OR : Module-5

What is Inventory?

An inventory consists of usable but idle resources such as men, machine, material or money.
When resources involved are a material, the inventory is also called as “stock”. Besides raw

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materials, inventory also includes work-in-process (WIP) products and finished products.

Necessity for Maintaining Inventory

Inventory exists because of mismatch between Supply and Demand. Though inventory is an
idle resource, yet almost every organization, whether it is a manufacturing organization or
service / trading industry, must maintain a proper level of inventory for efficient and smooth
running of its operations.

For example, an organization having no inventory of raw materials, would have to

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procure the raw materials each time it receives a sales order; then wait for receipt of the
order, perform the production operations and then supply the finished product to the
customer. The customer will thus have to wait a longer time for the delivery of goods and
may turn to other suppliers resulting in loss of business for the enterprise.

Following is a list of positive benefits that an organization will get by maintaining a

proper inventory level:

1. It helps to increase customer responsiveness of the organization. Goods / Services

can be delivered to the customers at a short notice.
2. It reduces the procurement cost of raw materials, as purchasing in large lot sizes
entails lower number of orders placed per year, and hence clerical costs are
reduced. Moreover, the enterprise can have the benefit of discounts while
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purchasing in larger lot sizes. Thus, Economies of Scale will be maintained.

3. In case of in-house manufacturing, producing in large lot sizes entails less
machine set-ups and hence a considerable amount of unproductive time is
reduced.
4. It helps to run the production processes un-interruptedly when the raw materials
are readily available.
5. It also helps to meet seasonal demand of products. e.g. Winter cloths.

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So, these are some of the advantages that an organization / enterprise may have by
maintaining a proper level of inventory. Negative of these benefits could be the adverse
results due to no inventory in the organization. That is why it is said that,

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“Inventory is a Necessary Evil”

Drawbacks of Inventory

• Too often, inventories are wrongly used as a substitute for management. For example:
▪ If there are large finished goods inventory, inaccurate sales forecasting by the
marketing department may never be apparent.
▪ A production foreman who has large in-process inventory may be able to hide
his poor planning since there is always something to manufacture.
• Inventory means “tide-up” capital of the enterprise. The capital could be better
utilized in other ventures as well.

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• With large inventory, there is always likelihood of obsolescence.
• Maintenance of inventory costs additional money to be spent on personnel,
equipment, insurance etc.

Thus, excess inventory is not at all desirable. This necessitates controlling the inventories in
the most useful way.

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CLASSIFICATION OF INVENTORIES

INVENTORY

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Direct Inventory Indirect Inventory

Production Transit / Pipeline

inventory inventory

WIP Buffer
inventory inventory

Finished Goods Decoupling

inventory inventory

MRO Seasonal
inventory inventory

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Miscellaneous Lot Size
inventory inventory

Anticipation
inventory

Direct Inventories

They include items that are directly used for production and are classified as:

(a) Production inventory: Raw materials, components and sub-assemblies used to

produce final products.

(b) Work-in-Process (WIP) inventory: Semi-finished items / products at different

stages of production.
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(c) Finished Goods Inventory: Final products ready to be dispatched to the customers or
distributors.

(d) MRO inventory: Maintenance, Repair and Operating items such as spare parts and
consumable stores. They are not a component of the final product, but are consumed
during the production processes. e.g. Copper wire for MIG welding.

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(e) Miscellaneous inventory: All other items such as scrap, obsolete and unusable
products, stationary and other items used in office, factory and sales department.

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Indirect Inventory

(a) Transit / Pipeline inventory: Also called Movement Inventory. This includes the
items currently under transit operation. e.g. coal from coalfields to thermal power
plants.

(b) Buffer inventory: Also called Safety Stock or Cushion Stock. This is the extra stock
required as protection against the uncertainties in Supply and Demand.

(c) Decoupling inventory: It is the inventory stock set aside between two interdependent
operations as a buffer against breakdown / unevenness in machine production rates for

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smooth and continuous production.

Example: The manufacturer of video game consoles requires the assembly of several
components. If the production rate for any one part is slower than the other or the production
rate for the part has become slower due to machine malfunctioning / breakdown; the entire
production of video game consoles will slow down or even come to a halt. But a decoupling
inventory of the particular component will enable smooth and continuous flow of the
production line during the resolution of the problem.

(d) Seasonal Inventory: Inventories to meet high demands of seasonal products like
sweaters in Winter, coolers and air-conditioners in Summer and raincoats in Monsoon
season etc.

(e) Lot Size Inventory: Also called Cycle Inventory. Cycle inventory exist because
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producing / procuring some items in large lots will enable the enterprise to take
advantage of Economies of Scale due to,

• Price discounts
• Reduced transportation & purchase costs
• Minimize handling and receiving costs

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Example: A textile industry may buy cotton in bulk during the cotton harvesting season
rather than buying every day.

(f) Anticipation inventory: They are held to meet the anticipated (expected) demand.

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e.g. Purchasing of crackers well before Diwali; ceiling fans before the approach of
Summer; purchasing of raw materials before an expected transporters’ strike, etc.

Inventory Control vs. Inventory Management

Though the two words, “Inventory Control” and “Inventory Management” are being used
interchangeably, but they differ from each other slightly.

Inventory control regulates the inventory that is already in the warehouse. This
includes maintaining a good record of the type of products in stock and their quantity;

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ensuring their good conditions and laying out the warehouse in a way that would minimize
the cost of retrieval and time for filling customer orders.

Inventory management, on the other hand, includes the activities of Forecasting and
Product Replenishment. It determines when to order the products, how much to order and the
most effective source of supply for each item to be ordered. This ensures that the organization
will have right quantity of items at the right time and in the right locations to meet the
customer demands effectively. It also involves the decision of how much safety stock is to be
maintained.

