Order Quantities

When Demand is
Approximately
Level
Dr. Islam Ali
Tentative Contents
• Introduction
• Order Quantities When Demand Is Approximately Level
• Lot Sizing for Individual Items with Time-Varying Demand
• Individual Items with Probabilistic Demand
• Managing the Most Important Inventories - Managing Class A items
• (S, S)
• (R, s ,S)
• Managing Slow-Moving and Low-Value (Class C) Inventories
• (s, Q)
• Style goods and perishable items
• Coordinated Replenishments at a Single Stocking Point
• Coordinating Inventory Management in the Supply Chain
• MRP and extensions
• Just-in-Time, Optimized Production Technology and Short-Range
Production
• Scheduling

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 Functions of Inventory
• To meet anticipated demand
• To smooth production requirements
• To decouple operations
• To protect against stock-outs
• To help hedge against price
increases
• To permit operations
• To take advantage of quantity
discounts

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• A typical washing
machine contains
about 60 parts and
many other smaller
components

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A typical modern car has over 30,000 parts including every screw and nut

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 Three basic questions

• How often the inventory status should be determined ?

• When a replenishment order should be placed ?

• How large the replenishment order should be ?

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Inventory Measures
• $ value of inventory held (balance sheet)
• Sum of individual items in raw materials,
work in process, and finished goods.
• A snapshot of inventory investment at the
end of time period.
• Inventory turns
• Inventory turns =
Annual sales (at cost)/$ value of inventory
• 6 or 7 turns per year is typical
• Average high-tech firm gets 3,
• Automobile firms report 40 turns per year for
selected products

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Inventory Turns
A measure of how effectively inventory is being used
Annual cost of goods sold
Inventory turns = Average inventory in dollars

Example:
Annual cost of goods sold = $1,000,000
Average inventory = $500,000

$1,000,000
Inventory turns = $500,000 = 2

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Days of Supply
Inventory on hand 6,000
Days of supply = = = 30 days
Average daily usage 200

• Used to measure the relationship between usage

(sales) and inventory
• In this example, 6,000 units are sold on average over
a period of 30 days at 200 units per day
• Inventory turns every 30 days, or 12 times a year
(inventory turns are 12)

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Functional Categories of Stock

• Cycle Stock
• Safety Stock
• Process stock
• Pipeline Stock
• Anticipation Stock

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Functional Categories of Stock
• Cycle Stock
• To cover anticipated demand over the cycle time. Consequence of
manufacturing in batches.
• Safety Stock
• To cover variations in demand and supply over the cycle time.

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Cycle Stock
• Cycle stock is required to cover periods of non-manufacture, since a
product cannot be produced continuously (assuming it is not a true
flow operation) Maximum Cycle Stock Holding

Cycle Stock - Average

Make/order Make Make Make

Minimum Cycle Stock Holding

• The average cycle stock held is half the interval between production
events (in days of demand) or half the produced amount (in units)

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Functional Categories of Inventory: Safety Stock
• Hedge against uncertainties in supply, demand, etc.

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Functional Categories of Stock: Safety Stock
• Safety Stock protects against the deviation of actual demand from
planned demand (Forecast Error) and the deviation of actual
production from planned production (timing or amount)
Inventory

Demand
Weeks

Forecast
Error

5000
10000
15000
Weeks

20000
25000
Safety Stock 0

Supply Forecast
Time Error 10000 15000 20000 25000 30000
Functional Categories of Stock: Safety Stock
• Is set to zero when
• Future demand rate is known with certainty
• Ordering/Replenishment lead times are known with certainty

• Safety stock is directly related to the desired level of customer service

• Service level (fill rate) refers to how often customer demand is met from stock

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Functional Categories of Stock
• Process stock
• Generated by process specifications that delay product release, including
hardening, quality assurance etc.
• Pipeline Stock
• To cover administrative and physical lags between customer order and delivery
or invoicing.
• Anticipation Stock
• To cope with seasonal demand which has to pre-produced because of limited
capacity.
• To cope with promotions which create high demand over short intervals.
• To cover manufacturing shutdowns.
• To gain a price advantage on raw or packaging materials.

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Total Stock
• Cycle Stock
• Safety Stock Stock
(days)
• Process stock
• Pipeline Stock
Cycle
• Anticipation Stock Anticipation
Safety
Process
FIXED
Pipeline
Time

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• Cycle Stock coverage is directly proportional to the production cycle time

Inventory

Average
Inventory
Day Weeks

One
Cycle Time

Pipeline Stock
Process Stock
Days

One Cycle per Period Two Cycles per Period

In this example, doubling the number of cycles reduces the average
cycle stock inventory level by one half.

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Stock Keeping
Unit (SKU)
• The specific unit of stock
to be controlled will be
called a Stock-Keeping
Unit (SKU)
• An SKU will be defined as
an item of stock that is
completely specified as to
function, style, size, color,
and, often, location.

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 ABC Inventory Control

Objective:
Application of different levels of control based on the relative importance of items

Key Questions
• What is the importance of the inventory items?
• How are they to be controlled?

