed as
a fixed charge per production run, regardless of
the size of the run
 Shortage Cost
 Results when demand exceeds the supply of
inventory on hand.
 Includes the opportunity cost of not making a sale,
loss of customer goodwill, late charges, and
expediting costs
 Is considered as cost of lost production or
downtime, if the shortage occurs in an item carried
for internal use (e.g. to supply an assembly line)
 Is sometimes difficult to measure and may be
subjectively estimated
 INVENTORY MODELS for
INDEPENDENT DEMAND
 Two most important questions in Inventory
Management:
a) how much to order
b) when to order
 Three independent demand models are:
1. Basic economic order quantity (EOQ) model
2. Production order quantity model (EPQ)
3. Quantity discount model (QD)
 Basic EOQ Model
 Used to identify the order size that will minimize the sum of
the annual costs of holding inventory and ordering inventory
 Assumptions:
1. Only one product is involved
2. Annual demand requirements are known, constant (spread
evenly throughout the year), and independent
3. Leadtime is known and does not vary
4. Receipt of inventory is instantaneous and complete, i.e.,
inventory from an order arrives in one batch at one time in
a single delivery
5. Quantity discounts are not possible
6. Stockouts (shortages) can be completely avoided if orders
are placed at the right time
 Basic EOQ Model Inventory ordering and
Usage occurs in CYCLES

Order size, Q = 350 units

Usage rate = 50 units per day
Leadtime = 2 days
Reorder Point = 100 units (2 days’
Q = 350 units Usage Rate = supply)
50 units / day
Qty
on hand

ROP
= 100

0 5 7 12 14 Day
Receive Place Receive Place Receive
order order order order order
LT = 2 days
 Basic EOQ Model

 The optimal order quantity reflects a trade-off between

carrying costs and ordering costs.
 As order size varies, one type of cost will increase while the
other decreases.
 If order size is relatively small, the average inventory will
be low, resulting in low carrying costs. However, a small
order size will necessitate frequent orders, which will drive
up annual ordering costs.
 Conversely, ordering large quantities at infrequent intervals
can hold down annual ordering costs, but that would result
in higher average inventory levels and therefore increased
carrying costs.
 Basic EOQ Model
Q Many orders produce a low average inventory

Average Q
Inventory =
2

0 Time
1 year
Q

Average Q
=
Inventory 2

0 Few orders produce a high average inventory Time

 Basic EOQ Model
 Ideal Solution = order size that causes neither a few
very large orders nor many small orders but one that
lies somewhere in between
 The exact amount to order will depend on the relative
magnitudes of the carrying and ordering costs
 The objective is to minimize total costs
 Significant costs are ordering (or set-up) cost and holding
(or carrying) cost.
 All other costs, such as the cost of the inventory itself , are
constant
 Minimize ordering cost & holding cost = Minimizing TC
 Basic EOQ Model

Annual Cost
Q
Annual carrying cost = H
2
Where, Q H
Q = order quantity in units 2
H = holding (carrying) cost

Order Qty

Annual Cost
D
Annual ordering cost = S
Q D S
Where, Q
D = Annual Demand, in units
S = ordering cost
Order Qty
 Basic EOQ Model

The total annual cost associated with carrying and ordering inventory when Q
units are ordered each time is

Annual Annual
Q H + DS
TC = carrying + ordering =
2 Q
cost cost

TC The optimal order quantity

Annual Cost

Q* is when annual ordering

TCmin QH cost equals annual holding
2 cost, thus
D Q H = D
S S
Q 2 Q
Order Qty
Q*
 Basic EOQ Model
Solving for Q*,
Q H = D
S
2 Q

2DS = Q2H

Q2 = 2DS
H
(EOQ) Q* =
√ 2DS

D
Expected numberHof orders = N = Demand =
Q*
Order Quantity
Length of order cycle = Q* (the time between orders) or
D
No. of Working Days per Year
Expected time between orders = T =
N
 Basic EOQ Model –Example # 1
Sharp, Inc. a company that markets painless hypodermic
needles to hospitals, would like to reduce its inventory cost
by determining the optimal number of hypodermic needles
to obtain per order. The annual demand is 1,000 units; the
ordering cost is $10 per order; and the holding cost per unit
per year is $0.50. Using these figures,

c) Calculate he optimal number of units per order

d) Determine the expected number of orders placed during the
year
e) Determine the expected time between orders (assume 250
working days per year
f) Calculate the total annual inventory costs
 Basic EOQ Model –Example # 1
SOLUTION:

