RB/OR/INV/CN/1

Inventory Control Models

Inventories may be defined as a stock of idle resources of any kind having
an economic value.
Could be in the form of physical resources viz. RM, SFG, FG, human
resources -e.g. labor, and financial resources- e.g. working capital.
Inventories represent amounts of tied up capital usually 25 -60% of Total
Assets
Insufficient inventories hamper production, smooth functioning while
excessive inventories adversely affect production, cash flows and
liquidity
Why to use inventories?
1. Inventories smooth out time gap between supply and demand
2. Holding inventory may contribute to lower production costs
(produce in bulk)
3. Inventories provide a way of storing labor
4. Inventory can provide quick customer service (convenience)
Principle categories of inventory
1. Process (or Pipeline) inventories
2. Lot Size (or Cycle) inventories
Reasons (Economy of scale, Technological requirements)
3. Seasonal inventories
4. Safety (or buffer) Stocks
5. Decoupling inventories
a. Raw materials and component parts

RB/OR/INV/CN/2

b. Work in process inventories

c. Finished Goods inventories
d. Spare parts inventory

Reasons for Carrying inventories

1. Smooth production
2. Customer Satisfaction
3. Delayed Deliveries and uncertainties
4. Financial gains
Inventory Control
Basic Objective of inventory control is to release capital for more productive
use.
For every type of item held in inventory, two questions must be asked:
1. When to order ( When should a replenishment order be placed)
2. How much to order (what is the order quantity Q)?
Answer: The EOQ Model!
Tradeoffs
Ordering More Frequently vs. Ordering Less Frequently
Higher ordering costs vs. Lower ordering costs
Smaller average inventory vs. larger average inventory

RB/OR/INV/CN/3

FACTORS INVOLVED IN INVENTORY ANALYSIS

1. Inventory related costs
1.

Purchase (or production) costs

2.

Ordering (or Setup) costs

3.

Carrying (or Holding) costs

4.

Shortage (or Stock out ) costs

Total cost = Purchase + Ordering + Carrying + Shortage

2. Demand
Customer's demand, size of demand, rate of demand and pattern
of demand is important
Size of demand = no. of items demanded per period
Can be deterministic (Static or dynamic) or probabilistic
(governed by discrete or continuous probability distribution)
The rate of demand can be variable or constant
Pattern reflects items drawn from inventory -instantaneous (at
beginning or end) or gradually at uniform rate

RB/OR/INV/CN/4

3. Order Cycle
The time period between placements of two orders having two
types of review systems:
Continuous review
Periodic review

4. Time Horizon
The period over which inventory level will be controlled ...can
be finite or infinite.

5. Lead Time
The time between ordering a replenishment and receiving into
inventory ...can be deterministic- constant or variable or
probabilistic

6. Stock Replenishment
The rate at which items are added to the inventory... an be
instantaneous or uniform rate
THE BASIC DETERMINISTIC INVENTORY MODELS
1. EOQ Model with Uniform Demand
2. EOQ Model with Different rates of Demands in different cycles
3. EOQ Model with Shortages (backorders) allowed
4. EOQ Model with Uniform Replenishment

RB/OR/INV/CN/5

Notations used
Q = No of units (or quantity) ordered per order
D = Demand of units of inventory per year
N= No. of orders per year
TC = Total inventory cost (Birr / year)
Co = Ordering cost per order
Ch= Carrying or holding cost per unit per period of time (Birr/year)
Cs = Shortage cost , per unit of inventory or as % of Av. inventory
R = Reorder Point
L = Lead time (weeks or month etc.)
t = Reorder Cycle (fractional part of standard time)
rp = Replenishment (or production) rate at which lot size Q is added to the
inventory
Until stated otherwise, we generally assume a standard time horizon of 1
year.

Model 1- EOQ Model with Uniform Demand

Policy:

Whenever the inventory level is 0, order Q items

Objective: Choose a Q that will minimize total Inventory Cost

RB/OR/INV/CN/6

The behavior of inventory at hand with respect to time is

illustrated below:

EOQ Model with Uniform Demand

Inv.
Level

Q
Average Inv.
Level

Time

The inventory costs are determined as follows

1. Ordering cost = No. of orders per year X Co

RB/OR/INV/CN/7

= N x Co
= (Total Annual Demand / Quantity ordered) x Co
= D/Q x Co
2. Carrying Cost = Average units in inventory x Ch
= Q/2 x Ch
TC = D/Q x Co + Q/2 x Ch
For lowest TC ... Ordering cost = Carrying cost
Therefore, D/Q x Co = Q/2 x Ch
or Q2 = 2 D Co / Ch
Thus Optimal Q* (EOQ) =

2 DCo / Ch

Characteristic of Model 1
1. Optimum number of orders per year
N* = yearly demand / optimal order quantity
= D/ Q*
=D/
=

