Inventory

Management
OPERATIONS MANAGEMENT AND TQM
TOPIC NO. VIII
LEARNING OBJECTIVES
1. Define the term inventory
2. Discuss the functions of inventory and objectives of
inventory control
3. Explain the types of inventory counting systems.
4. Explain the different inventory costs
5. Describe the A-B-C approach and explain how it is useful.
LEARNING OBJECTIVES
6. Describe the basic EOQ model and its assumptions and solve
typical problems.
7. Describe the economic production quantity model and solve
typical problems.
8. Describe the quantity discount model and solve typical
problems.
9. Describe reorder point models and solve typical problems.
10. Describe situations in which the single period model would be
appropriate and solve typical problems.
 Introduction to INVENTORY MNGT

Economic Order Quantity

Economic Production Quantity

Reorder Point & Other Inventory

Inventory Management Models
Management
WHAT IS INVENTORY?
✓ Stock of material
✓ Stock or store of goods use
in an organization
✓ Stored capacity
INVENTORY
The inventory that firms will carry relates to the kind of
business they are in

Manufacturing firms:
✓ raw materials, purchased parts, partially finished items,
finished goods, spare parts for machines, tools, and other
supplies
INVENTORY
The inventory that firms will carry relates to the kind of
business they are in

Department stores
✓ clothing, furniture, carpeting, stationery, cosmetics, gifts,
cards, toys, sporting goods, paints, etc.
THE FUNCTIONS OF INVENTORY
➢ To meet anticipated customer demand

A customer may be anyone who just walks into your

store and would like to buy something from you.
These inventories are referred to as anticipation
stocks because they are held to satisfy expected
demand
THE FUNCTIONS OF INVENTORY
➢ To smooth production requirements
Firms that experience seasonal patterns in
demand - often build up inventories during
preseason periods to meet overly high
requirements during seasonal periods. These
inventories are aptly named seasonal
inventories
THE FUNCTIONS OF INVENTORY
➢ To decouple operations
Decoupling operations generally refer to the practice of
minimizing dependencies between different components or
processes within a system.
This is often done to enhance flexibility, scalability, and
maintainability. When operations are tightly coupled, changes in
one part of a system can have a significant impact on other
parts, making it harder to modify or extend the system.
Decoupling aims to reduce these interdependencies.
THE FUNCTIONS OF INVENTORY
➢ To decouple operations
In manufacturing operations, decoupling means the use of
inventories as a buffer between successive operations to
maintain continuity of production that may be disrupted by
events such as equipment breakdown or accidents.

