CHAPTER III

DETERMINISTIC INVENTORY MODELS

Deterministic Model in the context of Inventory Management

Deterministic models of inventory control are used to determine the optimal inventory

of a single item when demand is mostly largely obscure. Under this model, inventory is built up
at a constant rate to meet a determined or accepted demand. A deterministic model is a method
based on the assumption that all parameters and variables associated with an inventory stock are
known and that there is no uncertainty associated with demand and replenishment of inventory
stock. On the contrary, the probabilistic models recognize the fact that there is always some
degree of uncertainty associated with the demand pattern and lead times for inventory stock.

For example, a business has received an order in January for 100 model trains for
delivery to be completed by November for the holiday season. Due to the deadline
being 10 months away, the trains can be produced at a rate of ten per month.

ECONOMIC ORDER QUANTITY (EOQ) MODEL

EOQ stands for Economic Order Quantity. It is a measurement used in the field of
Operations, Logistics, and Supply Management. In essence, EOQ is a tool used to determine the
volume and frequency of orders required to satisfy a given level of demand while minimizing the
cost per order. One of the important decisions to be made in inventory management is how much
inventory stock to actually buy. Because of this model’s assumptions that demand, ordering, and
holding costs remain constant over time — it is best to use this model in similar circumstances.
EOQ also gives solutions to other problems like, at what frequency, when and helping determine
reserve stock quantities.

THE IMPORTANCE OF EOQ (ECONOMIC ORDER QUANTITY)

The Economic Order Quantity is a set point designed to help companies minimize the
cost of ordering and holding inventory. The cost of ordering inventory falls with the increase in
ordering volume due to purchasing on economies of scale. However, as the size of inventory
grows, the cost of holding the inventory rises. EOQ is the exact point that minimizes both of
these inversely related costs where in the ordering cost is the cost of having too little while
carrying cost is having too little.
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Illustration for EOQ Model graph:

As the size of inventory grows or order quantity increases, the carrying cost also
increases. The curve The cost of ordering inventory falls with the increase in ordering volume
due to purchasing on economies of scale while the total cost curve represent the sum of holding
cost and carrying cost. The aim of inventory is to balance and minimize the inversely related cost
which is called EOQ model.

EOQ FORMULA
The Economic Order Quantity formula is calculated by minimizing the total cost per
order by setting the first-order derivative to zero. The components of the formula that make up
the total cost per order are the cost of holding inventory and the cost of ordering that inventory.
The key notations in understanding the EOQ formula are as follows:

Components of EOQ Formula

Ordering Cost
The cost of placing an order in a certain period of time. It can be transportation cost,
taxes, loading and unloading charges, clerical support, and communication (loads and telephone
charges)
 The number of orders that occur annually can be found by dividing the annual demand
by the volume per order. The formula can be expressed as:

 For each order with a fixed cost that is independent of the number of units, S, the
annual ordering cost is found by multiplying the number of orders by this fixed cost. It is
expressed as:

Holding Cost
Holding inventory often comes with its own costs. This cost can be in the form of direct
costs incurred by financing the storage of said inventory or the opportunity cost of
holding inventory instead of investing the money elsewhere. It can be extra staffing, rent,
security, and electricity.
 The holding cost per unit is often expressed as the cost per unit multiplied by the
interest rate, expressed as follows:

H = iC
 The holding cost of the inventory is calculated by finding the sum product of the
inventory at any instant and the holding cost per unit. It is expressed as follows:
With the assumption that demand is constant, the quantity of stock can be seen to be depleting at
a constant rate over time. When inventory reaches zero, an order is placed and replenishes
inventory as shown:

TOTAL COST
 Summing the two costs together gives the annual total cost of orders. To find the
optimal quantity that minimizes this cost, the annual total cost is differentiated
with respect to Q. It is shown as follows:

EOQ (ECONOMIC ORDER QUANTITY)

 Square root of 2 times ordering cost times annual quantity demanded over
holding cost.

