Inventory Manegement For Minimun Cost

Inventory Management for Minimum Cost
Author(s): David P. Herron

Source: Management Science, Vol. 14, No. 4, Application Series (Dec., 1967), pp. B219-B235
Published by: INFORMS
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MANAGEMENT SCIENCE
Vol. 14, No. 4, December, 1967
Printed in U.S.A.
INVENTORY MANAGEMENT FOR MINIMUM COST*
DAVID P. HERRON
FMC Corporation, Santa Clara, California
One of the most popular types of inventory management is the (Q, r) system,
in which a quantity Q of an item is reordered whenever the inventory position
reaches the reorder point r. A number of packaged computer programs are
available for this system. However, these programs seldom give the minimum-
cost values of Q and r, since they usually employ the Wilson Economic Order
Quantity. Use of the Wilson EOQ may result in substantial excess costs, par-
ticularly for items of high annual cash flow. This article describes graphical and
algebraic methods suitable for computer application to determine accurately
the minimum-cost values of Q and r, employing either dollar stockout penalties
or specified service levels. Both the single-item and aggregate inventory cases
are included. The methods described can readily be applied on most computers
and can result in significant cost savings.
The use of (Q, r) inventory management, in which Q units of an item are

ordered when its inventory position (units on hand plus on order) reaches the
reorder point r, has grown rapidly as automatic data processing equipment has
become available to perform the necessary calculations. Computer firms have
developed detailed packaged programs for continuous transactions surveillance
and calculation of order quantities and reorder points.
The purpose of this article is to describe generalized graphical and numeric
techniques for (Q, r) inventory management for both stockout penalty and
service level cases. These techniques eliminate certain shortcomings in many of
the packaged computer programs. In particular:
1. The packaged programs usually employ the Wilson Economic Order Quan-
tity (EOQ). Hunt [3] has pointed out that the Wilson EOQ is in many instances
a good approximation to the minimum-cost order quantity. However, it is often
seriously in error for the items of highest cash flow, and these items are the major
determinants of total system cost.
2. Most packaged programs assume that the service level which minimizes the
sum of reordering costs, inventory carrying costs, and cost (or negative profit)
of stockouts is known and can be employed as an input to the calculations.
Logically, the minimum-cost service level should be determined as a result, and
not assumed as an input. If the stockout penalty is known, the minimum-cost
service level can in most cases be calculated directly, but often the stockout
penalty is highly uncertain. It would be quite useful to have generalized rela-
tions between the stockout penalty and the corresponding optimum service
level. Management could then know what level of service is optimal with a given
stockout penalty and, conversely, what stockout penalty is implicit in the choice
of a given service level and could then perhaps choose the penalty or service level
more rationally.
* Received March 1966; revised May 1967.

B-219
B-220 DAVID P. HERRON
3. Finally, it is difficult with most packaged programs to determine the effect

of service level -or stockout penalty on total annual cost, both for a single inven-
tory item and for an aggregate inventory of N items. If readily determinable,
total annual costs could often serve as guideposts for management's decision on
how high a service level it could afford.
The article is in three main sections. Section A describes graphical techniques
for determining the minimum-cost order quantity and safety stock without the
usual required iteration. Several different types of stockout penalties and service
levels are considered. Section B gives numerical approximations to the graphical
solutions, suitable for use on a computer. Section C describes a numerical exam-
ple for an N-item inventory and compares the annual costs of various possible
inventory policies.
In general, the symbols and assumptions of Hadley and Whitin [2] are em-
ployed. The principal postulates are:
1. Out-of-stock items may be backordered and delivered when available.
2. The variable portions of the costs of reordering, of carrying inventory,
and in some cases of stockouts are known quantities available for inputs to the
calculations.
3. Periods of stockout are of short duration, so that the average inventory on
hand can be approximated as the sum of the safety stock plus one-half the order
quantity.
4. The replenishment lead time may be constant or variable, but the distribu-
tion of demand over the lead time is known. For simplicity in presentation, the
lead-time demand is assumed to follow the normal probability distribution, al-
though the approach to be discussed is applicable for a number of other demand
distributions.
5. Insofar as premium costs are incurred, a stockout penalty should be im-
posed for either actual or impending stockouts. Thus a firm which follows a no-
stockout policy may nevertheless incur substantial stockout-avoidance penalties.
In principle, each firm should operate so as to balance the stockout-avoidance
costs of expediting, special runs, etc. against the expected profit loss if an actual
stockout occurs.
Table 1 summarizes commonly occurring premium costs caused by stockouts.
TABLE 1
Typical Premium Costs from Stockouts
Stockout Penalty Proportional to Number of Stockout Stockout Penalty Proportional to Number of Units Out
Occasions of Stock
Actual Stocksout
Actua Stokout Stockout Premiu
Avoidance AtaSocut Stockout Avoidance
Loss of customer. Setup cost for addi- Loss of gross margin. Manufacturing over-
High-cost product tional production High-cost product time cost per unit.
substitution and run. substitution and Premium shipping
delivery. Special delivery cost delivery. cost per unit.
(independent of
quantity).
INVENTORY MANAGEMENT FOR MINIMUM COST B-221
Under the above assumptions, the annual ordering cost for a single inventory
item is given by AX/Q, where A is the reordering cost per reorder occasion, X is
the annual number of units demanded, and Q is the order quantity. The annual
inventory carrying charge is given by IC(O.5Q + s), where I is the annual in-
ventory carrying charge rate, C is the unit cost of the item, and s is the safety
stock, defined as the expected stock on hand at the time of arrival of a procure-
ment. In terms of the reorder point r, s is equal to (r - ,u), where u is the expected
demand during the replenishment lead time. It will also be convenient to repre-
sent s/a by the symbol t, where a is the standard deviation between the actual
and expected demand during the lead time (often called the forecast error).
Thus t is the safety stock expressed as number of standard deviations.
A. Graphical Determination of Minimum-Cost Order Quantity and