The inventory buffer permit other operations to continue

temporarily while the problem is resolved
THE FUNCTIONS OF INVENTORY
➢ To protect against stockouts
Delayed deliveries and unexpected increases in demand
increase the risk of shortages.
Delays can occur because of weather conditions, supplier
stockouts, deliveries of wrong materials, quality problems,
and so on.
The risk of shortages can be reduced by holding safety
stocks, which are stocks in excess of expected demand to
compensate for variabilities in demand and lead time.
THE FUNCTIONS OF INVENTORY
➢ To take advantage of order cycles
To minimize purchasing and inventory costs, a firm often
buys in quantities that exceed immediate requirements or
produce in large rather than small quantities
This necessitates storing some or all of the purchased
amount or the excess output
THE FUNCTIONS OF INVENTORY
➢ To take advantage of order cycles
Inventory storage enables a firm to buy and produce in
economic lot sizes without having to try to match purchases
or production with demand requirements in the short run.
This results in periodic orders or order cycles.
THE FUNCTIONS OF INVENTORY
➢ To hedge against inflation
Occasionally a firm will suspect that a substantial price
increase is about to occur and purchase larger-than-normal
amounts to beat the increase.
The ability to store extra goods also allows a firm to take
advantage of price discounts for larger orders
THE FUNCTIONS OF INVENTORY
➢ To permit operations
The fact that production operations take a certain amount of
time (i.e., they are not instantaneous) means that there will
generally be some work-in-process inventory.
In addition, intermediate stocking of goods—including raw
materials, semifinished items, and finished goods at
production sites, as well as goods stored in warehouses—
leads to pipeline inventories throughout a production-
distribution system
THE FUNCTIONS OF INVENTORY
➢ To permit operations
Pipeline inventories refer to the stocks or quantities of
goods, materials, or work-in-progress items that are in
transit between different stages of a production or
distribution process.
These inventories are part of a supply chain and are in the
process of being moved from one point to another, such as
from the manufacturer to the distributor, from the distributor
to the retailer, or from a production facility to a warehouse.
THE FUNCTIONS OF INVENTORY
➢ To permit operations
Little’s Law can be useful in quantifying pipeline inventory.
It states that the average amount of inventory in a system is
equal to the product of the average rate at which inventory
units leave the system (i.e., the average demand rate) and
the average time a unit is in the system.
THE FUNCTIONS OF INVENTORY
➢ To permit operations
Little’s Law can be useful in quantifying pipeline inventory.
It states that the average amount of inventory in a system is
equal to the product of the average rate at which inventory
units leave the system (i.e., the average demand rate) and
the average time a unit is in the system.
THE FUNCTIONS OF INVENTORY
➢ To take advantage of quantity discounts
Suppliers may give discounts on large orders.
OBJECTIVE OF INVENTORY CONTROL
Inadequate control of inventories can result in both under- and
overstocking of items.
Understocking results in missed deliveries, lost sales,
dissatisfied customers, and production bottlenecks;
Overstocking unnecessarily ties up funds that might be more
productive elsewhere
The price tag for excessive overstocking can be staggering when
inventory holding costs are high
OBJECTIVE OF INVENTORY CONTROL
Two main concerns of inventory management
1. Level of customer service
to have the right goods, in sufficient quantities, in the
right place, at the right time.
2. Cost of ordering and carrying inventories
OBJECTIVE OF INVENTORY CONTROL
Overall Objective of Inventory Management
✓ Achieve a satisfactory level of customer service while
keeping inventory costs within reasonable bounds

Two fundamental decisions:

1. Timing of orders
2. Size of orders
▪ this means (when to order and how much to order)
OBJECTIVE OF INVENTORY CONTROL
Performance measures to judge the effectiveness of inventory
management
✓ Customer Satisfaction - measured by the number and
quantity of backorders and/or customer complaints
✓ Inventory Turnover – the ratio of the annual cost of goods
sold to average inventory investment
- indicates how many times a year the inventory is sold.
- Generally, the higher the ratio, the better, because that implies
more efficient use of inventories.
OBJECTIVE OF INVENTORY CONTROL
Performance measures to judge the effectiveness of inventory
management
✓ Days of inventory on hand – a number that indicates the
expected number of days of sales that can be supplied from
existing inventory
• Here, a balance is desirable; a high number of days might imply
excess inventory, while a low number might imply a risk of running
out of stock.
INVENTORY COUNTING SYSTEMS
✓ Periodic – physical count of items in inventory made
at periodic intervals in order to decide how much to
order of each item
✓ Perpetual (continual system)
o System that keeps track of removals from inventory
continuously, thus monitoring current levels of each item
o An order is placed when inventory drops to a
predetermined minimum level
INVENTORY COUNTING SYSTEMS
Perpetual Systems
✓ Two-bin system - Two containers of inventory; reorder
when the first is empty
✓ Universal Product Code - bar code printed on a label
that has information about the item to which it is attached.
o Point-of-sale (POS) systems electronically record items at time of
sale
o Some firms uses QR codes and RFID to keep track of inventory
INVENTORY COSTS
Holding or carrying costs
✓ Costs related to physically having an item in storage
✓ Interest, insurance, depreciation, obsolescence,
deterioration, spoilage, pilferage, breakage, warehousing
costs (heat, light, rent, security)
✓ Opportunity costs associated with funds tied up in inventory
INVENTORY COSTS
Ordering costs
✓ Costs for ordering & receiving inventory
✓ Placing an order, shipping costs, preparing invoices,
inspection costs, moving the goods to temporary storage
✓ Opportunity costs associated with funds tied up in inventory