√ √
a) Q* = 2DS = 2 (1,000) (10) = 200 units
0.50

b) N = D H = 1,000 = 5 orders per year

Q* 200
No. of Working Days per Year
c) T =
N
250 working days per year
=
5 orders per year
T = 50 days between orders
Q H + DS 200 (0.50) + 1,000 (10)
d) TC = =
2 Q 2
= 50 + 50 200order & carrying
Note that
TC = $100 costs are equal at the EOQ.
 Basic EOQ Model –Example # 2
A local distributor for a national tire company expects
to sell approximately 9,600 steel-belted radial tires of a
certain size and tread design next year. Annual
carrying cost is $16 per tire, and ordering cost is $75.
The distributor operates 288 days a year.

a) What is the EOQ?

b) How many times per year does the store reorder?
c) What is the length of an order cycle?
d) What is the total annual cost if the EOQ is ordered?
 Basic EOQ Model –Example # 2
SOLUTION:

√ √
a) Q* = 2DS = 2 (9,600) 75 = 300 tires
16

b) N = D H = 9,600 tires/year = 32 orders per year

Q* 300 tires/order
No. of Working Days per Year
c) T =
N
288 working days per year
=
32 orders per year
T = 9 working days between orders
Q H + DS 300 (16 ) + 9,600 (75 )
d) TC = =
2 Q 2
= 2,400 + 2,400 300 costs
Note that order & carrying
TC = $4,800 are equal at the EOQ.
 Basic EOQ Model –Example # 3
Piddling Manufacturing assembles security monitors. It purchases 3,600
black-and-white cathode ray tubes a year at $65 each. Ordering costs are
$31, and annual carrying costs are 20 percent of the purchase price.
Compute (a) the optimal order quantity and (b) the total annual cost of
ordering and carrying the inventory.

Solution: D = 3,600 cathode ray tubes per year

S = $31
H = (given as % of purchase price) = 0.20($65) = $13

√ √
a) Q* = 2DS = 2 (3,600) 31 = 131 cathode ray tubes
13
H
Q H + DS 131 (13 ) + 3,600 (31 )
b) TC = =
2 Q 2
= 852 + 852 = $131
1,704
 Economic Production Quantity
(EPQ) Model
 The batch mode of production is widely used in production.
(Even in assembly operations, portions of the work are done
in batches)
 Reason for Batch Production: the capacity to produce a part
exceeds the part’s usage or demand rate. (As long as
production continues, inventory will grow, so it makes sense
to periodically produce such items in batches, or lots)
 The assumptions of the EPQ model are similar to those of
EOQ model, except that instead of orders received in a
single delivery, units are received incrementally during
production.
 Economic Production Quantity
(EPQ) Model
 An economic order quantity technique applied to
production orders
 Assumptions:
1. Only one item is involved
2. Annual demand is known
3. The usage rate is constant
4. Usage occurs continually, but production occurs
periodically
5. The production rate is constant
6. Lead time does not vary
7. There are no quantity discounts
 Economic Production Quantity
(EPQ) Model
 During the production phase of the cycle, inventory builds
up at a rate equal to the difference between production and
usage rates.
 Example: if daily production rate is 20 units and the daily usage
rate is 5 units, inventory will build up at the rate of 20 – 5 = 15
units per day.
 As long as production occurs, the inventory level will
continue to build; when production ceases, the inventory
level will begin to decrease
 The inventory level will be at a maximum at the point
where production ceases
 When the amount of inventory on hand is exhausted,
production is resumed, and the cycle repeats itself
 Economic Production
Quantity (EPQ) Model
Production
and
Usage Usage only
Run size
Q*
Cumulative
Production
Inventory level

Imax

Amount
on hand

Part of inventory cycle Demand part of Time

during w/c production is cycle with no
taking place production
 Economic Production Quantity
(EPQ) Model
 Since the company makes the product (or components) itself,
there are no ordering costs as such.
 Instead, there are set-up costs with every production run
(batch).
 Set-up costs are the costs required to prepare the equipment
for the job, such as cleaning, adjusting, and changing tools &
fixtures.
 Set-up costs are analogous to ordering costs because they are
independent of the lot (run) size.
 They are treated in the formula in exactly the same way
 The larger the run size, the fewer the number of runs needed, and
hence the lower the annual set-up cost
 Economic Production Quantity
(EPQ) Model
Number of production runs or batches = D
Q
Annual set-up cost = number of runs per year x set-up cost per run = D S
Q
Total cost = TC = Carrying Cost + Setup cost = ( )I max
2
H + DS
Q*
where, Imax = maximum inventory = Q* ( p – u ) or Q* ( 1 – u / p )
p

