Economic Order Quantity

Inventory Management
Chapter 12
Prentice Hall 2007
General Considerations
Marketing-prefer large quantities of inventory

Accounting/Finance-tied up capital
Operations-tool that can be used to promote
efficient operation of the production facilities
Inventories are simply allowed to fluctuate so
that production can be adjusted to its most
efficient level.
Types of Inventory
Pipeline Inventories: exist because materials

must be moved from one location to another.
Buffer Inventories (safety stocks): provide
protection against irregularities or uncertainties
in an items demand or supply.
Anticipation Inventories: needed for products
with seasonal patterns of demand and uniform
supply.
3
Types of Inventory
Cycle Inventories (Lot-size inventories): exists

whenever orders are made in larger quantities
than needed to satisfy immediate requirements.
Results from ordering in batches or lots rather
than as needed.
Forms of Inventories
Raw Materials: objects, commodities, elements,

and items that are received (usually purchased)
from outside the organization to be used directly
in the production of the final output.
Maintenance, repair, and operating supplies:
used to support and maintain the operation,
including spares, supplies, and stores.
Forms of Inventories
Work-In-Process (WIP): all the materials, parts,

and assemblies that are being worked on or are
waiting to be processed within the operations
system.
Finished Goods: stock of completed products.
Placement of Inventories
Standard: An item is made to stock or ordered

to stock and normally the item is available upon
request.
Special: An item made to order.
Inventory-Related Costs
Ordering or Setup Costs: ordering costs are associated with
outside procurement of material and setup costs are costs
associated with internal procurement (i.e. internal manufacture)
of parts of material.
Ex: writing the order, processing the order through the purchasing
system, postage, processing invoices, handling, testing,
inspection, transportation, setup labor, machine downtime due
to a new setup, parts damaged during setup.
Inventory Carrying or Holding Costs: cost items related to
inventory quantity, items value, and length of the time the
inventory is carried.
Ex: interest on money invested in inventory and in the land,
buildings, and equipment necessary to hold and maintain the
inventory; heat, power, and light, salaries of security personnel,
taxes and insurance on equipment; insurance on inventory,
physical deterioration of the inventory.
Inventory-Related Costs
Stockout Costs: if inventory is unavailable when
customers request it, a situation that marketing
detests, or when it is needed for production, a
stockout occurs.
Ex: lost goodwill, lost sales, cost associated with
processing back orders (such as extra paperwork,
special handling, and higher shipping costs)
Determining inventory system

performance
Inventory turnover: relates inventory levels to the

products sales volume.
Turnover is often used to compare an individual
firms performance with others in the same industry
or to monitor the effects of a change in inventory
decision rules.
Inventory turnover
Cost of goods sold

Average aggregate inventory value
10
Example of measuring inventory

system performance
Suppose a companys new annual report
claims their costs of goods sold for the year
is $160 million and their total average
inventory (production materials + work-inprocess) is worth $35 million. This
company normally has an inventory turn
ratio of 10. What is this years Inventory
Turnover ratio? What does it mean?
11
Example of measuring inventory system

performance (Continued)
Cost of goods sold
Inventory turnover
Average aggregate inventory value
= $160/$35
= 4.57
Since the companys normal inventory turnover ratio is
10, a drop to 4.57 means that the inventory is not
turning over as quickly as it had in the past.
Without knowing the industry average of turns for
this company it is not possible to comment on how
they are competitively doing in the industry, but
they now have more inventory relative to their cost
of goods sold than before.
Determining inventory system

performance
Fill rate: to capture the benefits of having

inventory, some companies use customer service
to asses their inventory system performance.
The percentage of units immediately available
when requested by customers.
13
Priorities for Inventory

Management: The ABC Analysis
Classifying inventory according to some measure of

importance and allocating control efforts accordingly.
A items
15-20% of items that account for 75-80% of annual
inventory value, should be subject to the tightest
control.
B items
30-40% of items that account for 15% of annual
inventory value
C items
40-50% of items that account for 10-15% of annual
inventory value
14
ABC Inventory Categories
15
The Economic Order

Quantity (EOQ)
16
Economic Order Quantity

Assumptions
1. Demand rate is constant
2. No constraints on lot size
3. Only relevant costs are holding and
ordering/setup
4. Decisions for items are independent
from other items
5. No uncertainty in lead time or supply
17
When to use EOQ
Dont use; if you use the make-to-order

strategy
Modify it; if significant quantity discounts are
given for ordering larger lots
Use it; if you follow a make-to-stock strategy
(stable demand)
18

