Chapter 8

Inventory Models
1

8.1 Overview of Inventory Issues

Proper control of inventory is crucial to the success of an enterprise. Typical inventory problems include:
Basic inventory shortage Quantity discount review Production lot size Planned Periodic Single period

Inventory models are often used to develop an optimal inventory policy, consisting of:
An order quantity, denoted Q.

Type of Costs in Inventory Models

Inventory analyses can be thought of as cost-control techniques. Categories of costs in inventory models:
Holding (carrying costs) Order/ Setup costs Customer satisfaction costs Procurement/Manufacturing costs
3

Type of Costs in Inventory Models

Holding Costs (Carrying costs): These costs depend on the order size

Cost of capital h Storage space rental cost Costs of utilities Ch = Annual holding cost per un Labor in inventory Insurance H = Annual holding cost rate Security Theft and breakage C = Unit cost of an item Deterioration or Obsolescence

C =H*C

Type of Costs in Inventory Models

Order/Setup Costs These costs are independent of the order size.
Order costs are incurred when purchasing a good from a supplier. They include costs such as
Telephone Order checking Labor Transportation

Co = Order cost or setup cost

Setup costs are incurred when producing goods for sale to others. They can include costs of
Cleaning machines

Type of Costs in Inventory Models

Customer Satisfaction Costs
Measure the degree to which a customer is satisfied. Unsatisfied customers may:
Switch to the competition (lost sales). Wait until an order is supplied.

When customers are

Cb = Fixed administrative costs of an out of stock item ($/stockout unit). Cs = Annualized cost of a customer awaiting an out of stock item 6 ($/stockout unit

Type of Costs in Inventory Models

Procurement/Manufacturi ng Cost
Represents the unit purchase cost (including transportation) in case of a purchase. Unit production cost in case of in-house manufacturing. C = Unit purchase or manufacturing cost.

Demand in Inventory Models

Demand is a key component affecting an inventory policy. Projected demand patterns determine how an inventory problem is modeled. Typical demand patterns are:
Constant over time (deterministic inventory models) Changing but known over time (dynamic D = Demand rate (usually per year) models) 8 Variable (randomly) over time

Inventory Classifications
Inventory can be classified in various ways:
By Process By Process Rawmaterials aterials Rawm W ork in progress ork W in progress Finished goods Finished goods
Used typically by accountants at manufacturing firms. Enables management to track the production process.

By Imp an ce p ort ce By Imortan A, B, C A, B, C

Items are classified by their relative importance in terms of the firms capital needs.

By Sh elfLife elf By Sh Life Perishable Perishable Nonperishable Nonperishable

Management of items with short shelf life and long shelf life is very different
9

Review Systems
Two types of review systems are used:
Continuous review systems.
The system is continuously monitored. A new order is placed when the inventory reaches a critical point.

Periodic review systems.

The inventory position is investigated on a regular basis. An order is placed only at these times. 10

8.2 Economic Order Quantity Model Assumptions

Demand occurs at a known and reasonably constant rate. The item has a sufficiently long shelf life. The item is monitored using a continuous review system. All the cost parameters remain constant forever (over an infinite time horizon). 11

The EOQ Model

Inventory profile
The constant environment described by the EOQ assumptions leads to the following observation:

The optimal EOQ policy consists of same-size orders.

Q Q Q

is observation results in the following inventory prof

12

Cost Equation for the EOQ Model

Total Annual = Total Annual Total Annual + Total Annual + Inventory Costs Holding Costs ordering Costs procurement Costs

TC(Q) = (Q/2)Ch + (D/Q)Co +DC The optimal order Size

Q Q

Q* =

2Co Q D 2Co D

Ch

13

TV(Q) and Q*
TV(Q s Constructing the total annual variable cost curveost ize g sts ) s in o C Add the two curves to one another r c
e lg rd Hind o ler o Total annual holding and a al ord m To t i ordering costs pt nd e o ts a al h t t cos equ :a g re te in a g o ld rin N o h rde l o ta al to ot s T t s co

* ** o * *

Q*
The optimal order size

Q
14

Sensitivity Analysis in EOQ models

The curve is reasonably flat around Q*. Deviations from the optimal order size cause only small increase in the total cost.

