Inventory Management

Inventory Management
Important for all businesses Inventory is created when receipt exceeds disbursement It is depleted when disbursement exceeds receipt Challenge for a manager is not to cut cost by reducing inventory to such level so as to have dissatisfied customers (unfulfilled orders) or to have plenty to satisfy all demands Challenge is to have right amount of inventory to achieve competitive priority
Inventory Costs
Interest or

Opportunity Costs Storage and Handling Costs Taxes, Insurance, and Shrinkage Costs Ordering and Setup Costs Transportation Costs
Why have low inventory?

To control
Inventory holding cost Interest or opportunity cost Storage & handling cost Taxes, Insurance & Shrinkage
Shrinkages: Pilferage, Obsolescence & Spoilage/Damage
Why have high inventory?

Improved customer service
Speed up delivery, Improve on time delivery, reduced chances of stock outs & no back orders
Lower ordering cost & set up cost Maximize labour & equipment utilization Reduced transportation cost: transport in bulk Avail quantity discounts while purchasing in bulk
Types of Inventory
Types of Inventory
Cycle Inventory
Q+0 Average cycle inventory = 2
Types of Inventory
Cycle Inventory
Safety Stock Inventory
Types of Inventory
Cycle Inventory
Safety Stock Inventory Anticipation Inventory
Types of Inventory
Cycle Inventory
Safety Stock Inventory Anticipation Inventory Pipeline Inventory

Pipeline inventory = DL = dL
Types of Inventory
Cycle inventory
Portion of total inventory that varies with lot size is called cycle inventory. It follows two principles
Lot size varies directly with the time gap between orders Larger the time gap, greater the cycle inventory
Safety Stock inventory

It is held to avoid customer service problems and hidden costs of unavailable components Protects against uncertainties in demand, supply and lead time To create safety stock firm places orders earlier than the time when the item is actually needed
Types of Inventory
Anticipation inventory
When an inventory is built up in anticipation of demand (AC manufacturers face maximum demand during few months in summer inventory is built up throughout the year)
Pipeline inventory
Inventory moving from point to point in the materials flow system is called pipeline inventory It is computed by multiplying average demand by lead time
Types of Inventory
A plant makes monthly shipments of electric drills to a wholesaler in average lot size of 280 drills. The wholesalers average demand is 70 drills a week, and the lead time from the plant is three weeks. The wholesalers must pay for the inventory from the moment the plant makes a shipment. If the wholesaler is willing to increase its purchase quantity to 350 units, the plant will guarantee a lead time of two weeks. What is the effect on cycle and pipe line inventories?
Types of Inventory
Cycle inventory = Q/2
Example 13.1
Types of Inventory
Cycle inventory = Q/2 = 280/2 = 140 drills
Example 13.1
Types of Inventory
Cycle inventory = Q/2 = 280/2 = 140 drills Pipeline inventory = DL = dL
Example 13.1
Types of Inventory
Cycle inventory = Q/2 = 280/2 = 140 drills Pipeline inventory = DL = dL = (70 drills/week)(3 weeks) = 210 drills
Example 13.1
Types of Inventory
Figure 13.1
Inventory reduction tactics

For Cycle Inventory
Primary lever: Reduce lot size Secondary lever:
Streamline order placement and set up Increase repeatability
For Safety Stock Inventory

Primary lever: Place order closer to the time it may be received this may lead to unacceptable customer service level Secondary lever:
Improve demand forecast Cut lead time of produced or purchased items Reduce supply uncertainties Rely more on equipment & labour buffers
Inventory reduction tactics

For Anticipation Inventory
Primary lever: Match demand rate with production rate Secondary levers are used to level customer demand
Add new products with different demand cycles Provide off season promotional campaigns Offer seasonal pricing plans
For Pipeline Inventory

