IM355TBD – ADVANCED DECISION MODELLING

Unit – III
Inventory Control Models

Introduction, The Meaning of Inventory Control, Functional Role of Inventory, Reasons for
Carrying Inventory, Factors Involved in Inventory Problem Analysis, Inventory Model Building,
Single Item Inventory Control Models without Shortages, Single Item Inventory Control Models
with Shortages

Introduction:
Inventory refers to the stock of goods, materials, or resources that a business holds for
production, sales, or operational purposes. It includes:
 Raw Materials: Inputs used to produce goods.
 Work-in-Progress (WIP): Items currently being manufactured.
 Finished Goods: Products ready for sale.
 Maintenance, Repair, and Operating Supplies (MRO): Items supporting production, like
tools and spare parts.
According to Fred Hansman,
“Inventory is an idle resource of any kind provided such a resource has economic value”.
Resources may be classified into three broad categories:
i. Physical resources such as raw materials, semi-finished goods, finished goods, spare
parts, lubricants, etc.,
ii. Human resources such as unused labour (manpower), and
iii. Financial resources such as working capital, etc.

The following are a few examples of the type of inventory held by various organizations.
Type of Organization Type of Inventories Held
 Manufacturer Raw materials; semi-finished goods; finished goods; spare parts, etc.
 Hospital Number of beds; stock of drugs; specialized personnel, etc.
 Bank Cash reserves; tellers, etc.
 Airline company Seating capacity; spare parts; specialized maintenance crew, etc.

The Meaning of Inventory Control:

Inventory control refers to the process of managing and regulating a company's inventory to
ensure the right quantity of goods is available at the right time. It aims to avoid overstocking or
understocking, reduce costs, and meet customer demands efficiently.
The following few basic factors are required to be taken into consideration for an efficient
control of inventory:
1. Items to be Stocked: Since physical storage of inventory items is expensive, therefore a
control is needed to ensure that inventory level remains as low as possible. This implies that:
i. inventory level of existing items is kept at reasonable level.
ii. unnecessary items are not added to the inventory.
iii. items which have not been used for long time are removed from the inventory.
2. Time to Replenish Inventory: There are two different approaches to check stock of inventory
items:
i. Periodic Review System, where orders are placed at fixed intervals of time. The
quantity ordered varies, depending on the inventory in hand and consumption level at
the time of review.
 Inventory is reviewed at set intervals (e.g., weekly, monthly).
 The order quantity depends on current stock levels and consumption during
the review period.

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ii. Fixed Order Quantity System, where stock level of inventory items is monitored
regularly and when it drops to a specified level, a replenishment order for a fixed
quantity is place.
 Inventory is continuously monitored, and a replenishment order is triggered
when stock reaches a predetermined reorder level.
 A fixed quantity is ordered each time.
3. Quantity of Replenishment Order: Every time an order is placed, there are certain costs
incurred on account of administration, transportation, inspection, etc. The order quantity
usually depends on:
 Demand pattern
 Price of an item, discount options, total budget and warehouse space, etc.
 Lead time

Functional Role of Inventory:

Investment in inventory represents a substantial portion of the total capital investment in any
business, therefore questions like:
 Why invest funds in inventory? and
 What benefit can be derived by investing in inventories?

Certain distinct forms of inventories, and their functions are:

1. Transit (or pipeline) Inventory: Since replenishment of inventory may not be
instantaneous, optimal inventory level is required to be maintained to satisfy the demand
without delay. Thus, it is essential to keep extra (buffer) stock of inventory items at various
work places to meet the demand without delay while the supply is in transit. The amounts of
pipeline inventory depend on inventory supply time (or lead time) and the nature of the
demand.
Inventory Form
Inventory
Raw Material Work In Process Finished Goods
Function
Logistics Decisions
Transit Design of supply system, Design of layout and Design of plant location
(pipeline) supplier location, materials handling and product distribution
transportation mode system system

2. Cycle Inventory: It is the inventory necessary to meet the average demand during the
successive replenishments. The amount of such inventory depends upon
 the production lot size,
 economical order quantities,
 warehouse space available,
 replenishment lead time,
 price-quantity discount schedules, and
 inventory carrying cost, etc.
Inventory Form
Inventory
Raw Material Work In Process Finished Goods
Function
Product/Process Design Decisions
Cycle Order size, order cost Lot size, set-up cost Distribution costs, lot sizes
(EOQ, lots)

3. Buffer Inventory (or Safety Inventory): It refers to extra stock maintained to protect
against uncertainties in demand, supply, or lead time. It acts as a cushion to prevent stock
outs. Both demand and lead time are random variables with known probability distribution.
The level of buffer stock is determined by trade-off between protection against demand and
lead time and the desired level of investment in stock of inventory.
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Inventory Form
Inventory
Raw Material Work In Process Finished Goods
Function
Management Risk Level Decision and Uncertainty
Buffer Probability distribution Probability distribution Probability distribution of
(uncertainty) of price, supply, stock of machine and demand and associated
out and carrying costs product capabilities carrying and shortage costs

4. Anticipation Inventory (or Seasonal Inventory): It refers to extra stock held to meet
expected increases in demand during specific periods, such as holidays, festivals, or seasonal
peaks.
Inventory Form
Inventory
Raw Material Work In Process Finished Goods
Function
Price/Availability Decision and Uncertainty, Seasonality Capacity
Anticipation Know future supply Capacity, production costs Demand patterns
(price/shortage) and demand price of hire, fire, transfer, (seasonal)
levels overtime, idle time, etc.