Safety Stock
1. Dollar Stockout Penalty Proportional to Number of Stockout Occasions

The first case considered will be for a dollar stockout penalty which is propor-
tional to the number of stockout occasions occurring or avoided at premium
cost. For each inventory item, the annual stockout cost is the product of the
dollar stockout penalty v per stockout occasion, the number of replenishment
occasions X/Q, and the probability of stockout at each replenishment occasion 'Ii,
where 4 is equal to f (1//2r)e0 5u du. The total annual cost K for reorder-
ing, carrying inventory, and stockout penalties for an item may thus be written:
(1) K = AX/Q + IC(O.5Q + to-) + PX/Q.
The minimum-cost values of Q and t may be found by setting 9K/aQ and

aK/at equal to zero and solving the resulting equations:
(2) 9K/OQ = 0 = -AX/Q2 + 0.51C - b4X/Q2
(3) aK 0t 10 -IC- 'X/Q
where 4 is equal to -d&/dt, or (1/v

Hadley and Whitin [2] suggest that expressions such as equations (2) and (3)
may be solved for Q and t by an iterative procedure. Q is initially assumed equal
to the Wilson Economic Order Quantity Q,, , defined as (2XA/IC)0 5. Equation
(2) may then be solved for t and a new value of Q obtained from equation (3).
The process is repeated until satisfactory convergence is achieved.
However, a direct graphical solution for the minimum-cost values Q* and t*
may be obtained by eliminating Q from equations 2 and 3 and introducing Q"'
to give:
(4) 0.5(Qw/co)(v/A) = (1/4)[1 + (v/A)>115.

From this relation, t* may be found as a function of Q/o- and v/A. Q* ma
be calculated from equation (3) and the minimum-cost safety stock s* d
mined as t*oa.
The lower portion of Figure 1 shows t* and the dimensionless ratio Q*/Qw as
functions of QW/Io-, with v/A as the param

each value of v/A by assuming a value for t
and calculating Q/QW from equation (3). Fr
reorder point r* may be obtained as (g + t*o-).
A service level may be defined as the fraction of replenishment occasions in
99.99
-99.95
4.0 9.
-99.5
|vlA=50 99
3.5 _98
95
3.0 __~~~~~~~~~~~~90 _j
o 80
0~
E
E
:3
0.5 2.0 2 3 4 5 t0 20 30 4050 tO
Ratio of Wilson EOQ lo Standard Deviation Qw/r
FIGURE 1. Minimum-cost conditions for dollar stockout penalty proportional to number

of stockout occasions
which no stockouts occur and is given by the expression (1 - ci). The service
level corresponding to a minimum-cost value of t is shown in the upper portion
of Figure 1. A normal probability scale is employed on the ordinate to depict the
higher-values of service level more clearly.
Another type of service level could be defined as the expected number of stock-
out occasions D per year which correspond to the minimum-cost values of t and Q
found from equations (2) and (3). It may readily be shown that the dimensionless
ratio D*Qw,,/X is a unique function of Qw/o and v/A and hence could also be plotted
on Figure 1.
Combining equations (1) and (2) gives:
(5) K* = IC(Q + s) = ICQw(Q*/Qw + t*oy/Qw).
Hence the dimensionless ratio K*/ICQ. may be expressed as a fun