Q*

15

Cycle Time
The cycle time, T, represents the time that elapses between the placement of orders.
T = Q/D

Note, if the cycle time is greater than the shelf life, items will go bad, and the model must be

16

Number of Orders per Year

To find the number of orders per years take the reciprocal of the cycle time
N = D/Q
Example: The demand for a product is 1000 units per year. The order size is 250 units under an EOQ policy.
How many orders are placed per year? N = 1000/250 = 4 orders.
17

Lead Time and the Reorder Point

In reality lead time always exists, and must be accounted for when deciding when to place an order. The reorder point, R, is the inventory position when an order is placed. R =L R R is calculated by = L
D D L and D must be expressed in the same
18

Lead Time and the Reorder Point

Graphical demonstration: Short Lead Time
Reorder Point
y or nt ve In n tio si po

Place the order now

R = Inventory at hand at the beginning of lead19time

Lead Time and the Reorder Point

Graphical demonstration: Long Lead Time
Outstanding order = inventory at hand R at the beginning of lead time + one outstanding order = demand during lead time = LD

Inventory at hand

Place the order

20

Safety stock
Safety stocks act as buffers to handle:
Higher than average lead time demand. Longer than expected lead time.

With the inclusion of safety stock (SS), R is calculated by

R = LD + SS

The size of the safety stock is based on having a desired service level. 21

Safety stock
Planned situation

Reorder Point

Actual situation

Place the order now R = LD

L
22

Safety stock
Reorder Point
Actual situation

LD SS=Safety stock

Place the order now + R = LD SS

L
The safety stock prevents excessive shortages. 23

Inventory Costs
Including safety stock

Total Annual = Total Annual Total Annual + Total Annual + nventory Costs Holding Costs ordering Costs procurement Costs

TC(Q) = (Q/2)Ch + (D/Q)Co + + ChSS DC

Safety stock holding cost

24

ALLEN APPLIANCE COMPANY (AAC)

AAC wholesales small appliances. AAC currently orders 600 units of the Citron brand juicer each time inventory drops to 205 units. Management wishes to determine an optimal ordering policy for the Citron brand juicer
25

 Data

ALLEN APPLIANCE COMPANY (AAC)

Co = $12 ($8 for placing an order) + (20 min. to check)($12 per hr) Ch = C = $1.40 [HC = (14%)($10)] $10.

H = 14% (10% ann. interest rate) + (4% miscellaneous) D = le o Juc r oinformatione s the last 10 weeks S sdemandv rt el s w of 2 a f i es e h a t ek 2 wase W collected: 2 ek 2 2 2 2
Sl s ae We ek Sl s ae 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

26

ALLEN APPLIANCE COMPANY (AAC)

Data
The constant demand rate seems to be a good assumption. Annual demand = (120/week)(52weeks) = 6240 juicers.

27

AAC Solution:
EOQ and Total Variable Cost Current ordering policy calls for Q = 600 juicers. TV( 600) = (600 / 2)($1.40) + (6240 / 600)($12) = $544.80 The EOQQ
Savings of 16% 2(6240)(12) *= = 327.065 327 policy calls for orders of size 1.40

327) = (327 / 2)($1.40) + (6240 / 327) ( $12) =

28

AAC Solution:
Reorder Point and Total Cost
Under the current ordering policy AAC holds 13 units safety stock (how come? Observe): AAC is open 5 day a week.
The average daily demand = 120/week)/5 = 24 juicers. Lead time is 8 days. Lead time demand is (8)(24) = 192 juicers. Reorder point without Safety stock = LD = 192. Current policy: R = 205. Safety stock = 205 192 = 13. TV(327) + Procurement Safety stock +

7) = For safety stock of 13 juicers the total cost is $62,8 457.89 + 6240($10) + (13)($1.40) =
29

AAC Solution:
Sensitivity of the EOQ Results
Changing the order size
Suppose juicers must be ordered in increments of 100 (order 300 or 400) AAC will order Q = 300 juicers in each order. There will be a total variable cost increase of $1.71. This is less than 0.5% increase in variable costs.

Only 0.4% Suppose there is a 20% increase in demand. D=7500 juicers. increase The new optimal order quantity is Q* = 359. The new variable total cost = TV(359) = $502 TV(327) = (327/2)($1.40) + (7500/327)($12) = $504.13 30 If AAC still orders Q = 327, its total variable costs

Changes in input parameters

AAC Solution:
Cycle Time For an order size of 327 juicers we have:
T = (327/ 6240) = 0.0524 year.
working days per week = 0.0524(52)(5) = 14 days.

