Traditional Inventory Models for Independent

Demand

Dr. Saurabh Pratap

Mechanical Engineering Dept.
IIIT Jabalpur

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What is an Inventory System
Inventory is defined as the stock of any item or
resource used in an organization.
An Inventory System is made up of a set of
policies and controls designed to monitor the
levels of inventory and designed to answer the
following questions:
What levels should be maintained?
When stock should be replenished? and
How large orders should be? i.e. what is the
optimal size of the order?

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Cost of holding inventory
Capital cost (Interest)
Storage cost
Obsolescence cost
Consist of about 20% of total cost in the
United States

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Inventory issues
Demand
Constant vs. variable
deterministic vs. stochastic
Lead time Inventory
Review time
Continuous vs. periodic Decisions:
Excess demand
Backorders, lost sales
When, What,
Inventory change and how many
Perish, obsolescence
to order

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Two basic types of Inventory Systems
1) continuous (fixed-order quantity)
an order is placed for the same constant amount
when inventory decreases to a specified level, ie.
Re-order point

2) periodic (fixed-time)
an order is placed for a variable amount after a
specified period of time
used in smaller retail stores, drugstores, grocery
stores and offices

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basic inventory elements
1. Carrying cost, Cc
Include facility operating costs, record
keeping, interest, etc.
2. Ordering cost, Co
Include purchase orders, shipping, handling,
inspection, etc.
3. Shortage (stock out) cost, Cs
Sometimes penalties involved; if customer is
internal, work delays could result

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Carrying Costs
Cost (and Range) as a
Percent of Inventory
Category Value
Housing costs (including rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
Inventory
- to study methods to deal with
how much stock of items should be kept on
hands that would meet customer demand
Objectives are to determine:
a) how much to order, and
b) when to order

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Inventory models
Here, we only study the following three different
models:

1. Basic model

2. Model with discount rate

3. Model with re-order points

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1. Basic model
The basic model is known as:
Economic Order Quantity (EOQ) Models

Objective is to determine the optimal order size

that will minimize total inventory costs

How the objective is being achieved?

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 Profile of Inventory Level Over
Time

Q Usage
rate
Quantity
on hand

Reorder
point

Receive Place Receive Place Receive

order order order order order

Lead time

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Profile of Frequent Orders

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Basic EOQ models
Three models to be discussed:

1. Basic EOQ model

2. EOQ model without instantaneous
receipt
3. EOQ model with shortages.

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Basic Fixed-Order Quantity Model
This model attempts to estimate the order size (Q) and
determine the point (R) at which an order should be
placed.
Model assumptions:
1. Annual demand (D) for the product is known, constant
and uniform throughout the period,
2. Lead time (L) is known and constant,

3. Product unit price (C) is known and constant,

4. Per unit holding or carrying cost (Cc) is known and

constant,
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5. Ordering or setup cost (Co) is known and constant,

Basic Fixed-Order Quantity Model
Model assumptions:
6 No backorders are allowed,
7. There is no interaction with other products, the
inventory control system operates independent of its
environment.

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1 Economic Order Quantity (EOQ) Model

Q
Order Size
Q/2

R
L L Time

d
Daily Usage Rate

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 The Basic EOQ Model

The optimal order size, Q, is to minimize the sum of carrying costs and ordering costs.
Assumptions and Restrictions:
- Demand is known with certainty and is relatively constant over time.
- No shortages are allowed.
- Lead time for the receipt of orders is constant. (will consider later)
- The order quantity is received all at once and instantaniously.

How to determine
the optimal value
Q* ?

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Determine of Q
We try to
Find the total cost that need to spend for keeping
inventory on hands
= total ordering + stock on hands
Determine its optimal solution by finding its first
derivative with respect to Q

How to get these values?

1. Find out the total carrying cost
2. Find out the total ordering cost
3. Total cost = 1 + 2
4. d (Total cost) /d Q = 0, and find Q*

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 The Basic EOQ Model
We assumed that, we will only keep half the inventory over a year then

The total carry cost/yr = Cc x (Q/2). Total order cost = Co x (D/Q)

Then , Total cost = TC C D C Q

o c
Finding optimal Q*
Q 2

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 EOQ Derivation

Min. The Total Cost Function by finding first derivative and equating it to zero:

TC = DCo/Q + QCc/2
dTC 2
= (- DCo/Q ) + Cc/2 = 0
dQ
2DCo
Solving for Q: EOQ =
Cc

We could achieve the same result by equating Holding

(Carrying Cost) to Ordering Cost and solve for Q .
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Reorder point: R = d.L + SS (safety stock)

 The Basic EOQ Model To order inventory

To keep inventory
Total annual inventory cost is sum of ordering and carrying cost:

TC C D C Q
o c
Q 2

FigureThe EOQ cost model

Try to get this value
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The Basic EOQ Model
Example

Consider the following:

Model parameters: Cc $0.75, Co $150, D 10,000yd

Optimal order size : Q** 2CoD 2(150)(10,000) 2,000 yd

Cc (0.75)

Total annual inventory cost : TC min Co D Cc Qopt (150) 10,000 (0.75) (2,000) $1,500
Q* 2 2,000 2

Number of orders per year : D 10,000 5

Q * 2,000

Order cycle time 311 days 311 62.2 store days

D / Q* 5
Note: You should pay attention that
all measurement units must be the same
No. of working days/yr
Consider the same example, with yearly
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 The Basic EOQ Model
EOQ Analysis with monthly time frame

Model parameters : Cc $0.0625 per yd per month, Co $150 per order, D 833.3 yd per month

Optimal order size : Q* 2CoD 2(150)(833.3) 2,000 yd

Cc (0.0625)

Total monthly inventory cost : TC min Co D Cc Q * (150) (833.3) (0.0625) (2,000) $125 per month
Q* 2 2,000 2

Total annual inventory cost ($125)(12) $1,500

(unit be based on yearly)

12 months a
year

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Robust Model

The EOQ model is robust

It works even if all parameters
and assumptions are not met
The total cost curve is relatively
flat in the area of the EOQ
 2 Fixed-Order Quantity Model With Usage
In this model production and usage of the item being manufactured
occur simultaneously. The graph below illustrates the model.
Production Rate, p

Max.
Build up No production
Q
Usage Rate usage only

(p-d) Procurement
cost
R
Carrying/holding
L cost

Usage Rate, d
(p - d).Q.(Cc)
TC = DC + (Co)D/Q + 2p 26
 The EOQ Model with Noninstantaneous Receipt

The order quantity is received gradually over time and inventory is drawn on
at the same time it is being replenished.
Example: Let p = production, d = demand,

FigureThe EOQ model with noninstantaneous order receipt

Always greater than 0 27
why?
The EOQ Model with Noninstantaneous Receipt
Model Formulation

p daily rate at which the order is received over time ( or production rate)
d daily rate at which inventory is demanded

Total annual inventory cost :TC Co D Cc Q 1 d

Q 2 p
Assuming placing an order/yr

Optimal order size : Q* 2CoD

Cc(1 d / p)

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 The EOQ Model with Noninstantaneous Receipt
Example

Let,
Co $150, Cc $0.75 per unit,
D 10,000 yd per year, 10,000/311 32.2 yd per day, p 150 yd per day

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 The EOQ Model with Shortages

Here, we allow Q being shortage,

shortage so that we could borrow or replenish the stocks
later

Max level of inventory

In the EOQ model wth shortages, the assumption that shortages cannot exist is relaxed.
Assumed that unmet demand can be backordered with all demand eventually satisfied.

Shortage = S/Q
Shortage

What we needed Total cost is

On hand = (Q-S)/Q t1 + t2 = S/D + (Q-S)/D = Q/D
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 3 The EOQ Model with Shortages

*base* height = * (Q-S) * (Q-S)/Q Area = * (S/Q) * S

= * (Q-S)2 /Q = * S2 /Q

In the EOQ model wth shortages, the assumption that shortages cannot exist is relaxed.
Assumed that unmet demand can be backordered with all demand eventually satisfied.

Shortage = S/Q
Shortage

What we needed

On hand = (Q-S)/Q t1 + t2 = S/D + (Q-S)/D = Q/D

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 The EOQ Model with Shortages

Total cost Total shortage costs total carryingcosts total ordering cost

S2 (Q S ) 2 D
Total inventorycost : TC Cs Cc Co
2Q 2Q Q

2CoD Cs Cc
Optimal order quantity: Q*
Cc Cs

Cc
Shortage level: S * Q *
Cc Cs

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 The EOQ Model with Shortages
Example

Let,

Co $150, Cc $0.75 per yd, Cs $2 per yd, D 10,000 yd

Optimal order quantity : Q* 2CoD Cs Cc 2(150)(10,000) 2 0.75 2,345.2 yd

Cc Cs 0.75 2

Shortage level: S* Q * Cc 2,345.2 0.75 639.6 yd

Cc Cs 2 0.75

Total inventory cost :TC Cs S Cc (Q * S*) Co D (2)(639.6) (0.75)(1,705.6) (150)(10,000)

2 2 2 2

2Q * 2Q * Q * 2(2,345.2) 2(2,345.2) 2,345.2

$174.44 465.16 639.60
$1,279.20

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The EOQ Model with Shortages

Additional Parameters in Example

Number of orders D 10,000 4.26 orders per year

Q 2,345.2

Maximum inventory level Q S 2,345.2 639.6 1,705.6 yd

= Q/D
days per year 311
Time between orders t 73.0 days between orders
number of orders 4.26

Q S 2,345.2 - 639.6
Time during which inventory is on hand t1 0.171 or 53.2 days
D 10,000
Time during which there is a shortage t2 S 639.6 0.064 year or 19.9 days
D 10,000

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4. Model with discount rate
Price discounts are often offered if a
predetermined number of units is ordered or
when ordering materials in high volume.