and v/A. This relation also is shown in the upper portion of Figure 1 and illus-
trates the important point that the annual cost K* depends not upon the magni-
tude of the lead-time demand but upon the standard deviation between actual
and expected lead-time demand. Obviously, if one could forecast exactly the
lead-time demand, regardless of variability, there would be no need for safety
stock.
It will be noted that K*/ICQw approaches 1.0 (its value from the usual deriva-
tion of the Wilson EOQ) as Qw/o approaches infinity, that is, as the uncertainty
of demand during the replenishment lead time approaches zero. Hence the value
of K*/ICQw is a relative measure of the increased cost caused by the uncertainty
of lead-time demand. For example, at Qw/o = 10 (that is, the standard deviation
of demand during the replenishment lead time is 10% of the Wilson EOQ) and
v/A = 3.0, the value of K*/ICQw from Figure 1 is 1.235, indicating that the
annual cost is 23.5 % above its value for no uncertainty in lead-time demand. If
the value of o could be cut in half by shortening the lead time or adopting other
measures to reduce demand uncertainty, so that QW/T were 20, K*/ICQw would
decrease to 1.135, or a saving of about 8 % in the total annual cost for carrying
the item.
Figure 1 is also useful for determining consistent values of stockout penalty
and the corresponding most economic service level. By tabulating several sets
of such consistent values, the inventory manager may be able to arrive at a
decision as to the set which corresponds to his best judgment. Were he to attempt
to guess the most economic service level directly without knowledge of the im-
plied stockout penalty, he might select a service level which implied unrealisti-
cally high or low stockout penalties. Furthermore, it is obvious from Figure 1
that for a given value of stockout penalty, the most economic service level is a
function of the values of Qw/o and v/A for an item. Hence it may be uneconomic
to set the same service level for all items in a product group unless these items
have approximately the same values of Qw/o and v/A.
Brown [1] has pointed out that for many multi-item inventories there is an
empirical relation between o and the annual cash flow f for the item of the form
aC = bfY, where y lies in the range of 0.8 to 1.0. If this relation applies, then
Qwlo = (2A/I62)05fY05- ), so that as

high cash flow will thus tend to have low values of Qw/o and high values of
Q*/Qw . It may be seen from Figure 1 that the Wilson EOQ may be as much as
100 % in error for items having low values of Qw/lo.
In a multi-item inventory, it is often of interest to determine the effect of
changing various input values on the total annual cost 2Ki* without the nec
sity for re-optimizing each item and summing up the individual values of K.*.
(As examples, the rising cost of money may affect the value of I. Item sales at a
given location may increase or decrease due to new customers or reallocation
of customers among warehouses. Manufacturing set-up costs may increase a
fixed percentage because of wage increases.) If the values of A, I, and v are
constant for all items and the empirical relations just discussed are found to
apply, then (Qw/lo)i and (ICQw)i are functions only of fi. Hence Ki* is al
unique function of fi, that is, K* =K
Furthermore, Brown [1] has noted that if an ABC ranking of most N-item
inventories is made in sequence of descending annual cash flow fi, the ranked
items obey a log-normal relation:
rX
(6) i/N = f +(w) dw = ((wi)
Wi
where i is the number of items having cash flows equal to or greater than fi ,
wi = (In f - tf)f, P(w) = (1/V/27r)e-0 5W and jif and of are the mean and
standard deviation respectively of the log-normal distribution of cash flow.
(Numerically, gf = In fo.mo and 0f = In (fo.5o/fo.843), where fo.6o and fo.8413
the values of cash flow when i/N = 0.50 and 0.8413 respectively.)
Under these circumstances, the minimum total annual cost for N items is:
(7) Z 1=1 Ki* = f Ki*(fi) di = N w K*(fi)4(w) dw. WN
It is interesting to note from equation (7) that the total annual cost for all
items having cash flows within the range fi to fi is directly proportional t
the number of items N. The effect on aggregate yearly costs of adding more
items is thus easily determined so long as the log-normal relation and the func-
tion Ki*(fi) remain unchanged. (In some cases it has been found that a single
log-normal relation does not apply over the entire N items, but that several
such relations may be applied to different segments of the inventory and the
values of ZK~* calculated by equation (7) for the various segments summed to
give the total annual cost.) Graphical integration of equation (7) by selecting
spaced values of fi is straightforward and, for inventories made up of thousands
of items, saves considerable time over re-optimizing and summing up the costs for
each individual item whenever input parameters are changed.
2. Dollar Stockout Penalty Proportional to Annual Number of Units Out of Stock
The next case considered will be the minimum-cost inventory management of

a single item subject to a dollar stockout penalty which is proportional to the
annual number of units out of stock. The annual stockout cost is the product of
the unit stockout penalty -r, the number of replenishment occasions X/Q, and the
expected number of units out of stock at each replenishment occasion. As shown
by Hadley and Whitin [2], for the normal probability distribution of lead-time
demand this latter value is o( - t4). The total annual cost may thus be writ-
ten:
(8) K = AX/Q + IC(0.5Q + to) + rXo(( - tD)/Q.

Setting the partial derivatives of the annual cost with respect to Q and t equal
to zero gives:
(9) OK/OQ = 0 = -AX/Q2 + 0.5IC - (rXo/Q )(-t).
(10) OK/t = 0 = ICc - 7rXo/Q.
While an iterative solution of equations (9) and (10) for the minimum-cost
values of Q and t is possible, a graphical solution may also be developed for this
case by eliminating Q from the two equations and introducing QW1, to obtain:
(11) 0.5(ro/AA)(Qw/uo) = (1/b) [1 + ('ro/A) (0- t)]05.

