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IE 305 - BUS 307

CHAPTER 4
Inventory and Economic Order Quantity
(EOQ)
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INVENTORY
Adequate system to keep track of materials
received
Adequate, secure storage facilities and effective
requisition procedures
Inventory records must be kept up-to-date.
Physical inventory is essential to counter human
mistakes or mislaid parts.
The more the inventory is worth, the more
frequently physical checks should be made.
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INVENTORY
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Why Keep Inventory?
Example 1. Ajays Orange Juice consumption
Costs:
Risks:
1.8L carton / 1 each week 300ml carton/ 1 each day

Refrigeration
Capital tied up (interest cost)


Low volume surcharge
Travel to shop each day

May go bad


May want 2 on some days

OPTION 1 OPTION 2
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Example 2. Hospital blood bank
Setup time involved in procuring blood

- find a donor
- check for infection
- test for blood type

Patient cannot wait !
Why Keep Inventory?
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Example 3. Computer manufacture
Alternatives:
(a) fewer workers on speaker line
=> lose mass production efficiency
(b) run speaker line for short periods
=> inventory
computer assembly line
speaker assembly line
100
computers/hr
800
speakers/hr
Why Keep Inventory?
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Example 4. Retail
4.1. Empty shop less attractive to
customers
4.2.Out of stock loss of sale, loss of goodwill

Problem: cost of holding inventory
capital is held up (interest)
space is occupied (rental)
insurance
product obsolescence/decay
Why Keep Inventory?
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Components of Inventory Control Models
1. Ordering costs
how much does it cost to order a batch of materials

2. Holding costs
how much does it cost to store materials

3. Shortage penalty (out-of-stock penalty)
what is the estimated loss on an out-of-stock event

4. Revenue
what is the cash made by selling an item

5. Salvage cost
value of item at the end of its shelf life

6. Discount rate
to account for the time value of capital
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Inventory Control and EOQ
The primary questions of inventory control are
how much to order at any one time and when to
order.
Economic order quantity is the amount of goods
whose total procurement and carrying costs are
at a minimum.
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Relationship between time and quantity of inventory
Inventory Control and EOQ
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Time Relationship to Inventory Quantity
The ideal inventory (EOQ) quantity will
minimize total cost
Carrying cost
Procurement cost
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Time Relationship to Inventory Quantity
The ideal inventory (EOQ) quantity will
minimize total cost
Carrying (Holding) cost
Procurement (Order) cost
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Carrying Costs
Those costs that are associated with ordering
materials from the ordering cost through
receiving, inspection and storage
The cost component consists of:
Storage costs
Maintenance
Clerical tasks
Insurance
Obsolescence
Taxes
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Carrying Costs (contd.)

Relation between storage cost and quantity
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Procurement Costs
Comprises requisition cost, follow-up tasks, and
payment of invoices
Varies inversely with the inventory
Total procurement costs vary depending on the
frequency of ordering.
The two costs vary in opposite directions
Large lots minimize procurement costs but
increases storage costs.
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Procurement (Order) Costs (contd.)

Relation between procurement costs and quantity
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EOQ Determination

Relation between total variable costs and quantity
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Order Quantity
Annual Cost
Holding Cost
Order (Setup) Cost
EOQ Model
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Order Quantity
Annual Cost
Holding Cost
Total Cost Curve
Order (Setup) Cost
EOQ Model
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Order Quantity
Annual Cost
Holding Cost
Total Cost Curve
Order (Setup) Cost
Optimal
Order Quantity (Q*)
EOQ Model
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Background and Definition of EOQ
The approach is to build a model of an idealized
inventory system and calculate the fixed order
quantity that minimizes total costs. This optimal order
size is called the economic order quantity (EOQ).
EOQ, or Economic Order Quantity, is defined as
the optimal quantity of orders that minimizes total
variable costs required to order and hold
inventory.
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How to use EOQ in a Company?
How much inventory should
we order each month?
The EOQ tool can be used to model the amount of
inventory that we should order each month.
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How EOQ Works
The Principles Behind EOQ: The Holding Costs
Keeping inventory on hand
Interest
Insurance
Taxes
Theft
Obsolescence
Storage Costs

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How EOQ Works
The Principles Behind EOQ: The Procurement Costs
Primarily the labor costs associated with
processing the order:
Ordering and requisition
A portion of the freight if the amounts vary
according to the size of the order
Receiving, inspecting, stocking
Invoice processing


