INTRODUCTION TO INVENTORY MANAGEMENT

1.1 INTRODUCTION

Operational research (OR) encompasses a wide range of problem-solving

techniques and methods applied in the pursuit of improved decision-making and
efficiency, such as simulation, mathematical optimization, queuing theory and
other stochastic-process models, Markov decision processes, econometric
methods, data envelopment analysis, neural networks, expert systems, decision
analysis, and the analytic hierarchy process. Nearly all of these techniques involve
the construction of mathematical models that attempt to describe the system.
Because of the computational and statistical nature of most of these fields, OR also
has strong ties to computer science and analytics. Operational researchers faced with
a new problem must determine which of these techniques are most appropriate given
the nature of the system, the goals for improvement, and constraints on time and
computing power.

1.2 OR ACTIVITIES

OR’s role in both, the public and the private sectors is increasing rapidly.
In general, OR addresses a wide variety of issues in transportation, inventory
planning, production planning, communication operations, computer operations,
financial assets, risk management, revenue management, and many other fields
where improving business productivity is paramount. In the public sector, OR studies
may focus on energy policy, defense, health care, water resource planning, design
and operation of urban emergency systems, or criminal justice. To reiterate, OR
reflects an analytical method of problem solving and decision-making that is useful in
the management of organizations. In OR, problems are (1) decomposed into basic

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components and (2) solved via mathematical analysis. Some of the analytical methods
used in OR include mathematical logic, simulation, network analysis, queuing theory,
and game theory.

Employing techniques from other mathematical sciences, such as

mathematical modeling, statistical analysis, and mathematical optimization,
operations research arrives at optimal or near-optimal solutions to complex decision-
making problems. Because of its emphasis on human-technology interaction and
because of its focus on practical applications, operations research has overlap with
other disciplines, notably industrial engineering and operations management,
and draws on psychology and organization science. Operations research is often
concerned with determining the maximum (of profit, performance, or yield) or
minimum (of loss, risk, or cost) of some real-world objective. Originating in military
efforts before World War II, its techniques have grown to concern problems in a
variety of industries.

OR improves the effectiveness and the efficiency of an institution, hence some

of the benefits offered by OR include:

• Decrease Cost or Investment

• Increase Revenue or Return on Investment

• Increase Market Share

• Manage and Reduce Risk

• Improve Quality

• Increase Throughput while Decreasing Delays

• Achieve Improved Utilization form Limited Resources

• Demonstrate Feasibility and Workability

Origin of Operations Research The term Operations Research (OR) was first
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coined by MC Closky and Trefthen in 1940 in a small town, Bowdsey of UK. The main

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origin of OR was during the second world war – The military commands of UK and
USA engaged several inter-disciplinary teams of scientists to undertake scientific
research into strategic and tactical military operations. Their mission was to
formulate specific proposals and to arrive at the decision on optimal utilization of
scarce military resources and also to implement the decisions effectively.

Following the end of World War II, the success of military team attracted the
attention of industrial managers of U.K .Who were seeking solutions to their complex
executive type problems. It was becoming apparent that these were basically the
same problems but in a different context. In this way OR began to creep into business
and Industry. It was only in the early 1950’s that the industries in U.S.A realized
the importance of this new science in solving their management problems. Science
then, industrial OR developed rapidly in U.S.A .

In India, Operation Research came into existence in 1949 when an Operation

Research unit was established at Regional Research Laboratory, Hyderabad. In India
OR society founded in 1959, also became a member of international federation of OR
societies in 1959. The journal OPSEARCH was published for the first time in 1963.
Some of Indian organizations using OR techniques are Indian Airlines, Railways,
defense organization, Tata, Tele co., dcm, Stc etc.

In 1953, Prof. P.C. Mahalanobis [12] established an Operation Research team in

the Indian Statistical Institute, Calcutta to solve problems related to national
planning and survey. In 1958, project scheduling techniques: PERT (Program
Evaluation and Review Technique) and CPM (Critical Path Method) were developed
as efficient tools for scheduling and monitoring lengthy, complex and expensive
projects of that time. The real development of Operation Research in the national
field was carried out by Prof. Mohalanobis in India when he used it in national
planning. Operation Research is also being used in Railway, waiting or queuing
problems of passengers for tickets at booking windows or trains queuing up in
marshalling yard, waiting to be sorted out are tackled by various Operation Research
techniques.

Management science is also concerned with so-called" soft operation analysis",

which concerns methods for strategic planning , strategic decision support ,and
Problem Structuring Methods (PSM) . In dealing with these sorts of challenges
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mathematical modeling and simulation are not appropriate or will not suffice.
Therefore , during the past 30 days , a number of non- quantified modeling methods
have been developed. These include:

 Stakeholder based approaches including metagame analysis and drama

theory
 Morphological analysis and various forms of influence diagrams.
 Approaches using cognitive mapping
 The Strategic Choice Approach
 Robustness analysis

1.3 OR FUNCTION AND METHODS

Operation Research consists of different phases i.e. judgment phase, research

phase and action phase. In judgment phase it selects the appropriate goal and
various variables regarding the problems and formulates the problems in
mathematics form. In Research Phase it helps us to understand the problem and
formulation of hypothesis and models test the hypothesis, verification of hypothesis,
prediction of various results from the various hypothesis and generalization of the
results and consideration of alternative methods. The Action Phase is for
recommendation of decision making for the problem and selection of best outcomes
from different phases.

