Salvage Value: Estimated residual value of a depreciable asset or property at the end of its economical or useful life.

ExampleA trader stocks a particular seasonal product at the beginning of the season and cannot reorder. The item costs him Rs 25 and he sells it at Rs 50 each. For any item that cannot be met on demand, the trader has estimated a goodwill cost of Rs 15. Any item unsold will have a salvage value of Rs 10. Holding cost during the period is estimated to be 10% of the price. The probability of demand is as follows: Units Stocked: 2 3 0.25 4 0.20 5 0.15 6 0.05

Probability of demand: 0.35

Determine the optimal number of items to be stocked. Soln. Given, C=unit cost price=Rs 25, S=unit selling price=Rs 50, Ch=unit holding cost= Rs (0.10 X 25) = Rs 2.50, Cs = unit shortage cost = Rs 15, V = salvage value = Rs 10. Therefore, C1 = over-stocking cost = C + Ch V = Rs (25+2.50-10) = Rs 17.50 C 2 =under-stocking cost = S C Ch/2 + Cs = Rs (50 25 2.50/2 + 15) = Rs 38.75 Next, we calculate cumulative probability of demand Units Stocked: 5 6 Probability of demand, pR: 0.20 0.15 0.05 Cumulative Probability of demand, 0.80 0.95 1.00 2 0.35
Im

3 0.25

p
R =0

: 0.35

0.60

The desired optimum value for Im (i.e. the optimum number of items to be stocked) is determined by the following double inequality: pR Im 1 < C2/(C1 + C2) < pR Im

Now, C2/(C1 + C2) = 38.75/ (17.50 + 38.75) = 0.69. This ratio lies between cumulative probabilities of 0.60 and 0.80, which suggests that the value of Im lie between 3 and 4 since 0.60 < 0.69 < 0.80. Hence Im = 4 units. Ex- A newspaper boy buys papers for 5 paisa each and sells them for 6 paisa each. He cannot return unsold newspapers. Daily demand for newspapers follows the following distribution: R: 10 11 12 13 14 15 16 pR: 0.05 0.15 0.40 0.20 0.10 0.05 0.05 If each days demand is independent of the previous days, how many papers should be ordered each day? Soln. Let Im be the number of newspapers ordered per day and R be the demand for it i.e. the number that is actually sold per day. C1 = Over-stocking cost = Re 0.05 C2 = Under-stocking cost = Re (0.06-0.05) = Re 0.01 Next, we calculate cumulative probability of demand as R: pR: 10 11 12 13 14 15 16 0.05 0.15 0.40 0.20 0.10 0.05 0.05
R

p
R =0

Im

0.05 0.20 0.60 0.80 0.90 0.95 1.00

The optimum value of Im is determined by the double inequality as pR Im 1 < C2/(C1 + C2) < pR Im Now, C2/(C1 + C2) = 1/6 = 0.167 This indicates that Im must lie between 10 and 11 because 0.05 < 0.167 < 0.20. Hence, optimum Im = 11

Model 3(b): Instantaneous Demand, No Set-up Cost, Stock Levels Continuous, Lead Time Zero
For this model, all conditions are same as in Model 3(a) except that the stock-levels are continuous (rather than discrete). We therefore use the probability f(R) dR instead of pR, where f(R) is the probability density function of the demand rate R. Hence, the optimal value of the ordering quantity Im is determined when the value of cumulative probability distribution is equal to C2/ (C1 + C2) by computing
Im

R =0

f ( R ). dR =

C2 C1 + C 2

Ex- A baking company sells one of its types of cake by weight. It makes a profit of 95 paisa a pound on every pound of cake sold on the day it is baked. It disposes of all cakes not sold on the day they are baked at a loss of 15 paisa a pound. If demand is known to have probability density function f(R) = 0.03 0.0003R, Find the optimum amount of cake the company should bake daily. Soln. Penalty cost/ unit of oversupply, C1 = Rs 0.15 Penalty cost/ unit of undersupply, C2 = Rs 0.95
Im

Using the relation

Im

R =0

f ( R ). dR =
=

C2 , we get C1 + C 2

(0.03 0.0003 R). dR = 0.15 + 0.95

0 2 0.0003 I m 0.95 = 2 1. 1 2 0.00015 I m = 0.8636

0.95

0.95 1. 1

.03 I m 0 0.03 I m

2 3000 I m 15 I m = 86360 2 200 I m I m = 5757 2 I m 200 I m + 5757 = 0

I m =

200 (200 ) 2 4 5757 2 =165 .15 or 34 .85 pounds .

