Topic 4: Inventory Control Models

1. Introduction

Why Inventory?
Inventory is an expensive and important asset.

What is inventory?
Any stored resource used to satisfy a current or future need
 Raw materials
 Work-in-process
 Finished goods
Objective
Balance high and low inventory levels to minimise costs

Lower inventory levels? Minimise costs?

 Can reduce costs
 May result in stockouts and dissatisfied customers

How to determine the best inventory level?

Inventory planning and control system

Two fundamental decisions in controlling inventory:

 How much to order?
 When to order?

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2. Economic Order Quantity(EOQ): Determining How Much to Order
3.
EOQ- The amount of inventory ordered that will minimise the total inventory cost.
It is also called the optimal order Quantity.

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐿𝑒𝑣𝑒𝑙 = 𝑄/2

𝐷
𝐴𝑛𝑛𝑢𝑎𝑙 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = 𝐶𝑜
𝑄
𝑄
𝐴𝑛𝑛𝑢𝑎𝑙 𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑜𝑟 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = 𝐶
2 ℎ
2𝐷𝐶𝑜
𝐸𝑂𝑄 = 𝑄 ∗ = √
𝐶ℎ
𝐷 𝑄
𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑜𝑠𝑡: 𝑇𝐶 = 𝐶𝑜 + 𝐶ℎ
𝑄 2

𝑄 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑖𝑒𝑐𝑒𝑠 𝑡𝑜 𝑜𝑟𝑑𝑒𝑟

𝑄 ∗ = 𝑂𝑝𝑡𝑖𝑚𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑖𝑒𝑐𝑒𝑠 𝑡𝑜 𝑜𝑟𝑑𝑒𝑟
𝐷 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑖𝑡𝑒𝑚
𝐶𝑜 = 𝑜𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑎𝑐ℎ 𝑜𝑟𝑑𝑒𝑟
𝐶ℎ = ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑜𝑟 𝑐𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

4. Reorder Point (ROP): Determining when to order

ROP- ROP Determines when to order inventory

𝑅𝑂𝑃 = 𝑑𝑋𝐿
𝑑 = 𝑑𝑎𝑖𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑
𝐿 = 𝐿𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 (𝑇ℎ𝑒 𝑡𝑖𝑚𝑒 𝑖𝑡 𝑡𝑎𝑘𝑒𝑠 𝑡𝑜 𝑟𝑒𝑐𝑒𝑖𝑣𝑒 𝑎𝑛 𝑜𝑟𝑑𝑒𝑟 𝑎𝑓𝑡𝑒𝑟 𝑖𝑡 𝑖𝑠 𝑝𝑙𝑎𝑐𝑒𝑑)

Case 1 If ROP<Q
An order should be placed when the inventory drops to ROP.

Example: ROP=200 units, Q=300 units

Hence, when the inventory drops to 200 units, an order should be placed.
Case 2 If ROP>Q
An order should be placed when the inventory position (Inventory on hand + inventory on order)
drops to ROP.
Example: ROP=300 units, Q=200 units
Inventory position=Inventory on hand +Inventory on order
300=100+200

Hence, a new order have to be placed when the on-hand inventory fell to 100units.

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Example 1
James Electronics supplies microcomputer circuitry to a company that incorporates microprocessors into
refrigerators and other home appliances. One of the components has an annual demand of 250 units, and this
is constant throughout the year. Carrying cost is estimated to be $1 per unit per year, and the ordering cost is
$20 per order.
a. To minimise cost, how many units should be ordered each time an order is placed?
b. How many orders per year are needed with the optimal policy? (D/Q)
c. What is the average inventory if the cost is minimised?
d. Suppose ordering cost is not $20, and James has been ordering 150 units each time an order is placed.
For this policy to be optimal, what would the ordering cost have to be?

5. Optimal Production Quantity

The amount of inventory produced that will minimise the total inventory cost.

𝑄 𝑑
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = (1 − )
2 𝑝
𝑄 𝑑
𝐴𝑛𝑛𝑢𝑎𝑙 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = (1 − )𝐶ℎ
2 𝑝
𝐷
𝐴𝑛𝑛𝑢𝑎𝑙 𝑆𝑒𝑡𝑢𝑝 𝑐𝑜𝑠𝑡 = 𝐶𝑆
𝑄
2𝐷𝐶𝑆
𝑂𝑝𝑡𝑖𝑚𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑄 ∗ = √
𝑑
𝐶ℎ (1 − )
𝑝
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑦𝑐𝑙𝑒 = 𝑄/𝑝

𝑄 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑖𝑒𝑐𝑒𝑠 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟, 𝑜𝑟 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑟𝑢𝑛

𝐶𝑠 = 𝑆𝑒𝑡𝑢𝑝 𝑐𝑜𝑠𝑡
𝐶ℎ = ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
𝑝 = 𝑑𝑎𝑖𝑙𝑦 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
𝑑 = 𝑑𝑎𝑖𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑 𝑟𝑎𝑡𝑒

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Example 2
Brown Manufacturing produces commercial refrigeration units in batches. The firm’s estimated demand for
the year is 10,000 units. It costs about $100 to set up the manufacturing process, and the carrying cost is
about 50 cents per unit per year. When the production process has been set up, 80 refrigeration units can be
manufactured daily. The demand during the production period has traditionally been 60 units each day.
Brown operates its refrigeration unit production area 167 days per year. How many refrigeration units
should Brown Manufacturing produce in each batch? How long should the production part of the cycle last?