From equation (11), t* may be found as a function of Qw/o- and iro/A, and Q*
may then be calculated from equation (10).
The minimum annual cost K* for this case is also given by equation (5). In
addition, a service level may be defined as the fraction of annual units demanded
which were available for shipment and is given by [1 - o-(iO - zb)/Q]. This serv
ice level is equivalent to the expected fraction of time in stock.
The various minimum-cost conditions may be expressed using dimensionless
ratios as shown in Figure 2. Generally speaking, the same types of conclusions
may be drawn from Figure 2 as were discussed for Figure 1.
For the N-item case, there appears to be no applicable procedure employing
graphical integration such as was discussed in the previous section. If the em-
pirical relation among As, Ci, and fi is found to apply, then ar in the parameter
7ro/A is a function of C as well as of f, and hence the relation Kj* = Ki*(fi)
does not hold. Unless C is a unique function of f (which is not the case in many
N-item inventories), the value of SKi* must be obtained by a direct summation
of the individual values of KV*.
3. Specification of Service Level Based on Stockout Occasions

The cases considered in Sections A-1 and A-2 included a dollar stockout pen-
alty in the cost function. For given values of Q, , A, A, and this stockout penalty,
the most-economic service level was uniquely determined. Because of the
difficulty of estimating the stockout penalty, many (Q, r) inventory systems are
managed by arbitrarily specifying a service level and determining the values of Q
and r which minimize the sum of the annual ordering and carrying costs only.
In the N-item case, the specified service level may be of two types:
1. A uniform service level in which every item has the same service level.
2. A composite service level in which the average service level for all
items must be equal to or greater than a specified value.
99.99
\ \1ra/Az 1 CA Xa /A I/ / 9.95
99:,9
3.5 _ 50\ \ //50 </ / 99.8
99.5
99
30 C 0~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~S
0.5 1.0 2 3 4 5 10 20 30 40 50 095
o 5
.0 .5 10 2 3 4 5 t 0 3 05 O
Ratio Of Wilson EOQ to Standard Deviation, Q/f
FIGURE 2. Minimum-cost conditions for dollar stockout penalty proportional to number

of units out of stock
These service-level cases are of the constrained-optimum type and can be

handled in most cases by the Lagrange multiplier technique. Since management
of a single item may be considered as a special case of the N-item situation in
which N = 1, it is convenient to develop the N-item equations first.
One type of service criterion is that in which a maximum allowable value is
placed upon the expected fraction of replenishment occasions for which one
or more units may be out of stock. It has the logical flaw that the time frequency
of stockout occasions varies directly with the number of replenishment occasions

per year. However, it is a popular criterion, and in most cases the optimal
order quantity and annual demand for an item do not vary sufficiently from
year to year to affect the time frequency of stockout occasions to a major degree.
For this case, a composite dis-service level d will be defined as the expected
fraction of replenishment occasions in which stockouts will occur. That is:
(12) d= 2=()/Q) /2(X/Q)i.

For N items, the objective function and the constraint are thus:
(13) Minimize: 2K = A2((X/Q)i + I2[C(O.5Q + to)]i
(14) Subject to: d = I(X)V/Q) i (X/Q) i = constant.

The Lagrangean expression may be written:
(15) L = Ki -M[d -2(X/Q)i/2(X/Q)i]

where M is the Lagrange multiplier. The partial derivatives of L with respect
to Qi and ti are then set equal to zero:
(16) OL/OQi = 0- -A(X/Q2)i + 0.5ICi + M(X/Q2)i

* {-4i/2((X/Q)X + Z(X4/Q)i/[2(X/Q) i]2}
(17) OL/Oti = 0 = I(Coa) -M[(XO/Q) /Z(X/Q)i].

Equation (17) may be solved for (X/Q)i and the result substituted into equa-
tion (14), giving:
(18) M = (I/d)2(Ca4/cp) .
If equation (18) is then used to eliminate M from equation (17), there results:
(19) (QC1/X5) i = 2 (Cab/+ ) i/dZ (X/Q) i .

