UNIT 10 INVENTORY SYSTEMS AND MODELLING

Objectives
After going through this unit, you should be able to:
• understand various concepts used in inventory management models;
• classify various types of inventory related costs;
• identify various factors affecting inventory;
• develop simple inventory models;
• differentiate between deterministic and probabilistic inventory models; and
• apply simple inventory models in practical situations.
Structure
10.1 Introduction
10.2 Inventory Modelling
10.3 Deterministic Inventory Models
10.3.1 Economic Order Quantity (EOQ) Model with no Shortages
10.3.2 Economic Order Quanity (EOQ) Model with Shortages
10.3.3 Economic Production Lot Size Model (EPLS)
10.3.4 Economic Order Quantity (EOQ) Model with Price Breaks
10.4 Probabilistic Inventory Models
10.4.1 Single Period Discreet Probabilistic Demand Model
10.4.2 Single Period Continuous Probabilistic Demand Model
10.4.3 Multi-period Probabilistc Inventory Models
10.5 Summary
10.6 Self Assessment Exercises
10.7 References and Suggested Further Readings

10.1 INTRODUCTION
Inventory may be defined as ‘usable but idle’ resource. If the resource is some
tangible item such as materials, then it is termed as stock. Thus, inventory is a stock of
items on hand at a given time. There are three kinds of inventory stocks.
a) Raw materials used in production.
b) Semi-finished goods part way through production process (or work in progress).
c) Finished goods awaiting sale.
In general, the problem of inventory is, if too much of stock is kept then it amounts to
wasted cost. On the other hand, if too little stock is kept then it leads lost sales.
Therefore, the ideal situation is to have stock at desired levels. The inventory control
or management is a technique maintaining stock at desired levels. Like any stock,
inventory has inflow and outflow. Stock inflow is from new production or receipt of
material from suppliers. Stock outflow is finished goods to customers or use of
materials in the production process.
The demand for inventory could be:
a) External or independent demand: Where the usage is determined outside the
firm, as with finished goods inventory demanded by customers. In this case, with
many different customers, demand may be fairly constant.

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Inventory Policies and b) Internal or dependent demand: Where the usage is derived from firm’s rate
Systems of production of finished product, as with demand for materials and work-in-
progress. In this case, the demand may be constant or variable depending on
production scheduling.
In order to implement an optimal inventory policy, managers must answer two
questions:
a) Reorder point – when to order?
b) Order quantity – how many units to order?
Inventory Costs: An inventory system may be defined as one in which the following
three types of costs are significant:

1) Ordering Costs (Co): These are the costs of purchasing or producing items for
inventory replenishment. This is generally called ordering cost. The cost elements
may include administrative costs of preparing requisitions, placing orders or
setting up manufacturing runs. This cost is usually assumed to be independent of
the quantity ordered and therefore is a fixed cost of placing order or setting up
production run cost function. It is expressed as Rs./order.

2) Holding or Carrying Costs (Ch ): This is the cost of owning inventory and
using facilities for storing and safeguarding inventory stock through time. The
cost elements here may include:

a) Storage costs which includes maintenance and operating cost of storage

facilities; inventory taxes and insurance; expected losses due to casualty,
deterioration or obsolescence.
b) Opportunity cost of funds tied up in the value of inventory and the facilities
needed for managing it.
The inventory carrying (holding) cost is often expressed as a percent of inventory
value per year.

3) Shortage or Stockout Penalty Costs (Cs ): These are the costs of running out
of an item in inventory. These costs depend on how the company handles
shortages. The cost elements here may include:

a) Lost sales cost elements include shortages that cause customers to buy
elsewhere. The cost is the lost sales plus possible loss of the customer
forever.

b) Backorder cost elements include the firm backlogs shortages and satisfies
the unmet demand at the beginning of next period. The costs include lost
demand, penalty cost, loss of good will, and urgent replenishment costs. This
is generally expressed as Rs./item short/unit time.