Example
For example, a company faces an annual demand of 2,000 units. It costs the company
$1,000 for every order placed and $250 per unit of the product. It faces a carrying cost of 10% of
a unit cost. What is the economic order quantity?
The variables can be arranged as follows:

The solution will be as follows:

EOQ COMPUTATION:
STEP 1:
EOQ= 2 ( 1 , 000 x 2 ,000 )
√ −¿25 Square root of 2 time 1000 or
ordering cost times 2000 or
¿ 4 ,000 , 000
√ −¿25 annual quantity demanded over
25 or holding cost.
STEP 2:
=√ 160 , 000
Square root of 4,000,000 over
= 400 25
STEP 3:
Square root of 160,000 equals
1. TYPES OF DEMANDS Q 400 R
CONSUMPTION RATE
ORDER QUANTITY
DETERMINISTIC MODEL
- Wilson Haris / R is constant

T CYCLE TIME

(R=Q/T)
R
2. Ordering cost = Cσ
Q

1
Carrying cost = QCc
2

Total Inventory Cost = Cc + Cσ

1 R
QCc + Cσ
2 Q

3. In EOQ = Economic Order Quantity

Q=
√ 2 R Cσ
Cc
R R
Cσ Cσ √ Cc R Cσ Cc
4. Ordering cost = Q √ 2 R Cσ = 2 R Cσ X R Cσ (√ 2 ¿
Cc
√

1 1 √ 2 RCσ R Cσ Cc
5. Carrying cost = QCc ( )Cc = (√ ¿
2 2 Cc 2

6. Total Inventoy Cost (TIC)^2

√ 2 R CσCc

NOTE! In EOQ, Ordering cost is equal to Carrying cost ( Cσ=Cc )

3.1.3 EOQ DIMENSIONS

Let us now examine the physical dimensions involved in the EOQ equations or the equations 3.8.
●The demand, D, is expressed in terms of numbers of units per year
●The ordering cost, Co, is expressed in terms of dollars
●The interest rate, i, is given in % per year
●The unit price (cost), C, of the item is expressed in dollars per unit
Using the above, we get:

When we read it is, Economic Ordering Quantity equals square-root of unit per year times dollar
over 1 over year or number of year times dollars equal the square-root of units per year time’s
dollars times’ number of year times unit per dollar.

Simplifying the equation given above, we can see that physical dimensions for Q are a number of
units. It is important to know that the time units for D which is demand and C which is unit price
or cost must be the same. If the demand is given in units per year, then the holding cost must be
in dollars per unit per year. Like what I’ve said the demand and holding cost must always be the
same if the demand is annual the holding cost must be annual also.

This is equation is a substitution; the problem that need to substitute is always given. The most
needed in this equation is the unit per year (unit/year). Example: 200pcs/year. The dollars that
has mentioned above are the price.

You can see that there is one over year or year over one (1/year or year/1), we can call it number
of year because anything we divide in one will not change or will still the same.
TIC COMPUTATION: ALTERNATIVE METHOD

In these equations, we can use another method to determine the TIC or total inventory cost once
we determined the EOQ or economic ordering quantity. Id we ignore the annual purchasing cost
in Equation 3.7, we have:

This is the equation 3.10,

To read it, total inventory cost equals demand (D) over economic ordering quantity (EOQ) times
order cost (Co) plus the EOQ over 2 times holding inventory cost (i) times the unit price (C).

The two (2) there is constant or always given.

To clarify we’ve mentioned above the equation 3.7 but in our report we don’t have the equation
3.7 that is because the equation 3.7 is in the derivations.

In substituting the value of Q from Eq. 3.8 in Eq. 3.10 we get:

On simplification of that equation

above we get the Eq. 3.10a:
It’s either the Eq. 3.7, Eq. 3.10 or Eq. 3.10a may
be used to determine TIC. It should be noted that
Esq. 3.10 and Eq.3.10a does not include the cost of
purchase.
The Eq. 3.10 used if there’s no annual purchasing cost. The Eq. 3.10a is the simplest equation.
So let us now apply the EOQ concept in the given problem presented at the beginning of this
chapter.