On-hand inventory (units)
Receive
order
Inventory depletion
(demand rate)
Average
cycle
inventory
1 cycle
Time
19

Annual cost (dollars)
Total cost = HC + OC
Holding cost (HC)

Ordering cost (OC)
Lot Size (Q)

20

3000
Total cost =
Q
D
(H) +
(S)
2
Q
2000
Holding cost =
Q
(H)
2
1000
Ordering cost =
0
|
50
|
100
|
150
|
200
|
250
|
300
|
350
D
(S)
Q
|
400
Lot Size (Q)

21
Basic Economic-Order Quantity (EOQ)

Model Formula
Annual
Annual
Total cost = carrying + ordering
cost
cost
TC =
Q
H
2
DS
Q
TC=Total annual
cost
D =Demand
C =Cost per unit
Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
L =Lead time
H=Annual holding
and storage cost
per unit of inventory
22

3000
Total cost =
2000 Bird
Q
D
(H) +
(S)
2
Q
feeder costs
D = (18 /week)(52 weeks) = 936 units

H = 0.25 ($60/unit) = $15
S = 1000
$45
Q = 390 units
Q
D
C=
(H) +
(S)
2
Q
0
Holding cost =
Q
(H)
2
Ordering cost =
|
C = $2925
+ $108 =150
$3033
50 100
200
|
250
|
300
|
350
D
(S)
Q
|
400
Lot Size (Q)

23

Current
cost
3000
Total cost =
2000 Bird
Q
D
(H) +
(S)
2
Q
feeder costs

H = 0.25 ($60/unit) = $15
S = 1000
$45
Q = 390 units
Q
D
C=
(H) +
(S)
2
Q
0
Holding cost =
Q
(H)
2
Ordering cost =
|
C = $2925
+ $108 =150
$3033
50 100
200
|
250
Lot Size (Q)
|
300
|
350
D
(S)
Q
|
400
Current
Q
24

Current
cost
3000
Total cost =
2000 Bird
Q
D
(H) +
(S)
2
Q
feeder costs

H = 0.25 ($60/unit) = $15
S = 1000
$45
Q = 468 units
Q
D
C=
(H) +
(S)
2
Q
0
Holding cost =
Q
(H)
2
Ordering cost =
|
C = $3510
+ $90 = 150
$3600200
50 100
|
250
Lot Size (Q)
|
300
|
350
D
(S)
Q
|
400
Current
Q
25

Current
cost
Bird feeder costs
3000
Q
D
Total cost = D(H)
+ /week)(52
(S)
=
(18
weeks) = 936 units
2
Q
H = 0.25 ($60/unit) = $15

S = $45
Q = EOQ
2000
EOQ =
Q
Holding
cost
=
Q
D(H)
2DS
2
C=
(H) +
(S)
1000
Ordering cost =
0
|
50
|
100
|
150
|
200
|
250
Lot Size (Q)
|
300
|
350
D
(S)
Q
|
400
Current
Q
26

Current
cost
Bird feeder costs
3000
Q
D
Total cost = D(H)
+ /week)(52
(S)
=
(18
weeks) = 936 units
2
Q
H = 0.25 ($60/unit) = $15

S = $45
Q = 75
2000
EOQ =
Q
Holding
cost
=
Q
D(H)
2DS
2
C=
(H) +
(S)
1000
Ordering cost =
0
|
50
|
100
|
150
|
200
|
250
Lot Size (Q)
|
300
|
350
D
(S)
Q
|
400
Current
Q
27

Current
cost
Bird feeder costs
3000
Q
D
Total cost = D(H)
+ /week)(52
(S)
=
(18
weeks) = 936 units
2
Q
H = 0.25 ($60/unit) = $15

S = $45
Q = 75
2000
EOQ =
1000
Q
Holding
cost
=
Q
D(H)
2DS
2
C=
(H) +
(S)
C = $562 + $562 = $1124

Ordering cost =
|
50
|
100
|
150
|
200
|
250
Lot Size (Q)
|
300
|
350
D
(S)
Q
|
400
Current
Q
28

Current
cost
Bird feeder costs
3000
Q
D
Total cost = D(H)
+ /week)(52
(S)
=
(18
weeks) = 936 units
2
Q
H = 0.25 ($60/unit) = $15

S = $45
Q = 75
2000
EOQ =
1000
Q
Holding
cost
=
Q
D(H)
2DS
2
C=
(H) +
(S)
C = $562 + $562 = $1124

