Inventory Control Subject to

Certain Demand

Inventory Management

The fundamental problem of inventory management

can be described by the two questions
(1) When should an order be placed?
and (2) How much should be ordered?

The complexity of the resulting model depends

upon the assumptions one makes about the various
parameters of the system.

Inventory Management

The major distinction is between models that

assume known demand and those that assume
random demand

The form of the cost functions and the

assumptions one makes about the physical
characteristics of the system also play an important
role in determining the complexity of the resulting
model.

Inventory Management

When we consider inventories in the context of

manufacturing and distribution, there is a
natural classification scheme suggested by the
value added from manufacturing or processing.

This certainly is not the only means of

categorizing inventories, but it is the most
natural one for manufacturing applications.

Inventory Management

Raw materials. These are the resources required

in the production or processing activity of the
firm.
Work-in-process. Work-in-process (WIP) is
inventory either waiting in the system for
processing or being processed.
Finished goods. Also known as end items, these
are the final products of the production process.

Inventory Management

Reasons for holding inventories:

Economies of scale. Consider a company that

produces a line of similar items, such as air
filters for automobiles. Each production run of
a particular size of filter requires that the
production line be reconfigured and the
machines recalibrated.

Inventory Management

Because the company must invest substantial time

and money in setting up to produce each filter size,
enough filters should be produced at each setup to
justify this cost. This means that it could be
economical to produce a relatively large number of
items in each production run and store them for
future use. This allows the firm to amortize fixed
setup costs over a larger number of units.

Inventory Management

Uncertainties:
Uncertainty often plays a major role in
motivating a firm to store inventories.
Uncertainty of external demand is the most
important. For example, a retailer stocks
different items so that he or she can be
responsive to consumer preferences

Inventory Management

Uncertainties:
If a customer requests an item that is not
available immediately, it is likely that the
customer will go elsewhere. Worse, the
customer may never return. Inventory
provides a buffer against the uncertainty of
demand.

Inventory Management

Speculation:

If the value of an item or natural resource is

expected to increase, it may be more
economical to purchase large quantities at
current prices and store the items for future
use than to pay the higher prices at a future
date.

Inventory Management

Pipeline Inventories:

In-transit or pipeline inventories exist

because transportation times are positive.
When transportation times are long, as is the
case when transporting oil from the Middle
East to the United States, the investment in
pipeline inventories can be substantial.

Inventory Management

Characteristics of Inventory Systems:

Demand. The assumptions one makes about

the pattern and characteristics of the
demand often turn out to be the most
significant in determining the complexity of
the resulting control model.

Inventory Management

Constant versus variable. The simplest

inventory models assume that the rate of
demand is a constant. The economic order
quantity (EOQ) model and its extensions
are based on this assumption. Variable
demand arises in a variety of contexts,
including aggregate planning and materials
requirements planning.

Inventory Management

Known versus random. It is possible for

demand to be constant in expectation but still
be random. Synonyms for random are
uncertain and stochastic.

Random demand models are generally both

more realistic and more complex than their
deterministic counterparts.

Inventory Management

Lead Time:
If items are ordered from the outside, the lead
time is defined as the amount of time that
elapses from the instant that an order is
placed until it arrives. If items are produced
internally, however, then interpret lead time
as the amount of time required to produce a
batch of items.

Inventory Management

Review Time:
In some systems the current level of inventory
is known at all times. This is an accurate
assumption when demand transactions are
recorded as they occur. One example of such a
system is a modern supermarket with a visual
scanning device at the checkout counter that is
linked to a storewide inventory database.

Inventory Management

Characteristics of Inventory Systems:

Review Time:
As an item is passed through the scanner, the
transaction is recorded in the database, and the
inventory level is decreased by one unit. We
will refer to this case as continuous review.

Inventory Management

Review Time:
In the other case, referred to as periodic
review, inventory levels are known only at
discrete points in time. An example of
periodic review is a small grocery store in
which physical stock-taking is required to
determine the current levels of on-hand
inventory.