SETUP COSTS - The costs involved in preparing equipment for

a job.
INVENTORY COSTS
Shortage costs
✓ Costs which result when demand exceeds the supply of
inventory on hand
✓ Opportunity cost for not making a sale, loss of customer
goodwill, late charges
CLASSIFICATION SYSTEMS
Items held in inventory are not of equal importance in terms of
dollars invested, profit potential, sales or usage volume or
stockout penalties

Allocate control efforts according to the relative importance of

various items in inventory
A-B-C APPROACH
Classifies inventory items according to some measure of importance,
usually annual value (value per x annual usage rate) and then allocates
control efforts accordingly.
Typically, three classes of items are used:
✓ A – very important (generally accounts for 10%-20% of the number
of items in inventory, but 60%-70% of the annual value)
✓ B – moderately important
✓ C – least important (might account for 50%-60% of the number of
items, but only 10%-15% of the value of the inventory)
A-B-C APPROACH: HOW?
❑ Sort products from largest to smallest annual value.
❑ Divide into A, B, and C classes.
❑ Focus on A products.
❑ Develop class A suppliers more.
❑ Give tighter physical control of A items.
❑ Forecast A items more carefully.
❑ Consider B products only after A products.
A-B-C APPROACH:
EXAMPLE
A manager has
obtained a list of
unit costs and
estimated annual
demands for 10
inventory items and
now wants to
categorize the items
on an A-B-C basis.
Multiplying each
item’s annual
demand by its unit
cost yields its annual
dollar value:
A-B-C
APPROACH:
EXAMPLE
Arranging the annual
dollar values in
descending order can
facilitate assigning items
to categories.
Note that category A has
the fewest number of
items but the highest
percentage of annual
dollar value, while
category C has the most
items but only a small
percentage of the annual
dollar value.
INVENTORY ORDERING POLICIES
Two Basic Issues of Inventory Management
✓ How much to order
✓ When to order

• Cycle stock - Inventory that is intended to meet expected

demand
• Safety stock – inventory that is held to reduce the probability of
experiencing a stockout (i.e., running out of stock) due to
demand and/or lead time variability
ECONOMIC
ORDER
QUANTITY
HOW MUCH
TO ORDER?
HOW MUCH TO ORDER? EOQ MODELS
THREE ORDER SIZE MODEL
1. Basic Economic Order Quantity (EOQ)
2. Economic Production Quantity
3. Quantity Discounts
BASIC EOQ
• The basic EOQ model is the simplest of the three models.
• It is used to identify a fixed order size that will minimize the sum
of the annual costs of holding inventory and ordering inventory.
• The unit purchase price of items in inventory is not generally
included in the total cost because the unit cost is unaffected by the
order size unless quantity discounts are a factor.
• If holding costs are specified as a percentage of unit cost, then unit
cost is indirectly included in the total cost as a part of holding
costs.
BASIC EOQ
Important assumptions
• Only one product is involved
• Annual demand requirements are known
• Demand is spread evenly throughout the year so that the
demand rate is reasonably constant
• Lead time does not vary
• Each order is received in a single delivery
• There are no quantity discounts
 INVENTORY CYCLE
Q = 350 Usage Rate = 50/day Order Size Q = 350
Usage Rate = 50 per day
units Lead time = 2 days
Reorder Point = 100
Quantity units or 2 days supply
on Hand
Reorder Point =
100 units
0 5 7 12 14 Day

Receive Order Lead time - the time between submitting

order an order and receiving it
BASIC EOQ

Average
Inventory

Many orders produce a Time

low average inventory

BASIC EOQ

Average
Inventory

Few orders produce a Time

high average inventory
BASIC EOQ
Annual carrying cost = average amount of
inventory on hand x unit carrying cost for one
year
Average inventory = half of the order quantity
𝑄
𝑇𝑜𝑡𝑎𝑙 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡= 𝐻
2
Carrying costs = increase or decrease in direct
proportion to changes in order quantity
BASIC EOQ

Cost 𝑄
𝐻
2

Order quantity
BASIC EOQ
Ordering cost is inversely and nonlinearly related
to order size
Number of orders per year = annual demand /
order size
𝐷
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑜𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡= 𝑄 𝑆
Ordering cost is a function of the number of
orders per year and the ordering cost per order
BASIC EOQ

