Inventory Decision

Making

Economic Order Quantity Models

Two basic approaches to the reorder decisions are the Qsystem and the P-system. With certainty demand and lead
times, they yield the same policies. With uncertain demand
and lead times, there are significant differences. In practice,
these systems are often modified. We will concentrate only
on the Q and P systems.

1. Q-System (Fixed Order Quantity) when stock falls to a

predetermined level (reorder point), an order is placed for a
fixed quantity of the good. This Q-system entails higher
monitoring costs than the P-system but often lowers the
carrying costs.
on hand inventory

Q is fixed
time

Reorder Point
April 1st

April 10th

April 17th

2. P-System (Fixed order Interval, variable order

quantity)

a. Inventory reviewed at preset times (say, once a

month) and an order is placed for the difference
between a predetermined maximum inventory level and
the actual amount on hand and on order from previous
reviews.
b. The P-System has higher carrying and stockout costs
but lower monitoring costs than fixed order quantity Qsystem.
c. Allows coordination of multiple purchases to take
advantage of quantity discounts and better scheduling
and work patterns in warehouse.

time
April 1st

May 1st

June 1st

July 1st

Inventory Models

Fixed order-quantity models

1. Economic order quantity
(EOQ)
2. Production order quantity
(POQ)
3. Quantity discount

Probabilistic models

Fixed order-period models

How much and

when to order?

EOQ Assumptions

Known and constant demand

Known and constant lead time
Instantaneous receipt of material
No quantity discounts
Only order cost and holding cost
No stockouts

Why Holding Costs Increase

More units must be stored if more are ordered

Purchase Order
Description
Qty.
Microwave
2

Order quantity

Purchase Order
Description
Microwave

Qty.
1000

Order quantity

Why Order Costs Decrease

Cost is spread over more units

Example: You need 1000 microwave ovens

1 Order (Postage 0.34)

Purchase Order
Description
Microwave

Qty.
1000

500 Orders (Postage 170)

PurchaseOrder
Order
Purchase
Purchase
Order
Purchase
Order Qty.
Description
Description
Qty.
Description
Qty.
Microwave
Description
Qty.
Microwave
11
Microwave
1
Microwave
2

Order quantity

Deriving an EOQ

Develop an expression for total costs

Total cost = order cost + holding cost

Find order quantity that gives minimum

total cost (use calculus)

minimum is when slope is flat

slope = derivative
set derivative of total cost equal to 0 and
solve for best order quantity

EOQ Model Equations

D = Demand per year (known and relatively constant)
S = Order cost per order
H = Holding (carrying) cost per unit per year
d = Demand per day
L = Lead time in days (known and relatively constant)
Q = order size (number of pieces or items per order)

Expected Number of Orders per year = N =

Order Cost per year =

D
S
Q

D
Q

Holding Cost per year = (average inventory level) H

EOQ Model - average inventory level

Inventory Level
Order
Quantity
(Q)

Maximum inventory = Q
Minimum inventory = 0
Average
Inventory
(Q/2)

Time

Inventory Carrying Cost

Order or Setup Cost

Inventory Costs

EOQ Model - How Much to

Order?
Annual Cost

/2)H
S+(Q
)
Q
/
(D
rve =
u
C
t
/2)H
l Cos
=(Q
Tot a
t
s
Co
ing
d
l
o
H

Order Cost Curve = (D/Q)S

Optimal
Order Quantity (EOQ=Q*)

Order Quantity

EOQ Total Cost Optimization

Total Cost =

D
Q
S+
H
Q
2

Take derivative of total cost with respect to Q and set

equal to zero:

D
1
S+
H=0
2
Q
2
Solve for Q to get optimal order size:

EOQ = Q*= 2 D S
H

EOQ Model Equations

Optimal Order Quantity
Expected Number of Orders

2 D S
H
D
=N =
Q*

= Q* =

Expected Time Between Orders = T =

Working Days / Year

D = Demand per year

S = Order cost per order
H = Holding (carrying) cost
d = Demand per day
L = Lead time in days

EOQ Model - When to order?

