TXE-441

Industrial & Production Engineering-III

Inventory Models

MD. FAHIM BIN ALAM

Lecturer
Department of Textile Engineering
Key Inventory Terms
• Lead time: time interval between ordering and receiving the order
• Holding (carrying) costs: cost to carry an item in inventory for a length of time,
usually a year (heat, light, rent, security, deterioration, spoilage, breakage,
depreciation, opportunity cost,…, etc.,)
• Ordering costs: costs of ordering and receiving inventory (shipping cost, preparing
invoices, cost of inspecting goods upon arrival for quality and quantity, moving the
goods to temporary storage)
• Set-up Costs: cost to prepare a machine or process for manufacturing an order
• Shortage costs: costs when demand exceeds supply, the opportunity cost of not
making a sale
 Inventory Models
1) Single-Period Inventory Model: One-time ordering decision such as selling t-shirts at a football
game, newspapers, fresh bakery products. Objective is to balance the cost of running out of stock
with the cost of overstocking. The unsold items, however, may have some salvage values.

2) Multi-Period Inventory Models

• Fixed-Order Quantity Models: Each time a fixed amount of order is placed.
• Economic Order Quantity (EOQ) Model
• Production Order Quantity (POQ) Model/ Economic Production Quantity (EPQ) Model
• Quantity Discount Models
• Fixed-Time Period Models :Orders are placed at specific time intervals.
 Assumptions of EOQ Model
• Only one product is involved
• Annual demand requirements known
• Demand is even throughout the year
• Lead time does not vary
• Each order is received in a single delivery
• There are no quantity discounts
Calculating EOQ
Receive Inventory depletion
order (demand rate)

On-hand inventory (units)

Q Average
cycle
2 inventory

1 cycle
Time
Figure: Cycle-Inventory Levels
Calculating EOQ
Annual Holding Cost
Annual holding cost = (Average cycle inventory)  (Unit holding cost)

Annual ordering cost

Annual ordering cost = (Number of orders/Year)  (Ordering or setup costs)

Total annual cycle-inventory cost

Total costs = Annual holding cost + Annual ordering or setup cost
EOQ Total Cost of Inventory
Annual Annual
Total cost = carrying + ordering
cost cost

Q D
TC = H + S
2 Q

Where: Q=Order quantity

H=Holding cost per unit per year
D=Demand in units per year
S=Ordering costs per order
Cost Minimization Goal
The Total-Cost Curve is U-Shaped
Q D
TC = H + S
2 Q
Annual Cost

Holding Costs

Ordering Costs

Order Quantity (Q)

QO (optimal order quantity)
The Cost of a Lot-Sizing Policy
Current
cost

3000 –
Total Q D

Annual cost (dollars)

cost = 2 (H) + (S)
Q

2000 –
Q
Holding cost = (H)
2

1000 –
D
Ordering cost = (S)
Lowest Q
cost
| | | | | | | |
0–
50 100 150 200 250 300 350 400
Lot Size (Q)
Best Q Current
(EOQ) Q

Figure: Total Annual Cycle-Inventory Cost Function for the Bird Feeder
Deriving the EOQ (Minimum Total Cost)
Using calculus, we take the derivative of the total cost function and set
the derivative (slope) equal to zero and solve for Q.
The total cost curve reaches its minimum where the carrying and
ordering costs are equal.

2DS 2( Annual Demand )(Order or Setup Cost )

Q OPT = =
H Annual Holding Cost
Practice Problem
Practice Problem
Practice Problem
 Economic Production Quantity
• Production done in batches or lots
• Capacity to produce a part exceeds the part’s usage or demand rate
• Assumptions of EPQ are similar to EOQ except orders are received
incrementally during production

Economic Production Quantity Assumptions

❑ Only one item is involved

❑ Annual demand is known
❑ Usage rate is constant
❑ Usage occurs continually
❑ Production rate is constant
❑ Lead time does not vary
❑ No quantity discounts
EPQ Total Cost of Inventory
Carrying Setup
Total cost = cost + cost

Imax D
TC = H + S
2 Q

Where: Imax=Maximum inventory

Q=Run quantity
H=Holding cost per unit per year
D=Demand in units per year
S=Setup costs per run
Deriving the EPQ

2DS p
Q OPT =
H p-u

Where: p=production rate

u=usage rate
EPQ Equations
• Cycle time--time between the beginning of runs
Qo
Cycle time =
u
• Run time--the length of the production run
Qo
Run time =
p
• Maximum & average inventory

I max =
Qo
( p − u)
p
I max
I avg =
2
Practice Problem
Practice Problem
Practice Problem
 Quantity Discount Models
◆ These models are used where the price of the item ordered varies with the order size.

