CHAPTER 1

Introd
Inventory
Quantitative
Control
Models

LEARNING OBJECTIVES
After completing this chapter, students will be able to:
 OUTLINE
1 Introduction
2 Importance of Inventory Control
3 Inventory Decisions
4 Economic Order Quantity Model: Determining
How Much to Order
5 Production Lot Size Model
6 Quantity Discount Models

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 Introduction
• Inventory is an expensive and important
asset
• Any stored resource used to satisfy a
current or future need
– Raw materials
– Work-in-process
– Finished goods
• Balance high and low inventory levels to
minimize costs
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 Introduction
• Lower inventory levels
– Can reduce costs
– May result in stockouts and dissatisfied
customers
• All organizations have some type of
inventory planning and control system
• Determine what goods/services are
produced or purchased

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 Introduction
Inventory Planning Planning on
and Control what to stock
and how to
get it

Feedback
metrics to Forecasting
revise plans parts/product
and forecasts demand

Controlling
inventory
levels

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 Importance of Inventory Control
• Five uses of inventory
1. The decoupling function
2. Storing resources
3. Irregular supply and demand
4. Quantity discounts
5. Avoiding stockouts and shortages
• Decouple manufacturing processes
– A buffer between stages
– Reduces delays and improves efficiency

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 Importance of Inventory Control
• Storing resources
– Seasonal products stored to satisfy off-season
demand
– Materials stored as raw materials, work-in-process,
or finished goods
– Labor can be stored as a component of partially
completed subassemblies
• Irregular supply and demand
– Not constant over time
– Inventory used to buffer the variability

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 Importance of Inventory Control
• Quantity discounts
– Lower prices may be available for larger orders
– Higher storage and holding costs
– More cash invested
• Avoiding stockouts and shortages
– Stockouts may result in lost sales
– Dissatisfied customers may choose to buy from
another supplier
– Loss of goodwill

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 Inventory Decisions
• Two fundamental decisions
1. How much to order
2. When to order
• Major objective is to minimize total inventory
costs
1. Cost of the items (purchase or material cost)
2. Cost of ordering
3. Cost of carrying, or holding, inventory
4. Cost of stockouts

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 Inventory Cost Factors
TABLE 1

ORDERING COST FACTORS CARRYING COST FACTORS

Developing and sending purchase orders Cost of capital

Processing and inspecting incoming inventory Taxes

Bill paying Insurance

Inventory inquiries Spoilage

Utilities, phone bills, and so on, for the
Theft
purchasing department
Salaries and wages for the purchasing
Obsolescence
department employees
Supplies such as forms and paper for the
Salaries and wages for warehouse employees
purchasing department

Utilities and building costs for the warehouse

Supplies such as forms and paper for the

warehouse

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 Inventory Cost Factors
• Ordering costs are generally independent of
order quantity
– Many involve personnel time
– The amount of work is the same no matter the size
of the order
• Holding costs generally vary with the amount
of inventory or order size
– Labor, space, and other costs increase with order
size
– Cost of items purchased can vary with quantity
discounts

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 Economic Order Quantity
• Economic order quantity (EOQ) model
– One of the oldest and most commonly
known inventory control techniques
– Easy to use
– A number of important assumptions
• Objective is to minimize total cost of
inventory

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 Economic Order Quantity
• Assumptions:
– Demand is known and constant
– Lead time is known and constant
– Receipt of inventory is instantaneous
– Purchase cost per unit is constant
– The only variable costs are ordering cost
and holding or carrying cost
• These are constant throughout the year
– Orders are placed so that stockouts or
shortages are avoided completely