Primary lever: Reduce lead time (Because pipeline inventory is function of demand during lead time) Secondary lever:
Find more responsive suppliers, improve shipping time between two stocking locations Decrease lot size at least in those cases where lead time depends on lot size
ABC Analysis
Vifredo Pareto a nineteenth century Italian scientist proposed Commonly known as 80 20 Rule Also known as
Vital Essential Desirable Analysis
ABC Analysis
100
90
Percentage of dollar value
80 70 60 50 40 30
20
10 0 10 20 30 40 50 60 70 80 90 100
Figure 13.2
Percentage of items
ABC Analysis
100
90
80 70 60 50 40 30
20
10 0 10 20 30 40 50 60 70 80 90 100
Figure 13.2
Percentage of items
ABC Analysis
100 Class B Class C
90 Class A 80
70 60 50 40 30
20
10 0 10 20 30 40 50 60 70 80 90 100
Figure 13.2
Percentage of items
ABC Analysis
100 Class B Class C
90 Class A 80
70 60 50 40 30
20
10 0 10 20 30 40 50 60 70 80 90 100
Figure 13.2
Percentage of items
ABC Analysis
100 Class B Class C
90 Class A 80
70 60 50 40 30
20
10 0 10 20 30 40 50 60 70 80 90 100
Figure 13.2
Percentage of items
ABC Analysis
100 Class B Class C
90 Class A 80
70 60 50 40 30
20
10 0 10 20 30 40 50 60 70 80 90 100
Figure 13.2
Percentage of items
How Much? When!
Decision making in production and inventory management involves dealing with large number of items, with very diverse characteristics and with external factors. We want to resolve:
How often the inventory status (of an item) should be determined ? When a replenishment order should be placed ? How large a replenishment order should be?
Economic Order Quantity

Assumptions
1. Demand rate is constant 2. No constraints on lot size 3. Only relevant costs are holding and ordering/setup 4. Decisions for items are independent from other items 5. No uncertainty in lead time or supply

On-hand inventory (units)
Figure 13.3
Time

On-hand inventory (units)
Figure 13.3
Time

Receive order On-hand inventory (units)
Figure 13.3
Time

Figure 13.3
1 cycle
Time

Figure 13.3
1 cycle
Time

Receive order On-hand inventory (units) Inventory depletion (demand rate)
Figure 13.3
1 cycle
Time

Figure 13.3
1 cycle
Time

Q 2
Average cycle inventory
Figure 13.3
1 cycle
Time
EOQ: Assumptions
The demand rate is known and constant.
Therefore the depletion of inventory results in a straight line with slope equal to the negative of the demand rate.
EOQ: Assumptions
Replenishments arrive in a batch equal to the order quantity rather than piecemeal. There are no limitations on lot size.
The replenishment results in a vertical line on the graph, rather than a line with a positive finite slope.
EOQ: Assumptions
Annual holding cost and annual ordering cost are the only costs that are relevant to the order quantity decision.
There are no quantity discounts, so perunit price is irrelevant.
EOQ: Assumptions
Replenishment decisions for one item (say doughnuts) are made independently from replenishment decisions for other items (say coffee).
Model enhancements are required to consider situations where several items are purchased from the same supplier, or several items belong to a product family that can share the same setup.
EOQ: Assumptions
There is no uncertainty in lead time or supply.
Therefore, replenishment orders can be timed so that no stockouts occur. Because none occur, stockout costs are irrelevant to the decision. The minimum inventory equals zero, the maximum inventory equals the EOQ, and the average cycle inventory equals EOQ/2.
Annual cost (dollars)
Figure 13.4
Lot Size (Q)
Holding cost (HC)
Figure 13.4
Lot Size (Q)
Holding cost (HC) Ordering cost (OC)
Figure 13.4
Lot Size (Q)

Total cost = HC + OC Annual cost (dollars)
Holding cost (HC) Ordering cost (OC)
Figure 13.4
Lot Size (Q)

A museum of natural history opened a gift shop two years ago. Managing inventories has become a problem. Low inventory is squeezing profit margins and causing cash flow problems. One of the top selling items in the container group at the museums gift shop is a bird feeder. Sales are 18 units per week, and the supplier charges $ 60 per unit. The cost of placing an order with the supplier is $ 45. Annual holding cost is 25 per cent of a feeders value, and the museum operates 52 weeks per year. Management chose a 390-unit lot size so that new orders could be placed less frequently. What is the annual cost of the current policy of using a 390unit lot size? Would a lot size of 468 be better?

