Chapter 8

Inventory Models

8.1 Overview of Inventory Issues

Proper control of inventory is crucial to the success of an enterprise. Typical inventory problems include:
Basic inventory Quantity discount Production lot size Planned shortage Periodic review Single period

Inventory models are often used to develop an optimal inventory policy, consisting of:
An order quantity, denoted Q. A reorder point, denoted R.
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Type of Costs in Inventory Models

Inventory analyses can be thought of as cost-control techniques. Categories of costs in inventory models:
Holding (carrying costs) Order/ Setup costs Customer satisfaction costs Procurement/Manufacturing costs

Type of Costs in Inventory Models

Holding Costs (Carrying costs): These costs depend on the order size
Cost of capital Storage space rental cost Costs of utilities Labor Insurance Security Theft and breakage Deterioration or Obsolescence

Ch = H * C
Ch = Annual holding cost per unit in inventory H = Annual holding cost rate C = Unit cost of an item
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Type of Costs in Inventory Models

Order/Setup Costs These costs are independent of the order size.
Order costs are incurred when purchasing a good from a supplier. They include costs such as
Telephone Order checking Labor Transportation

Co = Order cost or setup cost

Setup costs are incurred when producing goods for sale to others. They can include costs of
Cleaning machines Calibrating equipment Training staff

Type of Costs in Inventory Models

Customer Satisfaction Costs
Measure the degree to which a customer is satisfied. Unsatisfied customers may: Cb = Fixed administrative costs of an out of stock Switch to the competition (lost sales). item ($/stockout unit). Wait until an order is supplied. Cs = Annualized cost of a customer awaiting an When customers are willing to wait out of stock item there are two types of costs ($/stockout unit per incurred: year).
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Type of Costs in Inventory Models

Procurement/Manufacturing Cost
Represents the unit purchase cost (including transportation) in case of a purchase. Unit production cost in case of inhouse manufacturing.

C = Unit purchase or manufacturing cost.

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Demand in Inventory Models

Demand is a key component affecting an inventory policy. Projected demand patterns determine how an inventory problem is modeled. Typical demand patterns are:
Constant over time (deterministic inventory models) Changing but known over time (dynamic models) Variable (randomly) over time (probabilistic models)
D = Demand rate (usually per year)
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Review Systems
Two types of review systems are used:
Continuous review systems.
The system is continuously monitored. A new order is placed when the inventory reaches a critical point.

Periodic review systems.

The inventory position is investigated on a regular basis. An order is placed only at these times.
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8.2 Economic Order Quantity Model Assumptions

Demand occurs at a known and reasonably constant rate. The item has a sufficiently long shelf life. The item is monitored using a continuous review system. All the cost parameters remain constant forever (over an infinite time horizon). A complete order is received in one batch.
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The EOQ Model

Inventory profile
The constant environment described by the EOQ assumptions leads to the following observation:

The optimal EOQ policy consists of same-size orders.

Q Q Q

This observation results in the following inventory profile :

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Cost Equation for the EOQ Model

Total Annual = Total Annual + Total Annual + Total Annual Inventory Costs Holding Costs ordering Costs procurement Costs

TC(Q) = (Q/2)Ch + (D/Q)Co + DC The optimal order Size

Q

Q* =

2D C o

Ch

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TV(Q) and Q*
TV(Q)
Constructing the total annual variable cost curve Add the two curves to one another Total annual holding and ordering costs

* * o * *

Q*
The optimal order size

Q
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Sensitivity Analysis in EOQ models

The curve is reasonably flat around Q*. Deviations from the optimal order size cause only small increase in the total cost.

