Chapter Two

Materials
Management
Outline
Introduction
Types of Inventory
Benefits of Inventory
Inventory Cost
Inventory Models
 Economic Order Quantity Models (EOQ)
 Economic Production Quantity (EPQ)
 Price Break Models (Discount)

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 Introduction
 Inventory: an inventory is a stock of material in store used to
facilitate production or to satisfy customer needs.
 Inventory Management: scientific method of finding out how
much stock should be maintained in order to meet the production
demands and be able to provide right type of material at right
time, in right quantities and at competitive prices.
 Inventory control is concerned with achieving an optimum
balance between two competing objectives.
 Minimizing the investment in inventory (Inventory cost).
 Maximizing the service levels to customer’s and it’s operating
departments.

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Types of Inventory
 Raw material (RM)
 Purchased but not processed
 Work-in-process (WIP)
 Undergone some change but not completed
 Maintenance/repair/operating (MRO)
 Replacement parts, tools, & supplies
 Necessary to keep machinery and processes productive
 Finished goods
 Completed product awaiting shipment
 Goods-in-transit to warehouses or customers

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Benefits of Inventory Management
 It helps to meet variation in product demand and have smooth production
requirements.
 The practice identifies and responds to trends to ensure there’s always enough
stock to fulfill customer orders and proper warning of a shortage.
 It provide a safeguard for variation in raw material delivery time.
 It ensures there is enough goods or materials to meet demand without creating
overstock, or excess inventory.

 It help hedge against price increases and to take advantage of quantity

discounts.
 It saves money because stock costs money until used. Carrying costs include
storage handling and transportation fees, insurance and employee salaries.
Inventory is also at risk of theft, loss from natural disasters.

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Inventory Costs
 Holding costs: the costs of holding or “carrying” inventory over
time.
 Housing costs (including rent or depreciation, operating costs,
taxes, insurance)
 Material handling costs (equipment lease or depreciation,
operating cost)
 Labor cost
 Ordering costs: the costs of placing an order and receiving
goods, fixed, constant amount incurred for each order placed.

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 Inventory Models
 Inventory models deals with determining optimum inventory level that should
be kept to keep the inventory cost to the minimum and customer satisfaction or
service level to maximum.
 When to order?
 How much to order?
 How much and when to produce?
 Important terms in inventory models:
 Lead time (L): time interval between ordering and receiving the order (L) or it is the
lapse in time between when an order is placed to replenish inventory and when the
order is received
 Reorder point (R) : is the level of inventory which triggers an action to replenish
that particular inventory stock. It is a minimum amount of an item which a firm
holds in stock, such that, when stock falls to this amount, the item must be
reordered.
 Safety Stock (SS) : It is the minimum quantity of inventory which a firm decides to
maintain always to protect itself against the risk and losses likely to occur due to
stoppage in production and loss of sale, due to non- availability of inventory.

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 Inventory Models
 Economic Order Quantity (EOQ)
 Economic Production Quantity (EPQ)
 Price Discount Models/Price Break Models

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 Economic Order Quantity (EOQ)
 Economic Order Quantity is the level of inventory
that minimizes the total inventory holding costs and
ordering costs. 
 It is one of the oldest classical production scheduling
models. 
 Economic order quantity refers to that number
(quantity) ordered in a single purchase so that the
accumulated costs of ordering and carrying costs are
at the minimum level.
 An optimizing method used for determining order
quantity and reorder points.

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 Part of continuous review system
which tracks on-hand inventory
each time a withdrawal is made.
 Assumptions:
 Only one product is involved
 Annual demand requirement is
known and constant.
 There are no quantity discounts
 Lead time does not vary.
 Each order is received in a
single delivery.

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 EOQ Model
1. You receive an order quantity Q. 4. The cycle then repeats.

Q Q Q

R
L L
2. You start using
them up over time. Time
3. When you reach down to a
R = Reorder point level of inventory of R, you
Q = Economic OQ place your next Q sized order.
L = Lead time

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 EOQ Model Costs

A. Carrying cost are

linearly related to
order size.

B. Ordering costs are

inversely and non
linearly related to
order size.

C. The total cost curve

U-shaped.