Ordering cost =
Lowest
cost
0
|
50
Best Q
(EOQ)
|
100
|
150
|
200
|
250
Lot Size (Q)
|
300
|
350
D
(S)
Q
|
400
Current
Q
29

Current
cost
Bird feeder costs
3000
Q
D
Total cost = D(H)
+ /week)(52
(S)
=
(18
weeks) = 936 units
2
Q
H = 0.25 ($60/unit) = $15

S = $45
Q = 75
2000
EOQ =
1000
Q
Holding
cost
=
Q
D(H)
2DS
2
C=
(H) +
(S)
C = $562 + $562 = $1124

Ordering cost =
Lowest
cost
0
|
50
Best Q
(EOQ)
|
100
|
150
|
200
|
250
Lot Size (Q)
|
300
|
350
D
(S)
Q
|
400
Current
Q
30

Current
cost
3000
2000
Bird feeder costs

Time between orders
Q
D
Total cost = D(H)
+ /week)(52
(S)
= (18
weeks) = 936 units
2
Q
EOQ = $15
HTBO
= 0.25 ($60/unit)
=
= 75/936 = 0.080 year
EOQ
D
S = $45
Q = 75
Q
Holding
cost
=
Q
D(H)
2DS
TBO
=
(75/936)(12)
=
0.96
months
2
C=
(H) +
(S)
EOQ =EOQ
2
Q
H
TBOEOQ = (75/936)(52) = 4.17 weeks
C = $562 + $562 = $1124
D days
TBOEOQ = (75/936)(365)
= 29.25
Ordering cost =
(S)
1000
Lowest
cost
|
50
Best Q
(EOQ)
|
100
|
150
|
200
|
250
Lot Size (Q)
|
300
|
350
|
400
Current
Q
31
EOQ Example (1) Problem Data

Given the information below, what are the EOQ and
reorder point?
Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
EOQ Example (1) Solution

Q O PT =
d =
2D S
=
H
2(1,000 )(10)
= 89.443 units or 90 units
2.50
1,000 units / year

= 2.74 units / day
365 days / year
_
R eorder point, R = d L = 2.74units / day (7days) = 19.18 or 20 units
In summary, you place an optimal order of 90 units. In

the course of using the units to meet demand, when
you only have 20 units left, place the next order of 90
units.
EOQ Example (2)
Given:
25,000 annual demand
$3 per unit per year holding cost
$100 ordering costs
2(25,000)(100)
EOQ =
1291
3
34
Independent vs. Dependent Demand

Independent Demand (Demand for the final endproduct or demand not related to other items)
Finished
product
E(1
)
Component parts
Dependent
Demand
(Derived demand
items for
component
parts,
subassemblies,
raw materials,
etc)
Decisions in Inventory
Management
Only two decisions need to be made in managing
independent-demand inventories:
When to order? (timing)
How much to order? (size)
36
Routine inventory decisions
These two decisions can be made routinely by using

any one of four inventory control decision rules in
figure below:
Order quantity
Order
frequency
Fixed Q
Variable S
Variable R
Q, R
S, R
Fixed T
Q, T
S, T
Q, order a fixed quantity Q

S, order up to a fixed expected opening inventory quantity S
R, place an order when the inventory balance drops to R
T, place an order every T periods
37
How
Much?
When!
38
Types of Inventory Management

Systems
Continuous review (Reorder point) systems

time between orders varies
constant order quantity
Periodic review systems

time between orders fixed
order quantity varies
Material requirements planning (MRP)
dependent demand items

39
Continuous Review (Reorder point

system)
Reorder point: whenever the inventory on hand reaches the

predetermined inventory level-the reorder point- an order
may be placed for a prespecified amount if there are no
current outstanding orders.
Order quantity is fixed, and the reorder period varies.
Lead time: the time between placement of an order and
receipt of the shipment.
The quantity of inventory to be ordered is often based on
economic order quantity (one answer to the question how
much to order). It can be also based on a price-break
quantity, or a container size (such as a truckload).
40
Continuous Review Systems
Two-bin system: much-used variation of the

reorder point system. Parts are stored in two binsone large and one small.
Small bin- holds sufficient parts to satisfy the
demand.
Large bin- parts are used from only the large bin,
until it is empty.
Advantage-inventory need not be continually
recounted to determine whether or not a reorder
should be placed.
41
Perpetual inventory system: System that keeps