In order to achieve better inventory management, it is necessary to have a good

inventory control. A good record of what is in stock will enable to take a good decision of
what is to be ordered.
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Inventory Problem

An inventory problem is said to exist if:

• Either the resources are subjected to control, or

• If there is at least one such cost that decreases as inventory increases.

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The inventory control problem consists of determination of three basic factors:

• When to order?
• How much to order?

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• How much safety stock should be kept?

When to order is related to Lead Time of an item, which is the time interval between
the placement of an order for an item and its receipt in stock. The minimum stock level of an
item that should be maintained to meet the customer demand during the Lead Time period is
called the Reorder Level / Reorder Point.

Each order has an associated ordering cost or acquisition cost. To keep it low, the
number of orders should be as few as possible; i.e. the ordered lot size should be large. But
large lot size would imply high inventory carrying cost. Thus, the problem of how much to
order is solved by compromising between the acquisition cost and inventory carrying cost.

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The answer to “How much safety stock should be kept” is very important to avoid
overstocking while ensuring that no stock-out take place.

Inventory Costs

Four costs are considered in inventory control / management models:

1. Purchase cost / Cost per unit

2. Inventory carrying cost / Stock holding cost
3. Procurement cost (for bought-outs) / Set-up cost (for made-ins)
4. Shortage Cost

1. Purchase Cost / Cost Per Unit (C)

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It is the price paid for purchasing an item / cost incurred in producing an item. It may
be constant per unit or may vary with the quantity purchased / produced (quantity
discount). If the cost per unit is constant, it does not affect the inventory control
decision. However, purchase cost is definitely considered when it is variable as in
Quantity Discount situation.

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2. Inventory Carrying / Stock Holding Cost

Inventory carrying cost / Stock holding cost refers to the Total Cost of Holding
Inventory. It varies directly with the size of the inventory as well as the time for which

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the item is kept in stock.

Various components of stock holding costs are:

(a) Cost of Capital: Interest paid to the banks for the borrowed money to invest
in the inventories. It can also be viewed as, how much the organization would
have earned, had the capital been invested in an alternative project such as
developing a new product.

(b) Occupancy Cost: Rent for space (warehouse); electricity bill for lighting,
heating and other atmospheric control measures.

(c) Depreciation / Deterioration Cost: Loss of the original value of the item

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with passage of time. Especially applicable to fashion items; items undergoing
chemical changes like medicines; fragile items etc.

(d) Pilferage Cost: Pilferage means “act of stealing a small quantity”. Therefore,
pilferage cost is the loss faced by the enterprise due to theft / stealing of
inventories. It can also be said as the extra cost incurred in buying secure
storages to keep valuable inventory items.

(e) Obsolescence (or Spoilage) Cost: Reduction in the value of the items kept in
inventory for being outdated. e.g. electronic and computer components etc.

(f) Handling Cost: Cost associated with movement of the stock. e.g. cost of
labour in loading and unloading; cost of overhead cranes, gantries and other
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machineries used for such purposes.

(g) Taxes and Insurances: Property taxes and insurance cover against theft, fire
etc.

(h) Record-keeping and Administrative Cost: Expenses in keeping and

maintaining a good record of the items in stock and other administrative
works.

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3. Procurement Cost / Set-up Cost / Ordering Cost

This includes the fixed cost associated with placing of an order or setting up of
machinery before starting production. It is also called as Replenishment Cost.

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It includes the cost of purchase, requisition, follow up, receiving the goods,
quality control; cost of mailing, telephone calls and other follow up actions; salaries
of persons for accounting and auditing etc.

It is independent of the quantity ordered / produced (lot size) but is directly

proportional to the number of orders placed.

4. Shortage Cost or Stock-out Cost

Cost associated with either a delay in meeting the demands or inability to meet the
demands at all. Therefore, shortage cost can be interpreted in two ways:

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(a) In case the unfulfilled demand can be fulfilled at a later stage (backlog), then
shortage cost will be equal to the quantity that is short as well as the delay
time and is expressed as Rs./Unit back order/unit time (Rs. 7/unit/year). It also
represents the loss of goodwill of the customer and cost of idle equipment.

(b) In case the unfulfilled demand is lost (no backlog), shortage cost becomes
equal to only the quantity that is short. This will result in cancelled orders; loss
of sales and profit; and even loss of the business too.

Total Variable Inventory Cost / Total Inventory Cost

TC = Purchase Cost + Holding Cost + Ordering Cost + Shortage Cost

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Classification of Demand

DEMAND

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Independent Dependent

Fixed Order Periodic Review

Quantity System System

The inventory control policy of an organization depends upon the demand

characteristics. The demand for an item may be Independent or Dependent.

As the name says, if the demand for an item does not depend on the demand for any

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other item, then such a demand is called as the Independent demand; otherwise Dependent
demand. For example, demand for different television models does not depend on the
demand for its sub-assemblies / components. Hence, the demand for television is
independent. But, the demand for the sub-assemblies / components depends on the demand
for television sets (sale) in the market. Therefore, such a demand is called as the dependent
demand.

Independent demand is usually ascertained by Forecasting, i.e. extrapolating the past

demand history. But, in case of dependent demand, simple arithmetic calculations are enough
to ascertain requirement of the items.

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Classification of Inventory Models

INVENTORY
MODELS

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Elementary Models with Models with
Models Price Breaks Restrictions

Deterministic Probabilistic

Model-1 Model-2
(no shortage (shortage
permitted) permitted)

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1. (a) Classical EOQ model 2. (a) Demand rate uniform,
(Demand rate uniform, Replenishment rate infinite
Replenishment rate infinite)

1. (b) Demand rate non-uniform, 2. (b) Demand rate non-uniform,

Replenishment rate infinite Replenishment rate infinite,
Time interval fixed.

1. (c) Demand rate uniform, 2. (c) Demand rate uniform,

Replenishment rate finite Replenishment rate finite

Inventory Models with Deterministic Demand

Formulating a single generalized inventory model which takes into account all the real
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life variations in the system is very difficult. Even if such model were developed, it may not
be analytically solvable. This is why, inventory models are developed for some specific
situations.