Rosetta’s uses a large quantity of vegetable oil for production of food products. The
demand for this item is fairly steady. The objective is to determine the economic order
quantity. We have the following information with us:

• Order cost Co is $80 per order.

• The unit price (C) of vegetable oil is $20 per liter. The inventory holding rate (i)
Is 30% per year?
• The demand is fairly constant at 7200 liters per year.

The first step is to verify that the time units for demand and holding cost are the same. In this
case, it is the same (both are expressed in years). Therefore, we can progress to the next step.
Substituting the above values in Eq. 3.8, we get

In a calculator we got the:

Now that we got the EOQ, 438.17 liters. It should be noted that the demand for the items is
continuous. This implies that the EOQ may be a non-integer, and this is perfectly acceptable.
The TIC can be calculated using Eq. 3.10. Substituting the values in Eq. 3.7, we get

In a calculator we got the:

Now that the TIC is $2629. It is noted that this code does not include the cost of investment or
the cost of purchase.

EXAMPLE PROBLEM

Compute the economic lot size for an item that has an annual demand of
5000 units. Assume the inventory holding costs are based on an annual
interest rate of 20%. Further, the purchase cost of the item is $10 and the
ordering cost is $25.20 per order. Also, compute the cycle time if there are
250 workdays in a year.

SOLUTION
In this problem, the time units for demand and carrying cost are the same. Other information
provided are as follows:
• D is 5000 per year
• i is 0.20.
• C is $10 per item.
Working Formula:
• Co is $25.20 per order.
√ 2 D Cσ
EOQ OR Q = iC

Based on the given problem, the derive working formula of Q or EOQ (which means Economic
order quantity), we have Q = square root of quantity 2 multiply by D multiply by Co over rate
multiply by C. Wherein each letter has its corresponding equivalent (example D=demand,
Co=ordering cost..etc) from the given problem it requires to find a.) Q (optimal order quantity)
and b.) t (cycle time) in day as its unit.

GIVEN:

D= 5000/ YEAR A.)

Co= $25.5 /ORDER
C=$10/ITEM
I=0.20

A.).Since all the values were given substitute it to equation for finding Q. So by substituting
all the values, Q = 355 units.

B.) We are looking for cycle time.ung formula ng cycle time or t = Q/D. Substitute t=
355units/500 units/year. The answer17.8 days.

When to order: Incorporating Lead Time

In the previous section, we discussed a solution to the question of "how much to. Order?".
This section describes the solution for "when to place an order?". In the basic EOQ model, we
assumed the order is filled instantaneously. In other words, the model assumed the procurement
lead time is zero. This is not true always. In this section, we relax the lead time assumption to
make the model more realistic. At the time of placing an order, the level of inventory on hand
should be such that it can satisfy the demand during the lead time. Clearly, this level of inventory
is a function of the consumption during lead time. This level, also referred to as reorder level S,
can be mathematically expressed as:

S 1/4 L D
Where the L is the lead time, in days, and D is the daily demand.

Example
Rosetta's case, if the procurement lead time for vegetables oil is 7 days, the reorder level become
S 1/4 7200÷360 L 1/4 140.
We assume Rosetta's is working 360 days a year. To clarify the inventory per year is 7200 liters,
to divide it become the 7200÷360. Lead time when the inventory goes down to a certain point.
Example to the scenario, when the inventory goes down to 140 L you need to reorder. In that
case, 7 days the lead time because it takes 7 days to fill the original inventory (438L). D in the
equation is the daily demand and that is the 7200÷360. The inventory control policy for the
example is based on a continuous review.

When the on-hand inventory level of vegetable oil goes down to 140 liters we place an
order for 438 liters.