Deterministic Inventory Models

Dr. Erwinna Chendra dan Robyn Irawan, MSc.

 DISCUSSION TOPICS
INTRODUCTION BATCH-TYPE PRODUCTION
01 Inventory, Types of Inventory, Inventory Problem
Classifications, Inventory Costs.
04 SYSTEMS
EPQ-Single Items, EPQ-Multiple Items, Run Out
Time (ROT) Method.
INDEPENDENT DEMAND SYSTEMS
02 Fixed Order Size Systems, Batch-Type Production
Systems, Fixed Order Interval Systems. 05
FIXED ORDER INTERVAL
SYSTEMS
EOI-Single Items, EOI-Multiple Items.
FIXED ORDER SIZE SYSTEMS
03 EOQ-Single Items, EOQ Sensitivity, Backordering,
Quantity Discounts.
INTRODUCTION
Inventory, Types of Inventory, Inventory
Problem Classifications, Inventory Costs
INVENTORY
The control and maintenance of inventory is a problem
common to all organizations in any sector of the economy.

The term inventory can be used to mean several different

things, such as:
• the stock on hands of materials at a given time
(a tangible asset which can be seen, measured, and
counted);
• an itemized list of all physicals assets;
• (as a verb) to determine the quantity of items on hand;
• the value of the stock of goods owned by organization at
a particular time.
• Supplies are inventory items consumed in the normal functioning of
an organization that are not a part of the final product.
• Raw materials are items purchased from suppliers to be used as
inputs into the production process. They will be modified into
finished goods.
• In-process goods are partially completed final products that are still
in the production process. They represent both the accumulation of
partially completed work and the queue of material awaiting further
processing.
• Finished goods are the final product, available for sale, distribution,
or storage.

TYPES OF INVENTORY
Inventory Problem Classifications

REPETITIVENESS SUPPLY SOURCE KNOWLEDGE OF KNOWLEDGE OF INVENTORY

DEMAND LEAD TIME SYSTEM
• Single Order • Outside Supply
• Repeat Order • Inside Supply • Constant / • Constant Lead • Perpetual
Variable Time • Periodic
Demand • Variable Lead • Material /
• Independent / Time Distribution
Dependent Requirements
Demand Planning
• Single Order
Quantity
 INVENTORY
COSTS
The objective of inventory management is to have the appropriate
amounts of materials in the right place, at the right time, and at low cost.
Inventory costs are associated with the operation of an inventory system
and result from action or lack of action on the part of management in
establishing the system. They are the basic economic parameters to any
inventory decision model, and the more relevant ones to most systems are:
1. purchase cost,
2. order / setup cost,
3. holding cost,
4. stockout cost.
 INDEPENDENT
DEMAND SYSTEMS
INDEPENDENT DEMAND SYSTEMS:
DETERMINISTIC MODELS

FIXED ORDER BATCH-TYPE FIXED ORDER

SIZE PRODUCTION INTERVAL
SYSTEMS SYSTEMS SYSTEMS
ECONOMIC ECONOMIC ECONOMIC
ORDER PRODUCTION ORDER
QUANTITY QUANTITY INTERVAL
(EOQ) (EPQ) (EOI)
FIXED ORDER SIZE
SYSTEMS
 ECONOMIC ORDER QUANTITY (EOQ) – SINGLE ITEM
The two fundamental questions posed to any inventory
system are how many and when to order. Demand in a
deterministic fixed order size system is assumed to be
known and presumed to be continues. Therefore, the
same number of units (how many) always is ordered,
and the time between orders (when) is not expected to
vary.

Thus, the two parameters of the systems are the

FIXED ORDER reorder point (𝑹) and the size of the order (𝑸). The
SIZE SYSTEMS order size that minimizes the total inventory cost is
known as the Economic Order Quantity (EOQ) model.
ECONOMIC ORDER QUANTITY
(EOQ) – SINGLE ITEM
ECONOMIC ORDER QUANTITY (EOQ) – SINGLE ITEM

