Inventory System

Independent vs. Dependent Demand

Independent Demand (Demand for the final end-

product or demand not related to other items)

Finished
product
Dependent
Demand
(Derived demand
items for
E(1 component
) parts,
subassemblies,
Component parts raw materials,
etc)
INVENTORY SYSTEM
Inventory is the stock of any item or resource
used in an organization and can include: raw
materials, finished products, component parts,
supplies, and work-in-process
An inventory system is the set of policies and
controls that monitor levels of inventory and
determines what levels should be maintained,
when stock should be replenished, and how
large orders should be
 INVENTORY COSTS
Holding (or carrying) costs
Costs for storage, handling, insurance, etc
Setup (or production change) costs
Costs for arranging specific equipment
setups, etc
Ordering costs
Costs of someone placing an order, etc
Shortage costs
Costs of canceling an order, etc
 Inventory Systems
Single-Period Inventory Model
One time purchasing decision (Example:
vendor selling t-shirts at a football game)
Seeks to balance the costs of inventory
overstock and under stock
Multi-Period Inventory Models
Fixed-Order Quantity Models
Event Triggered (Example: running out of
stock)
Fixed-Time Period Models
Time triggered (Example: Monthly sales call
by sales representative)
 Fixed-order quantity model
also called economic order quantity
(EOQ)
an inventory control model where the
amount requisitioned is fixed and the
actual ordering is triggered by
inventory dropping to a specified level
of inventory
 Fixed-Order Quantity Model
Assumptions

Demand for the product is constant and uniform

throughout the period

Lead time (time from ordering to receipt) is

constant

Price per unit of product is constant

 Fixed-Order Quantity Model
Assumptions
Inventory holding cost is based on average
inventory

Ordering or setup costs are constant

All demands for the product will be satisfied (No

back orders are allowed)
 Basic Fixed-Order Quantity Model and
Reorder Point Behavior
1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
L L
2. Your start using
them up over time. 3. When you reach down to
Time a level of inventory of R,
R = Reorder point
Q = Economic order quantity you place your next Q
L = Lead time sized order.
 Cost Minimization Goal
By adding the item, holding, and ordering costs
together, we determine the total cost curve, which in
turn is used to find the Qopt inventory order point that
minimizes total costs

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Order Quantity (Q)
 Basic Fixed-Order Quantity
(EOQ) Model Formula costTC=Total annual

Total Annual Annual Annual D =Demand

Annual = Purchase + Ordering + Holding C =Cost per unit
Cost Cost Cost Cost Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
L =Lead time

D Q H=Annual holding

TC = DC + S + H and storage cost

per unit of inventory
Q 2
 Deriving the EOQ
Using calculus, we take the first derivative of
the total cost function with respect to Q,
and set the derivative (slope) equal to zero,
solving for the optimized (cost minimized)
value of Qopt
2D S 2(A nnual D em and)(O rder or Setup Cost)
Q O PT = =
H A nnual H olding Cost
_
We also need a R eo rd er p o in t, R = d L
reorder point to
tell us when to _
d = average daily demand (constant)
place an order L = Lead time (constant)
 EOQ Example (1) Problem Data

Given the information below, what are the EOQ and

reorder point?

Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
 EOQ Example (1) Solution
2D S 2(1,000 )(10)
Q O PT = = = 89.443 units or 90 units
H 2.50

1,000 units / year

d = = 2.74 units / day
365 days / year

_
R eorder point, R = d L = 2.74units / day (7days) = 19.18 or 20 u n its

In summary, you place an optimal order of 90 units. In

the course of using the units to meet demand, when
you only have 20 units left, place the next order of 90
units.
 EOQ Example (2) Problem Data
Determine the economic order quantity
and the reorder point given the following

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost per
unit
Lead time = 10 days
Cost per unit = $15
 EOQ Example (2) Solution
2D S 2 (1 0 ,0 0 0 )(1 0 )
Q OPT = = = 3 6 5 .1 4 8 u n its, o r 3 6 6 u n its
H 1 .5 0

10,000 units / year

d= = 27.397 units / day
365 days / year

_
R = d L = 27.397 units / day (10 days) = 273.97 or 274 u n its

Place an order for 366 units. When in the course of

using the inventory you are left with only 274 units,
place the next order of 366 units.
 Economic Production Quantity (EPQ)

Production done in batches or lots

Capacity to produce a part exceeds the
parts usage or demand rate
Assumptions of EPQ are similar to EOQ
except orders are received
incrementally during production
 Assumptions:
Only one item involved
Annual demand is known
The usage rate is constant
Usage occurs continually, but
production occurs periodically
The production rate is constant
Lead time does not vary
There are no quantity discounts
Economic Production Quantity
Model
 Formulas:
No. of runs per year = D/Q
Annual setup cost = (D/Q)S
TCmin = Carrying Cost + Setup Cost = ( )H+(D/Qo)S
Qo = ; where p = production rate
u = usage rate

