CHAPTER FOUR

INVENTORY MANAGEMENT
4.1. Definition of Inventory
Inventory is the physical stock of items held in any business for the purpose of future production or sales. In a
production shop the inventory may be in the form of raw materials.
Although inventories are classified in many ways, the following classification is convenient for use in further
discussion of the topic (Dobler and Burt, 1996):
i. Production inventories. Raw materials, parts, and components which enter firm’s product in the
production process. These may consist of two general types: (1) special items manufactured to
company specifications and (2) standard industrial items purchased ‘off the shelf’.
ii. MRO inventories. Maintenance, repair, and operating supplies which are consumed in the production
process but which do not become part of the product (e.g., lubricating oil, soap, machine repair parts).
iii. In-process inventories. Semi-finished products found at various steps of the production operation.
iv. Finished goods inventories. Completed products ready for shipment.
The meaning of inventory can be defined in the following two ways (Ahuja, 1992)
i) Inventory is defined as ‘any idle resource of an enterprise”. The concept of idle resource in this
definition means that it is not kept for immediate use and shows the importance of having some
inventories for the smooth functioning of an organization.
ii) Inventory is made of all those items ready for sale of items that keep the process running well.
Inventory is a stock of materials that are used to facilitate production or to satisfy customers’ demand.
The concept of inventory control is as old as the concept of business itself. But the practical
applications of inventory management got emphasis after the Second World War. The development of
operations research and computer technology paved the way for the practical application of inventory
management.
4.2. Significance of Inventories
There are several reasons why organizations should maintain inventories of good. The fundamental reason for
doing so is that it is either physically impossible or economically unsound to have goods acquired in a given
system precisely only when demands for them arise. Without inventories, customers would have to wait until
their orders are to be filled from another source or until they are to be manufactured. However, customers will
not or cannot allow waiting for long periods of time. For this reason alone, the carrying of inventories is
necessary for almost all organizations that supply physical goods to customers. There are also other reasons for
holding inventories. For instance, the price of some raw materials used by manufacturers may exhibit
considerable seasonal fluctuation. When the price is low, it is profitable for organizations to procure a
sufficient quantity of it to last through the high price seasons and to keep it in inventory to be used as need
arises in production. Another reason for maintaining inventories especially for retail establishments is that sales
and profits can be increased if one has an inventory of goods to display to customer.
Inventories serve a number of functions. Among the most important are the following (Stevenson; 2005)
1. To meet anticipated customer demand. A customer can be a person who walks in off the street to buy a
new stereo system, a mechanic who requests a tool at a tool crib, or a manufacturing operation.
2. To smooth production requirements. Firms that experience seasonal patterns in demand often build up
inventories during pre-season periods to meet overly high requirements during seasonal periods. These
inventories are aptly named seasonal inventories. Companies that process fresh fruits and vegetables deal
with seasonal inventories.

