Inventory Control

DEFINITIONS, BASICS, EOQ , EXTENSIONS OF EOQ

Georgia Tech, 2014

ISyE 3104 Fall 2014

What Is Inventory?
Material that has been purchased from a supplier, may have been partially or
completely converted, but not yet sold to the customer

Raw material
Components
Work-in-process (WIP)
Finished goods

Where do we hold inventory?

Suppliers and manufacturers

Warehouses and distribution centers
Retailers

Georgia Tech, 2014

ISyE 3104 Fall 2014

Inventory Decision Making

Up to now, the decisions that weve looked at which impact inventory are production related
decisionsbatch sizes, number of parallel machines in a workstation, etcand these impact
the work-in-process inventories directly, but dont directly impact other inventories
But there are many other decisions in a manufacturing enterprise that will impact other
inventories, e.g., purchasing decisions will impact raw material inventories, marketing
decisions may impact finished goods inventories.
There is a large body of methods and tools devoted specifically to decisions about raw
material and finished goods inventories
Those are the kinds of inventory planning decisions considered in this lecture

Georgia Tech, 2014

ISyE 3104 Fall 2014

Inventory System Context

Replenishment
Process

Storage Process

How frequently to
replenish; how much to
replenish

Georgia Tech, 2014

Consumption
Process

Quantity discounts,
promotions; service
levels

ISyE 3104 Fall 2014

Inventory Context
Critical to clearly specify the context

What are the givens

What is known
What can be controlled
What is the criterion for evaluating inventory decisions

Costs

Other performance measures

Georgia Tech, 2014

ISyE 3104 Fall 2014

Characteristics of Inventory Systems

Demand
Known or Uncertain
Changing or Unchanging (level) in Time
Lead Times - time that elapses from placement of an order until its arrival.
Known or unknown.

Review Time - Is system reviewed periodically or is system state known at all times?
Treatment of Excess Demand:
Backorder all excess demand
Lose all excess demand
Backorder some and lose some
Inventory that changes over time
perishability
obsolescence
Georgia Tech, 2014

ISyE 3104 Fall 2014

Reasons for Holding Inventories

Demand uncertainty
Supplies uncertainty
Delivery lead-times uncertainty
Economies of scale (batch orders)
Changing costs over time
Ensuring high level of customer service

As before, inventories are a way to buffer the

impact on the enterprise of variability
whether it is due to a lack of knowledge
about the future or simply the randomness in
the behavior of the other actors (suppliers,
customers).

Costs of maintaining control system

Georgia Tech, 2014

ISyE 3104 Fall 2014

Goal of Inventory Management

Effectively manage inventory in the SC to have:
the correct inventory,
at the correct location,
at the correct time
To:
minimize system wide costs, AND
satisfy the customer service requirements.

Georgia Tech, 2014

NB: we are conceptualizing the inventory

management problem as an optimization
problem.

ISyE 3104 Fall 2014

Success Stories
By effectively managing inventory:

Xerox eliminated $700 million inventory from its supply chain

Wal-Mart became the largest retail company utilizing efficient inventory management
GM has reduced parts inventory and transportation costs by 26% annually

Georgia Tech, 2014

ISyE 3104 Fall 2014

Inventory Policy
The strategy, approach, or set of techniques used to determine how to manageinventory
The inventory policy is affected by:

Demand characteristics
Replenishment lead time
Number of products
Length of planning horizon
Objectives
Service level
Minimize costs

Cost structure

Georgia Tech, 2014

ISyE 3104 Fall 2014

10

Relevant Costs
Holding Costs - Costs proportional to the quantity of inventory held. Includes:
Physical Cost of Space
Taxes and Insurance
Breakage, Spoilage, Deterioration and Obsolescence
Opportunity Cost of alternative investment.
Ordering Cost (or Production Cost): Includes both fixed and variable components.
Penalty or Shortage Costs. All costs that accrue when insufficient stock is available to meet
demand:
Loss of revenue for lost demand
Loss of goodwill for being unable to satisfy demands when they occur
Loss of production capacity when raw material is not available when needed.
Note: shortage costs are usually hard to quantify

Georgia Tech, 2014

ISyE 3104 Fall 2014

11

Economic Order
Quantity
Georgia Tech, 2014

ISyE 3104 Fall 2014

12

Economic Order Quantity (EOQ) Model

Introduced by Harris in 1913 in How Many Parts to Make at Once
Insights:

Large production lots reduce setup costs but small production lots reduce inventory
We must balance the two: setup costs and inventory costs

Simple, not very practical but

provides important insights on the tradeoffs in inventory management, and

the results from the EOQ model are major components of the decision systems when some of the
(rather severe) EOQ assumptions are relaxed

Georgia Tech, 2014

ISyE 3104 Fall 2014

13

Economic Order Quantity (EOQ) Model

1.
2.
3.
4.
5.
6.
7.

