Chapter 10

Inventory Models

Learning Objectives

1. Learn where inventory costs occur and why it is important for managers to make good inventory
policy decisions.

2. Learn the economic order quantity (EOQ) model.

3. Know how to develop total cost models for specific inventory systems.

4. Be able to use the total cost model to make how-much-to-order and when-to-order decisions.

5. Extend the basic approach of the EOQ model to inventory systems involving production lot size,
planned shortages, and quantity discounts.

6. Be able to make inventory decisions for single-period inventory models.

7. Know how to make order quantity and reorder point decisions when demand must be described by a
probability distribution.

8. Learn about lead time demand distributions and how they can be used to meet acceptable service
levels.

9. Be able to develop order quantity decisions for periodic review inventory systems.

10. Understand the following terms:

inventory holding costs backorder

cost of capital quantity discounts
ordering costs goodwill costs
economic order quantity (EOQ) probabilistic demand
constant demand rate lead time demand distribution
reorder point service level
lead time single-period inventory model
lead time demand periodic review
cycle time
safety stock

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Solutions:

2 DCo 2(3600)(20)
Q*   438.18
Ch 0.25(3)
1. a.

3600
r dm  (5) 72
b. 250

250Q* 250(438.18)
T  30.43 days
c. D 3600

1 D 1 3600
TC  QCh  Co  (438.18)(0.25)(3)  (20) $328.63
2 Q 2 438.18
d.

2. Annual Holding Cost

1 1
QCh  (438.18)(0.25)(3) $164.32
2 2

Annual Ordering Cost

D 3600
Co  (20) 164.32
Q 438.18

Total Cost = $328.64.

2 DCO 2(5000)(32)
Q*   400
Ch 2
3.
D 5000
d   20 units per day
250 250

a. r = dm = 20(5) = 100

Since r  Q*, both inventory position and inventory on hand equal 100.

b. r = dm = 20(15) = 300

Since r  Q*, both inventory position and inventory on hand equal 300.

c. r = dm = 20(25) = 500

Inventory position reorder point = 500. One order of Q* = 400 is outstanding. The on-hand
inventory reorder point is 500 - 400 = 100.

d. r = dm = 20(45) = 900

Inventory position reorder point = 900. Two orders of Q* = 400 are outstanding. The on-hand
inventory reorder point is 900 - 2(400) = 100.

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2 DCo 2(12, 000)(25)

Q*   1095.45
Ch (0.20)(2.50)
4. a.

1200
r dm  (5) 240
b. 250

250Q* 250(1095.45)
T  22.82
c. D 12,000

1 1
d. Holding QC h= ( 1095.45 ) ( 0.20 ) ( 2.50 )=$ 273.86
2 2

D 12, 000
Co  (25) 273.86
Q 1095.45
Ordering

Total Cost = $547.72

2 DCo 2(150, 000)(250)

Q*   12,500
Ch 0.48
5. a.

300Q* 300(12,500)
T  25
b. D 150, 000 days

300 days/25 days = 12 orders per year

One order per month

c. Maximum inventory = Q* = 12,500

Metropolitan Bus Company does not need to expand its storage tanks.

150, 000
r dm  (10) 5, 000
d. 300 gallons

6. a.
2 DCo 2  1500   20  240Q * 240  632 
Q *pens   632 pens, Tpens   101 days
Ch  1.50  .10  D 1500

2 DCo 2  400   20  240Q * 240  224 

Q *
  200 pencils, Tpencils   120 days
pencils
Ch  4   .10 D 400
1 D 1 1500
TC pens  Q pensCh  Co   632   .1  1.5  20 $94.87
2 Q pens 2 632

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1 D 1 400
TC pencils  Q pencilsCh  Co   200   .1  4   20 $80
2 Q pencils 2 200
Thus, the total cost is $94.87 + $80 = $174.87.

b. Setting the cycle times of pens and pencils equal:

240Q pens 240Q pencils


D pens D pencils

Q pens 3.75Q pencils

which implies .