1
 3. To decouple operations. Historically, manufacturing firms have used inventories as buffers between
successive operations to maintain continuity of production that would otherwise be disrupted by events
such as breakdowns of equipment and accidents that cause a portion of the operation to shutdown
temporarily. The buffers permit other operations to continue temporarily while the problem is resolved.
Similarly, firms have used buffers of raw materials to insulate production from disruptions in deliveries
from suppliers, and finished goods inventory to buffer sales operations from manufacturing disruptions.
4. To protect against stock outs. Delayed deliveries and unexpected increases in demand increase the risk of
shortages. Delays can occur because of weather conditions, supplier stock outs, 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 average demand to compensate for variabilities in demand and lead time.
5. To take advantage of order cycles. To minimize purchasing and inventory costs, a firm often buys in
quantities that exceed immediate requirements. This necessitates storing some or all of the purchased
amount for later use. Similarly, it is economical to produce in large rather than small quantities. Again,
the excess output must be stored for later use. Thus, 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 resulting stock is known as cycle stock.
Order cycles are not always based on economic lot sizes. In some instances, it is practical or economical
to group orders and/or to order at fixed intervals.
6. To hedge against price increases. 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.
7. 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, semi-finished items, and finished goods at
production sites, as well as goods stored in ware-houses-leads to pipeline inventories throughout a
production-distribution system.
8. To take advantage of quantity discounts. Suppliers may give discounts on large orders.
4.3. Inventory Management/Control
Inadequate control of inventories can result in both under and over stocking of items. Under-stocking results
in missed deliveries, lost sales, dissatisfied customers, and production bottlenecks; overstocking unnecessarily
ties up funds that might be more productive elsewhere. Inventory management has two main concerns. One is
the level of customer service, that is, to have the right goods, in sufficient quantities, in the right place, at the
right time. The other is the cost of ordering and carrying inventories.
The overall objective of inventory management is to achieve satisfactory levels of customer service while
keeping inventory costs within reasonable bounds. Toward this end, the decision maker tries to achieve a
balance in stocking. He or she must make two fundamental decisions: the timing and size of orders (i.e., when
to order and how much to order).
In general, inventory control has the following major advantages (Jessop and Morrison: 1998):
 Helps in keeping the investment in the inventories as low as feasible.
 Ensures availability of materials by providing adequate protection against uncertainties of supplies and
consumption of materials.
 Allows full advantage of economics of bulk purchase and transportation.
 Reduce chances of going out of stock.
 Leads to reduction in inventory levels.

2
  Releases more capital for other operations.
 Increase profitability of an organization.
 Helps to render adequate customer services.
 Renders advantage of price discounts from bulk purchasing.
 Provides flexibility to allow changes in production time due to changes in demands or any other reason,
and
 Even-out the workloads on the shop in the face of functioning demands.
On the other hand, according to Ahuja (1992) the following issues need special consideration to get the
advantage from inventory management:
 The need to minimize the existence of time lags between manufacturing and transport operations.
 The need to schedule various stages of the system independently.
 The need to meet the fluctuation in demand and production rates.
 The need to maintain control over the quality of the finished product.
 The need to exercise influence over changes of materials.
Before inventory control process starts, inventory planning should be executed. Inventory planning is the
determination of the type and quantity of inventory items that would be required at future points for
maintaining production schedules.
4.4. Inventory Costs
Because we are interested in optimizing the inventory system, we must determine an appropriate optimization
or performance criterion. Virtually all inventory models used cost minimization as the optimization criterion.
An alternative performance criterion might be profit maximization. However, cost minimizations and profit
maximizations are essentially equivalent criteria for most inventory control problems. There are four major
elements of inventory costs that should be taken for analysis, such as
(1) Item costs (3) Holding costs
(2) Ordering costs (4) Shortage cost
1. Item (Purchased) costs
This is cost of the item whether it is manufactured or purchased. If it is manufactured, it includes such items
direct material and labor, indirect materials and labor and overhead expenses. When the item is purchased, the
item cost is the purchase price of one unit. Transportation costs, which also affect the lot size, often are
included in the purchase cost of the materials.
2. Ordering (setup) costs
These are fixed costs usually associated with the production of a lot internally or the placing of an order
externally with a vendor. In other words, these costs are independent of the number of units that are requested.
Setup costs are related to the amount of time needed to adjust the equipment to perform a specific task. This
would include the alignment of special tooling such as jigs and fixtures. Order costs pertain to the costs
involved in placing an order with a vendor. These may include telephone charges, a delivery fee, expediting
costs, and the time required to process a purchase order.
3. Holding (or carrying) costs
If the item is held in stock, the cost involved is the item carrying or holding cost. Carrying material in
inventory is expensive. A number of studies disclosed that the annual cost of carrying a production inventory
average approximately 25 percent of the value of the inventory. Let us briefly examine these carrying costs
(Dobler and Burt; 1996).
(i) Opportunity cost of invested funds. When a firm purchases $50,000 worth of a production material
and keeps it in inventory, it simply has this much less cash to spend for other purposes. Money

