Inventory Control Models: To Accompany

Chapter 6
Inventory Control Models
To accompany
Quantitative Analysis for Management, Tenth Edition,
by Render, Stair, and Hanna © 2008 Prentice-Hall, Inc.
Power Point slides created by Jeff Heyl © 2009 Prentice-Hall, Inc.
Introduction
 Inventory is an expensive and important
asset to many companies
 Lower inventory levels can reduce costs
 Low inventory levels may result in stockouts
and dissatisfied customers
 Most companies try to balance high and low
inventory levels with cost minimization as a
goal
 Inventory is any stored resource used to
satisfy a current or future need
 Common examples are raw materials, work-
in-process, and finished goods
© 2009 Prentice-Hall, Inc. 6–2

Introduction
 Basic components of inventory
planning
 Planning what inventory is to be
stocked and how it is to be acquired
(purchased or manufactured)
 This information is used in
forecasting demand for the inventory
and in controlling inventory levels
 Feedback provides a means to revise
the plan and forecast based on
experiences and observations

Introduction
 Inventory may account for 50% of the total
invested capital of an organization and 70% of the
cost of goods sold
Capital
Energy Costs
Costs
Labor Costs
Inventory
Costs

Introduction
 All organizations have some type of inventory
control system
 Inventory planning helps determine what
goods and/or services need to be produced
 Inventory planning helps determine whether
the organization produces the goods or
services or whether they are purchased from
another organization
 Inventory planning also involves demand
forecasting

The Inventory Process
Suppliers Customers
Inventory Storage
Raw Finished
Materials Goods
Work in Fabrication/
Process Assembly
Inventory Processing
Introduction
 Inventory planning and control
Planning on What
Forecasting Controlling
Inventory to Stock
Parts/Product Inventory
and How to Acquire
Demand Levels
It
Feedback Measurements
to Revise Plans and
Forecasts
Figure 6.1

Importance of Inventory Control
 Five uses of inventory

 The decoupling function
 Storing resources
 Irregular supply and demand
 Quantity discounts
 Avoiding stockouts and shortages
 The decoupling function

 Used as a buffer between stages in a
manufacturing process
 Reduces delays and improves efficiency

 Storing resources
 Seasonal products may be stored to satisfy
off-season demand
 Materials can be stored as raw materials,
work-in-process, or finished goods
 Labor can be stored as a component of
partially completed subassemblies
 Irregular supply and demand
 Demand and supply may not be constant over
time
 Inventory can be used to buffer the variability

 Quantity discounts
 Lower prices may be available for larger orders
 Cost of item is reduced but storage and insurance
costs increase, as well as the chances for more
spoilage, damage and theft.
 Investing in inventory reduces the available funds
for other projects
 Avoiding stockouts and shortages
 Stockouts may result in lost sales
 Dissatisfied customers may choose to buy from
another supplier
© 2009 Prentice-Hall, Inc. 6 – 10

Inventory Decisions
 There are only two fundamental decisions
in controlling inventory
 How much to order
 When to order
 The major objective is to minimize total
inventory costs
 Common inventory costs are
 Cost of the items (purchase or material cost)
 Cost of ordering
 Cost of carrying, or holding, inventory
 Cost of stockouts

Inventory Cost Factors
ORDERING COST FACTORS CARRYING COST FACTORS
Developing and sending purchase orders Cost of capital
Processing and inspecting incoming
Taxes
inventory
Bill paying Insurance
Inventory inquiries Spoilage

Utilities, phone bills, and so on, for the
purchasing department Theft
Salaries and wages for the purchasing

Obsolescence
department employees
Supplies such as forms and paper for the Salaries and wages for warehouse
purchasing department employees
Utilities and building costs for the
warehouse
Supplies such as forms and paper for the
warehouse
Table 6.1
Inventory Cost Factors
 Ordering costs are generally independent
of order quantity
 Many involve personnel time
 The amount of work is the same no matter the
size of the order
 Carrying costs generally varies with the
amount of inventory, or the order size
 The labor, space, and other costs increase as
the order size increases
 Of course, the actual cost of items
purchased varies with the quantity
purchased
Economic Order Quantity
 The economic order quantity (EOQ)