If stockouts are not permitted, the total inventory cost per year is
𝐶𝐷 𝐻𝑄
𝑇𝐶 𝑄 = 𝑃𝐷 + +
𝑄 2
where:
𝐷 : annual demand in units,
𝑃 : purchase cost of an item,
𝐶 : ordering cost per order,
𝐻 : holding cost per unit per year,
𝑄 : order quantity in units.
ECONOMIC ORDER QUANTITY (EOQ) – SINGLE ITEM
To obtain the minimum cost, take the first derivative of total annual cost with
respect the order quantity (𝑄) and set it equal to zero:
𝑑𝑇𝐶(𝑄) 𝐻 𝐶𝐷
= − 2 =0
𝑑𝑄 2 𝑄
Solving the equation for 𝑄, we get the EOQ formula:
2𝐶𝐷
𝑄∗ =
𝐻
Thus, the number of orders placed during the year, 𝑚, and the time between
orders, 𝑇, can be determined:
𝐷 𝐻𝐷 1 2𝐶
𝑚= = and 𝑇 = =
𝑄∗ 2𝐶 𝑚 𝐻𝐷
ECONOMIC ORDER QUANTITY (EOQ) – SINGLE ITEM
The reorder point, 𝑅, is obtained by determining the demand that will
occur during the lead time period. When the stock position (on hand +
on order - backorders) reach 𝑅, and order will be placed for 𝑄 ∗ units.
The following formula gives the reorder point when the lead time 𝐿 is
expressed in months:
𝐷𝐿
𝑅=
12

The minimum total cost per year is obtained by substituting 𝑄∗ for 𝑄 in

the total cost equation:
𝑇𝐶 𝑄∗ = 𝑃𝐷 + 𝐻𝑄 ∗
ECONOMIC ORDER QUANTITY (EOQ) – SINGLE ITEM
The classical EOQ model is based on the following
assumptions:
• The demand rate is known, constant, and continuous,
• The lead time is known and constant,
• The entire order quantity is added to the inventory at the
same time,
• No stockouts are permitted,
• The total cost is fixed,
• There is sufficient space, capacity, and capital to produce
the desired quantity,
• The item is a single product.
EOQ SENSITIVITY

In a fixed order size system, the order quantity which minimizes the total
variable cost (𝑇𝑉𝐶) per year dictates the optimum inventory policy. The
pertinent mathematical relationships are as follows:
𝑄∗ = 2𝐶𝐷 Τ𝐻
𝐶𝐷 𝐻𝑄 𝐶𝐷 𝐻𝑄∗
𝑇𝑉𝐶 𝑄 = + and 𝑇𝑉𝐶 𝑄∗ = + = 𝐻𝑄∗
𝑄 2 𝑄∗ 2
Assume there are errors in the estimation of parameters 𝐷, 𝐶, and 𝐻
with the respective error factors 𝑋𝐷 , 𝑋𝐶 , and 𝑋𝐻 . The model becomes:
𝑄 ∗ 𝑋 𝑋 𝑋
2𝐶𝐷 𝑋𝐶 𝑋𝐷 𝑋𝐶 𝑋𝐷 𝐶 𝐷 𝐻
𝑄= = 𝑄∗ =
𝐻 𝑋𝐻 𝑋𝐻 𝑋𝐻
𝑄−𝑄∗ 𝑋𝐶 𝑋𝐷
= − 1 = order quantity error fraction
𝑄∗ 𝑋𝐻
EOQ SENSITIVITY