In the inventory model for deterministic demand, it is assumed that the demand is fixed
and completely known. Models for such situations are also called as the Economic Lot Size
Model or Economic Order Quantity Model (EOQ).

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Objective

• Minimize total cost (actual / expected)

• In situations when inventory affects demand, the objective may be to maximize profit.

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Economic Order Quantity (EOQ) Model

EOQ Model gives the optimal lot size to be ordered in each order to keep the Total
Inventory Cost (TC) to minimum.

The EOQ Model works under the following Assumptions:

1. Demand is completely known, uniform and independent.

2. Lead Time is known and consistent.
3. Replenishment rate is instantaneous / infinite. i.e. the whole ordered quantity comes in

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a single lot; and shortage is not permitted.
4. Cost per unit of item remains constant over time. i.e. no quantity discount is available.
5. Inventory Carrying cost / Holding cost and Ordering cost per order remains constant
over time.
6. The inventory system pertains to a single item and the item is purchased in lots or
batches.

Limitations of the Classical EOQ Model

• In practice, the demand is neither known with certainty nor it is uniform. If the
fluctuations are mild, the classical EOQ formula can be applied. But, when the
fluctuations are large, the current EOQ formula losses its validity. Also, it is not
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possible to predict the demand with certainty for a new product to be introduced in the
market.

• The ordering cost is difficult to measure and may not be linearly related to the number
of orders. The inventory carrying cost is also difficult to measure and even to
precisely define.

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• Lead Time for an ordered item can hardly be zero, i.e. instantaneous replenishment
rate for the entire ordered quantity is hardly possible in practice.

• Price variations, quantity discounts and shortages are not considered while deriving
the classical EOQ model; but they do occur in practice.

Figure: Effect of Lot Size on various Inventory Costs

Inventory Carrying cost / Holding cost is linearly related to the quantity ordered. i.e. The
holding cost is assumed to be proportional to the amount of inventory as well as the time the
inventory is held in stock. Ordering cost is linearly related to the number of orders placed.

Lead Time: Time between placing an order and receipt of the ordered quantity.

References:

[1] Prem Kumar Gupta and D. S. Hira (2014), Operations Research (7th revised edition),
S. Chand, ISBN: 81-219-0281-9, Chapter 12, pp. 1098-1191.

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[2] “Supply Chain Management: Strategy, Planning, and Operation” (5th edition, 2014),
Sunil Chopra, Peter Meindl, D. V. Kalra, Chapter: 11, pp. 291-300, Pearson, ISBN:
978-81-317-8920-9

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Derivation of EOQ Formula

The inventory situation for the EOQ Model is shown below:

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Inventory
Level

Rate of Consumption
Max. Inv. (Uniform)
level Q

Avg. Inv.
level Q/2

t t Time

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T

Let,

Q = Maximum Inventory Level

D = Demand per unit time OR Inventory consumption rate per unit time

C = Cost per unit of item ordered OR Cost per unit of item produced (Rs./unit)

S = Order setup cost per order OR Setup cost per lot manufactured
(Rs./order)

H = Inventory holding cost for holding one unit in inventory for a unit of time (Rs./unit
item/unit time)
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h = Inventory holding cost expressed as a fraction of unit purchase cost (C).

H = h.C

t = time period after which inventory level becomes zero and an order for Q units is
placed at that point of time, provided Lead Time (L) is zero.

Average inventory level = (Q – 0)/2 = Q/2 [from the inventory triangle]

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1. Inventory Purchase Cost = (unit cost) × (Annual Demand) = C × D

2. Number of orders per year = 𝑫⁄𝑸

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3. Annual Ordering Cost = (Number of orders per year) x (Set-up cost or Ordering Cost
per order)
𝑫
= ×𝑺
𝑸

4. Annual Holding Cost = (Average inventory level) × (Holding cost per unit per year)

𝑸
= ×𝑯
𝟐

DERIVATION – 1

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From the Total Cost curve, at EOQ,

Annual Ordering Cost = Annual Holding Cost

𝐷 𝑄
⇒ ×𝑆 = ×𝐻
𝑄 2

2𝐷𝑆
⇒ 𝑄2 =
𝐻

𝟐𝑫𝑺 𝟐𝑫𝑺
∴ 𝑸∗ = √ =√
𝑯 𝒉𝒄
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DERIVATION – 2

Total Inventory Cost (TC) = Purchase Cost + Ordering Cost + Holding Cost

𝑫 𝑸
⇒ 𝑻𝑪 = (𝑪 × 𝑫) + ( × 𝑺) + ( × 𝑯)
𝑸 𝟐

In the above equation, the only variable is Q (lot size which can be varied in each order).

To have the minimum value of TC, differentiate the equation once w.r.t. Q and equate to zero.

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𝑑 𝑑 1 𝐻 𝑑
(𝐶 × 𝐷) + 𝐷𝑆 ( )+ (𝑄) = 0
𝑑𝑄 𝑑𝑄 𝑄 2 𝑑𝑄

𝐻
⇒ 0 + {𝐷𝑆 × (−1)(𝑄 −2 )} + ×1 =0
2

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𝐷𝑆 𝐻 𝟐𝑫𝑺 𝟐𝑫𝑺
⇒− + =𝟎 ⇒ 𝑸∗ = √ =√ = 𝑬𝑶𝑸
𝑄2 2 𝑯 𝒉𝒄

This is the optimal lot size for each order to be placed.

NOTE: For all the notations used in the EOQ formula, the unit of time and value should be
the same.

Therefore,

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1. Optimal number of orders per year = 𝑫⁄𝑸∗

𝑸∗⁄
2. Average inventory level / Cycle inventory in the system = 𝟐

3. Time between placement of orders

Number of Working Days in the Year (or 365 days) 𝑵

= =
Number of orders per Year 𝑫⁄ ∗
𝑸

If “Number of Working Days in a Year” is separately mentioned, then instead of 365 days, the
given number days should be used for calculation.

