QUANTITATIVE ANALYSIS IN MANAGEMENT

DECISIONS

Lecture 11
Inventory Model
Course leader : Dr. B Dayal
Mobile No.: 00251941962113
Email ID: i_dayal77@yahoo.com
 INTRODUCTION
 THE INVENTORY
Inventory is an idle stock of items for future use. The two key
issues in inventory model are:
 The quantity (how much)
 The timing (when)
The objective is to minimize the total inventory cost of carrying
(holding) cost and ordering cost.
An inventory model may be of:
 Independent demand or
 Dependent demand
In an independent demand model, the demand for an item is
independent of the demands for other items in inventory.
In a dependent demand model, the demand for an item is
dependent upon the demands for other items in inventory.
Usually end-products (finished goods) are example of
independent inventories while assembly – components are
examples of dependent demand inventories.
DETERMINATION OF FIXED ORDER
QUANTITIES
 We will consider optimal order quantities (EOQ), for the
following three cases:
 EOQ for purchasing
 EOQ for production
 EOQ for quantity discounts.
 Economic order quantity for purchasing
TC = Annual carrying cost + annual ordering cost = (Q/2)C
+ (D/Q)S
Where, D = annual demand
Q = quantity ordered
C = unit carrying cost per year
= holding rate ® x unit acquisition cost (P)
S = ordering cost
DETERMINATION OF FIXED ORDER
QUANTITIES
Where, TC = total annual inventory cost
To find EOQ, set the derivative of TC to zero and solve for Q:
EOQ = Q* = (2DS/C)0.5
Number of orders per year (frequency of ordering) = F = D/Q*
Example: given demand D = 420 items per year, ordering cost
= birr 45 and carrying cost C = birr 15 per unit. Find EOQ
and F.
Q* = (2DS/C)0.5 = (2 x 420 x 45/15)0.5 = 50.20 units
F = D / Q* = 420 / 50.20 = 8.37
 Economic order quantity for production
TC = Annual carrying cost + annual set up cost
= (Q/2) [(p – d)/p] + DS/Q
Where, d = demand rate (unit per time period)
DETERMINATION OF FIXED ORDER
QUANTITIES
Where, TC = total annual inventory cost
p = production rate
S = setup cost
(Q/2) [(p – d)/p] = average inventory level
To find EOQ, set the derivative of TC with respect to Q to zero
and solve for Q:
EOQ = Q* = [(2DS/C)(p/(p-d)]0.5
Example: given annual demand D = 20000 units per year, daily
production rate p = 160 units, daily usage rate d = 80 units,
setup cost S = birr 120, unit holding cost per year C = 20%
of unit manufacturing cost per year (birr 4.00). Find EOQ.
Q* = (2DS/C)(p/(p-d))0.5 = [2 x 20000 x 120/ (160/(160 – 80)]0.5 =
3464.10 units
DETERMINATION OF FIXED ORDER
QUANTITIES
Assuming the production rate p is larger than the demand
rate d,
Maximum inventory Im = (p – d)Q* / d = [(2DS(p – d)/Cp]0.5
Where, Q/p = length of production run or production run
time
Then annual inventory cost = TC = (Im . C/2) + (DS/Q*)
DETERMINATION OF FIXED ORDER
QUANTITIES
 Economic order quantity (EOQ) for quantity discounts
In the previous two cases, the unit purchasing cost or the unit
production cost (p) is constant and hence is not considered.
However, if quantity discounts or price breaks are offered
for large order quantities, p will depend upon order quantity.
Thus, in this model, p should also be considered in the total
cost equation as follows:
TC = annual carrying cost + annual ordering cost + annual
acquisition cost
For instantaneous delivery,
TC = QC/2 + DS/Q + DP
And the EOQ is determined by
EOQ = Q* = (2DS/C)0.5
DETERMINATION OF FIXED ORDER
QUANTITIES
 Economic order quantity (EOQ) for quantity discounts
(Contd)
For gradual delivery,
TC = (QC/2)[(p – d)/p] + DS/Q + DP
And the EOQ is determined by
EOQ = Q* = EOQ = Q* = (2DS/C)(p/(p-d))0.5
The price reductions are usually offered in a series of
ranges, as illustrated in the price list of the following
example.
Order quantity Price per unit
1 to 119 Birr 42
120 to 169 41
170+ 40
DETERMINATION OF FIXED ORDER
QUANTITIES
 Economic order quantity (EOQ) for quantity discounts
(contd)
The following approach is recommended in determining the
order quantity with the lowest annual total cost:
 Step 1: compute the EOQ using each of the unit prices.
 Step 2: determine which EOQ of step 1 is feasible.
 Step 3: the feasible EOQ corresponding to the lowest unit
price is the admissible EOQ.
 Step 4: Compute TCs for the admissible EOQ and for
quantities at lower unit price breaks.
 Step 5: The quantity with lowest TC is the optimum.
 DETERMINATION OF ORDER
POINTS (OP)
The above EOQ models dealt with one key issue of inventory
Models, namely “how much” to order. The other issue of “when” to order will
be handled by the OP models. It is time to order when the inventory level
falls to OP, which is determined by
OP = EDDLT + SS
Where EDDLT = expected demand during lead time
Lead time = time between points of order and receipt
SS = Safety Stock = Buffer stock to prevent stockouts, when actual demand
exceeds expected demand
Since it is difficult to evaluate the stockout cost, we will set the order point at
some specified customer service level, which is the probability that a
stockout will not occur.
 DETERMINATION OF ORDER
POINTS (OP)
There are two types of demand during lead time (DDLT) distributions:
 A discrete DDLT distribution for a small number of units and
 A continuous DDLT distribution for a large number of units
 solved problem 15.11 exemplifies the simple method of finding the
order point and safety stock for a discrete DDLT distribution, based
on sufficient past data. Also a Poisson distribution may be assumed
to describe a discrete DDLT distribution, as illustrated in the solved
problem 15.12.
On the other hand for a continuous DDLT random variable, we
assume a normal distribution. The order point is given by OP =
EDDLT + Z σdl
 DETERMINATION OF ORDER
POINTS (OP)
Where EDDLT = mean of demand during lead time
Z = number of standard deviations from the mean
σdl = standard deviation of demand during lead time
in developing OP models we assume the lead time to be stable
without seasonal patterns. There are three cases which contribute
to variability of demand during lead time:
 variable demand (with constant lead time)
 variable lead time (with constant periodic demand)
 variable demand and variable lead time.
Case 1: demand is variable and lead time is constant:
OP = d’t + Zσd(t)0.5
 DETERMINATION OF ORDER
POINTS (OP)
Where
d’ = average periodic demand
t = lead time duration
σd = standard deviation of periodic demand
σd(t)0.5 = σdl since the standard deviation of demand during lead time is the
square root of σd2t which is the sum of periodic demand variances.
Case 2: demand is constant and lead time is variable:
OP = dt’ + Zdσt
Where t’ = average lead time
σt = standard deviation of the lead time
d = periodic demand
Case 3: both demand and lead time are variable
OP = d’t’ + Z(σd2t’ + d’2σt2)0.5
2)0.5
 INVENTORY SHORTAGE
Since shortage cost is a function of the shortage amount, it is
necessary to know the average number of units short.
Assume that the demand during lead time has a normal
distribution then,
E(n) = E(Z). σd
Where E(n) = average number of units short during lead
time
E(Z) = standardized number of units short (from unit
normal loss function tables)
σd = standard deviation of demand during lead time
Average number of units short per year E(N) is determined as
follows.
E(N) = E(n) . D/Q
 FIXED ORDER PERIOD MODELS
So far we dealt with fixed order quantity models based on EOQ and OP
concepts, that is, to order the amount of EOQ when the inventory
level hits the amount of OP. In such models, the order quantity is
fixed while the order interval varies. However, the fixed order period
models deal with ordering varied amounts at fixed intervals of time.
Consider the case where demand is variable and lead time is constant.
Assume that the demand follows a normal distribution. Then the
order quantity is given by
Q* = d(T + t) + Zσd (T +t)0.5 - I
σd = standard deviation of demand
T = fixed order period
t = lead time duration
I = amount of inventory on hand
 SINGLE PERIOD MODELS