D = Demand per year (known and relatively constant)
d = Demand per day (known and relatively constant)
L = Lead time in days (known and relatively constant)
ROP = reorder point (number of pieces or items remaining when
order is to be placed)

d =

D
Working Days / Year
Suppose demand is 10 per day and
lead time is (always) 4 days.

ROP = d L

When should you order?

When 40 are left!

EOQ Model - When To Order

Inventory Level

Lead Time = time between placing

and receiving an order

Q*

Reorder
Point
(ROP)

Time
1st order
placed

1st order
received

2nd order

3rd order

4th order

EOQ Example
Demand = 1200/year
Order cost = 50/order
Holding cost = 5 per year per item
260 working days per year
2 1200 50 = 154.92 units/order; so order 155 each time
5
1200/year
Expected Number of Orders = N =
= 7.74/year
155
260 days/year
Expected Time Between Orders = T =
= 33.6 days
7.74
1200
155
Total Cost =
5 = 387.10 + 387.50 = 774.60/year
50 +
2
155
Q* =

EOQ is Robust
Demand = 1200/year
Order cost = 50/order
Holding cost = 5 per year per item
260 working days per year
Q = 155 units/order
Q* = 154.92 units/order

TC = 774.60/year
TC = 774.60/year = 387.30 + 387.30

Suppose we must order in multiples of 20:

Q = 140 units/order
TC = 778.57/year (+0.5%)
Q = 160 units/order
TC = 775.00/year (+0.05%)
Suppose we wish to order 6 times per year (every 2 months):
Q = 1200/6 = 200 units/order
TC = 800.00/year = 300.00 + 500.00
(200 units/order is 29% above Q* - but cost is only 3.3% above optimal)

10

EOQ Model is Robust

Annual Cost
tC
l Cos
Tot a

Small
variation
in cost

154.92

urve

Order Quantity

Large variation
in order size

Robustness

EOQ amount can be adjusted to facilitate

business practices.
If order size is reasonably near optimal (+ or
- 20%), then cost will be very near optimal
(within a few percent)
If parameters (order cost, holding cost,
demand) are not known with certainty, then
EOQ is still very useful.

11

EOQ Model - When to order?

Demand = 1200/year
Order cost = 50/order
Holding cost = 5 per year per item
260 working days per year
Lead time = 5 days

d =

1200/year
= 4.615/day
260 days/year

ROP = 4.615 units/day 5 days = 23.07 units

-> Place an order whenever inventory falls to (or below) 23 units

Sawtooth Models

12

Total Costs for Various EOQ Amounts

Graphical Representation of the EOQ

Example

13

Production Order Quantity Model

Assume material is not received

instantaneously

for example, it is produced in-house

Other EOQ assumptions apply

Model provides production lot size (like
EOQ amount) for one product
Similar to EOQ with setup cost rather
than order cost

Production Order Quantity Model

Consider one product at a time.

Produce Q units in a production run; then
switch and produce other products.
Later produce Q more units in 2nd
production run (Q units of product of
interest).
Later produce Q more units in 3rd
production run, etc.

14

POQ Model Inventory Levels

Inventory Level
Production portion of cycle

Demand portion of cycle with no

production (of this product)

Time
Production
Begins

Production
Run Ends

POQ Model Inventory Levels

Inventory Level

Production rate = p = 20/day

Demand rate = d = 7/day

Slope = p-d = 13/day

Slope = -d = -7/day

Time
Production
Begins

Production
Run Ends

Note: Not all of production goes into

inventory

15

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
Begins

Production
Run Ends

Note: 1-(d/p) = fraction of production

that goes into inventory

POQ Model Equations

D = Demand per year (known and relatively constant)
S = Setup cost per order
H = Holding (carrying) cost per unit per year
d = Demand per day
p = Production rate per day (known and relatively constant)
Q = Production run size (number of pieces or items per production
run)