Example 13.2
3000
2000
1000
| 50
| 100
| 150
| 200
| 250
| 300
| 350
| 400
Lot Size (Q)

Example 13.2
3000
Total cost =
2000
Q D (H) + (S) 2 Q
Holding cost =
Q (H) 2
1000
Ordering cost =
0 | 50 | 100 | 150 | 200 | 250 | 300 | 350 | 400
D (S) Q
Lot Size (Q)

Example 13.2
3000
Total cost =
2000 Birdfeeder
Q D (H) + (S) 2 Q
costs
Holding cost = Q (H) 2
D = (18 /week)(52 weeks) = 936 units H = 0.25 ($60/unit) = $15 S = 1000 $45 Q = 390 units Q D C= (H) + (S) 2 Q
0 | 50 | 100 | 150 | 200 | 250
Ordering cost =
| 300 | 350 | 400
D (S) Q
Lot Size (Q)

Example 13.2
3000
Total cost =
2000 Bird
Q D (H) + (S) 2 Q
feeder costs
D = (18 /week)(52 weeks) = 936 units H = 0.25 ($60/unit) = $15 S = 1000 $45 Q = 390 units Q D C= (H) + (S) 2 Q C=
0 | | | | $2925 + $108 = $3033 50 100 150 200 | 250
Ordering cost =
| 300 | 350 | 400
D (S) Q
Lot Size (Q)

Current cost
3000
Example 13.2
Total cost =
2000 Bird
Q D (H) + (S) 2 Q
feeder costs
0 | | | | $2925 + $108 = $3033 50 100 150 200 | 250
Ordering cost =
| 300 | 350 | 400
D (S) Q
Lot Size (Q)
Current Q

Current cost
3000
Example 13.2
Total cost =
2000 Bird
Q D (H) + (S) 2 Q
feeder costs
0 | | | | $2925 + $108 = $3033 50 100 150 200 | 250
Ordering cost =
| 300 | 350 | 400
D (S) Q
Lot Size (Q)
Current Q

Current cost
3000
Example 13.2
Total cost =
2000 Bird
Q D (H) + (S) 2 Q
feeder costs
D = (18 /week)(52 weeks) = 936 units H = 0.25 ($60/unit) = $15 S = 1000 $45 Q = 468 units Q D C= (H) + (S) 2 Q
0 | 50 | 100 | 150 | 200 | 250
Ordering cost =
| 300 | 350 | 400
D (S) Q
Lot Size (Q)
Current Q

Current cost
3000
Example 13.2
Total cost =
2000 Bird
Q D (H) + (S) 2 Q
feeder costs
0 | | $3510 + $90 50 100
Ordering cost =
| 250 | 300 | 350 | 400
D (S) Q
| | $3600200 150
Lot Size (Q)
Current Q

Current cost
3000
Figure 13.4
Total cost =
2000
Q D (H) + (S) 2 Q
Holding cost =
Q (H) 2
1000
Ordering cost =
0 | 50 | 100 | 150 | 200 | 250 | 300 | 350 | 400
D (S) Q
Lot Size (Q)
Current Q

Current cost
3000
Bird feeder costs

Q D Total cost = D(H)(18 /week)(52 weeks) = 936 units = + Q (S) 2
2000
H = 0.25 ($60/unit) = $15 S = $45 Q = EOQ EOQ = H
Q Holding cost = (H) Q 2DS 2 D (S) C= (H) +
1000
Ordering cost =
0 | 50 | 100 | 150 | 200 | 250 | 300 | 350 | 400
D (S) Q
Example 13.3
Lot Size (Q)
Current Q