This is useful information because:

Shelf life may be a problem. 31 Coordinating orders with other items might

AAC Excel Spreadsheet

=1/E11 Copy to cell H12 =$B$15*$B$10+$B$16INT(($B$15*$B$10+ $B$16)/E10)*E10 Copy to cell H13 =SQRT(2*$B$ 10*$B$14/$B$ 13) =E10/B10 Copy to cell H11

=(E10/2)*$B$13+ ($B$10/E10)*$B$14 Copy to cell H14

=$B$10*$B$11+E14+ 32 $B$13*B16

Service Levels and Safety Stocks

33

8.3 Determining Safety Stock Levels

Businesses incorporate safety stock requirements when determining reorder points. A possible approach to determining safety stock levels is by specifying desired service level .
34

Two Types of Service Level

The cycle service level

Service levels can be viewed in two ways.

The probability of not incurring a stockout during an inventory cycle. Applied when the likelihood of a stockout, and not its

The unit service level

The percentage of demands that are filled without incurring any delay. Applied when the percentage of 35 unsatisfied demand

The Cycle Service Level Approach

In many cases short run demand is variable even though long run demand is assumed constant. Therefore, stockout events during lead time may occur unexpectedly in each cycle. Stockouts occur only if demand 36 during lead time is greater than the

The Cycle Service Level Approach

To determine the reorder point we need to know:
The lead time demand distribution. The required service level.

In many cases lead time demand is approximately normally distributed. For the normal distribution case the reorder 1 R = by point is calculated L + zL = service level
37

The Cycle Service Level Approach

Service level = P(DL<R) = 1
=192

P(DL>R) =

P(DL> R) = P(Z > (R L)/L) = . Since P(Z > Z) = , we have Z = (R R = L + zL L)/L, which gives

38

AAC Cycle Service Level Approach

Assume that lead time demand is normally distributed. Estimation of the normal distribution parameters:
Estimation of the mean weekly demand = ten weeks average demand = 120 juicers per week.
39

AAC Cycle Service Level Approach

To find Land L the parameters (per week) and (per week) must be adjusted since the lead time is longer than one week.
Lead time is 8 days =(8/5) weeks = 1.6 weeks.

Estimates for the lead time mean demand and variance of demand

40

AAC Service Level for a given Reorder Point

Let us use the current reorder point of 205 juicers.

205 = 192 +

z (11.55)

z = 1.13

22 2 2.2

From the normal distribution table we have that a reorder point of 205 juicers results in an 87%
41

AAC
Reorder Point for a given Service Level Management wants to improve the Management wants to improve the cycle service level to 99%. cycle service level to 99%. The z value corresponding to 1% The z value corresponding to 1% right hand tail is 2.33. right hand tail is 2.33. R = 192 + 2.33(11.55) = 219 R = 192 + 2.33(11.55) = 219 juicers. juicers.
42

AAC
Acceptable Number of Stockouts per Year AAC is willing to run out of stock an AAC is willing to run out of stock an average of at most one cycle per average of at most one cycle per year with an order quantity of 327 year with an order quantity of 327 juicers. juicers. What is the equivalent service level What is the equivalent service level for this strategy? for this strategy?
43

AAC
Acceptable Number of Stockouts per Year There will be an average of There will be an average of 6240/327 = 19.08 lead times per year. 6240/327 = 19.08 lead times per year.

The likelihood of stockouts = 1/19 = 0.0524 The likelihood of stockouts = 1/19 = 0.0524

This translates into a service level of 94.76% This translates into a service level of 94.76%

44

The Unit Service Level Approach

When lead time demand follows a normal distribution service level can be calculated as follows:
Determine the value of z that satisfy the equation L(z) = Q* / L Solve for R using the equation

45

AAC
Cycle Service Level (Excel spreadsheet)

=NORMINV(B7,B 5,B6)

=NORMDIST(B8,B5,B6, TRUE)
46

8.4 EOQ Models with Quantity Discounts

Quantity Discounts are Common Practice in Business
By offering discounts buyers are encouraged to increase their order sizes, thus reducing the sellers holding costs. Quantity discounts reflect the savings inherent in large orders. With quantity discounts sellers can reward their
47

8.4 EOQ Models with Quantity Discounts

Quantity Discount Schedule
This is a list of per unit discounts and their corresponding purchase volumes. Normally, the price per unit declines as the order quantity increases. The order quantity at which the unit price changes is called a break point. There are two main discount plans:
All unit schedules - the price paid for all the units purchased is based on the total purchase. Incremental schedules - The price discount is based only on the additional units ordered beyond 48 each break point.

