INVENTORY
MANAGEMENT
Inventory.
Inventory is the stock of any items or resources held
in an organization for sale or use. It can also be
defined as materials in a supply chain or in a
segment of supply chain, expressed in quantities,
location/sites, and/or values.
2
Manufacturing Firm Inventory Vs Merchandising
Firm Inventory.
There is a distinction between manufacturing firm
inventory and merchandising firm inventory.
Manufacturing firms manage three distinct
inventory types - raw materials, work in progress
(WIP) and finished goods – to track products from
production to sale.
Merchandising firms, however, purchase finished
products for resale (stock in trade) and the supplies
necessary to administer the service. 3
Inventory Management
Inventory management is the process of planning,
organizing, and controlling all those activities
concerned with the flow of materials into an
organization. The scope of inventory management is
very large and includes a variety of activities which
includes material planning and control, production
planning, planning purchases, inventory control etc.
All these activities contribute to the undisturbed
and smooth running of the operations and
minimizing the various costs in the organization. 4
Objectives of Inventory Management
i) Obtaining the right quality of material:
The material needs to be matched to the product
specification as it is ultimately reflected in the
quality of the finished product. Compromising
quality in return for a lower price is not desirable.
The only consideration for procuring the material
should be to have the right quality and quantity of
the item as per the specifications, and at the right
price.
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ii) Not having stock-outs or zero-inventory:
This position should be avoided so that
production does not come to a halt suddenly,
due to shortage or non-availability of the
required material. Although stock-out costs are
not recorded in the books of accounts and are
notional costs, they affect a company in other
ways. For example, it cannot sell the volume it
could have, if the stock-out had not occurred.
You also lose the goodwill of a customer if
you cannot supply promised goods.
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iii) Not holding excess inventory:
This should be avoided since this will unnecessarily
cause money to be locked up in inventory, and
moreover could lead to the deterioration of the
unused inventory and cause its subsequent
obsolescence.
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iv) Ensuring minimum wastage of raw materials:
During the storing process or manufacturing
wastage should be minimized. Correctly stored
materials and efficient use of raw materials in
the manufacturing process is essential for this
purpose.
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The study of inventory models is concerned with
two basic questions:
a) How much should be ordered each time? This
relates to determining Economic Order Quantity
(EOQ) and can be answered with an analysis of
costs of maintaining certain levels of inventory.
b) At what level should the Reordering occur? This
relates to determining the point of ordering
inventory and can be answered by determining
the re-order point.
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The main reasons for holding inventory are:
a) To meet future shortages.
b) To hold inventory that will be sufficient to
produce goods to meet the expected demand.
c) To take advantage of bulk purchases.
d) To enable the production process to flow
smoothly and efficiently.
e) To meet seasonal fluctuations and variations in
availability of material.
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There are four categories of costs which are
associated with inventory known as the cost of
making a purchase (ordering costs), the cost of
holding the goods in inventory (carrying costs), the
shortage costs (stockout cost),and the purchase cost
1. Ordering Costs of Inventory comprise the costs of
placing a purchase order, including:
(a) clerical costs of preparing a purchase order
(Order placing costs )
(b) cost of receiving the material
(c) material inspection or testing costs 11
(a) Order Placing Costs
The cost of placing an order involves the cost of
order processing, costs of correspondence and
communication, advertising costs for inviting
tenders, tender evaluation costs, inspection and
receiving cost, etc.
These costs are directly proportional to the
number of orders to be placed in a year.
12
This means, an increase in the number of
orders increases the costs of order processing,
advertising for tenders, communication and
tender evaluation.
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(b) Cost of receiving the material
After the order is placed, the vendor will execute
the order by supplying the material. This involves
transport costs. The cost of receiving is the cost
incurred on the transport of material from the
supplier to the factory or depot, insurance on
transit, etc.
The transportation cost increases directly with
the number of purchase orders in a year and vice
versa.
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(c) Material Inspection or Testing Costs
The inspection cost of material affects the total
ordering costs only when inspection is taken up
on a sample basis, where only a sample of the
material is inspected from each purchase lot. In
this case, if the number of batches ordered in a
year increases, the inspection or testing will also
increase.
This will increase the inspection cost and
consequently the ordering cost of the
material.
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2. Holding (carrying) cost of inventory
This cost includes interest costs, storage costs,
insurance costs, and other costs (obsolescence or
no longer used, damage and deterioration or
failure). They are stated as either a percentage of
price or as a monetary amount per unit.
(a)Interest Costs
Every purchase requires payment to a supplier.