When first encountered, the methods commonly utilized in OR may seem

obscure. Technical labels such as multi-criteria decision analysis, linear and non-
linear programming, discrete-event simulation, queuing and stochastic process
modeling, conjoint analysis, or neural networking further foster this general
impression. Despite the wealth of labels available in the field of OR, most projects
apply one of three broad groups of methods, which may be described as:

 Simulation methods, where the goal is to develop simulators that provide

the decision-maker with the ability to conduct sensitivity studies to (1)
search for improvements, and (2) to test and benchmark the

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 improvement ideas that are being made.

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  Optimization methods, where the goal is to enable the decision maker to
search among possible choices in an efficient and effective manner, in
environments where thousands or millions of choices may actually be
feasible, or where some of the comparing choices are rather complex. The
ultimate goal is to identify and locate the very best choice based on certain
criteria’s.
 Data-analysis methods, where the goal is to aid the decision-maker in
detecting actual patterns and inter-connections in the data set. This
method is rather useful in numerous applications including forecasting
and data mining based business environments.

Within each of the three basic groups, many probabilistic methods provide the
ability to assess risk and uncertainty factors.

1.4 OR IN MANUFATURING

Manufacturing is the value added production of merchandise for use or sale

using labour and machines, tools, chemical and biological processing, or formulation.
The term may refer to a range of human activity, from handicraft to high-tech, but is
most commonly applied to industrial production. In which raw materials are
transformed into finished goods on a large scale. Such finished goods may be sold to
other manufactures for the production of other, more complex products, such as
aircraft, house hold appliances or auto mobiles or sold to wholesalers who in turn sell
them to retailers who then sell them to end users and consumers.

Manufacturing engineering are the steps through which raw materials are
transformed into a final product. The manufacturing process begins with the product
design , and materials specification from which the product is made. These materials
are then modified through manufacturing processes to become the required part.

Manufacturing takes turns under all types of economic systems. In a free

market economy, manufacturing is usually directed toward the mass production of
products for sale to consumers at a profit.

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 In a collectivist economy, manufacturing is more frequently directed by the
state to supply a centrally planned economy. In mixed market economic ,
manufacturing occurs under some degree of government regulation.

Modern manufacturing includes all intermediate processes required for the

production and integration of a products components. Some industries such as semi
conductor and steel manufactures use the term fabrication instead.

The manufacturing sector is closely connected with engineering and industrial

design.

1.5 PRODUCTION SYSTEMS

Businesses and organizations frequently face challenging operational problems

whose successful solution requires certain expertise in applied statistics, optimization,
stochastic modeling, or a combination of these areas. To illustrate, a company may
need to design a sampling plan in order to meet specific quality control objectives. In a
manufacturing environment, operations that compete for the same resources must be
scheduled in a way that deadlines are not violated. The manager of a supermarket
must determine how many checkout lines to keep open at various times during the
day and evening so that shoppers are not unnecessarily delayed. Or as a final
example, the size of the areas reserved for storing work in process at a number of
bottleneck stations has to be determined so that a smooth flow of work results, even at
the busiest (peak) production times. The area of operations research that concentrates
on real-world operational problems is called production systems. Production systems
problems may arise in settings that include, but are not limited to, manufacturing,
telecommunications, health-care delivery, facility location and layout, and staffing.
The area of production systems presents special challenges for operations researchers.
Production problems are operations research problems, hence solving them requires a
solid foundation in operations research fundamentals. Additionally, the solution of
production systems problems frequently draws on expertise in more than one of the
primary areas of operations research, implying that the successful production
researcher cannot be one-dimensional. Furthermore, production systems problems
cannot be solved without an in-depth understanding of the real problem, since
invoking assumptions that simplify the mathematical structure of the problem may

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lead to an elegant solution for the wrong problem. Common sense and practical
insight are common attributes of successful production planners. At the current time,
the field of OR is extremely dynamic and ever evolving. To name a few of the
contemporary (primary) research projects, current work in OR seeks to develop
software for material flow analysis and design of flexible manufacturing facilities using
pattern recognition and graph theory algorithms. Further, approaches for the design of
re-configurable manufacturing systems and progressive automation of discrete
manufacturing systems are under development. Additional OR projects focus on the
industrial deployment of computer-based methods for assembly line balancing,
business process reengineering, capacity planning, pull scheduling, and setup
reduction, primarily through the integration of the philosophies of the Theory of
Constraints and Lean Manufacturing.

Before the industrial revolution, most business and industry consisted of small
enterprises, each directed by a single boss who did the purchasing, planned and
supervised production, sold the product, hired and fired personal etc. Such
mechanization of production led to rapid growth of industrial enterprises that it
became impossible for one man to perform all these managerial function took place.
Inventory control is one such consequence.

The management of every economic sector gained interest after World War II to
study inventory management system due to much risk factor and uncertainty.
Consequently , the study of inventory literature has been enlarged day by day and
various inventory models have been published in different journals. In 1951 , Arrow,
Harries and Marschak established a mathematical analysis of inventory models on
"Optimal Inventory Policy" . Within analyzed a review of the inventory system on "The
Theory of Inventory Management" . The collection and processing of large quantity of
data are needed in every inventory problem. After 1950's, several researchers like
Starr and Miller , Hadley and Whitin , Naddor, Fabrycky and Banks , Silver and
Peterson etc. published different articles in this direction.

