INVENTORY MODEL

Dr. K. M. Salah Uddin
Associate Professor
Department of Management Information Systems
University of Dhaka
WHAT IS INVENTORY?

A physical resource that a firm holds in a stock 
with the intent of selling it or transforming it 
into more valuable state.
What is the optimal quantity to order? 

Total Cost  =  Purchasing Cost + Ordering Cost + 
Holding Cost

Purchasing Cost  =  (total units) x (cost per unit)

   Ordering Cost  =  (number of orders) x (cost per 
order)

Holding cost  =  (average inventory) x  (holding cost per 
unit)
BASIC EOQ MODEL
1. Demand is known, constant, and 
independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and 
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided
 THE EOQ MODEL D
Annual setup cost =      S
Q
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year) 
x (Setup or order cost per order)

Annual demand Setup or 
=
Number of units in each orderorder cost per 
order
D
=         (S)
Q
 THE EOQ MODEL D
Annual setup cost =      S
Q
Q
Q = Number of pieces per order Annual holding cost =       H
2
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual holding cost = (Average inventory level) 
x (Holding cost per unit per year)

Order quantity
=                                (Holding cost per unit per year)
2

Q
=         (H)
2
 THE EOQ MODEL D
Annual setup cost =      S
Q
Q
Q = Number of pieces per order Annual holding cost =       H
2
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Optimal order quantity is found when annual 
setup cost equals annual holding cost

D Q
S  =       H
Q 2
Solving for Q* 2DS = Q2H
Q2 = 2DS/H
Q* =     2DS/H
AN EOQ EXAMPLE
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H
2(1,000)(10)
Q* = =    40,000  = 200 units
0.50
 Finding the optimal quantity to order…
Let’s say we decide to order in batches of Q…

Inventory position D
Number of periods 
will be 
Q

The average 
inventory for each 
period is…
Time
Period over which demand for Q has  Q
occurred
2
Total Time
Finding the optimal quantity to order…

Purchasing cost  =  D x C

D
Ordering cost  =  x  S
Q

Q
Holding  cost   =  x  H
2
So what is the total cost?

D Q
TC    =   D C    +  S +  H
Q 2

In order now to find the optimal quantity we need to optimize the 
total cost with respect to the decision variable (the variable we 
control)

Which one is 
the decision 
variable?
What is the main insight from EOQ?
There is a tradeoff between holding costs and ordering costs

Total cost

Cost
Holding costs

Ordering costs

Order Quantity 
(Q*)
Economic Order Quantity ­ EOQ
2SD 
Q  = 
*

H 
Example:
Assume a car dealer that faces demand for 5,000 cars per
year, and that it costs $15,000 to have the cars shipped to
the dealership. Holding cost is estimated at $500 per car
per year. How many times should the dealer order, and
what should be the order size?

2(15,000)(5,000)
Q 
*
 548
500
 IF DELIVERY IS NOT INSTANTANEOUS, BUT THERE IS A LEAD TIME L:
WHEN TO ORDER? HOW MUCH TO ORDER? 

Order
Quantity
Q
Inventory

Lead Time
Time
Place Receive
order order
IF DEMAND IS KNOWN EXACTLY, PLACE AN ORDER 
WHEN INVENTORY EQUALS DEMAND DURING LEAD 
TIME.

Order Q: When shall we order? 
Quantity    A: When inventory = ROP
Q Q: How much shall we order? 
   A: Q = EOQ
Inventory

Reorder
Point
(ROP)
ROP = LxD

Lead Time
Time
D: demand per period
Place Receive
L: Lead time in periods
order order
Example (continued)…

What if the lead time to receive cars is 10 days?

(when should you place your order) order?)
Since D is given in years, first convert: 10 days = 10/365yrs

10 10
R  = D   =   5000 =  137
365 365

So, when the number of cars on the lot reaches 137, order 548 
more cars.
Problem 01: Overland Motors uses 25,000 gear assemblies each
year and purchases them at $ 3.40 each. It costs $ 50 to process
and receive an order, and inventory can be carried at a cost of $
0.78 per unit-year. (a) How many assemblies should be ordered
at time? (b) How many orders per year should be placed?