3
 invested in productive equipment or in external securities earns a return for the company.
Conceptually, then, it is logical for the firm to charge all money invested in inventory an amount equal
to that it could earn if invested elsewhere in the company. This is the “opportunity cost” associated
with inventory investment.
(ii) Insurance costs. Most firms insure their assets against possible loss from fire and other forms of
damage. An extra $50,000 worth of inventory represents an additional asset on which insurance
premiums must be paid.
(iii) Property taxes. As with insurance, property taxes are levied on the assessed value of a firm’s assets;
the greater the inventory value, the greater the asset value, and consequently the higher the firm’s tax
bill.
(iv) Storage costs. The warehouse in which a firm stores its inventory is depreciated a certain number of
dollars per year over the length of its life. One may say, then, that the cost of warehouse space is a
given number of dollars per cubic foot per year. And this cost conceptually can be charged against
inventory occupying the space.
(v) Obsolescence and deterioration. In most inventory operations, a certain percentage of the stock spoils,
is damaged, is pilfered, or eventually becomes obsolete. No matter how diligently warehouse
managers guard against these occurrences, a certain number always takes place. With new products
being introduced at an increasing rate, the probability of obsolescence is increased accordingly.
Consequently, the larger the inventory, typically the greater the absolute loss from this source.
Other types of costs included in the unit holding cost are:
 Cost of maintaining inventory records (stationary and other consumables used by the stores)
 The salaries and wages of storing, receiving and issue of material personnel.
NB: 1. Holding costs are stated in either of two ways: as a percentage of unit price or as a birr amount per unit.
However, as we generally measure inventory in unit rather than in birr, it is convenient to express the holding
cost in terms of birr per unit per year rather than per birr per year.
2. If holding cost per item is given for a period of less than a year, you need to convert the same into cost
per year.
(4) Shortage (penalty or Stock-out) costs.
Shortage costs result when demand exceeds the supply of inventory on hand. These costs can include the
opportunity cost of not making a sale, loss of customer goodwill, late charges, and similar costs. Furthermore,
if the shortage occurs in an item carried for internal use (e.g., to supply an assembly line), the cost of lost
production or downtime is considered a shortage cost. Such costs can easily run into hundreds of birrs a minute
or more. Shortage costs are sometimes difficult to measure, and they may be subjectively estimated.
4.5. Dependent and Independent Demand
Independent demand: - the demands for various items are unrelated to each other and therefore the required
quantities of each must be determined separately or independently.
Dependent demand: - the requirement for any one item is a direct result of the need for some other item,
usually a higher-level item of which it is a component or subassembly.
In concept, dependent demand is a relatively straight forward computational problem. The required quantities
of a dependent-demand item are simply computed, based on the number needed in each higher-level item
where it is used. For example, if an automobile company plans on producing 500 automobiles per day, then
obviously it will need 2,000 wheels and tires (plus spares). The number of wheels and tires needed is
dependent on the production level for automobiles and not derived separately. The demand for automobiles, on