How do we decide if we should order more to

take advantage of the discount being offered?

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All-Unit Quantity Discounts
Pricing schedule has specified quantity break points
q0, q1, , qr, where q0 = 0
If an order is placed that is at least as large as q i but
smaller than qi+1, then each unit has an average unit
cost of Ci
The unit cost generally decreases as the quantity
increases, i.e., C0>C1>>Cr
The objective for the company (a retailer for
example) is to decide on a lot size that will minimize
the sum of material, order, and holding costs

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All-Unit Quantity Discount Procedure
Step 1: Calculate the EOQ for the lowest price. If it is feasible
(i.e., this order quantity is in the range for that price), then
stop. This is the optimal lot size. Calculate TC for this lot
size.
Step 2: If the EOQ is not feasible, calculate the TC for this price
and the smallest quantity for that price.
Step 3: Calculate the EOQ for the next lowest price. If it is
feasible, stop and calculate the TC for that quantity and price.
Step 4: Compare the TC for Steps 2 and 3. Choose the
quantity corresponding to the lowest TC.
Step 5: If the EOQ in Step 3 is not feasible, repeat Steps 2, 3,
and 4 until a feasible EOQ is found.

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 All-Unit Quantity Discounts:
Example
Cost/Unit Total Material Cost

$3
$2.96
$2.92

5,000 10,000 5,000 10,000

Order Quantity Order Quantity

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All-Unit Quantity Discount:
Example
Order quantity Unit Price
0-5000 $3.00
5001-10000 $2.96
Over 10000 $2.92

q0 = 0, q1 = 5000, q2 = 10000
C0 = $3.00, C1 = $2.96, C2 = $2.92
D = 120000 units/year, Co = $100/lot,
Cc = 0.2

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 All-Unit Quantity Discount:
Example
Step 1: Calculate Q2* = Sqrt[(2DCo)/CcC2]
= Sqrt[(2)(120000)(100)/(0.2)(2.92)] = 6410
Not feasible (6410 < 10001)
Calculate TC2 using C2 = $2.92 and q2 = 10001
TC2 = (120000/10001)(100)+(10001/2)(0.2)(2.92)+ (120000)(2.92) =
$354,520
Step 2: Calculate Q1* = Sqrt[(2DCo)/CcC1]
=Sqrt[(2)(120000)(100)/(0.2)(2.96)] = 6367
Feasible (5000<6367<10000) Stop
TC1 = (120000/6367)(100)+(6367/2)(0.2)(2.96)+ (120000)(2.96) =
$358,969
TC2 < TC1 The optimal order quantity Q* is q2 = 10001

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 All-Unit Quantity Discounts
What is the effect of such a discount schedule?
Retailers are encouraged to increase the size of
their orders
Average inventory (cycle inventory) in the supply
chain is increased
Average flow time is increased
Is an all-unit quantity discount an advantage in the
supply chain?

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 5. Model with re-order points
The reorder point is the inventory level at which a new order is placed.
Order must be made while there is enough stock in place to cover demand during lead time.

Formulation: R = dL, where d = demand rate per time period, L = lead time
Then R = dL = (10,000/311)(10) = 321.54

Working days/yr

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 Reorder Point
Inventory level might be depleted at slower or faster rate during lead time.
When demand is uncertain, safety stock is added as a hedge against stockout.

Two possible scenarios

No Safety
stocks!

Safety stock!

We should then ensure

Safety stock is secured!

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 Determining Safety Stocks Using Service Levels

We apply the Z test to secure its safety level,

R d L (Zd L )

Safety stock

Reorder point

Average sample demand

How these values are represented in the diagram of normal distribution? 44

Reorder Point with Variable Demand
R d L Zd L
where
R reorder point
d average daily demand
L lead time
d the standard deviation of daily demand
Z number of standard deviations corresponding to service level probability
Zd L safety stock

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Reorder Point with Variable Demand
Example

Example: determine reorder point and safety stock for service level of 95%.

d 30 yd per day, L 10 days, 5 yd per day

d

For 95% service level, Z 1.65 (Appendix A)

R d L Z L 30(10) (1.65)(5)( 10 ) 300 26.1 326.1 yd

d

Safety stock is second term in reorder point formula : 26.1.

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