Management Science:

Operations Research(OR)

Chapter 10
INVENTORY MODELS

24-01-13 Lecture 1
10.4 The EOQ with Backorders
 When allowing backorders, so that IN may
become negative, in the sense that
unsatisfied demand is recorded or
“backordered,” and satisfied immediately
upon replenishment of the inventory.

 Shortage cost cs per unit and per period.

24-01-13 Lecture 2
 The net inventory level will be as in the figure
below, where S denotes the amount of the
maximal shortage.
 The maximal inventory directly after
replenishment is Q  S, as the stockouts are
satisfied first before new inventory is built up.

24-01-13 Lecture 3
 Here, t1 denotes the length of time during
which the net inventory IN is nonnegative
(there is no stockout); t2 denotes the
length of time during which there is no
stock at hand; t1 + t2 = tc. We find that t1/t2
= (Q − S)/S.
24-01-13 Lecture 4
Cost function
 The costs now include ordering and
holding costs as before, and also
shortage costs.

 The annual ordering costs are coD/Q.

24-01-13 Lecture 5
 For carrying costs, we find that the average inventory
level is obtained by averaging the inventory level when
no stockouts occur, which is ½(Q−S) during the time t1,
while the inventory level during the time stockouts
occur is zero for the duration t2. After some
calculations, this leads to inventory holding costs of
(Q  S ) 2
ch .
2Q
24-01-13 Lecture 6
 The average annual shortage is ½S during the time t2,
when we have shortages; this leads to total shortage
2
S
costs of cs .
2Q

24-01-13 Lecture 7
 The total inventory costs are

D (Q  S ) 2 S2
TC(Q, S) = co  ch  cs .
Q 2Q 2Q

Using partial derivatives, the total inventory costs are

minimized for
2 Dco ch  cs
Q*  &
ch cs

2 Dco ch ch
S*  = Q *.
c s ch  c s ch  c s

24-01-13 Lecture 8
Example
Demand of D = 800 car battery chargers per
year, co = $100 and the holding cost is ch =
$4 per charger per year. The unit shortage
costs of cs = $6 per unit.

 (1) What is the optimal order size and

shortage?
 (2) What is the optimal total ordering cost?

24-01-13 Lecture 9
Solution
The optimal order quantity is
2(800)(100) 4  6
Q* = 258.20 units,
4 6
The optimal shortage is
ch
S*  Q * 103.28
ch  c s

The total costs are

TC(Q*, S*) = 309.84 + 185.90 + 123.94 = $619.68.

24-01-13 Lecture 10
10.5 The EOQ with Quantity Discounts
 With the unit purchasing cost p constant
and independent of the order size Q, the
sum of ordering, holding, and purchasing
costs is
TC(Q, p) = coD/Q + ½chQ + pD
In practice, many suppliers offer incentives
for purchases of larger quantities in the
form of lower unit costs. Here we assume
that there are three price levels, the
original non-discounted price and two
discount levels.
24-01-13 Lecture 11
The unit holding cost ch is redefined as a proportion of
the unit purchasing price p, and the economic order
quantity becomes

2 Dco
Q*  .
ch p

The given (non-discounted) price level is p0, the price

with the small discount p1, and the price with the large
discount p2, so that p0 > p1 > p2. To obtain the lower
price of p1, we have to purchase at least a quantity Q1
and to get the even cheaper price p2, we must order at
least Q2 units where Q2 > Q1.

24-01-13 Lecture 12
Now we have a cost function for each of the price
levels as shown in the figure below.

The cost functions are TC(p0), TC(p1), and TC(p2), and

the dots indicate their optimal points.
24-01-13 Lecture 13
Example
 Annual demand is D=10,000 footballs with
purchasing costs of $2 per football,
 holding cost of 5% (2*0.05=0.1)of the price
per football and year;
 cost of placing an order is Co= $80.
 There is a ½% discount for orders of at
least 6,000 units(2*99.5%), and a 1%
discount for orders of at least 15,000 units
(2*99%).

24-01-13 Lecture 14
24-01-13 Lecture 15
24-01-13 Lecture 16
24-01-13 Lecture 17
10.6 The Production Lot Size Model
 In batch or intermittent production a
production run can be considered an
order, with the production run size
corresponding to the order size Q, and the
production setup cost corresponding to
the ordering costs co.

 Total setup costs are then co(D/Q).

24-01-13 Lecture 18
inventory on
hand
maximum
inventory level

tr td time

 For carrying costs, consider the

production phase tr (when production and
demand occur) and the demand phase td
(when demand but no production occurs)
separately.
24-01-13 Lecture 19
 inventory on
hand
maximum
inventory level

tr td time
 In the production phase, inventory
accumulates at the rate of (r−d), and since
the production phase lasts for tr = Q/r, the
maximal level of inventory at the end of
each production run is (r−d)Q/r.
24-01-13 Lecture 20
inventory on
hand
maximum
inventory level

tr td time

During the demand phase, the inventory

starts at (r−d)Q/r and linearly decreases to
zero at a rate of d. The average inventory
level during the entire cycle of duration tc
= tr + td is then ½ (r−d)q/r.
24-01-13 Lecture 21
 The total carrying cost per period is
½ch(r−d)Q/r.
 The total production- and inventory-
related costs are then
 TC = coD/Q + ½ch(r−d)Q/r

24-01-13 Lecture 22
inventory on
hand
maximum
inventory level

tr td time

We find TC ' = −coD/Q2 + ½ch(r−d)/r and the unique

optimal lot size of

2 Dco r
Q* 
ch r  d

24-01-13 Lecture 23
Example: A plant faces an annual demand of 200,000
bottles. It can produce them at a rate of 1,000 bottles
per day during each of the 300 working days in a year.
Setup costs for a production run are $1,000, and each
bottle has a carrying cost of 10¢ per bottle and year.

2(200,000)(1,000) 1,000
Q*= 109,545 bottles.
0.10 1,000  666.67

The corresponding costs are TC(Q*) = $3,651.50.

24-01-13 Lecture 24