To determine the sensitivity of the total variable cost per year to errors in
input parameters, a similar procedure of inserting error factors into the
cost formula is used:
𝐶𝐷 𝐻𝑄 𝐶𝐷𝑋𝐶 𝑋𝐷 𝑋𝐻 𝐻𝑋𝐻 𝑄 ∗ 𝑋𝐶 𝑋𝐷 𝑋𝐻
𝑇𝑉𝐶 𝑄 = + = +
𝑄 2 ∗
𝑄 𝑋𝐶 𝑋𝐷 𝑋𝐻 2𝑋𝐻
𝐶𝐷 𝐻𝑄 ∗ ∗
= ∗
+ 𝑋 𝐶 𝑋 𝐷 𝑋𝐻 = 𝑇𝑉𝐶 𝑄 𝑋𝐶 𝑋𝐷 𝑋𝐻
𝑄 2
Then
𝑇𝑉𝐶 𝑄 − 𝑇𝑉𝐶 𝑄∗ 𝑇𝑉𝐶 𝑄∗ 𝑋𝐶 𝑋𝐷 𝑋𝐻 − 𝑇𝑉𝐶 𝑄∗
∗
=
𝑇𝑉𝐶 𝑄 𝑇𝑉𝐶 𝑄∗
= 𝑋𝐶 𝑋𝐷 𝑋𝐻 − 1 = 𝑇𝑉𝐶 error fraction
EOQ SENSITIVITY
estimated EOQ
Assume that 𝑋𝑄 = = EOQ error factor and
actual EOQ
𝐶𝐷 𝐻𝑄∗ 𝑋𝑄
𝑇𝑉𝐶 𝑄 = + and 𝑇𝑉𝐶 𝑄 ∗ = 𝐻𝑄 ∗
𝑄∗ 𝑋𝑄 2
So we have
𝐶𝐷 𝐻𝑄∗ 𝑋𝑄 ∗
+ − 𝐻𝑄
𝑇𝑉𝐶 𝑄 − 𝑇𝑉𝐶 𝑄∗ 𝑄∗ 𝑋𝑄 2
∗
=
𝑇𝑉𝐶 𝑄 𝐻𝑄∗
∗ 2 2
2𝐶𝐷 + 𝐻 𝑄 𝑋𝑄 ∗
∗ − 𝐻𝑄 2
2𝑄 𝑋𝑄 2𝐶𝐷 + 𝐻 𝑄∗ 2 𝑋𝑄 − 2𝐻 𝑄∗ 2 𝑋𝑄
= =
𝐻𝑄 ∗ 2 𝑄∗ 2 𝑋𝑄 𝐻
2 2
1 1 𝑋𝑄 −2𝑋𝑄 +1 𝑋𝑄 −1
= + 𝑋 −1= = = TVC error fraction.
2𝑋𝑄 2 𝑄 2𝑋𝑄 2𝑋𝑄
 Backordering
A backorder is demand that will be filled later than desired. In the backordering situation, a
firm does not lose the sale when its inventory is depleted. However, backordering demand
may be more costly than routine order processing. It is assumed that all shortages are
satisfied from the next shipment. The size of the stockout is 𝑠 units, and the maximum
inventory level is 𝑄 − 𝑠 units. The backordering cost per unit per year is 𝐾, and it is directly
proportional to the length of the time delay.

During the time period 𝑇1 one order is placed, so the

order cost is 𝐶. There is a positive inventory balance
during the time period 𝑇1 , and the average holding
cost during 𝑇1 is:
𝐻(𝑄−𝑠)𝑇1 𝐻 𝑄−𝑠 2 𝑄−𝑠
= karena 𝑇1 =
2 2𝐷 𝐷
The stockout time period is 𝑇2 , and the average
backordering cost during 𝑇2 is as follows:
𝐾𝑠𝑇2 𝐾𝑠 2 𝑠
= karena 𝑇2 =
2 2𝐷 𝐷
 Backordering
Therefore, the total cost of one time period of length 𝑇1 is
𝐻 𝑄 − 𝑠 2 𝐾𝑠 2
𝑃𝑄 + 𝐶 + +
2𝐷 2𝐷
Since there are 𝐷 Τ𝑄 order periods of length 𝑇1 in a year, the total annual cost is
𝐶𝐷 𝐻 𝑄 − 𝑠 2 𝐾𝑠 2
𝑇𝐶 𝑄, 𝑠 = 𝑃𝐷 + + +
𝑄 2𝑄 2𝑄
To obtain optimal values for 𝑄 and 𝑠, partial derivatives of the total annual cost function with
respect to 𝑄 and 𝑠 are equated to zero. So we get
2𝐶𝐷 𝐻 + 𝐾
𝑄∗=
𝐻 𝐾
∗
𝐻𝑄
𝑠∗ =
𝐻+𝐾
∗ ∗
𝐾𝑄 ∗
𝑄 −𝑠 =
𝐻+𝐾
𝐻𝐾𝑄∗
The minimum total cost per year is 𝑇𝐶 𝑄∗ , 𝑠 ∗ = 𝑃𝐷 + = 𝑃𝐷 + 𝐾𝑠 ∗ .
𝐻+𝐾
 Quantity Discounts
It is common practice for suppliers to offer lower unit prices on orders for larger quantities as
an economic incentive to buyers to purchase in larger lot size. There are two general types
of quantity discount schedules offered by suppliers: the all-units discount and the
incremental discount.
The basic EOQ model assumes a fixed purchase price per unit. When all-units discounts
are offered, the objective function is still to find the minimum cost point on the total cost
curve. However, the total cost curve is not continuous, so the first derivative does not
indicate the minimum cost point.

With all-units discounts, the buyer is presented

by the supplier with a price schedule consisting
of 𝑗 quantity range such that the unit price is
equal for all units in an order and decreases with
increasing order size.
 All-units Quantity Discounts
The unit purchase cost is:
𝑃0 for 𝑈0 ≤ 𝑄 < 𝑈1
𝑃1 for 𝑈1 ≤ 𝑄 < 𝑈2
𝑃= ⋮
𝑃𝑗 for 𝑈𝑗 ≤ 𝑄 < 𝑈𝑗+1
where 𝑃𝑖 denotes the purchase cost of an item applicable to orders whose lot size falls in the
interval 𝑈𝑖 to 𝑈𝑖+1 .