4
the other hand, is independent-it comes from many sources external to the automobile firm and is not a part of
other products and so is unrelated to the demand for other products.
4.6. Inventory Systems for Independent Demand
If one has to make decisions about managing an inventory, it is useful to understand the behavior of the
inventory related cost factors discussed in the previous sections. These factors often help a manager to
determine which items should or should not be carried in inventory, what inventory levels should be carried for
specific items, and what order quantities are appropriate for given items. There are a number of mathematical
models that can be applied to determine the optimum (economical) level for independent demand materials.
Some of these models are discussed in this section.
4.6.1. Economic Order Quantity (EOQ) Model
The EOQ (Economic Order Quantity) model is one method of determining the adequate (optimum) inventory
level for independent demand materials. It is used to identify a fixed order size that will minimize the sum of
the annual costs of holding inventory and ordering inventory. This model involves a number of assumptions
including the following.
1. Only one product is involved.
2. Annual demand requirement are known.
3. Demand is spread evenly throughout the year so that the demand rate is reasonably constant.
4. Lead time does not vary.
5. Each order is received in a single delivery.
6. There are no quantity discounts.
Figure 4.1 below shows clearly that as the order or delivery quantity increases, carrying costs rise-and at the
same time ordering costs decrease. Carrying cost is thus a linear function of Q: carrying costs increase or
decrease in direct proportion to changes in the order quantity Q, as the figure illustrates. On the other hand,
annual ordering cost will decrease as order size increases because, for a given annual demand, the larger the
order size, the fewer the number of orders needed. Unlike carrying costs, ordering cots are relatively
insensitive to order size; regardless of the amount of an order, certain activities must be done, such as
determining how much is needed, periodically evaluating sources of supply, and preparing the invoice. Even
inspection of the shipment to verify quality and quantity characteristics is not strongly influenced by order size
since large shipments are sampled rather than completely inspected. Hence, ordering cost is treated as a
constant.

An TC (Total Cost)
nu
al
Co CC (carrying Cost)
sts

Co (Ordering Cost)
EOQ

0 Order quantity
Fig. 4.1 Relationship of inventory-related costs to inventory level

5
In constructing any inventory model, the first step is to develop a functional relationship between the variables
of interest and the measure of effectiveness. In this case, since we are concerned with cost, the following
equation would pertain:

Total Annual Annual Annual

Annual cost = Ordering cost + Holding cost + Purchase cost
To develop an equation for total inventory cost and for the purpose of analyzing inventory models, the
following symbols will be used throughout the chapter.
TC = Total annual cost
D = Annual demand in units
Cc = Carrying cost per unit
CO = Set up or Ordering cost
Q = Quantity to be ordered
P = Purchase price per unit or cost per unit.
NB: D and Cc must be in the same units, e.g., months, years.

Annual (Number of orders (Ordering cost

Ordering cost = Placed per year) x per order)
The number of orders per year will be D/Q, and hence:

D
Annual Ordering cost = Q Co

= (average inventory value) x (inventory carrying cost as a % of

Annual Holding inventory value)
cost
(inventory
= (average inventory in units) x (material unit x carrying cost as a
cost) % of inventory
value)

The average inventory is simply half of the order quantity, Q/2, and hence:

6
 Q
Annual holding cost = 2 Cc
The annual purchase cost for the units is the product of annual demand in units and cost per unit, hence:

Annual purchase cost = DP

Bringing those costs together, we have the following total cost equation.
D Q
Co + Cc + DP
TC = Q 2
The next step is to find that order quantity, Q, for which total cost is a minimum. This can be done in two
ways:
i. Using calculus. As depicted in figure 4.1, the total cost is minimum at the point where the slope of
the total cost curve is zero. Hence, the procedure is taking the first derivative of total cost with
respect to Q (which is the slope) and setting this equal to zero.
D Q
Co+ Cc+DP
Tc = Q 2
Q
Tc = D.Q-1.Co + 2 Cc + DP
dTC 1
= −D .Q .−2 .Co + Cc +0
Slope (MC) = dQ 2
Setting this equal to zero, we have:
1 D Cc 2 DCo
. Co = −
-D.Q . Co + 2 Cc = 0 2 Q = Cc
2
-Q
-2 2

D Cc D . Co Cc

√
. Co + = 2 D .Co
-Q
2 2 =0 Q2 2
Q= Cc
Q2. Cc = 2DCo

Equating ordering and carrying costs. Figure 4.1 also shows that the
ii.
total cost is minimum at a point where holding cost crosses ordering cost
(holding cost equal to ordering cost). Therefore, by equating these two
costs the formula to get the economic order quantity can be arrived at as
shown below.