Cycle Time =
Run Time =
Imax = (p-u) and
Iaverage =
 Example 1
A toy manufacturer uses 48,000 rubber wheels
per year for its popular dump truck series. The
firm makes its own wheels, which it can
produce at a rate of 800 per day. The toy trucks
are assembled uniformly over the entire year.
Carrying cost is $1 per wheel a year. Setup cost
for a production run of wheels is $45. The firm
operates 240 days per year.
Determine the
a.Optimal run size.
b.Minimum total annual cost for carrying
and setup.
c.Cycle time for the optimal run size.
d.Run time.
 Given:

D = 48,000 wheels per year

S = $45
H = $1 per wheel per year
p = 800 wheels per day
u = 48,000 wheels per 240 days, or 200
wheels per day
Solution:

a. Qo =

Qo = 2,400 wheels

b. TCmin = ( )H+(D/Qo)S
Thus, you must first compute Imax:
Imax = (p-u) = 2,400/800*(800-200) = 1,800 wheels
TC = (1,800/2)($1) + (48,000/2,400)($45) = $1,800
c. Cycle Time = = 12 days

Thus, a run of wheels will be made every 12 days.

d. Run Time = = 3 days

Thus, each run will require 3 days to complete.

 Example 2
The Dine Corporation is both a producer & a user of
brass couplings. The firm operates 220 days a year &
uses the couplings at a steady rate of 50 per day.
Couplings can be produced at a rate of 200 per day.
Annual storage cost is $2 per coupling, & machine setup
cost is $70 per run.

a.Determine the economic run quantity.

b.Approximately how many runs per year will there be?
c.Compute the maximum inventory level.
Solution
a. Qp = =

1,013 units

b. No. of runs = D = 11,000 = 10.86 11

per year Q0 1,013

c. Imax = Qp (p - u) = 1,013 (200 - 50)

p
Imax = 759.75 or 760 units
 Quantity Discounts
Quantity Discounts, also called Price-Break
Models, are price reductions for large orders
offered to costumers to induce them to buy in
large quantities.
The buyer must weigh the potential benefits
of reduced purchase price and fewer orders
that will result from buying in large quantities
against the increase in carry costs caused by
higher average inventories.
 Quantity Discounts

The buyers goal with quantity discounts is to select

the order quantity that will minimize total cost.

Total cost is the sum of carrying cost, ordering cost

and purchasing cost.
 Price-Break Model Formula
Based on the same assumptions as the EOQ model,
the price-break model has a similar Qopt formula:

2DS 2(Annual Demand)(Or der or Setup Cost)

Q OPT = =
iC Annual Holding Cost

i = percentage of unit cost attributed to carrying inventory

C = cost per unit

Since C changes for each price-break, the formula

above will have to be used with each price-break cost
value
Total Cost = Carrying Cost + Ordering Cost + Purchasing Cost

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

Where:
Q = Quantity P = Unit Price
D = Demand
S = Ordering Cost
 Example1
A company has a chance to reduce their inventory
ordering costs by placing larger quantity orders using
the price-break order quantity schedule below. What
should their optimal order quantity be if this company
purchases this single inventory item with an e-mail
ordering cost of $4, a carrying cost rate of 2% of the
inventory cost of the item, and an annual demand of
10,000 units?
Order Quantity(units) Price/unit($)
0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
Solution
First, plug data into formula for each price-break value of C
Annual Demand (D)= 10,000 units Carrying cost % of total cost (i)= 2%
Cost to place an order (S)= $4 Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 2499, the 2DS 2(10,000)( 4)

Qopt value is feasible Q OPT = = = 1,826 units
iC 0.02(1.20)
Interval from 2500-3999, the 2DS 2(10,000)(4)
Qopt value is not feasible Q OPT = = = 2,000 units
iC 0.02(1.00)
Interval from 4000 & more, the 2DS 2(10,000)(4)
Qopt value is not feasible Q OPT = = = 2,020 units
iC 0.02(0.98)
Solution
Since the feasible solution occurred in the first price-
break, it means that all the other true Qopt values occur
at the beginnings of each price-break interval. Why?

