INVENTORY MODELS

Instruction: Read the introduction part from text book page 198-201
Introduction
The word inventory means physical stock of goods that is kept in hand for the future affairs of an
organization. Sufficient level of inventory is a must for the smooth and efficient functioning of
any business organization and at the same time uncontrolled inventory may increase the cost of
production. Hence the problem is to take a decision regarding, how much should be stocked and
when should be ordered for stocking for an uninterrupted production process with minimum
funds blocked in inventories.
Costs associated with inventory problems.
1. Cost of the items: This is the actual production cost or purchase price of the items. It may
either constant or a variable. In most of the practical situations’ unit price depends on the
quantity purchased. But in many models, we assume it as constant for simplicity.
2. Setup cost or ordering cost or Replenishment cost: This is the cost associated with
replenishing the inventory. This include the costs for the following:
a) Developing and sending purchase orders.
b) Bill paying.
c) Inventory inquiries.
d) Stationary charges.
e) Salary of the employees of the purchase department.
3. Carrying cost or Holding cost: The cost of maintaining the inventory is termed as carrying
cost or holding cost. This is proportional to the quantity kept in inventory and the time to
which it is maintained. This cost includes cost of capital, taxes, insurance, spoilage, salary
and wages of warehouse employees, rent for the space and equipment, stationary charges etc.
4. Shortage cost or stock out cost: This cost arises due to un-filling the demand in the stock out
period. It is usually of two types. i) Proportional to the quantity short and the duration of
stock out. (This includes the loss of goodwill, cost of idle equipment, penalty etc.) It
frequently occurs when backorders are permitted, i.e. the customers do not cancel their orders
and wait till the next lot arrives. ii) Proportionate to the quantity short only and independent
of stock out period. This is the case when customers do not wait and go to some other agency
for their requirements.

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Inventory Problems
Two fundamental questions to be answered in any inventory problem are the following:
1. How much to order?
2. When to order?
These questions can be answered as follows depending upon the model under consideration.
1. A fixed quantity Q is to be ordered at each time or place the orders in such a way that the
level of inventory after replenishment rises to the fixed level S.
2. Replenish the inventory after each time T or replenish the inventory as soon as the level
reaches a pre-determined level.
Economic Lot Size Models OR Economic Order Quantity Models OR EOQ Models
Model with known and constant rate of demand: This is one of the oldest and most commonly
used inventory modeling technique. Many organizations still use this model as it is relatively
easy to use. But it makes a number of assumptions. The main assumptions are the following:
1. Demand is known and constant over time ( Say D units per year)
2. The lead time (that is the time gap between the placement of the order and the receipt of
the items in stock) is either zero or known and constant.
3. Supply of items is instantaneous, that is the items are received in one batch.
4. Purchase price per unit is constant throughout the year. Quantity discounts are not
possible. (Hence this cost need not be considered in cost minimization).
5. The only variable costs are the following:
a) Ordering cost say Co per order.
b) Holding cost per year say CH.
6. Shortages are not allowed. That is inventory is replenished as soon as it reaches the level
zero.
With these assumptions after every time T the same quantity Q is to be ordered. We want to find
out the optimum values for Q and T which minimizes the total cost per year. The model can be
represented by the following figure.

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 D per year

T
D
Annual ordering cost = (Number of orders per year) X (Ordering cost per order) = CO
Q
Q
Annual holding cost = (Average inventory) X Holding cost per unit per year = CH
2
It has been mathematically proved that total annual cost is minimum when annual holding cost
becomes equal to annual holding cost.
Q D 2 DCO
i.e., CH = CO Þ Q 2 =
2 Q CH

2 DCO
Economic Order Quantity = EOQ = Q* =
CH
Remark 1: Optimum time for ordering can be obtained as follows:
Q
Q = TD Þ T =
D
Q* 2CO
Hence T =
*
=
D CH D

Remark 2: Mathematically it can be easily proved as follows:

Q D
Total cost per annum = C ( Q ) = CH + CO
2 Q
The Economic Order Quantity is that value of Q for which C (Q) is minimum. Using the
principle of maxima and minima this is given by C ' ( Q ) = 0 and C '' ( Q ) > 0

Remark 3: In this problem instead of allowing the inventory to fall to zero suppose we always
æQ ö D
maintain a buffer stock B. Then the total cost per annum becomes C ( Q ) = ç + B ÷ CH + CO
è2 ø Q
Clearly this function also attains minimum at the same Q*

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Example: Patterson 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 minimize 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?
c) What is the average inventory if costs are minimized?
d) Suppose the ordering cost is not $20 and Patterson has been ordering 150 units each time
an order is placed. For this order policy to be optimal, what would be the ordering cost
have to be?

