Inventory Control Subject

to Deterministic Demand

Dr. M.N. Darghouth

Department of Systems Engineering: Industrial Engineering

Second Semester (202)

ISE 402 Production Systems and Inventory

Control
Types of Inventory

2
Reasons for Holding
Inventories (Motivation)
 Economies of Scale
It is more economical to produce a relatively
large number of items in each production
run and store them for the future. Cost of
setup is relatively high. “bigger is better”.

 Uncertainty in delivery lead-times

More responsive to consumer preferences.
Protection against uncertainty of demand. 3
Reasons for Holding
Inventories (Motivation)
 Speculation: Changing Costs Over Time
(increasing). Purchase large quantity at
current price and store the items than
to pay higher prices at future date.

 Smoothing: to account for seasonality

and/or Bottlenecks. Anticipates peaks of
demand and alleviate disruption
caused by changing WF level and PR. 4
Reasons for Holding
Inventories (Motivation)
 Demand Uncertainty: Reactive to
sudden changes in demand.

 Costs of Maintaining Control System:

Control cost. It is less costly to maintain
large inventories of inexpensive items
than to expand worker time to keep
detailed records of these items.
5
Characteristics of Inventory
Systems
 Demand:
 May Be Known or Uncertain
 May be Changing or Unchanging in Time

 Lead Times : time that elapses from

placement of order until it’s arrival. Can
assume known or unknown.
 Review Time: Is system reviewed periodically
or is system state known at all times?
(transaction recorded as they occur).
6
 Characteristics of Inventory
Systems (Cont.)
 Treatment of Excess Demand.
Definition: demand that cannot be filled immediately
from stock. How the system reacts to excess.
 Backorder all Excess Demand

 Lose all excess demand

 Backorder some and lose some

 Backorder: A customer order that cannot be filled when presented, and for
which the customer is prepared to wait for some time.
Inventory who’s quality changes over time
 Perishability (ex: food, flowers)
 Obsolescence (automotive spare parts)
7
Relevant Inventory Costs
 Holding Costs - Cost to carry an item
in inventory for a length of time,
usually a year.

Proportional to the quantity of inventory

held (Varies with the amount of
inventory).

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 Relevant Inventory Costs

Includes:
1. Physical Cost of Space (3%)
2. Taxes and Insurance (2 %)
3. Breakage Spoilage and Deterioration (1%)
4. Opportunity Cost of alternative investment. (18%)

Here these holding issues total: 24%

The total annual interest charge (I)
9
Relevant Inventory Costs
 Opportunity Cost of alternative
investment: The loss of potential gain
from other alternatives when one
alternative is chosen.

 Refers to a benefit that a person could

have received, but gave up, to take
another course of action.
10
 Relevant Inventory Costs
(continued)
 Therefore, in inventory systems, the holding
cost ($/unit/year) would be taken as:
h =I.c
 h: the holding cost in term of dollars per
unit per year,
 I: the annual interest rate,
 C: the dollar value of one unit of inventory.
h =.24*Cost of product
11
Lets Try one:
 Problem 4, page 208 – cost of
inventory

12
Relevant Costs (continued)

 Ordering Cost (or Production Cost). costs of

ordering and receiving inventory
Includes both fixed and variable components
slope =c

K C(x) = K + cx for x > 0; 0 for x = 0.

13
Relevant Costs (continued)

 Fixed component: the fixed cost K, is

incurred independent of the size of the order
as long as it is not zero.

 Variable component: cx depends of the

amount of inventory that is ordered.

C(x) = K + cx

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Relevant Costs (continued)

 Penalty or Shortage Costs. All costs

that accrue when insufficient stock is
available to meet demand. These
include:
 Loss of revenue due to lost demand
 Costs of book-keeping for backordered
demands (managing accounts)
 Loss of goodwill for being unable to satisfy
demands when they occur. (bad
reputation) 15
Relevant Costs (continued)

 When computing Penalty or Shortage

Costs inventory managers generally
assume cost is proportional to number
of units of excess demand that will go
unfulfilled.