Inventory Management

Another important distinguishing

characteristic is how the system reacts to
excess demand (that is, demand that cannot
be filled immediately from stock). The two
most common assumptions are that excess
demand is either backordered (held over to be
satisfied at a future time) or lost (generally
satisfied from outside the system).

Inventory Management

Because we are interested in optimizing the

inventory system, we must determine an
appropriate optimization or performance
criterion. Virtually all inventory models use
cost minimization as the optimization criterion.
An alternative performance criterion might be
profit maximization. These are equivalent
criteria.

Inventory Management

Virtually all inventory costs can be placed

into one of three categories: holding cost,
ordering cost, or penalty cost.

The holding cost, also known as the carrying

cost, is the sum of all costs that are
proportional to the amount of inventory
physically on hand at any point in time.

Inventory Management

The components of the holding cost include a

variety of seemingly unrelated items. Some of
these are
Cost of providing the physical space to store
the items.
Taxes and insurance,
Breakage, spoilage and obsolescence.
Opportunity cost of alternative investment.

Inventory Management

The last item often turns out to be the most

significant in computing holding costs for most
applications. Inventory and cash are in some
sense equivalent.
Capital must be invested to either purchase or
produce inventory, and decreasing inventory
levels results in increased capital. This capital
could be invested by the company either
internally, in its own operation, or externally.

Inventory Management

Finding the right interest rate for the opportunity

cost of alternative investment is difficult. Its value
is estimated by the firm's accounting department
and is usually an amalgam of different accounting
measures.

For convenience, we will use the term cost of

capital to refer to this component of the holding
cost.

Inventory Management

We may think of the holding cost as an

aggregated interest rate comprised of the four
components we listed. For example,
28% = Cost of capital
2% = Taxes and insurance
6% = Cost of storage
1% = Breakage and Spoilage
37% = Total interest charge

Inventory Management

This would be interpreted as follows: We would

assess a charge of 37 cents for every dollar that
we have invested in inventory during a one-year
period.
Let c be the dollar value of one unit of inventory,
I be the annual interest rate, and h be the holding
cost in terms of dollars per unit per year. Then
we have the relationship
h = Ic

Inventory Management

Hence, in this example, an item valued at

$180 would have an annual holding cost of h
= (0.37)($180) = $66.60.

If we held 300 of these items for five years,

the total holding cost over the five years
would be
(5)(300)(66.60) = $99,900

Inventory Management

The ordering cost, K, depends on the amount of

inventory that is ordered or produced.

The appropriate costs comprising K would be the

bookkeeping expense associated with the order, the
fixed costs independent of the size of the order that
might be required by the vendor, costs of order
generation and receiving, and handling costs.

Inventory Management

The penalty cost, also known as the shortage cost

or the stock-out cost, is the cost of not having
sufficient stock on hand to satisfy a demand when
it occurs.
This cost has a different interpretation depending
on whether excess demand is back-ordered (orders
that cannot be filled immediately are held on the
books until the next shipment arrives) or lost
(known as lost sales).

Inventory Management

In the back-order case, the penalty cost includes

whatever bookkeeping and/or delay costs might be
involved. In the lost-sales case, it includes the lost
profit that would have been made from the sale. In
either case, it would also include the loss-ofgoodwill cost, which is a measure of customer
satisfaction.
Estimating the loss-of-goodwill component of the
penalty cost can be very difficult in practice.

Inventory Management

Economic Order Quantity (EOQ) Model:

The EOQ model (or economic order quantity
model) is the simplest and most fundamental of
all inventory models.
It describes the important trade-off between
fixed order costs and holding costs, and is the
basis for the analysis of more complex systems.

Inventory Management

1.The demand rate is known and is a constant

units per unit time. (The unit of time may
be days, weeks, months, etc. In what follows
we assume that the default unit of time is a
year. However, the analysis is valid for other
time units as long as all relevant variables are
expressed in the same units.)
2. Shortages are not permitted.