5. Decoupling Inventory: It refers to the stock kept between different stages of production or
along the supply chain to ensure that each stage can operate independently without being
directly affected by fluctuations or delays in preceding or subsequent stages.
The decoupling inventories may be classified into four groups:
 Raw Materials and Component Parts: The raw materials inventory could act as a buffer
to take care of delays on the part of supplier(s), and guard against seasonal variations in
the demand of final product.
 Work-in-Process Inventory: The work-in process inventory takes the form of orders
waiting to be replenished at various stages of processing on a particular machine. The
level of such inventory can be changed by changing the manufacturing process, lot sizes
or production schedules.
 Finished Goods Inventory: The inventory level of finished products depends upon the
demand, and the ability of an organization to sell its products, to meet customer demand
and shelf-life of the product and storage capacity.
 Spare Parts Inventory: These are the parts that are used in the production process but are
not the part of the product. The size of the inventory depends on the average life of the
components.
Inventory Form
Inventory
Raw Material Work In Process Finished Goods
Function
Production Control Decisions
Decoupling Dependence/independence Dependence/independence Dependence/independence
(inter- from supplier behaviour of successive production from market behaviour
dependence) operations

Reasons for Carrying Inventory:

Inventory is viewed as a necessary evil (non-earning asset) that cannot be eliminated because
maintaining inventory increases carrying cost and blocks money that could have been used for
alternative productive purposes.
Important reasons for carrying inventory are as follows:
i. Meet Customer Demand: Ensures products are available when customers need them,
improving service levels and satisfaction.
ii. Buffer Against Supply Chain Disruptions: Protects against uncertainties like supply delays,
transportation issues, or unexpected demand spikes.
iii. Economies of Scale: Allows for bulk purchasing or production, reducing per-unit costs and
taking advantage of supplier discounts.

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iv. Smooth Production Flow: Keeps raw materials, work-in-progress, and finished goods
available to avoid production delays and downtime.
v. Handle Seasonal Demand: Provides the ability to stock up on items before periods of high
demand (e.g., holidays, festivals, or weather-related sales).
vi. Take Advantage of Price Fluctuations: Allows businesses to buy in advance during periods
of lower prices, reducing future costs when prices rise.
vii. Support Lead Time Variability: Compensates for unpredictable lead times from suppliers,
ensuring continuous production and delivery.
viii. Minimize Stockouts: Reduces the risk of running out of stock, which can lead to lost sales,
missed opportunities, or production delays.
ix. Improve Flexibility: Provides flexibility in meeting urgent orders, handling changes in
production plans, or adjusting to sudden demand shifts.

Factors Involved in Inventory Problem Analysis:

A number of factors must be considered while analysing inventory problems. Among the most
important are the following:
 Relevant inventory costs
 Demand for inventory items
 Replenishment lead time
 Length of planning period
 Constraint on the inventory system

Inventory System: An inventory system that comprises the various subsystems is shown in Fig.

 Inventory System’s Performance: The performance of an inventory system is measured in

terms of inventory turnover
Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory

 Replenishment Pattern: In a manufacturing system, the inventory of raw material, semi-

finished goods, etc., may be required either to keep in warehouse for future need or to be
used for immediate processing on arrival. The replenishment of such items may be either
instantaneous, constant or gradual, depending upon the lead time.

 Operating Constraints: The stock level of various items in the inventory is governed by
various constraints such as limited warehouse space, limited budget available for
inventory, degree of management attention towards individual items in the inventory, and
customer service level (probability of being able to fill a request for a product from the
current stock) to be achieved, etc.

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 Operating Decision Rules: Two types of managerial decisions need to be made in order
to determine efficient inventory policy. A key element in designing such a policy is to
determine:
i. Order quantity (units of an item to be ordered or produced) for each replenishment,
and
ii. Time (or set-up production) to replenish stock of inventory required.

Decisions regarding the size and timing of replenishment of stock are influenced by four main
factors:
i. Pattern of demand for an item,
ii. Replenishment lead time,
iii. Various inventory costs, and
iv. Management policies.

Decisions on the size and timing of replenishment of stock are based on the following basic
inventory control policies or systems:
Continuous Review Systems: is an inventory system where the current inventory level is
monitored on a continuous basis.
(s, Q) Policy: Whenever the inventory level (items on hand plus on order) drops to a given level,
s or below, an order is placed for a fixed quantity, Q. This policy is also known as
a fixed-order quantity policy or reorder-point policy. The inventory level, s (also
denoted by R) is also termed as reorder point (or level).
In the (s, Q) policy, the order quantity is fixed and the inventory level after
the replenishment of stock is variable from one replenishment cycle to another.
(s, S) Policy: Whenever the inventory level (items on hand plus on order) drops to a given level,
s or below, an order is placed for a sufficient quantity to bring the inventory level
up to a predetermined maximum level, S.
In the (s, S) policy, the inventory level just after the replenishment of stock
is fixed, and the order quantity is variable.

