1 Chapter 14 Inventory Models: Deterministic Demand Economic Order Quantity (EOQ) ModelEconomic Production Lot Size ModelInventory Model with Planned ShortagesQuantity Discounts for the EOQ Model
2 Inventory ModelsThe study of inventory models is concerned with two basic questions:How much should be ordered each timeWhen should the reordering occurThe objective is to minimize total variable cost over a specified time period (assumed to be annual in the following review).
3 Inventory CostsOrdering cost -- salaries and expenses of processing an order, regardless of the order quantityHolding cost -- usually a percentage of the value of the item assessed for keeping an item in inventory (including cost of capital, insurance, security costs, taxes, warehouse overhead, and other related variable expenses)Backorder cost -- costs associated with being out of stock when an item is demanded (including lost goodwill)Purchase cost -- the actual price of the itemsOther costs
4 Deterministic ModelsThe simplest inventory models assume demand and the other parameters of the problem to be deterministic and constant.The deterministic models covered in this chapter are:Economic order quantity (EOQ)Economic production lot sizeEOQ with planned shortagesEOQ with quantity discounts
5 Economic Order Quantity (EOQ) The most basic of the deterministic inventory models is the economic order quantity (EOQ).The variable costs in this model are annual holding cost and annual ordering cost.For the EOQ, annual holding and ordering costs are equal.
6 Economic Order Quantity AssumptionsDemand D is known and occurs at a constant rate.The order quantity Q is the same for each order.The cost per order, $Co, is constant and does not depend on the order quantity.The purchase cost per unit, C, is constant and does not depend on the quantity ordered.The inventory holding cost per unit per time period, $Ch, is constant.Shortages such as stock-outs or backorders are not permitted.The lead time for an order is constant.The inventory position is reviewed continuously.
7 Economic Order Quantity FormulasOptimal order quantity: Q * = 2DCo/ChNumber of orders per year: D/Q *Time between orders (cycle time): Q */D yearsTotal annual cost: [Ch(Q*/2)] + [Co(D/Q *)](holding + ordering)
8 Example: Bart’s Barometer Business Economic Order Quantity ModelBart's Barometer Business is a retail outlet thatdeals exclusively with weather equipment. Bart istrying to decide on an inventory and reorder policyfor home barometers.Barometers cost Bart $50 each and demand isabout 500 per year distributed fairly evenlythroughout the year.
9 Example: Bart’s Barometer Business Economic Order Quantity ModelReordering costs are $80 per order and holdingcosts are figured at 20% of the cost of the item. Bart'sBarometer Business is open 300 days a year (6 days aweek and closed two weeks in August). Lead time is60 working days.
11 Example: Bart’s Barometer Business Optimal Reorder QuantityQ * = 2DCo /Ch = 2(500)(80)/10 = 90Optimal Reorder PointLead time is m = 60 days and daily demand is d = 500/300 orThus the reorder point r = dm = (1.667)(60) = Bart should reorder 90 barometers when his inventory position reaches 100 (that is 10 on hand and one outstanding order).
12 Example: Bart’s Barometer Business Number of Orders Per YearNumber of reorder times per year = (500/90) = 5.56 or once every (300/5.56) = 54 working days (about every 9 weeks).Total Annual Variable CostTC = 5(90) + (40,000/90) = = $894
13 Sensitivity Analysis for the EOQ Model Optimal Order Quantities for Several CostsPossibleOptimalProjected TotalInventoryCost PerOrderAnnual CostHolding CostQnty. (Q*)Using Q*Using Q = 9018%$7591 units$82218859787587722758390891288967
14 Example: Bart’s Barometer Business We’ll now use a spreadsheet to implementthe Economic Order Quantity model. We’ll confirmour earlier calculations for Bart’s problem andperform some sensitivity analysis.This spreadsheet can be modified to accommodateother inventory models presented in this chapter.
15 Example: Bart’s Barometer Business Partial Spreadsheet with Input Data
16 Example: Bart’s Barometer Business Partial Spreadsheet Showing Formulas for Output
17 Example: Bart’s Barometer Business Partial Spreadsheet Showing Output
18 Example: Bart’s Barometer Business Summary of Spreadsheet ResultsA 16.15% negative deviation from the EOQ resulted in only a 1.55% increase in the Total Annual Cost.Annual Holding Cost and Annual Ordering Cost are no longer equal.The Reorder Point is not affected, in this model, by a change in the Order Quantity.