If the amount required for purchase is borrowed
from a bank or from a lender then the interest
payable is the cost of investment in inventory. 16
Suppose a working capital loan of Tshs 1,000,000/=
is taken at 8% from the bank for purchasing raw
materials, then the interest to be paid on this loan is
the cost of investment in inventory. That is Tshs
1,000,000 x 8% = 80,000/=
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(b) Storage costs mainly include costs relating to
renting the premises, insurance for the premises
and for the inventory. The insurance cost is
included in the holding costs only if it varies with
a variation in the size of the batch.
Normally the rent cost is fixed for an area
irrespective of the volume of material stored in
it. If the material ordered exceeds the capacity of
the storage space, additional space needs to be
hired. This additional space will often cost more.
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3. Stockout costs.
They are incurred as a result of items not being
in stock. These include loss of goodwill,
contribution lost due to not making a sale,
backorder costs, cost of idle resources, and cost of
having to speed up orders – personnel working
overtime or using a faster transportation mode.
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4. Purchase cost.
This is what is paid to the supplier or seller by the
buyer in exchange of the material or product.
Inventory is usually a large investment for many
firms. Thus, inventory should only be held if the
benefit (service to customers) exceeds the
inventory costs. Also in inventory modelling,
purchase cost is a relevant factor to inventory
policy due to availability of quantity discounts
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Objectives of Inventory Control
There are two main objectives of inventory
control.
(a) To maximize the level of customer service, i.e.
have the right goods, in sufficient quantities, in
the right place, and at the right time.
(b) To minimize the cost of providing a certain level
of customer service (determining optimal
stocking cost) which is made up of carrying
costs, ordering costs, and stockout costs.
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Requirements for Effective Inventory
Management
Management has two basic functions with
respect to inventory. One is to establish a system
of accounting for items in inventory, and the other
is to make decisions regarding how much to order
and when to order. To succeed in the two
functions, management must have the following:
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1. A system to keep track of the inventory on hand
(inventory management system), i.e. periodic or
perpetual inventory accounting system.
2. A reliable forecast of demand that include an
indication of possible forecast error.
3. Knowledge of lead time and lead time variability.
4. Reasonable estimate of inventory holding costs,
ordering costs, and stockout costs.
5. A classification system for inventor items.
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Basic Economic Order Quantity (EOQ) Model
Is a size of order for which the total of the ordering
and carrying costs is at the lowest point possible.
Sometimes is known as optimal re-order quantity.
Assumptions of the Basic EOQ Model
1. Demand rate is constant.
2. Lead time is constant and known with certainty.
3. No stockouts allowed.
4. Safety stocks are not utilized, orders are
received all at once.
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5. Unit cost is constant, i.e. no quantity discounts.
6. Carrying cost is constant per unit, and ordering
(setup) cost per order is fixed.
7. Item is a single product and demand is not
influenced by other items.
8. Planning horizon is finite, i.e. every order is
received exactly when the inventory level reduces
to zero (instantaneous delivery), and each order is
of the same size.
Consider the graph below;
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26
From the graph above, the total cost starts at a high
level when the ordering cost is initially high and the
holding cost is low. Also, when the ordering cost is
low and the holding cost is high the total cost is on a
rising trend. This happens when one cost is
minimized the other cost rises, and vice versa.
The EOQ can be determined by using the formula
2 × 𝐷 × 𝐶𝑜
𝐸𝑂𝑄 =
𝐶ℎ
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Where
𝐶𝑜 = Cost of ordering per order/consignment from
supplier.
𝐶ℎ = Cost of holding per unit of inventory per
annum
𝐷 = Total demand during the period.
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Example
Given that
Consumption of material per annum = 10,000kg
Order placing cost per order = Tsh 50,000/=
Cost per kilogram of raw material = Tsh 2,000/=
Storage cost = 8% of material cost
Determine the Economic Order Quantity, state the
number of orders to be placed in a year and explain
briefly the amounts you have calculated.
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Solution
Given 𝐷 = 10,000kg
𝐶𝑜 = Tsh 50,000
𝐶ℎ = 𝑖𝐶𝑝 = 8% × 2,000 = Tsh 160
2 × D × Co
EOQ =
Ch
2 × 10,000 × 50,000
EOQ =
160
1,000,000,000
EOQ =
160
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EOQ = 6,250,000
EOQ = 2,500kg
Consumption of material per annum
Number of order per year =
𝐸𝑂𝑄
10,000 kg
=
2,500 kg
=4
Therefore, 4 orders need to be placed per year with an
order size of 2,500 kilograms to keep the ordering and the
holding costs at the minimum level.
