MODULE

Inventory systems for independent demand

What is independent demand?

Inventories can be separated into two broad categories: dependent and independent demand. An inventory is considered
independent demand when the demand for the inventory is not dependent upon the demand of another inventory, it is
a demand for a finished product. Dependent demand inventory on the other hand is one which demand is dependent
upon another item, or the demand for component parts.

Deterministic models

Deterministic models of inventory control are used to determine the optimal inventory of a single item when demand is
mostly largely obscure. Under this model, inventory is built up at a constant rate to meet a determined or accepted
demand.

 ECONOMIC ORDER QUANTITY (EOQ)

Economic order quantity represents the least costly number of units to order. EOQ indicates the optimal balance between
ordering and carrying costs by mathematically equating total ordering costs to total carrying costs.

Economic order quantity is computed using the formula:

Where:
AR= Annual demand or requirement of the material in units
OC= Ordering cost per order
CC= carrying cost/storage cost per unit of material for a period

For example, a manufacturer uses 300,000 kilograms of material per year of production. Cost of placing one order is 50
and the cost to carry stock per kilogram is 5. Using the formula, the EOQ will be:

2 x 300,000 x 50

EOQ=2, 449
REORDER POINT AND SAFETY STOCK

EOQ tells how many units of materials to be ordered. But the management is also concerned on the order point which
reflects the level of inventory that triggers the placement of an order for additional unit. The order point considers usage,
lead time and safety stock. Usage refers to the quantity of inventory used or sold each day. The lead time for an order is
the time in days it takes from placing an order to obtaining or producing the goods. Safety stock is the minimum level of
materials that should be maintained to ensure that company does not run out of materials.
 Reorder Point= (Daily Usage x Lead Time) + Safety Stock

For example, a business wants to have 80 units on hand at all times. Ten units are used in daily production and it takes 3
days to receive an order. The reorder point will be:
Reorder Point= (10 x 3) + 80
Reorder Point= 110 units

Meaning when the material stocks reaches 110 units, the company will then place an order in the number units
computed in EOQ.

 QUANTITY DISCOUNT MODEL

Quantity discount model form of an economic order quantity (EOQ) model that takes into account quantity discounts.
Quantity discounts are price reductions designed to induce large orders. When offered with quantity discounts, weighing
of the benefit of price discount against the increase in inventory cost must be performed.

Illustration:
Demand for a product is 816 units
Ordering cost is $12
Carrying cost is $4
Price schedule is as follows
Quantity (Q) Price (P)
1-49 20
50-79 18
80-99 17
100 or more 16

2 x 816 x 12

4
EOQ= 70
The EOQ of 70 is in the 50-79 range. Therefore, the corresponding price is 18. Obviously, we do not consider P=20, but
what about P=17 or P=16? We will now compute the total cost at EOQ and at the quantity at different price discounts.

TC = Total CC + Total OC + Purchase Cost

TC= [ (EOQ/2) x CC ] + [ (AD/ EOQ) x OC ] + ( AD X Price )
@70 QTY
TC = [(70/2) x 4 ] + [(816/70) x 12] + (816x 18)
TC = 14968
@80 QTY
TC = [(80/2) x 4 ] + [(816/80) x 12] + (816x 17)
TC = 14154
@100 QTY
TC = [(100/2) x 4 ] + [(816/100) x 12] + (816x 16)
TC = 13354
With the given quantity discounts, it is least costly to purchase in quantities of 100.
 ECONOMIC BATCH QUANTITY (EBQ)

Economic Batch Quantity, also known as the optimum production quantity (EPQ), is a measure used to determine the
quantity of units that can be produced at the minimum average costs in a given batch or product run.

Economic batch quantity is computed using the formula:

Where:
Cs is the setup cost of a batch
D is the annual demand
P is the annual production capacity
Ch is the annual cost of holding one unit of finished inventory

Illustration: (from Accounting Simplified)

Sarah owns and operates a small factory that manufactures plastic bottles which she sells to bottling companies.

Additional information:
• Annual demand is 1 million bottles spread evenly over the year
• Setup cost is $5000 per batch
• Holding cost is $3 per annum for each bottle
• Maximum production capacity is 2 million bottles per annum
• Currently, bottles are manufactured in 10 batches

A. Find the optimum production quantity that Sarah should produce to minimize her costs
B. Calculate the current annual holding cost and setup cost

Solution A: Optimum Production Quantity

Economic Batch Quantity

Economic Batch Quantity = √ ( (2 x Cs x D ) / (Ch(1 – D/P)) )

= √((2 × 5000× 1,000,000) / (3 x (1-(1,000,000/2,000,000))))
= √(10,000,000,000 / 1.5)
= √(6,666,666,666)
= 81,650

Sarah should manufacture bottles in batches of 81,650 units.

Solution B: Current Costs

Batch Quantity = Annual Demand ÷ Number of batches
= 1,000,000 ÷ 10
= 100,000 units

Annual Holding Cost = (Batch Quantity/2) × Ch × (1- D/P)

= (100,000/2) × 3 × (1-(1,000,000/2,000,000))
= $75,000

Setup Cost = Number of setups × setup cost

= 10 × 5000
= $50,000

Total Current Cost = ($75,000 + $50,000) = $125,000

Reference used:

• Ammar Ali, “Economic Batch Quantity (EBQ)”

https://accounting-simplified.com/management/inventory/economic-order-quantity/batch/
• CSCMP and Nada Sanders, (Jan 23, 2014), “Operations Management Defined”
https://www.informit.com/articles/article