Inventory is a list for goods and materials, or those goods and materials themselves, held

available in stock by a business. It is also used for a list of the contents of a household
and for a list for testamentary purposes of the possessions(owner) of someone who has
died. In accounting inventory is considered an asset.
Inventory management is primarily about specifying the size and placement of stocked
goods. Inventory management is required at different locations within a facility or within
multiple locations of a supply network to protect the regular and planned course of
production against the random disturbance of running out of materials or goods. The
scope of inventory management also concerns the fine lines between replenishment lead
time, carrying costs of inventory, asset management, inventory forecasting, inventory
valuation, inventory visibility, future inventory price forecasting, physical inventory,
available physical space for inventory, quality management, replenishment(top up),
returns and defective goods and demand forecasting.

Assume that the demand for a product is constant over the year and that each new order is
delivered in full when the inventory reaches zero. There is a fixed cost charged for each
order placed, regardless of the number of units ordered. There is also a holding or storage
cost for each unit held in storage (sometimes expressed as a percentage of the purchase
cost of the item).
We want to determine the optimal number of units of the product to order so that we
minimize the total cost associated with the purchase, delivery and storage of the product
The required parameters to the solution are the total demand for the year, the purchase
cost for each item, the fixed cost to place the order and the storage cost for each item per
year. Note that the number of times an order is placed will also affect the total cost,
however, this number can be determined from the other parameters
Inventory Decisions: how much to order and when to order.

Underlying assumptions
1. The ordering cost is constant.

2. The rate of demand is constant

3. The lead time is fixed

4. The purchase price of the item is constant i.e no discount is available

5. The replenishment is made instantaneously, the whole batch is delivered at once.

EOQ (economic order quantity) is the quantity to order, so that ordering cost + carrying
cost finds its minimum.
Variables
• Q = order quantity

• Q * = optimal order quantity

• D = annual demand quantity of the product

• P = purchase cost per unit

• C = fixed cost per order (not per unit, in addition to unit cost)

• H = annual holding cost per unit (also known as carrying cost or storage cost) (warehouse space,
refrigeration, insurance, etc. usually not related to the unit cost)

The Total Cost function

The single-item EOQ formula finds the minimum point of the following cost function:
Total Cost = purchase cost + ordering cost + holding cost (p-o-s)
- Purchase cost: This is the variable cost of goods: purchase unit price × annual demand
quantity. This is P×D
- Ordering cost: This is the cost of placing orders: each order has a fixed cost C, and we
need to order D/Q (annual demand quantity/order quantity ) times per year. This is
C × D/Q
- Holding cost: the average quantity in stock (between fully replenished and empty) is
Q/2, so this cost is H × Q/2

.
To determine the minimum point of the total cost curve, set its derivative equal to zero:

.
The result of this derivation is:

.
Solving for Q gives Q* (the optimal order quantity):

Therefore: .
Note that interestingly, Q* is independent of P, it is a function of only C, D, H.

Reorder point
R = demand during lead time.= Lxd where d = daily avg. demand.
If delivery is instantaneous then the reorder point is Zero.
Inventory Notes

Types of Inventory Systems:

(1) Continuous Review (also called Fixed Quantity): when

inventory drops to the reorder level, a fixed quantity is ordered.
This is used for high volume, valuable, or important items.
(2) Periodic Review: when inventory drops at or below the reorder
level, a quantity that brings inventory up to the maximum
inventory level is ordered. This is used for moderate volume
items.
(3) A-B-C System: this combines the three systems above for high,
moderate and low importance items.

Example for the Basic Model

D=annual demand (units per year)= 10,000

H=carrying cost for one unit in inventory for one year (dollars per unit per year)=$4
S= order cost=$50
______ _____________
Then, EOQ = √ 2DS/C = √ 2*10,000*50/4 = 500 units per order

Second Inventory Model – Determining production lot size (Economic batch quantity)
Assumptions 1,3 and 4 for the Basic model still hold, but the second assumption is
changed so that delivery lead time is known but delivery takes place at a rate of p units
per day until the order is filled and the delivery rate p is greater than the usage rate d units
per day.

