Special

Inventory Models

Supplement D

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 Special Inventory Models
 Three common situations require relaxation of one
or more of the assumptions on which the EOQ
model is based.
 Noninstantaneous Replenishment occurs when
production is not instantaneous and inventory is
replenished gradually, rather than in lots.
 Quantity Discounts occur when the unit cost of
purchased materials is reduced for larger order
quantities.
 One-Period Decisions: Retailers and
manufacturers of fashion goods often face
situations in which demand is uncertain and occurs
during just one period or season.
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 Noninstantaneous
Replenishment
 If an item is being produced internally rather
than purchased, finished units may be used
or sold as soon as they are completed,
without waiting until a full lot is completed.
 Production rate, p, exceeds the demand
rate, d.
 Cycle inventory accumulates faster than demand
occurs
 a buildup of p – d units occurs per time period,
continuing until the lot size, Q, has been
produced.
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 Noninstantaneous
Replenishment
Production quantity
Q
On-hand inventory

Demand during
production interval
Imax
Maximum inventory

p–d

Time
Production Demand
and demand only
TBO
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 Noninstantaneous
Replenishment

 Cycle inventory is no longer Q/2, as it was with the

basic EOQ method; instead, it is the maximum
cycle inventory (Imax / 2)

Imax =
Q
p
(p – d) = Q (
p–d
p )
 Total annual cost (C) = Annual holding cost +
annual ordering or setup cost
D = annual demand
d = daily demand
Q p–d
C =2 p ( ) D
+ Q (S) p = production rate
S = setup costs
Q = ELS
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 Economic Lot Size (ELS)

 Economic production lot size (ELS) is the

optimal lot size in a situation in which
replenishment is not instantaneous.

D = annual demand
2DS p d = daily demand
ELS = p = production rate
H p–d S = setup costs
H = annual unit holding cost

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 Finding the ELS
Example D.1
The manager of a chemical plant must determine
the following for a particular chemical:
1. Determine the economic production lot size (ELS).
2. Determine the total annual setup and inventory
holding costs.
3. Determine the TBO, or cycle length, for the ELS.
4. Determine the production time per lot.
• What are the advantages of reducing the setup
time by 10 percent?

Demand = 30 barrels/day Setup cost = $200

Production rate = 190 barrels/day Annual holding cost = $0.21/barrel
Annual demand = 10,500 barrels Plant operates 350 days/year
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 Finding the ELS for the
Example D.1 chemical
D = annual demand
d = daily demand
2DS p p = production rate
ELS =
H p–d S = setup costs
H = unit holding cost
Q = ELS
2(10,500)($200) 190
ELS =
$0.21 190 – 30

ELS = 4873.4 barrels

Demand = 30 barrels/day Setup cost = $200

Production rate = 190 barrels/day Annual holding cost = $0.21/barrel
Annual demand = 10,500 barrels Plant operates 350 days/year
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 Finding the
Total Annual Cost
Example D.1 D = annual demand
d = daily demand
p = production rate
Q p–d
C =2 p ( D
(H) + Q (S) ) S = setup costs
H = unit holding cost
Q = ELS

C=
2 190
(
4873.4 190 – 30
) 10,500
($0.21) + 4873.4 ($200)

C = $430.91 + $430.91 C = $861.82

Demand = 30 barrels/day Setup cost = $200

Production rate = 190 barrels/day Annual holding cost = $0.21/barrel
Annual demand = 10,500 barrels Plant operates 350 days/year
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 Finding the TBO
Example D.1 D = annual demand
d = daily demand
ELS p = production rate
TBOELS = (350 days/year) S = setup costs
D H = unit holding cost
Q = ELS
4873.4
TBOELS = (350 days/year)
10,500

TBOELS = 162.4, or 162 days

Demand = 30 barrels/day Setup cost = $200

Production rate = 190 barrels/day Annual holding cost = $0.21/barrel
Annual demand = 10,500 barrels Plant operates 350 days/year
© 2007 Pearson Education
 Finding the
Production Time per Lot
Example D.1 D = annual demand
d = daily demand
p = production rate
ELS S = setup costs
Production time =
p H = unit holding cost
Q = ELS

4873.4
Production time =
190

Production time = 25.6, or 26 days

Demand = 30 barrels/day Setup cost = $200

Production rate = 190 barrels/day Annual holding cost = $0.21/barrel
Annual demand = 10,500 barrels Plant operates 350 days/year
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 Advantage of Reducing
Setup Time
OM Explorer Solver for the Economic Production Lot
Size Showing the effect of a 10 Percent Reduction
in setup cost.