Assumptions:
Demand is deterministic
Demand is constant over time at a rate of D units per unit time
Shortages are NOT allowed
Delivery of orders is instantaneous
Order quantity is fixed at Q per cycle
Infinite production capacity
Relevant cost structure:
a)

Ordering Cost: Fixed and marginal costs

b)

Holding cost per unit held per unit time

Georgia Tech, 2014

ISyE 3104 Fall 2014

14

EOQ: Example
Coffee shop sells coffee cups:

Demand is constant, at 50 cups per week.

Fixed order cost of $10 per order, regardless of quantity ordered.
Zero lead time to receive the cups from the supplier.
Holding cost of 20% of inventory value annually
Cup costs $2, sell for $6

Question

How many to order each cycle, how often? What is the annual cost associated with your solution?

Georgia Tech, 2014

ISyE 3104 Fall 2014

15

EOQ Notation
D= demand rate (units/year)
c = unit production cost ($/unit)
input
parameters

h = holding cost if the holding cost is consists entirely of interest on money tied
up in inventory, then h = ic where i is an annual interest rate. (h=ic) ($/unit/year)
A = constant setup cost($)

Decision
variable

T = time between orders

Q = lot size (units)

Georgia Tech, 2014

ISyE 3104 Fall 2014

16

EOQ

On-hand Inventory

D= demand rate (units/year)

c = unit production cost ($/unit)

A = constant setup cost($)

Slope = -D

h = holding cost ($/unit/year)

Q = lot size (units)
T = time between orders (yrs)

T=Q/D

2Q/D
Time

Georgia Tech, 2014

REMEMBER THE ASSUMPTIONS!

ISyE 3104 Fall 2014

17

Costs
Inventory Holding Cost:

Q2
Average inventory per cycle = area under each cycle =
2D
hQ 2

Inventory holding cost per cycle =

2D

Order (Setup) Cost:

Setup cost per cycle = A

Purchasing (production) Cost:

Production cost per cycle = cQ

Total cost per cycle =

Total Annual Cost =
Georgia Tech, 2014

Q2
h
+ A + cQ
2D

Q2
D

+ A + cQ
Y(Q ) = h
2D
Q

Q
D
+ cD
Y(Q ) = h + A
2
Q
ISyE 3104 Fall 2014

18

Finding EOQ=Q*
To optimize Y(Q) with respect to Q, we need:

dY (Q )
h
D
= A 2 =0
dQ
2
Q
2 AD
h

Q* =

To check whether Q* is a minima or a maxima, we check the second derivative

d2 Y(Q )
dQ 2

d2 Y(Q )
dQ

2AD
Q

>0

Y(Q) is a convex function of Q and Q* minimizes Y(Q)

Georgia Tech, 2014

ISyE 3104 Fall 2014

19

The Annual Cost at Q*

Substitute
=>

Q* =

Y(Q*) =

2AD
h

in

Y(Q ) = h

Q
D
+A
+ cD
2
Q

2ADh + cD

Let G(Q) be the average annual holding and set-up costs (relevant costs) function given by

=>

G(Q ) = h

Q
D
+A
2
Q

G(Q*) =

2ADh

Georgia Tech, 2014

ISyE 3104 Fall 2014

20

Back to the EOQ: Example

Coffee shop sells coffee cups:

Demand is constant, at D=50 cups per week.

Fixed order cost of A=$10, regardless of quantity ordered.
Zero lead time, L=0.
Holding cost of 20% of inventory value annually
Cup costs $2, sell for $6

Question

How many to order? How often? Whats the annual cost?