Periodic Review Systems: is an inventory system where inventory level is only reviewed
periodically.
(T, S) Policy: Inventory level (items on hand plus on order) is reviewed regularly time intervals
of length T. At each review, an order is placed for a sufficient quantity to bring
the inventory level up to a predetermined maximum level, S.
(T, S, S) Policy: Inventory level (items on hand plus on order) is reviewed regularly at time
intervals of length T. At each review, if the inventory level is at level, s or
below, an order is placed for a sufficient quantity to bring inventory level up to
a pre-determined level, S. But if the inventory level is above s, no order is
placed. This policy is also known as periodic review policy or fixed-interval
policy.

Inventory Cost Components:

The inventory costs are affected (i.e. increase or decrease) by the policies of an organization to
maintain a particular level of inventory. The inventory costs are classified as follows:
1. Purchase Cost: This cost is the actual price per unit (in Rs) paid for the procurement of
items. The price per unit, C of an item is independent of the size of the quantity ordered or
purchased (or manufactured).
The purchase cost is given by
Purchase cost = (Price per unit) × (Demand per unit time) = C × D
When price-break (or quantity discounts) are available on purchase, the unit price becomes
smaller as the size of order, Q exceeds a specified quantity level. In such cases, the purchase cost
become variable and depends on the size of the order. In this case purchase cost is given by
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Purchase cost = Price per unit when order size is Q × Demand per unit time
= C(Q) × D
2. Carrying (or holding) Cost: The inventory cost incurred for carrying (or holding) inventory
items in the warehouse is referred as carrying cost. The carrying cost includes cost incurred
on
i. storage cost for rent paid for warehouse space,
ii. inventory handling cost for payment of salaries,
iii. insurance cost against fire or other form of damage,
iv. opportunity cost of the money invested in inventory,
v. obsolescence costs, deterioration costs, lost or pilfered costs,
vi. depreciation, etc.
Carrying cost can be determined by two different ways:
Carrying cost = (Cost of carrying one unit of an item in the inventory for a given length of
time, usually one year) × (Average number of units of an item carried in
the inventory for a given length of time)
Carrying cost = (Cost of carrying one rupee’s worth of inventory for one year) × (Rupee
value of units carried)
Further, if r is the carrying (or holding) charges as a percentage of average rupee value on an
annual basis and C is the unit cost of the item in rupees, then the annual carrying cost may be
expressed in terms of percentage of the average rupee value of inventory as: r × C.
3. Ordering (or set-up) Cost: The inventory cost incurred each time an order is placed for
procuring items from the vendors is referred as ordering cost. The cost per order generally
includes:
i. requisition cost of handling of invoices, stationery, payments, etc.,
ii. cost of services which includes cost of mailing, telephone calls, transportation, and other
follow up actions,
iii. materials handling cost incurred in receiving, sorting, inspecting and storing the items
included in the order,
iv. accounting and auditing, etc.
When an item is produced ‘in-house’, ordering cost is referred as set-up cost, which includes
both paperwork costs and the physical preparation costs.
Ordering (or set-up) cost does not vary with size of the order (or production), but varies with the
number of orders placed during a given period of time. Ordering cost can be calculated as
follows:
Ordering cost = (Cost per order/per set-up) × (Number of orders/set-ups placed in the given
period)
4. Shortage (or stock out) and customer-service cost: The shortage occurs when inventory
items cannot be supplied due to delay in delivery or demand becomes more than the
expected demand. The shortage can be viewed in two different ways:
i. Customers are ready to wait for supply of items, (back ordered): In this case there is no
loss of sale but the nature and magnitude of back ordering cost, extra paper work and
expenses incurred in processing the order is not exactly known.
ii. Customers are not ready to wait for supply of items: In this case, an organization may
suffer with a loss of customer goodwill and therefore causes loss of sale. The loss of
goodwill is expected to increase in proportion to the length of the delay, and causes
decline in the growth of business due to loss of potential revenue.
Shortage cost in a given period may be calculated as follows:
Shortage cost = (Cost of being short one unit of an item) × (Average number of units short)
The average number of units short in a given period is determined as follows:

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5. Total Inventory Cost: If price discounts are offered, the purchase cost per unit becomes
variable, and depends on the quantity purchased. In such a case, the total inventory cost is
calculated as follows:
Total variable inventory cost (TVC)
= Purchase cost + Ordering cost + Carrying cost + Shortage cost
But, if price discounts are not offered, the purchase cost per unit of an item remains constant and
is independent of the quantity purchased, then the total inventory cost is calculated as follows:
Total inventory cost (TC) = Ordering cost + Carrying cost + Shortage cost

Inventory Model Building:

An inventory control problem can be solved by using several methods, starting from trial-and-
error methods to mathematical and simulation models. Mathematical models help in deriving
certain rules that may suggest how to minimize the total (or incremental) inventory cost when
demand is either deterministic or probabilistic.

Steps of Inventory Model Building:

The steps to develop a deterministic inventory model are summarized as follows:
Step 1: Collect the data regarding the pattern of demand, the replenishment policy, planning
period, relevant inventory costs, etc.
Step 2: Define an appropriate relationship (i.e., mathematical model) among various factors
obtained in Step 1 to known the features of the existing inventory system. The model so
developed may either be an unconstrained or constrained optimization model,
depending upon whether the constraints on limited resources (such as floor space for
storage, capital investment, etc.) are imposed or not.
Step 3: Derive an optimal inventory policy (i.e. economic order quantity) by using an
appropriate solution procedure so as to maintain balance amongst the inventory costs.