model is one of the oldest and most
commonly known inventory control
techniques
 It dates from a 1915 publication by
Ford W. Harris
 It is still used by a large number of
organizations today
 It is easy to use but has a number of
important assumptions
Economic Order Quantity
 Assumptions
1. Demand is known and constant
2. Lead time (the time between the placement and
receipt of an order) is known and constant
3. Receipt of inventory is instantaneous
 Inventory from an order arrives in one batch, at
one point in time
4. Purchase cost per unit is constant throughout
the year; no quantity discounts
5. The only variable costs are the placing an order,
ordering cost, and holding or storing inventory
over time, holding or carrying cost, and these
are constant throughout the year
6. Orders are placed so that stockouts or shortages
are avoided completely
Inventory Usage Over Time
 Inventory usage has a sawtooth shape
 Inventory jumps from 0 to the maximum when the shipment arrives
 Because demand is constant over time, inventory drops at a uniform
rate over time
Inventory
Level
Order Quantity = Q =
Maximum Inventory Level
Minimum
Inventory
0
Figure 6.2 Time
EOQ Inventory Costs
 The objective is to minimize total costs
 The relevant costs are the ordering and
carrying/holding costs, all other costs are constant.
Thus, by minimizing the sum of the ordering and
carrying costs, we are also minimizing the total costs
 The annual ordering cost is the number of orders per
year times the cost of placing each order
 As the inventory level changes daily, use the average
inventory level to determine annual holding or
carrying cost
 The annual carrying cost equals the average inventory
times the inventory carrying cost per unit per year
 The maximum inventory is Q and the average inventory
is Q/2.
Inventory Costs in the EOQ Situation
 Objective is generally to minimize total cost
 Relevant costs are ordering costs and carrying
costs
Q
Average inventory level 
2
INVENTORY LEVEL
DAY BEGINNING ENDING AVERAGE
April 1 (order received) 10 8 9
April 2 8 6 7
April 3 6 4 5
April 4 4 2 3
April 5 2 0 1
Maximum level April 1 = 10 units
Total of daily averages = 9 + 7 + 5 + 3 + 1 = 25
Number of days = 5
Average inventory level = 25/5 = 5 units Table 6.2

 Develop an expression for the ordering cost.
 Develop and expression for the carrying cost.
 Set the ordering cost equal to the carrying

cost.
 Solve this equation for the optimal order

quantity, Q*.

 Mathematical equations can be developed using

Q = number of pieces to order
EOQ = Q* = optimal number of pieces to order
D = annual demand in units for the inventory item
Co = ordering cost of each order
Ch = holding or carrying cost per unit per year
Number of Ordering
Annual ordering cost  orders placed  cost per
per year order
Annual Demand
 Cost per order
Number of units per order
D
 Co
Q
 Mathematical equations can be developed using
Q = number of pieces to order

EOQ = Q* = optimal number of pieces to order
D = annual demand in units for the inventory item
Co = ordering cost of each order
Ch = holding or carrying cost per unit per year
Average Carrying
Annual holding cost  inventory  cost per unit
per year
Q
 Ch
2
D Q
 Total Inventory Cost = Co  Ch
Q 2
Optimal Order Quantity is when the Total Cost curve is at its
lowest . This occurs when the Ordering Cost = Carrying Cost
Cost
Curve of Total Cost
of Carrying
and Ordering
Minimum
Total
Cost
Carrying Cost Curve
Ordering Cost Curve
Optimal Order Quantity

Order
Quantity
Figure 6.3 © 2009 Prentice-Hall, Inc. 6 – 22
Finding the EOQ
 When the EOQ assumptions are met, total cost is
minimized when Annual ordering cost = Annual
holding cost
D Q
Co  Ch
Q 2
 Solving for Q
2 DC o  Q 2C h
2 DC o
 Q2
Ch
2 DC o
 Q  EOQ  Q *
Ch
Economic Order Quantity (EOQ) Model
 Summary of equations
D
Annual ordering cost  C o
Q
Q
Annual holding cost  C h
2
2 DC o
EOQ  Q *
Ch

Sumco Pump Company Example
 Company sells pump housings to other
companies
 Would like to reduce inventory costs by finding
optimal order quantity
 Annual demand = 1,000 units
 Ordering cost = $10 per order
 Average carrying cost per unit per year = $0.50
2 DC o 2(1,000 )(10 )
Q*    40,000  200 units
Ch 0.50

