MODULE 3 - INVENTORY MODELS

• This module introduces inventory models.

• At the end of this module you will be able to
– State some reasons for carrying inventory
– State major items of cost of inventory, and
– State the main categories of inventory models
– State Deterministic Inventory model assumptions,
– Graphically present Deterministic Inventory time graphs,
– Derive the Economic Order Quantity and Production Lot Size
models,
– Solve Deterministic Inventory problems,
– Graphically present Non-Deterministic Inventory time graph,
– Estimate Inventory Safety Stock and Reorder Point at a
predetermined satisfaction level, and
– Solve certain Marginal Inventory Analysis problems.
 Unit 3.1: General Introduction to Inventory Models

• At the end of this unit, you should be able to

– State some functions of or reasons for carrying
inventory
– Depict a simple inventory system
– discuss major items of cost of inventory, and
– State the main categories of inventory models
 Unit 3.1: General Introduction to Inventory Models

• Inventory refers to stock of items spent in the operation of a

business. It could be items for sale or of/for the production
process or for other beneficial purposes.
• Some functions of or reasons for carrying inventory include to
- simplify the coordination of operations
- enhance uninterrupted flow of production or to help meet
variation in product demand (e.g. … years of famine … Genesis
41: 35, 36.)
- take advantage of economy of scale
- provide a means of hedging against inflation
• Our interest is to keep an optimal level of inventory to achieve
our objective, which is to minimize the total cost associated
with inventory.
General Intro. to Inventory models cont’d
 Inventory models cont’d

The major items of cost of inventory are

• Purchase cost; cost of acquiring stock items
• Ordering cost; cost incurred in placing an order (or
Setup cost for a manufacturer)
• Holding (or carrying) cost; cost of keeping items in
store (obsolescence, insurance, rent, etc)
• Stock-out (shortage) costs – costs of running out of
stock giving rise to customer dissatisfaction
The major part of total inventory costs is the sum of
purchase, ordering, holding and stock-out costs:
Total inventory Cost= Purchase cost + Ordering cost +
Carrying cost + Stock-out costs.
 Inventory models cont’d

• A model is a valid representation of a system.

Inventory models allow us to manipulate various
inventory decision variables with a view to
assessing their relative impact and to arriving at
an optimum decision.
• The major categories of inventory models are:
– Deterministic – demand pattern, lead time and other
cost parameters are known and constant.
– Stochastic (Probabilistic) – demand patterns, lead
time and other cost parameters are probabilistic
(estimated pattern).
 Unit 3.2 – Deterministic Models

• At the end of this unit, you will be able to

– state deterministic inventory model assumptions,
– graphically present deterministic inventory time
graphs,
– proof the Economic Order quantity and Production
Lot size models, and
– solve deterministic inventory problems
 Unit 3.2 – Deterministic Models

Deterministic Inventory Models

• Economic Order Quantity (EOQ) Model – (In
determination of the lot size that would minimize our
total inventory cost, when demand patterns, lead time,
and other cost parameters are known and constant).
• The explicit assumptions of this model include:
– Known and constant demand
– Backorder not allowed
– No constraint on order size
– Fixed ordering cost
– Fixed unit price (Banjoko, 2002)
• The next figure depicts the deterministic inventory
movement in time (dealer’s perspective/ not producer’s).
 Q
INVENTORY

d d

TIME

FIGURE 5: INVENTORY vs TIME (Dealer’s perspective)

Q

. . .

cycle cycle
 Deterministic Inventory Models cont’d
Recall that –
Total Annual Inventory cost = Total cost of items purchased +
Total Ordering Cost + Total carrying cost + Total Stock-out
cost.
• Let S = Ordering cost per order
H = Carrying cost per unit/annum
D = Annual Demand
Q = Order size
P = Unit price of item
Then Total Annual Inventory Cost (T) = D x P + D/Q x S + Q/2 x H
That is T = DP + DS/Q + QH/2
• The next figure shows total annual inventory cost changes
against order size.
 TOTAL ANNUAL INVENTORY COST
T*

Q* ORDER SIZE (Q)

FIGURE 6: ORDER SIZE (Q) vs TOTAL ANNUAL INVENTORY COST

 Deterministic Inventory Models cont’d

At the turning point (peak or lowest) dT/dQ = 0

dT
/dQ = –DS/Q2 + H/2
At the optimum turning point dT/dQ = 0;
i.e. –DS
/Q*2 + H/2 = 0
/2 = DS/Q2
H