10.2 INVENTORY MODELLING

In the earlier section you learned that one of the objective of inventory management is
to decide how much to order. This is determined by the Economic Order Quantity
(EOQ) by minimizing the total inventory cost using the following cost model:

The answer to the second objective of ‘when to order’ depends on the type of
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inventory system with which you are dealing with. There is a certain time needed to
process an order by the customer and the supplier. The time between placing an order
and its arrival is known as lead-time. The lead-time tells us, when to place an order
during each stock cycle. The level of stock that is enough to last the lead-time is
known as reorder level or reorder point.

The inventory models can be further classified as either deterministic (where demand
and lead-time are known) or probabilistic (where demand and/or lead-time are having
probability distribution). For building an inventory model, you should determine the
following:
a) Is demand for the item deterministic or probabilistic?
b) Is there a time lag between procurement and receipt?
c) Is monitoring of inventory level continuous or periodic?
d) Does firm backlog orders when inventory shortage occurs?
e) Does the inventory cycle (use, replenish) continue indefinitely or is there a
terminal cycle?
f) Does inventory lose value over time from deterioration, theft or obsolescence?

10.3 DETERMINISTIC INVENTORY MODELS

In this section, you will learn some simple inventory models with deterministic demand
and lead time.

10.3.1 Economic Order Quantity (EOQ) Model with no Shortages

This is simplest of the inventory models. Here, the items enter inventory in batches at
specified intervals, usedup gradually, and then replenished. It is popularly known as
EOQ Model or ‘Wilson’s lot size formula’. The following are the assumptions made in
this model:
a) Constant, deterministic, and uniform demand for a period,
b) No shortage costs involved,
c) The process is continuous, infinitely recurring inventory cycles, no quantity
discounts or backlogging of shortages.
Let us use the following symbols in developing the EOQ model with no shortages.
Co = Ordering cost or set-up cost per order (Rs. per order)
Ch = Carrying cost per unit per time period (Rs. per inventory unit per unit time)
t = Order cycle (length of time between two successive orders)
Q = Number of units ordered per order/produced per batch
D = Demand (the quantity used per year)
C = Cost per unit of purchase or manufacture
Q* = Economic order quantity or optimal number of units per order to minimize
the total cost
TC = Total annual inventory cost
L = Lead time
With these assumptions and symbols, the inventory level against time is shown in
Figure 10.1.

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Inventory Policies and
Systems
Time at which inventory was received
Inventory level

Reorder
level

Ordering cycle L
length (t) Order Ord
placed rece

Figure 10.1: Basic Inventory Model

An order size Q units is placed and received instantaneously when the inventory level
is zero. The stock is depleted at uniform rate D. The order cycle is,

The number of orders per year =Annual demand ÷ Order size =

Since the minimum level of stock is zero and maximum level of stock is Q, the

average inventory level (average number of units carried) is

Since there is no shortage cost in this model, the total inventory cost per year is,

Total  Purchase  Ordering  Carrying 

related  = cos t per  + cos t per  + cos t per 
       
cos t (TC)  year (PC)  year (OC)  year (CC)

 price  No. of units   Cost of  No. of orders 

      
=  per  purchased  +  ordering  placed  +
 unit  per year   per order  per year 

  

(1)

For an optimum inventory policy or EOQ, we minimize the total cost. For this we
apply first order and second order derivatives. Note that here CD is a fixed cost and

and are variable costs and are dependent on the order size Q.

Therefore, for total cost to be minimum, applying the first order derivative of TC with
respect to Q and setting equation (1) as zero,

(2)

or (3)
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  Annual   Annual 
   
 ordering  =  carrying 
or (4)
 cost   cost 
   
From equation (3), we get

EOQ = Q* = (5)

Applying the second order derivative of TC with respect to Q on equation (2),

Since is greater than zero, Q* is a minimum.