𝐷
Cost 𝑆
𝑄

Order quantity
BASIC EOQ
𝑇𝐶=𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 + 𝑎𝑛𝑛𝑢𝑎𝑙 𝑜𝑟𝑑𝑒r𝑖𝑛𝑔
𝑐𝑜𝑠𝑡

𝑄 𝐷
𝑇𝐶 = 𝐻+ 𝑆
2 𝑄
BASIC EOQ

𝑄 𝐷
𝑇𝐶 = 𝐻 + 𝑆 • Optimal order
2 𝑄 quantity – TC
Cost curve reaches its
minimum at the
quantity where
carrying and
ordering costs are
Q0 equal
Order quantity
ECONOMIC
ORDER
QUANTITY
HOW MUCH
TO ORDER?
HOW MUCH TO ORDER? EOQ MODELS
THREE ORDER SIZE MODEL
1. Basic Economic Order Quantity (EOQ)
2. Economic Production Quantity
3. Quantity Discounts
LEARNING OBJECTIVES
1. Describe the basic EOQ model and its assumptions and
solve typical problems.
2. Describe the economic production quantity model and
solve typical problems.
3. Describe the quantity discount model and solve typical
problems.
BASIC EOQ
From our previous discussion, total cost is the sum of the annual carrying cost and
the annual ordering cost
𝑄 𝐷
𝑇𝐶= 𝐻+ 𝑆
2 𝑄
We also discussed that the optimal order quantity is found when the annual
carrying cost equals the annual ordering cost, thus:
𝑄 𝐷 𝑄𝐻 𝐷𝑆
𝐻= 𝑆 which translates to: =
2 𝑄 2 𝑄
To solve for Q *, simply cross-multiply terms and isolate Q on the left of the equal
sign:
2𝐷𝑆 2𝐷𝑆
𝑄 2 𝐻 = 2𝐷𝑆 , then: 𝑄 2 = , therefore: 𝑄 =
𝐻 𝐻
BASIC EOQ
2𝐷𝑆
𝐸𝑂𝑄 𝑜𝑟 𝑄 =
𝐻

The length of an order cycle (i.e., the time between orders) is

𝑄
𝐿𝑒𝑛𝑔𝑡ℎ 𝑜𝑓 𝑜𝑟𝑑𝑒𝑟 𝑐𝑦𝑐𝑙𝑒= 𝑥 𝑛𝑜 𝑜𝑓𝑤𝑜𝑟𝑘 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐷
BASIC EOQ
A local distributor for a national tire company expects to sell approximately
9,600 steel-belted radial tires of a certain size and tread design next year.
Annual carrying cost is $16 per tire and ordering cost is $75. The distributor
operates 288 days a year

1. What is the optimal order quantity?

2. How many times per year does the store reorder?
3. What is the length of an order cycle?
4. What is the total annual cost if the EOQ quantity is ordered?
BASIC EOQ – SAMPLE PROBLEM
2𝐷𝑆 2 9,600 75
a. 𝑄 = 𝐻
= 16
= 300 𝑡𝑖𝑟𝑒𝑠

𝐷 9,600
b. 𝑄
=
300
= 32 orders

𝑄 300 1
c. 𝐷
= 9,600
= 32
𝑜𝑓 288 𝑑𝑎𝑦𝑠 = 9 𝑑𝑎𝑦𝑠
BASIC EOQ – SAMPLE PROBLEM
TC = carrying costs + ordering cost