Because the total annual cost function is

Total a u shaped function
annual
costs So the candidates
for the price-
breaks are 1826,
2500, and 4000
units

0 1826 2500 4000 Order Quantity

Solution
Next, we plug the true Qopt values into the total cost
annual cost function to determine the total cost under
each price-break

D Q
TC = DC + S+ iC
Q 2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
= $12,043.82
TC(2500-3999)= $10,041
TC(4000&more)= $9,849.20

Finally, we select the least costly Qopt, which is this

problem occurs in the 4000 & more interval. In summary,
our order quantity is 4000 units
 Example2
Consider the following case, where
D = 10,000 units (annual demand)
i = 20% of cost (annual carrying cost, storage, interest,
obsolescence, etc.)
S = $20 to place an order
C = Cost per unit (according to order size; 0-499 units,
$5 per unit; 500-999, $4.5 per unit; 1,000 and up, $3.9
per unit)

What quantity should be ordered?

Solution
First, plug data into formula for each price-break value of C

Annual Demand (D)= 10,000 units Carrying cost % of total cost (i)= 20%
Cost to place an order (S)= $20 Cost per unit (C) = $5, $4.5, $3.9

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 499, the Qopt 2DS 2(10,000)(20)

Q OPT = = = 632.46 units
value is feasible iC 0.2(5)

Interval from 500-999, the Qopt 2DS 2(10,000)(20)

Q OPT = = = 666.67 units
value is not feasible iC 0.2(4.50)

Interval from 1000 & more, the 2DS 2(10,000)( 20)

Qopt value is not feasible Q OPT = = = 716.11 units
iC 0.2(3.90)
Solution
Next, we plug the true Qopt values into the total cost
annual cost function to determine the total cost under
each price-break

D Q
TC = DC + S+ iC
Q 2
TC(0-499) = (10000*5)+(10000/634)*20+(634/2)(0.2*5)
= $50,632.46
TC(500-999) = $45,600
TC(1000&more) = $39,590

Finally, we select the least costly Qopt, which in this

problem occurs in the 1000 & more interval. In summary,
our order quantity is 1000 units
 ABC Classification System
Divides inventory into three classes based on
annual dollar volume
Class A - high annual dollar volume
Class B - medium annual dollar volume
Class C - low annual dollar volume
Used to establish policies/controls that focus on
the few critical parts and not the many trivial
ones
 ABC Classification System
A (Very Important Items)
Account for 10%-20% of the number of items in inventory
60%-70% of the dollar inventory of an inventory
B (Moderately Important)
Account for 20%-30% of the number of items in inventory
20%-50% of the dollar inventory of an inventory
C (Least Important)
Account for 50%-60% of the number of items in inventory
10%-15% of the dollar inventory of an inventory
 ABC Classification System
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

 ABC Classification System
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

 Example 1
The annual dollar value of 12 items has
been calculated according to annual
demand and unit cost. The annual dollar
values were then arrayed from highest to
lowest to simplify classification of items.
 Example 1
Annual Annual
Item Unit
(in units) x = Dollar Percentage Classification
Number Cost ($)
Demand Value ($)
8 1,000 4,000 4,000,000 40.06% A
5 3,900 700 2,730,000 27.34% A
3 1,900 500 950,000 9.52% B
6 1,000 915 915,000 9.16% B
1 2,500 330 825,000 8.26% B
4 1,500 100 150,000 1.50% C
12 400 300 120,000 1.20% C
11 500 200 100,000 1.00% C
9 8,000 10 80,000 0.80% C
2 1,000 70 70,000 0.70% C
7 200 210 42,000 0.42% C
10 900 2 1,800 0.02% C
9,983,800 100%
Example 1
 Example 2
The manager of an automobile repair shop
hopes to achieve a better allocation of control
efforts by adopting an ABC approach to
inventory control. Given the monthly usages in
the following table, classify the items in A, B,
and C categories according to dollar usage.
 Example 2
Usage Unit Monthly
Item Percentage Classification
(units) Cost ($) value ($)
1 50 1,400 70,000 35.18% A
2 300 12 3,600 1.81% C
3 40 700 28,000 14.07% B
4 150 20 3,000 1.51% C
5 10 1,020 10,200 5.13% C
6 80 140 11,200 5.63% C
7 2,000 15 30,000 15.08% B
8 400 20 8,000 4.02% C
9 7,000 5 35,000 17.59% B
199,000 100%
Exercise #8
Kindly answer the following problems from the
OM book of Stevenson and Chuong:
pp.599-601: #s 1, 2 (disregard b and c), 3, 4, 9,
10, 13, 14, 15 and 16
Answer the exercise during your comp lab
hours. Write your answers in one whole sheet
of yellow paper and submit it to your Comp
Lab professor afterwards.

PS: The items above were only chosen from the various
sample problems from the OM book. This does not stop you
from answering other items that are available.