2 DS 2(25000)(50)
EOQ    1,790 assemblies
(a) H 0.78

D 25,000
(b) orders/yr=   14 orders/yr
Q 1,790
Problem 2: A producer of photo equipment buys lenses 
from a supplier at $100 each. The producer requires 
125 lenses per year, and the ordering cost is $ 18 per 
order. Carrying costs per unit­year (based on average 
inventory) are estimated to be $20 each. What is the 
most economical amount to order at a time?
# Disregarding quantity discounts, the EOQ  amount 
would be:                                              
2 DS 2(125)(18)
EOQ    15 lense
H 20
 And the total annual cost associated with this EOQ is 
:TC=ordering +  carrying + purchase
   
D Q
 S  H  PD
Q 2
 125  15
 18  20  100(125)  $12,800
 15  2
Problem 3: A firm with an annual demand of 900 
units per year estimates its ordering costs at $ 
15.00 per order and its carrying costs $0.30 per 
year. Assuming that all the conditions of the 
EOQ model are met, what is the most economical 
quantity to order?

2 DS 2(900)(15)
Q   300 units
H 0.30
 PROBABILISTIC MODELS

Probabilistic inventory models

• Single- and multi- period models
• A single-period model with uniform distribution of demand
• A single-period model with normal distribution of demand

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PROBABILISTIC INVENTORY MODELS
 The demand is not known. Demand characteristics
such as mean, standard deviation and the distribution
of demand may be known.
 Stockout cost: The cost associated with a loss of
sales when demand cannot be met. For example, if
an item is purchased at $1.50 and sold at $3.00, the
loss of profit is $3.00-1.50 = $1.50 for each unit of
demand not fulfilled.

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SINGLE- AND MULTI- PERIOD MODELS

 In a single-period model, the items unsold at the end

of the period is not carried over to the next period.
The unsold items, however, may have some salvage
values.
 In a multi-period model, all the items unsold at the
end of one period are available in the next period.
 In the single-period model and in some of the multi-
period models, there remains only one question to
answer: how much to order.

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SINGLE-PERIOD MODEL
 Computer that will be obsolete before the next order
 Perishable product

 Seasonal products such as bathing suits, winter

coats, etc.
 Newspaper and magazine

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 Trade-offs in a Single-Period Models
Loss resulting from the items unsold
ML= Purchase price - Salvage value

Profit resulting from the items sold

MP= Selling price - Purchase price

Trade-off
Given costs of overestimating/underestimating demand
and the probabilities of various demand sizes
how many units will be ordered?

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Consider an order quantity Q
Let P = probability of selling all the Q units
= probability (demandQ)

Then, (1-P) = probability of not selling all the Q units

We continue to increase the order size so long as

P( MP)  (1  P) ML
ML
or, P 
MP  ML

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Decision Rule:

Order maximum quantity Q such that

ML
P
MP  ML
where P = probability (demandQ)

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Problem 4: Demand for cookies:

Demand Probability of Demand

1,800 dozen 0.05
2,000 0.10
2,200 0.20
2,400 0.30
2,600 0.20
2,800 0.10
3,000 0,05
Selling price=$0.69, cost=$0.49, salvage value=$0.29
a. Construct a table showing the profits or losses for each possible quantity
b. What is the optimal number of cookies to make?
c. Solve the problem by marginal analysis.

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Demand Prob Prob Expected Revenue Revenue Total Cost Profit
(dozen) (Demand) (Selling Number From From Revenue
all the units) Sold Sold Unsold
Items Items
1800 0.05
2000 0.1
2200 0.2
2400 0.3
2600 0.2
2800 0.1
3000 0.05

Sample computation for order quantity = 2200:

Expected number sold=1800(0.05)+2000(0.10)+2200(0.85) =2160
Revenue from sold items=2160(0.69)=$1490.4
Revenue from unsold items=(2200-2160)(0.29)=$11.6
Total revenue=1490.4+11.6=$1502
Cost=2200(0.49)=$1078
Profit=1502-1078=$424
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Demand Prob Prob Expected Revenue Revenue Total Cost Profit
(dozen) (Demand) (Selling Number From From Revenue
all the units) Sold Sold Unsold
Items Items
1800 0.05 1 1800 1242.0 0.0 1242 882 360
2000 0.1 0.95 1990 1373.1 2.9 1376 980 396
2200 0.2 0.85 2160 1490.4 11.6 1502 1078 424
2400 0.3 0.65 2290 1580.1 31.9 1612 1176 436
2600 0.2 0.35 2360 1628.4 69.6 1698 1274 424
2800 0.1 0.15 2390 1649.1 118.9 1768 1372 396
3000 0.05 0.05 2400 1656.0 174.0 1830 1470 360