1.6 INVENTORY

The word inventory doesn't have the same meaning in the USA and in the UK.
In American English and in a business accounting context, the word inventory is

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commonly used to describe the goods and materials that a business holds for the
ultimate purpose of resale. In American English, the word stock is commonly used to
describe the capital invested in a business, while in British English, the sentence
stock shared is used in the same context. In the rest of the English speaking world
stock is more commonly used, although the word inventory is recognized as a
synonym. In British English, the word inventory is more commonly thought of as a list
compiled for some formal purpose, such as the details of an estate going to probate,
or the contents of a house let furnished. In both British and American English, stock is
the collective noun for one hundred shares as shares were usually traded in stocks on
Stock Exchanges. For this reason the word stock is used by both American and British
English in the term Stock Exchange.

Inventories are materials stored, waiting for processing , or experiencing

processing. They are ubiquitous throughout all sectors of the economy. Observation
of almost any company balance sheet, for example, reveals that significant portion of
its assets comprises inventories of raw materials, components and subassemblies
within the production process, and finished goods. Most managers don't like
inventories because they are like money placed in a drawer, assets tied up in
investments that are not producing any return and , in fact, incurring a borrowing
cost. They also incur costs for the care of the stored material and are subject to
spoilage and obsolescence. In the last two decades there have been a spate of
programs developed by industry, all aimed at reducing inventory levels and
increasing efficiency on the shop floor. Some of the most popular are conwip,
kanban, just-in- time manufacturing, lean manufacturing , and flexible
manufacturing. Nevertheless , in spite of the bad features associated with
inventories, they do have positive purposes. Raw material inventories provide a
stable source of input required for production.

A large inventory requires fewer replenishments and may reduce ordering costs
because of economies of scale. In- process inventories reduce the impacts of the
variability of the production rates in a plant and protect against failures in the
processes. Final goods inventories provide for better customer service. The variety and
easy availability of the product is an important marketing consideration . there are
other kinds of inventories, including spare parts inventories for maintenance and

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excess capacity built into facilities to take advantage of the economies of scale of
construction. Because of their practical and economic importance, the subject of
inventory control is a major consideration in many situations. Questions must be
constantly answered as to when and how much raw material should be ordered, when
a production order should be released to the plant, what level of safety stock should
be maintained at a retail outlet, or how in-process inventory is to be maintained in a
production process. These questions are amenable to quantitative analysis with the
help of inventory theory.

1.7 INVENTORY MANAGEMENT

In any business or organization all functions are interlinked and connected to

each other and are often overlapping. Some key aspects like supply chain
management, logistics and inventory from the backbone of the business delivery
function. Therefore these functions are extremely important to marketing managers
as well as finance controllers.

Inventory management is a very important function that determines the health

of the supply chain as well as the impacts the financial health of the balance sheet.
Every organization constantly strives to maintain optimum inventory to be able to
meet its requirements and avoid over or under inventory that can impact the
financial figures.

Inventory is always dynamic. Inventory management requires constant and careful

evaluation of external and internal factors and control through planning and review.
Most of the organizations have a separate department or job function called
inventory planners who continuously monitor, control and review inventory and
interface with production, procurement and finance departments.

1.8 THE REASONS FOR KEEPING STOCK

There are three basic reasons for keeping and inventory :

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  Time - The time lags present in the supply chain , from supplier to user
at every stage , requires that you maintain certain amounts of inventory
to use in this "lead time" .
 Uncertainty - Inventories are maintained as buffers to meet uncertainties
in demand , supply and movements of goods.
 Economies of scale - Ideal condition of "one unit at a time at a place
where a user needs it, when he needs it " principle tends to incur lots of
costs in terms of logistics. So bulk buying , movement and storing brings
in economies of scale, thus inventory.

1.9 MATHEMATICAL TREATMENT

The inventory system involves the following steps:

 Development of a mathematical model of the system

 Obtaining a solution of the system
 Determination of the properties of the system
 Derive relationships between different related parameters of inventory
 Study of optimality

The above steps have been taken into account during the analysis of the
problems presented in the thesis. It is and initial work to develop a Mathematical
model of the inventory. This model is based on various assumptions and
approximations. It is a difficult device to operate accurately. In practice, it is not
easy to construct a truly realistic model with completely accuracy and very often it
may not be amenable to a mathematical treatment. Hence it is necessary to take
some approximation and simplification while constructing a feasible model.

In addition to, the inventory problem contains a set of parameters which

optimize the total cost of the system. Sometimes it is difficult to obtain the values of
these parameters due to general nature of the problem undertaken or due to some

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other reasons. So in these cases, simple differential calculus, numerical techniques,
scientific calculator , search techniques, different algorithms of various software's may
be used to optimize the objective function.

1.10 ECONOMIC PARAMETERS

The various economical parameters associated with our thesis are given below.

1.10.1 ORDERING OR SETUP OR REPLENISHMENT COST

Ordering costs, also known as setup costs, are essentially costs incurred every
time you place an order. Examples include:

Clerical costs of preparing purchase orders – There are many kinds of clerical costs,
such as invoice processing, accounting, and communication costs.

