DETERMINISTIC

INVENTORY MODELS
LECTURE 1
BASIC STATIC EOQ MODEL

©Dr. Majid Khan

Deterministic Inventory Models
Basic Economic Order Quantity
Model (EOQ Model)
➢How much to order? … Optimum quantity
➢When to order? … Optimum reorder point
➢What is the total cost?
➢What is the average inventory level?
➢What is the maximum inventory level?
 Deterministic Inventory Models
Basic Economic Order Quantity Model
(EOQ Model)
Assumptions
➢ Single item
➢ Deterministic demand (static)
➢ Deterministic lead time (constant)
➢ Uniform depletion of the inventory
 Deterministic Inventory Models
Basic Economic Order Quantity Model
(EOQ Model)
Assumptions
➢ Constant order quantity (OQ)
➢ Purchasing cost is independent of the OQ
➢ Unit holding cost is independent of the OQ
➢ No shortages, no surpluses
Deterministic Inventory Models

Basic Economic Order Quantity Model

(EOQ Model)
Inventory Replenishment
Level Depletion Maximum
Level
q

Average
q/2 Level

Order
Arrives
0
Cycle 1 Cycle 2 Cycle 3 Time
 Deterministic Inventory Models
Basic Economic Order Quantity Model
(EOQ Model)
Inventory
Depletion Replenishment Maximum
Level
Level
q

Average
q/2 Level

Order
Arrives
0
Cycle 1 Cycle 2 Cycle 3 Time
 Deterministic Inventory Models
EOQ Model
Example – Brewery
➢ Monthly production of beer = 4 000 hl
➢ Filling into glass bottles = 25% of production
➢ Empty bottles stored in plastic cases (20 pcs.)
➢ Annual holding cost per case = 20 CZK
➢ Ordering cost – transportation = 11 000 CZK per order
– other = 1 000 CZK per order
➢ Lead time = ½ of month
➢ Objective: minimize total annual cost
 Deterministic Inventory Models
EOQ Model
Example – Brewery

➢ Annual demand Q = 120 000 cases

➢ Annual holding cost c1 = 20 CZK per case

➢ Ordering cost c2 = 12 000 CZK per order

➢ Lead time d = 1/2 of month = 1/24 of year

 Deterministic Inventory Models
EOQ Model
Example – Brewery
➢ Total annual cost

TC = HC + OC

Total annual ORDERING cost

Total annual HOLDING cost

Deterministic Inventory Models
EOQ Model
Inventory
Level Maximum
Level
q

Order
quantity Average
q/2 Level

0
Time
 Deterministic Inventory Models
EOQ Model
Example – Brewery
➢ Order quantity - q
➢ Maximum inventory level
q max = q

➢ Average inventory level

q
qavg =
2
 Deterministic Inventory Models
EOQ Model
Example – Brewery
➢ Total annual HOLDING cost
q
HC = c1qavg = c1
2

➢ Total annual ORDERING cost

Q
OC = c 2 n = c 2
q
 Deterministic Inventory Models
EOQ Model
Example – Brewery
➢ Total annual cost
q Q
TC (q) = c1 + c2
2 q
 Deterministic Inventory Models
EOQ Model
Example – Brewery
Total cost

1 212 000

TC
624 000
HC

244 000 OC

0
10 000 60 000 120 000 q
 Deterministic Inventory Models
EOQ Model
Example – Brewery
Policy I Policy II Policy III
Annual demand Q 120 000 120 000 120 000
Order quantity q 10 000 60 000 120 000
Annual unit holding cost c1 20 20 20
Average inventory level q/2 5 000 30 000 60 000
Total annual holding cost HC 100 000 600 000 1 200 000
Unit ordering cost c2 12 000 12 000 12 000
Number of orders Q/q 12 2 1
Total annual ordering cost OC 144 000 24 000 12 000
Total annual cost TC 244 000 624 000 1 212 000
 Deterministic Inventory Models
EOQ Model
Example – Brewery

Inventory Level

Policy I

10 000

0 6 12 Time
 Deterministic Inventory Models
EOQ Model
Example – Brewery
Inventory
Level Policy II
60 000