𝑄 𝐷
𝑇𝐶 = 𝐻 + 𝑆
2 𝑄
300 9,600
= 16 + 75
2 300

= $2,400 + $2,400

= $4,800
BASIC EOQ – EXERCISE
A car rental agency uses 96 boxes of staples a year. The
boxes cost $4 each. It costs $10 to order staples, and
carrying costs are $0.80 per box on an annual basis. The
agency operates 290 days in a year. Determine:
1. The order quantity that will minimize the sum of
ordering and holding boxes of staples
2. The annual cost of ordering and carrying the boxes of
staples
3. How many times per year does the store reorder?
4. What is the length of the order cycle?
ECONOMIC PRODUCTION
QUANTITY
ECONOMIC PRODUCTION QUANTITY
• Batch mode of production is widely used in production
• Reason: the capacity to produce a part exceeds the part’s
demand rate
• As long as production continues, inventory will continue to
grow
• It would be better to periodically produce such items in
batches, or lots
ECONOMIC PRODUCTION QUANTITY
Important assumptions
• Only one item is involved
• Annual demand is known
• Usage rate is constant
• Usage occurs continually, but production occurs periodically
• Production rate is constant
• Lead time does not vary
• There are no quantity discounts
 ECONOMIC PRODUCTION QUANTITY
During the production
Production Production phase of the cycle,
Usage Usage
& Usage & Usage
Run inventory builds up at a
Size rate equal to the
Cumulative difference between
Production
production and usage
Imax rates.

For example, daily

production rate is 20 units
Inventory and the daily usage rate is
on Hand
5 units, inventory will build
up at the rate of 20 − 5 =
15 units per day.
ECONOMIC PRODUCTION QUANTITY
Setup costs – the costs required to prepare the equipment for
the job such as cleaning, adjusting and changing tools and
fixtures
ECONOMIC PRODUCTION QUANTITY
𝑇𝐶𝑚𝑖𝑛 = 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 + 𝑆𝑒𝑡𝑢𝑝 𝐶𝑜𝑠𝑡

𝐼𝑚𝑎𝑥 𝐷
𝑇𝐶𝑚𝑖𝑛 = 𝐻+ 𝑆
2 𝑄

Economic Run Quantity where

2𝐷𝑆 𝑝 p - Production or delivery rate
𝐸𝑃𝑄 𝑜𝑟 Q= u - Usage rate
𝐻 𝑝 −𝑢
ECONOMIC PRODUCTION QUANTITY
The cycle time (the time between orders or between the beginnings of runs) for the
economic run size model is a function of the run size and usage (demand) rate:
𝑄
𝐶𝑦𝑐𝑙𝑒 𝑡𝑖𝑚𝑒 =
𝑢

Similarly, the run time (the production phase of the cycle) is a function of the run
(lot) size and the production rate:
𝑄
𝑅𝑢𝑛 𝑡𝑖𝑚𝑒= 𝑝
ECONOMIC PRODUCTION QUANTITY
The maximum and average inventory levels are
𝑄
𝐼𝑚𝑎𝑥 = (𝑝 − 𝑢)
𝑝

𝐼𝑚𝑎𝑥
𝐼𝑎𝑣𝑒𝑟𝑎𝑔𝑒 =
2
EPQ – SAMPLE PROBLEM
A toy manufacturer uses 48,000 rubber wheels per year for its popular
dump truck series. The firm makes its own wheels, which it can produce
at a rate of 800 per day. The toy trucks are assembled uniformly over the
entire year. Carrying cost is $1 per wheel per year. Setup cost for a
production run of wheels is $45. The firm operates 240 days per year.
Determine the
1. Optimal run size
2. Minimum total annual cost for carrying & setup
3. Cycle time for the optimal run size
4. Run time
EPQ – SAMPLE PROBLEM
2𝐷𝑆 𝑝 2 48,000 45 800
a. 𝑄 = 𝐻 𝑝−𝑢
= 1 800−200
= 2,400

𝐼𝑚𝑎𝑥 𝐷
b. 𝑇𝐶𝑚𝑖𝑛 = 2
𝐻 + 𝑄
𝑆

𝑄 2,400
𝐼𝑚𝑎𝑥 = 𝑝−𝑢 = 800 − 200 = 1,800
𝑝 800

1,800 48,000
𝑇𝐶𝑚𝑖𝑛 = 1+ 45 = 1,800
2 2,400
EPQ – SAMPLE PROBLEM
𝑄0 2,400
c. 𝐶𝑦𝑐𝑙𝑒 𝑡𝑖𝑚𝑒 = 𝑢
=
200
= 12 𝑑𝑎𝑦𝑠
A run of wheels will be made every 12 days