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How EOQ Works
The Total Cost Formula
Total Cost = Purchase Cost + Order Cost + Holding
Cost
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How EOQ Works
The Total Cost Formula
This represents the
unchanging fixed costs
P = Purchase cost per unit
R = Forecasted monthly usage
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How EOQ Works
The Total Cost Formula
This represents the variable
order costs
P = Purchase cost per unit
R = Forecasted monthly usage
C = Cost per order event (not per unit)
Q = The number of units ordered
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How EOQ Works
The Total Cost Formula
This represents the variable
holding costs
P = Purchase cost per unit
R = Forecasted monthly usage
C = Cost per order event (not per unit)
Q = The number of units ordered
F = Holding cost factor
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How EOQ Works
The EOQ Formula
Total Cost
Formula
Taking the derivative of both sides of the equation and setting equal to
zero to find the minimum value of the function, one obtains:

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Order Quantity
Annual Cost
Holding Cost
Total Cost Curve
Order (Setup) Cost
Optimal
Order Quantity (Q*)
EOQ Model
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The result of differentiation

How EOQ Works
The EOQ Formula
The Economic Order Quantity
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How EOQ Works
The EOQ Formula
Review and Summary of the EOQ Formula
P = Purchase cost per unit
R = Forecasted monthly usage
C = Cost per order event (not per unit)
F = Holding cost factor
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Real Life Example:
Coca Cola Sales at Gas Station
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Real Life Example:
Coca Cola Sales at Gas Station
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Real Life Example:
First, Recall
the EOQ
Equation:
P = Purchase cost per unit
R = Forecasted monthly usage
C = Cost per order event (not per unit)
F = Holding cost factor
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Real Life Example:
Next lets identify the
correct variables
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Real Life Example:
Next lets identify the
correct variables
Forecasted
Amount
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Real Life Example:
Next lets identify the
correct variables
Ordering
Costs
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Real Life Example:
Next lets identify the
correct variables
Cost per Unit
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Real Life Example:
Next lets identify the
correct variables
Holding Cost
Factor
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Real Life Example:
R = Annual demand
C = Fixed ordering cost
P = Cost per case
F = Holding Cost Factor
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Real Life Example:
R = 5200
C = $10 per order
P = $2
F = 20% of value of inventory
per year
EOQ =
2 (10) (5200)
(2 )(.20)
510 Cases
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When to Order: The Reorder Point
Without safety stock:



With safety stock:
days/weeks in time lead
units in demand ly daily/week
units in point reorder where
=
=
=
=
L
d
R
dL R
units in stock safety where =
+ =
SS
SS dL R
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EOQ Example 2
Weekly demand = 240 units
No. of weeks per year = 52
Ordering cost = $50
Unit cost = $15
Annual carrying charge = 20%
Lead time = 2 weeks
a) Q=?
b) TC=?
c) R=?
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EOQ Example 2 Solution
year units D / 480 , 12 240 52 = =
year per unit per H 3 $ 15 2 . 0 = =
units
H
DS
Q 645 98 . 644
3
50 480 , 12 2 2
~ =

= =
units dL R
H
Q
S
Q
D
TC
480 2 240
$1,934.94 5 . 967 44 . 967
3
2
645
50
645
480 , 12
2
= = =
= + =
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Assumption for a basic model
The demand is known exactly, is continuous and is
constant over time.
All costs are known exactly and do not vary.
No shortages are allowed.
Lead time is zero so a delivery is made as soon as
the order is placed.
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Other assumptions implicitly in the model
We can consider a single item in isolation, so we
cannot save money by substituting other items or
grouping several items into a single order.
Purchase price and reorder costs do not vary with the
quantity ordered.
A single delivery is made for each order.
Replenishment is instantaneous, so that all of an order
arrives in stock at the same time and can be used
immediately.
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Some stock levels are not recorded continuously but
are checked periodically, perhaps at the end of the
week.
Then an unexpectedly large demand might reduce
stocks well below the reorder level before they are
checked.
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Another problem appears with large stocks, such as
chemical tanks, coal tips or raw materials, where the
stock level is only known approximately. Then the
reorder level might be passed without anyone
noticing.
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QUESTIONS???