D Q
( Co)= ( Cc )
Q 2
Q2
. Cc
D . Co = 2 (Multiplying both sides by Q)
2D.Co = Q2. Cc (Multiplying both sides by 2)

7
 2 D . Co
Q2 = Cc

Q= √
2 . D. Co
Cc

This formula is the fundamental mathematical representation of the EOQ concept. The EOQ concept can be
used in conjunction with a variety of inventory management systems including Just in Time (JIT). The costs
which are relevant in making an EOQ analysis are incremental costs.
Incremental costs are those costs that actually change as a result of a particular operating decision. For
example, if the decision is to issue more purchase orders during the year actually increases supply and service
costs also increases. These are incremental costs. Incremental costs are either reliable costs or opportunity costs
that represent a forgone opportunity to utilize an asset in some other productive way.
Even though the model has been set in the purchasing environment, the EOQ concept has broader application
as well. It can also be used to determine the economic production lot sized in a manufacturing operation. In
converting the formula for production use, the annual usage or demand and carrying cost factors are the same
as they were in the purchasing application. The unit cost factor, however, is no longer delivered price. It
consists of direct labor and materials and production overhead costs. Production acquisition cost is similar to
purchasing ordering cost.
Example 1:
A local distributor for Addis Tire expects to sell approximately 9,600 steel-belted radial tires of a certain
size and tread design next year. Annual carrying cost is Birr 16 per tire, and ordering cost is birr 75.
The distributor operates 288 days a year. The purchase price of the tires is birr 900 each.
a. What is the EOQ?
b. How many tires per year does the store reorder?
c. What is the length of an order cycle?
d. What is the total annual cost if the EOQ quantity is ordered?
Example 2:
Tebarek and Family Untied assemble Vestel Television. It purchases 3,600 color cathode ray tubes a
year at birr 65 each. Ordering costs are birr 31, and annual carrying costs are 20 percent of the
purchase price. Compute the optimal quantity and the total annual cost of ordering, carrying and
purchasing the inventory.
4.6.2. EOQ with Quantity Discount and Price Breaks
The concept of Economic Order Quantity fails in certain cases where there is a discount offered when
purchases are made in large quantities. Certain manufacturers offer reduced rate for items when a larger
quantity is ordered. It may appear that the inventory holding cost may increase if large quantities of
items are ordered. But if the discount offered is so attractive that it even outweighs the holding cost, then
probably the order at levels other than the EOQ would be economical. In such cases, the optimum quantity is
the one that makes the savings from the purchase cost equal to the total inventory cost.
The procedures to be followed to calculate the optimal order quantity in a situation that involves quantity
discount and price breaks are as follows:
i. For carrying costs that are constant, the procedure for determining the optimal order quantity is as
follows:

8
 1. Compute the common minimum point, EOQ point.
2. Identify the range in which the EOQ falls.
3. If the feasible minimum point is on the lowest price range, that is the optimal order quantity.
4. If the feasible minimum point is in any other range, compute the total cost for the minimum point and
for the price break of all lower unit costs.
5. Compare the total costs.
6. The quantity that yields the lowest total cost is the optimal order quantity.
ii. For carrying costs that are expressed as percentage of price, the procedure is:
1. Begin with the lowest unit price; compute the minimum point (EOQ) for each price range until you find
a feasible minimum point (EOQ).
2. If the minimum point for the lowest unit price is feasible, it is the optimal order quantity.
3. 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 cost of EOQ.
4. The quantity which yields the lowest total cost is the optimum.
Example 1:
A producer of photo equipment buys lenses from a supplier at Birr 100 each. The producer requires 125 lenses
per year, and the ordering cost is Birr 18 per order. Carrying costs per unit per year are estimated to be Birr 20
each. The supplier offers 6% discount for purchases of 50 lenses and an 8% discount for purchases of 100 or
more lenses. Determine the optimal order quantity.
Advantages and Limitations of EOQ
Limitations of EOQ are imposed by its underlying assumptions as discussed above. The EOQ can be
determined in the above manner only if the assumed conditions are in operation. But in real-life situations,
none of these conditions are found to be operating. Lead times vary; rate of usage, unit price, and carrying
costs are never constant. Moreover, companies often find it profitable to take advantage of quantity discounts.
Finally, safety stocks are needed to prevent the occurrence of stock out contingencies due to delayed deliveries
as well as higher than assumed rate of usage. The use of EOQ is also limited by the difficulty of estimating
ordering and carrying costs. Nevertheless, the model serves a useful purpose on an approximation of real-life
situations. Understanding of the mechanics of the model and its limitations also helps in determining economic
lot size of manufactured as well as purchased items in real-life situations.
The advantages of economic ordering can broadly be described as:
1. Substantial reduction in the number of purchase orders issued.
2. Materials department have more time to devote to the items, which contain large amount of money and
concentrate on the inventory control of these items.
3. The use of this formula helps to reduce possibility of stock out which may otherwise would result in
more sever losses and eliminate rush purchases with attendant problems.
4. It will require lesser amount of follow-up action because of better planning or purchases, as the system
is efficient, only a few hands are required.
4.6.3. Reorder Point (ROP)
EOQ model answer the question of how much to order, but not the question of when to order. The latter is the
function of models that identify the reorder point (ROP) in terms of a quantity. 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 stock out during lead time. Lead-time is defined as the time interval between the placing of the orders and the

9
actual receipt of goods. Note that in order to know when the reorder point has been reached, a perpetual
inventory is required.
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). There are four determinants of the reorder point
quantity:
1. The rate of demand (usually based on a forecast).
2. The lead time.
3. The extent of demand and/or lead time variability.
4. The degree of stock out risk acceptable to management
i. ROP when demand and lead time are both constant. If demand and lead time are both constant, the
reorder point is simply

ROP = d x LT

Where: d = Demand rate (units per day or week)

LT = Lead time in days or weeks.
Note: Demand and lead time must be expressed in the same time units.
Example1:
Mr. X takes Two-a-Day vitamins, which are delivered to his home by a route man seven days after an order is
called in. At what point should Mr. X reorder?
ii. Reorder point when variability is present in demand or lead time. Variability in demand or lead time
creates the possibility that actual demand will exceed expected demand. Consequently, it becomes
necessary to carry additional inventory, called safety stock, to reduce the risk of running out of inventory
(a stock out) during lead time. The reorder point then increases by the amount of the safety stock:
Expected demand
ROP = + Safety stock
during lead time
Because it costs money to hold safety stock, a manager must carefully weigh the cost of carrying safety stock
against the reduction in stock out risk it provides. The customers service level increase as the risk of stock out
decrease. Order cycle service level can be defined as the probability that demand will not exceed supply during
lead time. Hence, a service level of 95 percent implies a probability of 95 percent that demand will not exceed
supply during lead time. The risk of a stock out is the complement of service level; a customer service level of
95 percent implies a stock out risk of 5 percent. That is,
Service level = 100 percent – stock out risk.
The amount of safety stock that is appropriate for a given situation depends on the following factors.
1. The average demand rate and average lead time.
2. Demand and lead time variability.
3. The desired service level.
For a given order cycle service level, the greater the variability in either demand rate or lead time, the greater
the amount of safety stock that will be needed to achieve that service level. Selection of a service level may
reflect stock out costs (e.g., lost sales, customer dissatisfaction) or it might simply be a policy variable (e.g., the
manager wants to achieve a specified service level for a certain item.
Several models can be used in cases when variability is present. The models generally assume that any
variability in demand rate or lead time can be adequately described by a normal distribution. The value of z

10
used in a particular instance depends on the stock out risk that the manager is willing to accept. Generally, the
smaller the risk the manager is willing to accept, the greater the value of z.
The first model can be used if an estimate of expected demand during lead time and its standard deviation are
available. The formula is:

Expected demand + zdLT

=
during lead time
Where: z = Number of standard deviations.
dLT = The standard deviation of lead time demand.
Example 2:
Suppose that the manager of a construction supply house determined from historical records that demand for
sand during lead time averages 50 tons. In addition, suppose the manager determined that demand during lead
time could be described by a normal distribution that has a mean of 50 tons and a standard deviation of 5 tons.
Answer these questions, assuming that the manager is willing to accept a stock out risk of no more than 3
percent:
a. What value of z is appropriate?
b. How much safety stock should be held?
c. What reorder point should be used?
4.6.4. Economic Production Quantity (Economic Run Lengths)
We have seen the application of the EOQ model in determining the optimum order quantity of items
purchased/ordered from external suppliers. But when the company is the producer and user of its items, the run
size is the economic production quantity (EPQ). When a firm is producing its own inventory rather than
purchasing it, the order cost is replaced by manifesting setup costs. Setup costs are of a fixed nature like order
costs. They represent the onetime costs for machine adjustments, paperwork, scheduling efforts, and the like.
The assumptions of the EPQ model are similar to those of the EOQ model, except that instead of orders
received in a single delivery, units are received incrementally during production. The assumptions are:
1. Only one item is involved.
2. Annual demand is known.
3. The usage rate is constant.
4. Usage occurs continually, but production occurs periodically.
5. The production rate is constant.
6. Lead time does not vary.
7. There are no quantity discounts.
The EOQ equation must also be modified to account for the time it takes to produce item of which only a
portion go in to inventory. The other portion is used concurrently in the production process or is sold as
produced. The production rate, P, is of course non instantaneous and must be greater than or equal to the
demand rate.
The modification to the EOQ equation for non-instantaneous supply does not affect the ordering cost (which
now becomes the set up cost). But it acts to reduce carrying cost by deleting the carrying change on that
portion of the production that does not go into inventory.
If d = demand per day and P = production per day, then the ratio d/p represents the proportion of production
that is allocated to daily demand, and 1-d/p represents that portion of the production run that goes in to
inventory. If we take into account the decreased carrying cost of this reduced level of inventory, the economic

11
run length (ERL) or the economic production quantity (EPQ) number of units to produce per projection set up
is

