Independent Demand Inventory

Modeling Issues and Some Inventory Terminology

How are goods procured?
Is leadtime considered a relevant issue?
Is inventory carried in one or more than one location?
Does a single inventory decision cover one or more than one product?
How are inventory shortages handled?
How is demand (D) expressed?
What are the relevant costs?
What are the evaluation criteria?

Inventory questions:
When and
How Much?
EOQ Modeling Assumptions
1. Production is instantaneous -- there is no capacity constraint and the
entire lot is produced simultaneously.
2. Delivery is immediate -- there is no time lag between production and
availability to satisfy demand.
3. Demand is deterministic -- there is no uncertainty about the quantity or
timing of demand.
4. Demand is constant over time -- in fact, it can be represented as a straight
line, so that if annual demand is 365 units this translates into a daily
demand of one unit.
5. A production run incurs a fixed setup cost -- regardless of the size of the
lot or the status of the factory, the setup cost is constant.
6. Products can be analyzed singly -- either there is only a single product or
conditions exist that ensure separability of products.
Notation

D demand rate (units per year)

c unit production cost, not counting setup or
inventory costs (dollars per unit)
A fixed or setup cost to place an order (dollars)
h holding cost (dollars per year); if the holding
cost is consists entirely of interest on money
tied up in inventory, then h = ic where i is an
annual interest rate.
Q the unknown size of the order or lot size
Inventory vs Time in EOQ Model
Inventory

Q/D 2Q/D 3Q/D 4Q/D

Time
Costs
½(B)H = ½(Q/D)Q
Average inventory level = Q/2
Holding cost = h(Q/2) Average = ½(Q/D)Q
(Q/D)
Q
Number of orders = D/Q
Order cost = A(D/Q)

Price per unit = c Q/D

Purchase cost = Dc

Total Cost = h(Q/2) + A(Q/D) + Dc

Since Q is our choice, the relevant cost Y(Q) = h(Q/2) + A(Q/D)

Numerical Example of EOQ

D = 1000 units per year

Q = 100 units per lot
A = $50 per lot
h = $1 per unit per year
c = $5 per unit

Total relevant cost Y(100) =

Cost Structure

Y(Q)
Dollars

cD

Qh/2

DA/Q
Q*
The Optimal Order Quantity
The optimal order quantity will DA Qh
be found where total order/setup =
costs equal total holding cost Q 2
2 DA 2 DA 2 DA
Qh = Q =
2
Q=
Q h h

Or by using the calculus dY (Q) h A

= − 2 =0
dQ 2D Q

2 DA
Q =
*

h
Numerical Example Cost Minimized

D = 1000 units per year

A = $50 per lot
h = $1 per unit per year
c = $5 per unit

2(1000)50
Q =
*
≅ 316
1

Total relevant cost Y(316) = 1/2(316)1 + 1000/316(50) = $316

Example of the Vendor EOQ: Barrels of oil at Lube-Your-Car

Demand = 5000 units per year

Order cost = $25 per order
Holding cost =$1 per unit per year

2  5000 25
E O Q  Q  500
1

Orders = D/Q = 10 per year

Cycle length (T) = Q/D (365) = 36.5 days
Order Cost =A D/Q = $250 per year
Holding Cost = hQ/2 = $250 per year
The Producer EOQ
The amount of water in
The rate at which water is the pitcher before the
poured from the pitcher pouring begins is Q
into the funnel is P

When the pitcher has emptied,

the amount of water in the
funnel will be M

The rate at which water

dumps out of the
funnel is D As soon as the funnel empties,
another pitcher begins pouring
The Producer EOQ

Q*
Slope = ratio of rate of
M demand (D) to rate of
Inventory

production (P)

Q/D 2Q/D
Cost Structure of the Producer EOQ

Average Inventory = M(Q/D) / 2(Q/D)

M = Q - amount used during production: M = Q- (D/P)Q

Average Inventory = 1/2(Q-(D/P)Q)

1 D D
Total Cost = (Q − Q)h + A
2 P Q
Numerical Example of Producer EOQ

P = 500 units per month

D = 200 units per month
Q = 100 units per lot

D/P = 200/500 = .4 40 % of cycle will be production and demand

D/P)Q = (200/500)100 = 40 40 units will be consumed over this period

M = 100 - 40 = 60 Thus, maximum inventory is 60 units

Cost Minimized Producer EOQ

Using the Calculus or 2 AD

marginal analysis Q = *
D
h(1 − )
P
Example:
P = 100,000 units per week
2(30)20,000
D = 20,000 units per week Q =
*
≅ 38,730
20,000
A = $30 per lot .001(1 − )
h = $.001 per unit per week 100,000
EOQ with Backorders

