Inventory

Inventory refers to idle goods or materials held by an

organization for use sometime in the future.
 Introduction

• Items carried in inventory include raw materials, purchased

parts, components, subassemblies, work in process, finished
goods and supplies.

• Inventory serves as a buffer against uncertain and fluctuating

demand and supply of items by organization or its customers.

• Expense associated with financing and maintaining inventories

is a substantial part of the cost of doing business.
 
• The main purpose of the inventory model is to assist in
making how much to order and when to order inventory
decisions.
 Deterministic inventory

• Rate of demand for the item is constant or nearly constant.

• Economic Order Quantity (EOQ) is applicable

– when the demand for an item shows a nearly constant rate
– when the entire quantity order arrives in inventory at one point of time

• Inventory position is defined as the amount of inventory on

hand plus the amount of inventory on order.

• Total inventory cost is sum of holding cost and ordering cost.

• Holding costs are cost associated with carrying a given level
of inventory and is depend on the size of the inventory.

• Holding cost is considered as the cost of financing the

inventory investment.

• Other holding costs such as insurance, taxes, breakages,

pilferages and warehouse overhead also depend on the value
of inventory.

• Total holding costs includes both cost of capital and other

holding costs.
• Solution: R & B Beverage

• Total holding cost for the R & B beer inventory is

• 18% + 7% = 25% of the value of the inventory.

• With an annual holding cost rate of 25%,

• Cost of holding one case of Beer in inventory for one year is

• 0.25 ($8) = $2.00.

• Ordering cost is fixed regardless of order quantity.
– It covers the preparation of voucher, the processing of order including
payment, postage, telephone, transportation, invoice verification,
receiving and so on.

• Information regarding demand, holding cost and ordering cost

must be known prior to use of EOQ model.
 
• Let Q be the order quantity.

• Thus, how much to order decision involves finding the value

of Q that will minimize the sum of holding and ordering costs.

• Inventory will have a maximum value of Q units when an

order of size Q is received from supplier.
• In constant demand scenario for a given period the inventory
is decline at a constant rate over the period.
– Average inventory will be ½Q
– Maximum inventory is Q
– Minimum inventory is 0

• If the average inventory during each cycle is ½Q, the average

inventory over any number of times is also ½Q.
 
• Holding cost will be multiplying average inventory to the cost
of carrying one unit in inventory for the stated period.

• Annual cost of holding one unit in inventory is Ch = IC

– I = annual holding cost rate
– C = unit cost of the inventory item
• Annual holding cost for the average inventory of ½Q units is
– = average inventory x annual holding cost per unit
– = ½Q x Ch
 
• D be annual demand and Q be ordering units every time, then
D/Q be orders place per year with cost of one order is and Co.

• Annual ordering cost

– = no of orders per year x cost per order
– = (D/Q) x Co
 
• Total annual cost (TC)
– = annual holding cost + annual ordering cost
– = ½ QCh + D/QCo 
• Solution: R & B Beverage

• D = 52 weeks x 2000 cases per week = 104000 cases for year.

• Ch = $2, Co = $32.

• Total annual cost TC

• = ½ Q($2) + 104000/Q ($32)

• = Q + 3328000 / Q
• How Much to Order Decision

• Total cost as a function of how much should be ordered.

• Order quantity Q that minimizes the total cost by setting the

derivative dTC/dQ equal to zero and solving for Q*.

• dTC/dQ = ½ Ch – DCo / Q2 = 0

• ½ Ch = DCo / Q2

• Q2 = 2DCo/ Ch

• Q* = √(2DCo/ Ch) 
• Solution: R & B Beverage
• Total annual cost TC = Q + 3328000 / Q.
• If order quantity Q = 5000
• Then TC = 5000 + 3328000 / 5000 = $5666.
Costs for various order quantities of Bub Beer
Order Quantity Holding Ordering Total
5000 5000 666 5666
4000 4000 832 4832
3000 3000 1109 4109
2000 2000 1664 3664
1824 1824 1825 3649
1000 1000 3328 4328

• Q* = √(2 x 104000 x 32) / 2 = 1824 cases balancing the holding

and ordering cost. If the order quantity Q = 1824, then total cost
TC = 1824 + 3328000 / 1824 = $3649.
• When to Order Decision

• When to order decision is expressed as a reorder point i.e. the

inventory position at which a new order should be placed.
 