Classification of EOQ Models:

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List of symbols used:

C = purchase (or manufacturing) cost of an item (Rs per unit)
C0 = ordering (or set-up) cost per order (Rs per order)
r = cost of carrying one rupee’s worth of inventory expressed in terms of per cent
of rupee value of inventory (per cent per unit time)
Ch = C × r = cost of carrying one unit of an item in the inventory for a given length
of time (Rs per item per unit time)
Cs = shortage cost per unit per time (Rs per unit time)
D = annual requirement (demand) of an item
Q = order quantity (units) per order
ROL = reorder level (or point) at which an order is placed
LT = replenishment lead time (delivery time or period)
n = number of orders per time period
t = reorder cycle time (time period), i.e. time interval between successive orders
to replenish inventory stock.
tp = production period (time)
rp = production rate (quantity per unit time) at which quantity Q is added to
inventory
TC = total inventory cost (in Rs)
TVC = total variable inventory cost (in Rs)

Single Item Inventory Control Models Without Shortages:

Model I(a): EOQ Model with Constant Rate of Demand

The objective of this model is to decide an economic order quantity, Q* (EOQ), and the ordering
frequency (time when an order must be placed) in such a way that the total yearly inventory cost
is minimized.
Characteristics (or inputs) assumed are:
 The inventory system involves one type of item or product.
 The demand is known and constant and is resupplied instantaneously.
 The inventory is replenished in single delivery for each order.
 Lead time (LT) is constant and known, i.e. replenishment is instantaneous, so that
inventory increases by Q units as soon as an order is placed.
 Shortages are not allowed. That is, there is always enough inventory on hand to meet the
demand.
 Purchase price and reorder costs do not vary with the quantity ordered. That is, quantity
discount is not available.
 Carrying cost per year (as a fraction of product cost) and ordering cost per order are
known and constant.
 Each item is independent and money cannot be saved by substituting by other items or
grouping cost several items into a single order.

Figure depicts an inventory system that operates on certain assumptions listed above
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Fig. Trade-Off between EOQ and Inventory Costs

Important Formulae:
1. Optimal interval, t* between the successive orders
Q* = Annual demand × Reorder cycle time = D.t
or

2. Optimal number of orders (N*) to be placed in the given time period (assumed as one
year)

3. Optimal (minimum) total variable inventory cost (TVC*)

4. Optimal total inventory cost

TC = Fixed purchase cost + Total variable inventory cost
= D . C + TVC*
Problem:
1. The production department of a company requires 3,600 kg of raw material for
manufacturing a particular item per year. It has been estimated that the cost of placing an
order is Rs 36 and the cost of carrying inventory is 25 per cent of the investment in the
inventories. The price is Rs 10 per kg. Help the purchase manager to determine an ordering
policy for raw material.
Solution: From the data of the problem we know that
D = 3,600 kg per year; C0 = Rs 36 per order
Ch = 25 per cent of the price/unit of raw material
= Rs 10 × 0.25 = Rs 2.50 per kg per year
i. The optimal lot size is given by

ii. The optimal order cycle time

iii. Per year minimum total inventory variable cost

iv. Per year minimum total inventory cost

TC* = TVC* + DC = Rs. 804.98 + (3,600 kg) (Rs 10/kg) = Rs 36,804.98 per year

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Practice Problems:
1. A manufacturer has to supply his customer with 600 units of his product per year. Shortages
are not allowed and the storage cost amounts to Rs 0.60 per unit per year. The set-up cost per
run is Rs 80.00. Find the optimum run size and the minimum average yearly cost.
(D = 600 units/year; C0 = 80/run; Ch = Re 0.60 per year
Ans. Q* = 400 units, t* = 8 month, and TVC* = Rs 240)

2. A manufacturer has to supply his customer with 24,000 units of his product per year. This
demand is fixed and known. Since the unit used by the customer is an assembly-line
operation and the customer has no storage space for the units, the manufacturer must ship a
day’s supply each day. If the manufacturer fails to supply the required units, he will lose the
account and probably his business. Hence, the cost of shortage is assumed to be infinite, and,
consequently, none will be tolerated. The inventory holding cost amounts to 0.10 per unit per
month, and the set-up cost per run is Rs 350. Find the optimum lot size and the length of
optimum production run.
(D = 24,000 units/year; Ch = Re 0.01 per unit per month;
C0 = Rs 350/order
Ans. Q* = 3,740 units; t* = 1.87 months)

3. The production of a particular item is instantaneous. The cost of one item is Re 1 per month
and the set-up cost is Rs 25. If the demand is 200 units per month, find the optimum quantity
to be produced per set-up and hence determine the total cost of storage and set-up per month.
(D = 200 units/month; Ch = Re 1.00 per unit per month;
C0 = Rs 25/run
Ans. Q* = 100 units, therefore the cost of storage and set-up
= 25 + 100 × 1 = Rs 125)

4. A certain item costs Rs 235 per tonne. The monthly requirement is 5 tonnes and each time
the stock is replenished there is a set-up cost of Rs 1,000. The cost of carrying inventory has
been estimated at 10 per cent of the value of the stock per year. What is the optimal order
quantity?
(D = 5 × 12 = 60 tonnes/year; C0 = Rs 1,000/set-up;
Ch = 10% of value of stock per year = Rs (10/100) × 235
= Rs 23.5 per item/year
Ans. Q* = 71.5 tonnes)

5. An aircraft company uses rivets at a constant rate of 2,500 per year. Each unit costs Rs 30.
The company personnel estimate that it costs Rs 130 to place an order, and that the carrying
cost of inventory is 10 per cent per year. How frequently should orders be placed? Also
determine the optimum size of each order.
(D = 2,500 rivets/year; C0 = Rs 130/order;
Ch = 30 × (1/100) = Re 0.3/year
Ans. Q* = 466 rivets; t* = 0.18 years; n = orders (approx.))