Inventory Management

3. There is no order lead time.

4. The costs include:
a. Setup cost at K per positive order placed.
b. Proportional order cost at c per unit
ordered.
c. Holding cost at h per unit held per unit
time.

Inventory Management

Assume with no loss in generality that the on-hand

inventory at time zero is zero. Shortages are not
allowed, so we must place an order at time zero.
Let Q be the size of the order. It follows that the
on-hand inventory level increases instantaneously
from zero to Q at time t = 0.
If follows that the function that describes the
changes in stock levels over time is the familiar
sawtooth pattern

Inventory Management

Unless otherwise stated, we will assume that a unit of

time is a year, so that we minimize the average annual
cost.
Define G(Q) to be the average annual cost when a lot
size Q is ordered. Then,

K
hQ
G (Q) c

Q
2

Inventory Management

We now wish to find Q to minimize G(Q). We

have that
G(Q) = - K/Q2 + h/2
and
G(Q) = 2K/Q3 > 0 for Q > 0.
Since G"(Q) > 0, it follows that G(Q) is a
convex function of Q.

Inventory Management

The optimal value of Q occurs where G'(Q) =

0. This is true when Q2 = 2K/h, which gives

Q =

2K
h

Q* is known as the economic order quantity

(EOQ).

Inventory Management

Example:
Number 2 pencils at the campus bookstore
are sold at a fairly steady rate of 60 per
week. The pencils cost the bookstore 2 cents
each and sell for 15 cents each. It costs the
bookstore $12 to initiate an order, and
holding costs are based on an annual interest
rate of 25 percent.

Inventory Management

Determine the optimal number of pencils

for the bookstore to purchase. What are the
yearly holding and setup costs for this item?

First, we convert the demand to a yearly

rate so that it is consistent with the interest
charge, which is given on an annual basis.

Inventory Management

The annual demand rate is = (60)(52) =

3,120. The holding cost h is the product of
the annual interest rate and the variable cost
of the item. Hence, h = (0.25)(0.02) = 0.005
$/unit/year. Substituting into the EOQ
formula, we obtain,

2K
2(12)(3120)
Q

3870
h
0.005
*

Inventory Management

The average annual holding cost is h(Q/2) =

0.005(3,870/2) = $9.675. The average annual setup
cost is K/Q, which is also $9.675.
In this part we examine the issue of how sensitive
the annual cost function is to errors in the
calculation of Q. Consider the previous Example.
Suppose that the bookstore orders pencils in batches
of 1,000, rather than 3,870 as the optimal solution
indicates.

Inventory Management

What additional cost is it incurring by using

a suboptimal solution? To answer the
question, we consider the average annual
cost function G(Q).
By substituting Q = 1,000, we can find the
average annual cost for this lot size and
compare it to the optimal cost to determine
the magnitude of the penalty.

Inventory Management

We have
G(Q) = K/Q + hQ/2 = (12)(3,120)/1,000 + (0.005)
(1,000)/2 = $39.94, which is larger than the optimal
cost of $19.35.
One can find the cost penalty for suboptimal solutions
in this manner for any particular problem. However, it
is more instructive and more convenient to obtain an
analytical solution to the sensitivity problem.

Inventory Management
Let G (Q* ) be the optimal EOQ cost.
*
K

hQ
G (Q* ) *
Q
2

K
h 2K

h
2K 2
h

K h
=
+
2
= 2K h

K h
2

Inventory Management
G (Q)
K / Q hQ / 2
=
*
G (Q )
2K h
1 2K
Q
h
=
+
2Q
h
2 2K
Q*
Q
=
+
*
2Q
2Q

Inventory Management
G (Q)
1 Q * Q

*
G (Q )
2 Q Q *

To see how one would use this result, consider

using a suboptimal lot size in the Example.
The optimal solution was Q* = 3,870, and we
wished to evaluate the cost error of using Q=
1,000.

