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(DETERMINISTIC)

Outline

Inventory Control Questions

Inventory Control Costs

The Economic Order Quantity (EOQ) model

The EOQ Model Costs

The EOQ

Some Important Characteristics of the EOQ Cost

Function

1

In Chapter 2, Lessons 4-7, we discuss demand

forecasting

Forecasting provides the demand of products in the near

future

In Chapter 3, Lessons 8-10, we discuss aggregate

planning.

Aggregate production plan is translated into a detail

product-wise production plan by Master Production

Schedule (MPS).

The next question in the hierarchy of decision making is

inventory control.

F o re c a s t o f D e m a n d

A g g r e g a t e P la n n in g

M a s t e r P r o d u c t io n S c h e d u le

In v e n to ry C o n tro l

O p e r a t io n s S c h e d u lin g

V e h ic le R o u t in g

Inventory control questions:

Raw materials, components (subassemblies), and

finished goods may be purchased or produced inhouse.

Timing and amount of purchase and production must

be carefully planned. There are two major questions:

1. How much (lot size)?

How much to purchase or produce?

2. When?

When to purchase or produce?

4

There can be two extreme strategies:

Small lot sizes and too frequent inventory

replenishment

This strategy yields higher ordering costs (if the

items are purchased) or setup costs (if the

items are produced).

The demand forecast is for a short term and it

is more accurate.

Large lot sizes and too infrequent inventory

replenishment

5

Large lot sizes and too infrequent inventory

replenishment

This strategy requires a large investment in the

inventory and yields higher inventory holding

costs.

The demand forecast is for a long term and it is

less accurate.

Inventory holding costs, h Ic

Opportunity cost of capital

Cost of storage space

Taxes and insurance against fire, theft, and other losses

Breakage, spoilage, deterioration and obsolescence

Example of calculation of inventory holding costs

Cost of capital - 15%

Taxes and insurance 2%

Storage - 5%

Breakage/spoilage 3%

Total - 25%

Inventory holding costs, h Ic

Notation:

I = Annual interest rate

c = Dollar value of one unit of inventory

h = holding cost in terms of dollars per unit per year

Then, we have the relationship

h Ic

Order costs or setup costs, K

If the items are purchased, a fixed ordering cost may be

incurred each time an order is placed. Similarly, if the

items are produced, a fixed setup cost may be incurred

each time the production facility is set up to produce the

item.

Some examples are bookkeeping expense, order

processing fees, transportation costs, receiving costs,

handling costs, etc.

Order costs or setup costs, K

If there is a variable part of the order cost/setup that

depends on the number of units ordered/produced, the

variable cost is usually not considered in the order cost.

Instead, the variable cost may be included in the cost of

the item.

For example, the salary paid to the purchasing clerk does

not depend on the number of times orders are placed.

Such a cost is an overhead expense, and not a part of

the ordering cost.

Notation:

K = ordering/setup cost per order/setup.

10

Penalty costs, p

Shortages occur when the demand exceeds the amount of

inventory on hand. One of two types of costs is charged

depending on whether a shortage results in loss of sales or

not:

Backorder - if the excess demand is backlogged and

fulfilled in a future period, a backorder cost is charged

(bookkeeping and/or delay costs).

Lost sales - if the excess demand is lost because the

customer goes elsewhere, the lost sales is charged. The

lost sales include goodwill and loss of profit margin. So,

penalty cost = selling price - unit variable cost + goodwill,

if there exists any.

11

Penalty costs, p

In Chapter 4, Lessons 11-15, we assume that the

demands are known and fixed and shortages will not

take place. So, penalty costs are not considered.

In Chapter 5, Lessons 16-20, we assume that the

demands are uncertain and shortages may occur. So,

penalty costs are considered in Chapter 5.

12

Major assumptions

1. Demand is known and fixed (uniform). The rate of demand

is

units per

year. This assumption is relaxed in Chapter

5, Lessons 16-20, Stochastic Inventory Models.

2. The cost parameters, unit cost, holding cost,

and

ordering cost

are known and fixed.

h

c Given that the

inventory control

K decisions are made for a short term, its

likely that the costs will not change during the planning

period. Still, this assumption is a simplification. The costs

parameters may change over time.

3. Shortages are not permitted. This assumption is relaxed in

Chapter 5, Lessons 16-20, Stochastic Inventory Models.

13

Major assumptions

4. The inventory level increases instantaneously at one

point of time when an order is received. This assumption

is appropriate in the context of purchasing. The EPQ

model, discussed in Lesson 12, considers a gradual

increase in the inventory level. The EPQ model is

appropriate in the context of production.

5. There is no price discount for large order sizes. This

assumption is relaxed later. See Lesson 13, the EOQ

with price break.

14

Constant order size and inventory cycle

Since there is no uncertainty, its optimal to plan an order

receipt only when the inventory level reaches zero.

Suppose that there is no inventory in the beginning. So,

an order will be received in the beginning.

Since the demand and cost parameters do not change

over time

If its optimal to order Qunits in the beginning, its also

optimal to order units

Q next time.

The above observation provides two important concepts.

One is the constant order size and the other is the

inventory cycle.

15

Constant order size and inventory cycle

The order size, Q is chosen to minimize the total

inventory control costs. The formula for optimal order

quantity is given later.