The above fixed order quantity models and fixed order

period models are useful when the remaining inventory of
one order cycle can be forwarded to the next order cycle or
face a penalty for carryover. The objective of the single
period model is to minimize the costs of overstock and
under stock. This is achieved when the order quantity
satisfies the following optimum service level equation.
service level = CV / (CV - Co)
Where CV = understock cost = revenue/unit – cost/unit
Co = overstock cost = cost/unit + carrying cost / unit -
salvage value/unit
 EXAMPLE 1

 Consider an inventory system with the following data:

 Annual demand for a particular item: 1500 units
 Carrying cost of one unit; $ 0.15;
 Ordering cost: $15
Determine:
(a)Economic Order Quantity
(b) number of orders per year
(c) total inventory cost per year.
 EXAMPLE 2

 The Mesfin Retail Company has the following data

available for one of its items:
 D = 10,000 units
 S = $20.00;
 C = 25% 0f the acquisition cost: $25
Determine:
(a)Economic Order Quantity
(b) number of orders per year
(c) total inventory cost.
 EXAMPLE 2

 American Corporation supplies West Engineering

company a chemical at the rate of 5500 barrels per day at
the price of $19.10 per barrel. West Engineering uses the
chemical at the rate of 2200 barrels per day and 550000
barrels per years. The ordering cost is $3250 per year and
the holding cost is 25% of the price per barrel per year.
Determine:
(a)Economic Order Quantity
(b) TC at EOQ
(c) number of production days per order
(d)Maximum storage capacity for the chemical.