Various Inventory Costs

• Holding /
Carrying costs
• Ordering costs
• Purchase costs
• Total cost
• Shortage cost
The economic order quantity is the optimum quantity of goods to
be purchased at one time in order to minimize the annual total
costs of ordering and carrying or holding items in inventory. EOQ is
also referred to as the optimum lot size.
 1. Purchase Model without Shortage
Assumptions
1. Order arrives instantly
2. No out of stock situation
3. Constant rate of demand
Let us suppose
D= Annual demand in units
1. The number of order /year =D/Q
Co =Ordering cost/order
2. Average inventory = Q/2
Cc=Carrying cost/unit/year 3. Cost of ordering / year = (D/Q).Co
p= Purchase price per unit 4. Cost of carrying / year =(Q/2).Cc
Q= Order size 5. Purchase cost /year =Dp
Total inventory cost /year = [(D/Q).Co]+ [(Q/2).Cc]+D.p
Note : For Total
EOQ or the optimal order size is cost w.r.t. EOQ
replace Q by Q*
Total number of orders per year = D/Q* in above
Time between orders=Q*/D formula
Time between successive orders is obtained as Q*/D = 500/15000 =0.033 years
= 12 days.
EX2: The purchase manager currently follows EOQ
policy of ordering for an item in the stores of his
company. The annual demand of the item is 1,600
units. Its carrying cost is 40% of the unit cost
where the unit cost is Rs. 400. The ordering cost is
Rs. 500 per order. Recently, the vendor supplying
that item gives a discount of 10% in its unit cost if
the order size is minimum of 500 units.
(i) Find EOQ and the corresponding total cost per
year.
(ii) Check whether the discount offer given by the
vendor can be considered by the purchase
manager.
Ans :
Given D =1,600 units per yr
Co= Rs. 500 per order
p= Rs. 400 per unit
So Current ordering cost Cc=0.4 x 400 = Rs 160 per unit per yr
Q* = sqrt ( 2x500x1600/160) = 100units
TC(Q*) = (1600/100) x 500 +(100/2)x160+(400x1600) = Rs. 656,000/yr
Proposed ordering system :
Minimum order size (q) =500 units
p ( after 10% discount ) =400 - 40 (i.e. 10 % of 400) =Rs. 360
So new proposed Cc = 0.4x 360 =Rs. 144 per unit per yr
 Proposed TC =(D/Q)Co+(q/2)Cc+ p.D = (1600/500)x500 +(500/2) x
144 +(360x1600)
= Rs. 6,13,600 per year
Since , the total cost as per the proposed ordering system ( Rs.
6,13,600) is less than that of the current ordering system ( Rs.
6,56,000) , the purchase manager should avail the discount given by
its vendor by placing order for 500 units instead of 100 units as
decided by the EOQ formula.
 2. Purchase Model with Shortages
Variable list
D =Demand / period
Cc = Carrying cost/unit/period
Co = Ordering cost/order
Cs = Shortage cost/unit/period
Q = Order size
Q1= Maximum inventory
Q2 =Maximum stock out
t1 = period of positive stock
t2 = period of shortage
t= cycle time ( t1+t2)
Ex. The annual demand for a component is 7200 units. The carrying
cost is Rs. 500/unit/year, the ordering cost is Rs. 1500 per order and
the shortage cost is Rs. 2000/unit/year. Find the optimal values of
economic order quantity, maximum inventory, maximum shortage
quantity, cycle time, inventory period and shortage period.

Given D = 7200 units / year

Cc= Rs. 500/units/year
Co = Rs. 1500/order
Cs = Rs. 2000/units/year

(i) Q*= 233 units (approx)

(ii) Q1* = 186 units (approx)
(iii) Q2*= 47 units
(iv) t* = 12 days (approx)
(v) t1* = 10 days (approx)
(vi) t2* = 2 days
(vii) Number of orders per yr =30.9
Ex : A particular item has a demand of 9,000 units
/year. The cost of one procurement is Rs. 100 and
the holding cost per unit is Rs. 2.4 per year. The
replacement is instantaneous and any shortages
have to be dealt with. The cost of shortage is Rs.
5 per unit per year. Determine EOQ, no. of order
per year, time between orders.
Sol: Given Demand D=9000 units/year
Holding /carrying cost Cc=2.4 /unit /year
Ordering cost Co=Rs. 100 / procurement
Shortage cost Cs=Rs. % per unit per year
EOQ =  (2x100x9000/2.4) .((2.4+5)/5) =1053 units
No. of orders D/Q* = 9000/1053 = 8.55
Time between orders t* = Q*/D = 0.117 yrs.
 3. Manufacturing Model Without
Shortage
In this model the following assumptions are
made:
1. Demand is at a constant rate.
2.All cost coefficients are constants.
3.There is no shortage cost.
4.The replacement rate is finite and greater
then the demand rate.
Formulae
4. Manufacturing Model With Shortage
Ex1:In a two wheeler manufacturing company,
pistons are being fed into the main assembly line
from a product line situated in the next bay. The
annual demand for the piston is 8000 units and
the annual production capacity of the product
line manufacturing the piston is 12,000 units. The
set up cost is Rs. 125 per set up and the carrying
cost is Rs. 4 per piston per year. The shortage cost
is Rs. 8 per piston per year.
Find
(i) Economic batch quantity
(ii) Maximum inventory
(iii) Maximum stock out
Solution :
r=8000 pistons per year
k= 12,000 piston per year
Co= Rs. 125 per set-up
Cc= Rs. 4 per piston per year
Cs= Rs. 8 per piston per year