2 DCo / Ch

DCh / 2Co

Optimum length of time between orders T* = Total Time horizon / optimal

no. of orders

= T/ N* = T /

DCh / 2Co

2. Minimum total yearly inventory cost

TC*

= D/Q* x Co + Q*/2 x Ch

2CoT 2 / DCh

RB/OR/INV/CN/8

2 DCoCh

If the carrying cost is given as % terms, then Ch = I x P

EOQ Assumptions:
1. Single product with a constant and known demand rate
2. Goods arrive the same day they are ordered
3. No shortages allowed: reorder when inventory reaches 0
4. Lead time is zero

Model 2- EOQ Model with Different Rates of Demand

Assumptions of this model are same as those of model 1 except
Demand rate is different in different cycles. The total demand D is
specified as demand during time horizon T
Thus , Ordering Cost = D/Q Co
Carrying cost = Q/2 Ch T
TC = D/Q Co + Q/2 Ch T
1. Q* (EOQ ) = 2 DCo / TCh
2. The minimum total yearly inventory Cost =

( 2 DCoCh / T )

RB/OR/INV/CN/9

Model -3 EOQ Model with Shortages (backorders) allowed

Assumptions of this model are same as those of model 1 except
Shortages are allowed and shortages may occur regularly.

Cost of shortage is assumed to be directly proportional to the

number of units short

The behavior of inventory at hand with respect to time is illustrated

below:

Inv.
Level

M
Q

S
Time

EOQ Model with Shortages

Additional variable needed to be defined here are:
S = Maximum shortage per order ( back order quantity)
M = Maximum inventory level (Q-S)
t1 = Time during which there is a shortage and back orders occurs
t2= Time during which stock is available
t = Time between receipt of orders

RB/OR/INV/CN/10

(Reorder cycle time t = t1 + t2)

TC = Ordering cost (Co)+ Carrying cost (Ch) + Shortage Cost (Cs)

Ordering cost

= D/Q Co

Carrying cost

= M/2 t2 Ch
= M/2 (M/Q.t) Ch
= (M2/ 2Q) t Ch

Shortage Cost

= Average no. of units short

x Time of shortage per cycle
x Shortage cost per unit per time period
= S/2 t1 Cs
= S/2 (St/Q)Cs
= (S2/2Q) t Cs

Annual Shortage cost having N such periods

= (S2/2Q) t Cs x N
= (S2/2Q) Cs (since Nt = 1)
= ((Q-M)2/ 2Q) Cs
TC (Q, M) = D/Q Co + (M2/ 2Q) t Ch + ((Q-M)2/ 2Q) Cs
The optimal value of TC (Q,M) can be obtained by solving equation for
optimal value of both which gives:
Q* =

2 DCo Ch Cs
)(
)
Ch
Cs

RB/OR/INV/CN/11

M* =

2 DCo
Cs
)(
)
Ch
Ch Cs

Characteristics of Model 3
1. Time between receipt of orders (When to order)
t* = Q*/D =

2Co Ch Cs
)(
)
DCh
Cs

2. The total optimal inventory cost

TC* =

2 DCoCh (

Cs
)
Cs Ch

3. Reorder Level R = Q* - M*
=

Q * (1 -

Cs
)
Cs Ch

RB/OR/INV/CN/12

Model 4 EOQ Model with Uniform Replenishment

The objective of this model is to determine optimal production lot size Q*.
For this model it is assumed that Production begins immediately after production set up.
Production ends when lot size of production run is reached.
rd = demand rate in units per time period
rp = production rate (or replenishment) rp > rd
Shortages are not allowed
tp = length of each production run size

The behavior of inventory at hand with respect to time is illustrated

below:

RB/OR/INV/CN/13

Max
Inv.
Level

tp (rp- rd)

rp- rd

Inv.
Level

rd

r
Q
(1 d
2
rp

Average Inv.
tp
t

Production -to - Inventory Model with Uniform Replenishment

If Q is the number of units produced per order cycle, then the time of a
production run is
tp = Q / rp
Inventory building rate is rp- rd
Hence the Maximum inventory level - tp (rp- rd)
Average inventory = tp (rp- rd) / 2
=

Q
)(rp - rd)
2rp

rd
Q
)
) (1
rp
2

In this case setup cost is analogous to ordering costs, ie. number of setups
times the setup cost per production run

RB/OR/INV/CN/14

Set up Cost = (D/Q) Co

Carrying Cost =

TC = (D/Q ) Co +

rd
Q
)
) (1
rp Ch
2
(

rd
Q
)
) (1
rp Ch
2

Which leads to
Q* =

rp
2 DCo
)(
)
Ch
rp rd

Characteristics of Model -4
1. Optimal number of Production runs per year
N* = D/Q*
=D/

rp
2 DCo
)(
)
Ch
rp rd
DCh( r p rd )
2Cor p

2. Length of each lot size production run

tp = Q*/ rp
=

rp
2 DCo
)(
)
Ch
rp rd

/ rp

RB/OR/INV/CN/15

2 DCo
)
Chr p ( rp rd )

3. The total minimum production inventory cost

TC* =

2 DCoCh(1

rd
)
rp