Number of Production Runs per year =

D
Setup Cost per year =
S
Q

Holding Cost per year = (average inventory level) H

16

POQ Model Inventory Levels

Inventory Level
Maximum Inventory
= Q(1-(d/p))
Production
Portion of Cycle

Demand portion of cycle

with no supply

Time

POQ Model Equations

D = Demand per year (known and relatively constant)
S = Setup cost per setup
H = Holding (carrying) cost per unit per year
d = Demand per day
p = Production rate per day (known and relatively constant)
Q = Production run size (number of pieces or items per production run)

Number of Production Runs per year =

D
S
Setup Cost per year =
Q

Holding Cost per year = (ave. inventory level) H =

Q
H [1-(d/p)]
2

17

POQ Model Equations

Optimal Production Run Size = Qp* =

2 D S
H[1-(d/p)]

Maximum inventory level = Qp [1- (d/p)]

Total Cost =

D
Q
S+
H [1-(d/p)]
Q
2

D = Demand per year

S = Setup cost per setup
H = Holding (carrying) cost per unit per year
d = Demand per day
p = Production rate per day

Inventory Level

POQ Model Equations - cont.

Time

Production Run length (time) = Qp /p

Cycle length (time) = Qp /d

18

POQ Example
Demand rate = d = 1000/365
= 2.74/day

Demand = 1000/year (of product A)

Setup cost = 100/setup
Holding cost = 20 per year per item
Production rate = 10/day
365 working days per year
Qp * =

2 1200 50 = 117.36 units/run

5 [1-(2.74/10)]

Maximum inventory level = 117.36 [1- (2.74/10)] = 85.2 units

Total Cost =

1000
117.36

= 852.08

100 +

117.36

20 [1-(2.74/10)]

852.03

= 1704.11/year

POQ Example

Demand = 1000units/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

19

Robustness of POQ

POQ is robust (like EOQ):

Can adjust production run size.

Useful even when parameters are uncertain.

Consider last example: Set production run

length to 14 days (2 weeks) rather than
11.74 days (as was optimal).

Q = 140 units per run = 10/day*14 days (19%

over optimal Q)
Total cost = 1730.68 (1.6% over optimal Q)

POQ & Multiple Products

POQ computes a production run size for a

single product
For multiple products made on the same
equipment:

Compute POQ, run time, and cycle time for each

product.
Combine into a production schedule using a
common cycle time.
May require adjusting run size, run time and cycle
time to a common value.

20

Multiple Products Example

Example: Company makes 3 products:

A, B, C
A: optimal run time = 3 days; optimal cycle
time = 10 days
B: optimal run time = 8 days; optimal cycle
time = 18 days
C: optimal run time = 10 days; optimal cycle
time = 33 days
A

Use 30 days as a common cycle; adjust run & cycle

times:
A: run time = 3 days; cycle time = 10 days
(3 runs/30 days)
B: run time = 6 days; cycle time = 15 days
(2 runs/30 days)
C: run time = 9 days; cycle time = 30 days
(1 run/30 days)

21

Quantity Discount Model

Variation of EOQ (not POQ)

Allows quantity discounts

Reduced price for purchasing larger quantities

Other EOQ assumptions apply

Trade-off lower price to purchase item &

increased holding cost from more items
Total cost must include annual purchase cost
Total Cost = Order cost + Holding cost + Purchase cost

Quantity Discount Model - Holding Cost

Holding cost

depends on price
usually expressed as a % of price per unit time

20% of price per year, 2% of price per month, etc.

I = holding cost percent of price per year

P = price per unit
H = Holding cost = IP

22

Quantity Discount Equations

D = Demand per year
S = Order cost per order
H = Holding (carrying) cost = IP
I = Inventory holding cost % per year
P = Price per unit

Order Quantity = Q* =
Total Cost =

2 D S
IP

D
Q
S+
IP + PD
Q
2

Quantity Discount Model

D = 1000/year
S = 100/order
I = 20% per year

Q
<500
500-1000
1000

P
100
95
90

IP
20
19
18

To solve:
1. Find EOQ amount for each discount level.
2. If EOQ is not in range for discount level, adjust to the nearest
end of range.
3. Calculate total cost for each discount level.
4. Select lowest cost and corresponding Q.