All Units Discount Schedule

To determine the optimal order quantity, the total purchase cost must be included TC(Q) = (Q/2)Ch + (D/Q)Co + DCi + ChSS Ci represents the unit cost at the
th

49

 AAC is offering all units quantity discounts to its customers. Data

QuntyDisout ua t y isc un it Q anit D co nt Schdu he ule Sc edle
222 -- 2 222 2 2222 2 -- 2 2 222 2 2 2222 2 -- 2 2 222 2 2 2 2 -- 2 2 2222 2 2 22 2222 22 22 22 22 $22 ..22 $11 11 $211 ..22 $1 $211 ..22 $1 $222 ..22 $2 $222 ..22 $2

AAC - All Units Quantity Discounts

50

ould AAC increase its regular order of ould AAC increase its regular order of 7 juicers, to take advantage of the discou 7 juicers, to take advantage of the discou

51

AAC All units discount procedure

Find the optimal order Qi* for Step 1: Q* D Use each discount level i.= (2Co)/ Ch the formula Step 2: For each discount level i modify Q * as follows i
If Qi* is lower than the smallest quantity that qualifies for the i th discount, increase Qi* to that level. If Qi* is greater than the largest quantity that qualifies for the ith discount, eliminate this level from further consideration.

Step 3: Substitute the modified Q*i value in

52

AAC All units discount procedure

Step 1: Find the optimal order quantity
Qi* for each discount level i based on the Low cost ord sizep d est er er iscount level EOQ formula Qualifying D iscount Price
level 2 2 2 2 2 ord er p unit er 22 -22 2.2 22 22 2 2-22 22 .2 22 2 2-22 22 .2 11-11 11 11 11 .1 22 22 22 .2 Q * 22 2 22 2 11 1 22 2 22 2
53

 Step 2 : Modify Q
$10/unit
1

AAC All Units Discount Procedure

i *

$9.75/unit * * * * Q1* 336* 2 3 1QQ3 2

300 331 299

$9.50
599600 999

ModifiedQ* and total Cost odified Q* and total Cost M Qualified Price Modified Total odified Total Qualified Price M Urder per Unit Q* Q* Cost Urder per Unit Q* Q* Cost 222 -- 2 22 22 2 **** **** 222 2..1 2 12 11 22 2 **** **** 2222 21 2-- 2 .. 1 2 22 2 22 2,,222 2 2 2.. 2 1111 12 1 1 22 2 22 2222 2 2 22 2222 22 2-- 2 .. 2 2 22 2 22 2,,112 2 2 2.. 1 2222 22 2 2 22 2 22 1221 2 1 12 22-- 22 22 2222 2 22 2 22 2,,222 22 2 2.. 2 11 11 22 1111 .. 2 22 2 22 2222 22 2 22 22 22 22 .. 2 2 22 2 22 2,,222 22 2 2.. 2 22 22 22 22 2 22 2222 22 2 22

54

 Step 2 : Modify Q
$10/unit
1

AAC All Units Discount Procedure

i *
* * Q3* Q3* Q3* * $9.50 3 * 3 3Q * * Q 3 3 *Q * 3 * * * 3 * * QQ3* 3 Q1* 336 3 Q3* 2 1 2 3 3 *

300 331 299

ModifiedQ* and total Cost odified Q* and total Cost M Qualified Price Modified Total odified Total Qualified Price M Urder per Unit Q* Q* Cost Urder per Unit Q* Q* Cost 222 -- 2 22 22 2 **** **** 222 2..2 2 22 22 22 2 **** **** 2222 22 2-- 2 .. 2 2 22 2 22 2,,222 2 2 2.. 2 2222 22 2 2 22 2 22 2222 2 2 22 2222 22 2-- 2 .. 2 2 22 2 22 2,,222 2 2 2.. 2 2222 22 2 2 22 2 22 2222 2 2 22 22-- 22 22 2222 2 22 2 22 2,,222 22 2 2.. 2 22 22 22 2222 .. 2 22 2 22 2222 22 2 22 22 22 22 .. 2 2 22 2 22 2,,222 22 2 2.. 2 22 22 22 22 2 22 2222 22 2 22

600 999

55

AAC All Units Discount Procedure

Step 3: Substitute Q I * in the total Modified Q* and total Cost odified cost function Q* and total Cost M
Qualified Price Qualified Price Urder per Unit Urder per Unit 222 -- 2 22 222 2..2 2 22 22 2222 22 2-- 2 .. 2 2 2222 22 2 2 2222 22 2-- 2 .. 2 2 2222 22 2 2 22-- 22 22 2222 2 22 22 22 2222 .. 2 22 22 .. 2 2 22 22 22 22 Q* Q* 22 2 22 2 22 2 22 2 22 2 22 2 22 2 22 2 22 2 22 2 Modified Total odified Total M Q* Cost Q* Cost **** **** **** **** 22 2,,222 2 2 2.. 2 22 2222 2 2 22 22 2,,222 2 2 2.. 2 22 2222 2 2 22 22 2,,222 22 2 2.. 2 22 2222 22 2 22 22 2,,222 22 2 2.. 2 22 2222 22 2 22