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  D  Q 
 S
EOQ  Q   2 
TVC H
Total Annual Variable Costs = Annual
Ordering Costs + Annual Holding Costs
Where
TVC  total annual variable cost
D  annual demand
Q  quantity to be ordered
H  annual holding cost
S  ordering or setup cost
 The optimal quantity
occurs at the intersection
point of holding cost and
ordering cost. So using
this, the Q value at this Reorder level (R) can be computed
point can be computed. as demand during lead time times
lead time.

  =
Q=EOQ R= d*L

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Example
1. Sharp, Inc., a company that markets painless hypodermic
needles to hospitals, would like to reduce its inventory cost by
determining the optimal number of hypodermic needles to obtain
per order. The annual demand is 1,000 units; the setup or
ordering cost is $10 per order; and the holding cost per unit per
year is $.50. Sharp, Inc. has a 250-day working year. Given the
information above,
a) What are the Economic order quantity (EOQ)?
b) Order frequency (N)
c) Cycle interval (T) and
d) Total annual variable cost (TVC)?

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2.  Holding cost per unit per year
 Annual Demand = 1,000 units; = $2.50
 Days per year considered in average 365;  Lead time = 7 days;
 Daily demand = 1000/365;  Cost per unit = $15;
 Cost to place an order = $10;
Given
Given the
the information
information above,
above, what
what are
are the
the EOQ,
EOQ, reorder
reorder point
point
(R),
(R), Order
Order frequency
frequency (N)
(N) and
and Cycle
Cycle interval
interval (T)?
(T)? TVC
TVC and
and total
total
actual
actualcost
cost(TC)?
(TC)?
2D S 2(1,000 )(10)
Q OPT = = = 89.443 un its or 90 un its
H 2.50

1,000 units/year
d= = 2.74 units/day T= Q/d = 32.85 days
365 days/year
_
R = d L = 2.74units/day (7days) = 19.18 or 20 units

N = D/Q = 11.1 Orders  1000   90 

TVC   $10   $2.5  $223.6
 90   2 

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3. Thomas Kratzer is the purchasing manager for the headquarters of a large
insurance company chain with a central inventory operation. Thomas’s fastest-
moving inventory item has a demand of 6,000 units per year. The inventory
carrying cost is $10 per unit per year. The ordering cost is $30 per order. It
takes about 5 days for an order to arrive. There are 250 working days per year.
a) What is the EOQ?
b) What is the average inventory if the EOQ is used?
c) What is the optimal number of orders per year?
d) What is the cycle interval?
e) What is reorder point?
f) What is the total variable cost?

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 Economic Production Quantity (EPQ)
 An optimizing method used for determining production quantity
 Production done in batches.
 Capacity to produce a part exceeds the part’s usage or demand rate.
 Assumptions of EPQ are similar to EOQ except orders are received
incrementally during production.
 Only one item is involved
 Annual demand is known
 Usage rate d is constant
 Usage occurs continually, but production occurs periodically
 Production rate p is constant
 Lead time does not vary

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  The total cost at economic
production is the sum of
holding and setup costs.
 At the optimal point holding
cost and set up costs are equal.
Hence we can derive EPQ
formula as follows:

D  I 
TC EPQ   S    MAX H 
Q   2  t1 = Q/p
t2 = Imax/d
 d
I MAX  Q1  
 p
2 DS
EPQ 
 d
H
1  p 

 

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Example
1. Given:
 Annual demand = 15,000
 Setup cost = $500 per production run
 Holding cost = $50 per item per year
 Number of working days per year = 240
 Annual production rate = 25,000
(a) What is the EPQ?
(b) What is the total cost at EPQ?
(c) What is the maximum inventory level?
(d) What is the total number of production run in a year?
(e) What is the length of production run?
(f) What is the time between production?
(g) What is the length of time with no production?

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Solution :
2DS 2  15000  500
(a) EPQ    866
 d  15000 
H
 1 -  501  
 p
  25000 
 D 
(b) Total cost at EPQ  2  
 EPQ  S 

 
 15000 
 2  500   $17320
 866 
 d   15000 
(c) Maximum inventory, I max  EPQ  1  
  866  1    346
 p   25000 
Annual demand
(d) Total number of production runs in a year 
EPQ
15000
  18
866
EPQ 866
(e) Length of production run, t p    240  8 days
p 25000
240
(f) Time between each production run   14 days
18
(g) Length of time with no production run  14 - 8  6 days

