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Inventory Control

Models
Ch 4 (Known Demands)
R. R. Lindeke
IE 3265, Production And
Operations Management

Reasons for Holding


Inventories
Economies

of Scale
Uncertainty in delivery lead-times
Speculation. Changing Costs Over Time
Smoothing: to account for seasonality and/or
Bottlenecks
Demand Uncertainty
Costs of Maintaining Control System

Characteristics of Inventory Systems

Demand

May Be Known or Uncertain


May be Changing or Unchanging in Time

Lead Times - time that elapses from placement of


order until its arrival. Can assume known or
unknown.
Review Time. Is system reviewed periodically or
is system state known at all times?

Characteristics of Inventory Systems


Treatment

of Excess Demand.

Backorder

all Excess Demand


Lose all excess demand
Backorder some and lose some
Inventory

whos quality changes over time

perishability
obsolescence

Real Inventory Systems: ABC


ideas
This was the true basis of Paretos Economic
Analysis!
In a typical Inventory System most companies
find that their inventory items can be generally
classified as:

A Items (the 10 - 20% of skus) that represent up to 80% of


the inventory value
B Items (the 20 30%) of the inventory items that
represent nearly all the remaining worth
C Items the remaining 50 70% of the inventory items
skus) stored in small quantities and/or worth very little

Real Inventory Systems: ABC


ideas and Control
A

Items must be well studied and controlled


to minimize expense
C Items tend to be overstocked to ensure no
runouts but require only occasional review
See mhia.org there is an e-lesson on the
principles of ABC Inventory management
check it out! do the on-line lesson!

Relevant Inventory Costs

Holding Costs - Costs proportional to


the quantity of inventory held.
Includes:

1.
2.
3.
4.

Physical Cost of Space (3%)


Taxes and Insurance (2 %)
Breakage Spoilage and Deterioration (1%)
Opportunity Cost of alternative investment. (18%)

Here these holding issues total: 24%


Therefore, in inventory systems, the holding
cost would be taken as:
h .24*Cost of product

Lets Try one:


Problem

4, page 193 cost of inventory


Find h first (yearly and monthly)
Total holding cost for the given period:

THC = $26666.67

Average

Annual Holding Cost

assumes an average monthly inventory of trucks


based on on hand data
$3333

Relevant Costs (continued)


Ordering

Cost (or Production Cost).

Includes both fixed and variable components

slope = c

C(x) = K + cx for x > 0; 0 for x = 0.

Relevant Costs (continued)


Penalty

or Shortage Costs. All costs


that accrue when insufficient stock is
available to meet demand. These
include:
Loss of revenue due to lost demand
Costs of book-keeping for backordered
demands
Loss of goodwill for being unable to satisfy
demands when they occur.

Relevant Costs (continued)


When

computing Penalty or Shortage


Costs inventory managers generally
assume cost is proportional to number of
units of excess demand that will go
unfulfilled.

The Simple EOQ Model the


most fundamental of all!
Assumptions:

1. Demand is fixed at units per unit time


typically assumed at an annual rate (use care).
2. Shortages are not allowed.
3. Orders are received instantaneously. (this will
be relaxed later).

Simple EOQ Model (cont.)


Assumptions

(cont.):

4. Order quantity is fixed at a value Q per cycle.


(we will find this as an optimal value)
5. Cost structure:
a) includes fixed and marginal order costs (K +
cx)
b) includes holding cost at h per unit held per
unit time.

Inventory Levels for the EOQ


Model

The Average Annual


Cost Function G(Q)

Modeling Inventory:

K cQ

G(Q)
K : setup cost
c: Unit cost

T: cycle length T= Q

hQ

h: holding cost % of unit cost

Subbing Q/ for T

G (Q)

K cQ

hQ

K
hQ
G (Q)
c
Q
2

Finding an Optimal Level of Q


the so-called EOQ
Requires

us to take derivative of the


G(Q) equation with respect to Q
Then, Set derivative equal to Zero:

K h
G (Q )
0
2
Q
2
'

Now,

Solve for Q

Properties of the EOQ


(optimal) Solution

2K
Q
h
Q is increasing with both K and and decreasing
with h
Q changes as the square root of these quantities
Q is independent of the proportional order cost, c.
(except as it relates to the value of h = I*c)

Try ONE!
A

company sells 145 boxes of BlueMountain


BobBons/week (a candy)
Over the past several months, the demand
has been steady
The store uses 25% as a holding factor
Candy costs $8/bx and sells for $12.50/bx
Cost of making an order is $35
Determine EOQ (Q*) and how often an order
should be placed

Plugging and chugging:

2 *35* 7540
513.7 : 514
h = $8*.25 = $2 Q
2
= 145*52 =
*
Q
T
514
.068 yr
7540

7540
or: 514
3.54 wk
145
*

Annual Inventory Cost:

Then, In your
teams: Compute
Pr. 10, pg 201

35 7540 514 2
G Q

7540 8
514
2
G Q 513.42 514 60320 $61347.42
Cost of Ordering & Holding:
513.42 + 514 = $1027.42

But, Orders usually take time to


arrive!
This

is a realistic relaxation of the EOQ ideas


but it doesnt change the model
This requires the user to know the order
Lead Time

In

And then they trigger an order at a point before


the delivery is needed to assure no stock outs

our example, what if lead time is 1 week?