⇐ $180 vs original $200

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 Application D.1

2 DS p 2(10,080 )(100,000 ) 60
ELS = = = 1555.38
H p−d 2,000 60 − 35
or 1555 engines

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 Application D.1
continued

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 Quantity Discounts

 Quantity discounts, which are price incentives to

purchase large quantities, create pressure to
maintain a large inventory.
 For any per-unit price level, P, the total cost is:

Total annual cost = Annual holding cost + Annual

ordering or setup cost + Annual cost of materials
D = annual demand
Q D S = setup costs
C= (H ) + (S) + PD P = per-unit price level
2 Q
H = unit holding cost
Q = ELS

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 Quantity Discounts

C for P = $4.00 EOQ 4.00

C for P = $3.50 EOQ 3.50
C for P = $3.00 EOQ 3.00
Total cost (dollars)

Total cost (dollars)

PD for
P = $4.00 PD for
P = $3.50 PD for
P = $3.00

First Second First Second

price price price price
break break break break

0 100 200 300 0 100 200 300

Purchase quantity (Q) Purchase quantity (Q)

Total cost curves with EOQs and price break quantities

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Pearson Education
materials added
 Finding Q
with Quantity Discounts
 Step 1. Beginning with the lowest price, calculate
the EOQ for each price level until a feasible EOQ
is found.
 It is feasible if it lies in the range corresponding to its
price.
 Step 2. If the first feasible EOQ found is for the
lowest price level, this quantity is the best lot size.
 Otherwise, calculate the total cost for the first feasible
EOQ and for the larger price break quantity at each lower
price level. The quantity with the lowest total cost is
optimal.

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 Example D.2

A supplier for St. LeRoy Hospital has introduced

quantity discounts to encourage larger order quantities
of a special catheter. The price schedule is:

Order Quantity Price per Unit

0 – 299 $60.00 Annual demand (D) = 936 units
300 – 499 $58.80 Ordering cost (S) = $45
500 or more $57.00 Holding cost (H) = 25% of unit price

Step 1: Start with lowest price level:

2DS 2(936)(45)
EOQ 57.00 = = = 77 units
H 0.25(57.00)
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 Example D.2
continued
2DS 2(936)(45)
EOQ 57.00 = = = 77 units
H 0.25(57.00)
Not feasible
2DS 2(936)(45)
EOQ 58.80 = = = 76 units
H 0.25(58.80)
Not feasible
2DS 2(936)(45)
EOQ 60.00 = = = 75 units Feasible
H 0.25(60.00)
This quantity is feasible because it lies in the range corresponding to its price.
Order Quantity Price per Unit
Annual demand (D) = 936 units
0 – 299 $60.00 Ordering cost (S) = $45
300 – 499 $58.80 Holding cost (H) = 25% of unit price
500 or more $57.00
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 Example D.2
continued
 Step 2: The first feasible EOQ of 75 does not correspond to
the lowest price level. Hence, we must compare its total cost
with the price break quantities (300 and 500 units) at the
lower price levels ($58.80 and $57.00):
Q D
C= (H ) + (S) + PD
2 Q
75 936
C75 = [(0.25)($60.00)] + ($45) + $60.00(936) C75 = $57,284
2 75
300 936
C300 = [(0.25)($58.80)] + 300 ($45) + $58.80(936) = $57,382
2
500 936
C500 = [(0.25)($57.00)] + 500 ($45) + $57.00(936) = $56,999
2
The best purchase quantity is 500 units, which qualifies for the deepest
discount.
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 Decision Point:
If the price per unit for the range of 300 to 499 units is reduced to $58.00,
the best decision is to order 300 catheters, as shown below. This shows that
the decision is sensitive to the price schedule. A reduction of slightly more than
1 percent is enough to make the difference in this example.

