Inventory theory

By Prof.A.Chandrashekhar
How do companies use operations research to improve their
inventory policy for when and how much to replenish their
inventory?

• They use scientific inventory management

comprising the following steps:
– Formulate a mathematical model describing the
behavior of the inventory system.
– Seek an optimal inventory policy with respect to this
model.
– Use a computerized information processing system to
maintain a record of the current inventory levels.
– Using this record of current inventory levels, apply the
optimal inventory policy to signal when and how
much to replenish inventory.
• The mathematical inventory models used with
this approach can be divided into two broad
categories
– deterministic models and
– stochastic models
according to the predictability of demand involved.

• demand for a product in inventory is the number

of units that will need to be withdrawn from
inventory for some use (e.g., sales) during a
specific period.
• If the demand in future periods can be
forecast with considerable precision, it is
reasonable to use an inventory policy that
assumes that all forecasts will always be
completely accurate - deterministic inventory
model would be used.
• when demand cannot be predicted very well,
it becomes necessary to use a stochastic
inventory model where the demand in any
period is a random variable rather than a
known constant.
 19.1 EXAMPLES
1. Manufacturing Speakers for TV Sets
The company is interested in determining when to produce a batch of
speakers and how many speakers to produce in each batch. Several costs
must be considered:
– Each time a batch is produced, a setup cost of $12,000 is incurred.
This cost includes the cost of “tooling up,” administrative costs, record
keeping, and so forth. Note that the existence of this cost argues for
producing speakers in large batches.
– The unit production cost of a single speaker (excluding the setup cost)
is $10, independent of the batch size produced. (In general, however,
the unit production cost need not be constant and may decrease with
batch size.)
– The shortage cost is the cost of not having a bicycle on hand when
needed. This particular model is easily reordered from the
manufacturer, and stores usually accept a delay in delivery. Still,
although shortages are permissible, the distributor feels that she
incurs a loss, which she estimates to be $15 per bicycle per month of
shortage. This estimated cost takes into account the possible loss of
future sales because of the loss of customer goodwill. Other
components of this cost include lost interest on delayed sales revenue,
and additional administrative costs associated with shortages. If some
stores were to cancel orders because of delays, the lost revenues from
these lost sales would need to be included in the shortage cost.
Fortunately, such cancellations normally do not occur for this model.
• The cost of ordering an amount z (either through purchasing
or producing this amount) can be represented by a function
c(z). The simplest form of this function is one that is directly
proportional to the amount ordered, that is, c z, where c
represents the unit price paid. Another common assumption
is that c(z) is composed of two parts: a term that is directly
proportional to the amount ordered and a term that is a
constant K for z positive and is 0 for z 0. For this case,

• where K setup cost and c unit cost.

• The constant K includes the administrative cost of ordering or,
when producing, the costs involved in setting up to start a
production run.
• In Example 1, the speakers are produced and
the setup cost for a production run is $12,000.
Furthermore, each speaker costs $10, so that
the production cost when ordering a
production run of z speakers is given by