The total cost (for both pens and pencils) is:

1 D 1 D
TC  Q pensCh , pens  pens Co , pens  Q pencilsCh , pencils  Co , pencils
2 Q pens 2 Q pencils
Q pens 3.75Q pencils
Substituting , we obtain

1 D pens 1 D
TC  3.75Q pencilsCh , pens  Co , pens  Q pencilsCh , pencils  pencils Co , pencils
2 3.75Q pencils 2 Q pencils

Combining like terms:

D pensCo , pens
1  D pencilsCo , pencils
TC  Q pencils  3.75Ch , pens  Ch , pencils   3.75
2 Q pencils

Solving for Qpencils by observing that this total cost equation is the same as

 DCo 
'
1
TC  Q pencils Ch' 
2 Q pencils

D pensCo , pens
 DCo 
'
  D pencilsCo , pencils
C 3.75Ch , pens  Ch , pencils
'
h 3, 75
where and

Thus,

  1500   15 
2   400   15 
2  DCo 
'
 3.75  158 pencils
Q pencils  
Ch' 3.75  .1  1.5   .1  4 

Q pens 3.75  158  593 pens

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 Inventory Models

These quantities are ordered every T = (240)(593)/1500 = (240)(158)/400 = 95 days. The total cost
(for both pens and pencils) is:

1 1500 1 400
TC   593  .1  1.5   15   158  .1  4    15 $151.99
2 593 2 158

Thus, the consolidate shipments result in annual savings of $174.87 - $151.99 = $22.88.

7. a. We cannot directly use the EOQ equation because we are not given the annual demand, fixed
ordering cost, and ordering price. However, we can use the original value of Q and knowledge of
how we compute it to determine the revised economic order quantity corresponding to the updated
holding cost rate.

2 DCo 2 DCo
Q*  
Ch IC
That is, we know:

Let Q ' be the revised order quantity for the new carrying charge I ' . Thus

Q' =
√ 2 D C0
'
IC
2 DCo / I ' C I
Q '/ Q*  
2 DCo / IC I'
I *
Q '  Q
I'
0.22
Q'  (80) 72
0.27

b. Q' =Q¿
√ I
I'

8. Annual Demand D = (5/month)(12 months) = 60

Ordering Cost = Fixed Cost per class = $22,000

Holding Cost = ($1,600/month)(12 months) = $19,200 per year for one driver

2 DCo 2(60)(22, 000)

Q*   11.73
Ch (19, 200)

Use 12 as the class size.

D/Q* = 60/12 = 5 classes per year

1 1
QCh  (12)(19, 200) $115, 200
Driver holding cost = 2 2

Class ordering cost = ( D / Q)CO (60 /12)(22, 000) 110,000

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Total cost = $225,200

2 DCo 2(5000)(80)
Q*   400
Ch (0.25)(20)
9. a.
5000
r dm  (12) 240
b. 250

5000
r dm  (35) 700
c. 250 . The reorder point of 700 exceeds the order quantity of 400. This means
one order will be outstanding when the reorder point is reached.

d. Since r = 700 and Q* = 400, one order will be outstanding when the reorder point is reached. Thus
the inventory on hand at the time of reorder will be 700 - 400 = 300.

10. This is a production lot size model. However, the operation is only six months rather than a full
year. The basis for analysis may be for periods of one month, 6 months, or a full year. The
inventory policy will be the same. In the following analysis we use a monthly basis.

2 DCo 2(1000)(150)
Q*   1414.21
(1  D / P )Ch  1000 
1 
 4000  (0.02)(10)
 

20Q 20(1414.21)
T  28.28
D 1000 days

Q 1414.21
 7.07
Production run length = P / 20 4000 / 20 days

2 DCo 2(6400)(100)
Q*  
(1  D / P )Ch  6400 
1 P  2
11.  

a. P = 8,000 Q* = 1789
b. P = 10,000 Q* = 1333
c. P = 32,000 Q* = 894
d. P = 100,000 Q* = 827

EOQ Model:

2 DCo 2(6400)(100)
Q*   800
Ch 2

Production Lot Size Q* is always greater than the EOQ Q* with the same D, C0, and Ch values.