19 Economic Production Lot Size The economic production lot size model is a variation of the basic EOQ model.A replenishment order is not received in one lump sum as it is in the basic EOQ model.Inventory is replenished gradually as the order is produced (which requires the production rate to be greater than the demand rate).This model's variable costs are annual holding cost and annual set-up cost (equivalent to ordering cost).For the optimal lot size, annual holding and set-up costs are equal.
20 Economic Production Lot Size AssumptionsDemand occurs at a constant rate of D items per year or d items per day.Production rate is P items per year or p items per day (and P > D, p > d ).Set-up cost: $Co per run.Holding cost: $Ch per item in inventory per year.Purchase cost per unit is constant (no quantity discount).Set-up time (lead time) is constant.Planned shortages are not permitted.
21 Economic Production Lot Size FormulasOptimal production lot-size:Q * = 2DCo /[(1-D/P )Ch]Number of production runs per year: D/Q *Time between set-ups (cycle time): Q */D yearsTotal annual cost: [Ch(Q*/2)(1-D/P )] + [Co/(D/Q *)](holding + ordering)
22 Example: Beauty Bar Soap Economic Production Lot Size ModelBeauty Bar Soap is produced on a production line that has an annual capacity of 60,000 cases. The annual demand is estimated at 26,000 cases, with the demand rate essentially constant throughout the year. The cleaning, preparation, and setup of the production line cost approximately $135. The manufacturing cost per case is $4.50, and the annual holding cost is figured at a 24% rate. Other relevant data include a five-day lead time to schedule and set up a production run and 250 working days per year.
23 Example: Beauty Bar Soap Total Annual Variable Cost ModelThis is an economic production lot size problem withD = 26,000, P = 60,000, Ch = 1.08, Co = 135TC = (Holding Costs) + (Set-Up Costs)= [Ch(Q/2)(1 - D/P )] + [Co(D/Q)]= [1.08(Q/2)(1 – 26,000/60,000)] + [135(26,000/Q)]= .306Q + 3,510,000/Q
24 Example: Beauty Bar Soap Optimal Production Lot SizeQ * = 2DCo/[(1 -D/P )Ch]= 2(26,000)(135) /[(1.08)(1 – 26,000/60,000)]= 3,387Number of Production Runs (Cycles) Per YearD/Q * = 26,000/3,387= times per year
25 Example: Beauty Bar Soap Total Annual Variable CostOptimal TC = .306(3,387) + 3,510,000/3,387= 1, ,036.32= $2,073
26 Example: Beauty Bar Soap Idle Time Between Production RunsThere are cycles per year.Thus, each cycle lasts (250/7.6764) = days.The time to produce 3,387 per run = (3,387/60,000) = days.Thus, the production line is idle for:– = days between runs.The production line is utilized:/32.567(100) = 43.33%
27 Example: Beauty Bar Soap Maximum InventoryMaximum inventory = (1-D/P )Q *= (1-26,000/60,000)3,387 1,919.3Machine UtilizationMachine is producing D/P = 26,000/60,000= of the time.
28 EOQ with Planned Shortages With the EOQ with planned shortages model, a replenishment order does not arrive at or before the inventory position drops to zero.Shortages occur until a predetermined backorder quantity is reached, at which time the replenishment order arrives.The variable costs in this model are annual holding, backorder, and ordering.For the optimal order and backorder quantity combination, the sum of the annual holding and backordering costs equals the annual ordering cost.
29 EOQ with Planned Shortages AssumptionsDemand occurs at a constant rate of D items/year.Ordering cost: $Co per order.Holding cost: $Ch per item in inventory per year.Backorder cost: $Cb per item backordered per year.Purchase cost per unit is constant (no qnty. discount).Set-up time (lead time) is constant.Planned shortages are permitted (backordered demand units are withdrawn from a replenishment order when it is delivered).
30 EOQ with Planned Shortages FormulasOptimal order quantity:Q * = 2DCo/Ch (Ch+Cb )/CbMaximum number of backorders:S * = Q *(Ch/(Ch+Cb))Number of orders per year: D/Q *Time between orders (cycle time): Q */D yearsTotal annual cost:[Ch(Q *-S *)2/2Q *] + [Co(D/Q *)] + [S *2Cb/2Q *](holding + ordering + backordering)
31 Example: Higley Radio Components Co. EOQ with Planned Shortages ModelHigley has a product for which the assumptions ofthe inventory model with backorder are valid. Demandfor the product is 2,000 units per year. The inventoryholding cost rate is 20% per year. The product costsHigley $50 to purchase. The ordering cost is $35 perorder. The annual backorder cost is estimated to be $30per unit per year.