Economic run quantity, Q* =

√ √ 2DS p
p-u
or
√ 2DS

H
Where, p = daily production or delivery rate H(1–u/p)
u = usage rate per day
Q*
Cycle time (time between beginnings of runs) =
u
Run time (production phase of the cycle) = Q*
p
 EPQ Model - Example # 1
A toy manufacturer uses 48,000 rubber wheels per year for its popular dump
truck series. The firm makes its own wheels, which it can produce at a rate
of 800 per day. The toy tucks are assembled uniformly over the entire year.
Holding (carrying) cost is $1 per wheel a year. Setup cost for a production
run of wheels is $45. The firm operates 240 days per year. Determine
a) Optimal run size
b) Minimum total annual cost for carrying and setup
c) Cycle time for the optimal size
d) Run time

SOLUTION: D = 48,000 wheels per year

S = $45
H = $1 per wheel per year
p = 800 wheels per day
u = 48,000 wheels per 240 days, or 200 wheels per day
 EPQ Model - Example # 1
a) Q* =
√ √ 2DS p
p-u
=
5 √
2(48,000)4 800
√
800 - 200
= 2,400
wheels
H 1
= ( )
I 1,800 x $1 + 48,000
b) TCmin max
H + DS = x $45
2 Q* 2 2,400
= $900 + $900
= $1,800
Compute first for Imax = Q* ( p – u ) = 2,400 (800 – 200 ) = 1,800 wheels
p 800 Thus, a run of
c) Cycle time = Q* = 2,400 wheels wheels will be
= 12 days made every 12
u 200 wheels per day
days
Q* 2,400 wheels Each run will
d) Run time = = = 3 days
p 800 wheels per day require 3days
to complete
 EPQ Model - Example # 2

Nathan manufacturing, Inc., makes and sells specialty

hubcaps for the retail automobile market. Nathan’s
forecast for its wire-wheel hubcap is 1,000 units next
year, with an average daily demand of 4 units.
However, the production process is most efficient at
8 units per day. So the company produces 8 per day
but uses only 4 per day. Given the following values,
solve for the optimum number of units per order.
(Note: This plant schedules production of this hubcap
only as needed, during the 250 days per year the shop
operates.)
 EPQ Model - Example # 2
SOLUTION: Annual demand = D = 1,000 units
Setup cost = S = $10
Holding cost = H = $0.50 per unit per year
Daily production rate = p = 8 units daily
Daily demand rate = u = 4 units daily

Economic run quantity Q* =

√ √ 2DS p
p-u
or
√ 2DS

H H(1–u/p)
=
√ 2 (1,000) 10

0.50 ( 1 – 4 / 8)
=
√ 20,000 = √ 80,000

0.50 ( 1/2 )
= 282.3 hubcaps or 283 hubcaps
 Quantity Discount Model

 Quantity Discounts – are price reductions for large orders

offered to customers to induce them to buy in large
quantities.
 If quantity discounts are offered, the buyer must weigh the
potential benefits of reduced purchase price and fewer
orders that will result in buying in large quantities against
the increase in carrying costs caused by higher average
inventories.
 The buyer’s goal with quantity discounts is to select the
order quantity that will minimize total cost, where total cost
is the sum of carrying cost, ordering cost, and purchasing
cost
 Quantity Discount Model
TC = Carrying cost + Ordering Cost + Purchasing Cost
Q H + DS where P = Unit price
= + PD
2 Q

TC with PD
Annual Cost

TC without PD
QH
2
PD
D
S
Q
EOQ* Order Qty
 Quantity Discount Model
Note that no one curve applies to the entire range of
Order Price quantities; each curve applies to only a portion of the
Quantity per Box range. Hence, the applicable or feasible total cost is
1 to 44 $2.00 initially on the curve with the highest unit price and drops
45 to 69 1.70 down, curve by curve, at the price breaks, which are the
70 or more 1.40 minimum quantities needed to obtain the discounts.
Cost TC @ $2.00 each
Though each
curve has a TC @ $1.70 each
minimum, those
points are not
TC @ 1.40 each
necessarily
feasible.
PD @
The actual total- $2.00 each PD @
cost curve is $1.70 each PD @ 1.40 each
denoted by the
solid lines; only
those price-quantity Order Qty
combinations are feasible. 45 70
 Quantity Discount Model
 The objective of the QD model is to identify an order
quantity that will represent the lowest total cost for the
entire set of curves
 Two (2) general cases of the QD model:
 Carrying costs are constant (fixed amount per unit)
 Carrying costs are stated as a percentage of purchase price
TCa TCa
TCb TCb
Cost

Cost
TCc TCc
CC a,b,c CCa
CCb
CCc
OC OC
Quantity Quantity
EOQ* EOQ*
Quantity Discount Model
Procedures when CC = constant