Cost of finding suppliers and expediting orders – Costs spent on these will likely be
inconsistent, but they are important expenses for the business.

Transportation costs – The costs of moving the goods to the warehouse or store.
These costs are highly variable across different industries and items.

Receiving costs – These include costs of unloading goods at the warehouse, and
inspecting the goods to make sure they are the correct items and free of defects.

Cost of electronic data interchange (EDI) – These are systems used by large
businesses and especially retailers, which allow ordering process costs to be
significantly reduced.

1.10.2 HOLDING COSTS

Also known as carrying costs, these are costs involved with storing inventory
before it is sold.

Inventory financing costs :- This includes everything related to the investment made
in inventory, including costs like interest on working capital. Financing costs can be
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complex depending on the business.

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Opportunity cost of the money invested in inventory :– This is found by factoring in
the lost alternatives of tying money up in inventory, such as investing in term
deposits or mutual funds.

Storage space costs :– These are costs related to the place where the inventory is
stored, and will vary by location. There will be the cost of the storage facility itself,
or lease payments if it is not owned. Then there are facility maintenance costs like
lighting, heating, and ventilation. Depreciation and property taxes are also included
in this.

Inventory services costs :– This includes the cost of the physical handling of the
goods, as well as insurance, security, and IT hardware, and applications if these are
used. Expenses related to inventory control and cycle counting are further examples.

Inventory risk costs :– A major cost is shrinkage, which is the loss of products between
purchasing from the supplier and final sale due to any number of reasons: theft,
vendor fraud, shipping errors, damage in transit or storage. The other main example is
obsolescence, which is the cost of goods going past their use-by dates, or otherwise
becoming outdated.

1.10.3 SHORTAGE COST

These costs also called stock-out costs, occur when businesses become out of
stock for whatever reason.

Disrupted production :– When the business involves producing goods as well as selling
them, a shortage will mean the business will have to pay for things like idle workers
and factory overhead, even when nothing is being produced.

Emergency shipments :– For retailers, stock-outs could mean paying extra to get a
shipment on time, or changing suppliers.

Customer loyalty and reputation :– These costs are hard to pinpoint, but there are
certainly losses to these when customers are unable to get their desired product or
service on time.

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 1.10.4 PURCHASE COST

It is unit cost of an item obtained either from and external source or from the
unit replenishment cost of internal production. It is not necessarily constant. The
unit purchasing price depends on the quantity procured happening in many practical
situations. For examples, in a competitive market, there is a price discounting on
purchasing of big lot size so also there is a reduction of replenishment cost per unit
when production happens in large scale.

1.10.5 SELLING PRICE

It is unit price of an item sold to a customer on demand. It results revenue

from selling the commodity. It is necessarily not constant but sometimes depends on
the decision maker.

1.10.6 SALVAGE VALUE

Salvage value also called residual or scrap value is the estimated worth of an
asset at the end of its useful life. In other words, salvage value is the price
management believes it can sell an asset for after the asset is deemed unusable
because of time, abuse, and obsolescence. For non-accountants, the term scrap
value makes more sense because this is the value of the asset after it can no longer
be used. Scrap value is the amount of money that can be salvaged from the used
assets.

Salvage value is used in calculating depreciation and making equipment

purchase decisions. Management will often consider the estimated salvage value of an
asset when deciding to make a new equipment purchase because a salvage value will
often lower the total cost of the asset over time since the salvage value can be
recouped when the asset is later sold.

1.10.7 DEMAND

Demand in economics is how many goods and services are bought at various
prices during a certain period of time. Demand is the consumer's need or desire to
own the product or experience the service. It's constrained by the willingness and
ability of the consumer to pay for the good or service at the price offered.

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 Demand is the underlying force that drives everything in the economy.
Fortunately for economics, people are never satisfied.

They always want more. This drives economic growth and expansion. Without
demand, no business would ever bother producing anything.

1.10.8 LEAD TIME

The time gap between the placing of an order and receiving of the inventory is
called lead time. In other word a lead time is the latency between the initiation and
execution of a process. It may not be necessarily a constant.

1.10.9 TIME HORIZON

It is the time duration during which an optimal policy is to be determined to

maximize the profit or minimize the total inventory cost. It may be finite or infinite
depending upon the nature of the inventory system.

1.10.10 REPLENISHMENT

It is the rate of quantities added to the stock. The replenishment quantity may
be constant or variable depending upon the nature of the inventory system.
Instantaneous replenishment happens when the stock is added up from external
resource point in no time.

1.10.11 BUFFER OR SAFETY STOCK

As demand is uncertain and uncontrolled, some extra stock is advised to be

maintained to overcome any shortages occur during the lead time. This extra stock is
called as Buffer stock.

1.11 FLOW, INVENTORY & TIME

An inventory is represented in the simple diagram of Figure 1 (A system

component with inventory). Items flow into the system, remain for a time and then
flow out. Inventories occur whenever the time an individual enters is different than
when it leaves. During the intervening interval the item is part of the inventory.

