Inventory Control Models - I

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

2
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

3
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 6.1

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
FIGURE 1

Inventory
Level
Order Quantity = Q = Maximum
Inventory Level

Minimum
Inventory

0
Time

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 Q
Inventory Costs in the Average inventory level =
2
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
Total of daily averages = 9 + 7 + 5 + 3 + 1 = 25
Number of days = 5 TABLE 3
Average inventory level = 25/5 = 5 units
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Inventory Costs in the EOQ Situation
Q = number of pieces to order
EOQ = Q* = optimal number of pieces to order
D = annual demand in units for the inventory item
A = ordering cost of each order
hC = holding or carrying cost per unit per year

Annual Number of Ordering cost

ordering  orders placed  per order
cost per year

Annual demand Ordering D

 Number of units × cost per  A
in each order order Q
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Inventory Costs in the EOQ Situation

Annual Carrying cost

Average
holding   per unit
inventory per year
cost

Order quantity
  (Carrying cost per unit per year)
2
Q
 hC
2

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Inventory Costs in the EOQ Situation
FIGURE 3 – 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
A  hC
Q 2
Thus
Solving for Q Q 2 hC  2AD
2AD
2AD EOQ  Q *
Q 
2
hC
hC
2AD
Q
hC
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Finding the EOQ
• Equation summary
D
Annual ordering cost  A
Q
Q
Annual holding cost  hC
2
2AD
EOQ  Q 
*

hC

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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

2AD 2(1,000)(10)
Q 
*
  40,000  200 units
hC 0.50

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Sumco Pump Company
• Total cost
D Q
TC  A  hC
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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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

2AD
EOQ  Q 
*

hC

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Sensitivity Analysis with the EOQ Model
• Sumco Pump example
2(1,000)(10)
EOQ = = 200 units
0.50
• Increase A 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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Reorder Point:
Determining When To Order
• Next decision is when to order
• Time between placing an order and its receipt is called the lead
time (L) or delivery time
• Generally expressed as a reorder point (ROP)

Demand per Lead time for a new

ROP  day  order in days

dL

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Reorder Point Graphs
Inventory
FIGURE 4 Level
Q

ROP

0
Time
Lead time = L
ROP < Q

Inventory
Level On Order
Q

On hand

0
Time
Lead time = L
ROP > Q
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Procomp’s Computer Chips
• Annual demand = 8,000
• Daily demand = 40 units
• Delivery in three working days
ROP  d  L  40 units per day  3 days
 120 units

• An order for the EOQ (400) is placed when the

inventory reaches 120 units
• The order arrives 3 days later just as the inventory is
depleted

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Procomp’s Computer Chips
• Annual demand = 8,000
• Daily demand = 40 units
Now 12 days
• Delivery in three working days
ROP  d  L  40 units per day  12 days
 480 units
Inventory Inventory Inventory
 +
position on hand on order
480  80 + 400
• New order placed when inventory = 80 and one order is in
transit
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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 During There is No Production
Which Production is Taking Place During This Part of the
Inventory Cycle
Maximum
–
Inventory

t Time
FIGURE 6.5 – 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
h holding or carrying charge 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 æ dö
inventory = pt – dt = p – d = Q ç1 – ÷
level p p è pø

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

Qæ dö
Average inventory = ç1 – ÷
2è pø
and

Q d
Annual holding cost  1 –  hC
2 p

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

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 –  hC  Cs
2 p Q

Solving for Q, we get

2DCs
Q 
*

 d
hC 1 – 
 p

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Production Run Model
• Equation summary

Q d
Annual holding cost   1 –  hC
2 p
D
Annual setup cost  Cs
Q
2DCs
Optimal production quantity Q* 
 d
hC 1 – 
 p

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Brown Manufacturing
• Produces commercial refrigeration units in batches
Annual demand  D  10,000 units
Setup cost  Cs  $100
Carrying cost  hC  $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 =
æ dö p
Ch ç1 – ÷
è pø
=
4,000
= 50 days
2 ´10,000 ´100 80
Q =
*
æ 60 ö
0.5 ç1 – ÷
è 80 ø
2,000,000
= = 16,000,000
( )
0.5 1
4
= 4,000 units

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Quantity Discount Models
• Discount schedule and EOQs might not align
• Buying at the lowest unit cost may not result in lowest
total cost
TABLE 3 – Quantity Discount Schedule

DISCOUNT DISCOUNT DISCOUNT

NUMBER QUANTITY DISCOUNT (%) COST ($)
1 0 to 999 0 5.00
2 1,000 to 1,999 4 4.80
3 2,000 and over 5 4.75

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Quantity Discount Models
FIGURE 6 – Total Cost Curve for the Quantity Discount Model

Total
TC Curve for Discount 3
Cost $
TC Curve for
Discount 1

TC Curve for Discount 2

EOQ for Discount 2

0 1,000 2,000
Order Quantity
38
Quantity Discount Models
• Steps in the process
2DCo
1. For each discount price (C), compute EOQ =
IC

2. If EOQ < Minimum for discount, adjust the quantity to

Q = Minimum for discount

D Q
3. For each EOQ or adjusted Q, compute Total cost  DC + A + hC
Q 2

4. Choose the lowest-cost quantity

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Brass Department Store
• Toy race cars
• Quantity discounts available
Step 1 – Compute EOQs for each discount
(2)(5,000)(49)
EOQ1 = = 700 cars per order
(0.2)(5.00)
(2)(5,000)(49)
EOQ2 = = 714 cars per order
(0.2)(4.80)

(2)(5,000)(49)
EOQ3 = = 718 cars per order
(0.2)(4.75)
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Brass Department Store
Step 2 – Adjust quantities below the allowable discount range
– The EOQ for discount 1 is allowable
– The EOQs for discounts 2 and 3 are outside the allowable range,
adjust to the possible quantity closest to the EOQ

Q1  700
Q2  1,000
Q3  2,000

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Brass Department Store
Step 3 – Compute total cost for each quantity
TABLE 4 – Total Cost Computations for Brass Department Store

ANNUAL ANNUAL ANNUAL

UNIT ORDER MATERIAL ORDERING CARRYING
DISCOUNT PRICE QUANTITY COST ($) COST ($) COST ($)
NUMBER (C) (Q) = DC = (D/Q)Co = (Q/2)Ch TOTAL ($)

1 $5.00 700 25,000 350.00 350.00 25,700.00

2 4.80 1,000 24,000 245.00 480.00 24,725.00

3 4.75 2,000 23,750 122.50 950.00 24,822.50

Step 4 – Choose the alternative with the lowest total

cost

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