Also, M may be eliminated between equations (16) and (17) to give:
(20) Qi = ( -/ Z(X4/Q)' -(X/Q)i]

+ [(QW2)i + {(-v/)(X/Q)/ (X/Q) i- ]
For the case of a single item or a uniform service level for all N items, eq
(12) reduces to d = 'I'i, and equation (16) leads directly to Qi* = (Q.)i.
It will be noted that this value of Q* is different from that obtained in Section
A-1 and Figure 1 for a given service level and value of Qw/o-, since in Section A-1
a dollar stockout penalty is included in the cost function.
For the more complex N-item case in which a composite dis-service level is
permitted, Qi may be eliminated between equations (19) and (20) to obtain:
WX/Cq)i Y2(CA0) i = WA 4i T(Xb/Q)il

(21) dZ(X/Q)i L - (X/Q) l
+ [(QW2 +i {( /)i[pi Z (>%41}Q ]O.5
In principle, an iterative solution is possible by estimating initial values of the

three summations in equation (21) and solving this equation iteratively for ti,
then obtaining Qi from equation (19) and calculating new values of the summa-
tions. As described in Section B, an approximate solution without iteration is
also possible.
4. Specification of Service Level for Fraction of Units Out of Stock

A service level may also be specified in terms of the fraction of units ordered
which can be out of stock. For the N-item, composite service level case, the ob-
jective function and constraints are:
(22) Minimize: 2Ki = A2((X/Q)i + I2[C(0.5Q + to)]i
(23) Subject to: d = 2[(Xo-/Q) (0- t)]i/MXi = constant.

Setting up the Lagrangean as before and differenting yields:
(24) aL/aQi = 0 = -A (X/Q2) i + 0.51Ci - (M/ Xj) [(Xu/Q2) (Ob -ti))

(25) aL/ati = 0 = I(Ca)i - (M/2AX)(XAc/Q)i.
Eliminating M between equations (24) and (25) and solving for Qi gives:
(26) Qi = [o-(O - tv)/v]i + {(QW)i + [-cT(o - tb)bj .

Solving equation (25) for (X/Q) and substituting into equation (23) gives:
(27) M = (I/d)2[Cor(4P - t4)/].

If equation (27) is then used to eliminate M from equation (25) there results:
(28) (QC/Xf)i = Z[CT(q - t1)/b],ldTki

Also, elimiting Qi between equations (26) and (28) gives:
Ad2Xi
(29) ~(QW)il[Ca(0 - M))/4]

_ ~~~~0.5[41(Qw/qf)h
- t4)/ + (QW/)20.)2 + [6(0 -
Consider first the single-item case. If N = 1, equation (29) reduces to:
(30) Qw/ = [(p - t1)/d](1 - 2d/4)?b5.

Equation (30) permits a graphical solution for t* in terms
may then be obtained from equation (28), and hence Q*/Qt, may be expressed
as a function of Qu,/o and d. These relations are shown in Figure 3, as is the di-
mensionless ratio K*/ICQ., which may be shown to be equal to [(Q*/Qw)
(1 - d/l*) + t*/(Qw/o)]. It may also be readily proved that the values of t*
and Q*/Q. of Figure 3 could have been determined from Figure 2 by first utilizing
the known values of Q,>/O and the desired service level to obtain the imputed
value of 7r/A from the upper portion of Figure 2, then reading t* and Q*/Qw
from the lower portion of Figure 2.
c~ [ 99.5999.9% Service Level
8 ~~~~~~~95
9,0
2.0 0.5
,,1 XX
1.5
l~~~~~~~~~~~c~~~9.
.0
. 2 3 45681.0 2 3 45 68 10 2 34 568100
Ratio of Wiloon ECO to Standard Deviation, Ow/a
FIGURE 3. Minimum-cost conditions for specified service level based on maximum

allowable fraction of units out of stock
The values of t* and Q* in Figure 3 apply for each item of the N-item case when
a uniform dis-service level d is specified. For the N-item case with a composite
dis-service level, it may be noted that the right side of equation (29) is of the
form t[(Q@/a-)i, ti], and so a generalized set of curves can be constructed of
as a function of (Qw/a-)i and ti. The relation between the total annual cost
ZKi* and d may then be determined as follows:
1. A value of [d:Xi]/z[Cc(cp- t4/b]i is assumed.
2. 5 for each item is calculated from the left side of equation (29).
3. ti for each item is read from the set of curves mentioned above.
4. .[Cc(4- t)/4]i is calculated.
5. d is calculated from the Step 1 value of [dZXi]/2[Ccr(f-tb/~
6. Each Qj is calculated from equation

7. 2Ki* is calculated from equation (22
8. The above steps are repeated to obtain other values of 2Ki* as a func-
tion of d.
B. Numerical Approximations to Minimum-Cost Expressions
The graphical methods discussed in Section A do not lend themselves con-

veniently to computerization, and certain of the N-item equations are too
complex for routine management application. Hence there is a need for numerical
approximations which yield results reasonably close to optimal.
The approximations to be described follow the suggestion of Parker [4] that
appropriately selected expressions for the normal probability distribution will
often permit a solution for the approximate minimum cost order quantity Q
which is independent of t. It is then possible to use this value of Q to determine
t. Such expressions will be discussed for the various cases of Section A.
For a dollar stockout penalty proportional to the annual number of stockout
occasions (Section A-1), the approximation may be employed in equation (1)
that 1 = 0.60e-t?65 - 0.0049. Setting the partial derivatives of equation (1)
equal to zero results in the following expression:
(31) Q*/Qw = 0.65/(Qwl/o) + {1 - 00.049 v/A + [-0.65/(QW/c_)]2}05.

