Inventory control

Lecture 2 (LE)

Copyright ©2013 Pearson Education.

1 1-1
Topics for today

• Homework questions
• EOQ
• Extension: All unit quantity discounts
• Extension: EPQ
• Extension: Constraints
• Homework

11-2
 All unit quantity discount
𝐷 𝑄
• If 0 < 𝑄 < 𝑄𝑏 , 𝐶 = 𝐶0 and 𝑇𝐶 = 𝐶0 𝐷 + 𝑆 + ℎ𝐶0
𝑄 2
𝐷 𝑄
• If 𝑄 ≥ 𝑄𝑏 , 𝐶 = 𝐶1 (< 𝐶0 ) and 𝑇𝐶 = 𝐶1 𝐷 + 𝑆 + ℎ𝐶1
𝑄 2

Total cost
Holding cost

11-3
Example
Sheet Metal Industries purchases precut metal sheets direct
from the steel processor. Forecasts indicate that SMI will need to
purchase 200 000 sheets on an annual basis. The steel producer
has an MOQ of 1 000 sheets, and offers a sliding price scale
based on the quantity ordered, as follows:
Order quantity Unit price
1000 – 9999 2.35
10000-29999 2.20
30000 + 2.15

The purchasing department estimates that it costs 300 to

process each order, and SMI has an inventory carrying cost equal
to 15% of the value of inventory. Determine the EOQ and
describe your solution strategy!
Answers: Q=30000, TC = 436837
11-4
 Compare costs at the largest
Example - Solution feasible EOQ and at all the price
breakpoints that are greater than
the largest feasible EOQ.

2∙200000∙300
𝑄2.15 = = 19290, not allowed so consider 𝑄 =
0.15∙2.15
30000
2∙200000∙300
𝑄2.20 = = 19069 possible candidate
0.15∙2.20
200000 19069
𝑇𝐶2.20 = ∙ 300 + 200000 ∙ 2.20 + ∙ 0.15 ∙ 2.20
19069 2
= 446293
200000 30000
𝑇𝐶2.15 = ∙ 300 + 200000 ∙ 2.15 + ∙ 0.15 ∙ 2.15
30000 2
= 436837
TC lowest for 𝑄 = 30000

11-5
Lot-size vs volume-based discounts
Disadvantage of lot size-based discounts
• increase lot size and cycle inventory in the supply chain

Alternative: volume-based discounts

• more effective: increased profit without increasing lot
size and cycle inventory
• should be used with a rolling time horizon (why?)

11-6
The EPQ model
• Production occurs at a specified rate 𝑝 = 50 units/day
• Demand 𝑑 = 10 units/day, and a production lot is 500 units
• 𝑆 = € 4000, 𝐶 = € 500, ℎ = 0.2

𝑰𝒎𝒂𝒙
𝟐

11-8
To remind you of my disclaimer
From an arbitrary article about EPQ:

In recent years, researchers have expanded the EOQ and EPQ models to
increase their applications. For instance, while in the EPQ model it is
assumed that the rate of the production process is constant and that the
process has no setup wastage, Hou (2007) studied an EPQ model with
setup cost and process quality as functions of capital expenditure and
developed an efficient procedure to find the optimal production run time,
setup cost, and process quality. Moreover, Bayindir et al. (2007)
considered the EPQ model with general inventory cost rate function and
piecewise linear concave production costs and proposed an effective
solution procedure to achieve the economic order quantity. Li et al. (2007)
developed EPQ-based models with planned backorders to evaluate the
impact of the postponement strategy on a manufacturer in a supply chain
and derived the optimal total average costs per unit time for producing
and keeping end-products in a postponement system. Chiu et al. (2007)
presented a procedure to determine the optimal run time for an EPQ
model with scrap, rework, and stochastic machine breakdowns …