1. Compute the common minimum EOQ* point

2. Only one of the unit prices will have the minimum
point in its feasible range since the ranges do not
overlap. Identify that range.
 If the feasible minimum point is on the lowest price range, that
is the optimal order quantity.
 If the feasible minimum point is in any other range, compute
the total cost for the minimum point and for the price breaks of
all lower unit costs. Compare the total costs; the quantity
(minimum point or price break) that yields the lowest total cost
is the optimal order quantity.
 QD Model - Example No. 1
The maintenance department of a large hospital uses about 816
cases of liquid cleanser annually. Ordering costs are $12,
carrying costs are $4 per case a year, and the new price
schedule indicates that orders of less than 50 cases will cost
$20 per case, 50 to 79 cases will cost $18 per case, 80 to 99
cases will cost $17 per case and larger orders will cost $16 per
case. Determine the optimal order quantity and the total cost.

SOLUTION: Range Price

D = 816 cases per year 1 to 49 $ 20
S = $12 50 to 79 18
H = $4 per case per year 80 to 99 17
100 or more 16
 QD Model - Example No. 1

1. Compute the common EOQ* = √2DS/ H = √2(816)12/ 4 = 70 cases

2. The 70 cases can be bought at $18 per case because 70 falls in the range
of 50 to 79 cases. The total cost to purchase 816 cases a year, at the rate
of 0 cases per order will be
TC70 = Carrying cost + Order cost + Purchase cost
= (Q/2) H + (D/Q) S + PD
= (70 / 2) 4 + (816 / 70 ) 12 + 18 ( 816 ) = $14,968
6. Because lower cost ranges ($17 and $16) exist, each must be checked
against the minimum cost generated by 70 cases at $18 each:
TC80 = (80/2)4 + (816/80)12 + 17(816) = $14,154
TC100 = (100/2)4 + (816/100)12 + 16(816) = $13,354
Therefore, because 100 cases per order yields the lowest total cost,
100 cases is the overall optimal order quantity.
 Quantity Discount Model
Procedures when CC = percentage of
price
1. For each discount, calculate a value for the optimal order
size Q*, using the formula Q* = √2DS/ (% x P)
2. For any discount, if the order quantity is too low to qualify
for the discount, adjust the order quantity upward to the
lowest quantity (or price break) that will qualify for the
discount.
3. Compute the total cost (holding + ordering + purchase
costs) for every Q* determined in steps 1 and 2. Be sure to
use the adjusted value for Q* and the respective discounted
price and holding cost.
4. Select the Q* that has the lowest total cost, as computed in
step 3. It will be the quantity that will minimize the total
inventory cost
 QD Model - Example No. 2

Wohl’s Discount Store stocks toy race cars. Recently, the store
has been given a quantity discount schedule for these cars. This
quantity schedule is shown in the table below. Ordering cost is
$49.00 per order, annual demand is 5,000 race cars, and inventory
carrying charge is 20% of the price. What order quantity will
minimize the total inventory cost?

Discount Quantity Discount (%) Discount Price (P)

0 to 900 no discount $5.00
1,000 to 1,999 4 $4.80
2,000 and over 5 $4.75
 QD Model - Example No. 2
1) The first step is to compute Q* for every discount:
Q*5.00 = √2(5,000)(49)/ (.2)(5.00) = 700 cars order (FEASIBLE)
Q*4.80 = √2(5,000)(49)/ (.2)(4.80) = 714 cars order (Not in range)
Q*4.75 = √2(5,000)(49)/ (.2)(4.75) = 718 cars order (Not in range)
5) The second step is to adjust upward those values of Q* that are below the
allowable discount range:
Q*5.00 = 700 - as is (because it is in the range)
Q*4.80 = 1,000 - adjusted
Q*4.75 = 2,000 - adjusted
9) Compute total costs for each Q* [Note: TC = (D/Q)S + (Q/2)H + PD]:
Price Quantity OC CC PD Total
$5.00 700 $350 $350 $25,000 $25,700
$4.80 1,000 $245 $480 $24,000 $24,725
$4.75 2,000 $122.50 $950 $23,750 $24,822.50
• Select Q*4.80 = 1,000 toy cars that gives a TCmin of $24,725.
 QD Model - Example No. 3
Surge Electric uses 4,000 toggle switches a year. Switches are priced as
follows: 1 to 499, 90 cents each; 500 to 999, 85 cents each; and 1,000 or
more, 80 cents each. It costs approximately $30 to prepare an order and
receive it, and carrying costs are 40 % of purchase price per unit on an
annual basis. Determine the optimal order quantity and the total annual cost.