Inventory Management

Forming the ratio Q*/Q gives 3.87. Hence,

G(Q)/G(Q*) = (0.5)(3.87 + 1/3.87) = (0.5)
(4.128) = 2.06.
This says that the average annual holding and
setup cost with Q = 1,000 is 2.06 times the
optimal average annual holding and setup
cost.

Inventory Management

In general, the cost function G(Q) is

relatively insensitive to errors in Q. For
example, if Q is twice as large as it should
be, Q/Q* is 2 and G(Q)/G(Q*) is 1.25.

Hence, an error of 100 percent in the value of

Q results in an error of only 25 percent in the
annual holding and setup cost.

Inventory Management

EOQ with finite production rate:

An implicit assumption of the EOQ model is
that the items are obtained from an outside
supplier. When that is the case, it is reasonable
to assume that the entire lot is delivered at the
same time. However, if we wish to use the
EOQ formula when the units are produced
internally, this assumption may not be valid.

Inventory Management

If the rate of production is comparable to the rate

of demand, the EOQ formula will lead to
incorrect results.

Assume that items are produced at a rate P during

a production run. We require that P > for
feasibility. All other assumptions will be identical
to those made in the derivation of the EOQ.

Inventory Management

Let Q be the size of each production run. Let

T, the cycle length, be the time between
successive production startups.

Write T =T1 + T2, where T1 is the uptime

(production time) and T2 is the downtime.
Note that the maximum level of on-hand
inventory during a cycle is not Q.

Inventory Management

Define H as the maximum level of on-hand

inventory. As items are produced at a rate P for
a time T1, it follows that Q = PT1, or T1 = Q/P.

From Figure in textbook, we see that H/T1 = P . This follows from the definition of the slope
as the rise over the run, Substituting T1 = Q/P
and solving for H gives H = Q(1 - /P).

Inventory Management

We now determine an expression for the

annual cost function. Because the average
inventory level is H/2, it follows that

K
hH
G (Q) =
+
Q
2
K
hQ

=
+
1
Q
2
P

Inventory Management

Notice that if we define h = h(1 - /P), then

this G(Q) is identical to the basic EOQ
model with h substituted for h. It follows
that

Q
*

2K
h

Inventory Management

Quantity Discounts:
We have assumed up until this point that the cost c
of each unit is independent of the size of the order.
Often, however, the supplier is willing to charge
less per unit for larger orders. The purpose of the
discount is to encourage the customer to buy the
product in larger batches. Such quantity discounts
are common for many consumer goods.

Inventory Management

There are two quantity discount schedules that seem

to be the most popular: all-units and incremental. In
each case we assume that there are one or more
breakpoints defining changes in the unit cost.
However, there are two possibilities: either the
discount is applied to all the units in an order (allunits), or it is applied only to the additional units
beyond the breakpoint (incremental). The all-units
case is more common.

Inventory Management

The Weighty Trash Bag Company has the

following price schedule for its large trash
can liners. For orders of less than 500 bags,
the company charges 30 cents per bag; for
orders of 500 or more but fewer than 1,000
bags, it charges 29 cents per bag; and for
orders of 1,000 or more, it charges 28 cents
per bag.

Inventory Management

In this case the breakpoints occur at 500 and

1,000. The discount schedule is all-units
because the discount is applied to all of the
units in an order.

Why would Weighty actually charge less for a

larger order? One reason would be to provide
an incentive for the purchaser to buy more.

Inventory Management

If you were considering buying 400 bags,

you might choose to move up to the
breakpoint to obtain the discount.

Furthermore, it is possible that Weighty has

stored its bags in lots of 100, so that its
savings in handling costs might more than
compensate for the lower total cost.

Inventory Management

Assume that the company considering what

standing order to place with Weighty uses trash
bags at a fairly constant rate of 600 per year.
The accounting department estimates that the
fixed cost of placing an order is $8, and
holding costs are based on a 20 percent annual
interest rate. We have that, c0 = 0.30, c1 = 0.29,
and c2 = 0.28 are the respective unit costs.

