Chapter 2: Constant and Time Varying

Demand
¨ Costs in inventory models

¨ Economic order quantity (EOQ)

- Optimal Order Quantity, Reorder point.

- Safety stock

- Discount

¨ Planned shortage models

 1. Type of Costs in
Inventory Models
¨ Inventory analyses can be thought of as cost-control
techniques.

¨ Categories of costs in inventory models:

- Holding (carrying costs)

- Order/ Setup costs

- Customer satisfaction costs

- Procurement/Manufacturing costs
 Type of Costs in
Inventory Models
Holding Costs (Carrying costs): depend on the order size
¨ Cost of capital
¨ Storage space rental cost
¨ Costs of utilities
¨ Labor
¨ Insurance
¨ Security
¨ Theft and breakage
¨ Deterioration or Obsolescence
 Type of Costs in
Inventory Models
Order/Setup Cost: is independent of the order size.
¨ Order costs are incurred when purchasing a good from a
supplier. They include costs such as
- Telephone
- Order checking
- Labor
- Transportation
¨ Setup costs are incurred when producing goods for sale
to others. They can include costs of
- Cleaning machines
- Calibrating equipment
- Training staff
 Type of Costs in
Inventory Models
Customer Satisfaction Costs
¨ Measure the degree to which a customer is satisfied.
¨ Unsatisfied customers may:
- Switch to the competitors (lost sales).
- Wait until an order is supplied.
¨ When customers are willing to wait there are two types of costs
incurred:
 Type of Costs in
Inventory Models
Procurement/Manufacturing Cost
¨ Represents the unit purchase cost (including transportation)
in case of a purchase.
¨ Unit production cost in case of in-house manufacturing
 2. Economic Order Quantity
(EOQ) Model - Assumptions
¨ Demand occurs at a known and reasonably constant rate.
¨ The item has a sufficiently long shelf life.
¨ The item is monitored using a continuous review system.
¨ All the cost parameters remain constant forever (over an infinite
time horizon).
¨ A complete order is received in one batch (instantaneously).
 The EOQ Model –
Inventory Profile
The constant environment described by the EOQ assumptions
leads to the following observation:

¨ The optimal EOQ policy consists of same-size orders.

¨ This observation results in the following inventory profile :

 2.1. Cost Equation for the
EOQ Model
¨ Let is the order quantity or lot size

total annual total annual total annual total annual

inventory cost holding cost ordering cost procurement cost
 Costs in the EOQ Model
cost
total cost ost
c
ld ing
ho
al
tot

at the optimal order size

total holding costs and ordering costs
are equal

total ordering cost

Order quantity
 Sensitivity Analysis in
EOQ Models

cost The curve is reasonably flat around

Deviations from the optimal order size

cause only small increase in the total cost.

Order quantity
 Cycle Time
¨ The cycle time, T, represents the time that elapses between
the placement of orders.

¨ Note, if the cycle time is greater than the shelf life, items will
go bad, and the model must be modified.
 Number of Orders per Year

¨ To find the number of orders per years, take the reciprocal of the cycle time

Example: The demand for a product is 1000 units per year.

The order size is 250 units under an EOQ policy.
¨ How many orders are placed per year? N = 1000/250 = 4 orders.

¨ How often orders need to be placed (what is the cycle time)?

T = 250/1000 = ¼ years. {Note: the four orders are equally spaced}.
 Lead Time and Reorder Point

¨ In reality, lead time L always exists, and must be accounted

for when deciding when to place an order.
¨ The reorder point, R, is the inventory position when an order
is placed.
¨ R is calculated by:

¨ L and D must be expressed in the same time unit.

 Lead Time and Reorder Point –
Graphical demonstration: Short Lead Time

R = Inventory at hand at the beginning of lead time

reorder point

in
ve
nt
or
y
po
sit
io
n
place the order now
 Lead Time and Reorder Point –
Graphical demonstration: Long Lead Time

outstanding
order

place the order now

 2.2. Safety Stock
¨ Safety stocks act as buffers to handle:

- Higher than average lead time demand.

- Longer than expected lead time.

