Chapter 06 – Inventory Model

Learning Objectives

⚫ Know Inventory and Inventory system

⚫ Know function and application of Inventory
⚫ Know the types of Inventory models
Optimization Vs. Simulation

Optimization models Simulation models

➢ Yield decision ➢ Require the
variables as outputs decision variables
➢ Promise the best as inputs
(optimal) solution to ➢ Give only a
the model. satisfactory answer
Simulation – The basic Concept

➢ To simulate is to try to duplicate the characteristics of a real

system.
➢ Simulation is a decision modeling technique often used to
examine and evaluate the performance of complex systems.
➢ In some complex systems, knowledge of solutions around the
optimum are just as useful as the optimum itself, from a
practical point of view. Example: Weather Prediction
➢ Thus, it is not an optimization technique but can be articulated
to yield near optimum results.
➢ It is particularly useful where optimization cannot be used
because of their limitations or at times when representation of
real system is difficult.
Optimization Vs. Simulation
Inventory – Concepts
 Inventory – stock of any item (goods, commodities or other
economic resources) that are stored or reserved for smooth and
efficient running of business affairs.

 Forms of Inventory:
➢ Raw material inventory: materials kept for using in
production of goods.
➢ Work-in Process inventory: semi-finished goods kept during
production process.
➢ Finished goods inventory: finished goods awaiting
shipments/ready to be sold. E.g. computer
Why Inventory?
 To meet unexpected demand.
 To provide high levels of customer service (satisfy demand and
deliver at short notice).
 To meet smooth production requirements by meeting seasonal
or cyclical variations in demand.
 To provide a safeguard for variation in raw material delivery
time.
 To provide a stock of goods that will provide a “selection” for
customers.
 To take advantage of economic purchase-order size/ quantity
discounts.
 To take care of economic fluctuations/ avoid price increases.
Why Inventory?
 In general, inventory is critical to a firm’s strategic viability.

Inventory helps in smooth and efficient running of business

(or, helps to decide how much to order when to order).

It balances conflicting goals of Marketing, Finance, and

Production departments in a business firm.
Why Inventory?
What are the Conflicting goals?
❖ Marketing department wants large inventory, it does not
like stock outs.
❖ Finance department likes low inventory and high turnover to
minimize funds tied up in inventories; opportunity cost of
capital.
❖ Production department likes to keep production costs low. It
likes uniform production and long uninterrupted runs of a
small number of products.
 Inventory Models seek to find the best balance between these
goals so as to minimize the total cost (the cost of stock outs and
lost sales, the cost of funds tied up in inventories and the cost of
set-ups).
Inventory System

➢ An inventory system is the set of policies and controls

that monitor levels of inventory (determine what levels
should be maintained, when stock should be replenished
and how large orders should be).

Inventory Decision Questions:

✓ How much to order?
✓ When to order?
✓ How much to store in safety stock?
Terms used in inventory system

⚫ Inventory: stock of any item that are stored or reserved.

⚫ Reorder Point: the point at which the inventory is ordered for

replenishment

⚫ Lead time: the time from ordering to receipt of quantity.

⚫ Holding cost: the cost incurred for storage, handling,

insurance, etc.

⚫ Setup (ordering) cost: the cost of placing an order and receiving

goods.

⚫ Shortage cost: the cost incurred when demand exceeds supply

Requirements of Effective Inventory system

⚫ A system to keep track of inventory

⚫ A reliable forecast of demand
⚫ Knowledge of lead times
⚫ Reasonable estimates of
➢ Holding costs
➢ Ordering costs
➢ Shortage costs
Types of Inventory Models

There are two types of Inventory models widely used in

business.

➢ Multi-Period Inventory Models

▪ Multiple times purchasing decision (ordering more than one
times)

➢ Single-Period Inventory Model

▪ One time purchasing decision (ordering only once)
 Types of Inventory Models

Multi-Period Inventory Model:

• Fixed Order Size - Variable Order Interval Models
✓ Economic Order Quantity(EOQ) Model
✓ Economic Production Quantity, EPQ

Assignment
✓ EOQ with quantity discounts

Reading
• Fixed Order Interval - Variable Order Size Model
The Economic Order Quantity (EOQ) model

⚫ EOQ model is also called as Lot Size Formula first

developed by Harris and Wilson (independently) in 1915.