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Solution by marginal analysis:

Order maximum quantity, Q such that

ML 0.20
P  Probability demand  Q     0.50
MP  ML 0.20  0.20
Demand, Q Probability(demand) Probability(demandQ), p

MP  .69  .49  $0.20, ML  .49  .29  $0.20

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 DEMAND CHARACTERISTICS

Suppose that the historical sales data shows:

Quantity No. Days sold Quantity No. Days sold

14 1 21 11
15 2 22 9
16 3 23 6
17 6 24 3
18 9 25 2
19 11 26 1
20 12

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DEMAND CHARACTERISTICS
Mean = 20
Standard deviation = 2.49

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Demand Characteristics

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Problem 5: The J&B Card Shop sells calendars. The once-
a-year order for each year’s calendar arrives in
September. The calendars cost $1.50 and J&B sells them
for $3 each. At the end of July, J&B reduces the calendar
price to $1 and can sell all the surplus calendars at this
price. How many calendars should J&B order if the
September-to-July demand can be approximated by
a. uniform distribution between 150 and 850

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Solution to problem 5:

Loss resulting from the items unsold

ML= Purchase price - Salvage value =$1.5-$1=$0.5

Profit resulting from the items sold

MP= Selling price - Purchase price =$3-$1.5=$1.5

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 ML
P =
MP  ML
Now, find the Q so that P(demandQ) =

Q* =

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Problem 6: The J&B Card Shop sells calendars. The once-a-year order for each
year’s calendar arrives in September. The calendars cost $1.50 and J&B sells
them for $3 each. At the end of July, J&B reduces the calendar price to $1 and
can sell all the surplus calendars at this price. How many calendars should
J&B order if the September-to-July demand can be approximated by
b. normal distribution with  = 500 and =120.

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Solution to problem 6: ML=$0.50, MP=$1.50 (see problem 5 )

P
ML
MP  ML
Now, find the Q so that P =

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We need z corresponding to area =

z=
Hence, Q* =  + z =

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Problem 7: A retail outlet sells a seasonal product for $10 per unit. The cost of
the product is $8 per unit. All units not sold during the regular season are sold
for half the retail price in an end-of-season clearance sale. Assume that the
demand for the product is normally distributed with  = 500 and  = 100.
a. What is the recommended order quantity?
b. What is the probability of a stock out?
c. To keep customers happy and returning to the store later, the owner feels
that stock outs should be avoided if at all possible. What is your
recommended quantity if the owner is willing to tolerate a 0.15 probability of
stock out?
d. Using your answer to part c, what is the goodwill cost you are assigning to a
stock out?

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Solution to Problem 7:
a. Selling price=$10,
Purchase price=$8
Salvage value=10/2=$5
MP =10 - 8 = $2, ML = 8-10/2 = $3
Order maximum quantity, Q such that
ML 3
P   0.6
ML  MP 2  3
Now, find the Q so that
P = 0.6
or, area (2)+area (3) = 0.6
or, area (2) = 0.6-0.5=0.10

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Find z for area = 0.10 from the standard normal table given in Appendix D, p. 736
z = 0.25 for area = 0.0987, z = 0.26 for area = 0.1025
So, z = 0.255 (take -ve, as P = 0.6 >0.5) for area = 0.10
So, Q*=+z =500+(-0.255)(100)=474.5 units.

b. P(stockout) = P(demandQ) = P = 0.6

c. P(stockout)=Area(3)=0.15
From Appendix D,
find z for
Area (2) = 0.5-0.15=0.35

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z = 1.03 for area = 0.3485
z = 1.04 for area = 0.3508
So, z = 1.035 for area = 0.35
So, Q*=+z =500+(1.035)(100)=603.5 units.

d. P=P(demandQ)=P(stockout)=0.15
For a goodwill cost of g
MP =10 - 8+g = 2+g, ML = 8-10/2 = 3

Now, solve g in p =

Hence, g=$15.
ML 3
  0.15
ML  MP 2  g  3

Therefore, goodwill cost is $15

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