At the start of each inventory cycle, the inventory level

is Q . The inventory level decreases uniformly. In the

end of the inventory cycle the inventory level is zero. So,

the length of the cycle is the length of time over which

the demand is Q . Thus, the length of the cycle in years

is

Q

T

16

Demand

rate

Inventory Level

Order qty, Q

Reorder point, R

0

Lead

time

Order

Order

Placed Received

Lead

Time

time

Order

Order

Placed

Received

17

Lead time and reorder point

Sometimes, there may be a lead time associated with

the orders. The lead time, is the length of time

between order placement and order receipt.

The presence of lead time requires the order be placed

some time before it is needed. For example, if there is a

lead time of 2 days, the order must be placed when the

inventory is sufficient to meet the demand for 2 days.

Reorder point,

is the inventory level at the time of

order placement.

Since, reorder point must cover the lead time demand,

R

18

Inventory level uniformly varies from 0 to Q

Q

So, the average inventory

2

Q

So, the annual inventory holding cost h

2

Q

Q

The annual cost of buying the items, c is

independen t on Q and is not considered .

hQ K

Hence, the total annual cost, TC

2

Q

19

Slope = 0

Annual

cost ($)

Minimum

total cost

Total Cost

hQ K

TC

2

Q

hQ

Holding Cost =

2

K

Ordering Cost =

Q

Optimal solution, Q*, Economic Order Quantity (EOQ)

Order Quantity, Q

20

The EOQ

As the annual demand

and cost parameters

c, h andare

K

fixed (see major assumptions), its important to analyze the effect

of order quantity on the annual ordering, holding and total costs.

The previous slide shows such an effect.

Annual ordering cost, Kdecreases as the order quantity

increases

Q

Annual holding cost, hQincreases as the order quantity increases

The total cost,

. The total cost curve is nearly U2

shaped.

hQ K

TC

some order quantity thats neither too

The total cost is minimum

for

2

Q

small nor too large.

21

The EOQ

hQ K

Question : Find Q that minimizes TC

2

Q

d TC

h K

2 K

Answer : Set

0 or, 2 0 or, Q

d Q

2 Q

h

This order quantity is called Economic Order quantity (EOQ)

and denoted by Q* .

2 K

Hence, EOQ, Q

minimizes TC.

h

*

22

The EOQ

Recall that there are two major inventory control questions,

how much and when. The EOQ model answers these

questions as follows.

How much to order?

Order

2 K

EOQ, Q

h

*

When to order?

When the inventory on hand reaches the reorder point

R

23

product that has a constant annual demand rate of 3600

cases. A case of the soft drink costs R & B $3. Ordering

costs are $20 per order and holding costs are 25% of the

value of the inventory. R & B has 250 working days per

year, and the lead time is 5 days. Identify the following

aspects of the inventory policy:

a. Economic order quantity

24

b. Reorder point

c. Cycle time

25

The total cost curve is flat near the EOQ value. So, the

total cost does not change much because of a little change

in the order quantity from the EOQ value. See the

discussion under some important characteristics. Since the

number of cases of soft drinks is a whole number, the

EOQ value has been rounded to the nearest integer.

Its not a coincidence that the annual holding cost is nearly

the same as the annual ordering cost. If the EOQ units are

ordered the annual ordering cost is the same as the annual

holding cost. See the total cost curve and the discussion

under EOQ model costs and some important

characteristics. The little difference between two costs is

due to the rounding.

26

Cost Function

At EOQ, the annual holding cost is the same as annual

ordering cost.

hQ * h 2 K

K h

Annual holding cost

2

2

h

2

K

Annual ordering cost *

Q

2 K

h

K h

2

hQ * K

Total annual cost

* 2 K h

2

Q

27

Cost Function

If the order quantity is near the EOQ value, the total cost does

not change from the optimal value.

See the discussion under the EOQ model costs and the

figure showing various costs against order quantity. The

total cost curve is flat near EOQ. This supports the point.

The EOQ policy usually provides a good decision even

when the cost parameters are little off than the assumed

values (and, therefore, the EOQ value is incorrect). So, the

EOQ model is insensitive to errors. See text pp. 208-209

for a detail discussion. In this note, the insensitivity is

shown with an example.

28

Cost Function

3600

3400

3600

3600

I

25%

25%

35%

25%

K

20

20

20

30

Q*

438

426

370

537

Opt

Cost

329

319

389

402

Cost

with

Q =438

329

320

394

411

29

Cost Function

If the order quantity is near the EOQ value, the total cost

does not change from the optimal value.

Consider the Example 1 data. The assumed values of

the annual demand, holding cost and ordering costs

are 3600 units, 25% and $20/order respectively. So,

the EOQ=438 units.

30

Cost Function

If the order quantity is near the EOQ value, the total cost does

not change from the optimal value.

Suppose that the correct value of the annual demand is

3400 units. So, the correct EOQ=426 units and the optimal

total annual cost is $319. If the decision maker, being

unaware of the correct value of the annual demand, uses an

order quantity of 438 units, the total annual cost will be $320

which is less than 0.30% off the optimal value of $319.

Similarly, the order quantity of 438 units, does not produce a

large error when holding cost changes to 35% or ordering

cost to $30/order.

31

Lesson 11

Reading:

Section 4.1 - 4.5 , pp. 194-208 (4th Ed.), pp. 183-200

(5th Ed.)

Exercise:

10 and 12, p. 210 (4th Ed.), pp. 201-202 (5th Ed.)

32

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