⚫ Assumptions of the EOQ model (1/2):

➢ Annual Demand for the product is known, and is
constant.
➢ Lead time (time from ordering to receipt) is known
and constant.
➢ Price per unit of product is constant (no quantity
discounts)
➢ Inventory holding cost is based on average inventory
The Economic Order Quantity (EOQ) model

⚫ Assumptions of the EOQ model (2/2):

➢ Ordering or setup costs are constant.
➢ Use the inventory at a constant rate.
➢ All demands for the product will be satisfied.
➢ No stockouts (shortages) are allowed.
➢ The order quantity is received all at once
(Instantaneous receipt of material in a single lot)

The goal is to calculate the order quantitiy

that minimizes total cost.
 The Economic Order Quantity (EOQ) model

4. The cycle repeats

1. You receive an
order quantity Q 2. You start using Q Q
them up over time
Inventory Level

Reorder point, R

0 Lead Lead Time

time time
3. When you reach down to
a level of inventory of R, Order Order
you place your next Q size Placed Received
order
The Economic Order Quantity (EOQ) model

Note:
• Safety Stock (SS): the extra stock that is always maintained to
mitigate any future risks arising due to stock-outs because of
shortfall of raw materials or supply, breakdown in machine or
plant, accidents, natural calamity or disaster, or any other crisis.

• The quantity of safety stock is often derived by analyzing

historical data and is set to an optimized level by evaluating
carefully the current cost of inventory and losses that may be
incurred due to future risk.
The Economic Order Quantity (EOQ) model

Reorder Level (RL) = Safety Stock (SS) + Average Lead Time Demand (DL)
Inventory Model Fixed Reorder Quantity System
The Economic Order Quantity (EOQ) model

Example: The order quantity of an Item is 600 Units. The safety

Stock is 200 Units. The Average Lead Time is 5 Days and average
consumption per days is 40 units. Find:
a) Average lead time demand
b) Reorder Level
c) Minimum Level of inventory
d) Maximum level of inventory
The Economic Order Quantity (EOQ) model

Given:
• Order Quantity (O) = 600 Units
• Safety Stock (SS) = 200 Units
• Average Lead Time (TL) = 5 Days
• Average Demand ( DAv ) = 40 Units
Solution:
a) Average Lead Time Demand (DL) = DAv * TL
= 40*5 = 200 Units
a) Reorder Level (RL) = SS + DL = 200+ 200 = 400 Units
b) Minimum Level (LMin) = Safety Stock (SS) = 200 Units
c) Maximum Level (LMax) = SS+ O = 200+ 600 = 800 Units
The Economic Order Quantity (EOQ) model

Order qty, Q Inventory depletion

(Demand rate)
Inventory Level

Average
Inventory, Q/2

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
Placed Received Placed Received
The Economic Order Quantity (EOQ) model

Total Cost = Holding Cost + Order Cost

Annual Holding Cost = ( Ave. Inventory)( Holding Cost / unit / year)

Q
Annual Holding Cost =   H
2
Annual cost

Holding cost (HC)

Lot Size (Q)

The Economic Order Quantity (EOQ) model

⚫ Holding cost increases because more units must be stored

if more are ordered.
Example: Holding costs (HC) for different order quantity of Items

HC = 0.5(1)*HC per unit quantity HC = 0.5*1000*HC per unit quantity

The Economic Order Quantity (EOQ) model

Total Cost = Holding Cost + Order Cost

Annual Demand
Annual Order Cost =  Order Cost
Order Quantity

DS
Annual Order Cost =
Annual cost

Ordering cost (OC)

Lot Size (Q)

The Economic Order Quantity (EOQ) model

⚫ Ordering cost decreases because we order fewer times

over the year.
⚫ Cost is spread over more units.
Example: Ordering costs (HC) for a demand of 1000 items.
The Economic Order Quantity (EOQ) model

Total Cost = Holding Cost + Order Cost

Annual
cost TC = HC + OC

Slope = 0

Minimum
total cost

Holding cost (HC) =HQ/2

Ordering cost (OC)=SD/Q

Optimal order, Q* Order Quantity (Q)

The Economic Order Quantity (EOQ) model

Note
TC=Total annual cost
Q D
TC = PC + H+ S D =Annual demand
2 Q C =Cost per unit demand
Q =Order quantity
S =Ordering/setup cost
H = Holding/ storage cost

Total Annual Annual Annual

Annual = Purchase Holding Ordering
Cost Cost Cost Cost
The Economic Order Quantity (EOQ) model
Cost

Adding PC
doesn’t change EOQ TC with PC

TC without PC

PC

0 EOQ Quantity
The Economic Order Quantity (EOQ) model

How much to order?

⚫ Taking the first derivative of the total cost function with
respect to Q, and set the derivative (slope) equal to zero,
solving for the optimized (cost minimized) value of Q*,

SD HQ
TC = +
Q 2 Where,
TC SD H Q* – Optimal order quantity
=− 2 + =0 D – annual demand
Q Q 2
S – cost of placing order
H – annual holding cost
2 DS
Q =
* per-unit of inventory
H
The Economic Order Quantity (EOQ) model

When to order?
We also need a reorder point to tell us when to place an
Order.