Current cost
3000
Bird feeder costs

2000
H = 0.25 ($60/unit) = $15 S = $45 Q = 75 units EOQ =

1000
Ordering cost =
0 | 50 | 100 | 150 | 200 | 250 | 300 | 350 | 400
D (S) Q
Example 13.3
Lot Size (Q)
Current Q

Current cost
3000
Bird feeder costs

2000

1000
C = $562 + $562 = $1124

Ordering cost =
D (S) Q
| 50
| 100
| 150
| 200
| 250
| 300
| 350
| 400
Example 13.3
Lot Size (Q)
Current Q

Current cost
3000
Bird feeder costs

2000

1000
C = $562 + $562 = $1124

Ordering cost =
D (S) Q
| 50
| 100
| 150
| 200
| 250
| 300
| 350
| 400
Example 13.3
Lot Size (Q)
Current Q

Current cost
3000
Bird feeder costs

2000

1000
C = $562 + $562 = $1124

Ordering cost =
Lowest cost
0 | 50 | 100 | 150 | 200 | 250
D (S) Q
| 300
| 350
| 400
Example 13.3
Best Q (EOQ)
Lot Size (Q)
Current Q

Current cost
3000
Bird feeder costs

2000
H = 0.25 ($60/unit) = $15 S = $45 Q = 75 units EOQ = 2DS H C= D Q (H) + (S) Q 2
1000
C = $562 + $562 = $1124
Lowest cost
0 | 50 | 100 | 150 | 200 | 250 | 300 | 350 | 400
Example 13.3
Best Q (EOQ)
Lot Size (Q)
Current Q

Current cost
3000
2000
Birdfeeder costs Time between orders Q D Total cost = D(H)(18 /week)(52 weeks) = 936 units = + Q (S) 2 HTBO ($60/unit) = $15 = 0.080 year = 0.25 = EOQ= 75/936 EOQ D S = $45 Q = 75 units EOQ = 2DS H C= D Q (H) + (S) Q 2
1000
C = $562 + $562 = $1124
Lowest cost
0 | 50 | 100 | 150 | 200 | 250 | 300 | 350 | 400
Example 13.3
Best Q (EOQ)
Lot Size (Q)
Current Q

Current cost
3000
2000
Birdfeeder costs Time between orders Q D Total cost = D(H)(18 /week)(52 weeks) = 936 units = + Q (S) 2 HTBO ($60/unit) = $15 = 0.080 year = 0.25 = EOQ= 75/936 EOQ D S = $45 Q = 75 units TBOEOQ = (75/936)(12) = 0.96 months
1000
TBOEOQ = (75/936)(52) = 4.17 weeks TBOEOQ = (75/936)(365) = 29.25 days
Lowest cost
0 | 50 | 100
| 150
| 200
| 250
| 300
| 350
| 400
Example 13.3
Best Q (EOQ)
Lot Size (Q)
Current Q

Current cost
3000
Total cost =
2000
Q D (H) + (S) 2 Q
Holding cost =
Q (H) 2
1000
Lowest cost
0 | 50 | 100 | 150 | 200 | 250
Ordering cost =
| 300 | 350 | 400
D (S) Q
Figure 13.5
Best Q (EOQ)
Lot Size (Q)
Current Q
How Much? When!
Continuous Review
On-hand inventory
IP = Inventory Position SR = Scheduled receipt OH = On hand inventory BO = Back orders
Time
Figure 13.7
Continuous Review
Order received
On-hand inventory
OH
Time
Figure 13.7
Continuous Review
IP Order received
On-hand inventory
OH
R
Order placed L TBO Figure 13.7
Continuous Review
IP Order received Order received IP Order received
IP
Order received
On-hand inventory
OH
OH
OH
R
Order placed L TBO TBO Order placed L TBO Figure 13.7 Order placed L
Time
Continuous Review
Demand for Chicken soup at a super market is 25cases a day and the lead time is four days. The shelves were just restocked with chicken soup, leaving an on hand inventory of only 10 cases. There are no back orders, but there is an open order for 200 cases. What is the inventory position? Should a new order be placed?
Continuous Review
IP Order received Order received IP Order received IP Order received
On-hand inventory
Chicken Soup Q
OH
OH
OH
R
Order placed L TBO TBO Order placed L TBO Example 13.4
Order placed
L
Time
Continuous Review
IP
Order received
On-hand inventory
Chicken Soup
OH
OH
R
Order placed L TBO
R = Average OH demand during lead time = (25)(4) = 100 cases