16
The Simple Economic order quantity
(EOQ) Model – the most fundamental
of all!
 Assumptions:
1. Demand is fixed at l units per unit
time – typically assumed at an annual
rate.
2. Shortages are not allowed.
3. Orders are received instantaneously.
(this will be relaxed later).
17
Simple EOQ Model (cont.)
 Assumptions (cont.):
4. Order quantity is fixed at a value “Q” per
cycle. (we will find this as an optimal
value)
5. Cost structure:
a) includes fixed and marginal order costs
(K + cx)
b) includes holding cost at h per unit held
per unit time. 18
Inventory Levels for the EOQ Model
Saw structure is typical. First order when
inventory is 0. Reordering Q everytime
when inventory is 0 must be optimal
replenished
Inventory

19 Profile of Inventory Level Over Time

 The EOQ Model: Notation
D = λ is the demand rate (in units per year)
c = unit production cost, not counting setup or inventory costs
(in dollars per unit)
K = setup costs (per placed order) in dollars
h = holding cost (in dollars per unit per year), if the holding
cost consists entirely of interest on money tied up in
inventory,
h = ic, where i is an annual interest rate
Q = lot size (order size) in units
Q
T = time between orders (cycle length) T 
l
G(Q) = average annual cost Q K  cQ
G Q   h 
2 T
 Inventory (I(t))
Assume Constant

Relationships Demand

slope = -l

 Ordering Costs: (Order amount Q)

Q/2 Q
C(Q) = K + cQ
T Time (t)
Holding Cost: Time between orders Instantaneous
 Replenishment

h = I.c =(Interest Rate)(Cost of Inv.)

 Average Inventory Size?

Under constant demand: Q/2
Rate of consumption
 Time Between Orders: Q l
l  Q/T
T = Q/l
T
 Total Costs
 What is the average annual cost?

G(Q) = average order cost + average holding cost

K  cQ hQ
G (Q)  
T 2
Average ordering Average inventory
cost per time T level at any time
22
 Total Costs
 What is the average annual cost G(Q)?

K  cQ hQ
G (Q )  
Q
T T 2
l
K  cQ hQ
 
Q 2
l
hQ K l
   lc
2 Q
23
The Average Annual Cost Function G(Q)

Q K cQ hQ Kl
GQ   h      cl
2 T T 2 Q
The Total-Cost Curve is U-Shaped
- Fixed cost = holding
cost
- Around Q*, cost curve
is flat (robust)
Holding Costs

Ordering Costs

(optimal order quantity)

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 Average Annual Cost G(Q)

Kl hQ
G (Q)   lc 
Q 2
 Minimize Annual Average Cost
G  Q   non linear function of Q
 Take the derivative of G(Q)
Kl hQ
G (Q )   lc 
Q 2
K l h
G (Q )  2

Q 2
 Is this a minimum?
2K l
G(Q)  3  0, Q  0
Q
 EOQ:
K l h 2K l
2
  0  Q*  YES!
Q 2 h
 Properties of the EOQ Solution
2K l 2(Annual Demand Rate)(Order or Setup Cost)
QOPT = = 2K l
Q h Annual Holding Cost
h
 Q is increasing with both K and l and decreasing
with h

 Q changes as the square root of these quantities

 This formula is well-known economic order

quantity, is also known as economic lot size
 Q
T
l

28
Properties of the EOQ Solution
 This is a tradeoff between lot size and
inventory
 “Garbage in, garbage out” - usefulness
of the EOQ formula for computational
purposes depends on the realism of
input data
 Estimating setup cost is not easily
reduced to a single invariant cost K
Example
 An office supplies store sees a uniform
demand rate of 10 boxes of pencils per
week.
 Each box costs $5.
 If the fixed cost of placing an order is
$10 and the holding cost rate is .20 per
year, let us determine the optimal order
quantity using the EOQ model!
 Assume 52 weeks per year. 30
Example (Cont.)
 In this example K = 10, I = .20, C = 5,
and the annual demand rate is:
l =(10)(52) = 520.
 Substituting these values in EOQ
Equation, we get:

2K l 2 10  520 
*
Q = =  101.98 102 units
h  0.2  5
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