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@ In EOQ Model, We
assumed that the
entire order was
received at one time.
@ However, Some
Business Firms may
receive their orders
over a period of time.
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@ Such cases require a different inventory
model.
@ Here, we take into account the daily
production rate and daily demand rate.
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@ Since this model is especially suitable
for production environments, It is
called Production Order Quantity Model.
@ Here, we use the same approach as we
used in EOQ model.
@ Lets define the following:
|

 
 



@ p: Daily Production rate (units / day)
@ d: Daily demand rate (units / day)
@ t: Length of the production in days.
@ H: Annual holding cost per unit
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@ Average Holding Cost = (Average
Inventory)  H

= (Max. Inventory / 2)  H
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@ In the period of production (until the
end of each t period):
@ Max. Inventory = (Total Produced)
ƛ (Total Used)
= p.t - d.t
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@ Here, Q is the total units that are
produced.
@ Therefore,
@ Q = p.t t = Q/p
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@ If we replace the values of t in the Max.
Inventory formula:
@ Max. Inventory = p (Q/p) - d
(Q/p) = Q - dQ/p = Q (1 ƛ d/p)
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@ Annual Holding Cost = (Max.
Inventory / 2)  H = Q/2 (1 ƛ
d/p)  H

Annual Setup Cost = (D/Q)  S

 |

 
 



@ 6ow we will set
Annual Holding Cost = Annual
Setup Cost
Q/2 (1 ƛ d/p)  H = (D/Q)  S
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@ This formula gives us the optimum
production quantity for the Production
Order Quantity Model.

@ It is used when inventory is consumed

as it is produced.
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In this model, we
assume that stock
outs (and
backordering) are
allowed.
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@ In addition to previous assumptions, we
assume that sales will not be lost due to
a stock out.
@ Because, we will back order any
demand that can not be fulfilled.
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B: Backordering cost per unit per year
b: The amount backordered at the time
the next order arrives
Q ƛ b: Remaining units after the
backorder is satisfied
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J







@ Total Annual Cost = Annual Setup Cost
+ Annual Holding Cost + Annual
Backordering Cost
@ Annual Setup (Ordering) Cost = (D/Q)  S
@ Annual Holding Cost = (Average
Inventory Level)  H
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@ By using the graphical ratios, we know
that:

@ T1 / T = (Q ƛ b) / Q Therefore,
if we replace T1/T in the above
equation we get

@ Average Inventory Level = (Q ƛ b)2 / 2Q

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J







@ By using the graphical ratios, we know
that:
@ T2 / T = b / Q Therefore, if we
replace T2/T in the above equation we
get
@ Average Backordering = b2 / 2Q
and
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@ We find optimum order quantity (Q*)
and optimum backordering quantity
(b*) by taking the derivatives of
dTC/dQ = 0 and dTC / db = 0 and
then putting the values in their places.
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@ A quantity discount is simply a reduced
price (P) for an item when it is
purchased in LARGER quantities.
@ A typical quantity discount schedule is
as follows:
 



 



@ Since the unit cost for the Third
discount is the lowest, We might be
tempted to order 2000 or more units.
@ However, this quantity might not be the
one that minimizes the Total Cost.
@ Remember that, As the quantity goes
up, the holding cost increases.
 



@ Here, there is a trade off between
reduced product price (P) and increased
holding cost (H).
@ Total Cost = Setup Cost + Holding
Cost + Product Price (Cost)
@ Total Cost = DS / Q + QH / 2 + PD
where P is the price per unit
 



@ To determine the minimum Total Cost,
we perform the following process which
includes 4 steps:
 



@ 3 ep 1: Assume ha
@ I: is a percen age value, and
@ I  | represents the holding cost as a
percentage of price per unit (|).
 



@ For each discount alternative, calculate
a value of Q* = [2DS / I| 1/2
@ Here, instead of using a value of H, the
holding cost is equal to I . |
@ That is, If the item is expensive (such
as a Class A Item), Its holding cost will
be higher.
 



@ Since the price of item (|) is a factor in
Annual Holding Cost, we can no longer
assume that the holding cost is
constant (such as H) when price
changes.
 