AAC should order 5000 juicers AAC should order 5000 juicers

Step 4

56

Calculation of Optimal Inventory Policy Under All-Units Quantity Discounts

AAC All Units Discount Excel Worksheet

INPUTS Values 22. 2 2 22 2. 2 22 22 . 2 22 . 2 2. 2 22 11 1 1 . 11 2. 2 22 OPTIMAL OUTPUTS
Order quantity, Q* = Cycle Time (in years), T = # of Cycles Per Year, N = Reorder Point, R = Total Annual Cost, TC(Q*) =

Annual Demand, D = Per Unit Cost, C = Annual Holding Cost Rate, H = Annual Holding Cost Per Unit, Ch = Order Cost, Co = Lead Time (in years), L = Safety Stock, SS =

Values 22 22 11 1 1 1 1 . 1111 22 2 . 2 2 22 2 2. 22 1 1 11 11. 1

DISCOUNTS Level 2 2 2 2 2 2 2 2 2 Break point 2 22 2 22 2 22 22 22 22 Discount Price 2. 2 22 22 . 2 22 . 2 22 . 2 22 . 2 Q* 22 2 22 2 22 2 22 2 22 2 TC(Q*) 2 2 22 22. 2 2 2 22 22. 2 2 2 22 22. 2 2 2 22 22. 2 2 2 22 22. 2 Modified Q* 22 2 22 2 22 2 22 22 22 22

57

8.4 Production Lot Size Model - Assumptions

Demand rate is constant. Production rate is larger than demand rate. The production lot is not received instantaneously (at an infinite rate), because production rate is finite. There is only one product to be scheduled.
58

Production Lot Size Model

Inventory profile
The optimal production lot size policy orders the same amount each time. This observation results in the inventory profile below:

59

Production Lot Size Model

Understanding the inventory profile The production increases the

Demand accumulation during production run = DT1 Maximum inventory

nventory at a rate of P.

The inventory increases at a net rate of P - D

T1

Maximum inventory = (P D)T = (P D)(Q/P) = Q(1 D/P) Production Lot Size = Q = PT1

Demand accumulation Production during production run time The demand decreases the inventory at a rate of D.
60

Production Lot Size Model Total Variable Cost

The parameters of the total variable costs function are similar to those used in the EOQ model. Instead of ordering cost, we have here a fixed setup cost per production run (Co). In addition, we need to incorporate the annual production rate (P) in the model. 61

Production Lot Size Model Total Variable Cost

TV(Q) = (Q/2)(1 - D/P)Ch (D/Q)Co +
P is the annual production rate The average inventory

The Optimal Order Size 2DCo * Q =C (1-D/P) h

62

Production Lot Size Model Useful relationships

Cycle time T = Q / D. Length of a production run T1 = Q / P. Time when machines are not busy producing the product T2 = T - T1 = Q(1/D - 1/P).
63

FARAH COSMETICS COMPANY

Farah needs to determine optimal production lot size for its most popular shade of lipstick. Data
The factory operates 7 days a week, 24 hours a day. Production rate is 1000 tubes per hour. It takes 30 minutes to prepare the machinery for production. It costs $150 to setup the line. 64 Demand is 980 dozen tubes per week.

FARAH COSMETICS COMPANY Solution

Input for the total variable cost function D = 613,200 per year [(980
Dozens

dozen/week (12)/ 7](365) Ch = 0.4(0.5) = $0.20 per tube per year.

65

FARAH COSMETICS COMPANY Solution

Current Policy
Currently, Farah produces in lots of 84,000 tubes. T = (84,000 tubes per run)/(613,200 tubes per year)= 0.137 years (about 50 days). T1 = (84,000 tubes per lot)/(8,760,000 tubes per year)= 0.0096 years (about 3.5 days). T2 = 0.137 - 0.0096 = 0.1274 years (about 46.5 days).
66

FARAH COSMETICS COMPANY Solution

The Optimal Policy
The optimal order size

Using the input data we find Q

*

= 31,499 = (0.2)(1-613,200/8760,000)

2(613,200)(150)

TV(Q* = 31,499) =

(31,499/2) [167

(613,200/8,760,000)](0.2) +

FARAH COSMETICS COMPANY Production Lot Size Template (Excel)

68

8.5

Planned Shortage Model

When an item is out of stock, customers may:

Go somewhere else (lost sales). Place their order and wait (backordering).