HQ*2 = 2DS
Q*2 = 2DS/H
Q* = /H
2DS
 Deterministic Inventory Models cont’d

• Therefore, Q* = 2DS/H is the optimal order size

model, and Q* is the quantity to order that will
minimize total inventory costs.
• Example: A company purchases a particular
component directly from the supplier. The
company requires 1, 000 units per month. The
ordering cost is N2, 500 per order, unit cost is
N250 per component, and annual inventory
holding cost per unit is 20% of the component
unit price. What is the minimum total annual
inventory cost?
 Deterministic Inventory Models cont’d

a. D = 1, 000 x 12 = 12, 000 per annum

S = N2, 500; P = N250

2DS 2 x 12, 000 x 2500

Q = /H = /50

= 1, 095 units

 EOQ for this component is 1, 095 units

 Deterministic Inventory Models cont’d

DS Q*H
Ba. T = DP + /Q* + /2
12, 000 x 2, 500 1, 095 x 50
= N (12, 000 x 250) + N ( /1, 095) + N ( /2)
 N3, 054, 772
 The total annual inventory cost = 3, 054, 772
 Deterministic Inventory Models cont’d

Exercise
Suppose a company demands 50, 000 units of an
item per annum, and that it incurs N0.50 per unit
as carrying cost, and N10 per order. What order
lot size will minimize its total inventory cost?
 Deterministic Inventory Models cont’d

EOQ with Quantity Discounts –

In some situations, item cost varies with the quantity
purchased when suppliers offer quantity discounts.
• The procedure to follow is as follows:
- Compute the usual EOQ assuming no discount.
- Compute the total annual inventory cost at this EOQ.
- Compute the total Annual Inventory cost for each price
category using the least quantity you need to buy to qualify
for that discount.
- Select the price category that gives the minimum total
annual inventory cost, and the minimum quantity to qualify
is EOQ, except when the holding cost is a function of item
price, and on calculating the EOQ at that price category, the
new EOQ falls within its quantity range.
 Deterministic Inventory Models cont’d
Exercise

Suppose Annual Demand = 5, 000 units

Ordering cost per order = N10.0

Holding cost per unit per annum = 15% of unit price, and that the supplier

offers discount as shown below:

Units Price/Unit

1 – 200 N 10.0

201 – 400 N 9.0

401 or more N 8.0

Determine whether the company should take advantage of the price breaks.
Economic Production Lot Size Model (EPLSM)

Economic Production Lot Size Model (EPLSM)

• Here, we consider the inventory situation from the point of view of
the producer. The focus is to determine how much to produce (Q),
length of a production run (t), and how often we commence
production.
• The explicit assumptions of this model include:
- known and constant rate of demand (d)
- known and constant rate of production (p)
- production rate is greater than demand rate (p – d  o)
- fixed setup cost (s) (note – in place of ordering cost)
- fixed unit price/cost
- the system is never out of stock
- the product is never obsolete (Banjoko, 2002)
• The next figure shows the inventory movement against time
(producer’s perspective/ not dealer’s)
 Qp
INVENTORY

p-d p-d -d
-d

t
TIME

FIGURE 7: INVENTORY vs TIME (EPLS model)

 EPLSM Cont’d

Note
• Inventory accumulates at the rate of p – d.
• Assuming that the inventory pecks at time t, the
peck inventory is t(p – d), and the production lot
size Q is tp.
• Average inventory = t(P – d)/2 ----------------------- (i)
• Production lot size Q = tp => t = Q/P ------------ (ii)
• Setting t = Q/P into equation (i)
• Average Inventory = Q (P – d)/2P ---------------- (iii)
 EPLSM Cont’d

• Total Annual Inventory Cost = Total Annual

Production Cost + Total Annual Setup cost + Total
Annual Holding cost.
• That is T = DP + DS/Q + average inventory*H
Where D = Annual Demand
P = Cost of item
Q = Production Lot Size
S = Set-up cost per set-up
H = Carrying cost per unit/annum
 EPLSM Cont’d

• But Average inventory = Q(p-d)/2p

• Therefore, Total Annual Inventory Cost (T)

= DP + DS/Q + {Q(p-d)/2p} x H

• DP = Total Annual Production cost is not relevant

for Economic Production Quantity
determination.