Georgia Tech, 2014

ISyE 3104 Fall 2014

21

EOQ Example Solution

2 10 50 52
= 360.55 cups
0.2 2
Q * 360.55 cups / order
=
= 0.1664 year = 1.66 months = 50 days
T* =
D
50 52 cups/year
Y(360.55) = 2ADh + cD = 2 10 50 52 0.2 2 + 2 50 52 = $5344.22

Q* =

G(360.55) =

2ADh =

Georgia Tech, 2014

2 10 50 52 0.2 2 = $144.22

ISyE 3104 Fall 2014

22

Sensitivity Analysis
What if deviate from EOQ

72.111

180.27

288.44

324.5

360.56

396.61

432.67

540.83

721.11

Total Relevant Annual Cost

G(Q)

$374.98

$180.28

$147.83 $145.02 $144.22 $144.88 $146.63 $156.24 $180.28

Annual Holding Cost

$14.42

$36.06

$57.69

$64.90

$72.11

$79.32

$86.53

$108.17 $144.22

Annual Ordering Cost

$360.56

$144.22

$90.14

$80.12

$72.11

$65.56

$60.09

$48.07

$36.06

In this example, from 80% to 120% of optimum Q, the cost

really doesnt change appreciably. Is this generally true?

Georgia Tech, 2014

ISyE 3104 Fall 2014

23

Sensitivity Analysis
What if deviate from EOQ
$400.00

Total Relevant Annual Cost

$350.00

Annual Holding Cost

$300.00

Annual Ordering Cost

$250.00
$200.00
$150.00

What can you say about this

curve?

$100.00
$50.00
$0.00

100

Georgia Tech, 2014

200

300
Q

400

500

600

ISyE 3104 Fall 2014

700

800

24

Sensitivity of EOQ Model to Q and T

Annual Relevant Cost from Using Q':
Ratio: what if we order Q instead of Q*

G(Q ) =

hQ AD
+
2
Q

hQ 2 + AD Q 1 Q
Q*
=
=
= * +

*
*

2
Q
2ADh
Cost(Q ) G(Q )
Q

Cost(Q )

G(Q )

Example: If Q' = 2Q*, then the ratio of the actual to optimal cost is
(1/2)[2 + (1/2)] = 1.25
Recall that T=Q/D is the time between orders
T* =

Q*
=
D

2A
hD

What if we order every T instead of every T*

1 T'
T*
=
= * +

*
*
2
T
'
Cost(T ) G(T )

Georgia Tech, 2014

ISyE 3104 Fall 2014
Cost(T' )

G(T' )

25

Power of Two Policies

Assume that for the EOQ model the order interval is restricted to
powers of 2, for instance every 1 week, 2 weeks, 4, weeks, 8 weeks, etc.

Why do we care?

Power of two policies are effective in multi-product settings so as to order the products at the same
time to share trucks, simplify shipping and receiving schedules

Georgia Tech, 2014

ISyE 3104 Fall 2014

26

The Root-Two Interval

We can show that under such a restriction, the average cost penalty for this restriction as
compared to an optimal policy is under to 6.1%.

2m

T1*

2m

The maximum error in cost will occur when

T2*
T' =

2 m +1

2T*, or when T' = 1 /

1 T'
T* 1
1
=
= * +
= 1.06
= 2+

*
*
T'
2
Cost(T ) G(T ) 2
T
2
Cost(T' )

Georgia Tech, 2014

G(T' )

ISyE 3104 Fall 2014

27

2T *

Coffee Cups Example

Optimum: Q*=360, so T*=Q*/D = 50 days

G(360.55) =

2ADh =

2 10 50 52 0.2 2 = $144.22

Round to Nearest Power-of-Two: 50 is between 25=32 and 26=64, but since 322= 45.25,
therefore T*=50 is closest to 64. So, round to T=64 days or Q= TD=(64/365)50*52=462 cups.

Y(Q ' ) =

hQ ' AD 2 0.2 462 10 * 50 * 52

+
=
+
= $148
2
Q'
2
462

Georgia Tech, 2014

ISyE 3104 Fall 2014

Only 2.7% from the minimum

cost

28

Variations on EOQ
Georgia Tech, 2014

ISyE 3104 Fall 2014

29

Many Variations on EOQ

Lead time >0
Production capacity is finite
Quantity Discounts
Multi-items ordering with budget or space constraint
Multi-products production lots

Georgia Tech, 2014

ISyE 3104 Fall 2014

30

Variations- lead time>0

Reorder Point = demand during lead time = D*l
If l > T (lead time is larger than time between orders), reorder point = (l-T)*D

On-hand Inventory

Note: make sure units are consistent

Q

T=Q/D
Reorder point

2Q/D

Time

Place order

Georgia Tech, 2014

ISyE 3104 Fall 2014

31

Coffee Cups Example

Suppose the delivery is not instantaneous, the suppliers lead time = 30 days, what is the reorder
point?
Solution: order when on-hand inventory reaches 50*52*30/(7*52) = 214 cups

What if the lead time = 70 days, what is the reorder point?