SOLUTION: Range Price H

D = 4,000 switches per year 1 to 499 $0.90 0.40(0.90) = 0.36
S = $30 500 to 999 $0.85 0.40(0.85) = 0.34
H = 0.40P 1,000 or more $0.80 0.40(0.80) = 0.32
Minimum Point 0.80 = √2(4,000)30/0.32 = 866 switches (NOT
FEASIBLE)
Minimum Point 0.85 = √2(4,000)30/0.34 = 840 switches (FEASIBLE)
TC840 = (840 / 2)0.34 + (4,000/ 840)30 + 0.85(4,000) = $3,686
TC1000 = (1000/2)0.32 + (4,000/1000)30 + 0.80(4,000) = $3,480
 When to REORDER with
EOQ Ordering
 EOQ models answer the question of how much to order,
 The question of when to order is the function of models that
identify the reorder point (ROP) in terms of a quantity.
 ROP occurs when the quantity on hand drops to a
predetermined amount which:
 generally includes expected demand during leadtime plus an extra
cushion of stock
 serves to reduce the probability of experiencing a stockout during
leadtime
 requires perpetual inventory in order to know if it has been reached
 The goal in ordering is to place an order when the amount of
inventory on hand is sufficient to satisfy demand during the
time it takes to receive that order (i.e., leadtime).
 REORDER POINT

 Four determinants of the reorder point quantity

1. The rate of demand (usually based on forecast)
2. The leadtime
3. The extent of demand and/or leadtime variability
4. The degree of stockout risk acceptable to mgmt.
 If demand and leadtime are both constant, then
ROP = d x LT , where
d = demand rate (units per day or week)
LT = leadtime in days or weeks
Note: Demand and leadtime must have the same time units
 REORDER POINT - Example
Tingly takes Two-a-Day vitamins, which are delivered
to his home by a routeman seven days after an order is
called in. At what poit should Tingly reorder?

Usage = 2 vitamins a day

Leadtime = 7 days
ROP = usage x leadtime
= 2 vitamins per day x 7 days
= 14 vitamins
Thus, Tingly should reorder when 14 vitamin tablets
are left.
 PROBABILISTIC MODELS
with CONSTANT LEADTIME
 PROBABILISTIC MODEL is a statistic model applicable
when product demand or any other variable is not known,
but can be specified by means of a probability distribution
 An important concern in inventory management is
maintaining an adequate SERVICE LEVEL in the face of
uncertain demand
 SERVICE LEVEL = Complement of the probability of a
stockout, i.e., (SL = 1 – probability of a stockout). For
instance, if the probability of a stockout is 0.05, then the
service level is 0.95
 Uncertain demand raises the probability of a stockout; one
method of reducing stockouts is to hold extra units in
inventory, referred to as SAFETY STOCK.
 Safety Stock
 Reduces the risk of running out of inventory (a stockout)
during leadtime
 Acts as a buffer when added to the reorder point, thus
ROP = ( d x L ) + ss
 The amount of safety stock maintained depends on the
cost of incurring a stockout and the cost of holding the
extra inventory.
 Annual stock out cost is computed as follows:
= the sum of the units short x the probability x the
stockout cost/unit x the number of orders per year
 ROP with SS - Example
David Rivera Optical has determined that its reorder point for
eyeglass frames is 50 (d x LT) units. Its carrying cost per frame per
year is $5, and stockout (or lost sale) cost is $40 per frame. The
store has experienced the following probability distribution for
inventory demand during the reorder period. The optimum number
of orders per year is six.
Number of Units Probability
30 .2
40 .2
ROP → 50 .3
60 .2
70 .1
1.0
How much safety stock should David Rivera keep on hand?
 ROP with SS - Example
SOLUTION: The objective is to find the amount of safety stock that minimizes
the sum of the additional inventory holding costs and stockout cost. The annual
holding cost is simply the holding cost per unit multiplied by the units added to
the ROP. For example, a safety stock of 20 frames, which implies that the new
ROP, with safety stock, is 70 (= 50 + 20), raises the addnual carrying cost by
$5(20) = $100.
However, computing annual stockout cost is more interesting. For any
level of safety stock, stockout cost is the expected cost of stocking out. It is
computed by multiplying the number of frames short by the probability of
demand at that level, by the stockout cost, by the number of times per year the
stockout can occur (which in this case is the number of orders per year). Then
add stockout costs for each possible stockout level for a given ROP. For zero
safety stock, for example, a shortage of 10 frames will occur if demand is 60, and
a shortage of 20 frames will occur if the demand is 70.
 ROP with SS - Example
SOLUTION: (continued)
Thus the stockout costs for zero safety stock are