Equation (3) gives the minimum cost value of t for any value of Q. Hence t*
may be obtained from equation (3) as:
(32) t= 2 in
Figure 4 shows that this approximation for 4D deviates from the true value
by as much as 30 % over the range 3.0 ? t ? 0. However, the error in K* is
quite small when the corresponding values of Q* and P* are employed.
A computer may easily be programmed to calculate Q* from equation (31) an
t* from Equation (32), thus permitting direct determination of the approxim
minimum-cost values.
For a dollar stockout penalty proportional to the number of units out of stock
(Section A-2), the approximation ( - tb) = 0.50e t0.50 - 0.0009 may be
employed in equation (8), giving:
(33) Q*/Qw = 0.50/(Qw/u) + ti - 0.0009ru/A + [-0.50/(Qw/cT)]2}0.

The corresponding value of t* is obtained by inserting into equation (10) the
quite accurate quadratic approximation that (-ln b) = 0.4012 + 0.75 t + 0.693
to give:
(34) t= {0.879 + 2.5[ln (AX/"*IC) - 0.693]}?5 - 0.938.
Equations (33) and (34) may be programmed for a computer to give values of
Q and t that are close to optimal.
The two cases described above gave a direct solution for Q* when expressions
of the form (kae-tlkb + k,) were employed. For cases with a specified service
1.0 I I I
0.8
0.6
A - Exact relation between v and t
0.4 B --- Approximation: kaert/kb+ kc
0.4 9.SX C ... Approximation: k =kae-t/kb
D Exact relation between v-tv and t
0.2 ; E--- Approximation: 0 - t8 = kae-t/kb+kc

F 08-t Approximation: 9 - tv =kae-t/kb
0.1 \ B
0.08 \
0.06 E
0.04 -
F
0.02-
0.01
0.008
00006 0
0.004 -
0.002-
0.001
0.0008
0.0006
0.0004-
0.0002
0.0001
0 0.5 1.0 1.5 2.0 25 3.0
FIGUIRE 4. Exact and approximate relations between t and b or (4-t)
level, Q* cannot be solved for directly unless k, = 0, which, of course, adversely

affects the accuracy of the approximate equations representing the normal
distribution.
Hence for cases in which service level is specified, an alternate procedure
is to divide the usually encountered range of 3 ? t ? 0 into two parts and use two
different expressions of the form kae tlkb. The computer can be programmed to
calculate i* using one or the other of the two sets of constants and to test to
determine whether i* lies in the appropriate range. If not, t* can be calculated
using the alternate set of constants.
For an N-item inventory in which a maximum allowable composite dis-service
level d is specified based on the replenishment occasions in which stockouts occur
(Section A-3), substitution of the approximation 4D = kaet'kb into equation
(15) and solution of the correspondingly modified equations (16) and (17) for
Qi* gives:
(35) Qi /Qw = kb/( Qw/f)i + {1 + [-kb/(Qw/1C) ]2}05.
This expression is independent of both t and of the dis-service level d, so
that all values of Qi can be found directly. Combining equations (14) and (17
with the use of this same approximation results in
(36) ti= d2o (n d *) Q

With the individual Qi*'s available from equation (35)
calculated directly from equation (36). Use of these two equations is a great
saving in time over the iterative solution of equation (21) and is suitable for
routine computer application. Equation (36) may be further simplified for the
case of N = 1, which is applicable for a uniform dis-service level.
As may be seen from Figure 4, the following values of kb and kb may be em-
ployed to give acceptable accuracy:
For 1.5 > t > 0: ka 0.55, kb = 0.753.
For 3.0 t > 1.5: ka = 3.60, kb = 0.387.
For an N-item inventory with a composite dis-service level d based on the

allowable number of units out of stock (Section A-4), a similar procedure may be
employed with the approximation ( - tb) = kae kb. Use of this approximation
in equations (22) and (23) and solution of the correspondingly modified equa-
tions (24) and (25) for Qi* gives an equation identical with equation (35).
The expression for t* based on the same approximation is:
(37) kb In kad(I)i (x/Q*C)

