In partial fulfillment in

Quantitative Techniques in Business Management

Inventory Model
(Written report)

Submitted by:

Pilvera, Mary Louise D.

Yungod, Bliza Jane D.

Mofan, Rey D.

Submitted to:

Mr. Ernie C. Capuno

2018
What is Inventory?

An inventory is a store of goods. It may be thought of as a resource or as a list of some category

of materials, machines, people, money, or information for some organizational unit at some time.
Inventories are “added to” and “depleted from”; if the addition and depletion processes are stopped, what
remains is inventory. Alternatively, an inventory can be conceived as an idle usable resource.

Inventory is the raw materials, work-in-process products and finished goods that are considered
to be the portion of a business's assets that are ready or will be ready for sale. Inventory represents one of
the most important assets of a business because the turnover of inventory represents one of the primary
sources of revenue generation and subsequent earnings for the company's shareholders.

What is Inventory Model?

Inventory model is a mathematical model that helps business in determining the optimum level
of inventories that should be maintained in a production process, managing frequency of ordering,
deciding on quantity of goods or raw materials to be stored, tracking flow of supply of raw materials and
goods to provide uninterrupted service to customers without any delay in delivery.

Reasons for carrying inventory

 Smooth production

The demand for an item fluctuates widely due to a number of factors such as seasonality and
production schedules. Firms find it more economical to produce goods over a longer, slower
schedule and store them as inventor. Thus, they keep the labor force fairly stable and
expenditures for capital equipment are lower.

 Product availability

Most retail goods and many industrial goods are carried in inventory to ensure prompt delivery to
customer. Not only does a good inventory provide a competitive edge, it often means the
difference between success and failure. If a firm gains a reputation for constant being out of
stock, it may lose a significant number of customers.

 Advantage of producing or buying in large quantity

Most production runs involve machine setup time and production time. If setup time is
 significant, real savings can be achieved by producing in large lots. Also many firms often
quantity discounts for buying in large quantities.
 Hedge against long or uncertain lead terms

The time between ordering and receiving goods is known as lead time. Firms do not want to stop
manufacturing or selling goods during lead time; so it is necessary to carry inventory.

Proper inventory management is an essential function of all business operations. Proper inventory
would mean great savings to the company. Most of the inventory problems fall into one of the following
categories:

A. The proper quantity of inventory to order at given time. (How much to order.)
B. The proper time to order the quantity. (When to order.)

Four basic costs are associated with inventories:

purchase cost; holding or carrying cost; ordering cost, and shortage cost. Annual cost of inventory is the
sum of the annual ordering cost and annual carrying cost.

Holding or Carrying Cost

This cost is proportional to the amount of inventory and the time over which it is held. They
include interest, insurance, taxes, depreciation, absolescence, deterioration, spoilage, pilferage, breakage,
and warehousing cost. Holding cost also includes opportunity costs associated with having funds tied up
in inventory that could be used elsewhere. It essentially represents the explicit and implicit cost of
maintaining and owning the inventory. A significant component of carrying cost is the opportunity cost
associated with owning the inventory. Holding or Carrying Cost is stated in either of two ways. One way
is to specify cost as a percentage of unit price, and the other is to specify a peso amount per unit.

Inventory carrying costs typically include the physical cost of storage such as building and facility
maintenance related costs. These costs can include:

o Financing expenses

o The cost of storage space and warehousing

 o Security, which may include securing restricted or hazardous materials

o Insurance against theft, loss or damage

o Opportunity cost – capital tied up in inventory that could be spent elsewhere

o Deterioration, theft, spoilage, or obsolescence.

Building rent and warehousing expenses, including overheads such as electricity, lighting and
temperature control, are part of carrying costs.

Ordering or Set Up Costs

Ordering cost are costs associated with ordering and receiving inventory. This cost is incurred
whenever an inventory is replenished. Ordering cost is the term used for purchase or vendor models.
These costs include determining how much is needed, typing up invoices, inspecting goods to temporary
storage. These costs are generally expressed as a peso amount per order size. In production model, the
term “setup cost” is frequently used to include the cost of labor and material used in setting up machinery
for the production run.

The cost of acquisition and inbound logistics form part of the ordering cost of procuring inventory. These
include:

o Time spent finding suppliers and expediting orders

o Clerical costs of preparing purchase orders

o Transportation costs

o Receipt of inwards goods, unloading, inspection and transfer.

One, or many people are responsible for sourcing products, processing orders and paying accounts.
Add to that delivery, receipt of goods and movement of stock through the warehouse. Each step is a cost
to the company.

Purchase or Direct Production Cost

The purchase cost is for vendor supply environments or direct production cost in case of items produced
by user. In either situation the unit cost may be constant for all replenishment quantities, or it may vary
with the quantity purchased or produce. Businessmen frequently offer discounts or price breaks if the user
purchases quantities that exceed some specified quantity. Similarly, unit cost may decrease as larger
production runs are made due to economics of scale.

Shortage Costs

Shortage costs results when demands excess the supply of inventory on hand. The cost can include the
opportunity cost of not making a sale, loss of customer goodwill, lateness charges, and similar cost.