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2. Given
 Holding cost = $18 per unit
 Annual demand = 18,000 units
 Setup time= 5 days
 Production rate = 2500
 No. of operating days per month = 20
units/month
 Setup cost = $800
(a)
(a) What
Whatisisthe
theEPQ?
EPQ?
(b)
(b) What
Whatisisthe
themaximum
maximuminventory
inventorylevel?
level?
(c)
(c) What
Whatisisthe
thetotal
totalcost
costatatEPQ?
EPQ?
(d)
(d) What
Whatisisthe
thetotal
totalnumber
numberof ofproduction
productionrun
runininaayear?
year?
(e)
(e) What
Whatisisthe
thelength
lengthofofproduction
productionrun?
run?
(f)
(f) What
Whatisisthe
thelength
lengthofoftime
timewith
withno
noproduction?
production?
(g)
(g) What
Whatisisthe
thestarting
startingpoint
pointfor
forsetup?
setup?
2 DS
EPQ  N = Annual demand/ EPQ= 9 production
 d
H 1   = 2000 units cycles
 p

Imax = 800 units R = d*L= (1500/20)*5 = 375 Units

t1 = Q/p =16 days

TVC = holding cost + set up cost = $14,400
t2 = Imax/d = 10.66 days
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3. Race One Motors is an Indonesian car manufacturer. At its
largest manufacturing facility, in Jakarta, the company produces
subcomponents at a rate of 300 per day, and the demand 12,500
per year. Holding costs are $2 per item per year, and ordering
(setup) costs are $30 per order. There are 250 working days.
a)What is the economic production quantity?
b)How many production runs per year will be made?
c)What will be the maximum inventory level?
d)What is the total variable cost?

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 Quantity discounts Model
 The quantity discount, mean the price per unit decreases
as order quantity increases.
 Lower prices may be available for larger orders
 Higher storage and holding costs
 By investing in more inventory, you will have less cash to
invest elsewhere!
 If we have quantity discount, then we should weigh the
benefit of price discount against the increase in inventory
cost.

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QD Procedure
1. Calculate the EOQ at the lowest price
2. Determine whether the EOQ is feasible at that price
(will the vendor sell that quantity at that price?)
3. If yes, stop – if no, continue
4. Check the feasibility of EOQ at the next higher price
5. Continue until you identify a feasible EOQ
6. Calculate the total costs (including purchase price) for
the feasible EOQ model
7. Calculate the total costs of buying at the minimum
quantity allowed for each of the cheaper unit prices
8. Compare the total cost of each option & choose the
lowest cost alternative
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Optimal policy for “All- Units” Discount schedule
Example: The weighty trash bag Co. has the following price schedule

Order Price / Units ($)

Less than 500 bags 0.30
500 less than 1000 0.29
1000 + 0.28

The discount schedule is All- Units because the discount is applied to all of the units in an
order.
The order cost function C (Q) is defined as follows:
0.3Q 0≤ Q < 500
C(Q) = 0.29Q For 500≤ Q < 1000
0.28Q `1000≤ Q
 The weighty Trash bag Co uses trash bags at a fairly constant rate of 600 per year. The accounting
departments estimates the fixed cost of placing an order is $ 8 and the holding cost are based on a
20 percent annual interest rate.

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The average annual cost function
Same
•   as the EOQ, except:
Unit price depends upon the quantity ordered
 Adjusted total cost equation:
 TC = + S() + () (h)

+ S() + () (h) 0 Q 500

G (Q) = + S() + () (h) for 500 Q1000
+ S() + () (h) 1000 Q

= = =
Optimal solution
The largest realizable (feasible) EOQ
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Example
1. Given:
 Annual demand = 100 units
 Ordering cost = $45 per order
 Holding cost per year = 20% of item cost
 Quantity discounts:

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 Solution:
The lowest cost per item is $12 if ordered 60 units or more

2DS 2  100  45
EOQ    62 units
H 0.2  12
Ordering 62 units a time qualifies for the lowest
discounted price of $12 per item
 The EOQ is found feasible
D EOQ
TC EOQ  S  H  PD
EOQ 2
100 62
  $45   0.2  $12  $12  100
62 2
 73.5  73.5  1200  $1347

Order at 62 units at a time is the recommended policy

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2. Given:
 Annual demand = 100 units
 Ordering cost = $45 per order
 Holding cost per year = 20% of item cost
 Quantity discounts:

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 The lowest cost per item is $12 if ordered 100 units or
more
2DS 2  100  45
EOQ    62 units
H 0.2  12
Ordering 62 units a time does not qualify
for the discounted price of $12 per item
 The EOQ is found infeasible
 The next lowest cost per item is $16 if ordered between
51 to 99 units

2DS 2  100  45
EOQ    54 units
H 0.2  16
Ordering 54 units a time qualifies
for the discounted price of $16 per item
 The EOQ is found feasible
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 Cost comparison
D EOQ
TC EOQ  54  S  H  PD
EOQ 2
100 54
  $45   0.2  $16  $16  100
54 2
 85  85  1600  $1,770
D Q
TC Q  100  S  H  PD
Q 2
100 100
  $45   0.2  $12  $12  100
100 2
 45  120  1200  $1,365
 TC Q  100 yields a lower total cost

 Order at 100 units at a time is recommended.

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3. Given:
 Annual demand = 100 units
 Ordering cost = $45 per order
 Holding cost per year = 20% of item cost
 Quantity discounts:

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 The lowest cost per item is $12 if ordered 100 units or
more
2DS 2  100  45
EOQ    62 units
H 0.2  12
Ordering 62 units a time does not qualify
for the discounted price of $12 per item
 The EOQ is found infeasible

 The next lowest cost per item is $16 if ordered between

56 to 99 units
2DS 2  100  45
EOQ    54 units
H 0.2  16
Ordering 54 units a time does not qualify
for the discounted price of $16 per item
 The EOQ is found infeasible
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 The remaining cost per item is $18 if ordered less
than 56 units

2DS 2  100  45
EOQ    50 units
H 0.2  18
Ordering 50 units a time at $18 per item
 The EOQ is found feasible

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 Cost comparison
100 50
TC EOQ  50   $45   0.2  $18  $18  100
50 2
 90  90  1800  $1,980
100 56
TC Q  56   $45   0.2  $16  $16  100
56 2
 90  81  1600  $1,771
D Q
TC Q  100  S  H  PD
Q 2
100 100
  $45   0.2  $12  $12  100
100 2
 45  120  1200  $1,365
 TC Q  100 yields the lowest total cost

36
4.Given
 The weighty Trash bag Co uses trash bags at a fairly constant rate of 600 per year. The
accounting departments estimates the fixed cost of placing an order is $ 8 and the holding
cost are based on a 20 percent item cost.

Order Price / Units ($)

Less than 500 bags 0.30
500 less than 1000 0.29
1000 + 0.28

The discount schedule is All- Units because the discount is applied to all of the
units in an order.
The order cost function C (Q) is defined as follows:
0.3Q 0≤ Q < 500
C(Q) = 0.29Q For 500≤ Q < 1000
0.28Q `1000≤ Q

37
The average annual cost function
Same
•   as the EOQ, except:
Unit price depends upon the quantity ordered
 Adjusted total cost equation:
 TC = (Q) = + S() + () (h)

+ S() + () (h) 0 Q 500

G (Q) = + S() + () (h) for 500 Q1000
+ S() + () (h) 1000 Q

= = =
Optimal solution
The largest realizable (feasible) EOQ
One of the break points that exceed it
38

• For
  =0.28, = = = 414 Not feasible
 For =0.29, = = = 406 Not feasible
 For =0.30, = = = 400 feasible…stop
Evaluate TC
TC= G(400)=(600)(0.3) +(600)(8)/400 +(0.2)(0.3)(400)/2 = $204
TC= G(500)=(600)(0.29) +(600)(8)/500 +(0.2)(0.29)(500)/2 =
$198.1
TC= G(1000)=(600)(0.28) +(600)(8)/1000 +0.2(0.28)(1000)/2 =
$200.8

39
 Summary of the solution technique for
“All-Units” Discounts

1) Determine the largest realizable EOQ value. The most

efficient way to do this is to compute the EOQ for the
lowest price first, and continue with the next higher
price. Stop when the first EOQ value is realizable (that
is, with in the correct interval).
2) Compare the value of the average annual cost at the
largest realizable EOQ and at all the price breakpoints
that are greater than the largest realizable EOQ. The
optimal Q is the point at which the average annual cost
is minimum.

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THANK YOU!!!

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