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 Inventory Usage Over Time

Inventory
Level
Order Quantity = Q =
Maximum Inventory Level

Minimum
Inventory

0
Time

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 Inventory Costs in the
EOQ Situation
• Annual ordering cost is number of orders per year
times cost of placing each order
• Annual carrying cost is the average inventory times
carrying cost per unit per year
INVENTORY LEVEL
DAY BEGINNING ENDING AVERAGE
April 1 (order received) 10 8 9
April 2 8 6 7
April 3 6 4 5
April 4 4 2 3
April 5 2 0 1
Maximum level April 1 = 10 units TABLE 2
Total of daily averages = 9 + 7 + 5 + 3 + 1 = 25
Q
Number of days = 5
Average inventory level = 25/5 = 5 units Average inventory level =
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2
6 – 15
 Inventory Costs in the
Q = number ofEOQ Situation
pieces to order
EOQ = Q* = optimal number of pieces to order
D = annual demand in units for the inventory item
Co = ordering cost of each order
Ch = holding or carrying cost per unit per year

Annual Number of Ordering

ordering = orders placed ´ cost per
cost per year order

Annual demand Ordering D

= Number of units × cost per = Co
order Q
in each order

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 Inventory Costs in the
Q = number ofEOQ Situation
pieces to order
EOQ = Q* = optimal number of pieces to order
D = annual demand in units for the inventory item
Co = ordering cost of each order
Ch = holding or carrying cost per unit per year

Annual Carrying cost

Average
holding = ´ per unit
inventory per year
cost
Order quantity
= × (Carrying cost per unit per year)
2
Q
= Ch
2
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 Inventory Costs in the
EOQ Situation
Total Cost as a Function of Order Quantity

Cost
Curve for Total Cost
of Carrying
Minimum and Ordering
Total
Cost

Carrying Cost Curve

Ordering Cost Curve

Optimal Order Quantity

Order
Quantity
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 Finding the EOQ
• When the EOQ assumptions are met, total
cost is minimized when
Annual ordering cost = Annual holding cost
D Q
Co = Ch
Q 2
Thus
Solving for Q
Q 2Ch = 2DCo
2DCo
2 2DCo EOQ = Q =
*
Q = Ch
Ch
2DCo
Q=
Ch
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 Finding the EOQ
• Equation summary

D
Annual ordering cost = Co
Q
Q
Annual holding cost = Ch
2
2DCo
EOQ = Q * =
Ch

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 Sumco Pump Company
Sumco, a company that sells pump
housings to other manufacturers, would
like to reduce its inventory cost by
determining the optimal number of pump
housings to obtain per order. The annual
demand is 1,000 units, the ordering cost is
$10 per order, and the average carrying
cost per unit per year is $0.50

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 Sumco Pump Company
• Sells pump housings to other companies
• Reduce inventory costs by finding optimal
order quantity
Annual demand = 1,000 units
Ordering cost = $10 per order
Average carrying cost per unit per year = $0.50

2DCo 2(1,000)(10)
Q = *
= = 40,000 = 200 units
Ch 0.50

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 Sumco Pump Company
• Total cost

D Q
TC = Co + Ch
Q 2
1,000 200
= (10) + (0.5)
200 2
= $50 + $50 = $100

Number of orders per year = (D/Q) = 5

Average inventory (Q/2) = 100

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 Sumco Pump Company
Cost
Curve for Total Cost
of Carrying
and Ordering

$100

Carrying Cost Curve

$50 Ordering Cost Curve

Q = 200 Order Quantity

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 Purchase Cost of
Inventory Items
• Total inventory cost can be written to include
the cost of purchased items
– Annual purchase cost is constant at D x C no
matter the order policy, where
C is the purchase cost per unit
D is the annual demand in units
• The average dollar level of inventory
(CQ)
Average dollar level =
2

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 Purchase Cost of
Inventory Items
• Carrying cost often expressed as an annual
percentage of the unit cost or price of the
inventory
• New variable
Annual inventory holding charge as a
I= percentage of unit price or cost
Cost of storing inventory for one year = Ch = IC