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INVENTORY LEVEL
FLOW IN FLOW OUT
(RESIDENCE TIME)
 Figure 1 (A system component with inventory)

For example, say the box in Figure 1 (A system component with inventory) represents
a manufacturing process that takes a fixed amount of time. A product entering the
box at one moment leaves the box one hour later. Products arrive at a rate of 100
per hour. Clearly, if we look in the box, we will find some number of items. That
number is the inventory level. The relation between flow, time and inventory level is
basic to all systems is,

Inventory Level= (Flow rate)(Residence Time) ...(1)

Where the flow rate is expressed in the same time units as the residence time.
When the factors in Eq. (1) are not constant in time, we typically use their mean
values. Whenever two of the factors in the above expressions are given, the third is
easily computed. Consider a queuing system for which customers are observed to
arrive at an average rate of 10 per hour. When the customer finds the servers busy,
he or she must wait. Customers in the system, either waiting or be served, are the
inventory for this system. Using a sampling procedure we determine that the average
number of customers in the inventory is 5. We ask, how long on the average is each
customer in the system?

Using the relation between the flow, time and inventory, we determine the
answer as 0.5 hours. As we have in the Queuing Models, Eq.(1) is called Little’s
Law. The relation between time and inventory is significant, because very often
reducing the throughput time for a system is host as important as reducing the
inventory level. Since they are proportional, changing one factor inevitably changes
the other.

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 1.12 THE INVENTORY LEVEL

The inventory level depends on the relative rates of flow in and out of the system.
Define y(t) as the rate of input flow at time t and y(t) the cumulative flow into the
system. Define z(t) as the rate of output flow at time t and z(t) as the cumulative
flow out of the system. The inventory level, i(t) is the cumulative input less the
cumulative output.

t t
i(t) = y(t) − z(t) = ƒ y(x) − ƒ z(x) … (2)
0 0

Figure 2 (Inventory fluctuations as a function of time represents the inventory for a

system when the rates vary with time.

0 Inventory Level

0 0
Time
0

Figure 2 (Inventory fluctuations as a function of time)

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 The figure might represent a raw material inventory. The flow out of inventory is
a relatively continuous activity where individual items are placed into production
system for processing. To replenish the inventory, an order is placed to a supplier.
After some delay time, called the lead time, the raw material is delivered in a lot of a
specified amount. At the moment of delivery, the rate of input is infinite and at other
times it is zero. Whenever the instantaneous rates of input and output to a component
are not the same , the inventory level changes. When the input rate is higher,
inventory grows; when output rate is higher, inventory declines. Usually the inventory
level remains positive. This corresponds to the presence of on hand inventory. In cases
where the cumulative output exceeds the cumulative input, the inventory level is
negative. We call this a backorder or shortage condition. A backorder is a stored
output requirement that is delivered when the inventory finally becomes positive.
Backorders may only be possible for some systems. For example , if the item is not
immediately available the customer may go elsewhere; alternatively, some items may
have an expiration date like an airline seat and can only be backorders up to the day
of departure. In cases where backorders are impossible, the inventory level is not
allowed to become negative. The demands on the inventory that occur while the
inventory level is zero are called lost sales.

1.13 THE DETERMINISTIC MODEL

An abstraction to the chaotic behavior of Fig.2 is to assume that items are withdrawn
from the inventory at an even rate a, a lots are a fixed size Q, and lead time is zero or a
constant. The resulting behavior of the inventory is shown in Fig.3. We use this
deterministic model of the system to explain some of the notation associated with
inventory. Because of its simplicity , we are able to find an optimal solutions to the
deterministic model for several operation assumptions.

Inventory Level

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 S+Q

0
time

0 Q/a 2Q/a 3Q/a 4Q/a

(Figure 3)

1.14 NOTATION

This section lists the factors that are important in making decisions related to
inventories and establishes some of the notation that is used in this section.
Dimensional analysis is sometimes useful for modeling inventory systems, so we
provide the dimensions of each factor. Additional model dependent notation is

introduced later.

 Ordering cost (c(z)): This is the cost of placing an order to and outside
supplier or releasing a production order to a manufacturing shop. The
amount ordered is z and the function c(z) is often non linear. The
dimension of ordering cost is ($).
 Setup cost (K): A common assumption is that the ordering cost consists of
a fixed cost, that is independent of the amount ordered, and a variable
cost that depends on the amount ordered. The fixed cost is called the set
up cost and given in ($).
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 Product cost (c): This is the unit cost of purchasing the product as part of
an order. If the cost is independent of the amount ordered, the total cost
is cz , where c is the unit cost and z is the amount ordered. Alternatively,
the product cost may be a decreasing function of the amount
ordered.($/unit)
 Holding cost (h): This is the cost of holding and item in inventory for
some given unit of time. It usually includes the lost investment income
caused by having the asset tied up in inventory. This is not a real cash
flow, but it is an important component of the cost of inventory. If c is
the unit cost of the product, this component of the cost is ca, where a
is the discount or interest rate. The holding cost may also include the
cost of storage, insurance, and other factors that are proportional to
the amount stored in inventory. ($/unit time)
 Shortage cost(p): When a customer seeks the product and finds the
inventory empty, the demand can either go unfulfilled or be satisfied
later when the product becomes available. The former case is called a
lost sale, and the latter is called a backorder. Although lost sales are
often important in inventory analysis, they are not considered in this
section, so no notation is assigned to it. The total backorder cost is
assumed to be proportional to the number of units backordered and the
time the customer must wait. The constant of proportionality is p , the
per unit backorder cost per unit of time. ($/unit-time)
 Demand rate (a): This is the constant rate at which the product is
withdrawn from inventory. (units/time)
 Lot size (Q): This is the fixed quantity received at each inventory
replenishment.(units)
 Order level(S): The maximum level reached by the inventory is the
order level. When backorders are not allowed, this quantity is the same
as Q. When backorders are allowed, it is less than Q.(units)

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  Cycle time (v): The time between consecutive inventory replenishments is
the cycle time.
For the models of this section = Q/a.(time)
 Cost per time (T): This is the total of all costs related to the inventory
system that are affected by the decision under consideration. ($/time)
 Optimal Quantities (Q*, S* , * , T* ): The quantities defined above that
maximize profit or minimize cost for a given model are the optimal
solution.