(10 frames short)(.2)($40 per stockout)(6 possible stockouts per year)

+ (20 frames short)(.1)($40)(6) = $960

The following table summarizes the total costs for each alternative:
Safety Additional Total
Stock Holding Cost Stockout Cost Cost
20 (20)($5) = $100 = 0 $100
10 (10)($5) = $ 50 (10)(.1)($40)(6) = $240 $290
0 0 (10)(.2)($40)(6) +
(20)(.1)($40)(6) = $960 $960
The safety stock with the lowest total cost is 20 frames. Therefore, this
safety stock changes the reorder point to 50 + 20 = 70 frames.
 Service Level

 The cost of inventory policy increases dramatically with an

increase in service levels.
 Inventory costs, indeed, increases exponentially as service
level increases
 Because it costs money to hold safety stock, the cost of
carrying safety stock must be weighed against the reduction
in stockout risk it provides.
 The customer service level increases as the risk of stockout
decreases
 Order cycle service level can be defined as the probability
that demand will not exceed supply during the leadtime
 Service Level
 Service level when defined as meeting 95% of the
demand implies a probability of 95 percent that
demand will not exceed supply during leadtime
 Conversely, 95% service level implies having
stockout risk of only 5% of the time
 SL = 100 percent - Stockout risk
 The amount of safety stock depends on the
following factors:
1. The average demand rate and average leadtime
2. Demand and leadtime variability
3. The desired service level
 Service Level
 For a given order cycle service level, the greater the
variability in either demand rate or leadtime, the greater
the amount of safety stock that will be needed to achieve
that service level
 Similarly, for a given amount of variation in demand rate
or leadtime, achieving an increase in the service level will
require increasing the amount of safety stock.
 Selection of a service level may reflect stockout costs (e.g.
lost sales, customer dissatisfaction) or it might simply be a
policy variable (e.g. the manger wants to achieve a
specified service level for a certain item)
 ROP based on Normal
Distribution of LT demand
Expected demand + zσ dLT
ROP = during leadtime
Service where,
Level
z = number of standard deviations
(Probability of
no strockout) σ dLT = the standard deviation
of leadtime demand
Expected ROP Quantity
Demand The value of z depends on
Safety the stockout risk that the
stock manager is willing to
accept.
0 z z-axis The smaller the risk the
manager is willing to
Use Appendix B, Table B to obtain z-values, accept, the greater the
given desired service level for leadtime value of z.
 ROP based on Normal Distribution
of LT demand - Example No. 1
Example : Suppose that the manager of a construction supply
house determined from historical records that demand for sand
during leadtime averages 50 tons. In addition, suppose the
manager determined that the demand during leadtime could be
described by a normal distribution that has a mean of 50 tons
and a standard deviation of 5 tons. Answer the following
questions, assuming that the manager is willing to accept a
stockout risk of no more than 3 percent:
a) What value of z is appropriate?
b) How much safety stock should be held?
c) What reorder point should be used?
 ROP based on Normal Distribution
of LT demand - Example No. 1
SOLUTION: Expected leadtime demand = 50 tons
σdLT = 5 tons
Stockout risk = 3 percent

 From Appendix B, Table B, using a service level of 1 - .03 =

.9700, a value of z = +1.88 is obtained.
 Safety stock = zσdLT = 1.88(5) = 9.40 tons
 ROP = Expected leadtime demand + safety stock
= 50 + 9.40
= 59.40 tons
 ROP based on Normal
Distribution of LT demand
 If only demand is variable, then σdLT = √ LT σd and
ROP = d x LT + z √ LT σd
where, d = Average daily or weekly demand
 If only leadtime is variable, then σdLT = dσLT and
ROP = d x LT + z dσd
where, d = daily or weekly demand
LT = Average leadtime in days or weeks
σLT = Standard deviation of lead time in days or weeks
9) If both demand and leadtime are variable,
then σdLT = √ LT σd2 + d2 σ 2LT
and ROP = d x LT + z√ LT σd2 + d2 σ2LT

NOTE: Each of these models assumes that demand and leadtime are
 ROP based on Normal Distribution of
LT demand - Example No. 2
A restaurant uses an average of 50 jars of a special sauce each week.
Weekly usage of sauce has a standard deviation of 3 jars. The manager is
willing to accept no more than a 10 percent risk of stockout during leadtime,
which is two weeks. Assume the distribution of usage is normal.
a) Which of the above formulas is appropriate for this situation? Why?
b) Determine the value of z.
c) Determine the ROP.
SOLUTION: d = 50 jars per week LT = 2 weeks
σd = 3 jars per week SL = 1 - .10 = .90
• Because demand is variable (i.e., has a standard deviation), formula no. 1 is
appropriate.
• From Appendix B, Table B, using a service level of .9000, z = +1.28
• ROP = d x LT + z √ LT σd = 50 x 2 + 1.28 √ 2 (3) = 100 + 5.43 = 105.43
 Shortages and Service Levels

