Course : Production & Operation Analysis

Effective Period : September 2015

Inventory Control
Subject to Known
Demand

Session 3
 Inventory
• The fundamental problem of inventory management can be
succinctly described by the 2 questions:
1. when should an order be placed
2. how much should be ordered
 Types of Inventory
• Raw material
 Has been purchased but not processed
• Components
 Items that have not yet reached completion in the production
process
• Work-in-process
 Inventory either waiting in the system for processing or being
processed
• Finished goods
 Completed product awaiting shipment
 The Material Flow Cycle
Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time
 Inventory Models
Independent demand

A Dependent demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain

Dependent demand is certain
• Independent demand – finished goods, items that are
ready to be sold
– a chair; a computer
• Dependent demand – components of finished
products
– seats, backs, legs; parts that make up the computer
 Motivation for Holding
Inventories

• Economies of scale
• Uncertainties
• Speculation
• Transportation
• Smoothing
• Logistics
• Control costs
 Characteristics of Inventory
Systems

• Demand
1. constant versus variable
2. known versus random
• Lead time
• Review time
• Excess demand
• Changing inventory
 Relevant Costs

• Holding cost
The holding cost also known as the carrying cost or the inventory
cost, is the sum of a costs that are proportional to the amount of
inventory physically on hand at any poin in time. The
components of the holding cost include a variety of seemingly
unrelated items:
1. cost of providing the physical space to store the items
2. taxes and insurance
3. breakage, spoilage, deterioration and obsolescence
4. opportunity cost of alternative investment
 Relevant Costs

For example: cost of capital = 28%, taxes and insurance = 2%,

cost of storage = 6%, breakage & spoilage = 1% (total interest
change = 37%)
c = the dollar value of one unit of inventory
I = annual interest rate
h = holding cost in terms of dollars per unit per year
Then we have the relationship: h = Ic
Hence, in this example, an item valued at $180 would have an
annual holding cost of h = (0.37)($180) = $66.6
If we held 300 of these items for five years, the total holding cost
over the five years would be (5)(300)(66.6) = $99,900
 Relevant Costs (cont’d)
• Order cost
The order cost depends on the amount of inventory
that is ordered or produced
• Penalty cost
The penalty cost also known as the shortage cost or
the stock out cost, is the cost of not having sufficient
stock on hand to satisfy a demand when it occurs
 Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stock outs (shortages) can be completely avoided if
orders are placed at the right time
 The EOQ Model
Q = Number of units per order
Q* = Optimal number of units per order (EOQ)
λ = Annual demand in units for the inventory item
K = Setup or ordering cost for each order
h = Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order

λ
= (K)
Q
 The EOQ Model
Q = Number of units per order
Q* = Optimal number of units per order (EOQ)
λ = Annual demand in units for the inventory item
K = Setup or ordering cost for each order
h = Holding or carrying cost per unit per year

Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)
Order quantity
(Holding cost per unit per year)
2

Q (h)
2
 The EOQ Model
Q = Number of units per order
Q* = Optimal number of units per order (EOQ)
λ = Annual demand in units for the inventory item
K = Setup or ordering cost for each order
h = Holding or carrying cost per unit per year

Optimal order quantity is found when annual setup cost equals

annual holding cost

λ Q
K = h
Q 2
Solving for Q*
2λK = Q2h
Q2 = 2λK/h
Q* = 2Kλ/h
 Example
Sharp, Inc., a company that markets painless hypodermic needles to
hospitals, would like to reduce its inventory cost by determining the
optimal number of hypodermic needles to obtain per order. The annual
demand is 1,000 units; the setup or ordering cost is $10 per order and
the holding cost per unit per year $0.5

2λK
Q* =
h
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
Sharp, Inc., wants to determine the combined annual ordering and holding
costs

Total annual cost = Setup cost + Holding cost

λ Q
TC = Q K + 2 h

1,000 200
TC = 200 ($10) + ($.50)
2
TC = (5)($10) + (100)($.50) = $50 + $50 = $100
 Production Order Quantity Model
• Used when inventory continuously flows
or builds up over a period of time after an
order has been placed
• Used when units are produced and sold
simultaneously
 Production Order Quantity Model
Part of inventory cycle during which
production (and usage) takes place
Inventory level

Demand part of cycle with

no production
Maximum
inventory

t Time
 Production Order Quantity Model
Q = Number of units per order p = Daily production rate
h = Holding cost per unit per year λ = Daily demand/usage rate
t = Length of the production run in days
Annual inventory Holding cost
= (Average inventory level) x
holding cost per unit per year

Annual inventory
= (Maximum inventory level)/2
level

Maximum Total production during the Total used during the

= –
inventory level production run production run

= pt – dt
However, Q = total produced = pt, and thus t = Q/p. Therefore:
Maximum Q Q λ
inventory level =p –λ =Q 1–
p p p

Maximum inventory level Q λ

Holding cost = (h) = 1– h
2 2 p
 Production Order Quantity Model

Q = Number of units per order p = Daily production rate

h = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Setup cost = (λ/Q)K

Holding cost =
1 hQ[1 - (λ/p)]
2

(λ/Q)K = 1 hQ[1 - (λ/p)]

2
2λK
Q =
2
h[1 - (λ/p)]