1.15 LOT SIZE MODEL WITH NO SHORTAGES

The assumptions of the model are described in part by Fig.4, which shows a
plot of inventory level as a function of time. The inventory level ranges between 0
and the amount Q. The fact that it never goes below 0 indicates that no shortages
are allowed. Periodically an order is placed for replenishment of the inventory. The
order quantity is Q. The arrival of order is assumed to occur instantaneously , causing
the inventory level to shoot from 0 to the amount Q. Between orders the inventory
decreases at a constant rate a. The time between orders is called the cycle time, τ ,
and is the time required to use up the amount of the order quantity ,or Q/a.

0
Time
0 Q/a 2Q/a 3Q/a

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 (Figure 4 . Lot size model with no shortages)

The total cost expressed per unit time is ,

Cost/unit time =Setup cost + Product cost + Holding cost

aK ℎQ
T= + ac +
… (3)
Q 2

In Eq.(3) , aQ is the number of orders per unit time. The factor Q2 the average
inventory level. Setting to zero the derivative of T respect to Q we obtain,

dT aK h
=−
+ =0
dQ Q2 2
Solving for the optimal policy,

∗
2aK
Q=J
h

∗
τ∗ = Q

Substituting the optimal lot size into the cost expression, Eq. (3) , and

Preserving the breakdown between the cost components we see that

τ∗ = J2aK + ac + J2aK = ac + √2ahK … (4)

h h

At the optimum, the holding cost is equal to the setup cost. We see that optimal
inventory cost is a concave function of product flow through the inventory (a),
indicating that there is an economy of scale associated with the flow through
inventory. For this model, the optimal policy does not depend on the unit product cost.
The optimal lot size increases with increasing setup cost and flow rate and decreases
with increasing holding cost.

22
S
 (Figure 5 . Lot - size model with shortages allowed)

The total cost per unit time is

Cost /time = Setup cost + Product cost + Holding cost + Backorder cost

aK
T= + ac hS2 p(Q − S)2
+ … (5)
2
+ 2
Q

The factor multiplying h in this expression is the average on-hand inventory level.
This is the positive part of the inventory curve shown in Fig. 6. Because all cycles are
the same , the average on-hand inventory computed for the first cycle is the same as
for all time. We see the first cycle in Fig.6.

23 On-Hand
 (Figure 6 . The first cycle of the lot size with backorders model)

Defining O(t) as the on-hand inventory level and O as the average on-hand inventory

O¯ = (1/τ) ƒ O(t)dt = (1/τ)[OnhandArea]

0

a S2 S2
= ( ) ( ) = ) … (6)
Q 2a 2Q
(

Similarly the factor multiplying p is the average backorder level, B¯ ,

Where

1 (Q − S)2
¯ (
B= Backorder
= )
Area

Setting to zero the partial derivatives of T with respect Q and S yields

24
 ∗
2aK p
S =J J … (8)
h p+h

∗
2aK p + h
Q =J J … (9)
h p

And

τ∗ Q∗
… (10)
= a

Comparing these results to the no shortage case, we see that the optimal lot size and
the cycle times are increased by the factor

1
[(p + h)/h]2

The ratio between the order level and the lot size depends only on the relative values
of holding and backorder cost.
S∗ ƒph
= … (11)
Q∗ p + h

This factor is 1/2 when the two costs are equal , indicating that the inventory is in a
shortage position one half of the time.

1.16 QUANTITY DISCOUNTS

The third deterministic model considered incorporates quantity discount prices

that depend on the amount ordered. For this model no shortages are allowed, so the
inventory pattern appears as in Fig.6. The discounts will affect the optimal order
quantity. For this model we assume there are N different prices: c1, c2, c3, c4 … … . cN
with the prices decreasing with the index. The quantity level at which the kth price
becomes affective is qk with qN equal zero. For purposes of analysis define q N+1 equal to
infinity, indicating that the price cN holds for any amount greater than q N .Since the price
decreases as quantity increases the values of qk increase with the index k. To
determine the optimal policy for this model we observe that the optimal order quantity
25
for the no backorder case is not effected by the product price , c The value of Q∗k
would be the same for all price levels if not for the ranges of order size over which the
prices are effective. Therefore we compute the optimal lot size Q∗ using the
parameters of the problem.

