Inventory Management:

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Economic Order Quantity,
JIT, and the Theory of
Constraints
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 Economic Order Quantity Management 1
• To develop an inventory policy that deals with the
tradeoff between acquisition/ordering cost costs and
carrying costs, two basic questions must be
addressed:
• How much should be ordered (or produced) to
minimize inventory costs?
• When should the order be placed (or the setup
done)?

• minimize the probability that a product will sell out of stock

• company has a hard time predicting consumer demand
• higher inventory holding costs in return for a reduction in the number of
sales lost due to sold out inventory
 Economic Order Quantity Management 1

Total ordering and carrying cost can be

described as:

TC= O(AD/Q) + C(Q/2)

Where:
TC = the total ordering and carrying cost
O = the cost of placing and receiving an order
Q=the number of units ordered each time an order
is placed
AD = the known annual demand
C = the cost of carrying one unit of stock for one
year 3

O(D/Q)=C(Q/2)
D/Q=[C(Q/2)]/O
D=Q{[C(Q/2]/O}
D/{[C(Q/2]/O}= Q
DO/[C(Q/2] = Q
2DO/CQ =Q
2DO/C = Q^2
 Economic Order Quantity Management 1

The objective of inventory management is to

identify the order quantity that minimizes the total
cost – called the Economic Order Quantity

2*AD*O
C

Balance carrying cost and ordering cost

Economic Order Quantity Management 1

When to Order or Produce

Reorder point: the point in time when a new order should be placed
Lead time: the time required to receive the economic order quantity
once an order is place or a setup is initiated

Reorder point: Rate of usage * Lead time

Because the demand for a product is not known with certainty, the
possibility of a stock-out exits. Safety stock can help avoid this.
Safety stock: extra inventory carried to serve as insurance against
fluctuations in demand

Reorder point: (Average rate of usage * Lead time) + Safety

stock
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 ■ Normal time usage
= Normal Lead Time x Average Usage

■ Safety Stock
= (Maximum Lead Time- Normal Lead Time) x Average Usage

Total Order Cost = (Annual Demand/ EOQ) x Order Cost

Total Carrying Cost = (EOQ/2) x Carrying Cost

EOQ= how many units will you order

 ■ Emil Traders, Inc. sells cellphone cases which
it buys from a local manufacturer. Emil
Traders sells 24,000 cases evenly throughout
the year. The cost of carrying one unit in
inventory for one year is P11.52 and the order
cost per order is P38.40.
■ Compute the EOQ
■ Total Order Cost
■ Total inventory carrying cost

400
2304
2304
EOQ = 2 * 24,000 * 38.40
11.52
= 400 cases
Total OC = (24,000/400) * 38.40
= P2,304
Total CC = (400/2) * 11.52
= P2,304
 ■ The following information is available for Edgar
corporation’s Material X
■ Annual usage 12,600
■ Working Days 360
■ Normal lead time 20
The units of material x are required evenly
throughout the year.
1.Re-order point
Assuming that occasionally, the company
experiences delay in the delivery of Material X, such that
the lead time reaches a maximum of 30 days, how many
units of safety stock should the company maintain and
what is the reorder point.
1.Safety Stock
2.Re-order point

700
350
1050
 Reorder Point= (12,600/360) * 20
= 700 cases

Safety stock = (30 – 20) * (12,600/360)

= 350 cases
New Reorder Point= 700 + 250
= 1,050 cases

■Reorder point: Rate of usage(35) *

Lead time

■Normal time usage

= Normal Lead Time x Average
Usage

■Safety Stock
= (Maximum Lead Time- Normal
Lead Time) x Average Usage
 ■ Using the EOQ model, Apple Baby
Corporation computed the economic order
quantity for one of the products it sells to
be 4,000 units. Apple Baby Corporation
maintains safety stock of 300 units. The
quarterly demand for the product is
P10,000 units. The order cost is P200 per
order. The purchase price of the product is
P2.40. The company sells at a 100%
markup. The annual inventory carrying cost
is equal to 25% of the average inventory
level.

■ Total inventory Ordering Cost?

