1

Traditional Inventory
Models for Independent
Demand
Lecture by:
Dr A R SIngh
Supply Chain Management
2
What is an Inventory System
Inventory is defined as the stock of any item or
resource used in an organization.
An Inventory System is made up of a set of
policies and controls designed to monitor the
levels of inventory and designed to answer the
following questions:
What levels should be maintained?
When stock should be replenished? and
How large orders should be? i.e. what is the
optimal size of the order?

3
Inventories: Why and Why not




Large inventories hide operational
problems;
Financial costs to carrying excess inventory;
Risk of damage;
Tracking and accounting costs;
Risk of obsolescence and depreciation;



Allows managers to decouple operations;
Protects one system part from disruptions in others;
Reduces number of times orders are placed;
Allows quantity discounts from suppliers;
Allows firms to meet unexpected demand.
4
Inventory issues
Demand
Constant vs. variable
deterministic vs. stochastic
Lead time
Review time
Continuous vs. periodic
Excess demand
Backorders, lost sales
Inventory change
Perish, obsolescence
Inventory
Decisions:
When, What,
and how many
to order
5
ABC classification system
Divides on-hand inventory into 3 classes (A = very important; B = moderately
important; C = least important) usually on a basis of annual $ volume.

Policies based on the ABC:
Develop links with A suppliers more;
Get tighter control of A items;
Forecast A more carefully.
ABC Analysis
A Items
B Items
C Items
P
e
r
c
e
n
t

o
f

a
n
n
u
a
l

d
o
l
l
a
r

u
s
a
g
e

80
70
60
50
40
30
20
10
0
| | | | | | | | | |
10 20 30 40 50 60 70 80 90 100
Percent of inventory items
Figure 12.2
ABC Analysis
Policies employed may include
More emphasis on supplier
development for A items
Tighter physical inventory control for
A items
More care in forecasting A items
8
Other Inventory classification
systems: V-E-D Analysis


Divides on-hand inventory into 3 classes
V = Vital Inventory
E = essential Inventory
D = Desirable Inventory
Policies based on the ABC& VED:

A B C
V 95% 97% 99.99%
E 80% 88% 91%
D 60% 80% 90%
9
Other Inventory classification
systems F-S-N Analysis


Divides on-hand inventory into 3 classes

F = Fast Moving Items
S = Slow Moving Items
N = Non-moving Items
10
Two basic types of Inventory Systems
1) continuous (fixed-order quantity)
an order is placed for the same constant amount
when inventory decreases to a specified level, ie.
Re-order point

2) periodic (fixed-time)
an order is placed for a variable amount after a
specified period of time
used in smaller retail stores, drugstores, grocery
stores and offices
11
basic inventory elements
1. Carrying cost, C
c
Include facility operating costs, record
keeping, interest, etc.
2. Ordering cost, C
o
Include purchase orders, shipping, handling,
inspection, etc.
3. Shortage (stock out) cost, C
s

Sometimes penalties involved; if customer is
internal, work delays could result
Carrying Costs
Category
Cost (and Range) as a
Percent of Inventory
Value
Housing costs (including rent or depreciation,
operating costs, taxes, insurance)
6% (3 - 10%)
Material handling costs (equipment lease or
depreciation, power, operating cost)
3% (1 - 3.5%)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and
insurance on inventory)
11% (6 - 24%)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
13
Inventory
- to study methods to deal with
how much stock of items should be kept on
hands that would meet customer demand
Objectives are to determine:
a) how much to order, and
b) when to order

14
Inventory models
Here, we only study the following three different
models:

1. Basic model

2. Model with re-order points

15
1. Basic model
The basic model is known as:
Economic Order Quantity (EOQ) Models

Objective is to determine the optimal order size
that will minimize total inventory costs

How the objective is being achieved?

16
Quantity
on hand
Q
Receive
order
Place
order
Receive
order
Place
order
Receive
order
Lead time
Reorder
point
Usage
rate
Profile of Inventory Level Over
Time
17
Profile of Frequent Orders
18
Basic Fixed-Order Quantity Model
This model attempts to estimate the order size (Q) and
determine the point (R) at which an order should be
placed.
Model assumptions:
1. Annual demand (D) for the product is known, constant
and uniform throughout the period,
2. Lead time (L) is known and constant,
3. Product unit price (C) is known and constant,
4. Per unit holding or carrying cost (Cc) is known and
constant,
5. Ordering or setup cost (Co) is known and constant,
19
Basic Fixed-Order Quantity Model
Model assumptions:
6 No backorders are allowed,
7. There is no interaction with other products, the
inventory control system operates independent of its
environment.

20
1 Economic Order Quantity (EOQ) Model












Q
Order Size
L
Time

Q/2
d
L
R
Daily Usage Rate
21
The Basic EOQ Model
The optimal order size, Q, is to minimize the sum of carrying costs and ordering costs.
Assumptions and Restrictions:
- Demand is known with certainty and is relatively constant over time.
- No shortages are allowed.
- Lead time for the receipt of orders is constant. (will consider later)
- The order quantity is received all at once and instantaneously.
How to determine
the optimal value
Q
*
?
22
Determine of Q
We try to
Find the total cost that need to spend for keeping
inventory on hands
= total ordering + stock on hands
Determine its optimal solution by finding its first
derivative with respect to Q

How to get these values?
1. Find out the total carrying cost
2. Find out the total ordering cost
3. Total cost = 1 + 2
4. d (Total cost) /d Q = 0, and find Q
*



23
The Basic EOQ Model

We assumed that, we will only keep half the inventory over a year then

The total carry cost/yr = C
c
x (Q/2).