32 Example: Higley Radio Components Co. Optimal Order PolicyD = 2,000; Co = $25; Ch = .20(50) = $10; Cb = $30Q * = 2DCo/Ch (Ch + Cb)/Cb= 2(2000)(25)/10 x (10+30)/30= 115S * = Q *(Ch/(Ch+Cb))= 115(10/(10+30)) =
33 Example: Higley Radio Components Co. Maximum InventoryQ – S = – = unitsCycle TimeT = Q/D(250) = /2000(250) = working days
35 Example: Higley Radio Components Co. Stockout: When and How LongQuestion:How many days after receiving an order doesHigley run out of inventory? How long is Higleywithout inventory per cycle?
36 Example: Higley Radio Components Co. Stockout: When and How LongAnswerInventory exists for Cb/(Cb+Ch) = 30/(30+10) = .75of the order cycle. (Note, (Q *-S *)/Q * = .75 also,before Q * and S * are rounded.)An order cycle is Q */D = years =days. Thus, Higley runs out of inventory .75(14.434)= days after receiving an order.Higley is out of stock for approximately –= days.
37 EOQ with Quantity Discounts The EOQ with quantity discounts model is applicable where a supplier offers a lower purchase cost when an item is ordered in larger quantities.This model's variable costs are annual holding, ordering and purchase costs.For the optimal order quantity, the annual holding and ordering costs are not necessarily equal.
38 EOQ with Quantity Discounts AssumptionsDemand occurs at a constant rate of D items/year.Ordering Cost is $Co per order.Holding Cost is $Ch = $CiI per item in inventory per year (note holding cost is based on the cost of the item, Ci).Purchase Cost is $C1 per item if the quantity ordered is between 0 and x1, $C2 if the order quantity is between x1 and x2 , etc.Delivery time (lead time) is constant.Planned shortages are not permitted.
39 EOQ with Quantity Discounts FormulasOptimal order quantity: the procedure for determining Q * will be demonstratedNumber of orders per year: D/Q *Time between orders (cycle time): Q */D yearsTotal annual cost: [Ch(Q*/2)] + [Co(D/Q *)] + DC(holding + ordering + purchase)
40 Example: Nick's Camera Shop EOQ with Quantity Discounts ModelNick's Camera Shop carries Zodiac instant printfilm. The film normally costs Nick $3.20 per roll, andhe sells it for $ Zodiac film has a shelf life of 18months. Nick's average sales are 21 rolls per week.His annual inventory holding cost rate is 25% and itcosts Nick $20 to place an order with Zodiac.
41 Example: Nick's Camera Shop EOQ with Quantity Discounts ModelIf Zodiac offers a 7% discount on orders of 400rolls or more, a 10% discount for 900 rolls or more,and a 15% discount for 2000 rolls or more, determineNick's optimal order quantity.D = 21(52) = 1092; Ch = .25(Ci); Co = 20
42 Example: Nick's Camera Shop Unit-Prices’ Economical Order QuantitiesFor C4 = .85(3.20) = $2.72To receive a 15% discount Nick must orderat least 2,000 rolls. Unfortunately, the film's shelflife is 18 months. The demand in 18 months (78weeks) is 78 x 21 = 1638 rolls of film.If he ordered 2,000 rolls he would have toscrap 372 of them. This would cost more than the15% discount would save.
43 Example: Nick's Camera Shop Unit-Prices’ Economical Order QuantitiesFor C3 = .90(3.20) = $2.88Q3* = 2DCo/Ch = 2(1092)(20)/[.25(2.88)] = (not feasible)The most economical, feasible quantity for C3 is 900.For C2 = .93(3.20) = $2.976Q2* = 2DCo/Ch = 2(1092)(20)/[.25(2.976)] =(not feasible)The most economical, feasible quantity for C2 is 400.
44 Example: Nick's Camera Shop Unit-Prices’ Economical Order QuantitiesFor C1 = 1.00(3.20) = $3.20Q1* = 2DCo/Ch = 2(1092)(20)/.25(3.20) = (feasible)When we reach a computed Q that is feasible we stop computing Q's. (In this problem we have no more to compute anyway.)