 D 
R =   L = dL
 working days per year 

Where,
R = Reorder point
D = annual demand
d = average daily demand (constant)
L = Lead time (constant)
The Economic Order Quantity (EOQ) model

2 DS
Optimal order quantity: Q =
*

D
Expected number of orders: N=
Q

Expected time between orders T = Working days per year

(cycle Length): N

Reorder point: R = dL
The EOQ model - Examples

Example 1: R & B beverage company has a soft drink

product that has a constant annual demand rate of 3600
cases. A case of the soft drink costs $3. Ordering costs are
$20 per order and holding costs are 25% of the value of
the inventory. R & B has 250 working days per year, and
the lead time is 5 days. Identify the following aspects of
the inventory policy:
a. Economic order quantity
b. Reorder point
c. Cycle time
d. Total annual cost
The EOQ model – Sensitivity Analysis

Opt Cost with

D I S Q* Cost Q=438
3600 25% 20 438 329 329
3400 25% 20 426 319 320
3600 35% 20 370 389 394
3600 25% 30 537 402 411
The EOQ Model - Important Characteristics
1. The total cost curve is flat near EOQ:
➢ The total cost does not change much with a slight
change in the order quantity (see the total cost curve
and the example on sensitivity)

TC
Important Characteristics of the EOQ Cost function

2. At EOQ, the annual holding cost is the same as annual

ordering cost (see the cost curve).

HQ* H 2 DS DSH
Annual holding cost = = =
2 2 H 2
DS DS DSH
Annual ordering cost = *
= =
Q 2 DS 2
H
HQ* DS
Total annual cost = + * = 2 DSH
2 Q
Single Period Model
Single Period Model

⚫ In a multi-period model, all the items unsold at the end of

one period are available in the next period.
⚫ But in a single-period model, the items unsold at the end
of the period are not carried over to the next period. The
unsold items, however, may have some salvage value.
⚫ Single period model: is a model for ordering of perishables
and other items with limited useful lives.
⚫ This model is applied to problems like:
➢ A computer that will be obsolete before the next order
➢ Perishable products such as bread, flowers, fruits,
➢ Seasonal products such as calendars, raincoats, etc.
➢ Weekly/monthly products - Newspapers and magazines.
Single Period Model

⚫ In the single-period model, there remains a question to answer:

How much to order?
⚫ Single period model has the objective of properly balancing the
cost of Underage or shortage cost (having not ordered enough
products) vs. Overage or excess cost (having ordered more than
we can sell.

The Model Assumptions:

⚫ Only one order in time period
⚫ Probabilistic distribution of demand (uniform or normal)
⚫ End of time period
➢ Surplus - Penalty!
➢ Stockout - Penalty!
Single Period Model

⚫ Loss resulting from the items unsold (excess cost)

Marginal Loss (ML) = Purchase price - Salvage value

⚫ Unrealized Profit resulting from the items sold (shortage cost)

Marginal Profit (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?
Single Period Model

⚫ 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 or,
ML
P
MP + ML
Single Period Model

⚫ Decision Rule:
➢ Order maximum quantity Q such that
ML
P
MP + ML

Where, P = probability (demand  Q)

Single Period Model
Example 1: Demand for concrete admixture with the following probabilities:
Demand Probability of Demand
1,800 kg 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

If the selling price=$0.69/kg, cost=$0.49/kg, and salvage value=$0.29/kg,

a. Construct a table showing the profits or losses for each possible
quantity
b. What is the optimal kg of admixture to use?
c. Solve the problem by marginal analysis.
Single Period Model
Single Period Model
Solution: Table showing the profits or losses for each possible quantity

Sample computation for order quantity = 2200:

Expected kg sold=1800(0.05)+2000(0.10)+2200(0.85) = 2160
Revenue from sold quantity = 2160(0.69) = $1490.4
Revenue from unsold quantity = (2200-2160)(0.29) = $11.6
Total revenue = 1490.4+11.6 = $1502
Cost = 2200(0.49) = $1078
Profit = 1502-1078 = $424
Single Period Model

b) The optimal quantity to use would be 2400 kg. This yields an

expected profit of $436.

c) Solution by marginal analysis:

MP = 0.69 − 0.49 = $0.20, ML = 0.49 − 0.29 = $0.20

Order maximum quantity, Q such that

ML 0.20
P = Probability(demand  Q)  = = 0.50
MP + ML 0.20 + 0.20

The largest demand with probability of selling at least 0.50 is 2400

kg. So, use 2400kg.
Single Period Model
Example 2. Derba Cement Company sells an average of 2,400
safety shoes to its workers every year at affordable prices with a
standard deviation of 350. If the profit is 10 birr on every shoes
sold, but lose 5 birr on every shoes not sold, how many pairs of
shoes should the company supply to its workers?
Single Period Model
Solution: MP= $10 and ML = $5;
P  $5 / ($10 + $5) = .333
1 – P =0.667 (0.50+0.167)
a = Z.167 = .432 (From z-probability table)
Therefore, the company should supply 2,400 + .432(350) = 2,551 shoes
Thank you