√2.D.S
EPQ = Cc (1−d / p )
Where:
S = Set up cost in birr/set up
D = annual demand in units
Cc = Carrying costs in birr//unit/year
d = demand rate
P = production rate
Example 1:
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 Birr 1 per wheel a year. Setup cost for a production run of wheels is birr 45. The
firm operates 240 days per year.
Determine the:
a. Optimal run size.
b. Minimum total annual cost for carrying and setup.
c. Cycle time for the optimal run size.
d. Run time.
4.6.5. Single-Period Model
The single-period model (sometimes referred to as the news boy problem) is used to handle ordering of
perishables (fresh fruits, vegetables, seafood, cut flowers) and items that have a limited useful life (newspapers,
magazines, spare parts for specialized equipment). The period for spare parts is the life equipment, assuming
that the parts cannot be used for other equipment. What sets unsold or unused goods apart is that they are
typically carried over from one period to the next, at least not without penalty. Day-old baked goods, for
instance, are often sold at reduced prices; leftover seafood may be discarded; and out-of-date magazines may
be offered to used book stores at bargain rates. There may even be some cost associated with disposal of
leftover goods.
Analysis of single-period situations generally focuses on two costs: shortage and excess. Shortage cost may
include a charge for loss of customer goodwill as well as the opportunity cost of lost sales. Generally, shortage
cost is simply unrealized profit per unit. That is
Cshortage = Cs = Revenue per unit – Cost per unit.
If a shortage or stock out relates to an item used in production or to a spare part for a machine, then shortage
cost refers to the actual cost of lost production.
Excess cost pertains to items left over at the end of the period. In effect, excess cost is the difference between
purchase cost and salvage value. That is
Cexcess = Ce = Original cost per unit – Salvage value per unit.
If there is cost associated with disposing of excess items, the salvage will be negative and will therefore
increase the excess cost per unit.
The goal of the single-period is to identify the order quantity, or stocking level, that will minimize the long-run
excess and shortage costs. There are two categories of problems that we will consider: those for which demand
can be approximated using a continuous distribution (such as uniform or normal distribution) and those for
which demand can be approximated using a discrete distribution (such as historical frequencies or the Poisson).
12
The kind of inventory can indicate which type of model might be appropriate. For example, demand for
petroleum, liquids, and gases tend to vary over some continuous scale, thus lending itself to description by a
continuous distribution. Demand for tractors, cars, and computers is expressed in terms of the number of units
demanded and lends itself to description by a discrete distribution.
Continuous Stocking Levels
The concept of identifying an optimal stocking level is perhaps easiest to visualize when demand is uniform.
Choosing the stocking level is similar to balancing a seesaw, but instead of a person on each end of the seesaw,
we have excess cost per unit (Ce) on one end of the distribution and shortage cost per unit (C s) on the other.
The optimal stocking level is analogous to the fulcrum of the seesaw; the stocking level equalizes the cost
weights, as illustrated in Figure 4.2.
The service level is the probability that demand will not exceed the stocking level, and computation of the
service level is the key to determining the optimal stocking level, So.
Cs
Service level = C s +C e
Where: Cs = Shortage cost per unit
Ce = Excess cost per unit

Ce Cs
 

Service level
 Quantity 
So
So = Optimum
Balance point
Stocking quantity
Fig. 4.1 The optimal stocking level balances unit shortage and excess costs.
If actual demand exceeds So, there is a shortage; hence, C s is on the right end of the distribution. Similarly, if
demand is less than So, there is an excess, so Ce is on the left end of the distribution. When Ce = Cs, the optimal
stocking level is halfway between the endpoints of the distribution. If one cost is greater than the other, So will
be closer to the larger cost.
Example 1:
Mekonnen Bar sells, among others, a blend of cherry juice and apple cider. Demand for the blend is
approximately normal, with a mean of 200 liters per week and a standard
deviation of 10 liters per week. C s = 60 cents per liter, and Ce = 20 cents per liter. Find the optimal stocking
level for the apple-cherry blend.

Fixed-Order-Interval Model
The fixed-order-interval (FOI) model is used when orders must be placed at fixed time intervals (weekly, twice
a month, etc). The timing of orders is set. If demand is variable, the order size will tend to vary from cycle to
cycle. This is quite different from an EOQ/ROP approach in which the order size generally remains fixed from
cycle to cycle, while the length of the cycle varies (shorter if demand is above average and longer if demand is
below average).
Like the ROP model, the fixed-interval model can have variations in demand only in, lead time only, or in both
demand and lead time. However, for the sake of simplicity and because it is perhaps the most frequently
encountered situation, the discussion here will focus only on variable demand and constant lead time.
13
Order size in the fixed-interval model is determined by the following computation:

Expected demand Amount on

Safety
Amount to order = during protection + - hand at reorder
stock
interval time
= d (OI +LT ) +zδd √ OI +LT −A
Where:
OI = Order interval (length of time between orders)
A = Amount on hand at reorder time.
As in previous models, we assume that demand during the protection interval is normally distributed.
Example1:
Given the following information, determine the amount to order.
d = 30 units per day Desired service level = 99 percent
p = 3 units per day Amount on hand at reorder time = 71 units
LT = 2 days OI = 7 days
Z = 2.33 for 99 percent service level
Amount to order = d (OI +LT ) +zδd √ OI +LT −A
= 30 (7+2) + 2.33(3) √ 7+2 − 71
= 220 units

14