CHAPTER I

INVENTORY MODELS
Prepared by:
Engr. Romano A. Gabrillo
MEP - MEM

Definition

Inventory is an idle stock of items for future

use. The two key issues in inventory models
are the quantity (how much) and the timing
(when) of the orders.

The objective is to minimize the total inventory

cost consisting of carrying (holding) cost and
ordering cost.

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Dependent and Independent

Demand

In an independent demand model, the demand

for an item is independent of the demands for
other items in inventory, e.g. (end-products,
finished goods)

In a dependent model, the demand for an item

is dependent upon the demands for other items
in inventory, e.g. (assembly-components)

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Fixed Order Quantity Models

In this type of model, the quantity (how much)

of the order is fixed while the timing (when) of
the order varies.

In this model, we will consider optimal order

quantities, known as economic order quantities
(EOQ), for the following three cases:
(i) EOQ for purchasing
(ii) EOQ for production
(iii) EOQ for quantity discounts

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Case I: Economic Order

Quantity (EOQ) for Purchasing

In this model, total annual inventory cost

(TC) is determined as:
TC = annual carrying cost +
annual ordering cost
= (Q/2)C + (D/Q)S
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Total Annual Inventory Cost

where:

D = annual demand (units per year)

Q = quantity ordered (units per order)
C = unit carrying cost per year
= holding rate (R) x unit acquisition cost or unit price (P)
S = ordering cost (dollars per order)
TC = total annual inventory cost (dollars per year)

To find EOQ, set the derivative of TC with respect to Q, equal to

zero and solve for Q:
EOQ = Q* =

(2DS ) / C

Number of orders per year (frequency of ordering) = F= D/Q*

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Example No. 1

Given demand D = 420 items per year; ordering

cost S = $45; and carrying cost C = $15 per
unit; find EOQ and F.

Solution
Q* (2 DS ) / C [2(420)(45)] / 15 50.20units
F D / Q* 420 / 50.11 8.37

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Case II: Economic Order

Quantity (EOQ) for Production

In this model, the annual total inventory cost is

determined as:
TC annual carrying cost annual setup cost

(Q / 2)[( p d ) / p]C ( D / Q) S
where:
d = demand rate (units per time period)
p = production rate (units per time period)
S = setup cost ($)
(Q/2)[(p-d)/p] = average inventory level (units)
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To determine EOQ, set the derivative of

TC with respect to Q, equal to zero and
solve for Q:
EOQ Q* [(2DS ) / C][ p /( p d )]

Example No. 2

Given annual demand D = 20000 units;

daily production rate p = 160 units; daily
usage rate d = 80 units; setup cost S =
$120; unit holding cost per year C =
20% of unit manufacturing cost per year
$4.00; find EOQ:

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Solution

Q [2(20000)(120) /(0.20)(4.00)][160 /(160 80]

3464.10 units

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Maximum Inventory
Assuming the production rate p is larger than the
demand rate d, maximum inventory Im is computed as
follows:
where:
time.

Q*
2DS p d
Im ( p d )

,
p
C
p

Q/p = length of production run or production run

Then, the annual total inventory cost is determined as:

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Im
D
TC C
S
2
Q*

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Example No. 3

Americhem Corporation supplies West

Engineering Company with a construction
materials at the rate of 5500 barrels per day
and a price of $19.10 per barrel. West
Engineering uses the material at the rate of
2200 barrels per day and 550,000 barrels per
year. The ordering cost is $3250 per year and
the holding cost is 25% of the price per barrel
per year. Find (a) EOQ; (b) TC at EOQ; (c)
number of production days per order; (d)
maximum storage capacity for the material.

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Solution:

Given: D = 550000; S = $3250; C =

(0.25)(19.10); p = 5500; d = 2200.

(a)

Economic Order Quantity:

Q*

2 DS p
2(550000)(3250)
5500

C pd
(0.25)(19.10) (5500 2200)

35324.47 barrels
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(b) Annual total inventory cost:

Q* p d
D
C
S
2
p
Q*
35324.47 (5500 2200)
550000

(0.25)(19.10)
3250
2
5500
35324.47
50602.30 50602.30 $101204.60

TC

(c) Number of production days per order:

Q*/d = (35324.47)/(2200)=16.1 days
(d) Maximum storage capacity:
I m ( p d )(Q * / p) (5500 2200 )(35324 .47 / 5500 ) 21194 .68

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Case III: Economic Order

Quantity (ECQ) for Quantity
Discounts

In the previous two cases, the unit purchasing

cost or the unit production cost (P) is constant
and hence is not considered.