Order placed L TBO TBO Example 13.4 L
Order placed
Time
Continuous Review
IP
Order received
On-hand inventory
Chicken Soup
Q
OH
R = Average demand during lead time OH = (25)(4) = 100 cases OH

IP = OH + SR BO Order Order = 10 + 200 0 = 210 cases placed
placed L TBO TBO L TBO Example 13.4 L
R
Order placed
Time
Uncertain Demand
Uncertain Demand
Figure 13.8
On-hand inventory
Time
Uncertain Demand
Figure 13.6 IP Order received Order received IP Order received
On-hand inventory
Order received
Q OH
Q
Q
R
Order placed Order placed Order placed
L1 TBO1 TBO2
L2 TBO3
L3
Time
Reorder Point / Safety Stock

Records show that the demand for dishwasher detergent during the lead time is normally distributed, with an average of 250 boxes and standard deviation = 22. What safety stock should be carried for a 99 percent cycle service level? What is R?
Average demand during lead time
Figure 13.9

Cycle-service level = 85%
Probability of stockout (1.0 0.85 = 0.15) Average demand during lead time zL
Figure 13.9

Safety Stock/R Cycle-service level = 85%
Probability of stockout (1.0 - 0.85 = 0.15) 0.85 = 0.15) Average demand during lead time zL
Example 13.5

Safety Stock/R Safety stock = zL = 2.33(22) = 51.3 = 51 boxes Cycle-service level = 85%
Probability of stockout (1.0 - 0.85 = 0.15) Average demand during lead time zL
Example 13.5

Safety Stock/R Safety stock = zL = 2.33(22) = 51.3 = 51 boxes Cycle-service level = 85%
Reorder point = ADDLT + SS = 250 + 51 = 301 boxes Average demand during lead time zL
Example 13.5
Probability of stockout (1.0 - 0.85 = 0.15)
Lead Time Distributions

t = 15
+
75 Demand for week 1
Figure 13.10

t = 15
+
t = 15
+
Figure 13.10

t = 15
+
t = 15
+
t = 15
=
Figure 13.10

t = 15
t = 26
+
t = 15
+
t = 15
225 Demand for three-week lead time
=
Figure 13.10

t = 15
t = 26 Bird feeder Lead Time Distribution

t = 15
+
+
t = 15
=
Example 13.6

t = 15
t = 26 Bird feeder Lead Time Distribution t t = 15 = 1 week d = 18 L=2
+
+
t = 15
=
Example 13.6

t = 15
t = 26 Bird feeder Lead Time Distribution t t = 15 = 1 week d = 18 L =5 2 L=2 = 7.1
+
+
L = t
t = 15
=
Example 13.6

t = 15
t = 26 Bird feeder Lead Time Distribution t t = 15 = 1 week d = 18 L =5 2 L=2 = 7.1
+
+
75 Safety Demand for week 2
L = t
stock = zL =
t = 15
225 1.28(7.1)Demand for units = 9.1 or 9 three-week lead time
Reorder point = dL + Safety stock = 2(18) + 9 = 45 units
Example 13.6

t = 15
t = 26 Bird feeder Lead Time Distribution t t = 15 = 1 week d = 18 L=2 Reorder point = 2(18) + 9 = 45 units
+
t = 15
=
Example 13.6

t = 15
t = 26 Bird feeder Lead Time Distribution t t = 15 = 1 week d = 18 L=2 Reorder point = 2(18) + 9 = 45 units
+
75 936 225 C= ($15) + ($45) + 9($15) Demand for 2 75 three-week lead time
t = 15
C = $562.50 + $561.60 + $135 = $1259.10
=
Example 13.6
Periodic Review Systems