 The ROP computation does not reeal the expected

amount of shortage for a given leadtime service level.
 The expected number of units short can be determined
using the same information used in ROP
computations, with one additional piece of
information, E(z), (from the Table)
E(n) = E(z) σ dLT , where
E(n) = Expected number of units short per order cycle
E(z) = Standardized number of units short (from Table)
σdLT = standard deviation of leadtime demand
 Shortages – Example No.1
Suppose the standard deviation of leadtime demand is known to be
20 units. Leadtime demand is approximately normal.
b) For a leadtime service level of 90 percent, determine the expected
number of units short for any order cycle.
c) What leadtime service level would be an expected shortage of 2
units imply?
SOLUTION : σdLT = 20 units

• Leadtime (cycle) service level = .90. From table, E(z) = 0.048

E(n) = 0.048(20 units) = 0.96 unit, or about 1 unit
• For the case where E(n) = 2, solve for E(z) and determine from
the table the corresponding service level. Thus, E(z)=E(n)/ σdLT
= 2/20 = 0.100 which corresponds to SL = 81.5% (interpolating)
 Shortages – Example No.2

 Expected number of units short per year is

D
E(N) = E(n)
Q
 Example:
Given the following information, determine the expected number
of units short per year.

D = 1,000 Q = 250 E(n) = 2.5

Then, E(N) = 2.5 (1,000 / 250 ) = 10.0 units per year

 Annual Service Level

 Annual Service Level is the percentage of

demand filled directly from inventory (also
known as fill rate)
 Formula: SLannual = 1 – E(N)
D
E(N) = E(n)D/Q = E(z) σ dLT D/Q

SLannual = 1 – E(z) σ dLT

Q
 Annual Service Level – Example

Given a leadtime service level of 90, D = 1,000, Q = 250, and σdLT = 16,
determine the annual service level and the amount of cycle safety stock
that would provide an annual service level of .98.

From the table, E(z) = 0.048 for a 90 percent leadtime service level.
• SLannual = 1 – 0.048(16)/250 = .997
• SLannual = 1 – E(z) σdLT / Q
0.98 = 1 – E(z)(16)/250

Solving, E(z) = 0.312; From the table, with E(z)=0.312, it can be seen
that this value if E(z) is a little more than the value of 0.307. So it appears
that an acceptable value of z might be 0.19. The necessary safety stock to
achieve the specified annual service level is equal to z σdLT. Hence, the
safety stock is 0.19(16) = 3.04, or approximately 3 units
 How Much to Order:
Fixed-Order-Interval Model
 FOI Model is used when orders must be placed at fixed time
intervals (weekly, twice a month, etc.)
 Is widely used by retail businesses
 Question to be answered at each order point is: How much
should be ordered for the next (fixed)interval?
 If demand is variable, the order size will tend to vary from
cycle to cycle.
 Different from EOQ/ROP approach in which the order size
generally remains fixed from cycle to cycle, while the length of
the cycle varies (shorter if demand is above average, and longer
if demand is below average)
 How Much to Order:
Fixed-Order-Interval Model
 Reasons to use FOI Model:
1) A supplier’s policy might encourage orders at
fixed intervals
2) Grouping orders for items from the same supplier
can produce savings in shipping costs
3) An alternative for retail operations which do not
lend itself to continuous monitoring of inventory
levels (only periodic checks will do with the use
of fixed-interval ordering)
 Differences between Fixed-Quantity
Systems & Fixed-Order-Interval
Models
FIXED-QUANTITY MODEL FIXED-ORDER-INTERVAL
 Orders are triggerred by  Orders are triggered by time
quantity (ROP)  Stockout protection for
 Stockout protection only leadtime plus the next order
during leadtime cycle
 Higher than normal demand  Result of higher than
causes a shorter time normal demand is a larger
between orders order size
 Close monitoring of  Only a periodic review
inventory is required to (physical inspection) of
know when ROP is reached inventory on hand is needed
prior to ordering
 Fixed-Order-Interval Model

 Determining the amount to order

Amount Expected demand Safety Amount on hand
= during protection + -
to order stock at reorder time
interval
= d(OI + LT) + z σ d √ OI + LT - A

where OI = Order interval (length of time between orders)