Solution: order when on-hand inventory reaches 50*52*(70-50)/(7*52) = 143 cups

Georgia Tech, 2014

ISyE 3104 Fall 2014

32

Variations- finite production capacity

Suppose P = production rate (units/year)

On hand Inventory

Note that the maximum level of

inventory is not Q

Slope = P-D

?
Slope = -D

T1

2Q/D

T2

T
Time
T1: production and demand are happening together
T2: production stops, demand is still incoming
T: cycle length
Georgia Tech, 2014

ISyE 3104 Fall 2014

33

Variations- Quantity Discounts

1.

All Units Discounts: discount is applied to ALL of the units in the order.

2.

Incremental Discounts: discount is applied only to the number of units above the breakpoint.

Georgia Tech, 2014

ISyE 3104 Fall 2014

34

All-Units Discounts
C(Q)

Qb1
breakpoints
Georgia Tech, 2014

Qb2
Q
ISyE 3104 Fall 2014

35

All-Units Discounts
Y(Q)

The optimal Q* will occur at the bottom of one of the cost

curves or at a breakpoint. (It is generally at a breakpoint.)

Y1 (Q)
Y2(Q)
Y3 (Q)

Qb1
breakpoints
Georgia Tech, 2014

Qb2
Q
ISyE 3104 Fall 2014

36

Incremental Discounts
C(Q)

Qb1
breakpoints
Georgia Tech, 2014

Qb2
Q
ISyE 3104 Fall 2014

37

Incremental Discounts
Y(Q)

The optimal Q* will always occur at a realizable EOQ value.

Qb1
breakpoints
Georgia Tech, 2014

Qb2
Q

ISyE 3104 Fall 2014

38

All-Units Discounts Example

Consider the following three items. The supplier offers a 2% discount on any replenishment of
100 units or higher of a single item, assume interest rate is 24%

Item

C(Q)

416

14.2

1.50

104

3.10

1.50

4160

2.40

1.50

Georgia Tech, 2014

ISyE 3104 Fall 2014

39

All-Units Discounts Example

Item A:
1.
2.

EOQ discount = 19 units < 100 units (unrealizable)

Calculate cost of EOQ without discount

Y(EOQ) =

Y(Q b ) =

2 * 1.5 * 416 * 14.2 * 0.24 + 416 * 14.2 = $5972.42

100 * 14.2 * 0.98 * 0.24 1.5 * 416

+
+ 416 * 14.2 * 0.98 = $5962.29
100
2

=>Order Qb = 100 units

Georgia Tech, 2014

ISyE 3104 Fall 2014

40

All-Units Discounts Example

Item B:
1.
2.

EOQ discount = 21 units < 100 units (unrealizable)

Calculate cost of EOQ without discount

Y(EOQ) =
Y(Q b ) =

2 * 1.5 * 104 * 3.1 * 0.24 + 104 * 3.1 = $337.64

100 * 3.1 * 0.98 * 0.24 1.5 * 104

+
+ 104 * 3.1 * 0.98 = $353.97
2
100

EOQ =

2 * 1.5 * 104
= 20units
3.1 * 0.24

=>Order EOQ without discount

Georgia Tech, 2014

ISyE 3104 Fall 2014

41

All-Units Discounts Example

Item C:
1.

EOQ discount =

EOQ =
=>order 149 units

Georgia Tech, 2014

2 * 1.5 * 4160
= 149units > 100units
2.4 * 0.98 * 0.24

ISyE 3104 Fall 2014

42

All-Units Discounts: Finding Q*

The optimal will occur at the bottom of one of the cost curves or at a breakpoint. (Idea: Compare the cost at the
largest realizable EOQ and all of the breakpoints succeeding it.
Suppose you have n breakpoints, steps to find Q*:
1.

Calculate the EOQn of the lowest cn(Q)

2.

If EOQn is realizable (i.e. EOQn > Qbn) stop, Q* = EOQn

3.