0 6 12 Time
 Deterministic Inventory Models
EOQ Model
Example – Brewery
Inventory
Level

120 000
Policy III

0 6 12 Time
 Deterministic Inventory Models
EOQ Model
Example – Brewery
➢ Optimum order quantity

2Qc 2
q =
*
c1

2(120 000)(12 000)

q =
*
= 12 000 cases
20
 Deterministic Inventory Models
EOQ Model
Example – Brewery
➢ Optimum total annual cost

TC * = 2Qc1c 2

TC * = 2(120 000 )(20 )(12 000 ) = 240 000 CZK

 Deterministic Inventory Models
EOQ Model
Example – Brewery

cost
TC
240 000 HC

OC

0 12 000 q
 EOQ Model
Example – Brewery
➢ Optimum length of inventory cycle

1 q* 2c 2
t = * =
*
=
n Q Qc1

t * = 1/10 of year = 36.5 days

 Deterministic Inventory Models
EOQ Model
Example – Brewery
Inventory *
q max = q*
Level
*
q avg

12 000

6 000

0 73 146 219 292 365 Time

36.5 109.5 182.5 255.5 328.5 (days)
 Deterministic Inventory Models
EOQ Model
Example – Brewery
Inventory
Level
Order
q*

Delivery

r*

d Time
t*
 EOQ Model
Example – Brewery
➢ Optimum reorder point
q*
*
dq
r * = * = dQ
t
r*
1
r = 120 000 = 5 000 cases
*

24
d
t*
 Deterministic Inventory Models
EOQ Model
Example – Brewery
Inventory
Level
d > t*
q*

r * = dQ mod q *

r*

d Time
t*
EOQ Model
Economic Order Quantity
 Inventory Holding Costs
Reasonably Typical Profile

% of
Category Inventory Value
Housing (building) cost 6%
Material handling costs 3%
Labor cost 3%
Inventory investment costs 11%
Pilferage, scrap, & obsolescence 3%
Total holding cost 26%
 EOQ Model

Annual Cost

Order Quantity
 EOQ Model

Annual Cost

Holding Cost

Order Quantity
 Why Order Cost Decreases

• Cost is spread over more units

Example: You need 1000 microwave ovens
1 Order (Postage $ 0.35) 1000 Orders (Postage $350)

Purchase Order PurchaseOrder

Purchase Order
PurchaseOrder
Order
Description
Purchase Qty.
Description Qty. Description Qty.
Microwave 1000 Description
Microwave
Description Qty.1
Qty.
Microwave 11
Microwave
Microwave 1
Order
quantity
 EOQ Model

Annual Cost

Holding Cost
Order (Setup) Cost

Order Quantity
 EOQ Model

Annual Cost

Total Cost Curve

Holding Cost
Order (Setup) Cost

Order Quantity
 EOQ Model

Annual Cost

Total Cost Curve

Holding Cost
Order (Setup) Cost

Optimal Order Quantity

Order Quantity (Q*)
 EOQ Formula Derivation
D= Annual demand (units)
C= Cost per unit ($) Total cost = (Q/2) x I x C + S x (D/Q)
Q= Order quantity (units) inv carry cost order cost
S= Cost per order ($)
I = Holding cost (%) Take the 1st derivative:
H= Holding cost ($) = I x C
d(TC)/d(Q) = (I x C) / 2 - (D x S) / Q²

Number of Orders = D / Q To optimize: set d(TC)/d(Q) = 0

Ordering costs = S x (D / Q)
DS/ Q² = IC / 2
Average inventory
units = Q / 2 Q²/DS = 2 / IC
$ = (Q / 2) x C
Q²= (DS x 2 )/ IC
Cost to carry
average inventory = (Q / 2) x I x C Q = sqrt (2DS / IC)
= (Q /2) x H
Economic Order Quantity

2 D S
EOQ =
H
D= Annual demand (units)
S= Cost per order ($)
C= Cost per unit ($)
I = Holding cost (%)
H= Holding cost ($) = I x C
 EOQ Model Equations
2 D S
Optimal Order Quantity = Q * =
H
D
Expected Number Orders = N =
Q*
Working Days / Year
Expected Time Between Orders = T =
N
D
d= D = Demand per year
Working Days / Year S = Setup (order) cost per order
H = Holding (carrying) cost
ROP = d  L
d = Demand per day
L = Lead time in days
 EOQ
Example
You’re a buyer for SaveMart.

