Supply Chain Management

Topic 3
Inventory Management Part 2
– Inventory Models
– Know RFID & how it can be used in inventory
management
– Understand the EOQ model & its underlying
assumptions
– Understand the Quantity Discounts & the EMQ
Models & their relationships with the basic EOQ
model
– Understand & able to distinguish among the
various statistical ROP models
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 Inventory Models

Fixed Order Quantity Models

– Economic Order Quantity Model

– Quantity Discount Model
– Economic Manufacturing Quantity Model

These models use fixed parameters to derive the optimum

order quantity to minimize total inventory cost

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 Inventory cost

Inventory costs are categorized into 3 headings:

Ordering Cost

Cost of procurement & inbound logistics costs form part of

Ordering Cost.

Ordering Cost dependant and varies based on 2 factors;

Cost of ordering excess & Cost of ordering too less.

The two costs collectively known as Total Stocking Cost.

How much to order is determined by arriving at the Economic

Order Quantity or EOQ.
 Inventory cost
Carrying Cost

Inventory storage and maintenance involves various types of costs namely:

Inventory Storage Cost & Cost of Capital

Inventory carrying involves Inventory storage and management

either using in house facilities or external warehouses owned and managed by
third party vendors.

Inventory Storage Cost

Inventory storage costs typically include Cost of Building Rental/

facility maintenance and related costs.
Cost of Material Handling Equipments and IT
Hardware and applications, including cost of purchase,
depreciation or rental or lease as the case may be.
 Inventory cost
Cost of Capital

Includes the costs of investments, interest on working capital,

taxes on inventory paid, insurance costs and other costs
associate with legal liabilities.
 Economic Order Quantity

Managers and retailers face difficulty in determining the exact

number of items they should order to refill their stock of a
particular item.

Ordering too many items increases your holding cost, and

ordering too little can result in an out-of-stock situation.
Therefore it is important to reach an optimal quantity to order.

Economic Order Quantity (EOQ) formula helps to avoid

unwarranted situations from occuring. It calculates the ideal
number of units you should order, such that the cost involved
is minimal and number of units is optimal.
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 Economic Order Quantity

§ Economic Order Quantity (EOQ) Model –

A quantitative decision model based on the trade-off
between annual inventory holding costs & annual order costs

The EOQ model seeks to determine an optimal

order quantity, where the sum of the annual order
cost & the annual inventory holding cost is
minimized.
• Order Cost - direct variable cost associated with placing
an order. Sometimes called setup cost.

• Holding Cost - cost incurred for holding inventory in

storage. Sometimes called carrying cost.
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 The Economic Ordering Quantity

• .

Shown above are all three costs, i.e., total costs, carrying costs, and
ordering costs plotted on vertical axis and number of orders on horizontal
axis.
 Order cost & holding cost behaviour

Cost of ordering inventory falls with an increase in

ordering volume due to purchasing on economies of scale.

However, as the size of inventory grows, the cost of

holding the inventory rises.

EOQ is the exact point that minimizes both of these inversely

related costs.
 EOQ Formula Derivation
EOQ formula

§ Determine the demand in units

§ Determine the order cost (incremental cost to process and order)

§ Determine holding cost (incremental cost to hold one unit in inventory)

§ Multiply the demand by 2, then multiply the result by the order cost.

§ Divide the result by the holding cost.

Calculate the square root of the result to obtain EOQ.

 Mức độ sử dụng kho
Số lượng đặt hàng=Q
( cực đại tồn kho)
Hệ số sử dụng

Trung bình (Q/2)

Cực tiểu tồn kho

0
Thời gian
Chi phí tồn kho cực tiểu
 Mô hình lượng đặt hàng kinh tế EOQ
Q= L ượng đặt hàng
Q*= Lượng đặt hàng kinhtế EOQ
D= L ượng cầu hàng năm
S= Chi phí cho mỗi lần đặt hàng
H= Phí lưu kho/đơn vị.năm
 Mô hình EOQ
Phí lưu kho hàng năm
= ( Mức tồn kho trung bình)×(Phí lưu kho/hạng
mục.năm)

Lượng đặt hành kinh tế được xác định tại điểm có

chi phí đặt hàng = Chi phí tồn kho.
 Economic Order Quantity
(EOQ)

D= Annual demand (units)