Answer: 4000 units, 50 days. (The equipment will be set up to manufacture the units for a 50-day time span)

6. Quantity Discount Models

Objective: Minimize total inventory costs.

𝐷 𝑄
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝐷𝐶 + 𝐶𝑜 + 𝐶ℎ
𝑄 2

𝑄 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑖𝑒𝑐𝑒𝑠 𝑡𝑜 𝑜𝑟𝑑𝑒𝑟

𝐷 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑖𝑡𝑒𝑚
𝐶 = 𝑈𝑛𝑖𝑡 𝑐𝑜𝑠𝑡
𝐶𝑜 = 𝑜𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑎𝑐ℎ 𝑜𝑟𝑑𝑒𝑟
𝐶ℎ = ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑜𝑟 𝑐𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

Steps for solving Quantity Discount

Step 1: Compute EOQ for each discount price
Step 2: If EOQ < discount minimum level, let Q=minimum
Step 3: For each EOQ, compute the total cost
Step 4: Choose the lowest cost quantity from all levels

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Example 3
Dorsey Distributors has an annual demand for a metal detector of 1,400. The cost of a typical detector to
Dorsey is $400. Carrying cost is estimated to be 20% of the unit cost, and the ordering cost is $25 per order.
If Dorsey orders in quantities of 300 or more, it can get a 5% discount on the cost of the detectors. Should
Dorsey take the quantity discount? Assume the demand is constant.

7. Safety Stock
Safety Stock (SS)- Safety stock helps in avoiding stock outs. It is extra stock kept on hand.

𝑆𝑆 = 𝑍𝜎𝑑𝑙𝑡

𝑅𝑒𝑜𝑟𝑑𝑒𝑟 𝑃𝑜𝑖𝑛𝑡 𝑤𝑖𝑡ℎ 𝑆𝑎𝑓𝑒𝑡𝑦 𝑠𝑡𝑜𝑐𝑘, 𝑅𝑂𝑃 = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 + 𝑍𝜎𝑑𝑙𝑡

𝑄
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡, 𝑇𝐻𝐶 = 𝐶 + (𝑆𝑆)𝐶ℎ
2 ℎ

1. Demand is variable but lead time is constant 𝑅𝑂𝑃 = 𝑑̅ 𝐿 + 𝑍𝜎𝑑 √𝐿

2. Demand is constant but lead time is variable 𝑅𝑂𝑃 = 𝑑𝐿̅ + 𝑍𝑑𝜎𝐿
3. Both demand and lead time are variable
𝑅𝑂𝑃 = 𝑑̅ 𝐿̅ + 𝑍√𝐿̅𝜎 2 𝑑 + 𝑑̅ 2 𝜎 2 𝐿

𝑍 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑓𝑜𝑟 𝑎 𝑔𝑖𝑣𝑒𝑛 𝑠𝑒𝑣𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 (Appendix A page 642)
𝑑 = 𝑑𝑎𝑖𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑
𝐿 = 𝐿𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑑𝑎𝑦𝑠
𝑑̅ = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑
𝐿̅ = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑑𝑎𝑦𝑠
𝜎𝑑𝑙𝑡 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒
𝜎𝑑 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑑𝑎𝑖𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑
𝜎𝐿 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒
𝑆𝑆 = 𝑠𝑎𝑓𝑒𝑡𝑦 𝑠𝑡𝑜𝑐𝑘

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Example 4
The B.N Thayer Computer Company sells a desktop computer that is popular among gaming enthusiasts. In
the past few months, demand has been relatively consistent, although it does fluctuate from day to day. The
company orders computer cases from a supplier. It places an order for 5000 cases at the appropriate time to
avoid stock outs. The demand during lead time is normally distributed, with a mean of 1000 units and a
standard deviation of 200 units. The holding cost per unit per year is estimated to be $4. How much safety
stock should the company carry to maintain a 96% service level? What is the reorder point? What would the
total annual holding cost be if this policy is followed?

6
Class Exercise 7
Question 1
a) Paul Peterson is considering manufacturing hole-punch devices. The annual demand is 20,000 units.
The setup cost is $100 per order, and the carrying cost is $5 per unit per year. The demand rate is 100
units per day and the production rate is 150 units per day. Determine the economic lot size.

b) Paul Peterson has found a supplier of hole punches that offers quantity discounts. The annual
demand is 20,000 units, the ordering cost is $100 per order, and the carrying cost is 0.5 of the unit
price. For quantities that vary from 0 to 1,999, the unit price is $10. The price is $9.98 for quantities
that vary from 2,000 units to 3,999 units. How many units should Paul order each time an order is
placed?

Question 2
Annual demand for the Doll two-drawer filing cabinet is 50,000 units. Bill Doll, president of Doll Office
Suppliers, controls one of the largest office supply stores in Nevada. He estimates that the ordering cost is
$10 per order. The carrying cost is $4 per unit per year. It takes 25 days between the time that Bill places an
order for the two-drawer filing cabinets and the time when they are received at his warehouse. During this
time, the daily demand is estimated to be 250 units.

a. What is the economic order quantity?

b. What is the reorder point?
c. What is the optimal number of orders per year? (D/Q)