• Hence, T (EPQ) = DS/Q +{ Q (P – d)/2P }H

 TOTAL ANNUAL INVENTORY COST

PRODUCTION LOT SIZE (Q)

FIGURE 8: PRODUCTION LOT SIZE (Q) v TOTAL ANNUAL INVENTORY COST

 EPLSM Cont’d

• /dQ = 0 – DS/Q*2 + {P – d/2P }H = 0

dT

{P – d/2P }H = DS/Q*2
Q*2 (P – d)H = 2DSP
Q*2 = 2DSP/ (P-d) H
Q* = 2DSP
/ (P-d) H or 2DS
/ (1 – d/p) H
• Therefore, Q*= 2DS/ (1 – d/p) H is the optimal production
lot size quantity model, and Q* is the quantity to
produce that will minimize total inventory cost.
 EPLSM Cont’d

Example
AAA Unlimited produces cars. Demand for its cars is
approximately constant at 1, 000 units per month.
Its production system can make 4, 000 units per
month, its set-up is N2, 500, 000 per set-up, and
each car cost N1, 500, 000 to produce. Its
inventory holding cost per unit per annum is 20%
of the cost of the car.
• What production lot size should AAA run?
• What is the length of a production run if AAA
operates 200 days in a year?
• How often will the production process start?
 EPLSM Cont’d

Solution
Q*= 2DS/ (1 – d/p) H
D = 12, 000 units/annum
S = N2, 500, 000
H = 0.20 x N1, 500, 000 = N300, 000
d = 1, 000 units/month p = 4, 000 units/month
Note that the timing space is the same for d & p
\Q*= 2 x 12, 000 x 2, 500, 000/ (1 – 1/4) x 300, 000
= 60, 000, 000/225 = 266, 667  516 units
 EPLSM Cont’d

• Solution Cont’d
(b) t = Q/P = (516/4, 000 x 12 )x 200 days = 2.15days

(c) D
/Q = 12, 000/516 = 23. 26 times/year
 EPLSM Cont’d

Exercise:
Given that –
Demand per year (D) = 500, 000units
Monthly Production (P) = 50, 000units
Cost per unit = N120.00
Set-up Cost = N150.00
Holding Cost = 10% of Unit Cost
• Determine the optimum production lot size.
 Unit 3.3 - Probabilistic or Stochastic Models ( Safety Stock and Reorder Point )

• At the end of this unit, you will be able to

– estimate inventory Safety Stock and Reorder Point
at a predetermined satisfaction level, and
 Unit 3.3 - Safety Stock and Reorder Point
• In reality, demand is rarely known with certainty,
replenishment is not instantaneous, and stock-out
situations are probable because the lead time (the
time that elapses between when an order is placed
and when the order is received) varies.
• The top decisions to be made are:
- What size of safety stock (reserve stock held to
guard against a stock-out) to carry?
- When to place an order (reorder point), and
- Balancing cost and profit.
• The next figure depicts the inventory movement in
time.
 INVENTORY

RE-ORDER POINT

SAFETY STOCK LEVEL

KEY
TIME LEAD TIME
QUANTITY SOLD
(LEAD TIME)

QUANTITY
FIGURE 9: INVENTORY vs TIME (Stochastic) ORDERED
 Safety Stock Determination

• The safety stock a company decides to carry depends on

the service level the company chooses to operate.
• Once this level is decided, say 90% service level, the past
data on actual demand level is analyzed to produce;
- first, its cumulative distribution, then,
- its graph.
- the maximum demand level for any given level of
stock-out risk (100% - % service level) and the average
demand are graphically noted.
• The safety stock is simply the difference between the
maximum demand (stock-out risk) and the average
demand.
 Reorder Point Determination
Reorder Point = Safety Stock + Average demand
during lead time (DLT)
n

DLT = di[P(di)]
i=1

where di = demand during LTi,

and P(di) = Probability of demand di
 Safety Stock and Reorder Point Cont’d

Example
Suppose a company sells a particular type of printer that cost N25, 000 per unit, and that it
intends to assure a 90% service level. (1) What is the appropriate safety stock to keep, given
the demand pattern below? (2) Given that lead time demand approximates normal demand,
find re-order point.
Weekly demand (x) Frequency
Distribution
0≤x<100 2
100≤x< 200 4
200≤x< 300 5
300≤x< 400 9
400≤x< 500 6
500≤x< 600 4
600≤x 0
 Safety Stock Determination Cont’d

