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IM 322 Inventory Management

Chapter 3 Economic Order Quantity Model (EOQ)

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Textbook: Donald Waters, Inventory Control and Management, 2nd ed

Chapter Outline

Quantitative Inventory management


Quantitative Inventory management answers two primary questions:
How much to order:
Order Quantity or Economic Order Quantity (EOQ)

When to order:
Reorder point

Typical pattern of stock level over time

Inventory level

Q1

Q2

Reorder point

0 Lead Time Lead Time

Time
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Economic Order Quantity (EOQ)


Idealized stock To find the fixed order size that minimizes costs Basis of most independent demand
Order quantity, Q Inventory Level

Demand rate

Reorder point, R

Lead time Order placedOrder placedOrder receipt

Lead time Order placed receipt Order

Time

Basic Economic Order Quantity (EOQ)


Model Assumptions

Demand is known exactly, is continuous and is constant over time All costs are known exactly and do not vary
Ex: holding cost, purchase price, and reorder costs do not vary with the quantity ordered

No shortages are allowed Lead time is constant

Pressures for Low Inventories


When keeping inventory, there are always some cost incurred Inventory holding cost (or carrying cost)
The variable cost of keeping items on hand $/ unit-period

Inventory holding cost generally includes:


Interest of opportunity cost Storage and handling costs (e.g., electricity, utilities, documentation, labor costs) Tax, insurance, and shrinkage
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Pressures for High Inventory


Customer service Reorder or Ordering cost ($ / order) Setup cost Transportation cost Payment to suppliers Labor and equipment utilization
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Variables used in the analysis


Unit Cost (UC) Price charged by the suppliers for one unit of item, or Total cost to organization of acquiring one unit $ / unit Reorder cost (RC) Cost of placing a routine order $ / order, $/setup Holding cost (HC) Cost of holding one unit of the item in stock for one period of time $ / unit-period Shortage cost (SC) Cost of having a shortage and not being able to meet demand from stock $ / unit-period
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Variables used in the analysis


Order quantity (Q) Fixed order size Cycle time (T) Time between two consecutive replenishment Depends on Q Demand (D) The number of units to be supplied from stock in a given time period Basic EOQ assumes known constant demand

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Derivation of the EOQ


EOQ: the lot size or order size that minimizes total annual inventory holding and ordering cost Under basic EOQ
Amount entering stock in cycle, Q Unit cost component

Amount leaving stock in cycle, DxT Reorder Cost component Holding Cost component

Total cost per cycle

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Derivation of the EOQ

Total Cost Slope = 0 Minimum total cost Holding Cost

Reorder Cost

Optimal order Qo
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Ex 1: Carpet Sales
The I-75 Carpet store stocks carpet in its warehouse and sells it through a showroom. The store keeps several brands and styles of carpet in stock; however, its bigger seller is the BIG C carpet. The store wants to determine the optimal order size and total inventory cost for this brand of carpet given an estimated annual demand of 10,000 yards of carpet, an annual carrying cost of $0.75 per yard, and an ordering cost of $150.

The store would like to know the number of orders that will be made annually and the time between orders given that the store is open every except Sunday, Thanksgiving Day and Christmas Day.

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Adjusting EOQ

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Sensitivity Analysis
Use estimates of relevant costs Ignore uncertainty in demand What happen if the holding / ordering cost is off by 20%, 30%?
Consider 4 cases of variations of the model parameters. Both ordering and carrying costs are 10% less than the original estimates Both are 10% higher Ordering cost is 10% higher and carrying cost is10% lower Ordering cost is 10% lower and carrying cost is 10% higher

1. 2. 3. 4.

Determine EOQ in each case. Remark on the sensitivity of Q on the estimated total cost.
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Adding Finite Lead Time

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Reorder Level
Additional assumption: Lead time is known and constant No need to carrying stock from one cycle to the next So each order should be scheduled to arrive as existing stock runs out

Reorder level = demand during lead time = lead time x demand per unit tim ROL = LT x D
Revisit Ex 1: Carpet Sell. Given that product lead time is 5 days. Calculate reorder level (ROL) 17

Reorder Level with Longer Lead Time


When lead time is longer than the stock cycle There is always one order outstanding. Example:
when it is time to place order B, there is one order, A outstanding and due to arrive before B.

The stock on hand plus the outstanding order must be enough to last until B arrive or equal the lead time demand
ROL Stock on hand ROL

+ -

Stock on order Stock on order

LT x D

LT x D

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Reorder Level with Longer Lead Time


When lead time is very long Several orders are outstanding at anytime When lead time is between n and n+1 cycle length

n x T < LT < (n+1) x T


ROL

There are n orders outstanding

= =

Lead time demand LT x D

Stock on order n x Qo

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Ex 2
Demand for an item is steady at 1,200 units a year with an ordering cost of $16 and holding cost of $0.24 per unit per year. Describe a appropriate ordering policy if the lead time is constant at
(a) (b) (c)

3 months 9 months 18 months

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Discussion Questions

What are the benefit of short lead times? How can these be achieved in practice?

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EOQ. Derivation

EX1 Carpet Sales

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