Therefore, we interpret that:

a) Firm orders or manufactures “optimal economic order quantity” Q* units of
inventory items per batch.
Optimal Order Quantity Q * 2Co
b) Optimal inventory cycle length t* = = =
Annual Demand D Ch D years
(or periods).
c) The total number of orders per year (N) is the reciprocal of the cycle period (t*).
D Ch D
That is, there are = batches (orders) per year. Therefore, N = *
=
Q 2Co
d) When carrying cost Ch rises, optimal Q* and t* fall.
e) When fixed procurement cost CD rises, 1/t* = optimal number of batches per
year falls.
f) Optimal results are independent of variable procurement cost per unit C
g) The CD term in TC, while a cost of doing business, is not really an inventory
cost.
h) The reorder level = (Lead time in years)x(Demand rate per year)=LD.

i) From equation (1), the variable part of the total cost is

Example 1
A juice store sells 5200 cases of juice /year. Each case costs Rs.200 whole-sale.
There is a Rs. 1000 juice delivery charge. The store’s working capital could be
invested at 10%/year. The owner pays 10% of inventory value in theft insurance and
taxes. No other store costs are related to inventory. Find the optimal inventory policy?
If the lead time is 15 days, find reorder level.
Solution
For this problem:
Time period = 1 year
Co = Rs.1000/delivery
C = Rs.200/case
D = 5200 cases/year
Ch = 20% of value/case = 0.2C = Rs. 40 per case per year
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Inventory Policies and
Systems
L= 15 days =

2 ×1000 × 5200
Q* = = = = Approximately 510 cases/delivery
40

t* = = 0.098 years (˜ 36 days) between deliveries

N= = 10 deliveries/year

Therefore, TC of inventory system: = 200 (5200) +

1000(5200)/510 + 40(255) ˜ Rs.10,60,396/year

Kindly note of Rs.10,60,396/year, CD = Rs.10,40,000 is a fixed cost and independent
of the inventory policy. Therefore, the total variable cost = Rs.10,60,396–Rs.10,40,000
= Rs.20,396.
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Reorder level = L×D = × 5,200 = ≈ 214 units.
365
10.3.2 Economic Order Quantity (EOQ) Model with Shortages
In this model, stock-outs are permitted which implies that shortage cost is finite or it is
not large. All the assumptions of the model given in section 10.3.1 hold good here also.
Also, in addition to the symbols given in section 10.3.1, the following symbols are used
in this model.
Cs = Shortage cost (or back order cost) per unit per year
I = Inventory level
S = Shortage level
Q = Order size (Q = I+S)
t1 = Portion of the cycle period for inventory carrying
t2 = Time of the stock-out
t = Cycle period (t = t1+t2)

 Total   Annual   Annual   Annual 

       
 variable  =  ordering  +  carrying  +  shortage 
 cos t   cos t   cos t   cos t 
       

C o D I 2 C h (Q − I ) 2 C s
= + + (1)
Q 2Q 2Q
The problem here is to choose Q and I in order to minimize equation (1) above.
The optimization results are:

  2C o D  C s + C h 
  
EOQ = Q* =   C  C 
 h  s 


 2C o D  C s 
Inventory level = I* =   C  C + C 

 h  s h 
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Shortage level = Q* - I*

Cycle period = t* =

No. of orders/year =

Example 2
Suppose in example 1, the store allows backlogging juice shortages and the shortage
cost is Rs.100/case per year. Find the optimum inventory policy.
Solution
We have,
Time period = 1 year
Co = Rs.1000/delivery
C = Rs.200/case
D = 5200 cases/year
Ch = 20% of value/case = 0.2C = Rs. 40 per case per year
Cs = Rs.100/case per year.
The optimal policy is,

  2C o D  C s + C h    2 × 1000 × 5200  100 + 40  

   =     
EOQ = Q* =   C  C 
 h  s   40  100  

= 2,60,000 × 1.4 = 603 cases per order

  2C o D  C s 
    = 431 cases
Inventory level = I* =   C  C + C 
 h  s h 
Shortage level = Q* - I* = 603-431=172 cases

Cycle period = t* = = 0.116 years or 42 days

No. of orders/year = = 8.6 or say 9 deliveries per year

Total variable cost = = Rs.17,238

10.3.3 Economic Production Lot Size Model (EPLS)

The economic production lot size model is associated with a manufacturing
environment. Here no shortages allowed. The EPLS realistically shows that inventory
gradually built over a period of time because production and consumption go side by
side where production rate is higher than consumption rate. In this model also all the
assumptions made in EOQ model discussed in section 10.3.1 hold good. Here the
order size is taken as production size p units per day, daily demand rate
(demand¸working days) d units per working day, and p > d. When stock of inventory
reaches zero, new production begun. When stock of units on hand reaches maximum,
production stops until inventory hits zero. The following are the symbols used in the
model.