T
On-hand inventory
Time P
Figure 13.11

T On-hand inventory
Q1
Order placed
Time P
Figure 13.11

T On-hand inventory
Q1
Order placed
L P
Figure 13.11
Time P

T On-hand inventory
Order received Q1
Order placed
L P
Figure 13.11
Time P

T On-hand inventory
Order received Q1 Q2
Order received Q3
Order received
Order placed
Order placed
L P
Figure 13.11
L P
Time

T IP On-hand inventory
Order received
OH
IP
Order received OH Q3
IP Order received
Q1
IP1 IP3 Order placed IP2
Q2
Order placed
L P
Figure 13.11
L P
Time
Protection interval

Order received
OH
IP
Q1
Q2
Order Order IP Order received received BO IP = OH + SR received Q3 Qt = T - IPt OH
TV Set - P System IP
Order placed
T = 400 OH = 0
BO = 5 SR = 0
IP = 0 + 0 5 = 5 sets Q = 400 (5) = 405 sets

L P P L Time
Protection interval

Order received
OH
IP
Order received OH Q3
IP Order received
Q1
Q2
Order placed
L P
Example 13.7
L P
Time
Protection interval

Order Order Bird feeder Calculating P and T

received OH received
IP
IP Order received
Q1
Q2
OH
Q3
Order placed
L P
Example 13.8
L P
Time
Protection interval

T IP
Order Order Bird feederCalculating P and T

received received
IP
On-hand inventory
IP Order received
Q3 t = 1 units L = 2 weeks cycle/service level = 90% Q 18 OH OH Q2 EOQ = 75 units D = (18 units/week)(52 weeks) = 936 units IP1 IP3 Order placed IP2 Order placed
L P
Example 13.8
L P
Time
Protection interval


received received
IP
IP Order received
Q3 t = 1 units L = 2 weeks cycle/service level = 90% Q 18 OH OH Q2 EOQ = 75 units D = (18 units/week)(52 weeks) = 936 units IP1 IP3 IP2 EOQ 75 P= (52) = (52) = 4.2 or 4 weeks D 936 Order Order placed P+L = t P + L = 5 placed 12 units 6 =
L P
Example 13.8
L P
Time
Protection interval


received received
IP
IP Order received
Q3 t = 1 units L = 2 weeks cycle/service level = 90% Q 18 OH OH Q2 EOQ = 75 units D = (18 units/week)(52 weeks) = 936 units IP1 IP3 IP2 EOQ 75 P= (52) = (52) = 4.2 or 4 weeks D 936 Order Order placed P+L = t P + L = 5 placed 12 units 6 = T = Average demand during the protection interval + Safety stock = d (P + L) + zP + L L L L = (18 units/week)(16 weeks) + 1.28(12 units) = 123 units Time P P
Example 13.8
Protection interval


received received
IP
IP Order received
Q3 t = 1 units L = 2 weeks cycle/service level = 90% Q 18 OH OH Q2 EOQ = 75 units D = (18 units/week)(52 weeks) = 936 units IP1 IP3 Order placed IP2
P = 4 weeks
T = 123 units
Order placed
L P
Example 13.8
L P
Time
Protection interval


received received
IP
IP Order received
Q3 t = 1 units L = 2 weeks cycle/service level = 90% Q 18 OH OH Q2 EOQ = 75 units D = (18 units/week)(52 weeks) = 936 units IP1 IP3 Order placed IP2
P = 4 weeks
T = 123 units
Order 936placed
4(18) C= ($15) + ($45) + 15($15) 2 4(18)

C = $540 + $585 + $225 = $1350
L P P L
Time
Example 13.8
Protection interval
Comparison of Q and P Systems

P Systems
Convenient to administer Orders may be combined IP only required at review

Q Systems
Individual review frequencies Possible quantity discounts Lower, less-expensive safety stocks
ABC Analysis Solved Problem 2
Comparison of P and Q Systems Solved Problem 6
Estimating Inventory Levels

For one of the products, the average weekly demand at each distribution center (DC) will be 50 units. The product is valued at $650 per unit. Average shipment sizes into each DC will be 350 units per trip. The average lead time will be two weeks. Each DC will carry one weeks supply as safety stock, as the demand during the lead time sometimes exceeds its average of 100 units (50 units/wk * 2 wk). Anticipation inventory should be negligible.