A = Amount on hand at reorder time
As in previous models, demand during the protection interval
is normally distributed.
 Fixed-Order-Interval Model
Example
Given the following information, determine the amount to order.
d = 30 units per day Desired service level = 99 percent
σd = 3 units per day Amount on hand at reorder time = 71 units
LT = 2 days OI = 7 days

Z = 2.33 for 99 percent service level

Amount = d(OI + LT) + z σd √ OI + LT - A

to order = 30 (7 + 2) + 2.33(3) √ 7 + 2 - 71
= 220 units
 Fixed-Order-Interval Model

 An issue related to FIO system is the risk of

stockout
 Stockout can occur at two points in the order
cycle:
1) Shortly after the order is placed, while waiting to
receive the current order
2) Near the end of the cycle, while waiting to receive
the next order
 Fixed-Order-Interval Model

 Finding the Risk of Stockout

 To find the initial risk of a stockout, use the ROP
formula ROP = d x LT + z √ LT σd , setting ROP
equal to the quantity on hand when the order is placed,
and solve for Z, then obtain the service level for that
value of Z from Appendix B, Table B and subtract it
from 1.0000 to get the risk of a stockout
 To find the risk of a stockout at the end of the order
cycle, use the fixed-interval formula, Amount to Order
= d(OI + LT) + z σd √ OI + LT - A , and solve for z.
Then obtain the service level for that value of z from
Appendix B, Table B and subtract it from 1.0000 to get
the risk of a stockout
 Fixed-Order-Interval Model
Example – Risk of Stockout
Given the following information:
LT = 4 days A = 43 units
OI = 12 days Q = 171 units
d = 10 units/day σd = 2 units/day
Determine the risk of a stockout at
f) The end of the initial leadtime
g) The end of the second leadtime
SOLUTION;
i) For the risk of stockout for the first leadtime, ROP = 10 x 4 + z(2)(2) = 43
Solving, z = +.75. From Appendix B, Table B, the service level is .7734
The risk is 1 - .7734 = .2266, which is fairly high.
l) For the risk of a stockout at the end of the second leadtime, substituting the
given values, 171 = 10 x (4 + 12) + z(4)(2) – 43 . Solving, z = +6.75 . This
value is way out in the right tail of the normal distribution, making service
level virtually 100 percent, and thus, the risk of a stockout at this point is
essentially zero.
 Fixed-Order-Interval Model
 Benefits
 Results in the tight control needed for A items in an ABC

classification due to the periodic reviews it requires

 Grouping orders can yield savings in ordering, packing, and

shipping costs (when 2 or more items are ordered from the

same supplier)
 Practical approach if inventory withdrawals cannot be closely

monitored
 Disadvantages
 Necessitates a larger amount of safety stock for a given risk of

stockout because of the need to protect against shortages

during the entire order interval plus lead time (instead of
leadtime only)
 Higher carrying costs on top of the costs of periodic reviews
 Single-Period Model
 Sometimes referred to as the newsboy problem
 Used for ordering of perishables (fresh fruits,
vegetables, seafood, cut flowers) and other items with
limited lives (newspapers, magazines, spare parts for
specialized equipment)
 Analysis of single-period situations focuses on two
costs: shortage and excess
 Shortage cost – generally the unrealized profit per unit
 Excess cost – difference between purchase cost and
salvage value of items left over at the end of the period
 Single-Period Model
Continuous Stocking Levels
 Formula for costs:
Cshortage = Cs = Revenue per unit – Cost per unit
Cexcess = Ce = Original cost per unit – Salvage value per unit
 Continuous Stocking Levels
 Optimal stocking level = balance between shortage & excess
 Service Level = probability that demand will not exceed the

stocking level (SL computation is the key to determining the

optimal stocking level, So) Ce Cs

Service Level = Cs Service level

C s + Ce
where Cs = shortage cost per unit Quantity →
So
Ce = excess cost per unit Balance Point
 Single-Period Model - Example
Continuous Stocking Levels
Sweet cider is delivered weekly to Cindy’s Cider Bar. Demand varies
uniformly between 300 liters and 500 liters per week. Cindy pays 20 cents per
liter for the cider and charges 80 cents per liter for it. Unsold cider has no
slavage value and cannot be carried over into the next week due to spoilage.
Find the optimal stocking level and its stockout risk for that quantity.
SOLUTION:
Ce = cost per unit – Salvage value per unit
= $0.20 - $0
= $0.20 per liter
Cs = Revenue per unit – Cost per unit
= $0.80 - $0.20
= $0.60 per liter
SL = Cs / (Cs + Ce) = $0.60/($0.60+$0.20) = 0.75
So = 300 + 0.75(500 – 300) = 450 liters
75%
The stockout risk is 1.00 – 0.75 = 0.25 450 500