Economi Order Quantity

Decision Variable: Lot Size aka Batch Size aka Order Quantity

1. Each time we produce an item, or each time we order an item, what quantity should we produce/order.
2. When should we order.

We will assume that demand is known and constant, and arrives in perpetuity.
1. If you order too much at a time, you will face increasing holding costs (in various ways).
2. If you order enough each go, you will face increased frequency of orders, which will imply greater setup/fixed cos
Suppose we denote demand per period by D.
1. Total Inventory Holding Cost is proportional to your average inventory Q/2.
Suppose we denote holding cost per unit per period by h.
Total Inventory Holding Cost per period = Q/2 x h

2. Total Fixed Order Costs are proportiona; to frequency of ordering.

Suppose we denote Setup or Fixed Order cost (per order) by K.
Total Fixed Order or Setup Costs per period = D/Q x K

Suppose Q=1000 units each time; Suppose D= 100 units per day; Suppose h= $1 per unit/day, Suppose
Q= 1000 units Demand D= 100 units/day
h= HK$1.00 per unit/day
K= HK$200 per order
1 Total Inventory Holding Cost per period = Q/2 x h= 500 x 1 =
2 Total Fixed Order or Setup Costs per period = D/Q x K=

Total Cost= Q/2xh + D/Q x K

h/2-D/Q^2 x h --> Q = SQRT (2 D K/h)
3 What is the optimal or Economic Order Quantity= 200

Reorder Point=?
Suppose my Lead Time 1.5
When or at what inventory level would you re-order?
Reorder Point = Demand D x Lead Time L 150
Reorder Point protects against stockouts during the lead time.
ould we produce/order.

will imply greater setup/fixed costs over time.

pose h= $1 per unit/day, Suppose K = $200 per order.

$500 per day

HK$20 per day

units

days

units
When demand is uncertain:
1 What quantity should I order/produce each time
2 When should I reorder?

Safety stock is the average inventory level when the next replenishment arrives

Reorder point = demand during the lead time + Safety Stock

Hence ROP= D x L+ Safety Stock

Drivers of Safety Stock

a. Uncertainty (Stdev of Demand per period) - the more the uncertainty, the greater the ma
b. Lead time - the greater the lead time, the greater the magnitude of safety (positive or neg
c. Required Service Level - alpha; with alpha>50%, safety stock will be positive, and with alp

Safety Stock=z x Stdev x SQRT(L)

where z= NORMSINV(Service Level)

Suppose as before D= 100 units/day

Suppose as before L= 1.5 days
Suppose Stdev of Demand 20 units/day
Suppose alpha= 95% So z= 1.64485363
Safety Stock= 40.2905209 units/day
ROP or r = 190.290521 units

Expected or Mean Total Demand During Lead Time = 150

Stdev of Total Demand During Lead Time = 24.4948974
ROP or r= 190.290521 units
ent arrives

e uncertainty, the greater the magnitude of safety (positive or negative)

agnitude of safety (positive or negative)
tock will be positive, and with alpha<50%, safety stock will be negative.
Suppose Underage Cost= HK$19.00 unit
Suppose Overage Cost= HK$1.00 per unit
Critical Ratio aka Service Level = 95%
Suppose Mean Demand D= 150 units
Suppose Stdev of Demand Stdev = 25 units
Optimal Order Quantity= Expected Demand + z x Stdev of Demand
Optimal Order Quantity= 191.121341 units
191.121341 units