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Model I(b): EOQ Model with Different Rates of Demand

This inventory system also operates on the assumptions of Model I(a) except that the demand is
constant and varies from period to period. The objective is to determine the order size (or
production quantity) in each reorder cycle (or period) that will minimize the total inventory cost.
The total demand, D is specified over the planning period, T.

Fig. depicts the inventory system that operates under assumptions of Model I plus other
conditions.
If t1, t2, . . ., tn denotes time for successive replenishment and D1, D2, . . ., Dn are the demand
rates at these cycles, respectively, then the total period T is given by T = t1 + t2 + . . . + tn.

Problems:
1. A company that operates for 50 weeks in a year is concerned about its stocks of copper
cable. This costs Rs 240 a meter and there is a demand for 8,000 meters a week. Each
replenishment costs Rs 1,050 for administration and Rs 1,650 for delivery, while holding
costs are estimated at 25 per cent of value held a year. Assuming no shortages are allowed,
what is the optimal inventory policy for the company?
How would this analysis differ if the company wanted to maximize its profits rather than
minimize cost? What is the gross profit if the company sells the cable for Rs 360 a meter?
Solution: From the data of the problem, we have
Demand rate (D) = 8,000 × 50 = 4,00,000 meters a year
Purchase cost (C) = Rs 240 per meter; Ordering cost (C0) = 1,050 + 1,650 = Rs 2,700
Holding cost (Ch) = 0.25 × 240 = Rs 60 per meter per year
i. Optimal order quantity

ii. Total variable inventory cost, TVC = Q*.Ch = 6,000 × 60 = Rs 3,60,000 per year
iii. Total inventory cost, TC = D.C + TVC = 4,00,000 × 240 + 3,60,000 = Rs 9,63,60,000
It may be noted that in comparison of total inventory cost in excess of Rs 9,63,60,000 per
year, the total variable inventory cost is only Rs 3,60,000 or 0.36 per cent.
If the company desired to maximize profit rather than minimize cost, the analysis used
would remain exactly the same. In such a case, the selling price (SP) per unit is defined in such a
way that gross profit per unit time becomes:

The maximum profit with respect to Q can be obtained by solving this equation in the same
manner as discussed earlier.
If company sells the cable for Rs 360 a meter, its revenue is Rs 360 × 4,00,000 = Rs
14,40,00,000 a year. The total inventory cost of Rs 9,63,60,000 is subtracted from this revenue
to get a gross profit of Rs 4,76,40,000 a year.

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2. Each unit of an item costs a company Rs 40. Annual holding costs are 18 per cent of unit
cost of the item due to miscellaneous changes: 1 per cent for insurance, 2 per cent
allowances for obsolescence, Rs 2 for building overheads, Rs 1.50 for damage and loss, and
Rs 4 miscellaneous costs. The annual demand for the item is constant at 1,000 units. Placing
each order costs, the company Rs 100.
i. Calculate EOQ and the total costs associated with stocking the item.
ii. If the supplier of the item will only deliver batches of 250 units, how are the stock
holding costs affected?
iii. If the supplier relaxes his order size requirement, but the company has limited
warehouse space and can stock a maximum of 100 units at any time, what would be
the optimal ordering policy and associated costs?
Solution: From the data of the problem we have
Annual demand, (D) = 1,000 units; Purchase cost/unit (C) = Rs 40
Ordering cost, C0 = Rs 100 per order;
Holding cost, Ch = Rs (0.18 + 0.01 + 0.02) × 40 + Rs (2 + 1.50 + 4)
= 0.21 × 40 + 7.50 = Rs 15.90 per unit per year
i. EOQ(Q*) = (2DC0 / Ch)1/2
= [(2 ×1000 ×100) /15.9] 1/2 = 112.15 units
TVC* = Q Ch Rs per year *. = 112.15 × 15.9 = 1783.26
ii. If EOQ = 250 units, the variable inventory cost can be calculated as:

iii. The highest stock level occurs when an order has just arrived. If the maximum
permissible stock level is 100 units, then it becomes an upper limit on the amount that
can be ordered. The order size should be as close to Q* as possible and this is equal to
100. Thus,