4. Minimum Total Inventory Cost / Minimum Total Variable Inventory Cost per
year
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𝑫 𝑸∗
𝑻𝑪 = (𝑪 × 𝑫) + ( × 𝑺) + ( × 𝑯)
𝑸∗ 𝟐

Average Flow Time: Average time that an item remains in the inventory before being
𝑄 ∗⁄
consumed = 2𝐷

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Re-order Point (ROP)

Inventory
Level

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Rate of Consumption
Max. Inv. (Uniform)
level Q
ROP

Avg. Inv.
level Q/2

L L Time
t t
T

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Figure: Inventory situation with Lead Time

In the EOQ Model already derived, the Lead Time (𝑳) is assumed to be zero. But in
practical situations, there is always a positive lead time present for each order placed.

If 𝑳 is the lead time in “Days” and 𝑫 is the “Daily demand” (or inventory consumption
rate per day), the total inventory requirement during the lead time = 𝑳𝑫. Thus, an order
should be placed as soon as the stock level becomes equal to 𝑳𝑫. Therefore,

ROP = L× D = Daily Demand × Lead Time in Days

Annual Demand
Daily Demand (𝑑) =
Number of working days in a year (or 365 days)

𝑫
⇒𝒅=
𝑵
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If a Buffer stock B is to be maintained, then ROP is,

ROP = B + LD

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DERIVATION – 3

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Figure: Inventory situation for Model 1(a)

If D = 10 units/day and Q = 100 units, i.e demand is 10 units per day and there are 100 units
in the inventory, then it would take 10 days for the inventory level to become zero. That is,

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t = Q/D = 100 units/10 units per day => t = 10 days

Therefore, we can write,

Q = D.t ......... (eq. 1)

This means, Q = D.t is the amount that is to be ordered after each time interval t.

For a small time interval dt,

[Link] = dt. (D.t) = [Link](t) + [Link](D)

=> [Link] = [Link]

Therefore,
𝑡
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𝑄(𝑡) = ∫ 𝐷. 𝑡. 𝑑𝑡
0

𝟏 𝟐 𝟏
⇒ 𝑸(𝒕) = 𝑫𝒕 = 𝑸. 𝒕 [from (1)] … … … (eq. 2)
𝟐 𝟐

𝟏
⇒ 𝑸(𝒕) = 𝑸. 𝒕 = 𝐀𝐫𝐞𝐚 𝐨𝐟 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐫𝐢𝐚𝐧𝐠𝐥𝐞 𝐎𝐀𝐏
𝟐

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Inventory holding cost for time t,

𝟏
𝐻(𝑡) = 𝐻. 𝑄(𝑡) ⇒ 𝑯(𝒕) = 𝑯. 𝑫𝒕𝟐 [from (2)] … … … (eq. 3)
𝟐

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Total inventory cost for time t,

𝑇𝑐 (𝑡) = Inventory holding cost + ordering cost

𝟏
⇒ 𝑻𝒄 (𝒕) = 𝑯. 𝑫𝒕𝟐 + 𝑺 [from (3)]
𝟐

Therefore, average total inventory cost per unit time,

𝟏 𝑫𝒕𝟐 𝑺
𝑻𝒄 (𝒕) = 𝑯. +
𝟐 𝒕 𝒕

𝟏 𝑺
⇒ 𝑻𝒄 (𝒕) = 𝑯. 𝑫𝒕 +
𝟐 𝒕

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Now, TC (t) will be minimum if d/dt [TC(t)] = 0 and d2/dt2 [TC(t)] is positive.

Therefore,

𝑑 𝑑 1 𝑆
[𝑇𝑐 (𝑡)] = 0 ⇒ [ 𝐻. 𝐷𝑡 + ] = 0
𝑑𝑡 𝑑𝑡 2 𝑡

1 𝑆
⇒ 𝐻𝐷 − 2 = 0
2 𝑡

𝟐𝑺
⇒𝒕=√ … … … (eq. 4)
𝑯𝑫

Again,
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𝑑2 2𝑆
2
[𝑇𝑐 (𝑡)] = 3
𝑑𝑡 𝑡

This value is always positive for any value of t given by eq. 4.

Therefore, the total inventory cost (TC) is minimum for optimal time interval of t0.

𝟐𝑺
𝒕𝟎 = √ [from (4)]
𝑯𝑫

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NOTE: If the number of working days in a year is specifically mention to be other than 365
days, then instead of the above relation for to, the “Time between placement of orders”
shown under Derivation-2 of EQO formula should be used.

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Number of orders per unit time,

𝟏
𝒏𝟎 =
𝒕𝟎

And, the optimum quantity to be ordered after each time interval t0 is,

𝑄0 = 𝐷. 𝑡0 [from (1)]

2𝑆
⇒ 𝑄0 = 𝐷. √
𝐻𝐷

𝟐𝑫𝑺

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⇒ 𝑸𝟎 = √ … … … (eq. 5)
𝑯

Equation (5) is known as the Optimal Lot Size (Economic Order Quantity) formula. Any
other order quantity will result in a higher cost.

The resulting minimum average total inventory cost per unit time is,

1 𝑆 1 2𝑆 𝐻𝐷 𝐻𝐷𝑆 𝐻𝐷𝑆
𝑇𝐶 (𝑡0 ) = 𝐻. 𝐷𝑡0 + = 𝐻. 𝐷. √ + 𝑆. √ =√ +√
2 𝑡0 2 𝐻𝐷 2𝑆 2 2

⇒ 𝑻𝑪 (𝒕𝟎 ) = √𝟐𝑯𝑫𝑺 … … … (eq. 6)

If unit purchase cost (C) is given, then,

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⇒ 𝑻𝑪 (𝒕𝟎 ) = (𝑪 × 𝑫) + √𝟐𝑯𝑫𝑺 … … … (eq. 6)

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Problem 5.1:

A stockiest has to supply 12,000 units of a product per year to his customers. The demand is
fixed and known and the shortage cost is assumed is to be infinite. The inventory holding cost

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is Rs. 0.20 per unit per month and the ordering cost per order is Rs. 350. Determine:

(a) The optimum lot size.