The maximum inventory level = buildup rate* period of delivery = (p-d)*(Q/p)

Average Inventory = .5* Maximum inventory

= .5*(p-d)*(Q/p)
which is smaller than the average inventory in the basic model =.5*Q
_______________
The EOQ = √ (2DS/H)*[p/(p-d)]

Example for the Production Lot Size Model:

D=annual demand (units per year)= 10,000
H=carrying cost for one unit in inventory for one year (dollars per unit per year)=$4
S= order cost=$50
d=daily demand = annual demand/250= D/250= 10,000/250= 40 units per day
p=daily production rate = 90 units per day
_______________ ________________________
Then, EBQ = √ (2DS/C)*[p/(p-d)] = √(2*10,000*50/4)*[90/(90-40)] = 671 units

Third Inventory Model – EOQ with Quantity Discounts

Assumptions 1, 2 and 3 for the Basic model hold, but quantity discounts are allowed.

In addition to the previous notation, we’ll have

TMC= total annual material costs = carrying cost + order cost + acquisition cost

TMC=C*D+ (D/Q)*S+(Q/2)*H where

The procedure to be used is:

1. Compute the theoretical EOQ for each price using the formula for the basic model
______
√ 2DS/C and check the feasibility means this quantity is offered by that price or
not. If not then it’s a no feasible.
2. then chose the next lowest price and find the order quantity and check the
feasibility. Continue this process till getting a feasible quantity.
3. Then find out the total cost when Q = feasible order quantity and c = unit cost for
the feasible quantity.
4. Find total cost at the break points. ( the quantity where the price range is
changing) where Q = quantity at break point and c = unit cost at that break point.
5. Compare the costs and chose the minimum one.
6. So the Economical order quantity will be the quantity at where the total cost is
minimum.

EOQ with Quantity Discounts

Here C0 =S= ordering cost

i= H = holding cost or carrying cost

p1 , p2, p3 = unit price..

Assignment
1. Find the optimal order size for a product when the annual demand for the product is 500
units, the cost of storage per unit per year is 10% of the unit cost. The ordering cost per
order is Rs 180.00.
The unit costs are given below.
Quantity unit cost
0 ≤ Q 1<500 Rs 25.00
500 ≤ Q 2 <1500 Rs 24.80
1500 ≤ Q 3 <3000 Rs 24.60
3000 ≤ Q 4 Rs 24.40

2. A-1 Auto Parts has a regional tire warehouse in Atlanta. One popular tire, the
XRX75, has estimated demand of 25,000 next year. It costs A-1 $100 to place an
order for the tires, and the annual carrying cost is 30% of the acquisition cost. The
supplier quotes these prices for the tire:
Q unit cost
1 – 499 $21.60
500 – 999 $20.95
1,000 + $20.90

Find the Economical Order Quantity ?

Safety stock
Safety stock is a term used by inventory specialists to describe a level of extra
stock that is maintained below the cycle stock to buffer against stockouts. Safety
Stock (also called Buffer Stock) exists to counter uncertainties in supply and
demand. Safety stock is defined as extra units of inventory carried as protection
against possible stockouts (shortfall in raw material or packaging). By having an
adequate amount of safety stock on hand, a company can meet a sales demand
which exceeds the demand they forecasted without altering their production plan.
[1] It is held when an organization cannot accurately predict demand and/or lead
time for the product. It serves as an insurance against stock outs.

Safety stock = ss = z × σ
where z = normal statistic value for a service level
σ = standard deviation

Now Reorder point = demand during lead point + safety stock.

Periodic Review (P-System)

• Orders are placed after an elapsed period of time has passed for a variable
quantity of units.

• Other differences between Q- and P-System

(1) Perpetual versus periodic inventory accounting systems

(2) Higher than normal demand during the order cycle leads to a shorter time
between orders for Q-System while in P-System it leads to larger order sizes

(3) P-System typically require larger safety stocks in order to provide the same
level of customer service.

1. General model form with uncertain (variable) demand, constant lead time

Q = Expected Demand during Protection Interval + Safety Stock - On Hand Amount

2. Specific model Form w/ uncertain demand, constant lead time

Maximum inventory = d(RP+L) + SS

d is demand rate,
RP is review period,
L is lead time,
SS is safety stock,