However, if quantity discounts or price breaks

are offered for large order quantities, P will
depend upon order quantity. Thus, in this
model, P should also be considered in the cost
equation as follows:

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TC = annual carrying cost + annual ordering cost +

annual acquisition cost

For instantaneous delivery, TC is given by:

TC = (Q*/2)C + (D/Q*)S + (D)P
And the EOQ is determined by its derivative formula.
For gradual delivery, TC is given by:
TC = (Q*/2)[(p d)/p]C + (D/Q*)S + (D)P
And the EOQ is determined by its derivative formula.
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Determining the order quantity with

the lowest annual total cost

The price reduction are usually offered in

a series of ranges, as illustrated in the
price list below:
Order Quantity Price per unit (P)
1 to 119
$42
120 to 169
41
170+
40

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The following approach is recommended in

determining the order quantity with the
lowest annual total cost:
Step 1:
Compute the EOQ using each of the unit prices.
Step 2:
Determine which EOQs of Step 1 are feasible.
Step 3:
The feasible EOQ Corresponding to the lowest unit price is
the admissible EOQ.
Step 4:
Compute TCs for the admissible EOQ and for quantities at
lower price breaks.
Step 5:
The quantity with the lowest TC is the optimum.

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Example No. 4

Precision Construction Inc. sells cements to Best

Construction Co. as per following price list:
Order Quantity Price per unit (P)
1 to 299
$2.50
300-619
2.30
620+
2.00

The annual demand is estimated to be 15,000

cements per year. The carrying costs are 25%
of the unit price and the ordering costs are
$6.50. Assume instantaneous delivery. Find (a)
EOQ; (b) optimum TC; (c) time between orders.

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Solution

Given: D = 15,000; S = $6.50; (0.25)(P). The

EOQ is computed for each unit price:

Q *( 2.50)
Q *( 2.30)

2 DS
2(15000)6.50

582.35 cements (feasible)

C
(0.25)(2.30)

Q *( 2.00)
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2 DS
2(15000)6.50

558.57 cements (infeasible)

C
(0.25)(2.50)

2 DS
2(15000)6.50

624.50 cements (feasible)

C
(0.25)(2.00)

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(a)

The feasible EOQ of 624.50, corresponding to

the lowest unit price of $2.00, is the admissible
EOQ. Since there is no lower unit price break,
the optimal quantity is 624.50.

(b)

The corresponding optimum TC is found as

follows:
Q*
D
C
S ( D) P
2
Q*
624 .50
15000
TC ( 2.00 )
(0.25 )( 2.00 )
6.50 (15000 )2.00 $30 .312 .25
2
624 .50
TC

(c)

Time between orders

Q*/D = 624.49/15000=0.0416 year=15days

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Example No. 5

The Wizard Computers, Inc. purchases

5000 hard drives per year for use in its
computers. Each order costs $70.00.
The inventory holding cost is 25% of the
unit price. The supplier has provided the
following price list.
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Order Quantity

Price per unit (P)

1 to 499

$ 50.00

500 to 649

45.00

650+

42.50

Assuming instantaneous delivery, find (a)

optimal order quantity; (b) optimal TC.

SOLUTION:
Given D = 5000; S = $70.00;
C=(0.25)(P)

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The EOQ computer for each

unit price:
Q *(50.00)

2 DS
2(5000)70

236.64 units ( feasible)

C
(0.25)(50.00)

Q *( 45.00)

2 DS
2(5000)70

249.44 units (inf easible)

C
(0.25)(45.00)

Q *( 42.50)

2 DS
2(5000)70

256.68 units (inf easible)

C
(0.25)(42.50)

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The key quantities to examine are

236.64, 500, 650, at unit prices of
$50, $45, and $42.50 respectively.
Q*
D
TC
C
S ( D) P
2
Q*
236.64
5000
TC(50.00)
(0.25)(50)
70 (5000)(50) $252,958.04
2
236.64
500
5000
TC( 45.00)
(0.25)(45)
70 (5000)(45) $228,512.50
2
500
650
5000
TC( 42.50)
(0.25)(42.50)
70 (5000)(42.50) $216,419.59
2
650

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The lowest TC is $216.491.59

corresponding to the unit price
of $42.50
a)
b)

Optimal order quantity = 650 units

Optimum TC = $216491.59

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End of Chapter 1 Part 1

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Assignment No. 1
1.

Lincoln Construction produces 300

beams per day, which go into inventory.
It supplies 150 beams per day to
Murphy Builders. The annual demand is
37,500. The inventory holding cost is
$0.25 per beam per year and the setup
cost per production run is $200. Find:
(a) EOQ; (b) production run length;
number of production runs per year; (d)
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maximum inventory level.

2.

The Princeton Construction Company

buys 90,000 containers each year from
the Trenton Can Company. The
ordering cost is $90. The carrying cost
per container per year is assumed to be
20% of the unit price. The discount
price schedule is as follows:
Order Quantity

Price per unit (P)

1 to 10,0000

$0.45

10,000 to 20,000

0.38

20,000 +

0.35

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Assuming instantaneous delivery, find (a)

EOQ; (b) optimum TC; (c) number of
orders per year; (d) time between orders

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