Q*

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Cycle Time
The cycle time, T, represents the time that elapses between the placement of orders.
T = Q/D

Note, if the cycle time is greater than the shelf life, items will go bad, and the model must be modified.
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Number of Orders per Year

To find the number of orders per years take the reciprocal of the cycle time
N = D/Q
Example: The demand for a product is 1000 units per year. The order size is 250 units under an EOQ policy.
How many orders are placed per year? N = 1000/250 = 4 orders. How often orders need to be placed (what is the cycle time)? T = 250/1000 = years. {Note: the four orders are equally spaced}.
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Lead Time and the Reorder Point

In reality lead time always exists, and must be accounted for when deciding when to place an order. The reorder point, R, is the inventory position when an order is placed. R is calculated by
R=LD L and D must be expressed in the same time unit.
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Lead Time and the Reorder Point

Graphical demonstration: Short Lead Time
Reorder Point

Place the order now

L
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R = Inventory at hand at the beginning of lead time

Lead Time and the Reorder Point

Graphical demonstration: Long Lead Time
Outstanding order R = inventory at hand at the beginning of lead time + one outstanding order = demand during lead time = LD

Inventory at hand

Place the order

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Safety stock
Safety stocks act as buffers to handle:
Higher than average lead time demand. Longer than expected lead time.

With the inclusion of safety stock (SS), R is calculated by

R = LD + SS

The size of the safety stock is based on having a desired service level.
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Safety stock
Planned situation

Reorder Point

Actual situation

Place the order now

L
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R = LD

Safety stock
Actual situation

Reorder Point

LD SS=Safety stock

Place the order now

L
The safety stock prevents excessive shortages. 22

R = LD + SS

Inventory Costs
Including safety stock
Total Annual = Total Annual + Total Annual + Total Annual Inventory Costs Holding Costs ordering Costs procurement Costs

TC(Q) = (Q/2)Ch + (D/Q)Co + DC + ChSS

Safety stock holding cost

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ALLEN APPLIANCE COMPANY (AAC)

AAC wholesales small appliances.
AAC currently orders 600 units of the Citron brand juicer each time inventory drops to 205 units. Management wishes to determine an optimal ordering policy for the Citron brand juicer

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ALLEN APPLIANCE COMPANY (AAC)

Data
Co = $12 ($8 for placing an order) + (20 min. to check)($12 per hr)
Ch = $1.40 [HC = (14%)($10)] C = $10.

H = 14% (10% ann. interest rate) + (4% miscellaneous)

D = demand information of the last 10 weeks was collected:
Sales of Juicers over the last 10 weeks Week 1 2 3 4 Sales 105 115 125 120 Week 6 7 8 9 Sales 120 135 115 110

5 125 10 130
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ALLEN APPLIANCE COMPANY (AAC)

Data
The constant demand rate seems to be a good assumption. Annual demand = (120/week)(52weeks) = 6240 juicers.

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AAC Solution:
EOQ and Total Variable Cost

Current ordering policy calls for Q = 600 juicers.

TV( 600) = (600 / 2)($1.40) + (6240 / 600)($12) = $544.80

The EOQ policy calls for orders of size

Savings of 16%

Q* =

2(6240)(12) 1.40

= 327.065

327

TV(327) = (327 / 2)($1.40) + (6240 / 327) ( $12) = $457.89

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8.4 EOQ Models with Quantity Discounts

Quantity Discounts are Common Practice in Business
By offering discounts buyers are encouraged to increase their order sizes, thus reducing the sellers holding costs. Quantity discounts reflect the savings inherent in large orders.

With quantity discounts sellers can reward their biggest customers without violating the Robinson - Patman Act.
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8.4 EOQ Models with Quantity Discounts

Quantity Discount Schedule
This is a list of per unit discounts and their corresponding purchase volumes. Normally, the price per unit declines as the order quantity increases. The order quantity at which the unit price changes is called a break point. There are two main discount plans:
All unit schedules - the price paid for all the units purchased is based on the total purchase. Incremental schedules - The price discount is based only on the additional units ordered beyond each break point. 29

All Units Discount Schedule

To determine the optimal order quantity, the total purchase cost must be included TC(Q) = (Q/2)Ch + (D/Q)Co + DCi + ChSS
Ci represents the unit cost at the ith pricing level.