• For an inventory systems with constant demand rate and a
fixed lead time, the reorder point is the same as the lead time
demand i.e.
– Reorder point (r) = demand per day (d) x lead time for a new order in
days (m).
– r = dm
 
• The period between orders is referred as the cycle time.
– Cycle time (T) = (no of working days) x Q*/D
 
• Solution: R & B Beverage

• Annual demand of 104000 cases implies a daily demand of

104000 / 250 = 416 cases.

• Beer to be sold during two days i.e. (2 days) (416 cases) = 832
cases and it takes a new order to reach the warehouse.

• Two-day delivery period is a lead time for new order

• Anticipated demand of 832 case during this period is known as

lead time demand.

• Thus R & B should order a new shipment of Beer from the

manufacturer when the inventory reaches 832 cases.
• Solution: R & B Beverage

• Since D/Q is the number of orders that will be placed in a year.

• Thus D/Q* = 104000 / 1824 = 57 is the number of order R &

B Beverage will place for Bub Beer each year.

• R & B places 57 orders over 250 working days it will order

approximately every 250 / 57 = 4.39 working days.

• Thus cycle time is 4.39 working days

• At the cost per order ($32) and the holding cost rate (25%), it
is realized that these figures are at best estimates.
• Solution: R & B Beverage

• Minimum total cost order quantity under several different cost

possibilities is given below
Optimal Order Quantities for Several Cost
Projected
Total Annual Cost
Possible Optimal
Inventory Possible Order
Holding Cost per Quantity
Cost (%) Order (Q*) Using Q* Q = 1824
24 $30 1803 $3,461 $3,461
24 $34 1919 $3,685 $3,690
26 $30 1732 $3,603 $3,607
26 $34 1844 $3,835 $3,836
• Solution: R & B Beverage

• Q* appears relatively stable even with some variations in the

cost estimates.

• Best order quantity is the range of 1700 - 2000 cases.

• If operated properly, the total cost for Bub Beer inventory

should be close to $3400 - $3800 per year.

• If holding cost rate = 24% and Co = $34 and true optimal order
quantity Q* = 1919,

• R & B experience only a $5 increase in the total annual cost

that is $3690 - $3685 = $5 with Q = 1824.
• Solution: R & B Beverage soft drink

a) Q* = √2DCo/Ch = √[2(3600)(20)] / [0.25(3)] = 438.18

b) r = dm = 3600 (5) / 250 = 72
c) T = 250 Q* / D = 250(438.18) / 3600 = 30.43 days
d) Annual Holding Cost = ½ Q Ch = ½ (438.18) (0.25) (3) =
$164.32
e) Annual Ordering Cost = D/Q Co = 3600 (20) / 438.18 =
164.32
f) Total Cost = ½ Q Ch + D/Q Co = ½ (438.18) (0.25) (3) +
3600 (20) / 438.18 = $328.63
• EOQ Model Assumptions

– Demand D is deterministic and occurs at a constant rate.

– Order quantity Q is the same for each order. Inventory level increases
by Q units each time an order is received.
– Cost per order, Co, is constant and does not depend on the quantity
ordered.
– Purchase cost per unit, C, is constant and does not depend on the
quantity ordered.
– Inventory holding cost per unit per time period, Ch, is constant. Total
inventory holding cost depends on both Ch and size of the inventory.
– Shortages such as stock outs or backorders are not permitted.
– Lead time for an order is constant.
– Inventory position is reviewed continuously. As a result, an order is
placed as soon as the inventory position reaches the reorder point.
 Production Lot Size Model

• In production situations, once the order is placed, production

begins, and a constant number of units is added to inventory
each period until the production run has been completed.

• Constant supply rate assumption implies that

– the units supply to inventory at a constant rate over several period
(days or weeks or months)
– the same number of units is supplied to inventory in each period (10
units every day or 50 units every week).