 A small number of items will represent the most critical values

 ABC inventory control separates the most significant items from the less important

 It is used to determine the degree and level of control required

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ABC Classification
• A Items
• 20% of the items account for
• 80% of the total dollar usage
• B Items
• 30% of the items account for
• 15% of the total dollar usage
• C Items
• 50% of the items account for
• 5% of the total dollar usage

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ABC Process
Establish the item characteristics that influence the
results of inventory management:
• Annual dollar usage
• Scarcity of material
• Quality problems

Classify items into groups based on the criteria

established

Apply a degree of control in proportion to the

importance of the group

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Example of ABC Analysis – Step 1
Part Number Annual Usage Analysis
Annual Annual
Part Number Unit Usage Unit Cost $ Usage
1 1,100 $2 $ 2,200
2 600 40 24,000
3 100 4 400
4 1,300 1 1,300
5 100 60 6,000
6 10 25 250
7 100 2 200
8 1,500 2 3,000
9 200 2 400
10 500 1 500
Total $38,250
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ABC Classification Calculation Steps
• Rank part numbers by annual dollar usage in descending order
• Calculate cumulative dollar usage: add the dollar usage of each part
number to the cumulative total for the preceding part (Part 2’s
cumulative usage is $24,000)
• Calculate the cumulative percentage of dollar usage in the same way
(Part 2’s cumulative percentage of dollar usage is 63%)
• Calculate the cumulative percentage of items in ascending order: since
there are 10 parts, each part number accounts for 10% of the
cumulative total

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Example of ABC Analysis – Step 2
Ranking of Part Numbers by Annual Usage
Part Number Annual $ Cumulative $ Cumulative % $ Cumulative % of
Usage Usage Usage Items
2 24,000 24,000 63 10
5 6,000 30,000 78 20
8 3,000 33,000 86 30
1 2,200 35,200 92 40
4 1,300 36,500 95 50
10 500 37,000 97 60
3 400 37,400 98 70
9 400 37,800 99 80
6 250 38,050 99 90
7 200 38,250 100 100

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Control Based on ABC Classification
• Two general rules:
• Have plenty of low-value items
• Focus control effort on A items Level of Control
Tight

Level of Control
• Typically, for Class C items (low-value
items), most companies try to keep a Normal
Least
relatively large number of units on hand Possible
to minimize the amount of inconvenience
that a stockout of such insignificant parts
could cause. A B C
Item Classification

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Inventory Costs
Item

Carrying

Ordering

Stockout

Capacity-
Related

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Item Costs
Purchased Items Manufactured Items

Product Direct Material

Transportation Direct Labor

Customs Duties Factory Overhead

Insurance

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Carrying Costs
Capital Storage
Costs
Risk Costs
Costs

Obsolescence

Space Damage

Opportunity Cost Personnel Pilferage

Equipment Insurance

Deterioration

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Ordering Costs
Purchase Factory

Production Control
Purchasing Cost
Cost

Set up and Tear-

down Cost

Lost Capacity Cost

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Stockout Costs
CAUSES OF STOCKOUTS STOCKOUT COSTS

Backorder costs
Demand during lead time
exceeds forecast and Lost sales
available inventory

Lost customers

Production and supplier Expediting costs

problems
cause inventory shortages Additional manufacturing
and purchasing costs

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Capacity-Related Costs

Overtime

Hiring

Layoff

Training

Shift
Premiums

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Deterministic Single Item Models
• Deterministic means all problem parameters, including demand, are
known in advance

• Applied to a single item at a single stocking location

• Single-item models in multi-item systems

• Separately applied to each item
• Does not account for any coordination among items

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Opportunity Cost of Alternative investment
• Finding the right interest rate for the opportunity cost of alternative investment is
very difficult.

• Its value is estimated by the firm’s accounting department and is usually an

amalgam of the accounting measures listed below:
28% = cost of capital,
2% = property taxes and insurance,
6% = cost of storage,
1% = breakage and spoilage
37% = total interest charge.

• We would assess a charge of 37 piasters for every Egyptian Pound that we have
invested in inventory during a one-year period

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Opportunity Cost of Alternative investment
• However, as we generally measure inventory in units rather than in
dollars, it is convenient to express the holding cost in terms of dollars
per unit per year rather than dollars per dollar per year. Let v be the
dollar value of one unit of inventory, r be the annual interest rate, and
h be the holding cost in terms of dollars per unit per year. Then we
have the relationship
h=rxv
• Hence, in the example above, an item valued at $180 would have an
annual holding cost of h = (.37)($ 180) = $66.60. If we held 300 of
these items for five years, the total holding cost over the five years
would he
(5)(300)(66.60) = $99,990

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Ordering or Setup Cost

• The order cost depends on the amount of ordered or produced

inventory.

• The appropriate costs would be the bookkeeping expense associated

with the order, the fixed costs independent of the size of the order that
the vendor might require, costs of order generation and receiving, and
handling costs.