(b) Optimum scheduling period
(c) Minimum total variable yearly cost.

Solution: Given data,

Demand (D) = 12,000 units/year

= 12,000/12 = 1,000 units/month

Inventory holding cost (H) = Rs. 0.20/unit/month

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= 0.20 × 12 = Rs. 2.4/unit/year

Order setup cost (S) = Rs. 350/order

(a) Optimum Lot Size

2𝐷𝑆 2 × 12000 × 350

𝑄∗ = √ =√ = 1870.82 ⇒ 𝑸∗ ≈ 𝟏𝟖𝟕𝟏 𝐮𝐧𝐢𝐭𝐬/𝐨𝐫𝐝𝐞𝐫
𝐻 2.4

(b) Optimum Scheduling period

𝐷 12000
Number of orders per year (𝑛0 ) = ∗
= = 𝟔. 𝟒𝟏 𝐨𝐫𝐝𝐞𝐫𝐬/𝐲𝐞𝐚𝐫
𝑄 1871
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Therefore, Time between placement of orders,

Number of working days in the year 365

𝑡0 = =
Number of orders per year 6.41

⇒ 𝑡0 = 𝟓𝟔. 𝟗𝟒 𝐝𝐚𝐲𝐬 = 𝟏. 𝟖𝟗 𝐦𝐨𝐧𝐭𝐡𝐬 between orders

OR

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2𝑆 2 × 350
𝑡0 = √ =√
𝐻𝐷 0.20 × 1000

⇒ 𝒕𝟎 = 𝟏. 𝟖𝟕 𝐦𝐨𝐧𝐭𝐡𝐬 between orders

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(c) Minimum total variable yearly cost

TC = Total Purchase Cost + Total Order Setup Cost + Total Holding Cost

Since, the unit cost of an item is not mentioned in the question, therefore, the expression
becomes,

TC = Total Order Setup Cost + Total Holding Cost

=> TC = (Total number of orders per year × Ordering cost per order) + (Average Inventory
Level × Holding cost per unit per year)

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=> TC = (6.41 × 350) + [(1871/2) × 2.4] = 2243.5 + 2245.2

=> TC = 4488.7 ≈ Rs. 4489/year

OR

𝑇𝐶 = √2𝐻𝐷𝑆 = √2 × (0.20 × 12) × 12000 × 350

⇒ 𝑻𝑪 = 𝐑𝐬. 𝟒𝟒𝟖𝟗. 𝟗𝟖/𝐲𝐞𝐚𝐫 ≈ 𝐑𝐬. 𝟒𝟒𝟗𝟎/𝐲𝐞𝐚𝐫

Problem 5.2:

A particular item has a demand of 9,000 units/year. The cost of one procurement is Rs. 100
and the holding cost per unit is Rs. 2.40 per year. The replacement is instantaneous and no
Prepared by Ranbir Kalita

shortages are allowed. Determine:

(a) The economic lot size.

(b) The number of orders per year.
(c) The time between orders.
(d) The total cost per year if the cost of one unit is Rs. 1.

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Solution: Given data,

Demand (D) = 9,000 units/year

Order setup cost (S) = Rs. 100/order

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Inventory holding cost (H) = Rs. 2.40/unit/year

Unit purchase cost (C) = Rs. 1/unit

(a) The Economic Lot Size

2𝐷𝑆 2 × 9000 × 100

𝑄∗ = √ =√
𝐻 2.40

⇒ 𝑸∗ = 𝟖𝟔𝟔. 𝟎𝟑 ≈ 𝟖𝟔𝟔 𝐮𝐧𝐢𝐭𝐬 per order

(b) Number of orders per year

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𝐷 9000
Number of orders (𝑛0 ) = = ⇒ 𝒏𝟎 = 𝟏𝟎. 𝟒 𝐨𝐫𝐝𝐞𝐫𝐬/𝐲𝐞𝐚𝐫
𝑄∗ 866

OR

1 𝐻𝐷 2.40 × 9000
𝑛0 = =√ =√ ⇒ 𝒏𝟎 = 𝟏𝟎. 𝟒 𝐨𝐫𝐝𝐞𝐫𝐬/𝐲𝐞𝐚𝐫
𝑡0 2𝑆 2 × 100

(c) Time between orders

Number of working days in the year 365

𝑡0 = =
Number of orders per year(𝑛) 10.4

⇒ 𝑡0 = 𝟑𝟓. 𝟏𝟎 𝐝𝐚𝐲𝐬 = 𝟏. 𝟏𝟕 𝐦𝐨𝐧𝐭𝐡𝐬 between orders

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OR

2𝑆 2 × 100
𝑡0 = √ =√
𝐻𝐷 2.40 × 9000

⇒ 𝒕𝟎 = 𝟎. 𝟎𝟗𝟔𝟐 𝐲𝐞𝐚𝐫𝐬 = 𝟏. 𝟏𝟕 𝐦𝐨𝐧𝐭𝐡𝐬 between orders

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(d) Total cost per year

TC = Total Purchase Cost + Total Order Setup Cost + Total Holding Cost

=> TC = (C × D) + [(D/Q*) × S] + [(Q*/2) × H]

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=> TC = (1 × 9000) + [(9000/866) × 100] + [(866/2) × 2.40]

=> TC = 9000 + 1039.26 + 1039.2

=> TC = Rs. 11078.5/year

OR

𝑇𝐶 = (𝐶 × 𝐷) + √2𝐻𝐷𝑆 = (1 × 9000) + √2 × 2.40 × 9000 × 100

⇒ 𝑻𝑪 = 𝐑𝐬. 𝟏𝟏𝟎𝟕𝟖. 𝟓/𝐲𝐞𝐚𝐫

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Problem 5.3:

A stockiest has to supply 400 units of a product every Monday to his customers. He gets the
product at Rs. 50 per unit from the manufacturer. The cost of ordering and transportation
from the manufacturer is Rs. 75 per order. The cost of carrying inventory is 7.5% per year of
the cost of the product. Find:

(a) The economic lot size.