As the production rate P increases, the recommended Q* decreases, but always remains greater than

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the EOQ Q*.

2 DCo 2(6000)(2345)
Q*   1500
(1  D / P )Ch  6000 
 1  16000  20
12. a.  

b. D/Q* = 6000/1500 = 4 production runs

12 months/4 = 3 month cycle time

c. Current total cost using Q = 500 is as follows:

1 D  D 1 6000  6000
TC   1   QCh    Co   1   500(20)  (2345) 3125  28140 $31, 265
2 P Q 2  16000  500

Proposed Total Cost using Q* = 1500 is as follows:

1 6000  6000
TC   1   1500(20)  (2345) 9375  9380 $18, 755
2  16000  1500

Change to Q* = 1500

Savings = $31,265 - $18,755 = $12,510

12,510/31,265 = 40% savings over current policy

2 DCo 2(7200)(150)
Q*   1078.12
(1  D / P)Ch  7200 
 1  25000  (0.18)(14.50)
13. a.  

b. Number of production runs = D / Q* = 7200 / 1078.12 = 6.68

250Q 250(1078.12)
T  37.43
c. D 7200 days

Q 1078.12
 10.78
d. Production run length = P / 250 25000 / 250 days

e. Maximum Inventory

 D  7200 
 1  P  Q  1  25000  (1078.12) 767.62
   

f. Holding Cost

1 D 1 7200 
 1   QCh   1  (1078.12)(0.18)(14.50) $1001.74
2 P 2  25000 

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D 7200
 Co  (150) $1001.74
Q 1078.12
Ordering cost

Total Cost = $2,003.48

 D  7200
r dm   m (15) 432
g.  250  250

14. C = current cost per unit

C ' = 1.23 C new cost per unit

2 DCo 2 DC0
Q*   5000
(1  D / P)Ch (1  D / P) IC
Let Q' = new optimal production lot size

2 DCo
Q' 
(1  D / P) IC '

2 DCo 1
Q' (1  D / P ) IC ' C' C C 1
     0.9017
Q* 2 DCo 1 C' 1.23C 1.23
(1  D / P) IC C

Q' = 0.9017(Q*) = 0.9017(5000) = 4509

2 DCo  Ch  Cb  2(1200)(25)  0.50  5 

Q*     0.50  1148.91
Ch  Cb  0.50  
15. a.

 Ch   0.50 
S * Q *   1148.91  104.45
b.  Ch  Cb   0.50  5 

c. Max inventory = Q* - S* = 1044.46

250Q * 250(1148.91)
T  23.94
d. D 12000

(Q  S ) 2
Ch $237.38
2Q
e. Holding:

D
Co 261.12
Q
Ordering:

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S2
Cb 23.74
2Q
Backorder:

Total Cost: $522.24

The total cost for the EOQ model in problem 4 was $547.72. Allowing backorders reduces the total
cost.

 12000 
r dm   5 240
16.  250 

With backorder allowed the reorder point should be revised to

r = dm - S = 240 - 104.45 = 135.55

The reorder point will be smaller when backorders are allowed.

17. EOQ Model

2 DCo 2(800)(150)
Q*   282.84
Ch 3

1 D  282.84  800
 QCh  C0   3 (150) $848.53
Total Cost
2 Q  2  282.84

Planned Shortage Model

2 DCo  Ch  Cb  2(800)(150)  3  20 
Q*     20  303.32
Ch  Cb  3  

 Ch   3 
S * Q *   303.32   39.56
 Ch  Cb   3  20 

(Q  S ) 2 D S2
 Ch  Co  Cb 344.02  395.63  51.60 $791.25
2Q Q 2Q
Total Cost

Cost Reduction with Backorders allowed

$848.53 - 791.25 = $57.28 (6.75%)

Both constraints are satisfied:

1. S / Q = 39.56 / 303.32 = 0.13

Only 13% of units will be backordered.