¨ With the inclusion of safety stock (SS), R is calculated by

¨ The size of the safety stock is based on having a desired service level.
 Safety Stock

reorder point

place the order now

 Safety Stock

reorder point

The safety stock

place the order now prevents excessive
shortages.
 Inventory Costs
Including Safety Stock

total annual total annual total annual total annual safety stock
inventory cost holding cost ordering cost procurement holding cost
cost
 ALLEN APPLIANCE
COMPANY (AAC)
¨ AAC wholesales small appliances.
¨ AAC currently orders 600 units of the Citron brand juicer
each time inventory drops to 205 units.
¨ Management wishes to determine an optimal ordering policy
for the Citron brand juicer
 ALLEN APPLIANCE
COMPANY (AAC)
Data
¨ Co = $12 ($8 for placing an order) + (20 min. to check)($12 per hr)
¨ C = $10.
¨ H = 14% (10% ann. interest rate) + (4% miscellaneous)
¨ Ch = $1.40 [HC = (14%)($10)]
¨ D = demand information of the last 10 weeks was collected:

Sales of Juicers over the last 10 weeks

Week 1 2 3 4 5
Sales 105 115 125 120 125
Week 6 7 8 9 10
Sales 120 135 115 110 130
 ALLEN APPLIANCE
COMPANY (AAC)
Data
¨ The constant demand rate seems to be a good assumption.
¨ Annual demand = (120/week)(52weeks) = 6240 juicers.
 AAC – Solution:
EOQ and Total Variable Cost

¨ Current ordering policy calls for Q = 600 juicers.

TV( 600) = (600/2)($1.40) + (6240 / 600)($12) =$544.8

TV is total variable cost

¨ The EOQ policy calls for orders of size:

TV(327) = (327 / 2)($1.40) + (6240 / 327) ( $12) = $457.89

Savings of 16% is achieved by applying the EOQ solution.

 AAC – Solution:
Reorder Point and Total Cost

¨ Under the current ordering policy AAC holds 13 units safety stock (how come?
Observe):
¨ AAC is open 5 day a week.
- The average daily demand = (120/week)/5 = 24 juicers.
- Lead time is 8 days. Lead time demand is (8)(24) = 192 juicers.
- Reorder point without Safety stock = LD = 192.
- Current policy: R = 205.
- Safety stock = 205 – 192 = 13.
¨ For safety stock of 13 juicers the total cost is
TC(327) = 457.89 + 6240($10) + (13)($1.40) = $62,876.09
TV(327) + procurement cost + safety stock holding cost
 AAC – Solution:
Sensitivity of the EOQ Results
Changing the order size
¨ Suppose juicers must be ordered in increments of 100 (order 300 or 400)
¨ AAC will order Q = 300 juicers in each order.
¨ There will be a total variable cost increase of $1.71.
¨ This is less than 0.5% increase in variable costs.

Changes in input parameters

¨ Suppose there is a 20% increase in demand. D=7500 juicers.
¨ The new optimal order quantity is Q* = 359.
¨ The new variable total cost = TV(359) = $502
¨ If AAC still orders Q = 327, its total variable costs becomes
TV(327) = (327/2)($1.40) + (7500/327)($12) = $504.13 → only increase 0.4%
 AAC – Solution: Cycle Time

¨ For an order size of 327 juicers we have:

T = (327/ 6240) = 0.0524 year.

= 0.0524(52)(5) = 14 days.

working days per week

¨ This is useful information because:

- Shelf life may be a problem.

- Coordinating orders with other items might be desirable.

AAC – Excel Spreadsheet
 2.3. EOQ Models with
Quantity Discounts
Quantity Discounts are Common Practice in Business
¨ By offering discounts buyers are encouraged to increase
their order sizes, thus reducing the seller’s holding costs.
¨ Quantity discounts reflect the savings inherent in large
orders.
¨ With quantity discounts sellers can reward their biggest
customers.
 EOQ Models with
Quantity Discounts
Quantity Discount Schedule

¨ This is a list of per unit discounts and their corresponding purchase volumes.

¨ Normally, the price per unit declines as the order quantity increases.

¨ The order quantity at which the unit price changes is called a break point.

¨ There are two main discount plans:

- All unit schedules - the price paid for all the units purchased is based on the
total purchase.
- Incremental schedules - The price discount is based only on the additional
units ordered beyond each break point.
 All Units Discount Schedule

¨ To determine the optimal order quantity, the total purchase

cost must be included

¨ Ci represents the unit cost at the i th pricing level.

 AAC - All Units
Quantity Discounts
¨ AAC is offering all units quantity discounts to its customers.
¨ Data
Quantity Discount Schedule
1-299 $10.00
300-599 $9.75
600-999 $9.40
1000-4999 $9.50
5000 $9.00

Should AAC increase its regular order of

327 juicers, to take advantage of the discount?
 AAC – All units
discount procedure
¨ Step 1: Find the optimal order Qi* for each discount level “i” by using the formula

¨ Step 2: For each discount level “i” modify Qi* as follows

- If Q* < qi, then Qi* = qi.

- If qi  Q* < qi+1, then Qi* = Q*

- If qi+1  Q*, eliminate this level from further consideration.

¨ Step 3: Substitute the modified Qi* value in the total cost formula TC(Qi*).