@ 3 ep 2: For any discoun al erna ive,
@ If he calcula ed op imum order
quan i y (Q*) is oo low o qualify for
he discoun range,
@ Then, Adjus he order quan i y upward
o he lowes quan i y ha will qualify
for he par icular discoun al erna ive.
 



@ 3 ep 3: Using he o al cos (TC)
equa ion above, compu e a o al cos
for every order quan i y (Q). -





.
 



@ 3 ep 4: 3elec he discoun al erna ive
which has he minimum To al Cos
(TC).
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@ Consider the quantity discount schedule

given in the beginning (above).
@ Assume that the Ordering (Setup) Cost
(S) is $49 per each order.
@ Annual Demand (D) is 5000 units, and
@ Inventory carrying charge is a
percentage (I=0.20) of product cost
(|).
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@ Ô es
: Wha rder q a
y w
ll

m

m
ze he  al
ve ry c .
@ Awer:
@ 3 ep 1: Cmp e Ô* fr every d
c 
rage.
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@ 3 ep 2: Adjus values of Q* ha are

below allowable discoun ranges.
- For Q1, allowable range is 0-999. 3ince
Q1* = 700 is be ween 0 and 999, I
does no have o be adjus ed.
M 

- For Q2, allowable range is 1000-1999.

Since Q2* = 714 is not in the allowed
range, we adjust it to the lowest
allowable value, That is Q2* = 1000.
- For Q3, allowable range is 2000-. Since
Q3* = 718 is not in the allowed range,
we adjust it to the lowest allowable
value, That is Q3* = 2000.
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@ 3 ep 3: Compu e o al cos for each of

he order quan i ies (Q*)
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@ 3 ep 4: An Order quan i y of 1000 uni s

will minimize he o al cos .
@ However, if he hird discoun cos is
lowered o $4.65, selec ing This
discoun al erna ive (2000 uni s) would
be he op imum solu ion.
|



@ So far we assumed that demand is
constant and uniform.
@ However, In |robabilistic models,
demand is specified as a probability
distribution.
@ Uncertain demand raises the possibility
of a stock out (or shortage). (Why?)
|



@ One method of reducing stock outs is to
hold extra inventory (called 3afety
3tock).
@ In this case, we change the RO|
formula to include that safety stock
(ss).
|



RO| = d  L
d = daily demand, and
L = Order Lead Time
6ow it will be as follows:
RO| = d  L + (ss)
where (ss) is the safety stock
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@ AM| Ltd. company determined its RO|

= 50 units.
@ Its holding cost (H) is $5 per unit per
year.
@ Its stock out cost (B) is $40 per unit.
@ |robability of stock out is based on the
following probability distribution:
M 

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@ Ô e
: F
d he Level f Safe y S ck

() ha m

m
ze he  al add

al
hld
g c ad S ck  c 
(a ally).

@ S ck  c
 a expec ed c  Tha

:
M 

M 

@ |ossible stock outs per year is actually the

number of orders per year (D/Q).
@ Since it is not known (or not given) assume
that it is 6 times / year.
@ For zero safety stock, there is no additional
holding cost for extra (safety) stock.
@ But there are stock out costs for two levels:
M 

1) If demand is 60 units at the RO|, Then

a shortage of 10 units will occur.
(Because, RO| is 50 units)

2) If demand is 70 units at the RO|, Then

a shortage of 20 units will occur.
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M 

@ The safety stock with the lowest total

cost is (ss = 20) units.

@ Therefore, RO| = 50 + 20 = 70 units.

a
 





Managers may want

to limit the
possibility of stock
out only to a small
percentage, say 5%.
a
 




@ If demand level is assumed to be a
normal distribution,
@ By using mean and standard deviation
of the normal distribution,
@ We can determine a safety stock that is
necessary for %95 service level.
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@ The SAC company carries an inventory

item that has a normally distributed
demand.
@ The mean demand is (Ô=350) units and
standard deviation is ( =10).
M 

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@ We use the properties of a standardized

normal curve to get a z value that
corresponds to the.95 of the curve.

@ Using a standard 6ormal table we find z

= 1.65 for 95% confidence.
 M 

Reorder point is elevated up by 16.5 units.

M