Optimum Lot Size Span 2 Ingles - Rev

OPTIMAL LOT SIZE OR PURCHASE
December 2021
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Objective of the course
 Determine and apply the correct concept of generating the best purchase amount or optimal
production quantity in order to minimize the overall cost.
 To ensure the knowledge to be applied in the future in purchasing, planning, production

scheduling, spare parts and any other activity within the organization that requires cost
optimization.
 Know the most recent models to load digitally as fast as possible and avoiding finger errors.
 See tools that help you do calculations quickly and even connect to an ERP system
 Lokad
 Odoo
 Log-Hub
 Creation of probability scenarios in safety inventory creation.
Optimum Lot size span 2 EFESO © 2021 2

Methodologies and inventory determination
For inventory control and management, you must determine the quantities to be purchased,
always considering that you want to minimize total inventory costs as much as possible,
without having a negative impact on the level of customer service.
Inventory control is performed at the individual component level, also known as SKU (stock
keeping unit).
For this, they are classified into 3 different methods:
1. Lot by lot,
2. Fixed quantity orders and
3. Economic order quantity.

Lot by Lot
This method is based on ordering only what is required at the specific time it is required.
Its main features are:
• Does not generate inventory
• It is mainly used for type A materials, because they are very expensive.
• It is widely used in JIT or Just In Time processes.
For example:
A CNC machine service company has a CNC processor inventory of 1 part. The purchase lot
is 1 part, due to its complexity, critical operation, and high cost. The company waits until it
uses its available inventory to reorder a new lot.
Another example:
The supplier of a flavoring blend of natural and artificial ingredients, manufactured especially
for a food company, produces in batches of 10 kg. Because it is a special raw material that
cannot be sold to any other customer, the supplier demands that the company buys complete
batches from him, and that his purchases are in multiples of 10 kg.

Fixed Quantity Orders
This method buys the same amount for each order placed in a given time.
Its main features are:
• Used for simple and fast parts

• It is through requirement estimates
• It is not very accurate and, consequently, has opportunities
For example:
Contrary to the previous example, when servicing the machines, different screws are used,
which do not have a specific number, depending on the job. For this reason, a fixed quantity
is ordered at a certain time, since the cost of the parts is low and a very detailed control of
their use is not required.

Economic Order Quantity (EOQ) Economic Order Quantity
 EOQ (also known as EBQ - Economic Batch Quantity) is the amount of product or raw
material that must be ordered in order to balance the set-up cost with the inventory costs,
resulting in the lowest total cost.
 The difference between set-up (or order) costs in EOQ depends on whether the product is
purchased from a supplier (order cost), or received from an internal manufacturing process
(set-up cost):
 Ordering costs include all costs necessary to place an order (such as transportation,
maneuvering and other labor, plus technology-related costs).
 Setup costs are costs incurred when switching to a production line.
 Inventory costs correspond to Capital Expenditures, Service Inventory Costs, Risk

Inventory Costs and Warehouse Space Costs.

EOQ calculation
 If we minimize the sum of the costs of 'ordering' and the costs of 'carrying inventory', we
will consequently be minimizing the total costs.
 To help visualize this, you can graph the cost of 'ordering' (or ordering) and the cost of
'carrying inventory' as shown in the chart below:
Annual Cost
Total
cost
Order Carrying
Cost Cost
Quantity
Optimum Lot size span 2 EFESO © 2021

7 7
EOQ calculation
 Economic Order Quantity is the optimal break-even point between the annual
cost to produce/order and the annual cost to store a product.
 Therefore, the variables considered in the calculation are those represented in

the following formula:
𝐸𝑂𝑄=
√
2∗ 𝑨𝒏𝒖𝒂𝒍𝑽𝒐𝒍𝒖𝒎𝒆∗𝑪𝒐𝒔𝒕 𝒕𝒐𝒐𝒓𝒅𝒆𝒓
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒄𝒂𝒓𝒓𝒚𝒊𝒏𝒈 𝒄𝒐𝒔𝒕
where:
Cost of Carrying Inventory =.
Cost per Unit * Cost of Storage * Cost of Capital (%)
 EBQ (Economic batch quantity) is calculated in the same way as EOQ,

