Finding the optimum…

We get optimum point by setting:

Annual Setup Cost = Annual Holding Cost

(D/Q) . S = (Q/2) . H

Therefore,
Q2 = 2DS / H
Q* = [2DS / H]1/2

Q* value is also called as the EOQ.

 Example

An Inventory model has the following

characteristics:

Annual Demand (D) = 1000 units

Ordering (Setup) cost (S)= $10 per order;
Holding cost per unit per year (H) = $.50

Assume that there are 270 working days in a year

(excluding holidays and weekends).
Example…
Questions:
a) Find the Economic Order Quantity (Q*) for this
inventory model.
b) How many orders should be placed during one
year?
c) What is the expected time between two
consecutive orders?
d) What is the total annual cost of this inventory
model?
 Example…
Answers:
a) EOQ= Q* = [2(1000)10 / .50]1/2 = 200 units

b) Expected number of orders placed during the year (N) = D / Q* = 1000 / 200
= 5 times.

c) Expected time between orders (T) = (Working days in a year) / N = 270 / 5 =

54 days.

d) Total Annual Cost = Annual Setup Cost + Annual Holding Cost

= DS / Q* + (Q*) H / 2
= 1000 (10) / 200 + (200) (.50) / 2 = $100
Considering the Reorder Point
 So far, we only decided how much to order (That
is Q*).
 Now, we should find what time to order.
 We assumed that firm will wait until its inventory
reaches to zero before placing an order.
 And, we also assumed that the Orders will be
received immediately.
 However, there is a time between placement and
receipt of an order.
Considering the Reorder Point…

• This is called LEAD TIME or delivery time.

• Here, we will use the term “Reorder Point”
(ROP) for when to order.
• ROP (in units) = (Demand Per Day) x (Lead
time for a new order in days)

• ROP = dx L
 Reorder Point…
Inventory
ROP = d . L
Q* Slope = d (units/day)

ROP
(units)

Time
(Days)
L = Lead Time

When the inventory level reaches the ROP, a new order is required.

It will take a time that is equal to the Lead Time (L) to receive the
new order.
 Reorder Point…

• Demand per day (d) is found by the

following equation:
d = D / Number of working days in a year

• This ROP equation assumes that demand is

uniform and constant.

• If this is not the case, an extra (safety) stock

is added (because of uncertainty).
 Example

• Annual demand for an item is D =

8000/year.

• This year there will be 200 working days in

a year.

• Delivery of an order for this item takes 3

working days (L = 3 days).
 Example…

Questions:

a) Find the demand per day for this item.

b) What is the ROP for this item?

 Example…

Answers:
a) Demand per day for this item (d) = 8000 / 200
= 40 units / day.

b) ROP = d . L = 40 . 3 = 120 units.

When inventory level becomes 120 units, an Order
should be placed.
 Example
The demand for spring water at the Plano WalMart is 600 litres per week.
The setup cost for placing an order to replenish inventory is $25.

The order is delivered by the supplier which charges WalMart $0.10/liter

for the cost of transportation from the Ozark mountains to Plano. This
transportation cost increases the cost of water to $1.25/liter. The water
loses its freshness while stored at the Plano WalMart. To account for this,
the WalMart charges an annual holding cost of $2.6/liter.

Determine how often the WalMart should order for water and what size
each order should be.

Q*= 776 litres

D = 600 x 54 =31200
No. of orders over the year = 31200 / 776 = 40.2 = 41 orders
Time between two orders = 365/41 = 9 days
 Production Order Quantity Model

• In EOQ Model, We assumed that the entire

order was received at one time.
• However, Some Business Firms may
receive/ship their orders over a period of time.
• Such cases require a different inventory model.
• Here, we take into account the daily production
rate and daily demand rate.

13
Production Order Quantity Model..

Inventory

Production
occurs at a
rate of p Demand
Maximum occurs at
Inventory a rate of
d

Time

t
 POQ Model Inventory Levels
Inventory Level Production rate = p = 20/day
Demand rate = d = 7/day
Slope = p-d = 13/day
Inventory increases by 13 each day
while producing

Slope = -d = -7/day
Inventory decreases by 7/day
after producing

Time
Production Production Note: 1-(d/p) = fraction of
Begins Run Ends production that goes into inventory
 The blue line shows the
inventory development that
would occur with an infinite
production speed.

The green line shows the

inventory development that
would occur without any
demand.

The red line shows the actual

development of the inventory.
 Production Order Quantity Model..
Since this model is especially suitable for production
environments, It is called Production Order
Quantity Model.
Here, we use the same approach as we used in EOQ
model.
Lets define the following:
p: Daily Production rate (units / day)
d: Daily demand rate (units / day)
t: Length of the production in days.
H: Annual holding cost per unit
19
 Production Order Quantity Model..
Average Holding Cost = (Average Inventory) . H
= (Max. Inventory / 2) . H

In the period of production:

Max. Inventory = ??
= (Total Produced) – (Total Used)
= px t – dxt
How can you find ‘t’ above ??
If Q is the total number of units produced. Then
Q = p x t and t=Q/p
 Production Order Quantity Model..
Now we will set:
Annual Holding Cost = Annual Setup Cost
Q/2 (1 – d/p) . H = (D/Q) . S
2 DS 2 DS
Q 2
Q 
*

 d  d
H 1   H 1  
 p  p
This formula gives us the optimum production quantity for the
Production Order Quantity Model.