Total annual cost = Order cost + Holding cost

D Q
TC  C o  C h
Q 2
1,000 200
 (10)  (0.5 )
200 2
 $50  $50  $100

Program 6.1A
Program 6.1B
Purchase Cost of Inventory Items
 Total inventory cost can be written to include the
cost of purchased items
 Given the EOQ assumptions, the annual
purchase cost is constant at D  C no matter the
order policy
 C is the purchase cost per unit
 D is the annual demand in units
 It may be useful to know the average dollar level
of inventory
(CQ )
Average dollar level 
2
Purchase Cost of Inventory Items
 Inventory carrying cost is often expressed as an
annual percentage of the unit cost or price of the
inventory
 This requires a new variable
Annual inventory holding charge as

I  a percentage of unit price or cost
 The cost of storing inventory for one year is then
C h  IC
2 DC o
thus, Q 
*
IC
Sensitivity Analysis with the
EOQ Model
 The EOQ model assumes all values are know and
fixed over time
 Generally, however, the values are estimated or
may change
 Determining the effects of these changes is
called sensitivity analysis
 Because of the square root in the formula,
changes in the inputs result in relatively small
changes in the order quantity
2 DC o
EOQ 
Ch

Sensitivity Analysis with the
EOQ Model
 In the Sumco example
2(1,000)(10)
EOQ   200 units
0.50
 If the ordering cost were increased four times from

$10 to $40, the order quantity would only double
2(1,000 )( 40 )
EOQ   400 units
0.50
 In general, the EOQ changes by the square root

of a change to any of the inputs

Reorder Point:
Determining When To Order
 Once the order quantity is determined, the next
decision is when to order
 The time between placing an order and its
receipt is called the lead time (L) or delivery
time
 Inventory must be available during this period to
met the demand
 When to order is generally expressed as a
reorder point (ROP) – the inventory level at
which an order should be placed
Demand Lead time for a
ROP  per day  new order in days
dL
Determining the Reorder Point
 The slope of the graph is the daily inventory
usage
 Expressed in units demanded per day, d
 If an order is placed when the inventory level
reaches the ROP, the new inventory arrives at
the same instant the inventory is reaching 0

Procomp’s Computer Chip Example
 Demand for the computer chip is 8,000 per year

 Daily demand is 40 units
 Delivery takes three working days
ROP  d  L  40 units per day  3 days

 120 units
 An order is placed when the inventory reaches

120 units
 The order arrives 3 days later just as the
inventory is depleted

The Reorder Point (ROP) Curve
Inventory Level (Units)
Q*
Slope = Units/Day = d
ROP
(Units)
Lead Time (Days) L

EOQ Without The
Instantaneous Receipt Assumption
 When inventory accumulates over time, the
instantaneous receipt assumption does not apply
 Daily demand rate must be taken into account
 The revised model is often called the production
run model
Inventory
Level Part of Inventory Cycle There is No Production
During Which Production is During This Part of the
Taking Place Inventory Cycle
Maximum
Inventory
t Time
Figure 6.5
EOQ Without The
Instantaneous Receipt Assumption
 Instead of an ordering cost, there will be a
setup cost – the cost of setting up the
production facility to manufacture the desired
product
 Includes the salaries and wages of employees
who are responsible for setting up the
equipment, engineering and design costs of
making the setup, paperwork, supplies,
utilities, etc.
 The optimal production quantity is derived by
setting setup costs equal to holding or
carrying costs and solving for the order
quantity
Annual Carrying Cost for
Production Run Model
 In production runs, setup cost replaces ordering
cost
 The model uses the following variables
Q  number of pieces per order, or

production run
Cs  setup cost
Ch  holding or carrying cost per unit
per year
p  daily production rate
d  daily demand rate
t  length of production run in days

Maximum inventory level
 (Total produced during the production run)
– (Total used during the production run)
 (Daily production rate)(Number of days production)
– (Daily demand)(Number of days production)
 (pt) – (dt)
since Total produced  Q  pt