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AAC - All Units Quantity Discounts

AAC is offering all units quantity discounts to its customers. Data
Quantity Discount Quantity Discount Schedule Schedule
1-299 1-299 300-599 300-599 600-999 600-999 1000-4999 1000-4999 5000 5000 $10.00 $10.00 $9.75 $9.75 $9.40 $9.40 $9.50 $9.50 $9.00 $9.00
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Should AAC increase its regular order of 327 juicers, to take advantage of the discount?

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AAC All units discount procedure

Step 1: Find the optimal order Qi* for each discount level i. Use the formula Q * ( 2DCo ) / Ch Step 2: For each discount level i modify Q i* as follows
If Qi* is lower than the smallest quantity that qualifies for the i th discount, increase Qi* to that level. If Qi* is greater than the largest quantity that qualifies for the ith discount, eliminate this level from further consideration.

Step 3: Substitute the modified Q*i value in the total cost formula TC(Q*i ). Step 4: Select the Q i * that minimizes TC(Q i*)
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AAC All units discount procedure

Step 1: Find the optimal order quantity Qi* for each
Lowest cost order size per discount level Discount Qualifying Price level order per unit Q* 0 1-299 10.00 327 1 300-599 9.75 331 2 600-999 9.50 336 3 1000-4999 9.40 337 5000 4 9.00 345
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discount level i based on the EOQ formula

AAC All Units Discount Procedure

Step 2 : Modify Q i *
$10/unit
* Q1* Q2336* Q3

$9.75/unit
299 300 331

$9.50
599 600 999

Qualified Qualified Urder Urder 1-299 1-299 300-599 300-599 600-999 600-999 1000-4999 1000-4999 5000 5000

Modified Q* and total Cost Modified Q* and total Cost Price Modified Price Modified per Unit Q* Q* per Unit Q* Q* 10.00 300 **** 10.00 300 **** 9.75 331 331 9.75 331 331 9.50 336 600 9.50 336 600 9.40 337 1000 9.40 337 1000 9.00 345 5000 9.00 345 5000

Total Total Cost Cost **** **** 61,292.13 61,292.13 59,803.80 59,803.80 59,388.88 59,388.88 59,324.98 59,324.98

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AAC All Units Discount Procedure

Step 2 : Modify Q i *
$10/unit
1

Q3* Q3 * * Q1* Q2336* 3 Q3Q

299 300 331

Q3* Q3* * Q3

Q3*

$9.50

600 999

Qualified Qualified Urder Urder 1-299 1-299 300-599 300-599 600-999 600-999 1000-4999 1000-4999 5000 5000

Modified Q* and total Cost Modified Q* and total Cost Price Modified Price Modified per Unit Q* Q* per Unit Q* Q* 10.00 300 **** 10.00 300 **** 9.75 331 331 9.75 331 331 9.50 336 600 9.50 336 600 9.40 337 1000 9.40 337 1000 9.00 345 5000 9.00 345 5000

Total Total Cost Cost **** **** 61,292.13 61,292.13 59,803.80 59,803.80 59,388.88 59,388.88 59,324.98 59,324.98

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AAC All Units Discount Procedure

Step 3: Substitute Q I * in the total cost function
Qualified Qualified Urder Urder 1-299 1-299 300-599 300-599 600-999 600-999 1000-4999 1000-4999 5000 5000 Modified Q* and total Cost Modified Q* and total Cost Price Modified Price Modified per Unit Q* Q* per Unit Q* Q* 10.00 300 **** 10.00 300 **** 9.75 331 331 9.75 331 331 9.50 336 600 9.50 336 600 9.40 337 1000 9.40 337 1000 9.00 345 5000 9.00 345 5000 Total Total Cost Cost **** **** 61,292.13 61,292.13 59,803.80 59,803.80 59,388.88 59,388.88 59,324.98 59,324.98

Step 4

AAC should order 5000 juicers

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