WHEN TO ORDER When the stock which is continuously being used up by the customers demand, reaches the reorder level, an order of fixed size q is placed. Lead Time (LT): It is the time interval between placement of an order and receipt of goods against it. Lead time is usually short in case of local supplier and greater for out-station supplier. Lead time may not be a constant and is usually not so. However, due to mathematical complexities involved, it is assumed to be a constant. Reorder Level (R. O. L): It is the stock level at which fresh orders should be placed with the suppliers for procuring additional inventory equal to the economic ordering quantity. R. O. L is fixed in such a way that the customers can be served from the stock until the replenishment of size q arrives against the order placed. The problem of when to order reduces to fixing R. O. L with the operating policy that as the stocks cross this level, an order is placed. Lead Time Demand & Safety Stock: Lead Time Demand is the stock level, which on the average, is sufficient to fill customers orders as the stocks are being replenished. On the average implies that during this period of replenishment, 50% of the customers orders can be filled while 50% may be either refused or back ordered to be filled later. It is because the actual demand may be different from the predicted value. The extra stock in excess of the lead time demand is called the safety stock (or buffer stock or cushion stock). Safety Stock (SS) = [max. lead time in time units normal lead time in time units] X (average demand per unit time)

Or SS = [maximum usage per time unit average usage per time unit] X (lead time)

For short-term forecasts, R. O. L = Lead Time Demand (LTD) When the demand pattern is almost stationary and depicts no trend or seasonal variations, LTD = Lead Time (LT) X Average Demand (R) So, R.O.L = Lead Time X Average Demand. If the safety stock is provided, R.O.L = Lead Time Demand (LTD) i.e. demand in normal lead time + Safety Stock (SS) If time T is required for reviewing the system, R.O.L = LTD + SS + (R x T)/2 If there is no provision of safety stock, Maximum Inventory = q + SS Minimum Inventory = SS Average Inventory = [SS + (q + SS)]/2 = q/2 + SS.

Ex- A firm uses every year 12000 units of a raw material costing Rs 1.25 per unit. Ordering cost is Rs 15.00 per order and the holding cost is 5% of the cost of raw material per unit per year. i) Find the economic ordering quantity ii) The firm follows EOQ purchasing policy. It operates 300 days per year. Procurement time is 14 days and the safety stock is 400 units. Find the reorder point, the maximum inventory and the average inventory. Soln. i) EOQ = qo= iii)
2C3 R = C1 2 15 12000 = 2400 units (5 / 100 ) 1.25

Reorder level = safety stock + consumption during normal lead time = 400 + 14 x (12000/300) = 960 units.

Max. Inventory = qo + safety stock = 2400 + 400 = 2800 units. v) Min. Inventory = safety stock = 400 units Hence, Average Inventory = (2800 +400)/2 = 1600 units.
iv)

Ex- Calculate the various parameters for putting an item with following data on EOQ system: Annual consumption = 12000 units at the cost of Rs 7.50 per unit. Setup cost = Rs 6.00 per set up. Inventory holding cost = Re 0.12 per unit. Normal lead time = 15 days. Maximum lead time = 20 days Soln. The required parameters to be calculated for putting an item on EOQ system are:
i)

EOQ = qo =

2C 3 R = C1

2 6 12000 = 1096 units . 0.12

( 20 15 ) 12000 =165 units approx . 365

ii) iii)

Optimum Safety Stock, SS =

R. O. L = SS + Demand in normal lead time (i.e. demand in average lead time) = 165 + (normal lead time X demand per = 165 + 15 x [12000/(30 x 12)] = 665 units.

day)

Ex- The following information is provided for an item as: Yearly usage = 12000 units; ordering costs = Rs 60 per order; carrying costs = 10% of cost of item; Cost of one item = Rs 10; Lead time = 10 days. There are 300 working days/ year. Determine economic ordering quantity and number of orders per day. In the past two years the use rate has gone as high as 70 units per day. For a reordering system based on the inventory level, what should be the safety stock? What should be the reorder level at this safety stock? What would be the inventory carrying costs for a year? Soln. C3 = Rs 60/order, R = 12000 units/year, C1 = Rs 10 x (10/100) = Re 1 per item per year. EOQ = qo =
2C3 R = C1 2 60 12000 = 1200 units . 1

Number of orders/ year = 12000/1200 = 10. Average usage = 12000/300 = 40 units/day Maximum usage = 70 units/ day Safety Stock = [Max. usage Avg. usage] x lead time = [70 40] x 10 = 300 units.

R. O. L = SS + Demand in normal lead time (i.e. demand in average lead time) = 300 + 40 x 10 = 700 units. Average Inventory = qo/2 + safety stock = 1200/2 + 300 = 900 units. Inventory carrying costs per year = Rs [900 x 10 x (10/100)] = Rs 900.

Ex- An automobile company has determined that 16 spare engines will result in a stock-out risk of 25% while 20 will reduce the risk to 15% and 24 to 10%. If the lead time is 3 months and the average usage is 6 engines/month, what should be the R.O.L to maintain 85% service level? Soln. Lead time demand = lead time x average demand per month = 3 x 6 = 18 engines. Safety stock for 85% service or 15% disservice = 20 engines R. O. L = lead time demand + safety stock = 18 + 20 = 38 engines.