• In Example 2, the distributor orders bicycles

from the manufacturer and the ordering cost
is given by
• The holding cost (sometimes called the
storage cost) represents all the costs
associated with the storage of the inventory
until it is sold or used. Included are the cost of
capital tied up, space, insurance, protection,
and taxes attributed to storage. The holding
cost can be assessed either continuously or on
a period-by-period basis. In the latter case,
the cost may be a function of the maximum
quantity held during a period, the average
amount held, or the quantity in inventory at
the end of the period.
• The shortage cost (sometimes called the unsatisfied demand
cost) is incurred when the amount of the commodity required
(demand) exceeds the available stock. This cost depends upon
which of the following two cases applies.
• In one case, called backlogging, the excess demand is not lost,
but instead is held until it can be satisfied when the next
normal delivery replenishes the inventory. For a firm incurring
a temporary shortage in supplying its customers (as for the
bicycle example), the shortage cost then can be interpreted as
the loss of customers’ goodwill and the subsequent
reluctance to do business with the firm, the cost of delayed
revenue, and the extra administrative costs. For a
manufacturer incurring a temporary shortage in materials
needed for production (such as a shortage of speakers for
assembly into television sets), the shortage cost becomes the
cost associated with delaying the completion of the
production process.
• In the second case, called no backlogging, if any
excess of demand over available stock occurs, the
firm cannot wait for the next normal delivery to
meet the excess demand.
• Either (1) the excess demand is met by a priority
shipment, or
• (2) it is not met at all because the orders are
canceled.
• For situation 1, the shortage cost can be viewed
as the cost of the priority shipment. For situation
2, the shortage cost is the loss of current revenue
from not meeting the demand plus the cost of
losing future business because of lost goodwill.
• The salvage value of an item is the value of a
leftover item when no further inventory is
desired. The salvage value represents the
disposal value of the item to the firm, perhaps
through a discounted sale. The negative of the
salvage value is called the salvage cost. If
there is a cost associated with the disposal of
an item, the salvage cost may be positive. We
assume hereafter that any salvage cost is
incorporated into the holding cost.
• The discount rate takes into account the time value of
money. When a firm ties up capital in inventory, the
firm is prevented from using this money for alternative
purposes.
• For example, it could invest this money in secure
investments, say, government bonds, and have a return
on investment 1 year hence of, say, 7 percent. Thus, $1
invested today would be worth $1.07 in year 1, or
alternatively, a $1 profit 1 year hence is equivalent to α
= $1/$1.07 today. The quantity α is known as the
discount factor. Thus, in adding up the total profit from
an inventory policy, the profit or costs 1 year hence
should be multiplied by α; in 2 years hence by α 2 ; and
so on. (Units of time other than 1 year also can be
used.) The total profit calculated in this way normally is
referred to as the net present value.
• lead time, which is the amount of time
between the placement of an order to
replenish inventory (through either purchasing
or producing) and the receipt of the goods
into inventory. If the lead time always is the
same (a fixed lead time), then the
replenishment can be scheduled just when
desired.
• the current inventory level is being monitored
continuously or periodically.
• In continuous review, an order is placed as
soon as the stock level falls down to the
prescribed reorder point.
• In periodic review, the inventory level is
checked at discrete intervals, e.g., at the end
of each week, and ordering decisions are
made only at these times even if the inventory
level dips below the reorder point between
the preceding and current review times.
DETERMINISTIC CONTINUOUS-REVIEW
MODELS
• The most common inventory situation faced
by manufacturers, retailers, and wholesalers is
that stock levels are depleted over time and
then are replenished by the arrival of a batch
of new units.
• Economic order quantity model or, for short,
the EOQ model. (It sometimes is also referred
to as the Economic lot-size model.)
• Units of the product under consideration are assumed to be
withdrawn from inventory continuously at a known constant
rate, denoted by a; that is, the demand is a units per unit
time. It is further assumed that inventory is replenished when
needed by ordering (through either purchasing or producing)
a batch of fixed size (Q units), where all Q units arrive
simultaneously at the desired time.
• The basic EOQ model to be presented first, the only costs to
be considered are
– K = setup cost for ordering one batch,
– c = unit cost for producing or purchasing each unit,
– H = holding cost per unit per unit of time held in inventory
The objective is to determine when and by how much to
replenish inventory so as to minimize the sum of these
costs per unit time.
• We assume continuous review, so that inventory can be
replenished whenever the inventory level drops sufficiently
low. We shall first assume that shortages are not allowed (but
later we will relax this assumption). With the fixed demand
rate, shortages can be avoided by replenishing inventory each
time the inventory level drops to zero, and this also will
minimize the holding cost.
Example 1 in Sec. 19.1 (manufacturing
speakers for TV sets) fits this model
The Basic EOQ Model
• To summarize, in addition to the costs specified above,
the basic EOQ model makes the following assumptions.
• Assumptions (Basic EOQ Model).
1. A known constant demand rate of a units per unit time.
2. The order quantity (Q) to replenish inventory arrives all
at once just when desired, namely, when the inventory
level drops to 0.
3. Planned shortages are not allowed.
• the amount of time between the placement of
an order and its receipt is referred to as the
lead time.

• The inventory level at which the order is placed

is called the reorder point.