Hence for this case also direct algebraic solutions for Qj and j are possible.
From Figure 4, the following values of ka and kb give a good approximation to
the exact curve:
For 1.5 ? t _ 0: ka 0.44, kb = 0.576.
For 3.0 t > 1.5: ka = 2.49, kb = 0.346.
C. Numerical Example
The following example illustrates the effect of dollar stockout penalty on the
most economic service level and the effect of service level on total annual costs
for an N-item inventory.
An inventory of five items was postulated. The annual demand, unit cost, and
forecast error for each item are shown in Table 2. A reorder cost A of $6.00
and an inventory carrying charge rate I of 0.20 were employed.
In the first case, it was assumed that management applied a dollar stockout
penalty per unit out of stock, as described in Section A-2. For the five-item
inventory, Figure 2 was employed to determine the minimum annual cost for
each item, with values of the stockout penalty 7r ranging from $1.00 to $10.00.
Figure 5 shows the effect of the stockout penalty value on the total annual
cost for the aggregate inventory.
TABLE 2
Data and Results for Five-Item Inventory Example
Item 1 Item 2 Item 3 Item 4 Item 5 Total
Item Characteristics
Annual Demand X, Units/yr 3,430 2,000 1,091 750 960
Unit Cost C, $ 70 60 55 40 35
Forecast Error o, Units 60 30 15 7.5 6
Wilson EOQ, Units 54.25 44.73 34.50 33.55 40.60
Annual Costs, S/yr
Stockout Penalty ir = $1.00
Exact solution 1,697 927 536.5 328.0 331.6
Using Wilson EOQ 1,879 976 554.2 330.9 332.7
% Error Using Wilson EOQ 11 5 3 0.9 0.3 6.6
Using Eqs. 33 and 34 1,718 932 539.5 328.0 331.6
% Error Using Equations 1.2 0.5 0.6 0 0 0.7
96% Service Level
Composite service level 1,602 884.5 516.6 320.4 326.8 3,651
Uniform service level 1,762 885.7 497.1 295.2 323.4 3,763
5.5
7r =10
Y.'
5.0
0
0
o ~~~~~~~~~~~~~~~~7r 2.5
C4.5
2:
4.0
86 87 88 89 90 91 9 2 93 94 95 96 97 98 99 100
Service Level (%/6)
FIGURE 5. Relation between stockout penalty, service level, and minimum total annual
cost for five-item inventory
For the value 7r = $1.00, the minimum annual cost as obtained from Figure
2 was compared with two approximate methods of obtaining the minimum cost,
as shown in Table 2. These methods were as follows:
1. It was assumed that the Wilson EOQ was employed for the order quantity,
and the corresponding minimum-cost value of t was obtained by substituting
Q. into equation (10) for each item. For Item 1, which has the lowest value of
QwIo use of the Wilson EOQ results in an excess cost 11 % above the minimu
cost value of $1697 per year. For the remaining items, the excess costs were less,
and for the total five-item sample the use of Wilson EOQ's gave an annual
cost about 6.6 % higher than necessary.
2. It was assumed that the numerical approximations given in equations (33)
and (34) were employed to calculate Q* and t*. This method gave much better
agreement with the exact solution. As shown in Table 2, Item 1 had a calculated
cost about 1.2 % too high, with the error diminishing rapidly for the other items
and amounting to only 0.7 % for the aggregate five-item system.
For the second case of the example, it was assumed that instead of a dollar
stockout penalty, a service level was specified based on the fraction of units
demanded which could be supplied from stock. Figure 6 shows the savings
possible by employing a composite service level, defined by equation (23),
compared with a uniform service level of the same value. For both types of
service level, costs rise sharply at the higher service levels. The two curves meet
5-
4-
0
a Service Levl Service Level

Uniform L Composite
E 3 -
87 88 89 90 91 92 93 94 95 96 97 98 99 100
Service Level (Mo)
FIGURE 6. Effect of uniform versus composite service level on minimum total annual cost
for five-item inventory
at a service level of 100 %, of course, but at the lower service levels the composite
case shows increasing savings over the uniform case.
The last two rows of Table 2 give the sum of reordering costs and inventory
carrying costs for the individual items at a service level of 95 %. For the com-
posite case, minimum total cost is achieved by combining a service level of
93.2 % for Item 1 with service levels of 95 % or above for the remaining items.
The composite level permits a savings of about 3% in aggregate inventory
costs at a service level of 95 % and would show greater savings at lower specified
service levels.
References
1. BROWN, R. G., "Estimating Aggregate Inventory Standards," Naval Research Logistics

Quarterly, Vol. 10, No. 1 (March 1963), pp. 55-72.
2. HADLEY, G. AND WMITIN, T. M., Analysis of Inventory Systems, Prentice-Hall, Inc., Engle-
wood Cliffs, N.J., 1963, Chapter 4.
3. HUNT, J. A., "Balancing Accuracy and Simplicity in Determining Recorder Points,"
Management Science, Vol. 12, No. 4 (Dec. 1965), pp. 94-103.
4. PARKER, L. L., "Economical Order Quantities and Reorder Points with Uncertain De-
mand," Naval Research Logistics Quarterly, Vol. 11, No. 4 (Dec. 1964), pp. 351-358.

Inventory Manegement For Minimun Cost

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Inventory Manegement For Minimun Cost

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Inventory Management for Minimum Cost

Author(s): David P. Herron

INVENTORY MANAGEMENT FOR MINIMUM COST*

FMC Corporation, Santa Clara, California

The use of (Q, r) inventory management, in which Q units of an item are

* Received March 1966; revised May 1967.