In this model we consider the backordering case.

69

Planned Shortage Model the Total Variable Cost Equation

The parameters of the total variable costs function are similar to those used in the EOQ model. In addition, we need to incorporate the shortage costs in the model.
Backorder cost per unit per year (loss of goodwill cost) - Cs.
Reflects future reduction in profitability. Can be estimated from market surveys and focus 70 groups.

Planned Shortage Model the Total Variable Cost Equation

The Annual holding cost = Ch[T1/T](Average inventory) = Ch[T1/T] (Q-S)/2 The Annual shortage cost = Cb(number of backorders per year) + Cs(T2/T)(Average number of backorders). T
1

T2

To calculate the annual holding cost and T shortage cost we need to find
The proportion of time inventory is carried, (T1/T) The proportion of time demand is backordered, (T2/T).
71

Finding T1/ T and T2/ T

Q-S Average inventory = (Q - S) / 2 Proportion of time inventory exists = T1/T Q T1 S T T2
QS T 1

= (Q - S) / Q Proportion of time shortage exists = T2/T =S/Q

72

Average shortage = S / 2

Planned Shortage Model The Total Variable Cost Equation

Annual holding cost:
Ch[T1/T](Q-S)/2 = Ch[(Q-S) /Q](Q-S)/2 = Ch(Q-S)2/2Q Cb(Units in short per year) + Cs[T2/T](Average number of backorders) = Cb(S)(D/Q) + CsS2/2Q
73

Annual shortage cost:

Planned Shortage Model The Total Variable Cost Equation

The total annual variable cost equation

D + SC ) +S2 (Q -S)2 CS TV(Q,S) = 2Q Ch + (Co b Q 2Q

Holding Ordering Time independent dependent Time costs costs backorder costs backorder costs The optimal solution to this problem is obtained under the following conditions
Cs > 0 ; Cb < \ 2CoCh / D

74

Planned Shortage Model The Optimal Inventory

Policy
The Optimal Order Size 2DC C + C 2 h s (DCb) x Q* o Ch Cs ChCs = The Optimal Backorder level Q* Ch - DCb S* Ch + Cs = Reorder Point R = L D - S*
75

SCANLON PLUMBING CORPORATION

Scanlon distributes a portable sauna from Sweden. Data
A sauna costs Scanlon $2400. Annual holding cost per unit $525. Fixed ordering cost $1250 (fairly high, due to costly transportation). Lead time is 4 weeks. Demand is 15 saunas per week on the average.
76

SCANLON PLUMBING CORPORATION

Backorder costs
Scanlon estimates a $20 goodwill cost for each week a customer who orders a sauna has to wait for delivery. Administrative backordrer cost is $10.

Management wishes to know:

The optimal order quantity. The optimal number of backorders.
77

SCANLON PLUMBING
Solution Input for the total variable cost function
D = 780 saunas Co = $1,250 Ch = $525 Cs = $1,040 Cb = $10
78

[(15)(52)]

SCANLON PLUMBING
Solution The optimal policy

Q =

2(780) (1250) 52 5

525+1 (780)(10)2 74 x 040 (525)(1040) 1040

_ (74)(525)(780)(10) S* 525 + 1040

20

R = (4 / 52)(780) 20 = 40
79

SCANLON PLUMBING
Spreadsheet Solution
Calculation of Optimal Inventory Policy for a Planned Shortage Model
INPUTS Values OPTIMAL OUTPUTS Values ASSIGNED OUTPUTS Values

Annual Demand, D = 2 22 2. 2 Per Unit Cost, C = 22. 2 2 22 Annual Holding Cost Rate, H = 22 . 2 Annual Holding Cost Per Unit, Ch 2 . 2 2 22 = Order Cost, Co = 22. 2 2 22 Annual Backorder Cost, Cs = 2 2 . 2 2 22 Fixed Admin. Backorder Cost, Cb =. 2 2 22 Lead Time (in years), L = 22 2 2 . 22

Order Quantity, Q* = 1. 1 11 Backorder Level, S* = 1. 1 11 Cycle Time (in years), T = 22 2 . 22 # of Cycles Per Year, N = 1. 11 11 1 Reorder Point, R = 2. 22 22 2 Total Annual Variable Cost, TV(Q*)2 22 2= . 2 22 Total Annual Cost, TC(Q*) = 2 2 2 22 222. 2 % of Customers Backordered = 2. 2 22

Q= 2. 2 22 S= 2. 2 22 T= 22 2 . 22 N= 2. 22 22 2 R= 1. 11 11 1 TV(Q) = 2 2 22 22. 2 TC(Q) = 2 2 2 22 222. 2 % Back. = 2. 2 22

80

8.7 Review Systems Continuous Review

(R, Q) Policies
The EOQ, production lot size, and planned shortage models assume that
inventory levels are continuously monitored Items are sold one at a time.