• The time between consecutive replenishments

of inventory (the vertical line segments in Fig.
19.1) is referred to as a cycle.
• The total cost per unit time T is obtained from
the following components.
• Production or ordering cost per cycle = K + cQ.
• The average inventory level during a cycle is
(Q + 0)/2 = Q/2 units, and the corresponding
cost is hQ/2 per unit time. Because the cycle
length is Q/a,
 The EOQ model with planned shortages
• Planned shortages now are allowed. When a shortage
occurs, the affected customers will wait for the product
to become available again. Their backorders are filled
immediately when the order quantity arrives to replenish
inventory.

However, now the inventory levels extend

down to negative values that reflect the
number of units of the product that are
backordered.
 The EOQ Model with Quantity Discounts

• The EOQ model with quantity discounts

replaces this assumption by the following new
assumption.
– The unit cost of an item now depends on the
quantity in the batch. In particular, an incentive is
provided to place a large order by replacing the
unit cost for a small quantity by a smaller unit cost
for every item in a larger batch, and perhaps by
even smaller unit costs for even larger batches.
• To illustrate this model, consider the TV
speakers example introduced in Sec. 19.1.
• Suppose now that the unit cost for every
speaker is
– c1 = $11 if less than 10,000 speakers are
produced,
– c2 = $10 if production falls between 10,000 and
80,000 speakers, and
– c3 = $9.50 if production exceeds 80,000 speakers.
 What is the optimal policy?

• The solution to this specific problem will

reveal the general method.
Observations about EOQ Models
A Broader Perspective of the Speaker Example

• independent demand
• dependent demand.
• dependent-demand products
 Material requirements planning, (MRP)
• A popular technique for assisting in this task is material
requirements planning, abbreviated as MRP. MRP is a computer-
based system for planning, scheduling, and controlling the
production of all the components of a final product.
– The system begins by “exploding” the product by breaking it
down into all its subassemblies and then into all its individual
component parts. A production schedule is then developed,
using the demand and lead time for each component to
determine the demand and lead time for the subsequent
component in the process.
– a master production schedule for the final product, a bill of
materials provides detailed information about all its
components. Inventory status records give the current inventory
levels, number of units on order, etc., for all the components.
– When more units of a component need to be ordered, the MRP
system automatically generates either a purchase order to the
vendor or a work order to the internal department that
produces the component
 Just in time
• Just in time actually is a well-developed philosophy
for managing inventories. A just-in-time (JIT)
inventory system places great emphasis on reducing
inventory levels to a bare minimum, and so providing
the items just in time as they are needed.
• This philosophy was first developed in Japan,
beginning with the Toyota Company in the late
1950s, and is given part of the credit for the
remarkable gains in Japanese productivity through
much of the late 20th century.
• the focus of the just-in-time philosophy is on
avoiding waste wherever it might occur in the
production process.
• A JIT inventory system focuses on finding ways to
greatly reduce the setup costs so that the optimal
order quantity will be small. Such a system also
seeks ways to reduce the lead time for the
delivery of an order, since this reduces the
uncertainty about the number of units that will
be needed when the delivery occurs.
• Another emphasis is on improving preventive
maintenance so that the required production
facilities will be available to produce the units
when they are needed.
• another emphasis is on improving the production
process to guarantee good quality.
• Providing just the right number of units just in
time does not provide any leeway for including
defective units.
 A DETERMINISTIC PERIODIC-REVIEW
MODEL
• The preceding section explored the basic EOQ
model and some of its variations. The results
were dependent upon the assumption of a
constant demand rate. When this assumption
is relaxed, i.e., when the amounts that need to
be withdrawn from inventory are allowed to
vary from period to period, the EOQ formula
no longer ensures a minimum-cost solution.
• Consider the following periodic-review model.
Planning is to be done for the next n periods
regarding how much (if any) to produce or order
to replenish inventory at the beginning of each of
the periods. (The order to replenish inventory can
involve either purchasing the units or producing
them, but the latter case is far more common
with applications of this model, so we mainly will
use the terminology of producing the units.) The
demands for the respective periods are known
(but not the same in every period) and are
denoted by