𝑄0 2,400
c. 𝑅𝑢𝑛 𝑡𝑖𝑚𝑒 = 𝑝
=
800
= 3 𝑑𝑎𝑦𝑠
Each run will require 3 days to complete
EPQ – EXERCISE
Arthur Marte is the production manager of Marte Technova Machine Craft, a small producer
of metal parts, Marte Technova supplies Cal-Tex, a larger assembly company, with 10,000
wheel bearings each year. This order has been stable for some time. Setup costs for Marte
Technova is $40, and holding cost is $0.60 per wheel bearing per year. Marte Technova can
produce 500 wheel bearings per day. Cal-Tex is a just-in-time manufacturer and requires 50
bearings be shipped to it each business day.
1. What is the optimum production quantity?
2. What is the maximum number of wheel bearings that will be in inventory at Marte
Technova?
3. How many production runs of wheel bearings will Marte Technova will have in a year?
4. What is total cost for optimal run size?
QUANTITY DISCOUNTS
PRICE REDUCTIONS FOR LARGER ORDERS
OFFERED TO CUSTOMERS TO INDUCE THEM
TO BUY IN LARGE QUANTITIES
QUANTITY DISCOUNTS

• Price reductions for large orders

Annual Annual
TC = carrying + ordering + Purchasing
cost
cost cost

Q + D S + PD
TC = H
2 Q
QUANTITY DISCOUNTS
The objective of the quantity discount model is to identify the
order quantity that will represent the lowest total cost from all
the available range
QUANTITY DISCOUNTS: CONSTANT H
Compute the common minimum point.
• Only one of the unit prices will have the minimum point in its feasible range since the
ranges do not overlap. Identify that range.
• If the feasible minimum point is on the lowest price range, that is the optimal order
quantity.
• If the feasible minimum point is in any other range, compute the total cost for the
minimum point using the annual carrying costs associated with the minimum point.
• Then compute for the total costs for all price ranges that lie below the price range where
the minimum point belongs. Use the minimum point of the range in computing for the
total cost.
• Compare the total costs and the quantity (minimum point or price break) that yields the
lowest total cost is the optimal order quantity.
QUANTITY DISCOUNTS
The maintenance department of a large hospital uses about 816 cases of liquid
cleanser annually. Ordering costs are $12, carrying costs are $4/case/yr with the
new price schedule below:
Range Price
1 to 49 $20
50 to 79 18
80 to 99 17
100 or more 16
Determine the optimal order quantity and the total annual cost
QUANTITY DISCOUNTS
Step 1: Compute the common minimum Q
2𝐷𝑆 2 816 12
a. 𝑄0 = 𝐻
= 4
= 70

Step 2: Compute for the total cost of the minimum point.

𝑄 𝐷
b. 𝑇𝐶 = 2 𝐻 + 𝑄 𝑠 + 𝑃𝐷

@$18/case
70 816
= 4+ 12 + 18 816 = $14,968
2 70
QUANTITY DISCOUNTS
Step 3: Compute for the Total Cost of the lower ranges using the minimum point
each range and determine at optimal order quantity.

@$17/case
80 816
= 4+ 12 + 17 816 = $14,154
2 80
@16/case
100 816
= 4+ 12 + 16 816 = $13,354
2 100

Therefore, because 100 cases per order yields the lowest total cost, 100 cases is
the overall optimal order quantity.
QUANTITY DISCOUNTS - EXERCISE
A mail-order house uses 18,000 boxes a year. Carrying costs
are 60 cents per box a year, and ordering costs are $96. The
following price schedule applies. Determine:
a. The optimal order quantity.
b. The number of orders per year.
QUANTITY DISCOUNTS
Carrying Cost as a percentage of price
• Beginning with the lowest unit price, computer the minimum points for
each price range until you find a minimum feasible point - (*using the EOQ
formula*), until a minimum point falls in the quantity range for its price
• If the minimum point for the lowest unit price is feasible, it is the optimal
order quantity.
• If the minimum point is not feasible in the lowest price range, compare the
total cost at the price break for all lower prices with the total cost of the
feasible minimum point. The quantity which yields the lowest total cost is
the optimum.
QUANTITY DISCOUNTS - SAMPLE
Surge electric uses 4,000 toggle switches a year. Switches are priced as
shown below. It costs approximately $30 to prepare an order and
receive it, and carrying costs are 40% of the purchase price per unit.
Range Price H
1 to 499 $0.90 $0.36
500 to 999 0.85 0.34
1000 or more 0.80 0.32

Determine the optimal order quantity and the total annual cost
QUANTITY DISCOUNTS
Find the minimum point for each price, starting with the
lowest price, until you locate a feasible minimum point.