• If a production system has produced 50 units per day and

scheduled for 10 days of production, then production lot size =
50 (10) = 500 units.
• Lot size is the number of units in an order.

• Let Q be the production lot size in an inventory decision of

EOQ model and a holding and ordering cost that expresses the
total cost as a function of the production lot, then to find the
production lot size that minimizes the total cost.

• This model applies to situation where production rate is

greater than demand rate and the production system satisfy
demand.
– if the constant demand rate is 400 units per day, the production rate
must be at least 400 units per day to satisfy the demand.

• During production run, demand reduces the inventory, while

production adds to inventory.
• If the production rate exceeds the demand rate, each period
during a production run causes a gradual inventory buildup.

• When the production run completed, the continuing demand

causes gradually decline in inventory until a new production
run is started.

• EOQ model generally dealing with two costs such as the

holding cost and the ordering cost.

• In production run ordering cost is replaced by setup cost.

– Includes labour, material and lost production costs incurred while
preparing the production system for operation, is a fixed cost that
occurs for every production run regardless of the production lot size.
• Production Lot Size

• Given holding cost (Ch), setup cost (Co), annual demand rate
(D) and annual production rate (P)

• For various production lot sizes Q* = √2DCo/(1-D/P) Ch

• In production lot size model, a constant inventory buildup rate

occurs during the production run and a constant inventory
depletion rate occurs during the non-production period, thus
the average inventory will be one half the maximum inventory.

• However in this inventory system the production lot size Q

does not go into inventory at one point in time and thus the
inventory never reaches a level of Q units.
• Let d = daily demand rate
• p = daily production rate
• t = number of days for a production run

• If p will be larger than d, then the daily inventory buildup

during the production phase is p - d.

• If production run for t days and placed p - d units in inventory

each day, then the inventory at the end of production run will
be (p - d) t.

• Maximum inventory = (p - d) t

• Producing lot size of Q units at a daily production rate of p

units, Q = pt and the length of production run t = Q/P days
• Maximum inventory
– = (p - d) t = (p - d) x Q/p = (1- d/p) Q

• Average inventory
– = ½ (1- d/p) Q

• If Ch is annual holding cost per unit, then annual holding cost

– = average inventory x annual holding cost per unit
– = ½ (1- d/p) Q Ch
 
• If D is annual demand and Co is setup cost for a production
run, then annual setup cost
– = no of production runs per year x setup cost per production run
– = (D/Q) x Co
– Setup cost takes the place of annual ordering cost in the EOQ model.
 
• Total annual cost (TC) = ½ (1- d/p) Q Ch + (D/Q) Co
• Suppose that a production facility operates x days per year.

• Then daily demand d in terms of annual demand D is d = D/x.

• Let P be the annual production for the product and if the

product are produced everyday p units

• Then P = x p and p = P/x

 
• Thus d/p = (D/x) / (P/x) = D/P
 
• Total annual cost TC = ½ (1- D/P) Q Ch + (D/Q) Co
 
• Example: Beauty Bar Soap is produced on a production line
that has an annual capacity of 60000 cases. The annual
demand is estimated at 26000 cases with the demand rate
essentially constant throughout the year. The cleaning,
preparation and setup of the production line cost
approximately $135. The manufacturing cost per case is $4.50
and the annual holding cost is figured at a 24% rate. Other
relevant data include a five-day lead time to schedule and
setup a production run and 250 working days per year. What is
the recommended production lot size?
• Solution: Beauty Bar Soap

• Ch = IC = 0.24 ($4.50) = $1.08

• Q* = √2DCo / (1 – D / P) Ch
• = √[2 (26000) (135)] / [(1 -26000 / 60000) (1.08)] = 3387
 
• Total annual cost TC = ½ (1 – 26000 / 60000) 3387 ($1.08) +
(26000 / 3387) (135) = $2073
 
• Reorder point r = dm = demand per day x lead time for a new
order in day = (26000 / 250) x 5 = 520 case is lead time demand
 
• Cycle time is the time between production runs T = 250 x Q*/D
= [(250) (3387)] / 26000 = 33 working days.
 
• Plan a production run of 3387 units every 33 working days.