45 Example: Nick's Camera Shop Total Cost ComparisonCompute the total cost for the most economical, feasible order quantity in each price category for whicha Q * was computed.TCi = (Ch)(Qi*/2) + (Co)(D/Qi*) + DCiTC3 = (.72)(900/2) + (20)(1092/900) + (1092)(2.88) = 3,493TC2 = (.744)(400/2) + (20)(1092/400) + (1092)(2.976) = 3,453TC1 = (.80)(234/2) + (20)(1092/234) + (1092)(3.20) = 3,681Comparing the total costs for order quantities of 234, 400 and 900, the lowest total annual cost is $3,453. Nick should order 400 rolls at a time.
46 Chapter 14 Inventory Models: Probabilistic Demand Single-Period Inventory Model with Probabilistic DemandOrder-Quantity, Reorder-Point Model with Probabilistic DemandPeriodic-Review Model with Probabilistic Demand
47 Probabilistic ModelsIn many cases demand (or some other factor) is not known with a high degree of certainty and a probabilistic inventory model should actually be used.These models tend to be more complex than deterministic models.The probabilistic models covered in this chapter are:single-period order quantityreorder-point quantityperiodic-review order quantity
48 Single-Period Order Quantity A single-period order quantity model (sometimes called the newsboy problem) deals with a situation in which only one order is placed for the item and the demand is probabilistic.If the period's demand exceeds the order quantity, the demand is not backordered and revenue (profit) will be lost.If demand is less than the order quantity, the surplus stock is sold at the end of the period (usually for less than the original purchase price).
49 Single-Period Order Quantity AssumptionsPeriod demand follows a known probability distribution:normal: mean is µ, standard deviation is uniform: minimum is a, maximum is bCost of overestimating demand: $coCost of underestimating demand: $cuShortages are not backordered.Period-end stock is sold for salvage (not held in inventory).
50 Single-Period Order Quantity FormulasOptimal probability of no shortage:P(demand < Q *) = cu/(cu+co)Optimal probability of shortage:P(demand > Q *) = 1 - cu/(cu+co)Optimal order quantity, based on demand distribution:normal: Q * = µ + zuniform: Q * = a + P(demand < Q *)(b-a)
51 Example: McHardee Press Single-Period Order QuantityMcHardee Press publishes the Fast Food MenuBook and wishes to determine how many copies toprint. There is a fixed cost of $5,000 to produce thebook and the incremental profit per copy is $ Anyunsold copies of the the book can be sold at salvage ata $.55 loss.
52 Example: McHardee Press Single-Period Order QuantitySales for this edition are estimated to be normallydistributed. The most likely sales volume is 12,000copies and they believe there is a 5% chance that saleswill exceed 20,000.How many copies should be printed?
53 Example: McHardee Press Single-Period Order Quantitym = 12,000. To find note that z = 1.65 corresponds to a 5% tail probability. Therefore,(20, ,000) = 1.65 or = 4848Using incremental analysis with Co = .55 and Cu = .45, (Cu/(Cu+Co)) = .45/( ) = .45Find Q * such that P(D < Q *) = The probability of 0.45 corresponds to z = Thus,Q * = 12, (4848) = 11,418 books
54 Example: McHardee Press Single-Period Order Quantity (revised)If any unsold copies can be sold at salvage at a $.65 loss, how many copies should be printed?Co = .65, (Cu/(Cu + Co)) = .45/( ) = .4091Find Q * such that P(D < Q *) = z = -.23 gives this probability. Thus,Q * = 12, (4848) = 10,885 booksHowever, since this is less than the breakeven volume of 11,111 books (= 5000/.45), no copies should be printed because if the company produced only 10,885 copies it will not recoup its $5,000 fixed cost.
55 Reorder Point Quantity A firm's inventory position consists of the on-hand inventory plus on-order inventory (all amounts previously ordered but not yet received).An inventory item is reordered when the item's inventory position reaches a predetermined value, referred to as the reorder point.The reorder point represents the quantity available to meet demand during lead time.Lead time is the time span starting when the replenishment order is placed and ending when the order arrives.
56 Reorder Point Quantity Under deterministic conditions, when both demand and lead time are constant, the reorder point associated with EOQ-based models is set equal to lead time demand.Under probabilistic conditions, when demand and/or lead time varies, the reorder point often includes safety stock.Safety stock is the amount by which the reorder point exceeds the expected (average) lead time demand.