3. A chemical company is trying to find the optimal batch size for the reorder of concentrated
sulphuric acid. The management accountant has supplied the following information:
a. The purchase price of H2SO4 is Rs 150 per gallon.
b. The clerical and data processing costs are Rs 500 per order.
All the goods are transported by rail. Each time the special line to the factory is opened the
company is charged Rs 2,000. A charge of Rs 20 gallon is also made. The company uses
40,000 gallons per year. Maintenance costs of stock are Rs 400 per gallon per year.
Each gallon requires 0.5 sq ft of storage space. If warehouse space is not used, it can be
rented out to another company at Rs 200 per sq ft per annum. The available warehouse
space is 1,000 sq ft, the overhead costs being Rs 5,000 per annum. Assume that all free
warehouse space can be rented out.
i. Calculate the economic reorder size.
ii. Calculate the minimum total annual cost of holding and reordering stock.
Solution: Based on the data of the problem, both variable cost that vary with the change in order
size (Q) and fixed cost is summarized as follows:
Variable Costs Fixed Costs
Ordering  Clerical and data processing, Rs 500;  Rail transport, Rs 20 per gallon because
cost  Rail transport, Rs 2000 a fixed money of Rs 40,000 × 20 = Rs
8,00,000 will incur irrespective of size
of Q.
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Carrying  Maintenance cost, Rs 200;  Overhead cost, Rs 5,000

cost  Rented cost, Rs 200/2 = Rs 100
The variable costs such as ordering cost and carrying cost required to calculate EOQ are: C0 =
Rs 2,500; Ch = Rs 300. Thus,

Hence, the minimum total annual costs are:

Rail transport : 40,000 × 20 = Rs 8,00,000.00

Overhead cost : = Rs 5,000.00
Purchase cost : 40,000 × 150 = Rs 60,00,000.00
Total = Rs 70,49,949.02

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Model I(c): Economic Production Quantity Model When Supply (Replenishment) is

Gradual

This model is similar to that of EOQ Model I, the only difference being the time to replenish
inventory. In this model it is assumed that the replenishment is gradual. This is because in many
situations, the amount ordered is not delivered all at once, but the ordered quantity is sent or
received gradually over a length of time at a finite rate (i.e. given supply rate) per unit of time.
Gradual (i.e. non-instantaneous) supply may arise in two cases:
i. The amount ordered is delivered by the vendor in several shipments over a period of
time. Thus the inventory is being used while the new inventory is still being received at a
faster rate and, therefore, inventory gradually build up to its maximum level. At this level
incoming shipments stop but the its use continues and declines to its lowest level.
ii. The inflow and consumption of inventory most frequently overlaps internally on shop
floor when the process that fills the order is located near the operation that will use the
order as inputs. For example, after certain internal lead time the production process
begins and a batch of is produced over a period of time. The quantity produced is
gradually consumed (i.e. sold, shipped-out or used internally in making another item) till
such time a reorder point is reached.
The additional assumptions made in this model are as follows:
i. Demand is continuous and at a constant rate.
ii. During the production run, the production of the item is continuous and at a constant rate
until production of quantity (Q) is complete.
iii. The rate of receipt (p) of replenishment of inventory (i.e. items received per unit time) is
greater than the usage rate (d) (i.e. items consumed per unit time).
iv. Production runs in order to replenish inventory are made at regular interval.
v. Production set-up cost is fixed (independent of quantity produced).

In the inventory system as shown in Fig., if tp is the time period required to receive (or produce)
one entire batch amount Q at a rate p, then the rate at which the stocks arrive is: p = Q/tp or tp =
Q/p

Important Formulae:
1. The total minimum inventory variable cost.

On substituting the value of Q* and simplifying we get

2. Optimal length of each lot size production run,

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3. Optimal production cycle time,

4. Optimal number of production cycles,

Problems:
1. A contractor has to supply 10,000 bearings per day to an automobile manufacturer. He finds
that when he starts production run, he can produce 25,000 bearings per day. The cost of
holding a bearing in stock for a year is Rs 200 and the set-up cost of a production run is Rs
1,800. How frequently should production run be made?
Solution: From the data of the problem in usual notations, we have
C0 = Rs 1,800 per production run; Ch = Rs 200 per year
p = Rs 25,000 bearings per day Cd = 10,000 bearing per day
D = 10,000 × 300
= 30,00,000 units/year (assuming 300 working days in the year).
i. Economic batch quantity for each production run is given by

ii. Frequency of production cycles

2. A product is sold at the rate of 50 pieces per day and is manufactured at a rate of 250 pieces
per day. The set-up cost of the machines is Rs 2,000 and the storage cost is found to be Re
0.15 per piece per day. With labour charges of Rs 3.20 per piece, material cost at Rs 2.10 per
piece and overhead cost of Rs 4.10 per piece, find the minimum cost batch size if the interest
charges are 8 per cent (assume 300 working days in a year). Compute the optimal number of
cycles required in a year for manufacturing of this product.
Solution: From the data of the problem, we have
D = 50 × 300 = 15,000 pieces per year; C0 = Rs 2000 per production run
p = 250 × 300 = 75,000 pieces per year (production rate)
Ch = 0.15 × 300 + 0.08 (3.20 + 2.10 + 4.10) = Rs 45.752 per year.
i. Economic batch size for each production cycle

ii. Optimal number of cycles,

3. (a) At present a company purchases an item X from outside suppliers. The consumption of
this item is 10,000 units/year. The cost of the item is Rs 5 per unit and the ordering cost is
estimated to be Rs 100 per order. The cost of carrying inventory is 25 per cent. If the
consumption rate is uniform, determine the economic purchasing quantity.
(b) In the above problem assume that company is going to manufacture the item with the
equipment that is estimated to produce 100 units per day. The cost of the unit thus produced
is Rs 3.50 per unit. The set-up cost is Rs 150 per set-up and the inventory carrying charge is
25 per cent. How has your answer changed?
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Solution: (a) From the data of the problem, we have

D = 10,000 units per year; C = Rs 5 per unit
C0 = Rs 100 per order, Ch = Rs 25% of Rs 5 = Rs 1.25 per year
Economic order quantity,

(b) Given that

p = 100 units per day; C0 = Rs 150 per set up
C = 3.50 per unit; Ch = Rs 25% of Rs 3.50 = Rs 0.875 per year
d = 10,000/250 = 40 units per day (assuming 250 working days in the year)
Economic batch quantity (size) for each production cycle

The increase in EBQ in case of (b) may be due to following reasons:

i. Increased procurement cost (i.e. set-up cost C0)
ii. Consumption of inventory simultaneous with production reduces average inventory from
Q/2 to {1 – (d/p)} x Q/ 2.