We should place an order when we have 145
boxes in stock (the one week draw down)
Note make sure lead time units match units in T!

But, Orders usually take time to


arrive!

What happens when order lead times exceed T?


We proceed just as before (but we compute /T)

is the lead time is units that match T

Here, lets assume = 6 weeks then:


/T = 6/3.545 = 1.69 in the Blue Mount Bon-Bon case
Place order: 1.69 cycles before we need product!
Trip Point is then 0.69*Q* = .69*514 = 356 boxes
This trip point is not for the next stock out but the one
after that (1.69 T or 6 weeks from now!)

be very careful!!!

Sensitivity Analysis
Let G(Q) be the average annual holding and setup cost function given by

G (Q) K / Q hQ / 2
and let G* be the optimal average annual cost.
Then it can be shown that:

G (Q) 1 Q * Q


G*
2 Q Q *

Sensitivity
We

find that this model is quite robust to Q


errors if holding costs are relatively low

We

find, for a given Q a mistake in the


ordering quantity

that Q* + Q has smaller error than Q* - Q (Error


means we incur extra inventory maintenance
costs a penalty cost)
That is, we tend to have a smaller penalty cost if
we order too much compared to too little

Inventory Levels for Finite


Production Rate Model

EOQ With Finite Production Rate

Suppose that items are produced internally at a rate P


(> , the consumption rate). Then the optimal
production quantity to minimize average annual holding
and set up costs has the same form as the EOQ,
namely:

2k
Q
h'

Except that h is defined as h= h(1- /P)

This is based on solving:


K hH
G (Q)
T
2
K hQ

G (Q)

1 / P
Q
2
P is annual production rate
H is maximum on hand quantity

H Q 1

Lets Try one:


We

work for Sams Active Suspensions


They sell after market kits for car Tooners
They have an annual demand of 650 units
Production rate is 4/day (working at 250 d/y)
Setup takes 2 technicians working 45
minutes @$21/hour and requires an
expendable tool costing $25

Continuing:
Each

kit costs $275


Sams uses MARR of 18%, tax at 3%,
insurance at 2% and space cost of 1%
Determine h, Q*, H, T and break T down to:

T1 = production time in a cycle (Q*/P)

T2 = non producing time in a cycle (T T1)


Engineering Teams: (You can) Do It

Quantity Discount Models

All Units Discounts: the discount is applied to


ALL of the units in the order. Gives rise to an
order cost function such as that pictured in
Figure 4-9

All-Units Discount
Order Cost Function

Quantity Discount Models

Incremental Discounts:
the discount is applied
only to the number of
units above the
breakpoint. Gives rise to
an order cost function
such as that pictured in
Figure 4-10.

Incremental Discount
Order Cost Function

Properties of the Optimal


Solutions
For all units discounts, the optimal will occur at
the bottom of one of the cost curves or at a
breakpoint. (It is generally at a breakpoint.). One
compares the cost at the largest realizable EOQ
and all of the breakpoints beyond it. (See Figure
4-11).
For incremental discounts, the optimal will
always occur at a realizable EOQ value.
Compare costs at all realizable EOQs. (See
Figure 4-12).

All-Units Discount Average


Annual Cost Function

To Find EOQ in All Units discount


case:
Compute

Q* for each cost level


Check for Feasibility (the Q computed
is applicable to the range) we say it
is Realizable
Compute G(Q*) for each of the
realizable Q*s and the break points.
Chose Q* as the one that has lowest
G(Q)

Lets Try one:

Product cost is $6.50 in orders <600, $3.50 above


600.
Organizational I is 34%
K is $300 and annual demand is 900

2 300 900

2 300 900

*
1

*
2

0.34 6.50

495

0.34 3.50

674

Lets Try one:

Both of these are Realizable (the value is in


range)
Compute G(Q) for both and breakpoint (600)
G(Q) = c + (*K)/Q + (h*Q)/2

G (495) 900 (6.50)

900 300

495

.34 6.5 g495

674

.34 3.5 g674

G (495) $6942.43
G (674) 900 (3.50)

900 300

G (674) $3951.62
G (600) 900 (6.50)
G (600) $3957.00

900 300

600

.34 6.5 g600

Order
674 at a
time!