57 Safety Stock and Service Level The amount of safety stock in a reorder point determines the chance of a stock-out during lead time.The complement of this chance is called the service level.Service level, in this context, is defined as the probability of not incurring a stock-out during any one lead time.Service level, in this context, also is the long-run proportion of lead times in which no stock-outs occur.
58 Reorder Point Assumptions Lead-time demand is normally distributed with mean µ and standard deviation .Approximate optimal order quantity: EOQService level is defined in terms of the probability of no stock-outs during lead time and is reflected in z.Shortages are not backordered.Inventory position is reviewed continuously.
60 Example: Robert’s Drug Reorder Point ModelRobert's Drugs is a drug wholesaler supplying55 independent drug stores. Roberts wishes todetermine an optimal inventory policy for Comfortbrand headache remedy. Sales of Comfort are relativelyconstant as the past 10 weeks of data (on next slide)indicate.
61 Example: Robert’s Drug Reorder Point ModelWeek Sales (cases) Week Sales (cases)
62 Example: Robert’s Drug Each case of Comfort costs Roberts $10 andRoberts uses a 14% annual holding cost rate for itsinventory. The cost to prepare a purchase order forComfort is $12. What is Roberts’ optimal orderquantity?
63 Example: Robert’s Drug Optimal Order QuantityThe average weekly sales over the 10 week period is 120 cases. Hence D = 120 X 52 = 6,240 cases per year;Ch = (.14)(10) = 1.40; Co = 12.
64 Example: Robert’s Drug The lead time for a delivery of Comfort hasaveraged four working days. Lead time has thereforebeen estimated as having a normal distribution with amean of 80 cases and a standard deviation of 10 cases.Roberts wants at most a 2% probability of selling outof Comfort during this lead time. What reorder pointshould Roberts use?
65 Example: Robert’s Drug Optimal Reorder PointLead time demand is normally distributed with m = 80, = 10.Since Roberts wants at most a 2% probability of selling out of Comfort, the corresponding z value is That is, P (z > 2.06) = (about .02).Hence Roberts should reorder Comfort when supply reaches r = m + z = (10) = 101 cases.The safety stock is z = 21 cases.
67 Periodic Review System A periodic review system is one in which the inventory level is checked and reordering is done only at specified points in time (at fixed intervals usually).Assuming the demand rate varies, the order quantity will vary from one review period to another.At the time the order quantity is being decided, the concern is that the on-hand inventory and the quantity being ordered is enough to satisfy demand from the time the order is placed until the next order is received (not placed).
68 Periodic Review Order Quantity AssumptionsInventory position is reviewed at constant intervals.Demand during review period plus lead time period is normally distributed with mean µ and standard deviation .Service level is defined in terms of the probability of no stockouts during a review period plus lead time period and is reflected in z.On-hand inventory at ordering time: HShortages are not backordered.Lead time is less than the review period length.
69 Periodic Review Order Quantity FormulasReplenishment level: M = µ + zOrder quantity: Q = M - H
70 Example: Ace Brush Periodic Review Order Quantity Model Joe Walsh is a salesman for the Ace BrushCompany. Every three weeks he contacts DollarDepartment Store so that they may place an order toreplenish their stock. Weekly demand for Acebrushes at Dollar approximately follows a normaldistribution with a mean of 60 brushes and astandard deviation of 9 brushes.
71 Example: Ace Brush Periodic Review Order Quantity Model Once Joe submits an order, the lead time untilDollar receives the brushes is one week. Dollarwould like at most a 2% chance of running out ofstock during any replenishment period. If Dollarhas 75 brushes in stock when Joe contacts them,how many should they order?
72 Example: Ace Brush Demand During Uncertainty Period The review period plus the following lead time totals 4 weeks. This is the amount of time that will elapse before the next shipment of brushes will arrive.Weekly demand is normally distributed with:Mean weekly demand, µ = 60Weekly standard deviation, = 9Weekly variance, = 81Demand for 4 weeks is normally distributed with:Mean demand over 4 weeks, µ = 4 x = 240Variance of demand over 4 weeks, 2 = 4 x = 324Standard deviation over 4 weeks, = (324)1/2 = 18
73 Example: Ace Brush Replenishment Level M = µ + z where z is determined by the desired stock-out probability. For a 2% stock-out probability (2% tail area), z = Thus,M = (18) = 277 brushesAs the store currently has 75 brushes in stock, Dollar should order:= brushesThe safety stock is:z = (2.05)(18) = brushes