Practice Problems:
1. An item is produced at the rate of 50 items per day. The demand occurs at the rate of 25
items per day. If the set-up cost is Rs 100 per set-up and the holding cost is Re 0.01 unit of
item per day, find the economic lot size for one run, assuming that shortage is not permitted.
Also find the time of cycle and minimum total cost for one run.
(D = d = 25 units/day; p = 50 items/day; Ch = Re 0.01 per
unit per day; C0 = Rs 100 per set-up
Ans. Q* = 1,000 items; t* = 40 days; TVC* = Rs 5 per day
Total cost per run = Rs (5 × 40) = Rs 200.)

2. Amit manufactures 50,000 bottles of tomato ketchup in a year. The factory cost per bottle is
Rs 6, the set-up cost per production run is estimated to be Rs 90, and the carrying costs on
finished goods inventory amounts to 20 per cent of the cost per annum. The production rate
is 600 bottles per day, and the sales amount to 150 bottles per day. What is the optimal
production lot size and the number of production runs?
(d = 150 bottles per day; p = 600 bottles per day;
C = Rs 5/bottle; Ch = 20% of C = Re 1 per unit per year or
(1/365) per bottle per day; C0 = Rs 90 per run
Ans. Q* = 3,625 bottle (approx.))

3. In a paints manufacturing unit, each type of paint is to be ground to a specified degree of

fineness. The manufacturer uses the same mill for a variety of paints and after the completion
of each batch, the mill has to be cleaned and the ball charge has to be properly made up. The
set-up cost from one type of paint to another is estimated to Rs 80 per batch. The annual
sales of a particular grade of paint are 30,000 litre and the inventory carrying cost is Re 1 per
litre. Given that the rate of production is 3 times the sales rate, determine the economic batch
size.
(d = 30,000; p = 90,000; C = Rs 80; Ch = Re 1.
Ans. Q* = 2,683.38 liters; N* = 11.18 runs.)

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Single Item Inventory Control Models with Shortages:

Two main advantages with permitting shortage of inventory may be
 to increase the cycle time, and hence spreading the ordering (or set-up) costs over a
longer period, and
 to decrease inventory carrying cost.

Model II(a): EOQ Model with Constant Demand and Variable Order Cycle Time

If, shortages are allowed then following two types of situations may occur.
i. Customers are not ready to wait for their requirement (demand), causing loss of goodwill
and loss of potential sale.
ii. Customers wait to receive an order from the suppliers and such backorder(s) is filled on
stock availability. The backorder cost (cost of keeping back log reorders, cost of shipping
the items to the customers, loss of goodwill) depends upon how long a customer waits to
receive an order. It is expressed in rupees per unit of time.

In addition to the previously used notations, let

t1 = time between the receipt of an order and when the inventory level drops to zero, i.e.
time when no shortages exist.
t2 = time during which back order or shortage exists
t = total cycle time. t = t1 + t2
R = Maximum shortage (units).

Fig. Inventory Model with Shortages

Important Formulae:
1. Optimal shortage level (in units),

2. Total cycle time,

Remark: If we make an additional assumption that the production cost Cd per item is given,
then the TVC will become

Since D.Cd = constant, therefore optimum value of TVC will remain unaffected.

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Problems:
1. A commodity is to be supplied at a constant rate of 200 units per day. Supplies of any
amount can be obtained at any required time, but each ordering costs Rs 50; cost of holding
the commodity in inventory is Rs 2 per unit per day while the delay in the supply of the item
induces a penalty of Rs 10 per unit per day. Find the optimal policy (Q, t), where t is the
reorder cycle period and Q is the inventory after reorder. What would be the best policy to
adopt if the penalty cost becomes infinite?
Solution: From the data of the problem in usual notations, we have
D = 200 units/day; Ch = Rs 2 per unit per day
C0 = Rs 50 per order; Cs = Rs 10 per unit per day
a. Optimal order quantity

b. Reorder cycle time,

t* = Q*/D = 109.5/200 = 0.547 day.
Thus optimal order quantity of 109.5 units must be supplied after every 0.547 days. If the
penalty cost Cs = ∞, the expression for Q* will become

and
t* = Q*/D = 100/200 = 1/2 days

2. A dealer supplies you the following information with regard to a product that he deals in:
Annual demand = 10,000 units; Ordering cost = Rs 10 per order; Price = Rs 20 per unit
Inventory carrying cost = 20 per cent of the value of inventory per year
The dealer is considering the possibility of allowing some backorder (stockout) to occur. He
has estimated that the annual cost of backordering will be 25 per cent of the value of
inventory.
a. What should be the optimum number of units of the product he should buy in one lot?
b. What quantity of the product should be allowed to be backordered, if any?
c. What would be the maximum quantity of inventory at any time of the year?
d. Would you recommend to allow backordering? If so, what would be the annual cost
saving by adopting the policy of backordering.
Solution: From the data of the problem in usual notations, we have
D = 10,000 units/year C0 = Rs 10 per order C = Rs 20 per unit
Ch = 20% of Rs 20 = Rs 4 per unit per year Cs = 25% of Rs 20 = Rs 5 per unit per year
a. Economic order quantity (Q*)
i. When stockouts are not permitted

ii. When backordering is permitted

b. Optimal quantity of the product to be backordered

c. Maximum inventory level, M* = Q* – S* = 300 – 137 = 167 units

d. Minimum total variable inventory cost when
i. stockout are allowed
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ii. stockout are not allowed is as follows:

Since TVC (223.6) > TVC (666.67), the dealer should accept the proposal for backordering to
earn a profit of Rs (894.48 – 666.67) = Rs 227.76 per year.

Practice Problems:
1. A contractor undertakes to supply diesel engines to a truck manufacturer at a rate of 25 per
day. He finds that the cost of holding a completed engine in stock is Rs 16 per month and
that there is a clause in the contract penalizing him Rs 10 per engine per day for missing the
scheduled delivery date. Production of engines is in batches, and each time a new batch is
started there are set-up costs of Rs 10,000. How frequently should the batches be started, and
what should be the initial inventory level at the time each batch is completed.
(D = 25 engines/day; Ch = Rs 16/30 per day;
Cs = Rs 10 per engine/day and C0 = Rs 10,000
Ans. Q* = 943 engines/approx;
t* = Q*/D = 943/25 = 38 days)

2. A manufacturer has to supply his customer 24,000 units of his product per year. This demand
is fixed and known. The customer has no storage space and so the manufacturer has to ship a
day’s supply each day. If the manufacturer fails to supply, the penalty is Re 0.20 per unit per
month. The inventory holding cost amounts to Re 0.10 per unit per month and the setup cost
is Rs 350 per production run. Find the optimum lot size for the manufacturer.
(D = 24,000/12 units per month
Cs = Re 0.20 per unit per month
Ch = Re 0.10 per unit per month
C0 = Re 350 per production run
Ans. Q* = 4.578 unit per run.)

3. The demand of an item is uniform at a rate of 25 units per month. The fixed cost is Rs 15
each time a production run is made. The production cost is Re 1 per item, and the inventory
carrying cost is Re 0.30 per item per month. If the shortage cost is Rs 1.50 per item, per
month, determine how often should a production run be mads and of what size should it be?
(D = 25 units per month; C0 = Rs 15 per production run;
Ch = Re 0.30 per item/per month
Ch = Re 1 per unit of item ; Cs = Rs 1.50 per item per month.

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Model II(b): EOQ Model with Constant Demand and Fixed Reorder Cycle Time

Let the reorder cycle time, t be fixed, i.e. the inventory is to be supplied after every time period t.
Also, let Q = D. t, where D is the demand rate per unit time, Q is the fixed order size to meet the
demand for the period t.
The total variable inventory cost (TVC)

Since the TVC is the function of only M, therefore, the optimal value of M and minimum value
of TVC is obtained by differentiating TVC(M) with respect to M and then equating it with zero.
On simplifying, we get:

Substituting this value of M in TVC equation, the minimum TVC* so obtained is as follows:

Problems:
1. A commodity is to be supplied at a constant rate of 25 units per day. A penalty cost will be
charged at a rate of Rs 10 per unit per day, if it is late for missing the scheduled delivery
date. The cost of carrying the commodity in inventory is Rs 16 per unit per month. The
production process is such that each month (30 days) a batch of items is started and is
available for delivery any time after the end of the month. Find the optimal level of inventory
at the beginning of each month.
Solution: From the data of the problem, in usual notations, we have
D = 25 units/day Ch = Rs 16/30 = 0.53 per unit per day
Cs = Rs 10 per unit per day and t = 30 days
Thus the optimal inventory level is given by

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Model II(c): EOQ Model with Gradual Supply and Shortage Allowed

This model is based on the assumptions of Model I(c) except that shortages are allowed.

Fig. Inventory Model with Gradual Supply and Shortage

Important Formulae:
1. Production cycle time,

2. Optimal inventory level,

3. Total minimum variable inventory cost

Remark:
1. If, p =∞, then the various results obtained in Model II(c) are reduced to the form

2. If Cs = ∞, then the results of Model II(c) will be same as that of Model I(c).
3. If Cs = ∞, and p = ∞, then results of Model II(c) will be same as that of Model I(a).

Problem:
1. The demand for an item in a company is 18,000 units per year, and the company can produce
the item at a rate of 3,000 per month. The cost of one set-up is Rs 500 and the holding cost of
one unit per month is 15 paise. The shortage cost of one unit is Rs 240 per year. Determine
the optimum manufacturing quantity and the number of shortages. Also determine the
manufacturing time and the time between set-ups.
Solution: From the data of the problem using the usual notations, we have
D (= d) = 18,000 units/year = 1,500 units/month
p = 3,000 units/month; Ch = Re 0.15 per unit per month
C0 = Rs 500 per set-up; Cs = Rs 240 per year or Rs 20 per month.
a. Optimal batch quantity
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b. Optimal number of shortages,

c. Production time,

d. Production cycle time,

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