S= Cost per order ($)
C= Cost per unit ($)
I = Holding cost (%)
H= Holding cost ($) = I x C
 Economic Order Quantity
(EOQ)
Number of Orders = D / Q
Ordering costs = S x (D / Q)

Average inventory
units = Q / 2
$ = (Q / 2) x C

Cost to carry average inventory = (Q / 2) x I x C

= (Q /2) x H
 EOQ Formula Derivation
Total cost = (Q/2) x I x C + S x (D/Q)
inventory carry cost order cost

Take the 1st derivative:

d(TC)/d(Q) = (I x C) / 2 - (D x S) / Q²

To optimize: set d(TC)/d(Q) = 0

DS/ Q² = IC / 2

Q²/DS = 2 / IC

Q²= (DS x 2 )/ IC

Q = sqrt (2DS / IC)

 Calculate

ABC International uses 100,000 pounds of

aluminum ingots per year, and the cost to
place each order is $15. The carrying cost
for one pound of aluminum ingots is $5 per
year. Calculate EOQ
 Economic Order Quantity example
Carpet Discount Store in North Georgia stocks carpet in its
warehouse and sells it through an adjoining showroom.

The store wants to determine the optimal order size and total
inventory cost for this brand of carpet given;

- estimated annual demand of 10,000 yards of carpet,

- annual carrying cost of $0.75 per yard, and
- ordering cost of $150.

The store would also like to know the number of orders that
will be made annually and the time between orders (i.e., the
order cycle) given that the store is open every day except
Sunday, Thanksgiving Day, and Christmas Day (which is not
on a Sunday).
Caculate: EOQ, total cost, number of orders per year
 Optimal Order size

SOLUTION:
Cc = $0.75 per yard
Co = $150
D = 10,000 yards
The optimal order size is
 Total Annual Inventory

The total annual inventory cost is determined by

substituting Qopt into the total cost formula:
The number of orders per year
 Order Cycle

• Given that the store is open 311 days

annually (365 days minus 52 Sundays,
Thanksgiving, and Christmas), the order
cycle is
 Economic Order Quantity

Pam runs a mail-order business for gym

equipment.

Annual demand for the Trico Flexers is

16,000.
Annual holding cost per unit is $2.50 and
Cost to place an order is $50.
Calculate economic order quantity (EOQ)

Calculation:
 Economic Order Quantity

Demand for the Glenn cooker at Best Buy is 1,000 units per month.
Best Buy incurs a fixed order placement, transportation, and
receiving cost of $7,000 each time an order is placed.
Each computer costs Best Buy $1,000 and the retailer has a holding
cost of 35 percent.
Evaluate the number of computers that the store manager should
order in each replenishment lot.

Calculate ;
• Economic Order Quantity
• Cycle inventory
• Number of order per year
• Average flow time
 Solution

• EOQ = √ ( 2 x 12,000 x 7,000) ÷ (0.35 x 1,000)

= 693 units

• Cycle inventory = 693/ 2 = 346.5 units

• No of order per year = 12,000 / 693 = 17.4

times

• Average flow time = 693/12,000 = 0.06 per year

= 0.72 per month
 Economic Order Quantity

Nelson’s Hardware Store stocks a 19.2

volt cordless drill that is a popular seller.
Annual demand is 5,000 units, the
ordering cost is $15, and the inventory
holding cost is $4/unit/year.
a. What is the economic order quantity?
b. What is the total annual cost for this
inventory item?
 Economic Order Quantity

Advantages, such as:

üeasy to understand and use
ügiving good guidelines for order size
üfinding other values such as costs and
cycle lengths
üeasy to implement and automate
üencouraging stability
üeasy to extend, allowing for different
 Economic Order Quantity

Weaknesses:
● takes a simplified view of inventory systems
● assumes demand is known and constant
● assumes all costs are known and fixed
● assumes a constant lead time and no
uncertainty in supplies
● gives awkward order sizes at varying times
● assumes each item is independent of others
 UNCERTAIN DEMAND AND SAFETY STOCK

• The basic economic order quantity

assumes that demand is constant and
known exactly.
• In practice demand can vary widely and
have a lot of uncertainty
• When the variation is small, the EOQ
model still gives useful results, but they are
not so good when demand varies more
widely.
 UNCERTAIN DEMAND AND SAFETY STOCK

• An alternative is to hold additional stocks –

above the expected needs – to add a
margin of safety.