23

Quantity Discount Example

D = 1000/year
S = 100/order
I = 20% per year

Q
<500
500-1000
1000

P
100
95
90

IP
20
19
18

1. P = 100 IP = 20
EOQ = 100
in range!
Total Cost = 1,000 + 1,000 + 100,000 = 102,000/year
2. P = 95 IP = 19
EOQ = 102.6
not in range (500-1000)!
Adjust to Q = 500
Total Cost = 200 + 4,750 + 95,000 = 99,950/year

Quantity Discount Example cont.

Q
P
IP
<500
100
D = 1000/year
500-1000 95
S = 100/order
I = 20% per year
1000
90
3. P = 90 IP = 18
EOQ = 105.4
not in range (>1000)!
Adjust to Q = 1000
Total Cost = 100 + 9,000 + 90,000 = 99,100/year
Q
Total costs
<500
102,100
500-1000 99,950
1000
99,100

20
19
18

Lowest cost, so order 1000

24

Quantity Discount Model

Total
Cost

Initial Price

iscou
r No D
TC fo

Discount 1

Discount 2
1
unt
isco
D
r
o
TC f
2
unt
isco
or D
f
C
T

nt

Best order quantity

in range

Lowest cost not in

discount range

Quantity to
earn
Discount 1

Quantity to
earn
Discount 2

Order
Quantity

Quantity Discount Model

Total
Cost

Initial Price

nt
iscou
r No D
TC fo

Discount 1

Discount 2

isco
or D
TC f

isco
or D
TC f

1
unt

2
unt

Lowest Cost

Quantity to
earn
Discount 1

Quantity to
earn
Discount 2

Order
Quantity

25

Fixed Order Quantity Approach

(Condition of Certainty)

Summary and Evaluation of the

Fixed Order Quantity Approach:

EOQ is a popular inventory model.

EOQ doesnt handle multiple locations as well as a
single location.
EOQ doesnt do well when demand is not constant.
Minor adjustments can be made to the basic model.
Newer techniques will ultimately take the place of EOQ.

Fixed Order Quantity Approach

(Condition of Uncertainty)

Uncertainty is a more normal condition.

Demand is often affected by exogenous

factors---weather, forgetfulness, etc.
Lead times often vary regardless of carrier
intentions.
Note the variability in lead times and
demand.

26

Fixed Order Quantity Model

under Conditions of Uncertainty

Fixed Order Quantity Approach

(Condition of Uncertainty)

Reorder Point A Special Note

With uncertainty of demand, the reorder

point becomes the average daily demand
during lead time plus the safety stock.

27

Fixed Order Quantity Approach

(Condition of Uncertainty)

Uncertainty of Demand Affects Simple

EOQ Model Assumptions:

a constant and known replenishment time.

constant cost/price, independent of order
quantity or time.
no inventory in transit costs.
one item and no interaction among
the inventory items.
infinite planning horizon.
no limit on capital availability.

Probability Distribution of
Demand during Lead Time
Demand
100 units
110
120
130
140
150
160

Probability
0.01
0.06
0.24
0.38
0.24
0.06
0.01

28

Possible Units of Inventory Short or in Excess

during Lead Time with Various Reorder Points
Actual
Deman
d
100
110
120
130
140
150
160

100 110

Reorder Points
120 130 140

150

160

0
-10
-20
-30
-40
-50
-60

20
10
0
-10
-20
-30
-40

50
40
30
20
10
0
-10

60
50
40
30
20
10
0

10
0
-10
-20
-30
-40
-50

30
20
10
0
-10
-20
-30

40
30
20
10
0
-10
-20

Possible Units of Inventory Short or in Excess

during Lead Time with Various Reorder Points
Actual
Proba
Deman
-bility
d

100
110
120
130
140
150
160

0.01
0.06
0.24
0.38

Reorder Points
100 110 120 130 140 150 160

0.0
-0.6
-4.8
11.4
0.24 -9.6
0.06 -3.0
0.01 -0.6

0.1 0.2 0.3

0 0.6 1.2
-2.4 0 2.4
-7.6 -3.8 0

0.4
1.8
4.8
3.8

0.5
2.4
7.2
7.6

0.6
3.0
9.6
11.
4
-7.2 -4.8 -2.4 0 2.4 4.8
-2.4 -1.8 -1.2 -0.6 0 0.6
-0.5 -0.4 -0.3 -0.2 -0.1 0