Q
we know t
p
Maximum Q Q  d
inventory  pt  dt  p  d  Q 1  
level p p  p
 Since the average inventory is one-half the
maximum
Q d 
Average inventory   1  
2 p
and
Q d 
Annual holding cost   1  C h
2 p

Annual Setup Cost for
 Setup cost replaces ordering cost when a
product is produced over time
(independent of the size of the order and
the size of the production run)
D
Annual setup cost  C s
Q
and
D
Annual ordering cost  Co
Q

Determining the Optimal
Production Quantity
 By setting setup costs equal to holding costs, we
can solve for the optimal order quantity
Annual holding cost  Annual setup cost
Q d  D
 1   h
C  Cs
2 p Q
 Solving for Q, we get
2 DC s
Q* 
 d
C h  1 
 p
 Summary of equations
Q d 
Annual holding cost   1  C h
2 p
D
Annual setup cost  C s
Q
2 DC s
Optimal production quantity Q 
*
 d
C h  1 
 p
If the situation does not involve production but receipt
of inventory over a period of time, use the same model
but replace Cs with Co
Brown Manufacturing Example
 Brown Manufacturing produces commercial

refrigeration units in batches
Annual demand  D  10,000 units

Setup cost  Cs  $100
Carrying cost  Ch  $0.50 per unit per year
Daily production rate  p  80 units daily
Daily demand rate  d  60 units daily
How many refrigeration units should Brown produce

in each batch?
How long should the production cycle last?
2 DC s Q
1. Q 
*
Production cycle 
 d p
C h  1 
 p 4,000
  50 days
80
2  10,000  100
2. Q* 
 60 
0 .5  1  
 80 
2,000 ,000
  16,000 ,000
 
0.5 1
4
 4,000 units
Program 6.2A
Program 6.2B
Quantity Discount Models
 Quantity discounts are commonly available
 The basic EOQ model is adjusted by adding in the
purchase or materials cost
Total cost  Material cost + Ordering cost + Holding cost

D Q
Total cost  DC  C o  C h
Q 2
where
D  annual demand in units
Cs  ordering cost of each order
C  cost per unit
Ch  holding or carrying cost per unit per year
Because
 Quantity unitare
discounts cost is now variable
commonly available
 The basic EOQHolding
modelcost  Ch  IC
is adjusted by adding in the
purchase
I  holdingorcost
materials cost
as a percentage of the unit cost (C)
Total cost  Material cost + Ordering cost + Holding cost
D Q
Total cost  DC  C o  C h
Q 2
where
D  annual demand in units
Cs  ordering cost of each order
C  cost per unit
Ch  holding or carrying cost per unit per year
 A typical quantity discount schedule
DISCOUNT DISCOUNT DISCOUNT

NUMBER QUANTITY DISCOUNT (%) COST ($)
1 0 to 999 0 5.00
2 1,000 to 1,999 4 4.80
3 2,000 and over 5 4.75
Table 6.3
 Buying at the lowest unit cost is not always the

best choice

 Total cost curve for the quantity discount model
Total
TC Curve for Discount 3
Cost
$ TC Curve for
Discount 1
TC Curve for Discount 2
EOQ for Discount 2
0 1,000 2,000
Figure 6.6 Order Quantity
Brass Department Store Example
 Brass Department Store stocks toy race cars
 Their supplier has given them the quantity
discount schedule shown in Table 6.3
 Annual demand is 5,000 cars, ordering cost is $49, and
holding cost is 20% of the cost of the car
 The first step is to compute EOQ values for each
discount
(2)(5,000 )(49)
EOQ1   700 cars per order
(0.2)(5.00)
(2)(5,000)( 49)
EOQ 2   714 cars per order
(0.2)(4.80)
(2)(5,000)( 49)
EOQ 3   718 cars per order
(0.2)(4.75 )
 The second step is adjust quantities below the

allowable discount range
 The EOQ for discount 1 is allowable
 The EOQs for discounts 2 and 3 are outside the
allowable range and have to be adjusted to the
smallest quantity possible to purchase and
receive the discount
Q1  700
Q2  1,000
Q3  2,000

 The third step is to compute the total cost for
each quantity
ANNUAL ANNUAL ANNUAL