however, instead of order cost, we must consider the 'Change-Over' Cost.
 EBQ is the basis for Run Strategies in manufacturing companies.
8
EOQ - Economic Order Quantity
Method that determines the quantity to order, taking into account inventory carrying costs
(inventory carrying costs), order management and product costs, to minimize costs by
maintaining a safety inventory according to the level of customer service.
The principle of the EOQ method is that as the number of units to be ordered increases:
The cost of carrying inventory increases
Unit cost of order placement decreases

Example of EOQ calculation
For example, calculate the EOQ for both products considering that:
Product 1 Product 2
Period Average 30,000 Period Average 30,000
Demand Demand
Unit Cost $25 Unit Cost $29
Cost to order per order $200 Cost to order per order $189
Cost of inventory 23% Cost of inventory 21%
carrying carrying
1) How many orders will be placed annually?

2) What is the annual cost to purchase?
3) What is the average monthly inventory?
4) What will be the annual cost of carrying inventory?
5) What is the total annual cost?

Example of EOQ calculation
EOQ
EOQ 2 Annual Vol Order cost 2 30,000 200 12,000,000 25,043,478 5,004
Unit Cost Inv keep cost % 25 23% 0.47917
@ 12 meses
EOQ
EOQ 2 Annual Vol Order cost 2 30,000 189 11,340,000 22,344,828 4,727
Unit Cost Inv keep cost % 29 21% 0.50750
@ 12 meses

HOW IS THE EOQ DETERMINED?
The economic lot is determined at the point where the cost of holding inventory is
equal to the cost of ordering, or the break-even point is reached where these 2 costs
are equal.
This is best exemplified in the following graph:
Cost
Order cost
Cost to maintain
inventory
Total cost
Lot Size
Once you know what quantity to buy - using one of the 3 methods, lot-for-lot, fixed-
quantity orders, and economic order quantity - you must determine the frequency of
purchase.

Economic Order Quantity
Assumptions
1. Constant demand rate
2. No restriction on order size
3. Only relevant costs considered to order or setup
4. Decisions for one item are independent of other items.
5. No uncertainty about lead times or supplies.

Order Inventory delivered

received (demand rate)
Inventory on hand (units)
Q Cycle of
- inventory
2
1
cycle Time

Total Cost = CMI + CO

Annual Cost (dollars)
Cost to maintain
Inventory (CMI) Cost to
Order (CO )
Lot size Q

3000 -
Total Cost = CMI + CO
2000 -
Cost to maintain Q = x C x I
inventory 2
1000 -
D
Ordering Cost = (S )
Q
||||||||
0-
50 100 150 200 250 300 350 400
Lot size (Q)

Example
A company sells 18
units per week of
a product, the value of
purchase of the product is
60 and the handling fee of
inventory 25%, the cost of
place an order for
purchase is $45.
Currently places
orders of 390 units.
Calculate the total cost of

inventory management.

Example
D = 18 units/week x 52 weeks/year = 936

units/year
CMI = 390/2 x 60 x 0.25 = 2925 $/year

CO = 936/390 x 45 = 108 $/year
TC = 2925 + 108 = 3033 $/year

Example Cont.
D = 18 units/week x 52 weeks/year = 936

units/year CMI = 390/2 x 60 x 0.25 = 2925 $/year
CO = 936/390 x 45 = 108 $/year
TC = 2925 + 108 = 3033 $/year
3033 $
3000 -
2000 -
1000 -
| | | | | | | |
0-
50 100 150 200 250 300 350 400
Q=390
Lot size (Q)
Example Cont.
We match the cost of holding inventory with the cost of ordering.
Q/2 x C x I = D/Q x S 2 xDxS
Q² = (2 x D x S) / (C x I) EOQ =
CxI
EOQ = 2 x 936 x 45
60 x 0.25
EOQ = 75 Units