∗
2ak
Q =J … (12)
h

We then find the optimal order quantity for each price

range. Find for each k the value of Qk∗ such that

If Q∗ > qk+1 then Q∗k = qk+1

If Q∗ < qk then Qk∗ = qk

If qk ≤ Q∗ then Q∗k = Q∗

1.17 STOCHASTIC INVENTORY MODELS

There is no question that uncertainty plays a role in most inventory

management situations. The retail merchant wants enough supply to satisfy customer
demands, but ordering too much increases holding costs and the risk of losses
through obsolescence or spoilage. An order too small increases the risk of lost sales
and unsatisfied customers. The water resources manager must set the amount of
water stored in a reservoir at a level that balances the risk of flooding and the risk of
shortages. The operations manager set a master production schedule considering the
imprecise nature of forecasts of future demands and the uncertain lead time of the
manufacturing process. These situations are common, and the answers one gets from
a deterministic analysis very often are not satisfactory when uncertainty is present.
The decision maker faced with uncertainty doesn't act in the same way as the one
who operates with perfect knowledge of the future. In this section we deal with
inventory models in which the stochastic nature of demand is explicitly recognized.
Several models are presented that again are only abstractions of the real world, but
whose answers can provide guidance and insight to the inventory manager.

26
 1.18 PROBABILITY DISTRIBUTION FOR DEMAND

The one feature of uncertainty considered in this section is the demand for
products from the inventory. We assume that demand is unknown , but that the
probability distribution of demand is known. Mathematical derivations will determine
optimal policies in terms of the distribution.

 Random Variable for Demand (x): This is a random variable that is the
demand for a given period of time. Care must be taken to recognize the
period for which the random variable is defined because it differs among
the models considered.
 Discrete Demand Probability Distribution Function (P(x)) : When demand is
assumed to be a discrete random variable , P(x) gives the probability that
the demand equals x.
 Discrete Cumulative Distribution Function (F(b)): The probability that
demand is less than or equal to b is F(b) when demand is discrete.
b

F(b) = Σ P(x)
x=0

 Continuous Demand Probability Density Function (F(x)): When demand is

assumed to be continuous, f(x) is its density function. The probability
that the demand is between a and b is
b

P(a ≤ X ≤ b = ƒ f(x)dx
a

We assume that demand is nonnegative, so f(x) zero for negative values.

 Continuous Cumulative Distribution Function (F(b)) : The probability that

demand is less than or equal to b when demand is continuous

27
 b

F(b) = ƒ f(x)dx
0

 Standard Normal Distribution Function (∅(x) and d(x)) : These are the
density function and cumulative distribution function for the standard
normal distribution.

 Abbreviations : In the following we abbreviate probability distribution

function or probability density function as pdf. We abbreviate the
cumulative distribution function as CDF.

1.19 SELECTING A DISTRIBUTION

An important modeling decision concerns which distribution to use for demand.

A common assumption is that individual demand events occur independently. This
assumption leads to the Poisson distribution when the expected demand in a time
interval is small and the normal distribution when the expected demand is large. Let a
be the average demand rate. Then for an interval of time t the expected demand is at.
The Poisson distribution is then

(at x )e–(at)
( )

When at is large the Poisson distribution can be approximated with a normal

distribution with mean and standard deviation

μ = at and σ = √at

Value of F(b) are evaluated using tables for the standard normal distribution. We
include these tables at the end of this chapter.

28
 Of course other distributions can be assumed for demand. Common
assumptions are the normal distribution with other values of the mean and standard
deviation, the uniform distribution, and the exponential distribution. The latter two
are useful for their analytical simplicity.

1.20 FINDING THE EXPECTED SHORTAGE AND THE

EXPECTED EXCESS

We are often concerned about the relation of demand during some time period
relative to the inventory level at the beginning of the time period. If the demand is less
than the initial inventory level, there is inventory remaining at the end of the interval.
This is the condition of excess. If the demand is greater than the initial inventory level,
we have the condition of shortage.

1.21 THE (S,Q) INVENTORY POLICY

We now consider inventory systems similar to the deterministic models

presented in section 25.2, but allow the demand to be stochastic. There are a number
of ways one might operate and inventory system with random demand. At this time,
we consider the (S,Q) inventory policy, alternatively called the reorder point, order
quantity system. Figure 7 shows the inventory pattern determined by the (S,Q)
inventory policy .The model assumes that the inventory level is observed at all times.
This is called continuous review. When the level declines to some specified reorder
c,s,and order is placed for a lot size Q. The order arrives to replenish the inventory
after a lead time , L.

Inventory Level

Q
L

29
0
Time
0
 (Figure 7 . Inventory Operated with the reorder point-lot size Policy Model)

The values of s and Q are the two decisions required to implement the policy.
The lead time is assumed known and constant. The only uncertainty is associated
with demand. In Fig.7 ,we show the decrease in inventory level between
replenishments as a straight line, but in reality the inventory decreases in a stepwise
and uneven fashion due to the discrete and random nature of the demand process.

If we assume that L is relatively small compared to the expected time required

to exhaust the quantity Q , it is likely that only one order is outstanding at any one
time. This is the case illustrated in the figure. We call the period between sequential
order arrivals an order cycle. The cycle begins with the receipt of the lot, it
progresses as demand depletes the inventory to the level s , and them it continues
for the time L when the next lot is received. As we see in the figure, the inventory
level increases instantaneously by the amount Q with the receipt of an order. In the
following analysis, we are most concerned with the possibility of shortage during an
order cycle, that is the event of the inventory level falling below zero. This is also
called the stock out event. We assume shortages are backordered and are satisfied
when the next replenishment arrives. To determine probabilities of shortages, one
need only be concerned about the random variable that is the demand during the
lead time internal. This is the random variable X with pdf , f(x) ,and CDF F(x). The
mean and standard deviation of the distribution are μ and σ respectively. The
random demand during the lead time gives rise to the possibility that the
inventory level will be
30
depleted before the replenishment arrives. With the average rate of demand equal to a,
the mean demand during the lead time is

μ = aL

A shortage will occur if the demand during the period L is greater than s.