Inventory Management

The first step toward finding a solution is to

compute the EOQ values corresponding to
each of the unit costs, which we will label
Q(0), Q(1) and Q(2), respectively.

(0)

2K
(2)(8)(600)

400
Ic0
(0.2)(0.3)

Inventory Management
Q

(1)

(2)

2K
(2)(8)(600)

406
Ic1
(0.2)(0.29)
2K
(2)(8)(600)

414
Ic2
(0.2)(0.28)

Inventory Management

We say that the EOQ value is realizable if it falls

within the interval that corresponds to the unit
cost used to compute it. Since 0 < 400 < 500, Q0
is realizable.

However, neither Q(1) nor Q(2) is realizable (Q(1)

would have to have been between 500 and 1,000,
and Q(2) would have to have been 1 ,000 or more).

Inventory Management

There are three candidates for the optimal

solution: 400, 500, and 1,000. In general, the
optimal solution will be either the largest
realizable EOQ or one of the breakpoints that
exceeds it.

The optimal solution is the lot size with the

lowest average annual cost.

Inventory Management

The average annual cost functions are given by

Gj(Q) = cj + K/Q + Icj Q/2
for j = 0, 1, and 2.

Substituting Q equals 400, 500, and 1,000, and

using the appropriate values of cj, we obtain:

Inventory Management

G(400)
= G0(400)
= (600)(0.30) + (600)(8)/400 + (0.2)(0.30)(400)/2
= $204.00
G(500)
= G1(500)
= (600)(0.29) + (600)(8)/500 + (0.2)(0.29)(500)/2
= $198.10

Inventory Management

G(1000)
= G2(1000)

= (600)(0.28) + (600)(8)/1000 + (0.2)(0.28)

(l000)/2 = $200.80.

Hence, we conclude that the optimal solution is

to place a standing order for 500 units with
Weighty at an average annual cost of $198.10.

Inventory Management

Summary of the Solution Technique for AllUnits Discounts

1. Determine the largest realizable EOQ value.
2. Compare the value of the average annual cost
at the largest realizable EOQ and at all the price
breakpoints that are greater than the largest
realizable EOQ. The optimal Q is the point at
which the average annual cost is a minimum

Inventory Management
Consider the previous Example, but assume
Incremental Quantity Discounts. That is, the trash
bags cost 30 cents each for quantities of 500 or
fewer; for quantities between 500 and 1,000, the first
500 cost 30 cents each and the remaining amount
cost 29 cents each; for quantities of 1,000 and over
the first 500 cost 30 cents each, the next 500 cost 29
cents each, and the remaining amount cost 28 cents
each.

Inventory Management
0 Q<500
0.3Q

C (Q) 150 0.29(Q 500) 5 0.29Q 500 Q<1000

295 0.28(Q 1000) 15 0.28Q 1000 Q

Inventory Management

The average annual cost function, G(Q), is

G(Q) = C(Q)/Q + K/Q + I[C(Q)/(Q)]Q/2.
We have that
G0(Q) = (600)(0.30) + (8)(600)/Q + (0.20)
(0.30)Q/2

Inventory Management

Which is minimized at,

Q

(0)

2K
(2)(8)(600)

400
Ic0
(0.20)(0.30)

G1(Q) = (600)(0.29 + 5/Q) + (8)(600)/Q

+ (0.20)(0.29 + 5/Q)(Q/2)

Inventory Management

Which is minimized at,

Q

(1)

(2)(13)(600)

519
(0.20)(0.29)

Finally,
G2(Q) = (600)(0.28 + 15/Q) + (8)(600)/Q
+ (0.20)(0.28 + 15/Q)Q/2

Inventory Management

Which is minimized at,

(2)

(2)(23)(600)

702
(0.20)(0.28)

Inventory Management

Both Q(0) and Q(1) are realizable. Q(2) is not

realizable because Q(2) < 1,000. The optimal
solution is obtained by comparing G 0(Q(0)) and
G1(Q(1)). Substituting into the earlier expressions
for G0(Q) and G1(Q), we obtain

G0(Q(0)) = $204.00,

and
G1(Q(1)) = $204.58.

