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Keywords, Notations Often Used for the Modeling and Analysis Tools
for Inventory Control
Manish Kumar,
Department of Business Administration (LUMBA), University of Lucknow.
Term Paper: EOQ & EPQ
2
Demand rate: A constant rate at which the product is withdrawn from
x inventory
Ordering cost: It is a fixed cost of placing an order independent of the
C1 amount ordered.
Set-up cost
Holding cost: This cost usually includes the lost investment income
C2 caused by having the asset tied up in inventory. This is not a
real cash flow, but it is an important component of the cost of
inventory. If P is the unit price of the product, this component
of the cost is often computed by iP, where i a percentage
that includes opportunity cost, allocation cost, insurance, etc.
It is a discount rate or interest rate used to compute the
inventory holding cost.
Shortage cost: There might be an expense for which a shortage occurs.
C3
Backorder This cost includes the expense for each backordered item. It
cost: C4 might be also an expense for each item proportional to the
time the customer must wait.
It is the time interval between when an order is placed and
Lead time: L
when the inventory is replenished.
The widely used deterministic and probabilistic models are presented
in the following sections.
The Classical EOQ Model: This is the simplest model constructed
based on the conditions that goods arrive the same day they are ordered
and no shortages allowed. Clearly, one must reorder when inventory
reaches 0, or considering lead time L
The following figure shows the change of the inventory level with
time:
Manish Kumar,
Department of Business Administration (LUMBA), University of Lucknow.
Term Paper: EOQ & EPQ
The figure shows time on the horizontal axis and inventory level on the
vertical axis. We begin at time 0 with an order arriving. The amount of
the order is the lot size, Q. The lot is delivered all at one time causing
the inventory to shoot from 0 to Q instantaneously. Material is
withdrawn from inventory at a constant demand rate, x, measured in
units per time. After the inventory is depleted, the time for another
order of size Q arrives, and the cycle repeats.
The inventory pattern shown in the figure is obviously an abstraction
of reality in that we expect no real system to operate exactly as shown.
The abstraction does provide an estimate of the optimum lot size,
called the economic order quantity (EOQ), and related quantities. We
consider alternatives to those assumptions later on these pages.
Ordering Holding
Total Cost
C1x/Q + C2/(2Q)
=
The Optimal Ordering Quantity = Q* = (2xC1/C2) 1/2, therefore,
The Optimal Reordering Cycle = T* = [2C1/(xC2)]1/2
Numerical Example 1: Suppose your office uses 1200 boxes of typing
paper each year. You are to determine the quantity to be ordered, and
how often to order it. The data to consider are the demand rate x =
1200 boxes per year; the ordering cost C1 = $5 per order; holding cost
C2 = $1.20 per box, per year.
The optimal ordering quantity is Q* = 100 boxes, this gives number of
orders = 1200/100 = 12, i.e., 12 orders per year, or once a month.
Notice that one may incorporate the Lead Time (L), that is the time
interval between when an order is placed and when the inventory is
replenished.
Manish Kumar,
Department of Business Administration (LUMBA), University of Lucknow.
Term Paper: EOQ & EPQ
4
Models with Shortages: When a customer seeks the product and finds
the inventory empty, the demand can be satisfied later when the
product becomes available. Often the customer receives some discount
which is included in the backorder cost.
A model with backorders is illustrated in the following figure:
Manish Kumar,
Department of Business Administration (LUMBA), University of Lucknow.
Term Paper: EOQ & EPQ
Q* = (2xC1/C2)1/2, with S* = 0.
5
However, if shortage cost C3 = 0, the above optimal decision values
will reduce to:
Q* = [2xC1(C2 + C4)/(C2C4)]1/2, and , S* = [2xC1C2/(C2C4 + C42)]1/2
Numerical Example 2: Given C3 = 0, and C4 = 2 C2, would you choose
this model? Since S* = Q*/3 under this condition, the answer is, a
surprising "Yes". One third of orders must be back-ordered.
Numerical Example 3: Consider the numerical example no. 1 with
shortage cost of C4 = $2.40 per unit per year.
The optimal decision is to order Q* = 122 units, allowing shortage of
level S = 81.5 units.
Rather than the lot arrives instantaneously, the lot is assumed to arrive
continuously at a production rate K. This situation arises when a
production process feeds the inventory and the process operates at the
rate K greater than the demand rate x.
The maximum inventory level never reaches Q because material is
withdrawn at the same time it is being produced. Production takes
place at the beginning of the cycle. At the end of production period, the
inventory is drawn down at the demand rate x until it reaches 0 at the
end of the cycle.
Ordering Holding
Manish Kumar,
Department of Business Administration (LUMBA), University of Lucknow.
Term Paper: EOQ & EPQ
(K-x)QC2/
Total Cost = xC1/Q + 6
(2K)
Optimal Run Size Q* = {(2C1xK)/[C2(K - x)] }1/2
Run Length = Q*/K
Depletion Length = Q*(K-x)/(xK)
Optimal Cycle T* = {(2C1)/[C2x(1 - x/K)] }1/2
Numerical Example 3: Suppose the demand for a certain energy saving
device is x = 1800 units per year (or 6 units each day, assuming 300
working days in a year). The company can produce at an annual rate of
K = 7200 units (or 24 per day). Set up cost C1 = $300. There is an
inventory holding cost C2 = $36 per unit, per year. The problem is to
find the optimal run size, Q.
Q* = 200 units per production run. The optimal production cycle is
200/7200 = 0.0278 years, that is 8 and 1/3 of a day. Number of cycle
per year is 1800/200 = 9 cycles.
You may like using Inventory Control Models JavaScript for checking
your computation. You may also perform sensitivity analysis by means
of some numerical experimentation for a deeper understanding of the
managerial implications in dealing with uncertainties of the parameters
of each model
Further Reading:
Zipkin P., Foundations of Inventory Management,
McGraw-Hill, 2000.
Manish Kumar,
Department of Business Administration (LUMBA), University of Lucknow.
Term Paper: EOQ & EPQ
8
The Optimal Ordering Quantity:
Q* = (2xC1/C2) 1/2 = [ 2(2500)(200)/190] 1/2 = 72.5 units.
The total cost is = [(2500)(200)/72.5] + [(190)(72.5)/2] + [(1100)(200)]
= $233784
The total cost for ordering quantity Q = 90 units is:
TC(90) = [(2500)(200)/90] + [(190)(90)/2] + [(900)(200)] = $233784,
this is the lowest total cost order quantity.
Therefore, should order Q = 90 units
Manish Kumar,
Department of Business Administration (LUMBA), University of Lucknow.