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Discussion Problem:
AP Equipment Company estimates its carrying cost at 15%
of per unit cost, and its ordering cost at Tsh. 900 per order.
The estimated annual requirement is 48,000 units at a
price of Tsh. 4,000 per unit.
Required:
(a) Determine the most economical number of units to
order.
(b) Determine the total annual ordering cost.
(c) Determine the total annual inventory cost for the
company. 32
EOQ Model with Quantity Discounts.
In developing the basic EOQ model, we assumed
that quantity discounts were not available.
Sometimes you are required to determine EOQ
when discounts are received. In this situation you
are supposed to follow the following steps:
Step 1: Calculate the Economic Order Quantity,
without considering discounts.
Step 2: If the feasible EOQ is in the lowest price
interval, that is the optimal order quantity.
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Step 3: If the Economic Order Quantity calculated
above is less than the minimum order
quantity required to avail the discount,
calculate the Total Annual Costs for the EOQ
obtained above and for the minimum order
size required to avail the discount.
Step 4: Compare the Total Annual Costs for both
the quantities, that is, the EOQ and the
minimum order size required to avail the
discount. Select the quantity with minimum
Total Annual Cost.
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Step 5: If there is a further discount available for an
even larger order size, repeat the same
calculations for the higher discount level.
Step 6: The order size with the least Total Annual
Cost shall be optimal ordering quantity.
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Example
A firm is eligible to quantity discounts on its orders
of material as follows:
Price per tonne
Tonnes
(Tshs (‘000’))
8.0 Less than 500
7.9 500 and less than 1500
7.8 1500 and less than 3000
7.7 3000 and less than 5000
7.6 5,000 and over
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If the annual demand for the material is 5,000 tonnes,
inventory holding costs are 15% of material cost per
annum and the ordering cost is Tshs7,000 per order.
Calculate the optimal quantity to order at which costs
are kept to a minimum.
37
Let us calculate the EOQ using the following formula:
2×𝐷×𝐶𝑜 2×5,000×7,000
𝐸𝑂𝑄 = = = 241.52 ≈ 242
𝐶ℎ 0.15×8,000
So, feasible EOQ without discounts = 242 units
Price per tonne = 8,000/=
Purchasing cost Demand of price per
= ×
of 5,000 tonnes the material tonne
= 5,000 × 8,000
= 40,0000,000/=
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Annual consumption
No of orders to be placed =
ordering quantity
5,000
=
242
= 20.66 orders
Ordering cost = 20.66 × 7,000/-
= 144,620/−
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Inventory holding Average 15% of
= ×
cost inventory purchase price
Ordering quantity 15% of
= ×
2 purchase price
242
= × 0.15 × 8,000
2
= 145,200/=
40
Purchasing Ordering Inventory
Total cost = + +
price cost holding cost
= 40,000,000 + 144,620 + 145,200
Total cost = Tshs 40,289,820/=
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Ordering Price per tonne Purchasing cost No of orders to Ordering cost Inventory Total cost (Tshs
quantity (Tshs (‘000’)) of 5,000 tonnes be placed during (Tshs ‘000’) holding cost ‘000’)
(tonnes) the year (Tshs ‘000’)
5,000 T x price (5,000 T/ (No. of orders to (Ordering
per tonne ordering be placed x 7) quantity / 2) x
quantity) purchase price
per ton x 15%
242 8.00 40,000.00 20.66 144.62 145.20 40,289.82
500 7.90 39,500.00 10.00 70.00 296.25 39,866.25
1,500 7.80 39,000.00 3.33 23.33 877.50 39,900.83
3,000 7.70 38,500.00 1.67 11.67 1,732.00 40,244.17
5,000 7.60 38,000.00 1.00 7.00 2,850.00 40,857.00
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The total cost is the minimum at the ordering
quantity of 500 units. Therefore, the optimal
ordering quantity is 500 units.
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Discussion Problems:
1. ABC Company uses 4,000 units of an item in its
production process per year. The item is priced as
follows: 1 to 499, Tsh 90 each; 500 to 999, Tsh 85
each; and 1000 or above, Tsh 82 each. It costs
approximately Tsh 1,800 to prepare an order and
receive it, and carrying costs are 18 percent of
purchase price per unit on an annual basis.
Determine the optimal order quantity and the total
annual material cost.