Q*
M= Q - S All backorders
are satisfied upon
Inventory

replenishment

S*
Q/D 2Q/D 3Q/D
Cost Structure of EOQ with Backorders

1  Q − S  1  (Q − S )2 
Average Inventory =
2
( Q − S )  = 
 Q  2  Q


2
1 S S
Average Shortage = S =
2 Q 2Q

(Q − S ) 2 D S2
h+ A+ B
Total Cost = 2Q Q 2Q
Cost Minimized EOQ with Backorders

2 AD B + h h
Q =
*
( ) S =Q (
* *
)
h B B+h

Numerical Example:
2(50)1000 2 + 1
D = 1000 units per year Q* = ( ) = 387.3
A = $50 per order 1 2
h = $1 per unit per year 1
S = 387.3(
*
) = 129.1
B = $2 per unit per year 2 +1
Numerical Example (cont.)

Maximum Inventory = 387.3 - 129.1 = 258.2

Costs
Holding = (387.3-129.1)2 / 2(387.3) = $86.07
Shortage = ((129.1)2/2(387.3))2 = $43.03
Order = (1000/387.3)50 = $129.10
Total $258.20
Example of Vendor EOQ With Backorders: Microcomputers For Sale At DECK Computers

Demand = 1000 computers per year

Shortage cost = $250 per unit per year (Cb = 250)
Holding cost = $50 per unit per year
Order cost = $2000 per order

2 ( 2000 ) ( 1000 ) 250  50 50

Q  310 S  310 51.67
50 250 250 50

Orders = D/Q = 3.226 per year

Cycle length (T) = Q/D (365) = 113.15
Order Cost =A D/Q = $6451.61 per year
Holding Cost = (Q-S)2/2Qh = $5381.81 per year
Shortage Cost = S2/2Q Cb = $1076.53 per year

Note: order cost = holding cost + shortage cost

EOQ with Quantity Discounts

Total Cost c=$100

Total Cost c=$95
Total Cost c=$90

PB1 PB2
Numerical Example of EOQ
with Price Breaks
D = 500 tons per year Unit cost: 0-51 $100 per ton
A = $100 per order 51-151 $95 per ton
h = $5 per ton per year 151 + $90 per ton
2(500)100
EOQ = Q* = = 141.42
5

1 500
Total CostEOQ = (141.42)5 + 100 + 500(95) = $48,207
2 141.42

1 500
Total Cost151 = (151.00)5 + 100 + 500(90) = $45,708
2 151.00
Continuous Review of Inventory
(ROP or Q System)

Place an order for Q units whenever

inventory withdrawal brings inventory
position to R

L L The reorder point (R) is

normally calculated by
L
adding some level of
safety stock (B) to the
expected demand over
Inventory

leadtime
R
R = DL + B

Time
Numerical Example of a Q system

Demand over leadtime = N(36,15) and CSL = 90%

σ = 15

1-CSL

36
B B=1.28(15)=19.2
R R=36+19.2=55.2
Periodic Review of Inventory
(PRS or P System)
Review an item’s inventory position
every P time periods. At that time,
place and order to replenish to T units

T The up-to order level(T) is

normally calculated by
L L
adding some level of
safety stock (B) to the
expected demand over the
Inventory

protection interval (L + P)

T = DP + L + B
P

Time
Numerical Example of a P System

D = N(40,15) per week

L = 3 weeks
CSL = 80%

What P is required to approximate the 400

= 10 weeks
cost tradeoffs of a 400 unit EOQ? 40

What is the desired σ P + L = 152 * (10 + 3) ≅ 54

level of T? T = 40(13) + .84(54) ≅ 520 + 45 ≅ 565
Numerical Example
D = N(15,6) units per week A = $50 per order
h = $12 per unit per year L = 2 weeks CSL = 80%

Assume Continuous review System

A. What is the EOQ?

2(15(52))50
= 80.6
12

B. What is the desired B? σ L = σ * L = 6 * 2 ≅ 8.5

t
2 2

C. What is the desired R ? B = .84(8.5) = 7.14

1 5(2) + 7.14 ≅ 3 7.1 4

Numerical Example (cont.)
D = N(15,6) units per week A = $50 per order
h = $12 per unit per year L = 2 weeks CSL = 80%

Assume Periodic Review

A. What value of P provides approximate EOQ tradeoffs?

80.6is the desired

B. What
52 = 5.4 weeks ≅ 5 weeks P + L = 7 weeks
B780
and T?

σ P + L = 6 2 * 7 ≅ 15.9
B = .84(15.9) ≅ 13.4
T = 7(15) + 13.4 = 118.4
Advantages of P and Q Systems
• Continuous (Q) systems
• Carry less safety stock
• Order size is constant
• Individualize replenishment intervals
• Suited to quantity discounts and capacity limitations

• Periodic (P) systems

• Less need to take additional physical inventory
• Fixed replenishment intervals
• Can coordinate replenishment of multiple items