Inventory Management

Hence, the optimal solution is to place a

standing order with the Weighty Trash Bag
Company for 400 units at the highest price of
30 cents per unit. The cost of using a standard
order of 519 units is only slightly higher.
Notice that compared to the all-units case, we
obtain a smaller batch size at a higher average
annual cost.

Inventory Management

Summary of the Solution Technique for

Incremental Discounts
1. Determine an algebraic expression for C(Q)
corresponding to each price interval. Use that to
determine an algebraic expression for C(Q)/Q.
2. Substitute the expressions derived for C(Q)/Q
into the defining equation for G(Q).

Inventory Management

2. Compute the minimum value of Q

corresponding to each price interval
separately.
3. Determine which minima computed in
(2) are realizable (that is, fall into the correct
interval). Compare the values of the annual
costs at the realizable EOQ values and pick
the lowest.

Inventory Management

Multi-Product EOQ:
The EOQ model and its extensions apply only to
single inventory items. However, these models
are often used in companies stocking many
different items. Although we could certainly
compute optimal order quantities separately for
each different item, there could exist constraints
that would make the resulting solution infeasible.

Inventory Management

Three items are produced in a small

fabrication shop.

The shop management has established the

requirement that the shop never have more
than $30,000 invested in the inventory of
these items at one time.

Inventory Management

The management uses a 25 percent annual

interest charge to compute the holding cost.
The relevant cost and demand parameters
are given in the following table.

What lot sizes should the shop be producing

so that they do not exceed the budget?

Inventory Management
Item

Demand rate j

1,850

1,150

800

Variable cost cj

50

350

85

100

150

50

Setup cost Kj

Inventory Management

If the budget is not exceeded when using

the EOQ values of these three items, then
the EOQs are optimal. Hence, the first step
is to compute the EOQ values for all items
to determine whether or not the constraint is
active.

(2)(100)(1,850)
EOQ1
172
(0.25)(50)

Inventory Management
(2)(150)(1150)
EOQ 2
63
(0.25)(350)

(2)(50)(800)
EOQ3
61
(0.25)(85)

Inventory Management

If the EOQ value for each item is used, the

maximum investment in inventory would be

(172)(50) + (63)(350) + (61)(85) = $35,835.

Because the EOQ solution violates the

constraint, we need to reduce these lot sizes.
But how?

Inventory Management

The optimal solution turns out to be very

easy to find in this case. We merely multiply
each EOQ value by the ratio (30,000)/
(35,835) = 0.8372.

In order to guarantee that we do not exceed

the $30,000 budget, we round each value
down.

Inventory Management

Letting Q1 , Q2 , and Q3 be the optimal values,

we obtain
Q1 = (172)(0.8372) = 144,
Q2 = (63)(0.8372) = 52,
Q3 = (61)(0.8372) = 51.
The total budget required for these lot sizes is
$29,735.

Inventory Management

In general, budget or space-constrained

problems are not solved so easily. Suppose
that n items have unit costs of c1, c2, ., cn,
respectively, and the total budget available
for them is C. Then the budget constraint
can be written
c1Q1 + c2Q2 + + cnQn < C

Inventory Management

Let,

for i=1,,n
There are two possibilities: either the
constraint is active or it is not. If the
constraint is not active, then

2 K i i
EOQi
hi

c EOQ
i 1

Inventory Management

And the optimal solution is Qi = EOQi. If the

constraint is active, then
n

c EOQ
i 1

and the EOQ solution is no longer feasible.

If we include the following assumption, the

solution to the active case is relatively easy to find:

Inventory Management

Assumption: c1/h1 = c2/h2 = . = cn/hn.

If this assumption holds and the constraint

is active, we can show that the optimal
solution is
Qi* = mEOQi, where

(c EOQ )

mC

i 1

Inventory Management

Since ci/hi = ci/(Iici) = 1/Ii, the condition that

the ratios be equal is equivalent to the
requirement that the same interest rate be
used to compute the holding cost for each
item, which is reasonable in most
circumstances.
Suppose that the constraint is on the
available space.