81

8.7

Review Systems

Continuous Review
(R, Q) Policies
The above models call for order

point (R) order quantity (Q)

inventory policies. Such policies can be implemented by
A point-of-sale computerized system. The two-bin system.
82

Continuous Review Systems

(R, M) policies
When items are not necessarily sold one at a time, the reorder point might be missed, and out of stock situations might occur more frequently. The order to level (R, M) policy may be implemented in this situation.
83

Continuous Review Systems

(R,M) policies
The R, M policy replenishes inventory up to a pre-determined level M. Order Q = Q* + (R I) = (M

SS) + (R I) each time the

inventory falls to the reorder point R or below.
84

Periodic Review Systems

It may be difficult or impossible to adopt a continuous review system, because of:
The high price of a computerized system. Lack of space to adopt the two-bin system. Operations inefficiency when ordering different items from the same vendor separately.

The periodic review system may be

85

Periodic Review Systems

Under this system the inventory position for each item is observed periodically. Orders for different items can be better coordinated periodically.
86

Periodic Review Systems

(T,M) Policies In a replenishment cycle policy
(T, M), the inventory position is reviewed every T time units. An order is placed to bring the inventory level back up to a maximum inventory level M. M is determined by
Forecasting the number of units demanded during the review period T. 87 Adding the desired safety stock to the

Periodic Review Systems

Calculation of the replenishment level and order size
M = TD + T =Review period SS L = Lead time Q = M + LD I
SS= Safety stock Q = Inventory position D = Annual demand I = Inventory position

88

AAC operates a (T, M) policy

Every three weeks AAC receives deliveries of different products from Citron. Lead time is eight days for ordering Citrons juicers. AAC is now reviewing its juicer inventory and finds 210 in stock. How many juicers should AAC order for a safety stock of 30 juicers?

89

AAC operates a (T, M) policy Solution

Data
Review period T = 3 weeks = 3/52 = . 05769 years, Lead time = L = 8 days = 8/260 = . AAC operates 03077 years, 260 days a year. Demand D = 6240 juicers per year,260. (5)(52) = Safety stock SS = 30 juicers, Inventory position I = 210 juicers
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AAC operates a (T, M) policy Solution

Review period demand = TD = ( 3/52)(6240) = 360 juicers, M = TD + SS = 360 + 30 = 390 juicers, Q = M + LD I = 390 + . 03077(6240) - 210 = 372 juicers.
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AAC operates a (T, M) policy Solution

Replenishment level
Order Order = maximum inventory M

Inventory position Inventory position SS

Review point

SS
Review L point

SS

e: I + Q is designed to satisfy the demand within an interval o To obtain the replenishment level add SS to I + Q.
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8.8 Single Period Inventory Model Assumptions

Demand is Demand is stochastic with a stochastic with a known of the Shelf life known item is limited. distribution. distribution. Inventory is saleable only within a single time period. Inventory is delivered only once during a time period. At the end of At the end of each period, each period, unsold inventory unsold inventory is disposed of for is disposed of for some salvage. some salvage. The salvage value The salvage value is less than the is less than the cost per item. cost per item. Unsatisfied Unsatisfied demand may demand may result in shortage93 result in shortage costs.

The Expected Profit Function

To find an optimal order quantity we need to balance the expected cost of over-ordering and under ordering.

Expected Profit = (Profit when

Demand=X)Prob(Demand=X) x

The expected profit is a function of the order size, the random demand, and the various
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 Developing an expression for EP(Q)

Notation

The Expected Profit Function

p = per unit selling price of the good. c = per unit cost of the good. s = per unit salvage value of unsold good. K = fixed purchasing costs Q = order quantity.