(b) The total optimal cost (including the capital cost).
(c) The total weekly profit if the item is sold for Rs. 55 per unit.

Solution: Given,
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Demand (D) = 400 units/week

= 400 × 52 = 20800 units/year

Purchase cost (C) = Rs. 50/unit

Order setup cost (S) = Rs. 75/order

Inventory Holding Cost (H) = 7.5% of Unit product cost

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= 0.075 × Rs. 50 = Rs. 3.75/unit/year

(a) The economic lot size

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2𝐷𝑆 2 × 20800 × 75
𝑄∗ = √ =√
𝐻 3.75

⇒ 𝑸∗ = 𝟗𝟏𝟐. 𝟏𝟒 𝐮𝐧𝐢𝐭𝐬 ≈ 𝟗𝟏𝟐 𝐮𝐧𝐢𝐭𝐬/𝐨𝐫𝐝𝐞𝐫

(b) The total optimal cost (including the capital cost)

𝐷 𝑄∗
𝑇𝐶 = (𝐶 × 𝐷) + ( ∗ × 𝑆) + ( × 𝐻)
𝑄 2

20800 912
⇒ 𝑇𝐶 = (50 × 20800) + ( × 75) + ( × 3.75)
912 2

⇒ 𝑇𝐶 = 1040000 + 1710.526 + 1710

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⇒ 𝑻𝑪 = 𝐑𝐬. 𝟏𝟎𝟒𝟑𝟒𝟐𝟎. 𝟓𝟐/𝐲𝐞𝐚𝐫 = 𝐑𝐬. 𝟐𝟎𝟎𝟔𝟓. 𝟕𝟖/𝐰𝐞𝐞𝐤

OR

𝑇𝐶 = (𝐶 × 𝐷) + √2𝐻𝐷𝑆 = (50 × 20800) + √2 × 3.75 × 20800 × 75

⇒ 𝑻𝑪 = 𝐑𝐬. 𝟏𝟎𝟒𝟑𝟒𝟐𝟎. 𝟓𝟐/𝐲𝐞𝐚𝐫 = 𝐑𝐬. 𝟐𝟎𝟎𝟔𝟓. 𝟕𝟖/𝐰𝐞𝐞𝐤

(c) The total weekly profit if the item is sold for Rs. 55 per unit

Profit (P) = Total Selling Price – Total Expense = (400 × 55) – 20065.78

=> P = Rs. 1934.22/week

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Problem 5.4:

A stockiest purchases an item at the rate of Rs. 40 per piece from a manufacturer. 2,000 units
of the item are required per year. What should be the order quantity per order if the cost per
order is Rs. 15 and the inventory charges per year is Rs. 8 per unit.

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Solution: Given data,

Purchase Cost (C) = Rs. 40/unit

Demand (D) = 2000 units/year

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Order setup cost (S) = Rs. 15 per order

Inventory holding cost (H) = Rs. 8/unit/year

Economic Order Quantity

2𝐷𝑆 2 × 2000 × 15
𝑄∗ = √ =√
𝐻 8

⇒ 𝑸∗ = 𝟖𝟔. 𝟔𝟎 𝐮𝐧𝐢𝐭𝐬 ≈ 𝟖𝟕 𝐮𝐧𝐢𝐭𝐬/𝐨𝐫𝐝𝐞𝐫

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Problem 5.5:

The demand for a commodity is 100 units per day. Every time an order is placed, a fixed cost
of Rs. 400 is incurred. Holding cost is Rs. 0.08 per unit per day. If the lead time is 3 days,
determine the economic lot size and the reorder point.

Solution: Given data,

Demand (D) = 100 units/day

= 100 × 365 = 36500 units/year

Order setup cost (S) = Rs. 400/order

Inventory holding cost (H) = Rs. 0.08/unit/day

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= 0.08 × 365 = Rs. 29.2/unit/year

Lead Time (L) = 3 days

Economic Lot Size

2𝐷𝑆 2 × 36500 × 400

𝑄∗ = √ =√ ⇒ 𝑸∗ = 𝟏𝟎𝟎𝟎 𝐮𝐧𝐢𝐭𝐬/𝐨𝐫𝐝𝐞𝐫
𝐻 29.2

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Reorder Point (ROP)

ROP = L × D = 3 × 100

=> ROP = 300 units

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Problem 5.6:

ABC manufacturing company purchases 9,000 parts of a machine for its annual requirement,
ordering one month’s usage at a time. Each part costs Rs. 20. The ordering cost per order is
Rs. 15, and the carrying charges per year are 15% of the unit inventory cost.

You have been asked to suggest a more economical purchasing policy for the company. What
advice would you offer and how much would it save the company per year?