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2. The maintenance department of a large hospital
uses 816 cases of liquid cleanser annually. Ordering
costs are Tsh 1,200 per order, carrying costs are Tsh
400 per case a year, and the new price schedule
indicates that orders of less than 50 cases will cost
Tsh 2,000 per case, 50 to 79 cases will cost Tsh 1,800
per case, 80 to 99 cases will cost Tsh 1,700 per case,
and 100 or above will cost Tsh 1,600 per case.
Determine the optimal order quantity.
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3. A jewelry firm buys semi-precious stones that it
uses in making bracelets and rings. The supplier has
quoted a price of $8 per stone for quantities of 600
or more; $9 per stone for orders of 400 to 599
stones and $10 for lesser quantities. The jewelry
firms operates 200 days per year. Usage rate is 25
stones per day, and ordering costs are $48 per
order. Annual carrying costs are 17 percent of
purchase cost.
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Required:
(a) Determine the optimal order size for this firm.
(b) If lead time is six working days, what should be
the re-order point (ROP).
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Determine EOQ for production model or
the small lot sizes model
In this model the optimal re-order quantity is known
as the Economic Batch Quantity. The Economic
Batch Quantity (EBQ) is the production lot size of
the inventory that is required to be produced by the
manufacturer so that the production of the main
product continues smoothly and the holding costs
are also low.
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In this model the ordering cost is replaced by the
setup cost. Setup cost is the cost incurred to prepare a
machine or process for manufacturing an order.
This same model is used where a manufacturer orders
raw materials rather producing it but the supplier
supplies the inventory in small sizes gradually (non-
instantaneously). When this model is used for
calculating optimal order size for inventory purchased
rather than produced, the setup cost shall be replaced
by the normal ordering cost.
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The EBQ can be determined by using the formula below
2 × 𝐷 × 𝐶𝑜
𝐸𝐵𝑄 =
𝑑
𝐶ℎ × 1 −
𝑝
Or
2 × 𝐷 × 𝐶𝑜 × 𝑝
𝐸𝐵𝑄 =
𝐶ℎ × 𝑝 − 𝑑
𝐶𝑜 = Set up cost per order
𝐶ℎ = Carrying cost per unit per annum
𝐷 = Annual demand or requirement of material
p = Rate of production per time period
d = Rate of usage/demand per time period 50
The EBQ model is used under the following environment:
1. When a firm receives its inventory over a period of
time.
2. When inventory continuously flows or builds up over a
period of time after an order has been placed (the
receipt of the inventory items is not instantaneously)
3. When units are produced and sold simultaneously or
when production of an inventory item and usage of
that item take place simultaneously.
Because this model is especially suited to the production
or manufacturing environment, it is commonly called the
production run model.
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Example:
Umoja Engineering Company manufactures parts, coded
B-2, on a special lathe machine at the rate of 4,000 units
per day for use in a continuous assembly. The assembly
requirements of B-2 per day is 1,200 units. When parts are
being run, deliveries are made to the assembly area.
Otherwise the assembly department draws part from
inventory. The inventory holding cost is Tsh. 20 per unit
per annum, and the setup cost per order is Tsh. 110,000.
Unit variable production cost is Tsh. 2,000/-. The
acquisition lead time is 10 working days and operational
year is 250 working days.
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Required:
(a) Calculate the production department’s economic batch
quantity.
(b) Determine the length of: (i) production run; (ii) break
between production runs; (iii) cycle time.
(c) What is the total material cost associated with
production policy formulated in (a) and (b) above.
(d) Determine the assembly department’s re-order level
(i.e. ROP for the assembly department)
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Discussion Problems.
1. (a) Explain three reasons for holding inventory.
(b) Describe the major decisions that must be made in
inventory control.
(c) What is the difference between perpetual and
periodic inventory accounting systems?
(d) What is the difference between re-order point and
safety stock?
(e) What happens to the ordering costs and the holding
costs if the order quantity (size of order) is increased.
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2. A toy manufacturer uses 48,000 rubber wheels per year
for its popular dump truck series. The firm makes its own
wheels, which it can produce at the rate of 800 per day.
The toy trucks are assembled uniformly over the entire
year. Carrying cost is Tsh. 100 per wheel per year. Setup
cost for production run of wheels is Tsh. 4,500. The firm
operates 240 days per year.
Required:
(i) Determine the run (lot) size.
(ii) The minimum total annual cost for carrying and setup
costs.
(iii) The cycle time for the optimal run size.
(iv) The run time. 55
3. Natural Plc. produces herbal soaps. The details of the
annual demand of the soap and the requirement of the
soap and the set up and holding costs are given below.