Example (Cont.)
CMI = 75/2 x 60 x 0.25 = $562.50 $/year

 CO = 936/75 x 45 = $562.5 $/year
CT = 562.50 + 532.50 = 1125 Savings = 3033 - 1125 = 1908
3033 $
3000 -
2000 -
1125
1000 -
| | | | | | | |
0-
50 100 150 200 250 300 350 400
Q=390
EOQ Lot size (Q)
Comparative Results
Parameters Initial Optimum

Demand (Units/year) 936 936
Product Cost ($) 60 60
Inventory management rate (%) 25% 25%
Cost of placing an order ($) 45 45
Order size (Units) 390 75
Number of orders/year (orders) 2.4 12.5
Interval between orders (days) 150 29
Average Inventory (Units) 195 37.5
Cost to purchase ($/year) 108 562.5
Cost of holding inventory 2,925 562.5
($/year)
Total cost ($/year) 3,033 1,125
Savings ($/year) 1,908

Variable Demand
How much Variable demand

demand?
When to order?
How much?
How much safety stock?
What service level ?
What lead times?

Continuous Review Models
Order
Order Order
receive
receive Order receive
receive
Available
stock R
Order Order Order

placed placed placed
Time

Reorder Points
Service level = 85%.
Breakage probability
(1.0 - 0.85 = 0.15) = 15%.
Demand
average
during
lead time R
zσL

Z Factor
VALOR DE Z
NIVEL DE S ERVICIO
INV.NORM.ESTAND(n.s .)
60% 0.2533
70% 0.5244
75% 0.6745
80% 0.8416
85% 1.0364
90% 1.2816
91% 1.3408
92% 1.4051
93% 1.4758
94% 1.5548
95% 1.6449
96% 1.7507
97% 1.8808
98% 2.0537
99% 2.3263
99.5% 2.5758
99.7% 2.7478
99.9% 3.0902
99.99% 3.7190
99.999% 4.2649
99.9999% 4.7534
99.99999% 5.1993
26
Reorder Points
R=m+s
Where:
R = Minimum inventory level for reordering the new order
(reorder point)
m = Inventory for Lead Time
s = Safety Inventory for Lead Time
s = z x σ σ = Standard deviation of the demand
z = Depends on the planned fill

rate

Reorder Points
SS
Probability of
Breakage

Example
A supermarket has the following demand for Detergents
D=200 boxes/day
L=4 days (Lead Time)
σ=150 boxes/day
Planned Fill Rate 95%
S=20 $/order
i=20%/year
C=10 $/box

Standard Deviation of leadtime
s t = 15
s t = 26
+
75
Demand week 1
s t = 15
+ 225
Demand during
75
Demand week 2 Three weeks of
s t = 15 lead time
=
75
Demand week 3

Another Example
Calculate the inventory planning parameters if the inventory is managed under the
continuous review system. "Q"

Periodic Review Systems
Order Order Order

receive receive receive
Available
stock
Order Order
placed placed
Time
Protection Interval

Target Inventory
T = m' + s'
Where:
T = Target inventory level at time of placing an order
m' = Service Inventory for Lead Time and Revision Period
s' = Safety Inventory for Lead Time plus revision period

Exercise
For the above exercise calculate the inventory planning parameters if the system is a
periodic review system. "P"

Parameter Continuous Periodical
Review Review
Cost of administration
Number of orders/year
Average Inventory
Safety Inventory
Fill Rate
Cost to maintain
inventory

Management Systems
For this, the safety stock calculation and 3 systems are used:
• Safety Stock
1. Reorder point system.

