# Costs involved in Inventory Models

• • • • • Ordering (Setup) cost Unit purchasing (Production) cost Holding (Carrying) cost Shortage (Penalty) cost Revenue (Selling price)

Basic EOQ Model
• EOQ: Economic Order Quantity • Assumptions of EOQ models:
– Demand is constant (unvarying ), expressed as annual demand (units per year ). – Models use continuous review, not periodic review. – Lead time is constant & known. – Quantity discounts are not possible. – 2 variable costs: setup cost and holding cost.

Inventory Levels
• Inventory vs. time.
Usage rate (D)

Reorder Point (ROP) Lead time ( L, l ) Cycle time (T) time

Symbols in EOQ models
• • • • • Order quantity: Optimal order quantity: Annual demand (units): Setup cost per order: Holding cost (per unit): Q Q* D K H

Total Cost vs. Order Quantity.
Annual Cost Combined curve: holding & setup.

Minimum annual cost We’ll find an equation for this amount

Holding cost curve

Setup cost curve Order Quantity

Optimal order quantity

Annual setup cost: equation
• What is related to it? Q, K, & D demand / quantity per order = # of orders. # of orders * K = annual setup cost.

D Annual setup cost = *K Q

Annual holding cost: equation.
• Q: order quantity Q & H. • inventory is replenished precisely when no inventory remains. • Average inventory = Q/2 Constant
slope

Q

time

Annual holding cost: equation.
Q H Annual holding cost = * 2
Q

time

Finding where they are equal.
• The minimum cost of the system will be found where ASC = AHC.

D K ASC = * Q

Q H AHC = * 2

Solve for Q
• The minimum cost of the system will be found where ASC = AHC.

D K * = Q

Q H * 2

Solve for Q
• The minimum cost of the system will be found where ASC = AHC.

2DK = Q2 H

Solve for Q
• The optimal order quantity that results in the lowest system cost is called Q*

2DK = Q* H

Holding costs
• Total annual holding cost: inc. monetary value of inventory, annual cost of capital, storage costs:

Hc =

cQ 2

Holding costs
• Total annual holding cost: inc. monetary value of inventory, annual cost of capital, storage costs:

Hf =

i * cQ 2

Holding costs
• Total annual holding cost: inc. monetary value of inventory, annual cost of capital, storage costs:

Hs =

sQ 2

Total holding costs
• Total annual holding cost: inc. monetary value of inventory, annual cost of capital, storage costs:

(s+ic)Q Ht = 2

Other factors (lurking in the shadows)
• Unit cost (production cost): cost per unit to buy the inventory: symbol “c” • Annual unit cost = cD

Other factors (lurking in the shadows)
• Revenue: profit per unit of inventory sold: symbol “r” • Annual revenue = rD

Total Cost of the System
DK ( s + i c ) Q Total cost = cD + + Q 2
Cost of inventory

Cost of the products

Cost of ordering

Determine reorder point
• Demand is constant. Lead time is known.

Q

ROP L = Q T

ROP

time L

MS Excel example
• (Go to it)

Homework: due Thursday
• p. 470, #1, 2, 4 - turn in ON PAPER
(preferably computer printouts, each on 1 sheet of paper that can be understood by someone who WASN’T there when you set it up.)

Preview of Thurs.: 2 other models (ind. D)
• Production Order Quantity Model • Quantity Discount Model