Operations of

Manufacturing Systems
IE-311
Dr. Muhammad Sajid
Assistant Professor
Industrial Engineering Department
UET Taxila

Stochastic Inventory Models and Inventory

Management
Lecture 03
CLO Covered: 2(c3)-1
Economic Order Quantity (EOQ) Model
When the EOQ assumptions are met, total cost is
minimized when Annual ordering cost = Annual holding
cost D Q
Co  Ch
Q 2
 Solving for Q D
Annual ordering cost  C o
Q
2 DC o  Q 2C h
2 DC o Q
 Q2 Annual holding cost  C h
Ch 2
2 DC o 2 DC o
 Q  EOQ  Q * EOQ  Q 
*
Ch Ch
 Purchase Cost of Inventory Items and Sensitivity
Analysis of EOQ Model

Inventory carrying cost is often expressed as an annual %age of

the unit cost or price of the inventory
This requires a new variable
Annual inventory holding charge as a percentage of unit price
I
or cost
 The cost of storing inventory for one year is then
C h  IC
2 DC o
thus, Q 
*

IC
 Purchase Cost of Inventory Items and Sensitivity
Analysis of EOQ Model

 If the ordering cost were increased four times from $10 to $40, the
order quantity would only double

2(1,000)(40)
EOQ   400 units
0.50
 Reorder Point
It is used to determine when to order
• Once the order quantity is determined, the next decision is
when to order
• The time between placing an order and its receipt is called
the lead time (L) or delivery time
• Inventory must be available during this period to met the demand
• When to order is generally expressed as a reorder point
(ROP) – the inventory level at which an order should be
placed

ROP  Demand per  Lead time for a new order

day in days
dL
 Reorder Point
It is used to determine when to order

Inventory Level (Units) Q*

Slope = Units/Day = d

ROP
(Units)

Lead Time (Days) L

 Reorder Point
It is used to determine when to order
Demand for the computer chip is 8,000 per year
Daily demand is 40 units
Delivery takes three working days
ROP d  L  40 units per day  3 days
 120 units
 An order is placed when the inventory reaches 120 units
 The order arrives 3 days later just as the inventory is depleted
 Production Run Model
It is the EOQ without instantaneous receipt assumption
Part of Inventory Cycle There is No Production During This
During Which Production is Part of the Inventory Cycle
Taking Place
Inventory
Level

Maximum
Inventory

t Time
 Production Run Model
It is the EOQ without instantaneous receipt assumption
• Instead of an ordering cost, there will be a setup cost – the
cost of setting up the production facility to manufacture the
desired product
• Includes the salaries and wages of employees who are
responsible for setting up the equipment, engineering and design
costs of making the setup, paperwork, supplies, utilities, etc.
• The optimal production quantity is derived by setting setup
costs equal to holding or carrying costs and solving for the
order quantity
 Production Run Model

• In production runs, setup cost replaces ordering cost

• The model uses the following variables

Q  number of pieces per order, or production run

Cs  setup cost
Ch  holding or carrying cost per unit per year
p  daily production rate
d  daily demand rate
t  length of production run in days
 Production Run Model

Maximum inventory level  (Total produced during the production run) – (Total used
during the production run)
 (Daily production rate)(Number of days production) – (Daily demand)(Number
of days production)
 (pt) – (dt)
since Total produced  Q  pt
Q
So Production Cycle = t
p
Maximum Q Q  d
inventory  pt  dt  p  d  Q 1  
level p p  p
 Production Run Model
Q d  D
Annual holding cost   1  C h Annual setup cost  C s
2 p Q

Q d D
 1 C h  Cs
2 p Q

 Solving for Q, we get

2 DC s
Q 
*

 d
C h  1 
 p
 Production Run Model
Q d  D
Annual holding cost   1  C h Annual setup cost  C s
2 p Q

Q d D
 1 C h  Cs
2 p Q

 Solving for Q, we get

2 DC s
Q 
*

 d
C h  1 
 p
 Production Run Model

Brown Manufacturing produces commercial refrigeration units in batches

Annual demand  D  10,000 units

Setup cost  Cs  $100
Carrying cost  Ch  $0.50 per unit per year
Daily production rate  p  80 units daily
Daily demand rate  d  60 units daily

How many refrigeration units should Brown produce in each batch?