2. Periodic Review System
3. MRP system.

Stock or Safety Inventory
Definitions
Demand:
 The quantities consumed by customers, on average, per unit of time.
Lead Time:
 The delay between the time at the reorder point (inventory level at which an order is
initiated) until the time that availability is renewed
Service Level:
 The probability that the Safety Stock level is efficient in such a way as to avoid stockout
 Naturally, the higher the desired level of service, the greater the safety inventory required.
Forecast Error:
 An estimate of how much the actual demand may vary from the forecast demand.
 Expressed as the standard deviation of demand.
* The model works with any time units (days, weeks, months, etc.). The key is to establish a time unit and then maintain
consistency across all analyses.
Safety Inventory Calculation (SS)
Basic Calculus is:
SS *FE
Z AvgLT2 2
*SE
AvgDemand2
Service Factor Protection

Forecast Error Protection of 'Supply Variability
('Service Factor')
Meaning:
 Z = NORMSINV(Service Level), for example Z=1.64 for a service level of 95%.
 AvgLT = Average Lead Time
 σFE = Standard deviation of demand (i.e. SFE)
 AvgDemand = The number of items consumed by customers, on average, per unit of time.
 σSE = Standard Deviation of Lead Time or Supply Error

Safety Inventory Calculation Example (Ss)
Safetystoc k  Z AvgLT *  Fe2  AvgDemand 2

*  Se2
Let there be two finished products with similar demand during the month, but
the following characteristics:
Product 1 Product 2
Period Average Demand 30,00 Period Average Demand 30,00
0 0
Forecast error for the period 35% Forecast error for the period 10%
Lead Time 0.500 Lead Time 0.500

Supply error (desv.std.LT) 10% Supply error (desv.std.LT) 50%
Service Level desire 95% Service Level desire 95%
Determine the Safety Stock needed considering that the period is monthly.

Example of Safety Inventory Calculation (SS)

*  Se2
Z Avg LT σFE2 Multiplicación 1

Multiplication
SAFETY STOCK PRODUCTO 1.645 0.500 110,250,000 55,125,000

Product 1
SAFETY STOCK PRODUCTO
Product 2
1.645 0.500 9,000,000 4,500,000
Avg Demand2 σSE2 Multiplicación 2

Multiplication
Product 1 900,000,000 0.0025 2,250,000
Product 2 900,000,000 0.0625 56,250,000
Suma
Sum Raíz
Root Safety Stock
Product 1 57,375,000 7,575 12,459
Product 2 60,750,000 7,794 12,820

Example of Safety Inventory Calculation (SS)
In this case
Period demand is monthly

*  Se2
0.5 30000 35% 10500 110,250,000.00 55,125,000.00
0.5 30000 10% 3000 9,000,000.00 4,500,000.00

@10%/2
30000 X 30000 900,000,000.00 0.05 0.05 0.0025 2,250,000.00
@50%/2
30000 X 30000 900,000,000.00 0.25 0.25 0.0625 56,250,000.00
57,375,000.00
60,750,000.00

Reorder Point
 The Reorder Point is the minimum inventory level at which a new purchase or production order
must be placed.
The reorder point considers the lead time to receive the new inventory, the typical inventory
consumption rate and the safety stock level.
 Therefore, the ROP is calculated through the following formula:
Reorder Point = Demand x Lead Time + Safety Inventory
 In other words, the ROP is the amount of inventory needed to cover the demand during the
waiting time for replenishment in order to avoid stock-outs.
If the Lead-Time for replenishment is one week, the

ROP will be when there is only one week's stock, plus
the remaining safety stock.
Inventory
Safety Stock
Time
Optimum Lot size span 2
1 2 3 4 5 6 7 (weeks)
EFESO © 2021 41
EXAMPLE - REORDER POINT
For the example above, calculate the Reorder Point (ROP) for both products.
ROP = Average Lead Time*Average Demand+ Safety Stock (SS)
Avg LT Avg Dmd Safety Stock Punto Reorden

Reorder Point
REORDER POINT PRODUCTO
Product 1 0.500 30,000 12,459 27,459
REORDER POINT PRODUCTO
Product 2 0.500 30,000 12,820 27,820
WATCH OUT FOR THE UNITS:

The LT must be expressed in the same unit of time.
than the average demand. That is to say, if we talk about an average demand of 30,000
units per month, the Lead Time should be expressed in months (for example, here
the 0.5 refers to a Lead Time of half a month)