Annual requirement of the soap = 3600 pieces
Rate of demand = 15 soaps / shift
Number of working shifts in a year = 480 shifts
Cost of the cake mix = Tshs15,000 per piece
Inventory holding cost per annum = 18% of the value of
the raw material. Set up cost per order = Tshs60,000.
Calculate the optimal reorder quantity.
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Determine EOQ when there is a planned
shortage
One of the basic assumptions of the EOQ model was
that there can be no situations of stock-outs /
shortages. However, to arrive at the EOQ with
planned shortages, this assumption needs to be
changed. The following assumptions need to be
replaced to calculate EOQ with planned shortages.
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Planned shortages are allowed in cases where
basically the holding cost of the inventory is very
high. This usually happens in case of high valued
products where the investment in maintaining the
inventory for finished goods is very expensive.
Therefore, in such situations permitting limited
planned shortages makes sense from a managerial
perspective.
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Here the management believes that no customers
shall be lost due to unavailability of the product in
the market. The customers are ready to wait for the
product to become available again. Their backorders
are noted and fulfilled immediately when the order
quantity arrives to replenish inventory.
Backorder quantity is the minimum number of
orders that a company needs to book, before it
resumes production to replenish the inventory.
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This model has been designed to determine the
optimal order and backorder quantity for any
manufacturing concern.
The variable costs in this model are annual holding
costs, backorder costs, and ordering costs.
For the optimal order and backorder quantity
combination, the sum of the annual holding and
backordering costs equals the annual ordering cost.
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When the company receives back orders from its
customers, it incurs backorder cost which includes
the real and perceived costs of the inability of the
company to fulfil an order. The costs can include
negative customer relations, interest expenses, etc.
and are typically represented in financial reports on
a per-unit basis.
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Backorder costs are important for companies to
track, as the relationship between holding costs of
inventory and backorder costs will determine
whether a company should over- or under-produce.
If the carrying cost of inventory is less than
backorder costs (this is true in most cases), the
company should over-produce and keep an
inventory.
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The formula for the optimal reorder quantity under
this method is given as:
∗
2𝐷𝐶𝑜 𝐶ℎ + 𝐶𝑏
𝑄 = ×
𝐶ℎ 𝐶𝑏
The maximum inventory level can be calculated as:
∗ 𝐶𝑏 2𝐷𝐶𝑜 𝐶𝑏
Qmax = 𝑄 × = ×
𝐶ℎ +𝐶𝑏 𝐶ℎ+ 𝐶𝑏 𝐶ℎ
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The maximum backorder quantity can be calculated
∗ 𝐶ℎ 2𝐷𝐶𝑜 𝐶ℎ
as: Bmax = 𝑄 × = ×
𝐶ℎ +𝐶𝑏 𝐶ℎ+ 𝐶𝑏 𝐶𝑏
Also note that Qmax = 𝑄 ∗ - Bmax
Where:
• 𝐷 – Annual demand or requirement of
material
• 𝐶𝑂 – Set up cost per order
• 𝐶ℎ – Carrying cost per unit per annum
• 𝐶𝑏 – Backorder costs per unit per annum
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Example: Global manufactures LED TVs for which
the assumptions of the inventory model with
shortages are valid. Demand for the product is
2,000 units per year. The inventory holding cost rate
is 20% of unit cost per year. The cost of TV from
Global is Tshs 50,000. The ordering cost is Tshs
25,000 per order. The annual shortage cost is
estimated to be Tshs 30,000 per unit per year.
Global operates 200 days per year. Calculate the
optimal order quantity for Global and the maximum
number of backorders the company can receive.
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Solution
Given
D = 2,000 units
CO = Tshs 25,000
Cb = Tshs 30,000
Ch = 20% of the cost
= 0.2 × 50,000
= 10,000
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∗ 2 × 2,000 × 25,000 10,000+30,000
𝑄 = ×
10,000 30,000
= 115.47 Units
The maximum number of backorders can be
calculated as:
∗ 𝐶ℎ
Bmax = 𝑄 ×
𝐶ℎ +𝐶𝑏
10,000
= 115.47 ×
10,000+30,000
= 28.87 or 29 Units
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Exercise:
A local Dar es Salaam electronics distributor
forecasts an annual demand (D) of 1,200 units. The
ordering cost (𝐶𝑂 ) is $20 per order, and the holding
cost (𝐶ℎ ) is $5 per unit per year. The backorder cost
(𝐶𝑏 ) is estimated at $10 per unit per year. Calculate
the optimal order quantity, maximum backorders,
maximum inventory, and total annual cost.
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