track of removals from inventory continuously,
thus monitoring current levels of each item.
Requires either a manual card system or a
computerized system to keep track of daily
usage and daily stock levels.
A reorder point system could not adequately perform
without either a two-bin system or perpetual inventory
system.
42
Continuous review system tracks the remaining

inventory of an item each time a withdrawal is
made to determine whether it is time to reorder.
At each review, a decision is made about an
items inventory position (IP).
Inventory position (IP)=On-hand inventory
(OH)+ scheduled receipts (open orders) (SR)backorders (BO)
43
Continuous Review (Reorder

point system)
IP
On-hand inventory
IP
Order
received
Order
received
Order
received
Order
received
OH
OH
IP
OH
R
Order
placed
Order
placed
L
TBO
Order
placed
L
TBO
Time
TBO
44
Example
Demand for chicken soup at a supermarket is

always 25 cases a day and the lead time is always
four days. The shelves were just restocked with
chicken soup, leaving an on-hand inventory of
only 10 cases. There are no backorders, but there
is one open order for 200 cases. What is the
inventory position? Should a new order be
placed?
45
Continuous Review
IP
On-hand inventory
IP
Order
received
Order
received
IP
Order
received
Order
received
Chicken Soup
Q
R = Average demand during lead time

OH = (25)(4) = 100
OH cases
OH
IP = OH + SR BO
Order
Order
=
10
+
200
0
= 210 cases
placed
placed
Order
placed
L
TBO
L
TBO
Time
TBO
46
Uncertain Demand
IP
Order
received
Order
received
On-hand inventory
IP
Order
received
Order
received
Q
Q
OH
L1
TBO1
Order
placed
Order
placed
Order
placed
L2
TBO2
L3
Time
TBO3
47
Reorder Point / Safety Stock
Because of uncertain demand, sales during lead time

are unpredictable, and safety stock is added to hedge
against lost sales.
Deciding on a small or large safety stock is a trade-off
between customer service and inventory holding costs.
The usual approach for determining R is for
management is to set a reasonable service level policy for
the inventory and then determine the safety stock level
that satisfies this policy.
Service level is the desired probability of not running out
of stock in any one ordering cycle, which begins at the
time an order is placed and ends when it arrives in
48
stock.
z=the number of standard deviations

for a specified service probability
L=standard deviation of demand during lead time
Cycle-service level = 85%
Probability of stockout
(1.0 0.85 = 0.15)
Average
demand
during
lead time
R
zL
49
Example
Records show that the demand for

dishwasher detergent during lead time is
normally distributed, with an average of 250
boxes and L=22. What safety stock should
be carried for a 99 percent cycle-service
level? What is R?
50

Safety Stock/R
Cycle-service level = 85%
Safety stock = zL
= 2.33(22) = 51.3
= 51 boxes
Probability of stockout
Reorder point = (1.0
ADDLT
+ SS
0.85
= 0.15)
= 250 + 51
Average
= 301 boxes
demand
during
lead time
R
zL
51
Sometimes average demand during lead time and the

standard deviation of demand during lead time are not
directly available.
Average demand may be known along with standard
deviation of demand, t, over some time interval t (days
or weeks), where t does not equal the lead time. In that
case standard deviation of demand during lead time can
be found as:
t= t 2 L= t L
52
Lead Time Distributions

t = 15
t = 26
+
75
Demand for week 1
t = 15
+
75
Demand for week 2
t = 15
225
Demand for
three-week lead time
=
75
Demand for week 3
53

t = 15
t = 26
Bird feeder Lead Time Distribution
t = 1 week
d = 18
75
Demand for weekService-level=90%
1
t=5
L=2
t = 15
L = t
L =5
= 7.1
Safety stock = zL = 1.28(7.1) = 9.1 or 9 units
225
Demand for
stock
three-week lead time
75
Reorder
point
= dL + Safety
Demand
for week
2
t = 15+ 9 = 45 units
= 2(18)
=
75
Demand for week 3
54
Calculating Total Q Systems Costs
Total cost=Annual inventory holding cost +

annual ordering cost +annual safety stock
holding cost
55

t = 15
t = 26
+
75
Demand for week 1
Bird feeder Lead Time Distribution

t = 1 week
t = 15
d = 18
L=2
Reorder point = 2(18) + 9 = 45 units
225
75
936
C=
($15) +
($45)
+ 9($15)
Demand
for
2
75 three-week
lead time
75
Demand for week 2
t = 15
C = $562.50 + $561.60 + $135 = $1259.10
=
75
Demand for week 3
56
Periodic Review System
Inventory level is reviewed at equal time

intervals, and at each review a reorder may be
placed to bring the level up to a desired quantity.
Appropriate for retailers ordering families of
goods.
57
Periodic Review System Without

