INVENTORY MANAGEMENT

II
Chetna Chauhan

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A QUICK REVIEW OF BASIC EOQ MODEL

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 BASIC EOQ MODEL
• The basic EOQ model is used to find a fixed order quantity
that will minimize total annual inventory costs

• Assumptions:
1. Only one product is involved
2. Annual demand requirements are known
3. Demand is even throughout the year
4. Lead time does not vary
5. Each order is received in a single delivery
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6. There are no quantity discounts
 THE INVENTORY CYCLE
Profile of Inventory Level Over Time
Q Usage
rate
Quantity
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
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Lead time
TOTAL ANNUAL COST

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GOAL: TOTAL COST MINIMIZATION

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 DERIVING EOQ

• Using calculus, we take the derivative of the total cost

function and set the derivative (slope) equal to zero
and solve for Q.
• The total cost curve reaches its minimum where the
carrying and ordering costs are equal.

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DERIVATION

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 TOTAL MINIMUM COST
CALCULATION
The total minimum cost is determined by substituting
the value for the optimal order size, Qopt, into the total
cost equation:

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 WHEN TO REORDER

• Reorder point
• When the quantity on hand of an item drops to this amount,
the item is reordered.
• Determinants of the reorder point
1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management
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 QUESTION
The ePaint Store stocks paint in its warehouse and sells it online on its
Internet Web site. The store stocks several brands of paint; however, its
biggest seller is Sharman-Wilson Ironcoat paint. The company wants to
determine the optimal order size and total inventory cost for Ironcoat paint
given an estimated annual demand of 10,000 gallons of paint, an annual
carrying cost of $0.75 per gallon, and an ordering cost of $150 per order.
They would also like to know the number of orders that will be made
annually and the time between orders (i.e., the order cycle).

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 GIVEN

H = $0.75 per gallon

S = $150
D = 10,000 gallons

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 ANSWERS

• Q= 2000 gallons

• TCmin= $1500

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QUANTITY DISCOUNTS

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 INTRODUCTION

• Quantity discounts are price reductions for larger orders offered to

customers to induce them to buy in large quantities.
• Give examples in retail, B2B, e-commerce?

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WHY IS IT IMPORTANT TO UNDERSTAND

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 WHY IS IT IMPORTANT TO UNDERSTAND

• Cost effective for both seller and buyer

Combine incidental per-order costs, such as shipping and packaging, into one sale
Economies of scale
• Competition
• Developing set of loyal customers
• Strategic pricing

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 HOW MUCH QUANTITY DISCOUNTS TO
OFFER
• “Since quantity discounts are partly expressions of cost savings and partly of a
promotional nature, it is not possible to lay down any general principles for the
determination of their magnitude.” (Gabor 1985, p.105)

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• What are the factors to consider when determining the appropriate discount
schedule?
• How do qty discounts impact customers?
• How do qty discounts impact buyers?

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 QUANTITY DISCOUNTS

• The buyer’s goal with quantity discounts is to select the order

quantity that will minimize total cost
• Total cost is the sum of carrying cost, ordering cost, and purchasing
(i.e., product) cost

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QUANTITY DISCOUNTS

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• In the basic EOQ model, determination of order size is not
impacted by unit price.
• The rationale for not including unit price in EOQ is that
under the assumption of no quantity discounts, price per unit
is the same for all order sizes.

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EXAMPLE

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• When quantity discounts are offered, there is a separate U-shaped
total-cost curve for each unit price
• Again, including unit prices merely raises each curve by a constant
amount

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The total-cost curve with quantity discounts is composed
of a portion of the total-cost curve for each price

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 EXAMPLE
• The maintenance department of a large hospital uses about 816 cases
of liquid cleanser annually. Ordering costs are $12, carrying costs
are $4 per case a year, and the new price schedule indicates that
orders of less than 50 cases will cost $20 per case, 50 to 79 cases
will cost $18 per case, 80 to 99 cases will cost $17 per case, and
larger orders will cost $16 per case. Determine the optimal order
quantity and the total cost.
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 PROCEDURE TO FIND OPTIMAL ORDER
QUANTITY IN QUANTITY DISCOUNTS
1. Compute the common minimum point.
2. Only one of the unit prices will have the minimum point in its feasible range
since the ranges do not overlap. Identify that range.
a. If the feasible minimum point is on the lowest price range, that is the optimal
order quantity.
b. If the feasible minimum point is in any other range, compute the total cost for the
minimum point and for the price breaks of all lower unit costs. Compare the total
costs; the quantity (minimum point or price break) that yields the lowest total cost is
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the optimal order quantity.

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• Compute the common minimum Q:

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The 70 cases can be bought at $18 per case because 70 falls in the range of 50 to 79 cases.
The total cost to purchase 816 cases a year, at the rate of 70 cases per order, will be

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Therefore, because 100 cases per order yields the lowest total
cost, 100 cases is the overall optimal order quantity.
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 TYPES OF QUANTITY DISCOUNTS
• Cumulative discount
Ex: There is 3% discount on orders of 400 units or more, a 4% discount on orders of 900
units or more, and a 5% discount on orders of 2,000 units or more.

• Non-cumulative discounts
Ex: A supplier offers a 15% discount on all orders of 2000 units or more. If a customer
buys 2000 units, they get 15% discount on that order only. Now if they place another
order for example 3000 units, they will receive the 15% discount again on that order.
Discount does not increase with order quantity. 33
 TYPES OF QUANTITY DISCOUNTS
• Unit discounts
This is discount on each item, regardless of the units purchased

• Incremental discount (see next slide)

Price = $10 per unit for orders of 100 units or less
Price = $7 per unit for quantity ordered above 100 units
If order quantity = 150 units
discount received $150 ($3 per unit on the additional 50 units).
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• While it might be more logical to apply the discount only to that part of the order
that exceeds the relevant threshold rather than the whole order, such quantity
discounts schemes are rarely used in practice (Leigh).
• This is probably because they are much more difficult to explain and customers
often feel that any scheme that does not apply the discount equally to every item
on their order is inherently unfair (Leigh).

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 SPECIAL ORDER (TIME-DEPENDED PRICE
INCREASE)
• A special order with time-based price rise is a pricing strategy in which a seller sells a
product or service to a client at a lower price than normal but with a time constraint.
• After a certain time period, the price of the product or service rises, generally owing
to changes in market circumstances, manufacturing costs, or other causes.
• For example, a supplier may give a special order price for the first two months of a
new product introduction, after which the price will raise to regular pricing.
• This generates a feeling of urgency for buyers to acquire the goods at a cheaper price
before the deadline, perhaps increasing sales and creating excitement around the new
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offering.
THANKS

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