It is used when inventory is consumed as it is produced.

 POQ Example
Demand = 1000/year (of product A) Demand rate = d = 1000/365
Setup cost = $100/setup = 2.74/day
Holding cost = $20 per year per item
Find:
Production rate = 10/day 1. Q*
365 working days per year 2. Maximum inventory level
3. Total Cost
4. Production run length
5. Cycle length
6. Number of production runs per year

2 ×1000×100 = 117.36 units/run

Qp* =
20×[1-(2.74/10)]
Maximum inventory level = 117.36 [1- (2.74/10)] = 85.2 units
1000 117.36
Total Cost = 100 + 20 [1-(2.74/10)]
117.36 2
= 852.08 + 852.03 = $1704.11/year
 POQ Example
Demand = 1000 units/year
Production rate = 10 units/day
Qp* = 117.36 units per run
42.8

Demand rate = d = 1000/365

= 2.74/day

11.74

Production run length = 117.36/(10/day) = 11.74 days

Cycle length = 117.36/(2.74/day) = 42.8 days

Number of production runs per year = 1000/117.36 = 8.52

12-24
 Example
You are a production planner for Stanley Tools. Stanley Tools makes 30,000 screw
drivers per year. Demand is 100 screw drivers per day & production is 300 per day.

Production setup cost is $150 per order. Carrying cost is $1.50 per screw driver. What
is the optimal lot size ? Max. Inv. Level?
 Example
A local company produces a programmable EPROM (erasable
programmable read-only memory) for several industrial clients.

They have experienced a relatively flat demand of 2500 units per year
for the product. The EPROM is produced at a rate of 10000 units per
year.

The accounting department has estimated that it costs $50 to initiate a

production run, each unit costs the company $2 to manufacture, and
the cost of holding is based on a 30% annual interest rate (30% of
manufacturing cost).

Determine the optimal size of a production run, the length of each

production run, and the average annual cost of holding and setup.
What is the maximum level of on-hand inventory of the EPROMs?
 Backorder Inventory Model
In this model, we assume that stock outs (and backordering) are
allowed.
In addition to previous assumptions, we assume that sales will
not be lost due to a stock out.
Because, we will back order any demand that can not be
fulfilled.
B: Backordering cost per unit per year
b: The quantity backordered at the time the next order arrives
Q – b: Remaining units after the backorder is satisfied

A situation in which the demand or requirement for an item

cannot be fulfilled from the current inventory.

A customer order that cannot be filled when

presented, and for which the customer is prepared
27
to wait for some time.
Backorder Inventory Model…
Inventory

(Q - b)

T1 T2
Time
0
b

b
 Backorder Inventory Model…
Total Annual Cost = Annual Setup Cost + Annual Holding Cost +
Annual Backordering Cost

Annual Setup (Ordering) Cost = (D/Q) . S

Annual Holding Cost = (Average Inventory Level) . H

Average Average inventory Proportion of time

Inventory = level during there is inventory
Level in stock period in stock

= (Q – b) / 2 . T1 / T
 Backorder Inventory Model…
By using the graphical ratios, we know that:
T1 / T = (Q – b) / Q
Therefore, if we replace T1/T in the above equation we
get
Average Inventory Level = ??
=(Q – b)2 / 2Q

(Q – b)2
Annual Holding Cost = ---------- . H
2Q
30
 Backorder Inventory Model…
Annual Backordering Cost = (Average Backordering) . B

Average Backordering = ?
= (Average number of stock outs during out of stock period) x (Proportion of
time inventory is on backorder)

=b/2 . T2 / T

By using the graphical ratios, we know that:

T2 / T = b / Q Therefore, if we replace T2/T in the above equation we get:
Average Backordering = b2 / 2Q and

b2
Annual Backordering Cost = ---------- . B
2Q
 Backorder Inventory Model…
Total Cost (TC) =?
DS (Q – b)2 b2
Total Cost (TC) = ------- + ---------- . H + --------- . B
Q 2Q 2Q
We find optimum order quantity (Q*) and optimum
backordering quantity (b*) by taking the derivatives of
dTC/dQ = 0 and dTC / db = 0 and then putting the values in
their places.
We find that:

 2 DS   H  B  Q* H
Q  
*
  b* 
 H  B  BH
32
 Example
For the following discount rates, assume:

Ordering/Setup Cost = 49$; Annual Demand = 5000 units

Holding cost = 20% of the Product cost
Solution

714 units ???

Adjusted quantities??

718 units ???