Reorder Point
A minimum inventory level is determined, which triggers the time in which a new order
must be placed, with enough time for the new material to arrive before the available
inventory is completely depleted.
The reorder point is calculated by the following equation:
Reorder Point = Demand x Lead Time + Safety Inventory
It refers to the safety inventory, the inventory determined to be able to cover any
contingency or peak demand, which exceeds the response capacity, in order not to
impact the customer.
The point of reordering is:
Where:
R = Reorder point in units = Average demand
L = Lead time (time elapsed between placing and receiving the order)
z = Number of standard deviations for a specific service probability
σL = Standard deviation of usage during lead time

Reorder Point
For example:
Assuming there is a weekly demand of 50 units and you want to maintain a safety
inventory of 20 pieces and the lead time is 6 weeks.
The reorder point - for this case, based on the equation shown - would be 320 pieces (50 x
6 + 20), i.e. when you have only 320 pieces in the warehouse, a new order must be placed.

Periodic Review System

This system is based on a constant frequency of order placement. Unlike the reorder point
system, where the time was variable, in this system the time is fixed and what varies is the
quantity to be ordered based on the available inventory and the determination of a target
inventory level.
The target level is determined through the equation:
Target Level = Demand in the fixed interval + Demand in the lead time + Safety Inventory
Once the target level has been determined, the order quantity is determined:
Order Quantity = Target Level - Inventory On Hand

For example:
A company has established to place orders every 15 days. They have a daily demand of 50
units and have a lead time of 5 days. Currently, they have an inventory of 120 units and
want to maintain a safety inventory of 10 units. We determine the target level and the
quantity to order:
Target level: 50 (15 + 5) + 10 = 1100
Order quantity: 1100 - 120 = 890
In this system, each time period the order quantity calculation must be performed to
determine the volume of the order to be placed. This system is used when the cost per
order placement is low.

MRP (Materials Resource Planning)
MRP
This system refers to the material requirement plan that is the tool of
organizations to plan purchase orders with their suppliers of materials and
raw materials, where it is required to collect information from different areas,
in order to have specific data to make purchasing decisions.
The MRP is based on the master production plan, which indicates how much
product needs to be manufactured. The BOM indicates the lowest level
components that must be purchased in order to complete the final product.
Inventories help us to determine the quantities needed to order from

suppliers. And finally, additional information such as waiting times,
percentages of waste, quality, minimum purchase lots, among others.
Optimum Lot size span 2 Ingles_rev EFESO © 2021 47

Balancing Value and Risk Potential of Situational Inventory
High
Protect
Margin With The cost of a situational inventory
Inventory build can be precisely calculated.
Product Margin
The upside value potential and

downside risks are equally
Invest in important to the economics, but
Supply can only be estimated.
Agility
Define Fixed
Supply and
Shape
Low Demand
Low High
Cost of Residual Inventory

Freight Mode Selection
Choosing between alternative transportation modes involves

comprehensive comparison of choices that involve trade-offs between
freight rate, lead time and supply quantity.
 Long lead time ocean vs. expensive air freight
 Long lead time rail vs. faster motor transport
The longer lead times and larger shipment quantities impact three different
types of inventory. This worksheet supports a comprehensive analysis of
cost/inventory trade-offs in the mode decision.
 Unit cost and annual, risk-adjusted carrying cost determines the attractiveness and
feasibility of slower modes with reduced freight rates

Value Chain/Channel Inventory Model
An end-to-end value chain or distribution channel is supported by many or all

of the six functions of inventory.
Illustrating and estimating the breakdown of inventory functions enables better
understanding and can catalyze collaboration to arrive at decisions that
improve capability and performance.
Compiling the estimates for full value chain inventory requires separate
calculation of all six functions. Cycle stock and safety stock calculations can
be supported by worksheets within this Toolkit. The remainder can be
estimated by applying Little's Law.