2𝐷𝑆 2 4,000 30
a. 𝑄 = = = 866 switches
𝐻 0.32

866 switches will cost $0.85 rather than $0.80, 866 is not a feasible
minimum point for $0.80 per switch.
QUANTITY DISCOUNTS
Next, we will try $0.85 per unit.
2𝐷𝑆 2 4,000 30
b. 𝑄=
𝐻
=
0.34
= 840 𝑠𝑤𝑖𝑡𝑐ℎ𝑒𝑠

This is feasible, because it falls in the $0.85 per switch range of 500 to 999
QUANTITY DISCOUNTS
Now compute the total cost for 840, and compare it to the total cost of
the minimum quantity necessary to obtain a price of $0.80 per switch.
𝑄 𝐷
c. 𝑇𝐶 =
2
𝐻+
𝑄
𝑠 + 𝑃𝐷

840 4,000
@840 cases TC = $0.34 + 𝑆30 + 𝑆0.85 4,000 = $3,686
2 840

1,000 4,000
@1,000 cases TC = $0.32 + $30 + $0.80 4,000 = $3,480
2 1,000

Thus, the minimum-cost order size is 1,000 switches.

QUANTITY DISCOUNTS - EXERCISE
A jewelry firm buys semiprecious stones to make bracelets and
rings. The supplier quotes a price of $8 per stone for quantities
of 600 stones or more, $9 per stone for orders of 400 to 599
stones, and $10 per stone for lesser quantities. The jewelry firm
operates 200 days per year. Usage rate is 25 stones per day,
and ordering costs are $48. If annual carrying costs are 30
percent of unit cost, what is the optimal order size?
REORDER POINT
REORDER POINT
• EOQ models answer the question of how much to order, but not the
question of when to order.
• The reorder point occurs when the quantity on hand drops to a
predetermined amount.
• That amount generally includes expected demand during lead time
and perhaps an extra cushion of stock, which serves to reduce the
probability of experiencing a stockout during lead time.
• The goal in ordering is to place an order when the amount of
inventory on hand is sufficient to satisfy demand during the time it
takes to receive that order (i.e., lead time)
REORDER POINT
Four determinants of the reorder point quantity:
• The rate of demand (usually based on a forecast).
• The lead time.
• The extent of demand and/or lead time variability.
• The degree of stockout risk acceptable to management.
REORDER POINT
Constant demand and lead time
𝑅𝑂𝑃=𝑑 𝑥 𝐿𝑇
Example: Tingly takes two-a-day vitamins, which are delivered
to his home by a routeman seven days after an order is
called in. At what point should Tingly reorder?

𝑅𝑂𝑃=2 𝑥 7=14 𝑣𝑖𝑡𝑎𝑚𝑖𝑛𝑠

ROP – VARIABLE DEMAND RATE
• Variable demand and lead time – creates a possibility that
actual demand will exceed expected demand.
• It becomes necessary to carry safety stock, to reduce the risk
of running out of inventory during lead time

• 𝑅𝑂𝑃 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑒𝑚𝑎𝑛𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 + 𝑆𝑎𝑓𝑒𝑡𝑦 𝑆𝑡𝑜𝑐𝑘

