Inventory Management

EOQ & Quantity

Discounts
Operations Management
P. Kalyanasundaram
 Purposes of Inventory

■ Meet anticipated demand

■ Decouple production & distribution
● permits constant production quantities
■ Take advantage of quantity discounts
■ Hedge against price increases
■ Protect against shortages
 Types of Inventory

■ Raw Materials
■ Work in progress (WIP)
■ Finished products
■ Maintenance, Repairs & Operating
Supplies
 Disadvantages of
Inventory
■ Higher costs
● Item cost (cost of the item)
● Ordering (or setup) cost
▲ cost of forms, clerk’s wages, EDI system
● Holding (or carrying) cost
▲ Building lease, insurance, money tied up
■ Difficult to control
■ Hides production problems
 Inventory Costs

What costs do we experience because

we carry inventory?
 Inventory Costs

Costs associated with inventory:

■ Cost of the products
■ Cost of ordering
■ Cost of holding
■ Cost of disposal
 Shrinkage Costs

■ How much is stolen?

● 2% for discount, dept. stores, hardware,
convenience, sporting goods
● 3% for toys & hobbies
● 1.5% for all else
■ Where does the missing stuff go?
● Employees: 44.5%
● Shoplifters: 32.7%
● Administrative / paperwork error: 17.5%
● Vendor fraud: 5.1%
 Inventory Holding
Costs
Category % of Value
Housing (building) cost 6%
Material handling 3%
Labor cost 3%
Opportunity/investment 11%
Pilferage/scrap/obsolescence 3%
Total Holding Cost 26%
 ABC Analysis
■ Divides on-hand inventory into 3 classes
● A class, B class, C class
■ Basis is usually annual $ volume
● $ volume = Annual demand x Unit cost
■ Policies based on ABC analysis
● Develop class A suppliers more
● Give tighter physical control of A items

● Forecast A items more carefully

 Classifying Items
as ABC
% Annual $ Usage Class % $ Vol % Items
100 A 80 15
B 15 30
80
C 5 55
60
40 A
20 B C
0
0 50 100 150
% of Inventory Items
 ABC Classification
Solution

Stock # Vol. Cost $ Vol. % ABC

206 26,000 $ 36 $936,000
105 200 600 120,000
019 2,000 55 110,000
144 20,000 4 80,000
207 7,000 10 70,000
Total 1,316,000
 ABC Classification
Solution

Stock # Vol. Cost $ Vol. % ABC

206 26,000 $ 36 $936,000 71.1 A
105 200 600 120,000 9.1 A
019 2,000 55 110,000 8.4 B
144 20,000 4 80,000 6.1 B
207 7,000 10 70,000 5.3 C
Total 1,316,000 100.0
 Inventory Models
■ Fixed order quantity models
● Economic order quantity

● Quantity discount

■ Fixed order period models

 Economic Order
Quantity
Assumptions
■ Demand rate is known and constant
■ No order lead time
■ Shortages are not allowed
■ Costs:
● S - setup cost per order
● c - unit cost

● h - holding cost per unit time

 EOQ
Inventory
Level

Q* Decrease Due to
Optimal Constant Demand
Order
Quantity

Time
 EOQ
Inventory
Level

Q* Instantaneous
Optimal Receipt of Optimal
Order Order Quantity
Quantity

Time
 EOQ

Inventory
Level

Q*
Optimal
Order
Quantity

Time

Lead Time
 EOQ

Inventory
Level
Q*

Reorder
Point
(ROP)

Time

Lead Time
 EOQ

Inventory
Level
Q*
Average
Inventory Q/2
Reorder
Point
(ROP)

Time

Lead Time
 Total Costs
■ Average Inventory = Q/2
■ Annual Holding costs = H * Q/2
■ # Orders per year = D / Q
■ Annual Ordering Costs = S * D/Q
■ Annual Total Costs = Holding + Ordering
Q D
TC (Q) = H * + S *
2 Q
 How Much to Order?

Annual Cost

Holding Cost
= H * Q/2

Order Quantity
 How Much to Order?

Annual Cost

Ordering Cost
= S * D/Q

Holding Cost
= H * Q/2

Order Quantity
 How Much to Order?
Total Cost
Annual Cost = Holding + Ordering

Order Quantity
 How Much to Order?
Total Cost
Annual Cost = Holding + Ordering

Optimal Q Order Quantity

 Optimal Quantity

Q D
Total Costs = H* +S*
2 Q
 Optimal Quantity

Q D
Total Costs = H* +S*
2 Q
Take derivative H D
with respect to Q = −S* 2
2 Q
 Optimal Quantity

Q D
Total Costs = H* +S*
2 Q
Take derivative H D Set equal
with respect to Q = −S* 2 =0 to zero
2 Q
 Optimal Quantity

Q D
Total Costs = H* +S*
2 Q
Take derivative H D Set equal
with respect to Q = −S* 2 =0 to zero
2 Q
Solve for Q:

H DS
= 2
2 Q
 Optimal Quantity

Q D
Total Costs = H* +S*
2 Q
Take derivative H D Set equal
with respect to Q = −S* 2 =0 to zero
2 Q
Solve for Q:

H DS 2 DS
= 2 Q =
2
2 Q H
 Optimal Quantity

Q D
Total Costs = H* +S*
2 Q
Take derivative H D Set equal
with respect to Q = −S* 2 =0 to zero
2 Q
Solve for Q:

H DS 2 DS 2 DS
= 2 Q =
2
Q=
2 Q H H
 Adding Lead Time

■ Use same order size Q = 2 DS

■ H
Order before inventory depleted
■ ROP = Safety Stock + CR * LT
● CR = Consumption Rate
● LT = Lead Time
 A Question:

■ If the EOQ is based on so many

horrible assumptions that are never
really true, why is it the most
commonly used ordering policy?
 Benefits of EOQ

■ Even if conditions don’t hold

perfectly, profits are close to optimal
■ Estimated parameters will not throw
you off very far
Example: ABC Plumbing
Supply Company
ABC Plumbing Supply Company stocks
thousands of plumbing items sold to regional
plumbers, contractors and retailers. Mr. Henry,
the firm’s general manager, wonders how much
money could be saved annually if EOQ were used
instead of the firms present rules of thumb. He
instructs Mary, an inventory analyst to conduct
an analysis of one material only (Material #3025, a
brass valve) to see if significant savings might
result from using EOQ. Mary develops the
following estimates from accounting information:
 Accounting
Information
■ D = 10000 valves per year
■ Q = 400 valves per order (present
order quantity)
■ H = $0.40 per valve per year
■ S = $5.50 per order
 Solution

Mary calculates the present total

annual stocking costs:
TSC1 = Q/2 * H + D/Q*S
= 400/2 * 0.4 + 10000/400 *5.5
= 80 + 137.5
= $217.50
 The EOQ is calculated

EOQ = √2DS/H
= √2 (10000)(5.5)/0.4
= √275000
= 524.4 Valves
 The total annual stocking costs if
EOQ were employed is calculated

TSC2 = Q/2 * H + D/Q*S

= (524.4/2) * 0.4 + (10000/524.4) *5.5
= 104.88 + 104.88
= $209.76
Estimated savings = TSC1 - TSC2
= 217.50-209.76
= $7.74
 Conclusion

Mary concludes that if the annual

savings on this one material were
applied to the thousands of items in
inventory, the savings from EOQ
would be significant.
 Quantity Discounts

■ How does this all change if price

changes depending on order size?
■ Explicitly consider price
■ Compare the total annual material
costs (TMC)
■ TMC = Total annual stocking costs +
Annual acquisition cost
= TSC + D(ac)
■ Compute EOQ with each of the sales prices. Note
that H is usually a function of sales price or
production cost. For example H may be defined
as 20 percent of the sales price. Therefore EOQ
will change as H and ac will change.
■ Determine which EOQ from step 1 above is
feasible. In other words, is the computed EOQ in
the quantity range of price?
■ The total annual material cost (TMC) is computed
for the feasible EOQ and the quantity at any price
break with lower sales prices.
■ The order quantity with the lower total annual
material cost (TMC) is the economic order
quantity.
 Discount Example

D = 10,000 S = $20 H = 20% of

ac

Price Quantity EOQ

c = 5.00 Q < 500 633
4.50 501-999 666
3.90 Q >= 1000 716
 Discount Pricing

Total Cost

Price 1 Price 2 Price 3

X 633
X 666
X 716

500 1,000 Order Size

 Discount Pricing

Total Cost

Price 1 Price 2 Price 3

X 633
X 666
X 716

500 1,000 Order Size

 Discount Example

Order 666 at a time:

Hold 666/2 * 4.50 * 0.2= $299.70
Order 10,000/666 * 20 = $300.00
Mat’l 10,000*4.50 = $45,000.00 45,599.70

Order 1,000 at a time:

Hold 1,000/2 * 3.90 * 0.2=$390.00
Order 10,000/1,000 * 20 = $200.00
Mat’l 10,000*3.90 = $39,000.00 39,590.00
 Discount Model

1.Compute EOQ for each price

2.Is EOQ ‘realizeable’? (is Q in range?)
3.Compute total cost for this quantity
4.Select quantity/price with lowest
total cost.
When to Reorder with
EOQ Ordering

■ Reorder Point - When the

quantity on hand of an item
drops to this amount, the item is
reordered
■ Safety Stock - Stock that is held
in excess of expected demand
due to variable demand rate
and/or lead time. (Safety Stock
to be considered while ROP is
decided)
Continuous (Q) Review System Example: A computer company
has annual demand of 10,000. They want to determine EOQ
for circuit boards which have an annual holding cost (H) of $6
per unit, and an ordering cost (S) of $75. They want to
calculate TC and the reorder point (R) if the purchasing lead
time is 5 days.

■ EOQ (Q)

2DS 2 * 10,000 * $75

Q= = = 500 units
H $6
■ Reorder Point (R)
10,000
R = Daily Demand x Lead Time = * 5 days = 200 units
250 days

■ Total Inventory Cost (TC)

 10,000   500 
TC =   $75 +  $6 = $1500 + $1500 = $3000
 500   2 
Quantity Discount Example: Collin’s Sport store is considering going
to a different hat supplier. The present supplier charges $10 each
and requires minimum quantities of 490 hats. The annual demand is
12,000 hats, the ordering cost is $20, and the inventory carrying
cost is 20% of the hat cost, a new supplier is offering hats at $9 in
lots of 4000. Who should he buy from?
■ EOQ at lowest price $9. Is it feasible?
2(12,000)(20)
EOQ$9 = = 516 hats
$1.80
■ Since the EOQ of 516 is not feasible, calculate the total
cost (C) for each price to make the decision
12,000 490
C$10 = ( $20) + ( $2) + $10( 12,000) = $120,980
490 2
12,000 4000
C$9 = ( $20) + ( $1.80) + $9( 12,000) = $101,660
4000 2

■ 4000 hats at $9 each saves $19,320 annually.