2. Length of backorder period = S / d = 39.56 / (800/250) = 12.4 days

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18. Reorder points:

 800 
r dm   20 64
EOQ Model:  250 

Backorder Model: r = dm - S = 24.44

2 DCo 2(480)(15)
Q*   34.64
Ch (0.20)(60)
19. a.

1 D
 QCh  C0 207.85  207.85 $415.70
2 Q
Total Cost:

2 DCo  Ch  Cb  2(480)(15)  0.20(60)  45 

Q*     39
Ch  Cb  (0.20)(60)  45 
b.

 Ch 
S * Q *   8.21
 Ch  Cb 

(Q  S ) 2 D S2
 Ch  Co  Cb 145.80  184.68  38.88 $369.36
2 Q 2Q
Total Cost

S 8.21
  5.13
c. Length of backorder period d 480 / 300 days

d. Backorder case since the maximum wait is only 5.13 days and the cost savings is

$415.70 - 369.36 = $46.34 (11.1%)

 480 
r dm   6 9.6
e. EOQ:  300 

Backorder: r = dm - S = 1.39

2 DCo
Q
Ch
20.

2(120)(20)
Q1  25.30 Q1 25
0.25(30)

2(120)(20)
Q2  25.96 Q2 50
0.25(28.5)
to obtain 5% discount

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2(120)(20)
Q3  26.67 Q3 100
0.25(27)
to obtain 10% discount

Order Holding Purchase Total

Category Unit Cost Quantity Cost Order Cost Cost Cost

1 30.00 25 93.75 96 3600 $3,789.75

2 28.50 50 178.13 48 3420 $3,646.13
3 27.00 100 337.50 24 3240 $3,601.50
Q = 100 to obtain the lowest total cost.

The 10% discount is worthwhile.

2 DCo
Q
Ch
21.

2(500)(40)
Q1  141.42
0.20(10)

2(500)(40)
Q2  143.59
0.20(9.7)

Since Q1 is over its limit of 99 units, Q1 cannot be optimal (see problem 23). Use Q2 = 143.59 as
the optimal order quantity.

1 D
 QCh  Co  DC 139.28  139.28  4,850.00 $5,128.56
2 Q
Total Cost:

22. D = 4(500) = 2,000 per year

Co = $30

I = 0.20

C = $28

Annual cost of current policy: (Q = 500 and C = $28)

TC = 1/2(Q)(Ch) + (D/Q)Co + DC
= 1/2(500)(0.2)(28) + (2000/500)(30) + 2000(28)
= 1400 + 120 + 56,000 = 57,520

Evaluation of Quantity Discounts

2 DCo
Q* 
Ch

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Q to obtain
Order Quantity Ch Q* Discount TC
0-99 (0.20)(36) = 7.20 129 * —
100-199 (0.20)(32) = 6.40 137 137 64,876
200-299 (0.20)(30) = 6.00 141 200 60,900
300 or more (0.20)(28) = 5.60 146 300 57,040

*Cannot be optimal since Q* > 99.

Reduce Q to 300 pairs/order. Annual savings is $480; note that shoes will still be purchased at the
lowest possible cost ($28/pair).

1 D
TC  QIC  Co  DC
2 Q
23.

At a specific Q (and given I, D, and C0), since C of category 2 is less than C of category 1, the TC
for 2 is less than TC for 1.

category 1

category 2
TC

minimum for group 2

Thus, if the minimum cost solution for category 2 is feasible, there is no need to search category 1.
From the graph we can see that all TC values of category 1 exceed the minimum cost solution of
category 2.