How long should the production cycle last?
Production Run Model
2 DC s 2  10,000  100
Q 
*
Q 
*

 d  60 
C h  1  0 .5  1  
 p  80 
2,000,000
 
0 .5 
1
4
16,000,000

 4,000 units

Q
Production cycle 
p
4,000
  50 days
80
 Quantity Discount Model
• Quantity discounts are commonly available
• The basic EOQ model is adjusted by adding in the purchase or
materials cost

Total cost  Material cost + Ordering cost + Holding cost

D Q
Total cost  DC  Co  Ch
Q 2
where
D  annual demand in units
Cs  ordering cost of each order
C  cost per unit
Ch  holding or carrying cost per unit per year
 Quantity Discount Model
• Quantity discounts are commonly available
• The basic EOQ model is adjusted by adding in the purchase or
materials cost

Total cost  Material cost + Ordering cost + Holding cost

D Q
Total cost  DC  Co  Ch
Q 2
where
D  annual demand in units
Cs  ordering cost of each order
C  cost per unit
Ch  holding or carrying cost per unit per year
Quantity Discount Model

A typical quantity discount schedule

DISCOUNT DISCOUNT DISCOUNT
NUMBER QUANTITY DISCOUNT (%) COST ($)
1 0 to 999 0 5.00

2 1,000 to 1,999 4 4.80

3 2,000 and over 5 4.75

 Buying at the lowest unit cost is not always the best

choice
 Quantity Discount Model
• Brass Department Store stocks toy race cars
• Their supplier has given them the quantity discount.
• Annual demand is 5,000 cars, ordering cost is $49, and holding cost is 20% of the cost of
the car
• The first step is to compute EOQ values for each discount

(2)(5,000)(49) Adjust to the smallest quantity

EOQ 1   700 cars per order possible to purchase and receive
(0.2)(5.00)
the discount
(2)(5,000)(49)
EOQ 2 
(0.2)(4.80)
 714 cars per order Q1  700
EOQ 3 
(2)(5,000)(49)
 718 cars per order
Q2  1,000
(0.2)(4.75 )
Q3  2,000
 Quantity Discount Model
The third step is to compute the total cost for each quantity

ANNUAL ANNUAL
ANNUAL ORDERIN CARRYIN
UNIT ORDER MATERIA G COST ($) G COST ($)
DISCOUNT PRICE QUANTIT L COST ($)
NUMBER (C) Y (Q) = DC = (D/Q)Co = (Q/2)Ch TOTAL ($)

1 $5.00 700 25,000 350.00 350.00 25,700.00

2 4.80 1,000 24,000 245.00 480.00 24,725.00

3 4.75 2,000 23,750 122.50 950.00 24,822.50

 The fourth step is to choose the alternative with the lowest total
cost
Use of Safety Stock

• If demand or the lead time are uncertain, the exact

ROP will not be known with certainty
• To prevent stockouts, it is necessary to carry extra
inventory called safety stock
• Safety stock can prevent stockouts when demand is
unusually high
• Safety stock can be implemented by adjusting the
ROP
 Use of Safety Stock
The basic ROP equation is
ROP  d  L
d  daily demand (or average daily demand)
L  order lead time or the number of working
days it takes to deliver an order (or average lead time)
 A safety stock variable is added to the equation to accommodate
uncertain demand during lead time

ROP  d  L + SS
where
SS  safety stock
 Use of Safety Stock
Inventory
on Hand

Inventory on
Hand

Safety Stock,
SS Stockout is Avoided

Time
Time
Stockout
 Inventory Management
ABC Classification
• It groups products, markets, or customers with
similar characteristics to facilitate inventory
management.
• The classification process recognizes that not all
products and markets have the same characteristics
or degree of importance.
 Inventory Management

ABC classification is a method for determining level of control of

inventory items
A Pareto analysis can be done to segment items into value categories
depending on annual dollar volume
A Items – typically 20% of the items accounting for 80% of the
inventory value.
B Items – typically an additional 30% of the items accounting for 15% of
the inventory value
C Items – Typically the remaining 50% of the items accounting for only
5% of the inventory value
Inventory Management
Inventory Management
Inventory Management
 Inventory Management
The A items (106 and 110) account
for 60.5% of the value and 13.3%
of the items
The B items (115,105,111,and 104)
account for 25% of the value and
26.7% of the items
The C items make up the last
14.5% of the value and 60% of the
items
THANKS