Gradual replenishment of inventory

The situations we have looked at so far have involved inventory levels being replenished
immediately when organisations buy inventory from suppliers. Similar problems are faced by
organisations who replenish inventory levels gradually by manufacturing their own products
internally.

The decisions faced by organisations that manufacture and store their own products
involve deciding whether to produce large batches at long intervals OR produce small
batches at short intervals.

An amended EOQ model is used to help organisations to decide which course of action
to take.

The amended EOQ model is known as the EBQ (economic batch quantity) model.

As the items are being produced, there is a machine setup cost. This replaces the
ordering cost of the EOQ.

In the EOQ, inventory is replenished instantaneously whereas here, it is replenished

over a period of time.

Depending on the demand rate, part of the batch will be sold or used while the
remainder is still being produced.

For the same size of batch (Q), the average inventory held in the EOQ model (Q/2) is
greater than the average in this situation (see diagram on the next page).

The EBQ model can be shown graphically as follows.

Inventory
(units)

The maximum inventory level will never be as great as the batch size, because some of
the batch will be used up while the remainder is being produced.

The EBQ
The EBQ model is primarily concerned with determining the number of items that should be
produced in a batch (compared to the size of an order with the EOQ).
The formula for the EBQ is as follows:

Where:
Q = Batch size
D = Demand per annum
Ch = Cost of holding one unit for one year
Co = Cost of setting up a batch ready to be produced
R = Annual replenishment rate
Large or small batches?

Producing large batches at long intervals will lead to low machine setup costs (as fewer
machine setups will be needed) and high holding costs (high average inventory levels as
more inventory held).

Producing small batches at short intervals will lead to high machine setup costs (as more
machine setups will be needed) and low holding costs (low average inventory levels as
less inventory held).

Illustration 1 Gradual replenishment of inventory

The following is relevant for Item X:

Production is at a rate of 500 units per week.

Demand is 10,000 units per annum; evenly spread over 50 working weeks.

Setup cost is $2,700 per batch.

Storage cost is $2.50 per unit for a year.

Required:
Calculate the economic batch quantity (EBQ) for Item X.

Solution
Annual production rate, R = 500 x 50 = 25,000 units
Annual demand rate = 10,000 units
Cost per setup, Co = $2,700
Cost of holding one item in inventory per year, Ch = $2.50

Test your understanding

AB Ltd makes a component for one of the engines that it builds. It uses, on average, 2,000 of
these components, steadily throughout the year. The component costs $16 per unit to make and
it costs an additional $320 to setup the production process each time a batch of components is
made. The holding cost per unit is 10% of the unit production cost. The company makes these
components at a rate of 200 per week, and the factory is open for 50 weeks per annum.
Required:
Calculate the EBQ.