Total order cost = C
o
x (D/Q)

Then , Total cost =
2
Q
C
Q
D
C TC c o
Finding optimal Q
*

24
Cost Relationships for Basic EOQ
(Constant Demand, No Shortages)
Total
Cost
Carrying
Cost
Ordering
Cost
EOQ balances carrying
costs and ordering
costs in this model.
Q*
Order Quantity (how much)
25
The Basic EOQ Model

EOQ occurs where total cost curve is at minimum value and carrying cost equals
ordering cost:





Where is Q* located in our model?
c
o
c
o
C
D C
Q
Q
C
Q
D C
TC
2
2
*
min

(How to obtain this?) Then,
*
c
o
c
o
C
D C
Q
Q
C
Q
D C
TC
2
2
*
min

26
EOQ Derivation

Min. The Total Cost Function by finding first derivative and equating it to zero:
TC = DCo/Q + QCc/2
dTC

Solving for Q: EOQ =

We could achieve the same result by equating Holding
(Carrying Cost) to Ordering Cost and solve for Q .
Reorder point: R = d.L + SS (safety stock)





dQ
= (- DCo/Q ) + Cc/2 = 0
2
2DCo
Cc

27
The Basic EOQ Model

Total annual inventory cost is sum of ordering and carrying cost:
2
Q
C
Q
D
C TC c o
Figure The EOQ cost model

To order inventory

To keep inventory
Try to get this value
28
The Basic EOQ Model
Example
Consider the following:
days store 62.2
5
311
* /
days 311
time cycle Order
5
000 , 2
000 , 10
: year per orders of Number
500 , 1 $
2
) 000 , 2 (
) 75 . 0 (
000 , 2
000 , 10
) 150 (
2
: cost inventory annual Total
yd 000 , 2
) 75 . 0 (
) 000 , 10 )( 150 ( 2 2
* : size order Optimal
10,000yd D $150, C $0.75, C : parameters Model
*
*
min
o c





Q D
Q
D
Q
C
Q
D
C TC
C
D C
Q
opt
c o
c
o
No. of working days/yr
*
Note: You should pay attention that
all measurement units must be the same

Consider the same example, with yearly
29
The Basic EOQ Model
EOQ Analysis with monthly time frame
$1,500 ($125)(12) cost inventory annual Total
month per 125 $
2
) 000 , 2 (
) 0625 . 0 (
000 , 2
) 3 . 833 (
) 150 (
2
*
*
: cost inventory monthly Total
yd 000 , 2
) 0625 . 0 (
) 3 . 833 )( 150 ( 2 2
* : size order Optimal
month per yd 833.3 D order, per $150 C month, per yd per $0.0625 C : parameters Model
min
o c




Q
C
Q
D
C TC
C
D C
Q
c o
c
o
(unit be based on yearly)
12 months a year
30
Robustness of EOQ model
Order Quantity
Total
Cost
Q* Q*-DQ

Q*+DQ
DTC
Would have to mis-specify Q* by quite a bit
before total annual inventory costs would
change significantly.
Very Flat Curve - Good!!
31
Key observations
Optimal order size depends on SQUARE
ROOT of
Demand (double demand, order size goes up by 1.4)
Fixed cost (double cost, order size goes up by 1.4)
Holding cost (double, order size goes down by 1.4)
Optimal total cost is relatively insensitive to
deviations in order size

Robust Model
The EOQ model is robust
It works even if all parameters
and assumptions are not met
The total cost curve is relatively
flat in the area of the EOQ
33
2. Model with re-order points
The reorder point is the inventory level at which a new order is placed.
Order must be made while there is enough stock in place to cover demand during lead time.
Formulation: R = dL, where d = demand rate per time period, L = lead time
Then R = dL = (10,000/311)(10) = 321.54
Working days/yr
34
Reorder Point
Inventory level might be depleted at slower or faster rate during lead time.
When demand is uncertain, safety stock is added as a hedge against stockout.
Two possible scenarios
Safety stock!
No Safety
stocks!
We should then ensure
Safety stock is secured!

35
Determining Safety Stocks Using Service Levels

We apply the Z test to secure its safety level,
) ( L Z L d R d
Reorder point
Safety stock
Average sample demand
How these values are represented in the diagram of normal distribution?
36
Reorder Point with Variable Demand












stock safety
y probabilit level service to ing correspond deviations standard of number
demand daily of deviation standard the
time lead
demand daily average
point reorder
where

L Z
Z
L
d
R
L Z L d R
d
d
d

37
Reorder Point with Variable Demand
Example
Example: determine reorder point and safety stock for service level of 95%.
26.1. : formula point reorder in term second is stock Safety
yd 1 . 326 1 . 26 300 ) 10 )( 5 )( 65 . 1 ( ) 10 ( 30
1.65 Z level, service 95% For
day per yd 5 days, 10 L day, per yd 30 d

L Z L d R
d
d