EBQ(Q*) =1500 piston

Q1* = 333.33 units = 333 piston ( approx.)
Q2* = 166.67 units = 167 piston ( approx.)
Example
month.
cost is
 Quantity Discount or Price Break model
• When an item is purchased in bulk, buyers are usually
given discount in the purchase price of the item.
• Let i be the percentage of the purchase price accounted
for carrying cost/unit/period.
• This discount may be a step function of purchase quantity
as shown below
Quantity Purchase price per unit model
0  Q1 < b1 p1 --
b1 Q2 (<b2) p2 1 price break model
b2 Q3 p3 2 price break model
 Algorithm for 2 price break
Quantity Purchase price per unit
0  Q1 < b1 p1
b1  Q2 <b2 p2
b2  Q3 p3
The procedure to compute the optimal order size (EOQ)
for this situation is given in the following steps
Step 1: Consider the lowest price p3 and determine Q3*
by using the EOQ formula.
2Co D
Q 
*
3
i. p3

If Q3*  b2 , then EOQ (Q*) =Q3* and the optimal cost

TC(Q3*) is the cost associated with Q3*.
Or if Q3* < b2 , then go to step 2
Step 2: Calculate Q2* based on price p2 by using the
EOQ formula.
2Co D
Q 
*
2
i. p2

Compare Q2* with b1 and If b1 Q2*<b2 , then

compare TC(Q2*) and TC(b2) .
Where TC= (D/Q*) Co +(Q*/2)Cc +D.p
But if TC(Q2*) TC( b2), then EOQ =b2 , otherwise
EOQ =Q2* .
If Q2* or Q3* < b1 as well b2 , then go to step 3.
Step 3: Calculate Q1* based on price p1 and
compute
TC(b1) , TC(b2) and TC(Q1*) , to find EOQ.
The quantity with lowest cost will be the required
EOQ.
 Summary for Quantity Discount Problem

Q3* Q2* Q1* Optimum

Initial Step 
Compare Q3* > b2 yes-> Q3*
no-> 
Compare --- Q2* b1 no -> 
Yes then find
TC(Q2*) & Select the least
TC(b2) of these two
Yes then find
TC(Q1*) , Select the least
TC(b2) of these three
TC(b1)
Ex : Annual Demand for an item is 6000 units . Ordering cost is Rs. 600
per order. Inventory carrying cost is 18% of the purchase
price/unit/year. The price breaks ups are shown below.
Quantity Price (in Rs. ) per unit
0  Q1 < 2000 20
2000  Q2 < 4000 15
4000  Q3 9
Find the optimal order size.

Solution : Given b1=2000, b2=4000 , p1=20, p2=15, p3=9, D= 6000/yr,

Co= Rs. 600/order and I = 18% of the purchase price/unit/year.
The least c
 Student Exercise
• A company currently purchases one of its items for Rs. 2 per units
without quantity discount. The ordering cost is Rs. 20 per order
and the carrying cost is 20% of its purchase price per unit per year.
The annual demand is 2500 units. A new vendor offers quantity
discount for the same item as per the following quantity discount
scheme. Find the best order quantity.
Quantity Price (in Rs. ) per unit
0  Q1 < 1500 p
1500  Q2 < 2500 97% of p
2300  Q3 95% of p
Ex : The annual demand of a product is 10,000 units. Each unit cost Rs. 100 if
orders placed in quantities below 200 units but for orders of 200 or above
the price is Rs. 95. The annual inventory holding costs is 10 per cent of the
value of the item and the ordering cost is Rs. 5 per order. Find the
economic lot size.
Sol : D=10,000 units/yr Co= Rs. 5/order r =10 % of the price of an item =Re
0.10
Quantity Price per unit (Rs)
0<Q1<200 100.00
200<Q2 95.00

Note if Q2*>b1 Q*=Q2* and TC(Q2*) is the optimum cost

Q2* based on price C2 =Rs. 95 is 103 units

So Q2*< 200 so we find Q1* based on C1=100
Q1* = 100 units
TC(Q1*)= Rs 1001,000
TC(b1=200) =1001,250

Since (Q1*)< TC(b) , therefore the optimum order quantity is Q8+ Q1* =100
units
• A shopkeeper estimated annual requirement
of an item as 2,000 units. He buys from
supplier at a cost of Rs. 10 per item and the
cost of ordering is Rs. 50 each time. If the
stock-holding costs are 25 per cent per year of
stock value, how frequently should he
replenish his stock? Further, suppose the
supplier offers a 10 per cent discount on order
between 100 to 499 items, and a 20 percent
discount on orders exceeding or equal to 500.
Can the shopkeeper reduce his cost by taking
advantage of either of these discounts?
D=2,000 units/ yr, r=0.25 C=Rs 10 per item Co= Rs. 50 /
order Ch=Cc= Cxr =10x 0.25 =Rs. 2.50

Q8= 283 units( approx.)

Number of order N=D/Q* = 7 orders
TC(Q*) =20,707.10

Quantity Price per unit (Rs)

0<Q1<100 10
100<Q2<500 9 (10% discount)
500 Q3 8(20% discount)