• Remember: stockout protection is needed only during lead
time
ROP – VARIABLE DEMAND RATE
• Service Level - Probability that demand will not exceed
supply during lead time.
• The lead time is constant. In this case, we need extra buffer
of safety stock to insure against stock-out risk.
• Since it cost money to carry safety stocks, a manager must
weigh carefully the cost of carrying safety stock against the
reduction in stock-out risk (provided by the safety stock
ROP – VARIABLE DEMAND RATE
• In other words, he needs to trade-off the cost of safety stock and
the service level.
• Service level = 1 - stock-out risk
• ROP = Expected lead time demand + safety stock
• 𝑅𝑂𝑃 = (𝑑 𝑥 𝐿𝑇) + 𝑧σ
• σ = SD of the lead time demand
• Therefore: 𝑅𝑂𝑃 = 𝑑ҧ 𝑥 𝐿𝑇 + (𝑧)( 𝐿𝑇)(σ𝑑 )
ROP – VARIABLE DEMAND RATE
Variable demand
𝑅𝑂𝑃 = (𝑑ҧ 𝑥 𝐿𝑇) + (𝑧 . 𝐿𝑇. σ𝑑 )
where
𝑑ҧ = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑜𝑟 𝑤𝑒𝑒𝑘𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑
σ𝑑 = 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦 𝑜𝑟 𝑤𝑒𝑒𝑘
𝑧 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛𝑠

LT = lead time
ROP, Variable 𝒅 ̅, Constant LT
The hotel uses 400 washcloths per day. The actual number
tends to vary with the number of guests on any given night.
Usage can be approximated by normal distribution that a
mean of 400 and a standard deviation of 9 washcloths per day.
A linen supply company delivers towels and washcloths with a
lead time of three days. If the hotel policy is to maintain a
stockout risk of 2 percent, what is the minimum number of
washcloths that must be on hand at reorder time, and how
much of that amount can be considered safety stock?
ROP, Variable 𝒅 ̅, Constant LT
𝑑ҧ = 400/𝑑𝑎𝑦
σ𝑑 = 9/𝑑𝑎𝑦
LT = 3 days
Risk = 2%, service level = 98%,
z = +2.054

𝑅𝑂𝑃 = 𝑑ҧ 𝑥 𝐿𝑇 + 𝑧 𝐿𝑇σ𝑑
𝑅𝑂𝑃 = 400 𝑥 3 + 2.054 3 (9)
𝑅𝑂𝑃 = 1,200 + 32.02 𝑜𝑟 32
𝑅𝑂𝑃 = 1,232
FIXED-ORDER INTERVAL
FIXED ORDER INTERVAL
• In the EOQ/ROP models, fixed quantities of items are
ordered at varying time interval.
• However, many companies ordered at fixed intervals: weekly,
biweekly, monthly, etc. They order varying quantity at fixed
intervals. We called this class of decision models fixed-order-
interval (FOI) model.
• The question, then, at each order point, is how much to
order.
FIXED ORDER INTERVAL
Assuming lead time is constant, we need to consider the
following factors
• the expected demand during the ordering interval and the
lead time
• the safety stock for the ordering interval and lead time
• the amount of inventory on hand at the time of ordering
FIXED ORDER INTERVAL
Amount to order = expected demand during protection interval +
Safety stock – Amount on hand at reorder time
𝑄 = 𝑑ҧ 𝑥 𝑂𝐼 + 𝐿𝑇 + [𝑧. 𝑂𝐼 + 𝐿𝑇. σ𝑑 − 𝐴
• OI = Length of order interval
• A = amount of inventory on hand
• LT = lead time
• σd = Standard deviation of demand
• Q = amount to order
FIXED ORDER INTERVAL
Given the following information, determine the amount to order.
𝑑ҧ = 30 units per day
σ𝑑 = 3 units per day
Amount on hand at reorder time = 71 units
LT = 2 days
OI = 7 days
Desired service level = 99 percent
Z = 2.33 for 99 percent service level

𝐹𝑂𝐼 = 𝑑ҧ 𝑂𝐼 + 𝐿𝑇 + 𝑧 . 𝑂𝐼 + 𝐿𝑇 . σ𝑑 − 𝐴

𝐹𝑂𝐼 = 30 𝑥 7 + 2 + {2.33 𝑥 7 + 2 𝑥 3} − 71 = 220 𝑢𝑛𝑖𝑡𝑠

- END OF LESSON-
ANY QUESTIONS?