24. a. Cost of overestimation, co = $9

Cost of underestimation, cu = $10 - $9 -$0.50 = $0.50

cu 0.5
P( demand ≤ Q*) = = =0.0526
c u+ c o 9.5

From the normal table, a cumulative probability of 0.0526 corresponds to z = -1.62

Thus,

Q* = µ - 1.62σ = 9000 – (1.62)(400) = 8352 magazines.

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b. Cost of overestimation, co = $9 - $8 = $1
Cost of underestimation, cu = $10 - $9 -$0.50 = $0.50

Cu .5
cu 0.5  0.3333
P(demand ≤ Q*) = c +c = 1.5 =0.3333 Cu  Co 1.5
u o

From the normal table, a cumulative probability of 0.3333 corresponds to z = -0.43

Thus, Q* = µ - 0.43σ = 9000 – (0.43)(400) = 8828 magazines.

25. a. co = 80 - 50 = 30

cu = 125 - 80 = 45

cu 45
P( D Q*)   0.60
cu  co 45  30

P(D Q*) = 0.60  =8

20
Q*
For the cumulative standard normal probability 0.60, z = 0.25

Q* = 20 + 0.25(8) = 22

b. P(Sell All) = P(D  Q*) = 1 - 0.60 = 0.40

26. a. co = $150

b. The city would have liked to have planned for more additional officers at the $150 per officer rate.
However, overtime at $240 per officer will have to be used.

cu = $240 - $150 = $90

cu 90
P(Demand Q*)   0.375
cu  co 90  150
c.

For the cumulative standard normal probability 0.375, z = -0.32

 Q*   z = 50 - 0.32(10) = 46.8

Recommend 47 additional officers

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d. P(Overtime) = 1 - 0.375 = 0.625

27. a. co = 1.19 - 1.00 = 0.19

cu = 1.65 - 1.19 = 0.46

cu 0.46
P( D Q*)   0.7077
cu  co 0.46  0.19

P(D Q*) = 0.7077  = 30

150
Q*
For the cumulative standard normal probability 0.7077, z = 0.55

Q* = 150 + 0.55(30) = 166.5

b. P(Stockout) = P(D  Q*) = 1 - 0.7077 = 0.2923

c. co = 1.19 - 0.25 = 0.94

cu 0.46
P( D Q*)   0.3286
cu  co 0.46  0.94

For the cumulative standard normal probability 0.3286, z = -0.45

Q* = 150 - 0.45(30) = 136.50

The higher rebate increases the quantity that the supermarket should order.

28. a. co = 8 - 5 = 3

cu = 10 - 8 = 2

cu 2
P( D Q*)   0.40
cu  co 2  3

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Q* is 40% of way between 700 and 800

Q* = 200 + 0.40(600) = 440

b. P(stockout) = P(D  Q*) = 1 - 0.40 = 0.60

c. P(D  Q*) = 0.85 P(Stockout) = 0.15

Q* = 200 + 0.85(600) = 710

d. Let g = goodwill cost

cu = lost profit + goodwill cost = (10 - 8) + g = 2 + g

cu
P( D Q*)  0.85
cu  co

Solve for cu = 17
cu = 2 + g = 17
g = 15

29. a. r = dm = (200/250)15 = 12

b. D / Q = 200 / 25 = 8 orders / year

The limit of 1 stockout per year means that

P(Stockout/cycle) = 1/8 = 0.125

 = 2.5

P(Stockout) = 0.125

12 r

P(No Stockout/cycle) = 1 – 0.125 = 0 .875

For the cumulative standard normal probability 0.875, z = 1.15

r  12
z 0.15
Thus, 2.5
or

r = 12 + 1.15(2.5) = 14.875 Use 15

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c. Safety Stock = 3 units

Added Cost = 3($5) = $15/year

√ ( 300
100 )
 800 
2  52   (15)

√
 15 2(52)
2 DC0
  100   2 D Co
Ch  10  .15 = =¿
30. a. Q* = Ch ( 10 ) (.15) 55.86 ≈ 56 boxes.

b. r = µ + zσ = 300 + (2.33)(75) = 474.75 ≈ 475 cups.