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 Application D.2

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 Application D.2
Solution

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 One-Period Decisions

 This type of situation is often called the newsboy problem. If

the newspaper seller does not buy enough newspapers to
resell on the street corner, sales opportunities are lost. If the
seller buys too many newspapers, the overage cannot be
sold because nobody wants yesterday’s newspaper.

1. List the different levels of demand that are possible, along

with the estimated probability of each.
2. Develop a payoff table that shows the profit for each
purchase quantity, Q, at each assumed demand level.
3. Calculate the expected payoff for each Q (or row in the payoff
table) by using the expected value decision rule.
4. Choose the order quantity Q with the highest expected
payoff.
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 One-Period Decisions

 The payoff for a given quantity-demand combination depends on

whether all units are sold at the regular profit margin, which results in
two possible cases.
1. If demand is high enough (Q < D) then all of the cases are sold at the
full profit margin, p, during the regular season.
Payoff = (Profit per unit)(Purchase quantity) = pQ
1. If the purchase quantity exceeds the eventual demand (Q > D), only D
units are sold at the full profit margin, and the remaining units
purchased must be disposed of at a loss, l, after the season.

Payoff = (Profit per unit during season) (Demand) – (Loss per unit) (Amount
disposed of after season) = pD – l(Q – D)
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 Example D.3
A gift museum shop sells a Christmas ornament at a $10 profit per unit
during the holiday season, but it takes a $5 loss per unit after the season is
over. The following is the discrete probability distribution for the season’s
demand:
Demand 10 20 30 40 50
Demand Probability 0.2 0.3 0.3 0.1 0.1

Q 10 20 30 40 50 Expected Payoff
10 $100 $100 $100 $100 $100 100
20 50 200 200 200 200 170
30 0 150 300 300 300 195
40 –50 100 250 400 400 175
50 –100 50 200 350 500 140

Payoff
Expected
Payoff if=Q30=ifand
payoff
if Q 30
Q and=D20:
=D30: = 40:
pD –pD
l(Q= –10(30) = $300
0(0.2)+(150(0.3)+300(0.3+0.1+0.1)
D)=10(20) – 5(30 – 20)= =$195
$150
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 Example D.3 OM Explorer Solution

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 Solved Problem 1

 For Peachy Keen, Inc., the average demand for

mohair sweaters is 100 per week. The production
facility has the capacity to sew 400 sweaters per
week. Setup cost is $351. The value of finished
goods inventory is $40 per sweater. The annual per-
unit inventory holding cost is 20 percent of the item’s
value.
 a. What is the economic production lot size (ELS)?
 b. What is the average time between orders (TBO)?
 c. What is the minimum total of the annual holding
cost and setup cost?
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 a.
Solved Problem 1
D = 5,200 d = 100
2DS p p = 400
ELS = S = $351
H p–d H = 20% of $40

2(100)(52)($351) 400
ELS = = 780 sweaters
0.20($40) (400 – 100)

b. ELS 780
TBOELS = = = 0.15 year or 7.8 weeks
c. D 5,200
Q p–d
C =2 p ( D
(H) + Q (S) )
C=
780
2
( )
400 – 100
400
5,200
(0.20 x $40) + 780 ($351)

= 2,340/year + $2,340/year = $4,680/year

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 Solved Problem 3
 For Swell Productions, a concession stand will sell poodle
skirts and other souvenirs of the 1950s a one-time event.
Skirts are purchased for $40 each and are sold during for
$75 each.
 Unsold skirts can be returned for a refund of $30 each. Sales
depend on the weather, attendance, and other variables.
 The following table shows the probability of various sales
quantities. How many skirts should be ordered?

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 Solved Problem 3

The highest expected payoff occurs when 400 skirts are ordered.

Probabilities
0.05 0.11 0.34 0.34 0.11 0.05

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