Average Annual Cost Function


for Incremental Discount Schedule

In an Incremental Case:
Cost is a strictly varying function of Q -- It varies
by interval!
Calculate a C(Q) for the applied schedule
Divide by Q to convert it to a unit cost function
Build G(Q) equations for each interval
Find Q* from each G(Q) Equation (derivative!)
Check if Realizable
Compute G(Q*) for realizable Q*s

Trying the previous problem (but


as Incremental Case):

Cost Function: Basically states that we pay 6.50 for


each unit up to 600 then 3.50 for each unit ordered
beyond 601:

C(Q) = 6.5(Q), Q < 600


C(Q) = 3.5(Q 600) + 6.5*600, Q 600
C(Q)/Q = 6.5, Q < 600 (order up to 600)
C(Q)/Q = 3.5 + ((3900 2100)/Q), Q 600 or
C(Q)/Q = 3.5 + (1800)/Q (orders beyond 601)

Trying the previous but as


Incremental Case:

For the First Interval:

Q* = [(2*300*900)/(.34*6.50)] = 495 (realizable)

For order > 600, find Q* by writing a G(Q)


equation and then optimizing:

[G(Q) = c + (*K)/Q + (h*Q)/2]

1800
300 900 0.34 3.5 1800
G2 (Q2* ) 900 3.5

2
Q2
Q2
Q

G2 (Q2* ) 900 3.5

900 2100

Q2

.34 3.5
.34 900
2

Q2

Q2

Differentiating G2(Q)
d G2 Q2
dQ2

.34 3.5
900 2100

0
0

2
Q2
2

Set equal to 0 and solve for Q 2

900 2100

2
2

0.595 0

900 2100

Realizable!

0.595

1783

Now Compute G(Q) for both and


cusp
G(495)

= 900*6.5 + (300*900)/495 + .
34((6.5*495)/2) = $6942.43
G(600) = 900*6.5 +(300*900/600) + .
34((6.5*600)/2) = $6963.00
G(1763) = 900*(3.5 +(1800/1783)) +
(300*900)/1783 + .34*(3.5
+(1800/1783))*(1783/2) = $5590.67
Lowest cost
purchase
1783 about
every 2

Properties of the
Optimal Solutions
Lets jump back into our
teams and do some!
TRY 22b and 23 on Pg 211

Resource Constrained MultiProduct Systems


Consider

an inventory system of n items in


which the total amount available to spend
is C and items cost respectively c1, c2, . . .,
cn. Then this imposes the following
constraint on the system:

c1Q1 c2Q2 ... cnQn C

Resource Constrained MultiProduct Systems

When the condition that:

c1 / h1 c2 / h2 ... cn / hn

is met, the solution procedure is


straightforward. If the condition is not met,
one must use an iterative procedure involving
Lagrange Multipliers.

EOQ Models for Production


Planning

Consider n items with known demand rates,


production rates, holding costs, and set-up
costs. The objective is to produce each item
once in a production cycle. For the problem to
be feasible the following equation must be true:

j
1

j 1 Pj
n

Issues:
We

are interested in controlling Family


MAKESPAN (we wish to produce all products
within our chosen cycle time)
Underlying Assumptions:

Setup Cost (times) are not Sequence Dependent


(this assumption is not always accurate as we will
later see)
Plants uses a Rotation Policy that produces a
single batch of each product each cycle a
mixed line balance assumption

EOQ Models for Production


Planning

The method of solution is to express the average


annual cost function in terms of the cycle time, T.
The optimal cycle time has the following
mathematical form:
n

T*

2 K j
j 1

h
j 1

' j

We must assure that this time allows for all setups


and all production times.

Working forward:
This

last statement means:

(sj+(Qj/Pj)) T
sj is set up time
Of course: Qj = j*T
So with substitution: (sj+((j*T )/Pj) T
Or: T((sj/(1- j/Pj)) = Tmin

Finally,

we must Choose
T(chosen cycle time) = MAX(T*,T min)

Lets Try Problem 30


ITEM

Mon
Reqr

Daily
Reqr

h=.
2*c

/P

Setup
Time

Setup
Cost

Unit
Cost

Daily
Pr.
Rate

Mon.
Pr.
Rate

J55R

125

6.25

.045

3.82

1.2

$102

$20

140

2800

H223

140

.032

6.78

0.8

$68

$35

220

4400

K-18R

45

2.25

0.6

.023

0.58
6

2.2

$187

$12

100

2000

Z-344

240

12

.073

8.34

3.1

$263.
5

$45

165

3300

Given: 20 days/month and 12


month/year; $85/hr for setup

Compute the Following in


teams!:

2 K j
j 1

T n
j h'j
j 1

TMin

j 1

P
j 1
j

Topt T , TMin

MAX

Lot Size: Topt Demand Rate


Uptime; Drawdown Time; Utilization