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Inventory Policies and Co = fixed set-up costs per production run
Systems
Ch = holding cost per unit per year
p = daily production rate (capacity/working day)
Q = number of units produced per run
D = demand per year (month, etc.)
d = daily demand rate (demand/working day)
C = cost per unit of manufacture
t1 = length of production run in working days
t = length of inventory cycle (years or time periods)
I = level of inventory
During each production run, Q units are produced in t1 days.

Therefore, Q = pt1 ⇒ production time = t1 =

Cycle time = t =
During production run, inventory is growing by (p – d) units per day.

Maximum inventory level =

Minimum inventory level = 0

Average inventory carried = I =

(p − d ) Q + 0
=
p
=
(p − d ) Q
2 2p

2C o D   2C D  p  
Q* = =   o   
Ch ( p − d )  C
 h  p − d  

p

Q*
t* =
D
Example 3
A company sells 20,000 cases of detergent per year. Production set up costs Rs.5,000
a run. Manufacturing costs are Rs.250 per case. The company has production
capacity of 50,000 cases per year. The company is open for 300 days per year for
business. Annual inventory carrying costs is 20% of inventory value. Find optimum
inventory policy.
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Solution
Time period = 1 year
Co = Rs.5000/run
C = Rs.250/case
D = 20,000 cases/year or d = 20,000¸300 = 67 cases/day
Ch = 20% of Rs.250 = Rs.50 per unit per year = Rs. 0.14 per unit per day
P = 50,000/cases per year or p = 50,000¸300 = 167 cases per day
The optimal policy is,

  2 × 5000 × 67  167  
Q* =      = 2827 cases per production run
 0.14  167 − 67  

= = 2827÷167 = 17 production days per cycle or run

Q*
t* = = 2827÷20000 = 0.14 years per cycle (or 42 business days per cycle)
D

= 1÷0.14 = 7.14 cycles per year

Total variable cost = = Rs.35491 per year

10.3.4 Economic Order Quantity (EOQ) Model with Price Breaks

When the items are bought in bulk by the firm, the supplier usually offers some
discount in price. Here no shortages allowed. This model is the same as the EOQ
model discussed in section 10.3.1 except that the inventory item may be purchased at
a discount if the size of the order exceeds a given limit.
Whenever, the quantity discounts are available, the price C may vary according to;

------------------------------------

----------------------------------

Where C1 > C2 …> Cj > …>Cn

Cj = price per unit for the jth lot size
Purchasing cost per unit time of the respective lot sizes are DC1, DC2, …DCj,…,DCn
The total cost of the respective lot sizes are:

------------------------------------

------------------------------------

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Inventory Policies and Ch = iCj,
Systems
Where i = percentage of change for j = 1,2,…,j,…,n
Also, since price varies with size of the purchase, the fixed cost DCj cannot be
ignored for minimizing the total cost. The functions DC1, DC2, …DCj,…,DCn are
illustrated in Figure 10.2. The bold faced part of the respective curves show feasible
part of the total cost.
Total cost

q1 q2 q3

Figure 10.2 Quantity Discounts

The steps for determining EOQ are :

Step 1: Find the EOQ for lowest price

If , the optimum order quantity is . If , go to step 2.

Step 2: Find the EOQ for the next lowest price

If , then compare the total cost TCn-1 for purchasing quantity qn and

select last cost purchase quantity. If , go to step 3

Step 3: Find the EOQ for the next lowest price

If Q n*− 2 ≥ q n − 2 , then compare the total cost TCn-1 for purchasing quantity qn and select

last cost purchase quantity. If , continue in this manner until

Example 4
The demand for a particular component used in manufacturing TV sets is 3000 units
per annum. Ordering cost is Rs. 500, inventory carrying charge is 25% of the purchse
10 price per year. The supplier has offered the following purchase prices:
Rs. 10 for purchasing Q1 < 500
Rs. 9 for purchasing 500=Q2<1000
Rs. 8 for purchasing Q3>1000
Find the optimum purchase quantity.
Solution

2 × 500 × 3000
= Q3 =
*
Step 1: = 1225 units
0.25x8

Since, , that is 1225?1000, the optimum order quantity is 1225 units.