This probability , defined as Ps, is

Ps = P{x > s} = ƒ f(x)dx = 1 − F(s)

0

The service level is the probability that the inventory will not be depleted during one
order cycle, or

Service level = 1 − Ps = F(s)

In practical instances the reorder point is significantly greater than the mean demand
during the lead time so that Ps is quite small. The safety stock, SS, is defined as

SS = s − μ

This is the inventory maintained to protect the system against the variability of
demand. It is the expected inventory level at the end of an order cycle (just before a
replenishment arrives). This is seen in Fig.8, where we show the (s,Q) policy for
deterministic demand. This figure will also be useful for the cost analysis of the
system.

Inventory Level

s
S

031

0 Time
 (Figure 8 . The (s,Q) policy for deterministic demand)

1.22 INVENTORY CONTROL METHODS

The choice of inventory control technique was based on factor such as usage,
simplicity etc. It can be seen that EOQ is the most basic model used for inventory
control. However , the basic EOQ model was based on the assumption that demand is
constant, no shortage is considered and the lead-time is zero or constant. These
assumptions are not faced in real life applications. The EOQ model does not take into
consideration of the demand pattern of the end product before determining the
inventory levels of parts and materials. This is another major shortcoming of this
model. The Material Requirement Planning( MRP) model determines the demand of a
product using orders obtained from the sales department. Inventory levels are then
calculated using these figures and the cost inputs from the purchasing department. It
is basically a push type inventory control system. The other popular model is the just
- in - time model (JIT) that is a pull type of inventory control. This model takes into
consideration of various uncertainties in the industry such as machine failure,
demand fluctuations, stochastic set-up times and random yields.

1.22.1 ECONOMIC ORDERING QUANTITY (EOQ)

The most common method to find out how much to order is called economic
order quantity (EOQ). Though it is not feasible and advisable for complex systems, it
is

32
the most fundamental inventory control policy and many complex heuristic models are
modified models of EOQ policy. This mathematical approach balances between holding
and ordering costs and gives the order level where total costs are minimized.

Let

S = Purchasing

cost D = Annual

usage

I = Holding cost as percentage of stock value

C = Unit purchasing cost

Q = Economic order quantity (EOQ)

Therefore , Unit purchasing cost = S

Q , Annual purchasing cost = S.D
,
Q

Average quantity held per year = S

Q , Annual carrying cost = I.€.Q
, Total costs =
2

Annual purchasing costs + annual carrying costs.

Total

Cost
s

Holding

33 Order
 (Figure 9:Economic Order Quantity)

The EOQ model is the basic model for inventory control in production
companies. It is very simple to execute , however, it is based on unrealistic
assumptions. The demand is assumed to be constant. Such unrealistic assumptions
make EOQ not very attractive in current industrial settings. Besides the basic model,
there are many extensions to the simple EOQ models. For example, reorder lead
time, allowing a lead time between placing an order and receiving it. This introduces
the problem of when to reorder; stock outs, allowing stock outs (often called
shortages) i.e. no stock currently available to meet orders. Often replenishment s but
received all at once. It is the EPQ (economic production quantity ) extension. For
example , if the replenishment comes from another part of the same factory then
items may be received as they are produced.

1.22.2 JUST-IN-TIME (JIT) SYSTEM

Just-in-time system , which is a pull-type inventory control system. This is one

of the most popular systems , which is adopted in new technologies. It originally
referred to the production of foods to meet customer demand exactly in time,
quality and quantity, whether the customer is the final purchaser of the product or
another process further along the production line. It has meant for producing with
minimum waste. Waste is taken in its most general sense and includes time and
resources as well as materials (Kiyoshi,1987). Most research efforts have focused on
descriptions of JIT philosophy. There were conceptual and experimental studies,
mathematically models and simulations in many cases. Goldhar and Stamm (1991) [14]
presented a complete review of JIT systems. These research efforts indicate that the
JIT technique

34
 is a highly effective method for controlling the flow of inventory on shop floors as it
reduces the inventory level to a bare minimum and thus reduces production costs.

1.22.3 MATERIAL REQUIREMENT PLANNING(MRP)

MRP is a set of procedures for converting fore cast demand for a manufactured
product into a schedule for obtaining components, subassemblies and raw materials.
From a logistics point of view, the purpose of MRP is to avoid, as much as possible in
carrying these items in inventory. The MRP approach emphasizes on a realistic master
production schedule (MPS) to coordinate the production stages in terms of volume of
production that prevents the creation of extraordinary instrastage slack. MRP also
stresses on calculating dependent demand. It prevents the creation of superfluous
inter stage slack due to unbalanced lot sizing of matched set of parts. Thus only
safety stocks, which are allowed in such an approach, are stocks at the MPS level.
MRP decides the following two factors: timing (When to order 0 and quantity how
much to order). With respect to the timing decision, orders are made as late as
possible , but never order before one needs to , never allow to stock out. Thus MRP
effectively reduces the cost of production by minimizing the inventory levels.

35

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