SaveMart needs 1000 coffee makers per

year. The cost of each coffee maker is
$78. Ordering cost is $100 per order.
Carrying cost is 40% of per unit cost. Lead
time is 5 days. SaveMart is open 365
days/yr.

What is the optimal order quantity & ROP?

 SaveMart EOQ

2 D S
EOQ =
H
D= 1000
2 1000  $100
S= $100 EOQ =
C= $ 78 $31.20
I= 40%
H= CxI
H= $31.20 EOQ = 80 coffeemakers
 SaveMart ROP
ROP = demand over lead time
= daily demand x lead time (days)
=dxl

D = annual demand = 1000

Days / year = 365
Daily demand = 1000 / 365 = 2.74
Lead time = 5 days

ROP = 2.74 x 5 = 13.7 => 14

 SaveMart
Average (Cycle Stock) Inventory

Avg. CS = OQ / 2
= 80 / 2 = 40 coffeemakers
= 40 x $78 = $3,120

Inv. CC = $3,120 x 40% = $1,248

Note: unrelated to reorder point

Economic Order Quantity

2 D S
EOQ =
H
D= Annual demand (units)
S= Cost per order ($)
C= Cost per unit ($)
I = Holding cost (%)
H= Holding cost ($) = I x C
 2 D S
EOQ =
H
What if …
1. Interest rates go up ?
2. Order processing is automated ?
3. Warehouse costs drop ?
4. Competitive product is introduced ?
5. Product is cost-reduced ?
6. Lead time gets longer ?
7. Minimum order quantity imposed ?
Economic Order Quantity
 How EOQ Works
The Principles Behind EOQ: The Total
Cost Curve

& →
 How EOQ Works
The Principles Behind EOQ: The Holding
Costs
➢Keeping inventory on hand
➢Interest
➢Insurance
➢Taxes
➢Theft
➢Obsolescence
➢Storage Costs
 How EOQ Works
The Principles Behind EOQ: The Holding Costs
Interest

Obsolescence

Storage
 How EOQ Works
The Principles Behind EOQ: The
Procurement Costs
Primarily the labor costs associated with
processing the order:
➢Ordering and requisition
➢A portion of the freight if the amounts
vary according to the size of the order
➢Receiving, inspecting, stocking
➢Invoice processing
 How EOQ Works
The Total Cost Formula

Total Cost = Purchase Cost + Order Cost + Holding Cost

 How EOQ Works
The Total Cost Formula

This represents the

unchanging fixed costs
P = Purchase cost per unit
R = Forecasted monthly usage
 How EOQ Works
The Total Cost Formula

This represents the variable order costs

P = Purchase cost per unit
R = Forecasted monthly usage
C = Cost per order event (not per unit)
Q = The number of units ordered
 How EOQ Works
The Total Cost Formula

P = Purchase cost per unit

This represents
R = Forecasted monthly usage
the variable
C = Cost per order event (not per unit)
holding costs
Q = The number of units ordered
F = Holding cost factor
 How EOQ Works
The EOQ Formula

Total Cost Formula

Taking the derivative of both sides of the equation and setting

equal to zero to find the minimum value of the function, one
obtains:
 How EOQ Works
The EOQ Formula
The result of differentiation

The Economic Order Quantity

 How EOQ Works
The EOQ Formula
Review and Summary of the EOQ Formula

P = Purchase cost per unit

R = Forecasted monthly usage
C = Cost per order event (not per unit)
F = Holding cost factor
 How EOQ Works
Review and Summary of the EOQ
Formula
Here is the a graphic representation of the EOQ equation
 CLOSING COMMENTS

➢EOQ is a tool, not a simple solution.

➢EOQ is useful in determining optimal

order quantity

➢Understand the equation and what you

are trying to find

➢Find accurate inputs for the equation