◆ Reduced prices are often available when larger quantities are ordered.

◆ The buyer must weigh the potential benefits of reduced purchase price and fewer
orders that will result from buying in large quantities against the increase in
carrying cost caused by higher average inventories.

◆ Hence, three is trade-off is between reduced purchasing and ordering cost and
increased holding cost
Total Costs with Purchasing Cost
Annual Annual
TC = carrying + ordering + Purchasing
cost
cost cost

Q D
TC = H + S + PD
2 Q
Where P is the unit price.
Remember that the basic EOQ model does not take into consideration the
purchasing cost. Because this model works under the assumption of no quantity
discounts, price per unit is the same for all order size. Note that including
purchasing cost would merely increase the total cost by the amount P times the
demand (D). See the following graph.
Quantity Discount Models
• There are two general cases of quantity discount models:

1. Carrying costs are constant (e.g. $2 per unit).

2. Carrying costs are stated as a percentage of purchase price (20% of unit price)
 EOQ when carrying cost is constant
1. Compute the common minimum point by using the basic economic order
quantity model.

2. Only one of the unit prices will have the minimum point in its feasible range
since the ranges do not overlap. Identify that range:

a. if the feasible minimum point is on the lowest price range, that is the optimal
order quantity.

b. if the feasible minimum point is any other range, compute the total cost for the
minimum point and for the price breaks of all lower unit cost. Compare the total
costs; the quantity that yields the lowest cost is the optimal order quantity.
Practice Problem (Quantity Discount Model with Constant Carrying Cost)
QUANTITY PRICE
S = $2,500
1 - 49 $1,400 H = $190 per computer
50 - 89 1,100 D = 200
90+ 900

2SD 2(2500)(200)
Qopt = = = 72.5 PCs
H 190

For Q = 72.5 SD H Qopt

TC = + 2 + PD = $233,784
Qopt

For Q = 90 HQ
SD
TC = + 2 + PD = $194,105
Q
EOQ when carrying cost is a percentage of the unit price
1. Beginning with the lowest unit price, compute the minimum points for each
price range until you find a feasible minimum point (i.e., until a minimum point
falls in the quantity range of its price).

2. If the minimum point for the lowest unit price is feasible, it is the optimal order
quantity. If the minimum point is not feasible in the lowest price range, compare
the total cost at the price break for all lower prices with the total cost of the
feasible minimum point. The quantity which yields the lowest total cost is the
optimum
 Practice Problem (QD when carrying cost is a percentage of the unit price)
A typical quantity discount schedule, Inventory Carrying cost is 20% of unit price

Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80

3 2,000 and over 5 $4.75

 Practice Problem (QD when carrying cost is a percentage of the unit price)
Calculate Q* first for the lowest price range
Q* = 2DS
IP
2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

D= $5000
2(5,000)(49)
Q2* =
(.2)(4.80)
= 714 cars/order S= $49

2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
Practice Problem (QD when carrying cost is a percentage of the unit price)

2(5,000)(49) 2DS
Q* =
Q1* = = 700 cars/order IP
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
2,000 — adjusted
Practice Problem (QD when carrying cost is a percentage of the unit price)
Annual Annual Annual
Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

Choose the price and quantity that gives

the lowest total cost
Buy 1,000 units at $4.80 per unit
 Inventory Control Systems
• Continuous review (Q) system
• Reorder point system (ROP) and fixed order quantity system
• For independent demand items
• Tracks inventory position (IP)
• Includes scheduled receipts (SR), on-hand inventory (OH), and back orders (BO)

Inventory position = On-hand inventory + Scheduled receipts – Backorders

IP = OH + SR – BO
 When to Reorder with EOQ Ordering
• The EOQ models answer the equation of how much to order, but not the question of
when to order. The reorder point occurs when the quantity on hand drops to
predetermined amount.

• That amount generally includes expected demand during lead time.

• In order to know when the reorder point has been reached, a perpetual inventory is
required.

• The goal of ordering is to place an order when the amount of inventory on hand is
sufficient to satisfy demand during the time it takes to receive that order (i.e., lead time)
 When to Reorder with EOQ Ordering
When to Order: Reorder Points (Make sure demand and lead time are expressed in the
same time units)
◆ If the demand and lead time are both constant, the
reorder point (ROP) is simply:

Demand per Lead time for a new

ROP = day order in days

=dxL

D
d= Number of working days in a year
Selecting the Reorder Point
IP IP IP
Order Order Order Order
received received received received

On-hand inventory
Q Q Q

OH OH OH
R
Order Order Order
placed placed placed

L L L Time
TBO TBO TBO

Figure : Q System When Demand and Lead Time Are Constant and Certain
Reorder Point Curve

Q*
Resupply takes place as order arrives

Inventory level (units) Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days
D
d=
Number of working days in a year

= 8,000/250 = 32 units

ROP = d x L
= 32 units per day x 3 days = 96 units
When to reorder
• When variability is present in demand or lead time, it creates the possibility that
actual demand will exceed expected demand.