Solution: Given data,

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Demand (D) = 9000 units/year

Ordered Quantity (Q) = 9000/12 = 750 units/order

Purchase cost (C) = Rs. 20/unit

Order setup cost (S) = Rs. 15/order

Inventory holding cost (H) = 15% of the unit inventory cost

= 0.15 × 20 = Rs. 3/unit/year

Therefore,

Total number of orders per year,

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𝐷 9000
𝑛= = ⇒ 𝒏 = 𝟏𝟐 𝐨𝐫𝐝𝐞𝐫𝐬/𝐲𝐞𝐚𝐫
𝑄 750

And, Total variable cost per year,

TC = Total purchase cost + Total ordering cost + total holding cost

=> TC = (C × D) + [(D/Q) × S] + [(Q/2) × H]

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=> TC = (20 × 9000) + [(9000/750) × 15] + [(750/2) × 3]

=> TC = 180000 + 180 + 1125

=> TC = Rs. 181305/year

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OR

𝑇𝐶 = (𝐶 × 𝐷) + √2𝐻𝐷𝑆 = (20 × 9000) + √2 × 3 × 9000 × 15

⇒ 𝑻𝑪 = 𝐑𝐬. 𝟏𝟎𝟖𝟗𝟎𝟎/𝐲𝐞𝐚𝐫

NOTE: The TC values calculated above using two different approaches are not the same. In
fact, TC = Rs. 108900 is the same as that calculated below after finding the EOQ value. This
has happened because, the second expression for TC does not have the Q term and a different
Q value has been given in the question and we are supposed to compare the TC values
without EOQ value and with EOQ value.

Prepared by Ranbir Kalita

Now, economic Order Quantity,

2𝐷𝑆 2 × 9000 × 15
𝑄∗ = √ =√
𝐻 3

⇒ 𝑸∗ = 𝟑𝟎𝟎 𝐮𝐧𝐢𝐭𝐬/𝐨𝐫𝐝𝐞𝐫

Therefore,

Total number of orders per year,

𝐷 9000
𝑛0 = ∗
= ⇒ 𝒏𝟎 = 𝟑𝟎 𝐨𝐫𝐝𝐞𝐫𝐬/𝐲𝐞𝐚𝐫
𝑄 300

And, Total variable cost per year,

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TC = (C × D) + [(D/Q) × S] + [(Q/2) × H]

=> TC = (20 × 9000) + [(9000/300) × 15] + [(300/2) × 3]

=> TC = 180000 + 450 + 450

=> TC = Rs. 180900/year

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Hence, if the company ABC places 30 orders per year and purchases 300 units in each order
instead of placing 12 orders per year purchasing 750 units per order, the company would be
able to save Rs. (181305 – 180900) = Rs. 405 per year.

Prepared by Ranbir Kalita

Problem 5.7:

Sharp Corporation Limited, a company that markets painless hypodermic needles to hospitals would
like to reduce its inventory cost by determining the optimal number of hyperdemic needles to obtain
per order. The annual demand is 1000 units, the setup cost or ordering cost is Rs. 10 per order, and the
holding cost per unit per year is Rs. 0.50. Assuming that the company has a 250 day working year,
calculate:

(a) The optimal number of units per order (EOQ)

(b) The number of orders
(c) The expected time between orders

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Solution: Given data,

Demand (D) = 1000 units/year

Order setup cost (S) = Rs. 10/order

Inventory holding cost (H) = Rs. 0.50/unit/year

Number or working days in a year (N) = 250 days

(a) The optimal number of units per order (EOQ)

2𝐷𝑆 2 × 1000 × 10
𝑄∗ = √ =√
𝐻 0.50

⇒ 𝑸∗ = 𝟐𝟎𝟎 𝐮𝐧𝐢𝐭𝐬/𝐨𝐫𝐝𝐞𝐫
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(b) Number of orders

𝐷 1000
𝑛0 = = ⇒ 𝒏𝟎 = 𝟓
𝑄∗ 200

OR

1 𝐻𝐷 0.50 × 1000
𝑛0 = =√ =√ ⇒ 𝒏𝟎 = 𝟓
𝑡0 2𝑆 2 × 10

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(c) Expected time between orders

Number of working days in a year 𝑁 250

𝑡0 = = =
Number of orders per year 𝑛0 5

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⇒ 𝒕𝟎 = 𝟓𝟎 𝐝𝐚𝐲𝐬

OR

2𝑆 2 × 10
𝑡0 = √ =√
𝐻𝐷 0.50 × 1000

⇒ 𝒕𝟎 = 𝟕𝟑 𝐝𝐚𝐲𝐬

NOTE: It is to be noted that, the two values of to found using two different approaches are different.
This is because, the number of working days in the year is specifically mentioned as 250 days. This
value cannot be incorporated in the second formula used for to above. The correct answer is 50 days.

Prepared by Ranbir Kalita

References:
[1] Prem Kumar Gupta and D. S. Hira (2014), Operations Research (7th revised edition),
S. Chand, ISBN: 81-219-0281-9, Chapter 12, pp. 1098-1191.
[2] “Supply Chain Management: Strategy, Planning, and Operation” (5th edition, 2014),
Sunil Chopra, Peter Meindl, D. V. Kalra, Chapter: 11, pp. 291-300, Pearson, ISBN:
978-81-317-8920-9
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On-line Resources:
• Inventory Control Vs. Inventory Management:
[Link]
Inventory-And-Controlling-Inventory--17757

--- 000 ---

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Problem 5.8:

A company purchases 10,000 items per year for use in its production shop. The unit cost is
Rs. 10 per unit, holding cost is Rs. 0.80 per unit per month and cost of making a purchase is

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Rs. 200. Determine the following if no shortages are allowed:

(a) The optimum order quantity

(b) The optimum total yearly cost
(c) The number of orders per year
(d) The time between orders

Solution: Given data,

Demand (D) = 10,000 units/year

Purchase Cost (C) = Rs. 10/unit

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Inventory holding cost (H) = Rs. 0.80/month = Rs. 9.6/year

Order setup cost (S) = Rs. 200/order

(a) The optimum order quantity

2𝐷𝑆 2 × 10000 × 200

𝑄∗ = √ =√
𝐻 9.6

⇒ 𝑸∗ = 𝟔𝟒𝟓. 𝟓 𝐮𝐧𝐢𝐭𝐬 ≈ 𝟔𝟒𝟓 𝐮𝐧𝐢𝐭𝐬/𝐨𝐫𝐝𝐞𝐫

(b) The optimum total yearly cost

𝐷 𝑄∗
𝑇𝐶 = (𝐶 × 𝐷) + ( ∗ × 𝑆) + ( × 𝐻)
𝑄 2
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10000 645
⇒ 𝑇𝐶 = (10 × 10000) + ( × 200) + ( × 9.6)
645 2