Solution
Weekly demand Frequency No. of Weeks demand % of time demand
(x) Distribution exceeded lower exceeded lower Boundary
Boundary
0 ≤ x <100 2 30 100.0
100 ≤ x < 200 4 28 93.3
200 ≤ x < 300 5 24 80.0
300 ≤ x < 400 9 19 63.3
400 ≤ x < 500 6 10 33.3
500 ≤ x < 600 4 4 13.03
600 ≤ x 0 0 0.0
Total 30

% of the demand exceeded lower boundary = number of weeks demand exceeded

lower boundary divided by total number of weeks multiplied by 100.
The graph of the percentage of the time demand exceeded lower bound against the
weekly demand lower bound is shown below:
 700

600

520
500
UNITS OF INVENTORY

400
350

300

200

100

0
0 20 40 60 80 100 120
10 50
PERCENTAGE OF TIME DEMAND EXCEEDED LOWER BOUNDARY

FIGURE 10 - PERCENTAGE OF TIME DEMAND EXCEEDED LOWER

BOUNDARY VS THE WEEKLY DEMAND LOWER BOUNDARY
 Safety Stock Determination Cont’d

• The median of the cumulative distribution curve

gives average demand as 350 units.
• Given a desired 90% service level, the stock out
risk is 10%.
• The maximum demand associated with this stock
out risk is 520 units.
• Hence, safety stock = (520 – 350) units
= 170units.
 
 Safety Stock Determination Cont’d

Lead time demand (di) Probability of di Given that lead time demand di P(di)
approach actual demand
50 0.05 0.07 3.5
150 0.2 0.13 19.5
250 0.1 0.17 42.5
350 0.15 0.30 105.0
450 0.2 0.20 90.0
550 0.3 0.13 71.5
TOTAL 1.00 1.00 332

n
Average demand during lead time = DLT = di [P(di)] = 332
i=1

 Reorder point = SS+DLT

= 170 + 332
= 502units
Reorder Point: Average Demand During Lead
Time Calculation Example

Lead time demand (di) Probability of di di P(di)

10 0.2 2

20 0.1 2

30 0.05 1.5

40 0.3 12.0

50 0.2 10.0

60 0.15 9.0

TOTAL 1.0 36.5

 Unit 3.4 - Inventory Marginal Analysis
• At the end of this unit, you will be able to
– solve certain marginal inventory analysis problems
 Unit 3.4 - Inventory Marginal Analysis
• The problem here is figuring out how much extra units of
inventory to carry in order to avoid incurring losses on unsold
stock.
• The seller would stop adding extra stock at the point where
the profit from the last sold item is greater than or, at least,
equal to the loss on that item.
• Let R = Profit from the last stock item added to inventory
sold.
L = Loss resulting from the last stock item added to
inventory unsold or sold below cost
p = Probability of selling the last stock item added to inventory
and
1 – p or q = Probability of not selling the last stock item added
to inventory
 Inventory Marginal Analysis cont’d
• The Marginal Analysis Approach implies that the
following statement must be true for the last item
of stock added to inventory:
Rp ≥ Lq, Which is Rp ≥ L(1 – p)
Solving for P:
Rp ≥ L – pL => Rp + Lp ≥ L => p(R + L) ≥ L => p
≥ L/(R + L)

• That is, we can add extra unit to our stock as long

as the probability of selling the extra unit is equal
to or greater than L/(R + L)
 Inventory Marginal Analysis cont’d
– Your chance of winning with God (p) is much more
higher than the fraction of your losses (L) to the sum
of the gains (R) and losses (L).
– The fear of the Lord is the beginning of knowledge:
but fools despise wisdom and instruction (Prov. 1:7).
 Inventory Marginal Analysis cont’d
Example
• The selling price of an article is N350 and it costs N245. Any article not
sold by the end of a week is disposed at N105. Weekly demand ranges
from 50 – 54 units. Use the marginal analysis approach to determine
the optimal quantity to stock, given the probability of sales below.

Units demanded Probability of

Demand (p)
50 0.20
51 0.25
52 0.30
53 0.15
54 0.10
55 or more 0.00
 Inventory Marginal Analysis cont’d
Solution
The probability of selling an extra unit, p,
must be equal to or greater than L/(R + L) i.e.
p ≥ L/(R + L)
But L = N (245 – 105) = N140
and R = N (350 – 245)= N105
 p ≥ 140/(140 + 105)
p ≥ 140/245
p ≥ 0.57
 Inventory Marginal Analysis cont’d
Units demanded Probability of Cumulative
Demand (p) Probability of
demand
50 0.20 1.00
51 0.25 0.80
52 0.30 0.55
53 0.15 0.25
54 0.10 0.1
55 or more 0.00 0.0