How many dollars, on the average, of cycle inventory will be held at each DC? How many dollars of safety stock will be held at each DC? How many dollars of pipeline inventory, on the average, will be in transit for each DC? How much inventory, on the average, will be held at each DC? Which type of inventory is your first candidate for reduction?
Example 1
Terminator, Inc., order motorcycle part in lots of 250 units, which valued at $450 each. The lead time for delivery is 3 weeks, and annual demand is 4,000 units. Assume 50 working weeks per year.
Average cycle inventory in units? Value? Average pipeline inventory in units? Value?
Example 2
A local retailer faces demand at a rate of 30,000 unit per year. It cost $10 to process an order, and annual holding cost is $1 per unit. Stock is received 4 working days after an order has been placed. Assume 300 working days a year.
Example 2 (Contd)
What is the optimal ordering quantity? What is the optimal number of orders per year? What is the optimal interval (in working days) between orders? What is the demand during the lead time? What is the reorder point? What is the inventory position immediately after an order has been placed?
Ok, Now What Happens If We Manufacture the Inventory?

Well, assuming were not producing JIT, we are producing at a rate faster than our usage Well have holding costs for the inventory we build We have setup costs (taking the place of ordering cost) We still have an annual demand
Profile of Inventory Level Over Time for EOQ. EPQ? Q

Quantity on hand
Usage rate
Receive order
Reorder point
Place order
Receive order
Place order
Receive order
Lead time
EPQ Model
Q = production quantity, units/production run D= annual demand, units/year S = setup cost, $/production run H = inventory-holding cost, $/unit/year P = production rate, unit/year
Calculating EPQ
Annual holding cost
Q( P D) H 2P
= average inventory in cycle stock H = cost of holding one unit in inventory for a year.
Q( P D) 2P
Calculating EPQ
Annual ordering cost
D S Q
With Q in the denominator, the annual setup cost varies inversely with Q D = annual demand D/Q = number of production run in one year S = average cost of setup one run
Calculating EPQ
Total inventory costs (C)
Q( P D) D C ( H ) (S ) 2P Q
EPQ
Using calculus, we take the derivative of the total cost function (TC) and set the derivative (slope) equal to zero and solve for Q
QOPT = = P 2 DS PD H Pr oduction Rate 2( Annual Dem )(Setup Cost) and Pr oduction Rate Usage Rate Annual Uni Holding Cost t
EPQ
Time between production runs.
TBO Q / D
Finding EPQ
A local company produces EPROM. It has a demand of 2,500 units per year. The EPROM is produced at a rate of 10,000 units per year. It costs $50 to initiate a production run, each unit costs $2 to manufacture, and cost of holding is based on a 30% annual interest rate.
Finding EPQ
What is the EPQ ? What is the total annual cost with using the EPQ ? What is the time between runs for the EPQ policy, expressed in weeks ? What is the maximum level of the onhand inventory of the EPROMs?
Example for EPQ

A chemical plant faces a steady demand of 30 barrels per day. Production rate is 190 barrels per day, setup cost is $200, annual holding cost is $0.21 per barrel, and the plant operates 350 days per year. Determine.
The economic production quantity (EPQ), The total annual cost, the TBO, or cycle length for the EPQ, the production time per production run. What are the advantages of reducing the setup time by 10 percent?
Newsvendor Model
Perishable goods
Finite lifespan Single purchase opportunity Shortage cost Salvage value
Optimal Quantity?
So how would we go about determining the optimal quantity?
Define cost equation Take partial derivative w.r.t. quantity Set to 0 Solve for Q
Seems Just Like What We Did for the EOQ

Seems just like what we did for the EOQ so whats different In this case, the items demand is stochastic (i.E. NOT deterministic) Defining costs means defining EXPECTED cost Therefore, were differentiating a much more complex equation
Newsvendor Model
Lets consider the cost equation : CQ =Cshortage + Cexcess
But These Costs Are Dependent on Demand