10.4 PROBABILISTIC INVENTORY MODELS

In section 10.3 we have discussed simple deterministic inventory models where the
demand and lead time are known. But in actual business life we may not be knowing
the actual demand and lead time. In such situations we may have to go for
probabilistic inventory models The probability distribution of future demand is usually
determined from the past experience. In such situations, we minimize the expected
costs rather than actual costs. The expected costs are calculated by multiplying the
actual cost for a particular situation with probability of occurrence of that situation.
We assume that the demand D is a random variable with probability distribution p(D).
The demand pattern may be either discreet probability distribution or continuous
probability distribution. Also, the probabilistic inventory models can be single period or
multi period models. In section 10.4.1, we will discuss simple single period discreet
probabilistic inventory models. In section 10.4.2, we will discuss simple single period
continuous probabilistic inventory models. Section 10.4.3 covers multi period
probabilistic inventory models.

10.4.1 Single Period Discreet Probabilistic Demand Model

You may understand that perishable goods, spare parts and other seasonal goods
requires one time purchase only. The demand for such items should be either discreet
or continuous. In such cases, since the purchases are made only once, the lead time
factor do not apply in these models. The following symbols are used in this model:
D = Demand for an item in units (assumed to be a random variable); D = dj with
probabilities p(dj), j = 1,2,3,…n
P(D) = Cumulative probabiility
Q = The number of units stocked (or purchased)
C = Unit cost price
Ch = Carrying cost for the entire period
Cs = Shortage cost
S = Selling price per unit
V = Salvage value
C1 = Cost of over stocking (or cost of over ordering) = C+Ch-V
C2 = Cost of under stocking (or cost of under ordering) = S-C-(Ch/2)+Cs
Since, the demand D = dj, j = 1,2,3,… is a random variable, p(dj) denotes the
probability of demand such that, p(d1)+ p(dj)+ p(dj)+… = 1.
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Inventory Policies and If dj < Q, the item is over stocked and incur a marginal over stocking cost C1 per unit
Systems of excess inventory.
If dj > Q, the item is under stocked and incur a marginal under stocking penalty cost
of C2 per unit shortage.
To find the optimal quantity Q*, we minimize the expected inventory cost. For this we
use marginal analysis.
Let E[C(Q)] = expected inventory cost if Q units are ordered
E[C(Q+1)] = expected inventory cost if Q+1 units are ordered
MC = Marginal cost of ordering one extra unit
E(MC) = E[C(Q+1)] – E[C(Q+)] = expected marginal cost of ordering one extra unit
Then, optional order quantity Q* = the smallest Q for which E(MC) = 0
If D < Q, increasing Q by one unit will increase overstock by a unit, so MC =c1. This
occurs with probability P(Q).
If D = Q+1, increasing Q by one unit will decrease shortage by a unit, so MC = -c2.
This occurs with probability 1-P(Q).
Therefore, E(MC) = c1P(Q) – c2(1-P(Q))
= (c1 + c2)P(Q) – c2 = 0

Thus,

The optimal demand Q* is the smallest Q for which P(Q*) = P(D)

Example 5
A news paper seller buys Q news papers (in multiples of 50) at a price of Rs 2 each
and sells them at a price of Rs. 2.50. He can return unsold papers for Rs. 1.25
refund. The probability distribution of demand is shown below.
Demand Probability
100 0.30
150 0.20
200 0.30
250 0.15
300 0.05
How many papers should be ordered.
Solution
Demand (dj) Probability (p(dj) Cumulative probability P(D)
100 0.30 0.30
150 0.20 0.50
200 0.30 0.80
250 0.15 0.95
300 0.05 1.00
Marginal cost of overstock = C1 = Rs. 2 – Rs. 1.25 = Rs. 0.75
Marginal cost of overstock = C2 = Rs. 2.50 – Rs. 2 = Rs. 0.50

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For Q* = 150, P(150) = 0.50 > 0.40, but P(100) = 0.30 < 0.40
Therefore, the optimal quantity is 150 papers.