• Consequently, it becomes necessary to carry additional inventory, called “safety

stock”, to reduce the risk of running out of stock during lead time. The reorder
point then increases by the amount of the safety stock:

ROP = expected demand during lead time + safety stock (SS)

 Safety Stock
Safety stock reduces risk of stockout during lead time

Quantity
Maximum probable demand
during lead time
Expected demand
during lead time

ROP

Safety stock
LT Time
 Safety Stock
• Because it costs money to hold safety stock, a manager must carefully weigh the
cost of carrying safety stock against the reduction in stockout risk it provides.

• The customer service level increases as the risk of stockout decreases.

• The order cycle “service level” can be defined as the probability that demand will
not exceed supply during lead time. A service level of 95% implies a probability of
95% that demand will not exceed supply during lead time.
• The “risk of stockout” is the complement of “service level”
Service level = 1 - Probability of stockout
• Higher service level means more safety stock
• More safety stock means higher ROP
ROP = expected demand during lead time + safety stock (SS)
Reorder Point with a Safety Stock

Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Time
 Practice Problem
A regional distributor purchases discontinued appliances from various suppliers and then sells them on demand to
retailers in the region. The distributor operates 5 days per week, 52 weeks per year. Only when it is open for
business can orders be received. Management wants to reevaluate its current inventory policy, which calls for
order quantities of 440 counter-top mixers. The following data are estimated for the mixer:

Average daily demand (d) = 100 mixers a. What order quantity Q, and reorder
Standard deviation of daily demand (σd) = 30 mixers point, R, should be used?
Lead time (L) = 3 days b.What is the total annual cost of the
Holding cost (H) = $9.40/unit/year system?
Ordering cost (S) = $35/order c. If on-hand inventory is 40 units, one
open order for 440 mixers is pending,
Cycle-service level = 92 percent
and no backorders exist, should a new
The distributor uses a continuous review (Q) system order be placed?
Practice Problem

SOLUTION
a. Annual demand is D = (5 days/week)(52 weeks/year)(100 mixers/day)
= 26,000 mixers/year

The order quantity is

2DS 2(26,000)($35)
EOQ = =
H $9.40
= 193,167 = 440.02 or 440 mixers
Practice Problem
The standard deviation of the demand during lead time distribution is

σdLT = σd L = 30 3 = 51.96

A 92 percent cycle-service level corresponds to z = 1.41

Safety stock = zσdLT = 1.41(51.96 mixers) = 73.26 or 73 mixers

Average demand during lead time = dL = 100(3) = 300 mixers

Reorder point (R) = Average demand during lead time + Safety stock
= 300 mixers + 73 mixers = 373 mixers

With a continuous review system, Q = 440 and R = 373

Practice Problem
b. The total annual cost for the Q systems is
Q D
C = (H) + (S) + (H)(Safety stock)
2 Q
440 26,000
C= ($9.40) + ($35) + ($9.40)(73) = $4,822.38
2 440

c. Inventory position = On-hand inventory + Scheduled receipts – Backorders

IP = OH + SR – BO = 40 + 440 – 0 = 480 mixers

Because IP (480) exceeds R (373), do not place a new order

Operations Strategy During Lead Time
• Too much inventory
• Tends to hide problems
• Easier to live with problems than to eliminate them
• Costly to maintain
• Wise strategy
• Reduce lot sizes
• Reduce safety stock
 Fixed-Order-Interval Model
• Tight control of type A items
• Items from same supplier may yield savings in:
• Ordering
• Packing
• Shipping costs
• May be practical when inventories cannot be closely
monitored
Fixed-Order-Interval Model
Fixed-Interval Benefits

• Orders are placed at fixed time intervals

• Order quantity for next interval?
• Suppliers might encourage fixed intervals
• May require only periodic checks of inventory levelS
Fixed-Interval Disadvantages
• Requires a larger safety stock
• Increases carrying cost
• Costs of periodic reviews
Comparative Advantages
• Primary advantages of P systems
• Convenient
• Orders can be combined
• Only need to know IP when review is made

⚫ Primary advantages of Q systems

◆ Review frequency may be individualized
◆ Fixed lot sizes can result in quantity discounts
◆ Lower safety stocks
THANK YOU