Shortage costs are computed differently depending on whether or not, back ordering is possible. When
back ordering is permitted, explicit costs are incurred for overtime, special clerical and administrative
efforts, expediting, and special transportation. When the unavailable item is a finished good, there is often
as implicit cost reflecting loss of goodwill. This is a difficult cost to measure, since it supposedly accounts
for lost future sales.

Shortage costs are those costs that are incurred when a business runs out of stock, including:

o Time lost when raw materials are not available

o Cost of shrinkage, pilferage and obsolescence

o Idle employees

o Lost sales

o Machinery set up costs,

Filling back-orders through expedited shipping or replenishing stock at higher than wholesale prices
are some examples of shortage costs. The most damaging cost of shortage however is a dissatisfied
customer and the temporary or permanent loss of sales through insufficient stock levels.

Economic Quantity Model (EOQ)

EOQ model identifies the optimal order, quantity in terms of minimizing the sum of certain annual costs
which vary with order size. It is the best known and most fundamental inventory model. This model is
applicable when the demand for the item has a constant or nearly constant rate and when the entire
quantity ordered arrives in the inventory at one point in time. The constant demand rate condition means
simply that the same number of units is taken from the inventory each period of time.

The how-much-to-order decision involves in selecting an order quantity that draws a

compromise between:

1. Keeping small inventories and ordering frequently,

2. Keeping large inventories and ordering frequently.

The first alternative would result in undesirably high ordering cost, while the second alternative
would result in undesirably high inventory holding costs.

The Economic Order Quantity (EOQ) Formula stated by:

2 ( Annual inventory )( Cost per code)

EOQ=
√ ( percentage of carrying cost ) (Cost per unit)

Derivation:

The total cost function and derivation of EOQ formula

The single-item EOQ formula finds the minimum point of the following cost function:

Total Cost = purchase cost or production cost + ordering cost + holding cost

Where:

 Purchase cost: This is the variable cost of goods: purchase unit price × annual demand quantity.
This is P × D
 Ordering cost: This is the cost of placing orders: each order has a fixed cost K, and we need to
order D/Q times per year. This is K × D/Q
 Holding cost: the average quantity in stock (between fully replenished and empty) is Q/2, so this
cost is h × Q/2

DK hQ
TC=PD+ +
Q 2
 To determine the minimum point of the total cost curve, calculate the derivative of the total cost with
respect to Q (assume all other variables are constant) and set it equal to 0:

−DK h
O= +
Q2 2

Solving for Q gives Q* (the optimal order quantity):

−2 DK
Q ¿2 =
h

Therefore:

2 DK
Q∗¿
√ h

EOQ Cost Model

D - annual demand
Q - order quantity 2 DS
S - cost of placing order Q* 
H - annual per-unit holding cost H
Ordering cost = SD/Q
Holding cost = HQ/2

Total cost = SD/Q + HQ/2

 THE EOQ MODEL

Demand
Order qty, Q rate

Inventory Level
Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
Placed Received Placed Received
4

The annual inventory holding or carrying costs can be calculated using the average inventory.
That is, we can calculate the annual inventory carrying costs by multiplying the average inventory by
costs of carrying one unit in the inventory for a year. Thus, the general equation for annual inventory
costs is as follows:

Annual Inventory Carrying Cost = (Average Inventory)(Annual holding cost per unit)
or

Annual Carrying Cost = Average inventory costs times percentage of carrying costs

The annual ordering costs can be calculated by multiplying the number of order per year and the
cost per order. Thus, the general equation for annual inventory cost is as follows:

Annual Ordering Cost = (Number of orders per year)(Cost per order)

Thus the total annual cost = annual inventory carrying cost plus annual ordering cost

Example:

Suppose that R&C Beverage Company has a beverage product that has a constant annual demand rate
of 7200 cases. A case of soft drink costs R&C Php288. Ordering cost is Php200 per order and inventory
carrying cost is charged at 25% of the cost per unit. Identify the following aspects of the inventory policy:
 a. Economic Order Quantity
b. Annual Carrying Cost
c. Total Annual Cost

Solution:

a. Given:
Annual inventory = 7200 cases
Cost per case of soft drinks = Php288
Cost per order = Php200
Percentage of Carrying Cost = 25%

2 ( Annual inventory )( Cost per code)

EOQ=
√ ( percentage of carrying cost ) (Cost per unit)

2 ( 7,200 ) (200)
EOQ=
√ ( 0.25 ) (288)

2,880,000
EOQ=
√ 72
=√ 40,000

Q = 200 cases

b. Annual Carrying Cost = ( average inventory cost ) ( percentage of carrying cost )

1
Average Inventory = Economic Order Quantity
2
1
Annual Carrying Cost = ( 200 ) ×0.25(288)
2
= 100 × 72
= Php7,200
c. Annual Ordering Cost = No. of orders × Cost per order
Annual Inventory
No. of Orders =
EOQ

Annual Inventory
No. of Orders =
EOQ
7200
= 200 cases
Total annual ordering cost = 36 × Php200
= Php7,200

d. Total Annual Cost = Annual Ordering Cost + Annual Carrying Cost

Total Annual Cost = Php7,200 + Php7,200

= Php14,400
References:

Inventory https://www.investopedia.com/terms/i/inventory.asp#ixzz55oGfVed1