• Higher safety stocks obviously give a

greater cushion against unexpectedly high
demand, and better customer service.
 Inventory Models
Illustration
Inventory on hand & relationships to – EOQ, average
inventory, lead time, reorder point, & order cycle

(Fig. 7.6)
 Inventory Models (Continued)

§ The Quantity Discount Model or price-break model

– Relaxes the constant price assumption by allowing purchase
quantity discounts

– Considers the tradeoff between purchasing in large quantity to

take advantage of the price discount and issuing fewer orders,
against holding higher inventory

– Due to the step-wise shape of the total inventory cost curve, the
optimal order quantity lies on either one of the feasible EOQs or
at the price break point.

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 Inventory Models (Continued)

§ The Economic Manufacturing Quantity Model or

Production Order Quantity Model

– Relaxes the instantaneous replenishment assumption by

allowing usage during production or partial delivery.

– Inventory builds up gradually during the production period rather

than at once as in the EOQ model.

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 Inventory Models (Continued)

§ Economic Manufacturing Quantity Model

– The production rate, P, which can be expressed as Q/TP, is the
production lot size divided by the time required to produce the lot.
�
P=
��
– The maximum inventory, QM, can be obtained by multiplying the
inventory build-up rate with the production period, and can be
expressed as (P – D) × TP.

QM = (P – D) × TP

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 Inventory Models (Continued)

§ The Statistical Reorder Point (ROP)

– The lowest inventory level at which a new
order must be placed to avoid a stock out.

– Demand and delivery lead time are never

certain and require safety stock.

(Maximum daily usage rate x Lead time) + Safety

§ stock= Reorder Point (ROP)

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 Calculate safety stock

ABC Ltd. is engaged in production of tires.

It purchases rims from DEL Ltd. an
external supplier. DEL Ltd. takes 5 days
in manufacturing and delivering an order.
ABC's requires 10,000 units of rims. Its
ordering cost is $2,000 per order and its
carrying costs are $5.30 per unit per year.
The maximum usage per day could be 40
per day. Calculate the safety stock. The
company operates for 350 days a year.
Safety stock = (Max. daily usage – Ave daily usage) x
Lead time

Safety stock [40 - 28.5 (10,000/ 350)] x 5 = 57.5

 Calculate safety stock

• ABC Ltd. is engaged in production of tires.

It purchases rims from DEL Ltd. an external
supplier. DEL Ltd. takes 20 days in
manufacturing and delivering an order.
ABC's requires 24,000 units of rims. Its
ordering cost is $1,500 per order and its
carrying costs are $6 per unit per year. The
maximum usage per day could be 75 per
day. Calculate the safety stock. Operates
350 days a year.
 Example

• A company makes bicycles. It produces

450 bicycles a month. It buys the tires
for bicycles from a supplier at a cost of
$20 per tire. The company’s inventory
carrying cost is estimated to be 15% of
cost and the ordering is $50 per order.
• Calculate the EOQ In this problem:
 Working

• Annual demand
=____________________________

• Ordering cost =
_____________________________

• Carrying cost
=_____________________________
• Annual demand: 2 (tires) x 480 x 12 = 10,800 units

• Ordering cost = $50 per order

• Holding cost = 15% x $20 = $3 per unit

• EOQ = √ ( 2 x 10,800 x 50) ÷ (0.15 x 20) = 600 units

 Work Example
• Bernard Callebaut operates a chocolate shop in
Kensington. The annual demand for chocolate-covered
cherries is 2,500 units. The setup cost is $15 per order.
The holding cost per unit per year is $0.25.

• What is the optimum number of units per order?

• What is the expected number of orders per year?
• Assuming a 250 day working year, what is the expected
time between orders?
• What are the total annual inventory costs?
• If delivery of the chocolates takes 2 days, at what level of
stock should a new order be placed?
 Working

N = D / Q* =

T = Days per year / N =

TC = (D / Q) S + (Q / 2) H =

ROP = dL =
 Working

EOQ = Sq root (2 x 2500 x 15)/ 0.25 = 548

N = D / Q* = 2500/ 548 = 4.5

T = Days per year / N = 250 / 4.5 = 55

TC = (D / Q) S + (Q / 2) H = (2500/ 548) x 15
+ 4.5/2 (0.25)
= 68.4 + 0,56 = 68.9