10.4.2 Single Period Continuous Probabilistic Demand Model

This model is similar to that discussed in 10.4.2. The only difference is that in this
model we assume the demand D is a continuous random variable with probability
density function f(d) and cumulative probability density function F(D). The optimal

quantity Q* is found where

Example 6
A training institute reserves Q rooms in a nearby hotel for its trainees at Rs.500 per
room. If the demand is greater than Q then rooms can be obtained at Rs.900 each.
The demand is normally distributed. D~N(µd σ2d ) where µd = 5,000 and σd = 2000.
How many rooms should be reserved now?
Solution
Marginal cost of over stock c1 = Rs.500
Marginal cost of under stock c2 = Rs.900 – Rs.500 = Rs.400

Q* − 5000
P (D ≤ Q* ) = P ( Z ≤ ) = 0.4444
2000
Using the standard normal table

Q* = – 0.14(2000)+5000 = 4720 rooms

10.4.3 Multi-period Probabilistic Inventory Models

In single period inventory models, demand is a significant factor and the lead time do
not have any role to play. However, in multi period inventory models both demand and
inventory play significant role in the inventory policy decision process. The variations
in demand and/or lead time pose risks in taking right decisions. We try to absorb the
risks by carrying inventories called safety stocks or buffer stocks. In this Unit we will
consider reorder level with variable demand.

A constant buffer stock is maintained throughout the planning period. The size of the
buffer stock is determined such that the probability of running out of stock during lead
time does not exceed a prescribed value. The following symbols are used in this
model:
U = Random variable representing demand during lead time
L = Lead time
= Average daily demand
µL = Average demand during lead time
σL = Standard deviation of the demand during lead time
σd = Standard deviation of daily demand
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Inventory Policies and B = Buffer stock (or safety stock)
Systems
Z = Number of standard deviations needed for a specified confidence interval
R = Reorder level
The assumption of the model is that the demand U during the lead time L is normally
distributed with mean µL and standard deviation σL. Symbolically N(µL, σL).

Figure 10.3 shows buffer stock (B), lead time (L), average demand during lead time
(µL), reorder level (B+µL), EOQ(Q*) and the maximum level of inventory (B+Q*).
Inventory level

*
B+Q

B+µL

Figure 10.3: Relationship between buffer stock, lead time reorder level, and EOQ

Average demand during lead time = µL =

Buffer stock = B = Z

Standard deviation of demand during lead time = σL =

Therefore, the reorder level is

R* = Average lead time demand + Buffer stock
= µL +B

= +Z

EOQ = Q* =

Maximum inventory level = B+Q*

Average inventory level = B+(Q*/2)
Example 7
The daily demand for an item is normally distributed with mean 30 units and standard
deviation 5 units. Lead time is 10 days. Find the reorder point with 95% service level
and 5% stock out probability. Also, find the buffer stock.

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Solution
D = 30 units
Dd = 5 units
L = 10 days
Z = 1.65 (for a 95% service level)

Reorder level = R = +Z = 30(10) + (1.65) (5) ( ) = 326.1 units

Buffer stock = Z = (1.65) (5) ( ) = 26.1 units

Example 8
For an item the daily demand is distributed normal with mean 100 and standard
deviation 10. Lead time is 15 days. The cost of placing an order is Rs.9 and carrying
costs are 20% of the unit price. The unit price is given as Rs.1.50. Back orders are
allowed but there is no stock out cost. A 95% service level is desired. Find the
following:
a) Buffer stock
b) Reorder level
c) Average inventory level
d) Maximum inventory level
Solution
D = 100 units daily × 365 days = 36,500 units
Co = Rs.9
Ch = 0.2 × 1.50 = 0.3
= 100
σd = 10
L = 15 days
Z = 1.65(for 95% service level)

a) Buffer stock = Z =1.65 × 10 × = 64 units

b) Recorder level = +Z = 100 × 15 + 64 = 1564 units

c) Average inventory level = = 64 + (1480/2) = 804 units.