2λK
Q* =
p h[1 - (λ/p)]
Nathan manufacturing, Inc., makes and sells specialty hubcaps for the retail automobile aftermarket. Nathan’ forecast for
its wire wheel hubcap is 1,000 units next year, with an average daily demand of 4 units. However, the production
process is most efficient at 8 units per day. So the company produces 8 per day but uses only 4 per day. The company
wants to solve for the optimum number of units per order. (note: this plant schedules production of this hubcap only as
needed, during the 250 days per year the shop operates)

λ = 1,000 units p = 8 units daily

K = $10 λ = 4 units daily
h = $0.50 per unit per year

2λK
Q* = h[1 - (λ/p)]

Q* = 2(1,000)(10) = 80,000
0.50[1 - (4/8)]

= 282.8 or 283 hubcaps

 Production Order Quantity Model
Note:

1,000 d= = λ =4

250 Number of days the plant is in operation

When annual data are used the equation becomes

2λK
Q*p =
annual demand rate
h 1– annual production rate
 Quantity Discount Models
• Quantity discount is simply a reduced price (P) for
an item when it is purchased in larger quantities
• Trade-off when considering quantity discounts is
between reduced product cost and increased
holding cost
Total cost = Setup cost + Holding cost + Product cost
λ Q
TC = K+ h + PD
Q 2
 Quantity Discount Models
A quantity discount schedule
Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80

3 2,000 and over 5 $4.75

 Now, we have to determine the quantity that will minimize the
total annual inventory cost. Because there are several
discounts, this process involves 4 steps:
• 1. For each discount, calculate a value for optimal order size
Q*, using the following equation:
2K
Q* 
IP

Note that the holding cost is IP instead of h. Thus, it is common

to express the holding cost as a percent (I) of unit price (P)
instead of as a constant cost per unit per year, h
• 2. For any discount, if the order quantity is too low to qualify
for the discount, adjust the order quantity upward to the lowest
quantity that will qualify for the discount
• 3. Using the preceding total cost equation, compute a total
cost for every Q* determined in steps 1 and 2
• 4. Select the Q* that has the lowest total cost, as computed in
step 3
Example
• Wohl’s discount store stocks toy race cars. Recently,
the store has been given a quantity discount schedule
for these cars. The normal cost for the toy race cars is
$5. For orders between1,000 and 1,999 units, the unit
cost drops to $4.8; for orders of 2,000 or more units,
the unit cost is only $4.75. Furthermore, ordering cost
is $49 per order, annual demand is 5,000 race cars,
and inventory carrying charge, as a percent of cost, I, is
20% or 0.2. What order quantity will minimize the total
inventory cost?
The first step is to compute Q* for every discount

2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80)
2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
The second step is to adjust upward those values of Q*
that are below the allowable discount range

2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)
2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80) 1,000 — adjusted

2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75) 2,000 — adjusted
 The third step is to use the total cost
equation and compute a total cost
for each order quantity

Annual Annual Annual

Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 $24,000 $245 $480 $24,725

1,000
3 $4.75 $23,750 $950 $24,822.50
2,000 $122.50

The fourth step is to select that order quantity with the

lowest total cost.
Looking at above table, you can see that an order
quantity of 1,000 toy race cars will minimize the total
cost.
Resource Constrained Multiple Product
Systems

• Although we could certainly compute optimal order

quantities separately for each of the different items, there
could exist constraints that would make the resulting
solution infeasible
Example
• 3 items are produced in a small fabrication shop. The
shop management has established the requirement
that the shop never have more than $30,000 invested
in the inventory of these items at one time. The
management uses a 25% annual interest charge to
compute the holding cost. The relevant cost and
demand parameters are given in the following table.
 Item
1 2 3 The first step is to
Demand rate 1,850 1,150 800 compute the EOQ
values for all
Variable cost 50 350 85 items to
determine
Setup cost 100 150 50
whether or not the
(2)(100)(1,850) constraint is
( 2)(150)(1,150)
EOQ1   172 EOQ2   63
(0.25)(50) active
(0.25)(350 )

(2)(50)(800)
EOQ3   61
(0.25)(85)

If the EOQ value for each item is used, the maximum investment in inventory
would be (172)(50) + (63)(350) + (61)(85) = $35,835
Because the EOQ solution violates the constraint, we need to reduce these lot
sizes. But how?
• The optimal solution turns out to be very easy to find in this case
• We merely multiply each EOQ value by the ratio (30,000)/(35,835) =
0.8372
• In order to guarantee that we don’t exceed the $30,000 budget, we round
each value down
• Letting Q1*, Q2*, Q3* be the optimal values, we obtain
Q1* = (172)(0.8372) ≈ 144
Q2* = (63)(0.8372) ≈ 52
Q3* = (61)(0.8372) ≈ 51
• The total budget required for these lot sizes is $29,735
• The remaining $265 can now be used to increase the lot sizes of product
1 and 3 slightly. (for example, Q 1 = 147, Q3* = 52 results in a budget of
$29,970)
• Nahmias, Steven. Production and operations analysis,
McGraw-Hill, 2009
• Render, Barry and Jay Heizer. Principles of operations
management, Pearson, 2008
D1316
Production and Operations Analysis