2 DCo 2(1000)(25.5)
Q*   79.84
Ch 8
31. a.

b.

 =5

P(Stockout) = 0.02

25 r

P(No Stockout/cycle) = 1 – 0.02 = 0 .98

For the cumulative standard normal probability 0.98, z = 2.05

r  25
z 2.05
Thus, 5
or

r = 25 + 2.05(5) = 35.3 Use 35

Safety Stock = 35 - 25 = 10

Safety Stock Cost = (10)($8) = $80/year

c.

 =5

P(Stockout) = ?

25 30

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 Inventory Models

The cumulative standard normal probability for z = 1 is 0.8413.

Thus, P(Stockout/cycle) =1.0.8413 = 0.1587

Number of Stockouts/year = 0.1587 (Number of Orders) = 0.1587 D/Q = 2

2 DCo 2(300)(5)
Q*   31.62
Ch (0.15)(20)
32. a.

b. D / Q* = 9.49 orders per year

2
P(Stockout )  0.2108
D / Q*

 =6

P(Stockout) = 0.2108

25 r

P(No Stockout) = 1 – 0.2108 = 0.7892

For the cumulative standard normal probability 0.7892, z = 0.80

r  25
z 0.80
Thus, 6
or

r = 15 + 0.80(6) = 19.8 Use 20

c. Safety Stock = 20 - 15 = 5

Safety Stock Cost =5(0.15)(20) = $15

33. a. 1/52 = 0.0192

b. P(No Stockout) = 1 – 0.0192 = 0.9808

For the cumulative standard normal probability 0.9808, z = 2.07

M  60
z 2.07
Thus, 12
or

M = µ + z = 60 + 2.07(12) = 85

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Chapter 10

c. M = 35 + (0.9808)(85-35) = 84

34. a. P(Stockout) = 0.01 z = 2.33

P(No Stockout) = 1 – 0.01 = 0.99

For the cumulative standard normal probability 0.99, z = 2.33

r  150
z 2.33
Thus, 40
or

r = µ + z = 150 + 2.33(40) = 243

b. Safety Stock = 243 - 150 = 93 units

Annual Cost = 93(0.20)(2.95) = $54.87

c. z = 2.33

M = µ + z = 450 + 2.33(70) = 613 units

d. Safety Stock = 613 - 450 = 163 units

Annual Cost = 163(0.20)(2.95) = $96.17

e. The periodic review model is more expensive ($96.17 - $54.87) = $41.30 per year. However, this
added cost may be worth the advantage of coordinating orders for multi products. Go with the
periodic review system.

f. Unit Cost = $295 Annual Difference = $4,130

Use continuous review for the more expensive items.

24  18
z 1.0
35. a. 6
The cumulative standard normal probability for z = 1.0 is 0.8413.

P(Stockout) = 1.0000 - 0.8413 = 0.1587

b. P(Stockout) = 0.025

P(No Stockout) = 1 – 0.025 = 0.975

For the cumulative standard normal probability 0.975, z = 1.96

M  18
z 1.96
Thus, 6
or

M = µ + z = 18 + 1.96(6) = 29.76

Use M = 30.

The manager should have ordered Q = 30 - 8 = 22 units.

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 Inventory Models

36. a. µ = Week 1 demand + Week 2 demand + Lead Time demand

= 16 + 16 + 8 = 40

b. 2 = Var (Week 1) + Var (Week 2) + Var (Lead Time)

= 25 + 25 + 12.25 = 62.25

  62.25 7.9

c. 26 orders per year

P(Stockout) = 1/26 = 0.0385 per replenishment

P(No Stockout) = 1 – 0.0385 = 0.9615

For the cumulative standard normal probability 0.9615, z = 1.77

M  40
z 1.77
Thus, 7.9
or

M = µ + z = 40 + 1.77(7.9) = 54

d. 54 - 18 = 36

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