29

Calculation of Lowest-Cost Reorder Point

Demn
d

100

110

120

130

140

150

160

(e)

0.0

0.1

0.8

3.9

10.8

20.1

30.0

$97.50

$27 $502.5 $75

0
0
0

(VW)

$2.50 $20

(g)

30

20.1

10.8

3.9

0.8

0.1

0.0

G=gw

$30
$201 $108
0

$39

$8

$1

$0

GR/Q

$45 $301 $162

00
5
0

$585

$12
0

$15

$0

TAC

$45 $301 $164 $682.5 $39 $517.5 $75

00
8
0
0
0
0
0

Fixed Order Quantity Approach

(Condition of Certainty): Expanded

EOQ Model

Where R = 3600 units V = $100; W = 25%;

A = $200 per order; G = 8
Q=

2 R(A + G)
VW

2 * 3600 * ($200 + 8)
$100 * 25%
Q = approximately 242 units

30

Fixed Order Quantity Approach

(Condition of Certainty): Expanded

EOQ Model

Where R = 3600 units V = $100; W = 25%;

A = $200 per order; G = 8; Q = 242; e = 10.8
TAC = QVW + AR + eVW + GR
2
Q
Q
TAC = (242*$100*25%) + (200*3600) + (10.8*$100*25%) + (8*3600)
2
242
242
TAC =

$3025

$2975

$270

$119

TAC =

$6389 (New value for TAC when uncertainty introduced)

Fixed Order Quantity Approach

(Condition of Uncertainty):

Conclusions

Following costs will rise to cover the uncertainty:

Stockout costs.
Inventory carrying costs of safety stock

Results may or may not be significant.

In text example, TAC rose $389 or approximately

6.5%.
The greater the dispersion of the probability
distribution, the greater the cost disparity.

31

Area under the Normal Curve

Reorder Point Alternatives and

Stockout Possibilities

32

Fixed Order Interval Approach

A second basic approach

Involves ordering at fixed intervals and
varying Q depending upon the remaining
stock at the time the order is placed.
Less monitoring than the basic model
Examine Figure 7-11.
Amount ordered over each five weeks in the
example varies each week.

Fixed Order Interval Model

(with Safety Stock)

33

Summary and Evaluation of EOQ

Approaches to Inventory
Management

Four basic inventory models:

Fixed quantity/fixed interval

Fixed quantity/irregular interval
Irregular quantity/fixed interval
Irregular quantity/irregular interval

Where demand and lead time are known,

basic EOQ or fixed order interval model best.
If demand or lead time varies, then safety
stock model should be used

Summary and Evaluation of EOQ

Approaches to Inventory
Management

Relationship to ABC analysis

A items suited to a fixed quantity/irregular

interval approach.
C items best suited to a irregular
quantity/fixed interval approach.

Importance of trade-offs

Familiarity with EOQ approaches assists the

manager in trade-offs inherent in inventory
management.

34

Summary and Evaluation of EOQ

Approaches to Inventory
Management

New concepts

JIT, MRP, MRPII, DRP, QR, and ECR also take

into account a knowledge and understanding
of applicable logistics trade-offs.

Number of DCs

The issue of inventory at multiple locations in a

logistics network raises some interesting
questions concerning the number of DCs, the
SKUs at each, and their strategic positioning.

Additional Approaches to
Inventory Management

Three approaches to inventory

management that have special relevance
to supply chain management:

JIT (Just in Time)

MRP (Materials Requirements into Planning)
DRP (Distribution Resource Planning)

35

Sawtooth Model Modified for

Inventory in Transit

EOQ Costs Considering Volume

Transportation Rate

36

Annual Savings, Annual Cost, and

Net Savings by Various Quantities
Using Incentive Rates

Net Savings Function for Incentive

Rate

37