3. Finally, it is difficult with most packaged programs to determine the effect

A. Graphical Determination of Minimum-Cost Order Quantity and

1. Dollar Stockout Penalty Proportional to Number of Stockout Occasions

(1) K = AX/Q + IC(O.5Q + to-) + PX/Q.

The minimum-cost values of Q and t may be found by setting 9K/aQ and

(2) 9K/OQ = 0 = -AX/Q2 + 0.51C - b4X/Q2

(3) aK 0t 10 -IC- 'X/Q

where 4 is equal to -d&/dt, or (1/v

(4) 0.5(Qw/co)(v/A) = (1/4)[1 + (v/A)>115.

functions of QW/Io-, with v/A as the param

0.5 2.0 2 3 4 5 t0 20 30 4050 tO

Ratio of Wilson EOQ lo Standard Deviation Qw/r

FIGURE 1. Minimum-cost conditions for dollar stockout penalty proportional to number

(5) K* = IC(Q + s) = ICQw(Q*/Qw + t*oy/Qw).

Hence the dimensionless ratio K*/ICQ. may be expressed as a fun

Qwlo = (2A/I62)05fY05- ), so that as

(7) Z 1=1 Ki* = f Ki*(fi) di = N w K*(fi)4(w) dw. WN

2. Dollar Stockout Penalty Proportional to Annual Number of Units Out of Stock

The next case considered will be the minimum-cost inventory management of

(8) K = AX/Q + IC(0.5Q + to) + rXo(( - tD)/Q.

(10) OK/t = 0 = ICc - 7rXo/Q.

(11) 0.5(ro/AA)(Qw/uo) = (1/b) [1 + ('ro/A) (0- t)]05.

3. Specification of Service Level Based on Stockout Occasions

3.5 _ 50\ \ //50 </ / 99.8

Ratio Of Wilson EOQ to Standard Deviation, Q/f

FIGURE 2. Minimum-cost conditions for dollar stockout penalty proportional to number

These service-level cases are of the constrained-optimum type and can be

of stockout occasions varies directly with the number of replenishment occasions

(12) d= 2=()/Q) /2(X/Q)i.

(13) Minimize: 2K = A2((X/Q)i + I2[C(O.5Q + to)]i

(14) Subject to: d = I(X)V/Q) i (X/Q) i = constant.

(15) L = Ki -M[d -2(X/Q)i/2(X/Q)i]

(16) OL/OQi = 0- -A(X/Q2)i + 0.5ICi + M(X/Q2)i

(17) OL/Oti = 0 = I(Coa) -M[(XO/Q) /Z(X/Q)i].

(19) (QC1/X5) i = 2 (Cab/+ ) i/dZ (X/Q) i .

(20) Qi = ( -/ Z(X4/Q)' -(X/Q)i]

WX/Cq)i Y2(CA0) i = WA 4i T(Xb/Q)il

In principle, an iterative solution is possible by estimating initial values of the

4. Specification of Service Level for Fraction of Units Out of Stock

(22) Minimize: 2Ki = A2((X/Q)i + I2[C(0.5Q + to)]i

(23) Subject to: d = 2[(Xo-/Q) (0- t)]i/MXi = constant.

(24) aL/aQi = 0 = -A (X/Q2) i + 0.51Ci - (M/ Xj) [(Xu/Q2) (Ob -ti))

(26) Qi = [o-(O - tv)/v]i + {(QW)i + [-cT(o - tb)bj .

(27) M = (I/d)2[Cor(4P - t4)/].

(28) (QC/Xf)i = Z[CT(q - t1)/b],ldTki

(29) ~(QW)il[Ca(0 - M))/4]

(30) Qw/ = [(p - t1)/d](1 - 2d/4)?b5.

c~ [ 99.5999.9% Service Level

Ratio of Wiloon ECO to Standard Deviation, Ow/a

FIGURE 3. Minimum-cost conditions for specified service level based on maximum

6. Each Qj is calculated from equation

B. Numerical Approximations to Minimum-Cost Expressions

The graphical methods discussed in Section A do not lend themselves con-

(31) Q*/Qw = 0.65/(Qwl/o) + {1 - 00.049 v/A + [-0.65/(QW/c_)]2}05.

(33) Q*/Qw = 0.50/(Qw/u) + ti - 0.0009ru/A + [-0.50/(Qw/cT)]2}0.

(34) t= {0.879 + 2.5[ln (AX/"*IC) - 0.693]}?5 - 0.938.

0.2 ; E--- Approximation: 0 - t8 = kae-t/kb+kc

(5) K* = IC(Q + s) = ICQw(Q/Qw + toy/Qw).

(7) Z 1=1 Ki* = f Ki(fi) di = N w K(fi)4(w) dw. WN