Inventory Management

Let wi be the space consumed by one unit of

product i for i = 1, 2 ..... n (this could be
floor space measured, say, in square feet, or
volume measured in cubic feet), and let W
be the total space available. Then the space
constraint is of the form
w1Q1 + w2Q2 + + wnQn < W.

Inventory Management

This is mathematically of the same form as

the budget constraint so the same analysis
applies. However, our condition for a simple
solution now is that the ratios wi/hi are equal.

That is, the space consumed by an item

should be proportional to its holding cost.

Inventory Management

When the interest rate is fixed, this is

equivalent to the requirement that the space
consumed should be proportional to the value
of the item. This requirement would probably
be too restrictive in most cases.

For example, fountain pens take up far less

space than legal pads, but are more expensive.

Inventory Management

Let us now consider the problem in which the

constraint is active, but the proportionality
assumption is not met. This problem is more
complex than that just solved (for the budget
constraint)

It can be shown that, the optimal lot sizes are

now of the form:

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*
i

2 K i i
hi 2 wi

where is a constant chosen so that

n

wQ
i 1

*
i

= W

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EOQ Models for Production Planning:

Simple lot-sizing models have been
successfully applied to a variety of
manufacturing problems.
We consider an extension of the EOQ model
with a finite production rate, discussed
previously, to the problem of producing n
products on a single machine.

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Following the notation used, let

j = Demand rate for product j,

Pj = Production rate for product j,

hj = Holding cost per unit per unit time for

product j,
Kj = Cost of setting up the production
facility to produce product j.

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The goal is to determine the optimal

procedure for producing n products on the
machine

This is to minimize the cost of holding and

setups, and to guarantee that no stock-outs
occur during the production cycle.

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We also will assume that the policy used is

a rotation cycle policy.

That means that in each cycle there is

exactly one setup for each product, and
products are produced in the same sequence
in each production cycle.

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At first, one might think that the optimal solution is

to sequentially produce lot sizes for each product
optimized by treating each product in isolation.
This would result in a lot size for product j of
Qj =

2K j j
where hj = hj(1 - j/P
hjj).

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The problem with this approach is that we

have only a single production facility.

It is likely that some of the lot sizes Qj will

not be large enough to meet the demand
between production runs for product j, thus
resulting in stock-outs.

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Let T be the cycle time. During time T we

assume that exactly one lot of each product
is produced. In order that the lot for product
j will be large enough to meet the demand
occurring during time T, it follows that the
lot size must be
Qj = jT.

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From previous results, the annual cost

associated with product j can be written in the
form
K j j hj Q j

G (Q j )

Qj
2
The annual cost for all products is:
n

K j j

j 1

G(Q )
j 1

Qj

hj Q j

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Substituting T = Qj/j, we obtain the annual

cost associated with the products in terms of
the cycle time T as

K j hj jT
G (T )

2
j 1 T
n

The goal is to find T to minimize G(T)

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The necessary condition for an optimal T is,

dG (T )
0
dT

Setting the first derivative with respect to T

to zero gives,

K j hj j

=0
2
T
2
j 1
n

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Solving, we obtain the optimal cycle time,

T*, as
n

2 K j
j 1

h
j 1

'
j

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If setup times are a factor, we must check

that there is enough time each cycle to
account for both setup times and production
of the n products. Let sj be the setup time
for product j. Ensuring that the total time
required for setups and production each
cycle does not exceed T leads to the
constraint:

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Q j
T
s j

Pj
j 1

Using the fact that Qj = jT, this condition

translates to,

jT
T
s j

P
j 1
j
n

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This gives after rearranging terms,

n

s
j 1

1 ( j / Pj )
j 1

= Tmin

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Tmin is the minimum cycle time.

The optimal solution is to choose the cycle

time T equal to the larger of T* and Tmin.