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The Expected Profit Function

Scenario 1: Demand X is less than the units stocked, Q. Profit = pX + s(Q - X) - cQ - K Scenario 2: Demand X is greater than or equal to the units stocked.
Profit = pQ - g(X - Q) - cQ - K
[pX+s(Q - X) - cQ - K]P(X) +Q X
X< Q

Q) =

[pQ - g(X - Q) - cQ - K]
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The Optimal Solution

To maximize the expected profit order Q*
For the discrete demand case take the smallest value of Q*

that satisfies the condition P(D Q*) (p - c + g)/(p s + g)

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THE SENTINEL NEWSPAPER

Management at Sentinel wishes to know how many newspapers to put in a new vending machine. Demand distribution is Data discrete uniform between
Unit selling price is $0.30 and 49 newspapers. 30 Unit production cost is $0.38. Advertising revenue is $0.18 per newspaper. Unsold newspaper can be recycled and net $0.01. 98 Unsatisfied demand costs $0.10 per

SENTINEL - Solution
Input to the optimal order quantity formula p = 0.30 c = 0.20 [0.38-0.18] p+ g - c The level s = 0.01 probability of the optimal service p+ g= s g = 0.10 0.30 + 0.10 - 0.20 = 0.513 = 0.30 + 0.10 - 0.01 K = 1.20 99

SENTINEL Solution
1. 0

Finding the optimal order quantity Q*

P(D 39) = 0.50 P(D 40) = 0.55

0.513 0.55 0.50

Q* = 40

30

3940

49

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SENTINEL Spreadsheet
Solution
=(B5+B8-B6)/ (B5+B8-B7)

=(E6-B10+1)/(B11B10+1) =ROUNDUP(B10+E5*(B 11-10),0)

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WENDELLS BAKERY

Management in Wendells wishes to determine the number of donuts to prepare for sale, on weekday Demand is normally distributed evenings with a mean of 120, and a Data standard deviation of 20 donuts
Unit cost is $0.15. Unit selling price is $0.35. Unsold donuts are donated to charity for a tax credit of $0.05 per donut. Customer goodwill cost is $0.25. Operating costs are $15 per evening.102

WENDELLS BAKERY Solution

Input to the optimal order quantity formula p = $0.35 c = $0.15 p+ g - c s = $0.05 The optimal service level = - s p+ g g = $0.25 0.35+ 0.25 - 0.15 = 0.8182 = 0.35+0.25 - 0.05 K = $15.00
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 From the relationship F(Q ) = 0.8182 we find the corresponding z value. From the standard normal table we have z = 0.3186. The optimal order quantity is calculated by
.8182

WENDELLS BAKERY Solution Finding the optimal order quantity *

Q* = + z

=120 Q*

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WENDELLS BAKERY Solution Calculating the expected profit

For the normal distribution

Q**) = (p -- s) -- (c -- s)Q** -- (p + g -- s) ()L[(Q** -- )) /] (Q ) = (p s) (c s)Q (p + g s) ()L[(Q /]

L [(Q* - ) /] is obtained from the partial expected value table. For Wendells
EP(138) = (0.35 - 0.05)(120) - (0.15 - 0.05)(138) (0.35 + 0.25 - 0.05)x(20)L[(138 - 120) / L(0.9) = 15 = $6.10 105 20] - 0.1004

WENDELLS BAKERY Spreadsheet Solution

=NORMINV (E5,B10,B1 1) =(B5-B7)*B10-(B6-B7)*E6-(B5+B8B7)*B11*(EXP(-(((E6-B10)/B11)^2)/2)/ ((2*PI())^0.5)-((E6-B10)/B11)*(1NORMSDIST((E6-B10)/B11)))-B9

=(B5+B8B6)/ (B5+B8-B7)

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WENDELLS
The commission strategy
When commission replaces fixed wages
Compare the maximum expected profit of two strategies:
$0.13 commission paid per donut sold, $15 fixed wage per evening (calculated before).

Calculate first the optimal quantity for the alternative policy. 107

WENDELLS
The unit selling price changes to
c = 0.35 - 0.13 = $0.22

The commission strategy Solution

The optimal order:

F(Q*) = (0.22 + 0.25 - 0.15) / (0.22 + 0.25 0.05)= 0.7616. Z = .71

Q* = + z = 120 + (0.71)(20) 134 donuts.

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WENDELLS
The commission strategy Solution
Will the bakerys expected profit increase?
EP(134) = (0.22 - 0.05)(20) - (0.15 - 0.05) (134) - (0.22 + 0.25 - 0.05)x(20)L[(134 120) / 20] = $5.80 < 6.10

The bakery should not proceed with the alternative plan.

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WENDELLS
The commission strategy Solution
Comments
The operator expected compensation will increase, but not as much as the bakerys expected loss. An increase in the mean sales is probable when the commission compensation plan is implemented. This may change the analysis results.
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