¨ Step 4: Select the Qi* that minimizes TC(Qi*)

 AAC – All units
discount procedure
¨ Step 1: Find the optimal order Q i* for each discount level “i”
by using the formula

Lowest cost order size per discount level

Discount Qualifying Price
level order per unit Q*
0 1-299 10.00 327
1 300-599 9.75 331
2 600-999 9.50 337
3 1000-4999 9.40 336
4 5000 9.00 345
 AAC – All units
discount procedure
¨ Step 2:

Lowest cost order size per discount level

Discount Qualifying Price
level order per unit Q* Qi *
0 1-299 10.00 327 ****
1 300-599 9.75 331 331
2 600-999 9.50 337 600
3 1000-4999 9.40 336 1000
4 5000 9.00 345 5000
 AAC – All units
discount procedure
¨ Step 3: Substitute the modified Q i* value in the total cost
formula TC(Qi*).

Modified Q* and total Cost

Qualified Price Modified Total

Q* Qi *
Urder per Unit Cost
1-299 10.00 300 **** ***

300-599 9.75 331 331 $61,309.88

600-999 9.50 336 600 $59,192.71
1000-4999 9.40 337 1000 $60,037.17
$59,341.36
5000 9.00 345 5000
 AAC – All units
discount procedure
¨ Step 4: AAC should order 600 juicers as it results in the
minimum total annual cost

Modified Q* and total Cost

Qualified Price Modified Total

Q*
Urder per Unit Q* Cost
1-299 10.00 300 **** ****
300-599 9.75 331 331 $61,309.88
600-999 9.50 336 600 $59,192.71
1000-4999 9.40 337 1000 $60,037.17
$59,341.36
5000 9.00 345 5000
AAC – All Units Discount Excel
Worksheet
 3. Planned Shortage Model
¨ When an item is out of stock, customers may:
- Go somewhere else (lost sales).
- Place their order and wait (backordering).
¨ In this model we consider the backordering case.
¨ All the other EOQ assumptions are in place.
 Planned Shortage Model –
the Total Variable Cost Equation

¨ The parameters of the total variable costs function are similar to those
used in the EOQ model.
¨ In addition, we need to incorporate the shortage costs in the model.
¨ Backorder cost per unit per year (loss of good will cost) - Cs.
¨ Reflects future reduction in profitability.
¨ Can be estimated from market surveys and focus groups.
¨ Backorder administrative cost per unit - Cb.
¨ Reflects additional work needed to take care of the backorder.
 Planned Shortage Model –
the Total Variable Cost Equation

¨ The Annual holding cost =

Ch[T1/T](Average inventory) = Ch[T1/T] (Q-S)/2

¨ The Annual shortage cost =

Cb(number of backorders per year) +
CS(T2/T)(Average number of backorders).

¨ To calculate the annual holding cost and

shortage cost we need to find

¨ The proportion of time inventory is carried, (T1/T)

¨ The proportion of time demand is backordered, (T2/T).

Finding T1/ T and T2/ T
average inventory (Q-S)/2

Proportion of time
inventory exists
= T1/T
= (Q - S) / Q

Proportion of time
shortage exists
= T2/T
=S/Q

Average shortage = S / 2
 Planned Shortage Model –
The Total Variable Cost Equation

¨ Annual holding cost:

Ch[T1/T](Q-S)/2 = Ch[(Q-S) /Q](Q-S)/2
= Ch(Q-S)2/2Q
¨ Annual shortage cost:
Cb(Units in short per year) +
Cs[T2/T](Average number of backorders) =
Cb(S)(D/Q) + CsS2/(2Q)
 Planned Shortage Model –
The Total Variable Cost Equation

¨ The total annual variable cost equation

Time independent Time independent

backorder costs backorder costs

¨ The optimal solution to this problem is obtained under the following

conditions
- Cs > 0 ;
- Cb < (2CoCh / D)1/2
 Planned Shortage Model –
The Optimal Inventory Policy
¨ The Optimal Order Size

¨ The Optimal Backorder level

¨ Reorder Point
 SCANLON PLUMBING
CORPORATION
¨ Scanlon distributes a portable sauna from Sweden.

¨ Data

- A sauna costs Scanlon $2400.

- Annual holding cost per unit $525.

- Fixed ordering cost $1250 (fairly high, due to costly transportation).

- Lead time is 4 weeks.

- Demand is 15 saunas per week on the average.

 SCANLON PLUMBING
CORPORATION
¨ Backorder costs
- Scanlon estimates a $20 goodwill cost for each week a
customer who orders a sauna has to wait for delivery.
- Administrative backordrer cost is $10.

¨ Management wishes to know:

- The optimal order quantity.
- The optimal number of backorders.
 SCANLON PLUMBING –
Solution
¨ Input for the total variable cost function
- D = 780 saunas [(15)(52)]
- Co = $1,250
- Ch = $525
- Cs = $1,040
- Cb = $10
SCANLON PLUMBING –
Spreadsheet Solution