Thus
2DCo
Q =
*

IC
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 Sensitivity Analysis with the
EOQ Model
• The EOQ model assumes all values are know
and fixed over time
• Values are estimated or may change
• Sensitivity analysis determines the effects of
these changes
• Because the EOQ is a square root, changes
in the inputs result in relatively small changes
in the order quantity
2DCo
EOQ = Q =
*

Ch
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 Sensitivity Analysis with the
EOQ Model
• Sumco Pump example
2(1,000)(10)
EOQ = = 200 units
0.50
• Increase Co to $40
2(1,000)(40)
EOQ = = 400 units
0.50

• In general, the EOQ changes by the square

root of the change to any of the inputs
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 EOQ Without
Instantaneous Receipt
• When inventory accumulates over time, the
instantaneous receipt assumption does not
apply
– Daily demand rate must be taken into account
– Production run model
Inventory
Level Part of Inventory Cycle There is No Production
During Which Production is During This Part of the
Taking Place Inventory Cycle
Maximum –
Inventory

t Time
Inventory Control and the Production Process
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 Annual Carrying Cost for
Production Run Model
• Setup cost replaces ordering cost
– Model variables

Q= number of pieces per order, or production run

Cs = setup cost
Ch = holding or carrying cost per unit per year
p= daily production rate
d= daily demand rate
t= length of production run in days

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 Annual Carrying Cost for
Production Run Model
• Maximum inventory level
= (Total produced during the production run)
– (Total used during the production run)
= (Daily production rate)(Number of days production)
– (Daily demand)(Number of days production)
= (pt) – (dt)
Q
Since Total produced = Q = pt and t =
p
Maximum Q Q ! d$
inventory = pt – dt = p – d = Q #1 – &
level p p " p%

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 Annual Carrying Cost for
Production Run Model
• Average inventory is one-half the maximum

Q! d$
Average inventory = #1 – &
2" p%
and

Q! d$
Annual holding cost = #1 – &Ch
2" p%

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 Annual Setup Cost for
Production Run Model
• Setup cost replaces ordering cost

D
Annual ordering cost = Co
Q

becomes

D
Annual setup cost = Cs
Q

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 Determining the Optimal
Production Quantity
• Set setup costs equal to holding costs and
solve for the optimal order quantity
Annual holding cost = Annual setup cost

Q! d$ D
#1 – C
& h = Cs
2" p% Q

Solving for Q, we get

2DCs
Q =
*
! d$
Ch #1 – &
" p%
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 Production Run Model
• Equation summary

Q! d$
Annual holding cost = #1 – &Ch
2" p%
D
Annual setup cost = Cs
Q
2DCs
Optimal production quantity Q = *
! d$
Ch #1 – &
" p%

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 Brown Manufacturing
Brown Manufacturing produces commercial
refrigeration units in batches. The firm’s estimated
demand for the year is 10,000 units. It costs about
$100 to set up the manufacturing process, and the
carrying cost is about 50 cents per unit per year.
When the production process has been set up, 80
refrigeration units can be manufactured daily. The
demand during the production period has traditionally
been 60 units each day. Brown operates its
refrigeration unit production area 167 days per year.
1. How many units should Brown produce in each batch?
2. How long should the production part of the cycle last?
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 Brown Manufacturing
• Produces commercial refrigeration units in
batches
Annual demand = D = 10,000 units
Setup cost = Cs = $100
Carrying cost = Ch = $0.50 per unit per year
Daily production rate = p = 80 units daily
Daily demand rate = d = 60 units daily

1. How many units should Brown produce

in each batch?
2. How long should the production part of
the cycle last?
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 Brown Manufacturing
2DCs Q
1. Q = *
2. Production cycle =
! d$ p
Ch #1 – &
" p% 4,000
= = 50 days
80
2 ×10,000 ×100
Q = *
! 60 $
0.5 #1 – &
" 80 %
2,000,000
= = 16,000,000
0.5 1 ( )
4
= 4,000 units

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