d) Maximum inventory level = B + Q* = 64 + 1480 = 1544 units

10.5 SUMMARY
In this unit, you have learned the introductory concepts used in the inventory models.
Various factors determine the inventory policy decisions. Primarily, there are two
factors which decide the deterministic or probability nature of the models. These are
demand and lead time. Some of the other factors that determine the inventory are
cost, demand, lead time, shortages. Depending on the situation, you have to choose the
right model. In this Unit, only simple inventory models are used. The understanding of
these models will provide you a basic understanding of inventory model. 15
Inventory Policies and
Systems 10.6 SELF ASSESSMENT EXERCISES
1) Define inventory. What are the two sources of demand for inventory?
2) What are the cost elements in ordering costs, carrying costs, and shortage costs?

3) An item is produced at the rate of 100 units per day and is consumed at the rate
of 50 units per day. The set up cost is Rs.200 per production run and carrying
cost in stock is Rs.400 per unit per year. Find the economic lot size per run,
number of runs per year, and the total related cost?
4) A stationery shop supplies 5000 reams of paper a year. He charges Rs.1.50 per
ream plus a fixed Rs.50 for delivery. A ream of paper loses about Rs.0.45 in
value each year. The annual fire insurance premium per ream is Rs.0.05. Find
the store’s optimal paper inventory policy.
5) In problem 4 given above, suppose the stationery shop adopts a policy of
backlogging un-filled demand for paper, at a cost of Rs.0.25 per ream per year.
What is the store’s optimal inventory policy?
6) A company sells 1,40,000 bolts per year. It produces the bolts in its own factory
in discreet production runs. The production set up costs are Rs.1500 per run and
production costs are Rs.104 per bolt. The company has production capacity of
3,50,000 bolts per year and is open for business 300 days a year. Annual
inventory holding cost is 16% of inventory value. Find the optimal policy.
7) For an item annual demand is 1000 units, set up cost is Rs.20, and carrying cost
is 2% per month of purchase price. The minimum stock is 200 units. Purchase
price per unit is Rs.2 per order below 2000 units and Rs.1 if the order is 2000 or
more. For the above data find optimum inventory policy.
8) A textile firm sells 10,000 meters of a particular brand of cloth per year. The
daily production rate is 150 meters. Production set up costs Rs.150 per run.
Weaving costs are Rs.0.75 per meter. The firm open for business 311 days per
year. Find the optimal inventory policy.
9) A mobile phone shop offers the following price discounts on a particular brand
phone:
Quantity Price
1-49 Rs.1400
50-89 Rs.1100
90+ Rs.900
The demand is 200 units. The ordering cost is Rs.2500. The inventory carrying
charges are Rs.190 per unit per year. Find the optimum purchase quantity.
10) An item is bought at Rs.50 each unit and sold at Rs.75 each unit. If shortage is
there then there will be a goodwill cost of Rs.15 each unit. If the item is not sold
then there will be a salvage value of Rs.10. Carrying cost during the period is
estimated to be 20% of the cost price. The probability distribution for the demand
is given below:
Units Stocked 2 3 4 5 6
Probability of Demand 0.30 0.25 0.20 0.15 0.10
Find the optimum number of units that can be stocked.
11) Daily demand for an item is normally distributed with mean 80 units and standard
deviation of 12 units. Lead-time is 4 days. The cost of placing an order is Rs.16
16 and annual carrying costs are 25% of the unit price. The unit price is Rs.1.75.
Find the optimum inventory policy for 90% service level.
10.7 REFERENCES AND SUGGESTED FURTHER
READINGS

Kapoor, V.K. (1999) Operations Research, Sultan Chand & Sons, New Delhi
Mustafi, C.K. (1988) Operations Research: Methods and Practice, Wiley Eastern
Ltd.
Peterson, R. And Silver, E.A. (1981) Decision Systems for Inventory Management
and Production Planning, John Wiley & Sons, New York
Taha, H.A. (2001) Operations Research: An Introduction, Prentice Hall of India,
New Delhi

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