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Shortage Cost
• The shortage cost, also known as the penalty cost or the stock-out cost, is
the cost of insufficient stock on hand to satisfy demand when it occurs.

• This cost has a different interpretation depending on whether excess

demand is:

• back ordered (orders that cannot be filled immediately are held on the books until
the next shipment arrives); or

• lost (known as lost sales).

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Shortage Cost
• In the back-order case, the penalty cost includes whatever bookkeeping
and/or delay costs might be involved.

• In the lost-sales case, it includes the lost profit that would have been made
from the sale.

• In either case, it would also include the “loss-of-goodwill” cost, which

measures customer satisfaction. Estimating the loss-of-goodwill
component of the penalty cost can be very difficult in practice.

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Other factors

• Replenishment lead time

• Time that elapses from the moment an order is placed until it is received

• Demand pattern
• At what stage is the product in its lifecycle?
• Different control mechanisms must be used at different stages of the lifecycle
• Dependent vs. independent items

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Economic Order Quantity (EOQ) Model
• Earliest quantitative inventory model

• Harris 1913, Wilson 1934

• Fundamental tradeoff
• Ordering cost versus inventory carrying cost
• Order frequency versus average inventory level

• Need to understand fundamental assumptions to avoid misuse.

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Economic Order Quantity Model Assumptions
1. The demand rate is constant and deterministic.

2. The order quantity need not be an integral number of units, and there
are no minimum or maximum restrictions on its size.

3. The unit variable cost does not depend on the replenishment quantity;
in particular, there are no discounts in either the unit purchase cost or
the unit transportation cost.

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Economic Order Quantity Model Assumptions
4. The cost factors do not change appreciably with time; in particular,
inflation is at a low level.

5. The item is treated entirely independently of other items; benefits from

joint review or replenishment do not exist or are simply ignored.

6. The replenishment lead time is of zero duration, extension to a

deterministic, nonzero replenishment lead time creates no problem.

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Economic Order Quantity Model Assumptions
7. No shortages are allowed.

8. The entire order quantity is delivered at the same time.

9. The planning horizon is very long. In other words, we assume that all
the parameters will continue at the same values for a long time.

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 Economic Order Quantity Model
• Q =replenishment order quantity in units
• A =ordering cost (independent of order size) in $/order
• v = unit variable cost in $/unit
• value of item, including raw materials and value-added through processing/assembly
operations
• r =carrying charge in $/$/unit time
• Cost of having one dollar of item tied up in inventory for a unit of time interval
• D =demand rate of the item in units/time unit
• TRC(Q) =Total costs in $/unit time

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Economic Order Quantity Model
• Q/D =time between replenishments
• D/Q =number of orders placed per unit time (usually a year)
• A + Qv =replenishment cost
• Cr =Replenishment cost per unit time

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Economic Order Quantity Model
• Cc =Carrying cost per unit time

• Average inventory in units

*Since the term vD does not depend on Q, we omit it from TRC(Q)

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Economic Order Quantity Model

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Economic Order Quantity Model: Derivation of EOQ
• The optimal order quantity can be computed using the necessary
condition that the slope (hence derivative) of the curve TRC(Q) is zero
at the minimum.

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Economic Order Quantity Model: Total Cost at the
EOQ

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Economic Order Quantity Model: Other Expressions
• The EOQ can also be expressed in number of months of demand it will
satisfy

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Economic Order Quantity Model: Other Expressions
• The EOQ can also be expressed as a “turnover ratio”
• Annual demand divided by the average inventory

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 Economic Order Quantity Model: Sensitivity Analysis
• What is the impact on the TRC if we used an order quantity Q’ that is α
percent of EOQ?. That is

• The % cost penalty (PCP) in this case is

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Economic Production Quantity (EPQ) MODEL
• We assume that the order cannot be received all at once but can be
replenished at a rate m units/unit time

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Economic Production Quantity MODEL: EPQ formula

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Quantity Discounts
• Here, we assume that an item’s unit variable cost/price, v, depends on
the quantity ordered.

• Several discount structure schemes

• We assume an “all-units” discount

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Quantity Discounts
• The total replenishment cost now includes the acquisition cost Dv

• TRC(Q) has the lowest value for Q ≥ Q1

• If EOQ ≥Q1 , then it the optimal quantity to order
• If the EOQ<Q1 , then the decision depends on a tradeoff between carrying extra
inventory versus a reduction in acquisition cost

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Quantity Discounts

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Quantity Discounts

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Quantity Discounts

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Quantity Discounts: Procedure for computing EOQ
• Step 1: compute EOQ at discount variable cost

• Step 2:
• if EOQ(d) ≥ Q1, then EOQ(d) is the best order quantity (case 3)
• if EOQ(d)<Q1, go to step 3
• Step 3: compute

• and TRC(Q1)

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Quantity Discounts: Procedure for computing EOQ
• If TRC(EOQ) <TRC(Q1), then the best order quantity is (case 2)

• if TRC(EOQ) >TRC(Q1), then the best order quantity is Q1 (case 1)

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Thanks…
Questions
islam.ali@ejust.edu.eg

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