Considering On-Order Quantity
58
Periodic Review System
Review period (therefore the reorder period) is

fixed, and the order quantity varies.
Since inventory is not continuously tracked,
there is a significant chance of stocking out.
This possibility can be avoided by using safety
stock.
59
Periodic Review System (Assumes

None On Order at Time of Reorder)
Source: Meredith and Shafer, Operations Management for MBAs, Wiley, 2nd edition, 2002; Chase, Jacobs, Aquilano, Operations Management for
Competitive Advantage, Mc-Graw Hill 2004; J. Krajewski, Larry P Ritzman, and Manoj K. Malhotra, Operations Management: Process and Value
Chains, Seventh Edition, Prentice Hall, 2005.
60
Supplement D
Special Inventory (Price-Break) Models
Based on the same assumptions as the EOQ model,
the price-break model has a similar Qopt formula:
2DS
2(Annual Demand)(Order or Setup Cost)
QOPT =
=
iC
Annual Holding Cost
i = percentage of unit cost attributed to carrying inventory
C = cost per unit
Since C changes for each price-break, the formula
above will have to be used with each price-break cost
value
Total Costs with Purchasing Cost

Annual
Annual
Purchasing
+
TC = carrying + ordering cost
cost
cost
Q
H
TC =
2
DS
Q
DC
The buyers goal with quantity discounts (price breaks)

is to select the order quantity that will minimize total
cost, where total cost is the sum of carrying cost,
ordering cost, and purchasing cost.
62
Price-Break Example Problem Data

A company has a chance to reduce their inventory
ordering costs by placing larger quantity orders using
the price-break order quantity schedule below. What
should their optimal order quantity be if this company
purchases this single inventory item with an e-mail
ordering cost of $4, a carrying cost rate of 2% of the
inventory cost of the item, and an annual demand of
10,000 units?
Order Quantity(units) Price/unit($)
0 to 2,499
$1.20
2,500 to 3,999 1.00
4,000 or more .98
Price-Break Example Solution

First, find Q for each price, starting with the lowest price, until
you locate a feasible minimum point.
Annual Demand (D)= 10,000 units
Cost to place an order (S)= $4
Carrying cost % of total cost (i)= 2%

Cost per unit (C) = $1.20, $1.00, $0.98
Interval from 4000 & more, the

QOPT =
Qopt value is not feasible
2DS
=
iC
2(10,000)(4)
= 2,020 units
0.02(0.98)
Interval from 2500-3999, the

Qopt value is not feasible
QOPT =
2DS
=
iC
2(10,000)(4)
= 2,000 units
0.02(1.00)
Q OPT =
2DS
=
iC
2(10,000)(4)
= 1,826 units
0.02(1.20)
Interval from 0 to 2499, the

Qopt value is feasible
Price-Break Example Solution

Next, we plug the Qopt value into the total cost annual
cost function to determine the total cost for 1826, and
compare it to the total cost of the minimum quantity
necessary to obtain the minimum price of .98
D
Q
TC = DC +
S+
iC
Q
2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
= $12,043.82
TC(4000&more)= $9,949.20
Finally, we select the least costly Qopt, which is this

problem occurs in the 4000 & more interval. In summary,
our optimal order quantity is 4000 units
Procedure for Price-Break Models
Beginning with the lowest unit price, compete the Q for

each price range until you find a feasible Q.
If the Q for the lowest unit price is feasible, it is the
optimal order quantity.
If the Q is not feasible in the lowest price range,
compare the total cost of feasible Q/Qs with the total
cost of the minimum quantity in the lowest price range.
66

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Economic Order Quantity

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Inventory Management

Prentice Hall 2007

Marketing-prefer large quantities of inventory

Pipeline Inventories: exist because materials

Cycle Inventories (Lot-size inventories): exists

Raw Materials: objects, commodities, elements,

Work-In-Process (WIP): all the materials, parts,

Standard: An item is made to stock or ordered

Determining inventory system

Inventory turnover: relates inventory levels to the

Cost of goods sold

Example of measuring inventory

Example of measuring inventory system

Determining inventory system

Fill rate: to capture the benefits of having

Priorities for Inventory

Classifying inventory according to some measure of

ABC Inventory Categories

The Economic Order