UNIT ORDER MATERIAL ORDERING CARRYING
DISCOUNT PRICE QUANTITY COST ($) COST ($) COST ($)
NUMBER (C) (Q) = DC = (D/Q)Co = (Q/2)Ch TOTAL ($)
1 $5.00 700 25,000 350.00 350.00 25,700.00
2 4.80 1,000 24,000 245.00 480.00 24,725.00
3 4.75 2,000 23,750 122.50 950.00 24,822.50
Table 6.4
 The fourth step is to choose the alternative

with the lowest total cost
Program 6.3A
Program 6.3B

Use of Safety Stock
 If demand or the lead time are uncertain,

the exact ROP will not be known with
certainty
 To prevent stockouts, it is necessary to
carry extra inventory called safety stock
 Safety stock can prevent stockouts when
demand is unusually high
 Safety stock can be implemented by
adjusting the ROP

Use of Safety Stock
 The basic ROP equation is
ROP  d  L
d  daily demand (or average daily
demand)
L  order lead time or the number of
working days it takes to deliver an order
(or average lead time)
 A safety stock variable is added to the equation
to accommodate uncertain demand during lead
time
ROP  d  L + SS
where
SS  safety stock

Use of Safety Stock
Inventory
on Hand
Time
Figure 6.7(a) Stockout
Use of Safety Stock
Inventory
on Hand
Safety
Stock, SS
Stockout is Avoided
Time
Figure 6.7(b)

Inventory Control Models: To Accompany

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Chapter 6

Inventory Control Models

© 2009 Prentice-Hall, Inc. 6–2

© 2009 Prentice-Hall, Inc. 6–3

© 2009 Prentice-Hall, Inc. 6–4

© 2009 Prentice-Hall, Inc. 6–5

© 2009 Prentice-Hall, Inc. 6–7

 Five uses of inventory

 The decoupling function

© 2009 Prentice-Hall, Inc. 6–8

© 2009 Prentice-Hall, Inc. 6–9

© 2009 Prentice-Hall, Inc. 6 – 10

© 2009 Prentice-Hall, Inc. 6 – 11

Inventory inquiries Spoilage

Salaries and wages for the purchasing

 The economic order quantity (EOQ)

© 2009 Prentice-Hall, Inc. 6 – 18

 Develop an expression for the ordering cost.

 Develop and expression for the carrying cost.

 Set the ordering cost equal to the carrying

 Solve this equation for the optimal order

© 2009 Prentice-Hall, Inc. 6 – 19

 Mathematical equations can be developed using

 Mathematical equations can be developed using

Q = number of pieces to order

Carrying Cost Curve

Ordering Cost Curve

Optimal Order Quantity

© 2009 Prentice-Hall, Inc. 6 – 24

© 2009 Prentice-Hall, Inc. 6 – 25

Total annual cost = Order cost + Holding cost

© 2009 Prentice-Hall, Inc. 6 – 26

Annual inventory holding charge as

 The cost of storing inventory for one year is then

© 2009 Prentice-Hall, Inc. 6 – 31

 If the ordering cost were increased four times from

 In general, the EOQ changes by the square root

© 2009 Prentice-Hall, Inc. 6 – 32

© 2009 Prentice-Hall, Inc. 6 – 34

 Demand for the computer chip is 8,000 per year

ROP  d  L  40 units per day  3 days

 An order is placed when the inventory reaches

© 2009 Prentice-Hall, Inc. 6 – 35

Lead Time (Days) L

Q  number of pieces per order, or

© 2009 Prentice-Hall, Inc. 6 – 39

since Total produced  Q  pt

© 2009 Prentice-Hall, Inc. 6 – 41

© 2009 Prentice-Hall, Inc. 6 – 42

Annual holding cost  Annual setup cost

 Solving for Q, we get

 Brown Manufacturing produces commercial

Annual demand  D  10,000 units

How many refrigeration units should Brown produce

Total cost  Material cost + Ordering cost + Holding cost

DISCOUNT DISCOUNT DISCOUNT

2 1,000 to 1,999 4 4.80

3 2,000 and over 5 4.75

 Buying at the lowest unit cost is not always the

© 2009 Prentice-Hall, Inc. 6 – 51

TC Curve for Discount 2

EOQ for Discount 2

 The second step is adjust quantities below the