And we dont know demand (demand is stochastic) But we can determine expected demand Therefore we can determine expected costs We simply need to take the expected value of our costs
Calculating Optimal Quantity

Our expected cost equation now looks like this
E[CQ] =E[Cshortage] + E[Cexcess]
Calculating Optimal Quantity

Recall what an expected value is So we have the formula for the optimal quantity (Q) of the classic newsvendor model F(Q)= cshortage/(cshortage+ cexcess)
Optimal Quantity
This equation tells us the optimal service level corresponding to the shortage and holding costs This service level corresponds to a cumulative normal probability (in the continuous case) We can use a cumulative probability table to find the corresponding optimal order quantity
Heres an Example
Weekly demand for the Journal is normally distributed with
Mean = 11.73 Standard deviation = 4.74
Magazines cost $0.25 each with a salvage value of $0.10 Magazines sell for $0.75 each
Example Contd
First we find the costs of excess and shortage ce = cost - salvage = 0.25 - 0.10 = 0.15 cs = revenue cost =0.75 - 0.25 = 0.50
Example Contd
Next we find the desired service level p = cs/(cs+ce) = 0.50/(0.50+0.15)= 0.7692
Example Contd
Finally, we calculate the order quantity Determine the z corresponding to a cumulative probability of 0.77 Calculate the optimal order quantity
Q = mean + z * standard deviation Q =11.73 + 0.74 * 4.74 = 15.25
Continuous Distribution of Demand

The limiting assumptions of the model
Stationary demand Single order opportunity Known costs and salvage values Known selling price (and corresponding cost of shortage)
How to apply this in the case of a discrete distribution
Discrete Demand
If the newsvendor estimate following probability distribution for the demand of the Journal
Demand 10 20 30 0.3 40 0.1 50 0.1
Probability 0.2 0.3
Discrete Demand
How many copies should the newsvendor order? p = cs/(cs+ce) = 0.50/(0.50+0.15)= 0.7692 Cumulative probabilities
Demand 10 20
0.5
30
0.8
40
0.9
50
0.9
Cumulative 0.2 Probability
Discrete Demand
Optimal order quantity between 20 and 30 (0.5 and 0.8) Always round up Q = 30
Extensions
This model is an important starting point for a lot of research.
Multi-period. Multiple purchase opportunities. Backordering. Stochastic lead time. Secondary sources of supply. Etc.
Inventory Management IV
More Examples for Newsboy Model
Newsboy: Example I
Demand distribution is continuous.
Billys bakery bakes fresh bagels each morning. The daily demand for bagels is a random variable with a normal distribution of mean=18, and standard deviation of 8.9. The bagels cost 8 cents to make, and sole for 35 cents each. Unsold bagels at the end of day are purchased by a charity soup kitchen for 3 cents each. How many bagels should Billys bake at the start of each day? (Answers should be a multiple of 5).
Newsboy: Example II
Demand distribution is discrete.
Billys bakery bakes fresh bagels each morning. The daily demand for bagels is a random variable with a distribution given as following.
0 5 10 15 20 25 30 35 0.05 0.10 0.10 0.20 0.25 0.15 0.10 0.05

Bagels cost 8 cents to make, and sole for 35 cents each. Unsold bagels at the end of day are purchased by a charity soup kitchen for 3 cents each. How many bagels should Billys bake at the start of each day?
Expected Return
So, how to find out the expected return?
Example III
Discrete Demand
Irwins sell a model of fan, with most sales being made in the summer months. Irwins makes a onetime purchases of the fans prior to each summer season at a cost of $40 each and sells each fan for $60, any fans unsold at the end of the summer season are marked down to $29. All marked-down fans are sold. The following is the number of sales of fans during the past 10 summers: 30,50,30,60,10,40,30,30,20,40.
Example III Contd

Based on the observed 10 values of the prior demand, construct an empirical probability distribution of summer demand, and Determine the optimal number of fans for Irwins to buy based on the empirical distribution, and Calculate the expected return when ordering the optimal number of fans from above

Inventory Management

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Inventory Management

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