Load: Which Model is Better?
RRT
Set-up time Single, big and not A A B C D E A A B C D E

flexible Machine
reduction
M T W T F S M T W T F S
RRT
Single, big and A C E A C E A C E A C E

flexible Machine
Set-up time A B D A B D A B D A B D
reduction
or splitting RRT
E E E
D D D D
Big and very flexible
C C C C C
Machine or a lot of
B B B B B B B
small not flexible
A A A A A A A A A A A A
Machine A A A A A A A A A A A A
Batch Size and System Performance
cycle stock
Stock level
Safety stock
Lead
Time
Product Product Prod. Prod. Product Product Prod. Prod. Prod.
A B C D A B C D A
uncertain supply period

Stock level
cycle stock
Safety stock
Lead
Time
A B C D A B C D A B C D A
uncertain supply period

Conclusion
The management of the batches to be produced and the inventories are a

complex issue, which if carried out correctly, will help to minimize costs
without impacting the service levels. In summary, batch and inventory control
are the processes of adopting procedures to limit the total cost of inventory
(exact inventory).
The control procedures ensure that they are available to produce and are
accurate inventory, integrate the efficiency in the purchase of supplies,
continuous improvement efforts, synchronized production, aggregate
planning and adequate logistics to fulfill the orders.
Remember that inventory is an asset, so quantity, handling, turnover and

quality must be taken care of.

PARTNER FOR
PROGRESSION
EXCELLENCE
www.efeso.com

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OPTIMAL LOT SIZE OR PURCHASE

 To ensure the knowledge to be applied in the future in purchasing, planning, production

 Creation of probability scenarios in safety inventory creation.

Optimum Lot size span 2 EFESO © 2021 2

For this, they are classified into 3 different methods:

Optimum Lot size span 2 EFESO © 2021 3

Optimum Lot size span 2 EFESO © 2021 4

Its main features are:

• Used for simple and fast parts

Optimum Lot size span 2 EFESO © 2021 5

 Setup costs are costs incurred when switching to a production line.

 Inventory costs correspond to Capital Expenditures, Service Inventory Costs, Risk

Optimum Lot size span 2 EFESO © 2021 6

Optimum Lot size span 2 EFESO © 2021

 Therefore, the variables considered in the calculation are those represented in

 EBQ (Economic batch quantity) is calculated in the same way as EOQ,

 EBQ is the basis for Run Strategies in manufacturing companies.

The cost of carrying inventory increases

Unit cost of order placement decreases

Optimum Lot size span 2 EFESO © 2021 9

1) How many orders will be placed annually?

Optimum Lot size span 2 EFESO © 2021 10

Optimum Lot size span 2 EFESO © 2021 11

Optimum Lot size span 2 EFESO © 2021 12

1. Constant demand rate

2. No restriction on order size

3. Only relevant costs considered to order or setup

4. Decisions for one item are independent of other items.

5. No uncertainty about lead times or supplies.

Optimum Lot size span 2 EFESO © 2021 13

Order Inventory delivered

Optimum Lot size span 2 EFESO © 2021 14

Total Cost = CMI + CO

Optimum Lot size span 2 EFESO © 2021 15

Total Cost = CMI + CO

Lot size (Q)

Optimum Lot size span 2 EFESO © 2021 16

Calculate the total cost of

Optimum Lot size span 2 EFESO © 2021 17

D = 18 units/week x 52 weeks/year = 936

CMI = 390/2 x 60 x 0.25 = 2925 $/year

Optimum Lot size span 2 EFESO © 2021 18

D = 18 units/week x 52 weeks/year = 936

Annual Cost (dollars)

We match the cost of holding inventory with the cost of ordering.

Q/2 x C x I = D/Q x S 2 xDxS

Optimum Lot size span 2 EFESO © 2021 20

CMI = 75/2 x 60 x 0.25 = $562.50 $/year

Parameters Initial Optimum

Optimum Lot size span 2 EFESO © 2021 22

How much Variable demand

How much safety stock?

What service level ?

What lead times?

Optimum Lot size span 2 EFESO © 2021 23

Order Order Order

Optimum Lot size span 2 EFESO © 2021 24

Service level = 85%.

Optimum Lot size span 2 EFESO © 2021 25

s = Safety Inventory for Lead Time

s = z x σ σ = Standard deviation of the demand

z = Depends on the planned fill

Optimum Lot size span 2 EFESO © 2021 27