⇒ 𝑇𝐶 = 100000 + 3100.775 + 3096

⇒ 𝑻𝑪 = 𝐑𝐬. 𝟏𝟎𝟔𝟏𝟗𝟔. 𝟖/𝐲𝐞𝐚𝐫

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OR

𝑇𝐶 = (𝐶 × 𝐷) + √2𝐻𝐷𝑆 = (10 × 10000) + √2 × 9.6 × 10000 × 200

⇒ 𝑻𝑪 = 𝐑𝐬. 𝟏𝟎𝟔𝟏𝟗𝟔. 𝟖/𝐲𝐞𝐚𝐫

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(c) The number of orders per year

𝐷 10000
𝑛0 = = ⇒ 𝒏𝟎 = 𝟏𝟓. 𝟓𝟎
𝑄∗ 645

OR

1 𝐻𝐷 9.6 × 10000
𝑛0 = =√ =√ ⇒ 𝒏𝟎 = 𝟏𝟓. 𝟓𝟎
𝑡0 2𝑆 2 × 200

(d) The time between orders

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number of working days in the year 365
𝑡0 = =
number of orders per year 15.50

⇒ 𝒕𝟎 = 𝟐𝟑. 𝟓𝟒 𝐝𝐚𝐲𝐬

OR

2𝑆 2 × 200
𝑡0 = √ =√
𝐻𝐷 9.6 × 10000

⇒ 𝒕𝟎 = 𝟎. 𝟎𝟔𝟒𝟓 𝐲𝐞𝐚𝐫 ≈ 𝟐𝟑. 𝟓𝟔 𝐝𝐚𝐲𝐬

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Problem 5.9:

An aircraft company uses rivets at an approximate consumption rate of 2,500 kg per year.
The rivets cost Rs. 30 per kg and the company personnel estimate that it costs Rs. 130 to

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place an order and the inventory carrying cost is 10% per year. How frequently should orders
for rivets be placed and what quantities should be ordered?

Solution: Given data,

Demand (D) = 2,500 kg/year

Purchase cost (C) = Rs. 30/kg

Order setup cost (S) = Rs. 130/order

Inventory carrying cost (H) = 10% per year

= 0.10 × 30 = Rs. 3/unit/year

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Economic Order Quantity

2𝐷𝑆 2 × 2500 × 130

𝑄∗ = √ =√
𝐻 3

⇒ 𝑸∗ = 𝟒𝟔𝟓. 𝟒𝟕 𝐮𝐧𝐢𝐭𝐬/𝐨𝐫𝐝𝐞𝐫

Frequency of order

𝑁 365 365
𝑡0 = = =
𝐷⁄ ∗ 2500⁄ 5.3709
𝑄 465.47

⇒ 𝒕𝟎 = 𝟔𝟕. 𝟗𝟓 𝐝𝐚𝐲𝐬 ≈ 𝟔𝟖 𝐝𝐚𝐲𝐬

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OR

2𝑆 2 × 130 260
𝑡0 = √ =√ =√
𝐻𝐷 3 × 2500 7500

⇒ 𝒕𝟎 = 𝟎. 𝟏𝟖𝟔𝟐 𝐲𝐞𝐚𝐬 = 𝟔𝟕. 𝟗𝟔 𝐝𝐚𝐲𝐬 ≈ 𝟔𝟖 𝐝𝐚𝐲𝐬

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Problem 5.10:

A computer company sells a particular type of personal computer. It costs the store Rs.
25,000 each time it places an order with the manufacturer. The annual carrying cost is Rs.

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9000. The manager estimates the annual demand of P.C.’s to be 1,200 units. Determine the
optimal order quantity and the total minimum inventory cost.

Solution: Given data,

Order setup cost (S) = Rs. 25,000/order

Inventory holding cost (H) = Rs. 9000/unit/year

Demand (D) = 1,200 units/year

Optimal Order Quantity

2𝐷𝑆 2 × 1200 × 25000

Prepared by Ranbir Kalita

𝑄∗ = √ =√
𝐻 9000

⇒ 𝑸∗ = 𝟖𝟏. 𝟔 𝐮𝐧𝐢𝐭𝐬/𝐨𝐫𝐝𝐞𝐫

Total minimum inventory cost

𝐷 𝑄∗
𝑇𝐶 = (𝐶 × 𝐷) + ( ∗ × 𝑆) + ( × 𝐻)
𝑄 2
1200 81.6
⇒ 𝑇𝐶 = 0 + ( × 25000) + ( × 9000) = 367647.0588 + 367200
81.6 2
⇒ 𝑻𝑪 = 𝐑𝐬. 𝟕𝟑𝟒𝟖𝟒𝟕/𝐲𝐞𝐚𝐫
OR
𝑇𝐶 = √2𝐻𝐷𝑆 = √2 × 9000 × 1200 × 25000
⇒ 𝑻𝑪 = 𝟕𝟑𝟒𝟖𝟒𝟔. 𝟗𝟐 ≈ 𝐑𝐬. 𝟕𝟑𝟒𝟖𝟒𝟕/𝐲𝐞𝐚𝐫
Prepared by Ranbir Kalita

References:
[1] Prem Kumar Gupta and D. S. Hira (2014), Operations Research (7th revised edition),
S. Chand, ISBN: 81-219-0281-9, Chapter 12, pp. 1098-1191.
[2] “Supply Chain Management: Strategy, Planning, and Operation” (5th edition, 2014),
Sunil Chopra, Peter Meindl, D. V. Kalra, Chapter: 11, pp. 291-300, Pearson, ISBN:
978-81-317-8920-9

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Mechanical Engineering Department Jorhat Engineering College