Answer: Given the following input parameters.

D = 250 units; CH = $1 per unit per year ; CO = $20 per order

2 DCO 2*250*20
a) As per the model EOQ = Q* = = = 100
CH 1
D 250
b) Number of orders per year = = = 2.5 order per year
Q* 100
Q* 100
c) Average inventory = = = 50
2 2
2 DCO 2*250* Co
d) Q = Þ 150 =
CH 1
Solving Co = $45

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Reorder Point: If the lead time is zero the next order is to be placed when the inventory level
falls to zero. But, if the lead time is positive say L days then, the reorder point is given by
ROP = d x L , where d is the demand per day. This means the next order is to be placed when the
inventory level reaches d x L

ROP

L
Remark: If ROP > Q* then the reorder point is to be obtained such that
dL= ( Inventory on hand ) + ( Inventory on transit/order)

Example: 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
4 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
200 units.
a) What is the economic order quantity?
b) What is the reorder point?
c) What is the optimal number of orders per year?

Answer: Given the following input parameters.

D = 50,000 units; CH = $4 per unit per year ; CO = $10 per order ; L = 25 days ; d = 250 units

2 DCO 2*50000*10
a) As per the model EOQ = Q* = = = 500
CH 4
b) Reorder point (ROP) = d X L = 4 x 200 = 800
Inventory position = ROP = (Inventor on hand) + (Inventory on transit)

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 Inventory position = 800 = 300 + 500
c) Optimal number of orders = 50000/500 = 100

ROP(300)

Lead Time (L)

EOQ without instantaneous receipt assumption OR EOQ with finite rate of replenishment OR
Production Run Model
The model is same as of the previous model, except the rate of replenishment is not
instantaneous, finite say p units per day. This model is applicable when the inventory is
continuously flows or buildup over a period of time after the order has been placed or when the
units are produced and sold simultaneously. Under these circumstances the daily demand rate is
also to be taken into account. The various input parameters are the following.
Q = Number of units per order or per production run.
Co = Ordering cost or setup cost
CH = Holding cost per unit per year
p = Daily production or replenishment rate.
d = Daily demand rate.
t = Length of the production run in days
D = Annual demand
The model can be represented by the following figure:

p-d per day d- per day

S = Q - dt

t days

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Using the diagram given above it can be easily proved that EOQ can be obtained using the
formula:

2 DCo
Q* =
æ dö
Ch ç 1 - ÷
è pø
Example: Brown manufacturing produces commercial refrigeration units in batches. The firms
estimated demand for the year is 10,000 units. It cost about $100 to setup the manufacturing
process, and carrying cost is 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.
a) How many refrigeration units should Brown Manufacturing produce in each batch?
b) What will be the length of a production cycle?
c) How many productions run will bet there in a year?
Answer:
Given the following input parameters:
D = 10,000 units Co = $100 Ch = $0.50 p = 80 units d = 60 units

2 DCo 2*10000*100
Optimum production size = Q* = = = 4000
æ dö æ 60 ö
Ch ç 1 - ÷ 0.5 ç1 - ÷
è p ø è 80 ø

a) Number of units to be produced in a batch = 4000

b) Length of a production cycle = 4000/80 = 50 days
c) Number of production run per year = 10,000/4000 = 2.5

EOQ Models with shortages

All assumptions are same as of basic model except shortages are permitted with shortage cost Cs
per unit per year. In this case it can be easily shown that EOQ is given by

2 DCO æ CH + CS ö
EOQ = Q* = ç ÷
C H è CS ø

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EOQ Models with shortages and Finite Rate of replenishment

æ ö
ç ÷
2 DCo æ CH + CS ö ç 1 ÷
EOQ = Q* = ç ÷
C H è CS ø ç æ d ö ÷
çç ç1 - ÷ ÷÷
èè pøø

Examples:

1. The annual demand for an item is 2500 units per year. Ordering cost is Rs.15/- and price of
the item is Re.1/- per unit. Inventory carrying cost is 30% of the value of the item per year.
Shortage cost is Rs.1.50 per item per year. Determine the optimum order size.
D = 2500 per year, Co = Rs. 15, Ch = 0.30

2*2500*15 æ 0.30 + 1.5 ö

EOQ = Q* = ç ÷ = 547.7 ! 548
0.3 è 1.5 ø

2. A company has a demand of 12,000 units per year for an item. It can produce the item 100
units per day and the daily demand is 60 units. The cost of one setup is Rs.400 and holding
cost per unit per year is Rs.1.8. The shortage cost per unit per year is Rs. 20. Find the
optimum lot size and time gap between setups.

æ ö
2*12000* 400 æ 1.8 + 20 ö ç 1 ÷
EOQ = Q* = ç ÷ ç ÷ = 3812.26 ! 3813
1.8 è 20 ø ç æ1 - 60 ö ÷
ç ç 100 ÷ ÷
èè øø

Quantity Discount Models:

The EOQ models are developed under the assumption that quantity discounts are not
permissible. But we know in many of the practical situations discounts are offered for bulk
purchases. Hence if such a discount is possible, and all other EOQ assumptions are met, it is
possible to find out the quantity that minimizes the total inventory cost by using the regular EOQ
formula and making some adjustments.

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In this case the purchase price or materiel cost is also to be considered while calculating the total
cost. Also carrying cost is usually expressed as the percentage of the value of the item to be
carried. That is:
Total cost = (Materiel Cost) + (Ordering Cost) + (Carrying Cost)
Suppose D = Annual demand in units
Co = Ordering cost per order
C = Cost per unit
Ch = C x I = Holding or carrying cost per unit
Where I = holding cost as percentage of the cost.
Total Cost = C(Q) = DC + (D/Q) Co + (Q/2)C I

2 DCO
EOQ = Q* =
CI

Procedure

2 DCO
1. For each discount price C compute EOQ = Q* =
CI
2. If EOQ < Minimum for discount adjust the quantity to Q = Minimum for discount
3. For each EOQ or adjusted EOQ find total cost using C(Q) = DC + (D/Q) Co + (Q/2)C I
4. Choose the lowest cost quantity

Example: The yearly demand for an item is 1600 units, cost of placing an order is Rs.5/- and
carrying cost is 10% per year. The price breaks for the item is given below
Quantity Unit cost
1 – 799 Re.1/-
800 and above Re.0. 98
Find the EOQ:
Answer: D =1600 Co = Rs.5/- Ch = 0.10C
EOQ when C = 0.98

2 DCO 2*1600*5
Q* = = = 404
CH 0.10*0.98

Since Q* < 800 this not possible

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EOQ when C = 1

2 DCO 2*1600*5
Q* = = = 400
CH 0.10*1
Next we compare the total cost when Q = 400 and Q =800 and decide the EOQ
C(400) = DC + (D/Q) Co + (Q/2)Ch = 1600 x 1+(1600/400)5 + (400/2) 0.10x1= 1640
C(800) = 1600 x 0.98 +(1600/800)x5+ (800/2)x0.10 x 0.98 = 1617.2
There for EOQ = 800
Example 2: The demand for an item is known to be 4800 units per year. The cost of one setup is
Rs.400/- and inventory carrying cost is 24% per annum of the cost of the item. The cost of the
item depends on the purchase lot size as per the schedule given below.
Quantity 1-999 1000- 1499 1500 and above
Price/unit Rs.20 Rs.18.50 Rs.17

2 DCO 2*4800*400
Answer: Q3* = = = 970
CH 17*0.24

Since Q3* < 999 we find

2 DCO 2*4800*400
Q1* = = = 894
CH 20*0.24

Now we compare the total cost

C(Q) = DC + (D/Q) Co + (Q/2)Ch

C (894) = 4800*20 + (4800/894)* 400 + (4800/2)*20*0.24 = 100293.3

C (1000) = 4800*20 + (4800/1000)* 400 + (4800/2)*20*0.24 = 92940
C (1500) = 4800*20 + (4800/1500)* 400 + (4800/2)*20*0.24 = 85940
Comparing EOQ = 1500
Practice Problems
Problems : 6-20,6-21,6-22,6-23,6-27,6-28,6-29,6-40,6-47

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