The units corresponding to p ≥ 0.57 is 51 units, and the expected

profit from stocking the 51st unit is p(R) – (1 – p) (L)
= N {(0.80)(105) – (0.20)(140)} = N56
 References
• Adewoye, S.O. & Okwa, L.I. (2005). Introduction to
Operational Research. Yaba, Lagos, Ng: Authors
• Banjoko, S.A. (2002). Production and Operations
Management. Akoka, Lagos, Ng: Pumark
• Beasley, J.E. (2013). Basic OR Concepts. Retrieved
from
http://people.brunel.ac.uk/~mastjjb/jeb/or/basic
or.html
• Tutor2u. (2015). Critical Path Analysis CPA
(Network Analysis). Retrieved from
www.tutor2u.net/business/production/crical-
path-analysis.htm
 MID-SEM 02/15
Use the Simplex method to solve the
following problem –
Maximize Z = –x1 + x2 + 2x3
Subject to: x1 + 2x2 – x3 ≤ 20
–2x1 + 4x2 + 2x3 ≤ 60
2x1 + 3x2 + x3 ≤ 50
and x1 ≥ 0; x2 ≥ 0; x3 ≥ 0.
 Mid-Semester Exam. 30 Min.
A. What is a model? 2 marks
B. State and explain the inventory models you
know. 13 marks
C. Suppose a company demands, regularly,
50,000 units of an item per annum, and that it
incurs N0.50 per unit as carrying cost per
annum, and N10 per order. What is the
minimum Total Annual Inventory Cost, given
that the cost of each item is ₦4? 5 marks
 Mid-Semester Exam. 30 Min.
A. Using the Simplex method, show that the following linear
programming problem is unbounded:
Maximize Z = 5X1 + X2 + 3X3 + 4X4
Subject to:
X1 - 2X2 + 4X3 + 3X4 ≤ 4
-4X1 + 6X2 + 5X3 - 4X4 ≤ 8
2X1 - 3X2 + 3X3 + 8X4 ≤ 10
X1≥0; X2≥0; X3≥0; X4≥0 (15 marks)
XYZ’s production line produces at the rate of 11,000 units of an
item per month. Its Annual demand is 72,000 units, Setup cost
is =N=100,000, and Holding cost is =N=3,000 per unit per
annum. What is the Economic Production Lot size? What is the
length of cycle time in months?
 Test CS A 2017 (25 Min.)
Using the Simplex method, show that the
following linear programming problem is
unbounded:
Maximize Z = 5X1 + X2 + 3X3 + 4X4
Subject to:
X1 - 2X2 + 4X3 + 3X4 ≤ 4
-4X1 + 6X2 + 5X3 - 4X4 ≤ 8
2X1 - 3X2 + 3X3 + 8X4 ≤ 10
X1≥0; X2≥0; X3≥0; X4≥0 (15 marks)
 Test CSA 2017

Suppose a company sells a particular type of

keyboard, and intends to assure a 95% service
level. What is the appropriate safety stock to
keep, given the weekly demand pattern below?
Weekly demand (x) Frequency distribution
0 ≤ X < 100 4
100 ≤ X < 200 8
200 ≤ X < 300 10
300 ≤ X < 400 18
400 ≤ X < 500 12
500 ≤ X < 600 8
600 ≤ X 0
 Test02 2018 20 minutes
1. In some situations, where the Economic
Order Quantity model is applicable, item cost
varies with the quantity purchased when
suppliers offer quantity discounts. State the
procedure you will follow in determining the
optimum quantity to buy. (6 marks)
2. Present Inventory versus Time graph, with
explanations, for EPLS model. (4 marks)

 
 Test CIS 2017
Troopers’ production line capacity is 2,400
units of an item per annum, and operates
in accordance with the Economic
Production Lot Size model. Its annual
demand is 1,280 units, setup cost is
₦200,000.00, and holding cost is
₦4,000.00, 20% of item cost, per unit per
annum. What is the minimum Total Annual
Inventory Cost?
 Mid-Semester summer 2018 (25 Min.)
Use the Simplex method to solve the
following problem –
Maximize Z = 2x1 – x2 + x3
Subject to: 3x1 + x2 + x3 ≤ 6
x1 – x2 + 2x3 ≤ 1
x1 + x2 – x3 ≤ 2
and x1 ≥ 0; x2 ≥ 0; x3 ≥ 0.