If EOQn is not realizable (i.e. EOQn < Qbn), calculate the total annual cost Y(Qbn) of the breakpoint for the lowest
cn(Q)

4.

Calculate the EOQn-1 of the next lowest cn-1(Q)

5.

If EOQn-1 is realizable, calculate the total annual cost of EOQn-1

6.

If Y(Qbn) < Y(EOQn-1 ), order Qbn, otherwise order EOQn-1

7.

If EOQn-1 is not realizable, repeat steps 4-6 until a realizable EOQ is achieved and then compare its cost to all the
previous breakpoints costs

Georgia Tech, 2014

ISyE 3104 Fall 2014

43

Resource Constrained Multi-Product Systems

Consider an inventory system of n items in which the total amount available to
spend is C and items cost respectively c1, c2, . . ., cn. Then this imposes the
following constraint on the system:
c1Q1 + c2Q2+cnQn < C

When the condition that

c1/h1 = c2/h2 ==cn/hn

is met, the solution procedure is straightforward. If the condition is not met,
one must use an iterative procedure involving Lagrange Multipliers.

Georgia Tech, 2014

ISyE 3104 Fall 2014

44

Resource Constrained Multi-Product Systems

When the condition that
c1/h1 = c2/h2 ==cn/hn
is met, steps to solve the problem:
1- compute the EOQ for all products, EOQ1, EOQ2, , EOQn
2- check if the budget constraint is violated:
- if C > c1EOQ1 + c2EOQ2+cnEOQn order the EOQ for each product
-if C < c1EOQ1 + c2EOQ2+cnEOQn, compute the multiplier m = C/(c1EOQ1 +
c2EOQ2+cnEOQn) and order Qi = mEOQi for each product
Georgia Tech, 2014

ISyE 3104 Fall 2014

45

Resource Constrained Multi-Product SystemsLagrange multiplier procedure

When the condition that
c1/h1 = c2/h2 ==cn/hn is not met
Q i* =

2A iDi
hi + 2ci

Find so that
n

*
c
Q
i i =C
i=1

Georgia Tech, 2014

ISyE 3104 Fall 2014

46

Example*
Three items are produced in a small shop. The shop should never have more
than $30,000 invested in inventory at one time. What lot sizes should the shop
produce so that they do not exceed the budget?
Item 1

Item 2

Item 3

Annual demand
rate

1850

1150

800

Production cost
per unit

50

350

85

Setup cost

100

150

50

Use interest rate = 25%

* From Production and Operations Analysis by Nahmias, 6th ed., McGraw-Hill, New York, NY

Georgia Tech, 2014

ISyE 3104 Fall 2014

47

Example
EOQ1 = 172, EOQ2 = 63, EOQ3 = 61
The total investment = 172*50+63*350+61*85 = $35,835 >$30,000
Since h1 / c1 = h2 / c2 =h3 / c3 we can calculate the ratio 30000/35835 = 0.8372
and multiply each EOQ by this ratio
=>Q1 = 144, Q2 = 52 and Q3 = 51 (rounding down to ensure no violation of the
budget constraint)

Georgia Tech, 2014

ISyE 3104 Fall 2014

48

Resource Constrained Multi-Product Systems

Consider an inventory system of n items in which the total space available to
store the item is W and the space required by one unit of item i is wi. Then this
imposes the following constraint on the system:
w1Q1 + w2Q2+wnQn < W

Q i* =

2A iDi
hi + 2w i

Find so that
n

w iQ *i = W
i=1

Georgia Tech, 2014

ISyE 3104 Fall 2014

49

Example
For the same small shop problem, suppose that there are only 2000 square feet of floor space
available, the products consumes, respectively, 9, 12, and 19 square feet per unit. What should
the Qs be?
Check if the Q*s are feasible
144*9+52*12+51*19=2889>2000
We need to find in
so that

Q i* =

2A iDi
hi + 2wi

wiQ *i = W
i=1

Use trial and error, fine tuning until the constraint is not violated while keeping the left hand
side as close as possible to the right hand side.

Georgia Tech, 2014

ISyE 3104 Fall 2014

50

Summary
Specified a procedure for selecting the appropriate size of a replenishment quantity under
constant and deterministic demand
Sizeable deviations from the EOQ produces small error in cost (robust)
Discussed several extensions of EOQ
Next:

Stochastic demand inventory models

Georgia Tech, 2014

ISyE 3104 Fall 2014

51