■ Total inventory Carrying Cost 11

4 (Quarterly ) x 10,000 = 40,000/4,000

= 10 x200 =2,000 ordering cost
Carrying Cost = (4,000/2) * (2.40*.25) + (300/2)*(2.40*.25)
1. The economic order quantity is the
order quantity that results in
A. the minimum total annual inventory
costs.
B. no inventory shortages.
C. the maximum total annual inventory
costs.
D. minimum ordering costs.
 KMU Company uses a small casting in one of its finished products.
The castings are purchased from a foundry located in another Asian
country. In total, KMU Company purchases 54,000 castings per year at a
cost of P8 per casting.
The castings are used evenly throughout the year in the production
process on a 360-day-per-year basis. The company estimates that it costs
P90 to place a single purchase order and about P3 to carry one casting in
inventory for a year. The high carrying costs result from the need to keep
the castings in carefully controlled temperature and humidity conditions,
and from the high cot of insurance.
Delivery from the foundry generally takes 6 days, but it can take as
much as 10 days. The days of delivery time and the percentage of their
occurrence are shown in the following tabulation:

Delivery Time (days) Percentage of Occurrence

6 75 %
7 10
8 5
9 5
10 5
100

EOQ = 1,800
Total Inv. Cost = 5,400
Assuming that the company is willing to assume a 15% risk of being
out of stock, what would be the number of safety stock? 150

Assuming that the company is willing to assume only a 5% risk of

being out of stock, what would be the reorder point? 1,350

Assuming a 5% stock-out risk, what would be the total cost of ordering

and carrying inventory for one year? 6,750

Assuming that the cost of stock out is P800 per occurrence, which
safety stock level is necessary in reducing the cost? 0
JIT Inventory Management 2

Setup and Carrying Costs: The JIT Approach

JIT reduces the costs of acquiring inventory to insignificant

levels by:
1. Drastically reducing setup time
2. Using long-term contracts for outside purchases

Carrying costs are reduced to insignificant levels by

reducing inventories to insignificant levels.

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JIT Inventory Management 2

Due-Date Performance: The JIT Solution

Lead times are reduced so that the company can meet requested
delivery dates and to respond quickly to customer demand.
Lead times are reduced by:
• Reducing setup times
• Improving quality
• Using cellular manufacturing

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JIT Inventory Management 2

Avoidance of Shutdown: The JIT Approach

• Total preventive maintenance to reduce machine failures

• Total quality control to reduce defective parts
• The use of the Kanban system is also essential

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JIT Inventory Management 2

What is the Kanban System?

A card system is used to monitor work in process

The Kanban system is

• A withdrawal Kanban
responsible for ensuring that the
• A production Kanban necessary products are
produced in the necessary
• A vendor Kanban
quantities at the necessary time.

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JIT Inventory Management 2
• Discounts and Price Increases: JIT Purchasing
versus Holding Inventories
• Careful vendor selection
• Long-term contracts with vendors
• Prices are stipulated (usually producing a

significant savings)
• Quality is stipulated

• The number of orders placed are reduced

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JIT Inventory Management 2
JIT Limitations:
1. Patience in implications is needed
2. Time is required
3. JIT may cause lost sales and stressed workers
4. Production may be interrupted due to an absence of
inventory

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 Basic Concepts of
Constrained Optimization 3
• Every firm faces limited resources and limited demand
for each product
• External constraints – market demand
• Internal constraints – machine or labor time
availability

Constrained optimization is choosing the optimal

mix given the constraints faced by the firm.

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 Basic Concepts of
Constrained Optimization 3

Linear Programming
Linear programming model: expresses a constrained optimization
problem as a linear objective function subject to a set of linear
constraints
A feasible solution is a solution that satisfies the constraints in the
linear programming model.
Linear programming is a method that searches among
possible solutions until it finds the optimal solution.

See Cornerstone 20-4

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Theory of Constraints (TOC) 4
• Goal – to make money now and in the future by
managing constraints
• Recognizes that the performance of any organization
is limited by its constraints
• TOC focuses on three operational measures of
systems performance
• Throughput = (sales revenue – unit level variable
expenses)/time
• Inventory is all the money the organization spends
in turning materials into throughput
• Operating expenses defined as all the money the
organization spends in turning inventories into
throughput and represent all other money that an
organization spends
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Theory of Constraints (TOC) 4
Five Step Method for Improving Performance
1) Identify an organization’s constraints
2) Exploit the binding constraints
3) Subordinate everything else to the decisions made
in Step 2
4) Elevate the organization’s binding constraints
5) Repeat the process as a new constraint emerges to
limit output

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