The EOQ for each unit price is as follows:

2𝐶𝐷 2𝐶𝐷
𝑄𝑖∗ = =
𝐻 𝑃𝑖 𝐹
The total cost is as follows:
𝐶𝐷 𝑃𝐹𝑄
𝑇𝐶 𝑄 = 𝑃𝐷 + +
𝑄 2
All-units Quantity Discounts
The following procedure indicates how to obtain the minimum cost when one or more
all-units quantity discounts are available:
1. Calculate the EOQ for the lowest price. If it is feasible (i.e., this order quantity is
in the range for that price), then stop. This is the optimal lot size. Calculate TC
for this lot size.
2. If the EOQ is not feasible, calculate the TC for this price and the smallest
quantity for that price.
3. Calculate the EOQ for the next lowest price. If it is feasible, stop and calculate
the TC for that quantity and price.
4. Compare the TC for Steps 2 and 3. Choose the quantity corresponding to the
lowest TC.
5. If the EOQ in Step 3 is not feasible, repeat Steps 2, 3, and 4 until a feasible EOQ
is found.
 Incremental Quantity Discounts
For incremental quantity discounts, the buyer is presented with a price schedule consisting of
quantity ranges such that the lower unit purchase costs only apply to the quantities in the
particular discount quantity interval. The price schedule is as follows:
𝑃0 for each 𝑈0 to 𝑈1 − 1
𝑃1 for each of the next 𝑈1 to 𝑈2 − 1
𝑃= ⋮
𝑃𝑗 for each of the next 𝑈𝑗 to 𝑈𝑗+1
The purchase cost for a lot size of 𝑄 units is as follows:
𝑀𝑖 = 𝐷𝑖 + 𝑃𝑖 𝑄
where 𝐷𝑖 = σ𝑖𝑘=1 𝑈𝑘 − 1 𝑃𝑘−1 − 𝑃𝑘 .
𝑀𝑖 𝐷𝑖
The purchasing cost per unit is = + 𝑃𝑖 .
𝑄 𝑄
Thus, the total cost per year of a lot size 𝑄 units is:
𝐷𝑖 𝐶𝐷 𝐹𝑄 𝐷𝑖 𝐶 + 𝐷𝑖 𝐷 𝑃𝑖 𝐹𝑄 𝐹𝐷𝑖
𝑇𝐶 𝑄 = 𝑃𝑖 + 𝐷+ + 𝑃𝑖 + = 𝑃𝑖 𝐷 + + +
𝑄 𝑄 2 𝑄 𝑄 2 2
 Incremental Quantity Discounts
Since the total cost curve for each unit purchase cost is convex, the minimum cost is obtained by
setting the first derivative of total annual cost with respect to the lot size equal to zero, which
results in:
𝑑𝑇𝐶(𝑄) 𝐶 + 𝐷𝑖 𝐷 𝑃𝑖 𝐹
=− 2
+ =0
𝑑𝑄 𝑄 2
and
2𝐷 𝐶 + 𝐷𝑖 2𝐷 𝐶 + σ𝑖𝑘=1 𝑈𝑘 − 1 𝑃𝑘−1 − 𝑃𝑘
𝑄𝑖∗ = =
𝑃𝑖 𝐹 𝑃𝑖 𝐹
Since the total cost curve with incremental discounts is continuous, the minimum total cost will
always occur at a valid EOQ. However, even if an EOQ is valid, it is not necessarily optimal, and
larger valid EOQ’s are not necessarily more desirable than smaller valid EOQ’s.

An EOQ is valid if 𝑈𝑖 ≤ 𝑄𝑖∗ ≤ 𝑈𝑖+1 (the EOQ must fall within the quantity range).
 Incremental Quantity Discounts
The following procedure will determine
the optimum lot size with incremental
discounts:
1. Calculate the EOQ for each unit
purchase cost,
2. Determine which EOQ’s are valid,
3. Calculate the total cost for each
valid EOQ,
4. Select the valid EOQ with the
lowest total cost.
BATCH-TYPE
PRODUCTION
SYSTEMS
 FIXED ORDER
INTERVAL SYSTEMS
 THANK YOU
Any Questions? Email: erwinna@[Link] or [Link]@[Link]