11-9
Example
• Production occurs at a specified rate 𝑝 = 50 units/day
• Demand 𝑑 = 10 units/day, and a production lot is 500 units
• 𝑆 = € 4000, 𝐶 = € 500, ℎ = 0.2

Questions
1. How many days do we need to produce the complete lot?
2. During this time, at what rate inventory is built up?
3. What is the maximum level of inventory, 𝐼max , that is reached?
4. After how many days the next batch will be scheduled for production?
5. Draw a ‘sawtooth’ of the situation (with the right numbers on the axes)
6. What is the average inventory level?
7. What are the annual holding costs (formula)?
8. What are the annual setup costs (formula)?
9. What optimal value for 𝑄 can we deduce?

11-10
Example - Solution
1. We need 500/50 = 10 days (= 𝑄/𝑝)
2. At the rate of 50 – 10 = 40 units per day (= 𝑝 − 𝑑)
𝑄 𝑑
3. 𝐼max = 10 ∙ 40 = 400 (= 𝑝 ∙ 𝑝 − 𝑑 = 𝑄 1 − 𝑝 )
4. After 10 days there are 400 units in inventory, they will be
depleted in 40 days. So after 50 days a next production run
𝑑
𝑄 𝑄 1−
𝑝
will start. ( + )
inventory
𝑝 𝑑
5.400

10 50 time
𝐼max
6. Average inventory level = = 200 units
2
11-11
Example - Solution

7. Annual holding costs = average inventory x holding cost per

𝑄 𝑑
unit = 200 ∙ 0.2 ∙ 500 = ∙ 1 − ∙ ℎ ∙ 𝐶 YEARLY demand!
2 𝑝
𝐷
8. Annual setup costs = nr of setups x cost per setup = ∙𝑆
𝑄
9. For the optimal lot size:
𝐷 𝑄 𝑑
𝑇𝐶(𝑄) = 𝐶𝐷 + 𝑆 + 1 − ℎ𝐶,
𝑄 2 𝑝
𝐷𝑆 ℎ𝐶 𝑑
𝑇𝐶 ′ 𝑄 =− 2+ 1− = 0
𝑄 2 𝑝

2𝐷𝑆
𝑄𝑃 =
𝑑
1 − ℎ𝐶
𝑝
11-12
EOQ under constraints
Multiple products compete for same resource (money, space, etc).
What if the EOQ solutions result in higher resource requirements
than available?

If the ratio
resource required per unit
holding cost per unit per year

is the same for all products, an optimal order quantity of each

product can be obtained by reducing its EOQ value by a constant
multiplication factor (proportional correction).

Fund constraints satisfy this condition, space constraints often

not.

11-13
Example proportional correction
A vegetable stand wants to limit the investment in inventory
to a maximum of € 300. The appropriate data are as follows:
Tomatoes Lettuce Zucchini
𝐷 (annual) 1000 1500 750
𝐶 (in €) 0.29 0.45 0.25

The ordering cost is € 5 in each case and the annual holding

cost rate is 25%. What are the optimal quantities that
should be purchased?

11-14
 Example – Solution
2∙1000∙5
𝑄𝑡 = = 371.39
0.25∙0.29

2∙1500∙5
𝑄𝑙 = = 365.15
0.25∙0.45

2∙750∙5
𝑄𝑧 = = 346.41
0.25∙0.25
Total fund required: 371 ∙ 0.29 + 365 ∙ 0.45 + 346 ∙ 0.25 = 358.34 >
300
300. Take as multiplication factor 𝑚 = = 0.8372
358.34
𝑄𝑡 = 0.8372 ∙ 371.39 = 311
𝑄𝑙 = 0.8372 ∙ 365.15 = 306
𝑄𝑧 = 0.8372 ∙ 346.41 = 290
Total fund required: 311 ∙ 0.29 + 306 ∙ 0.45 + 290 ∙ 0.25 ≈ 300

11-15
EOQ with warehouse space constraint
Procedure (using Lagrange multipliers 𝜆):

2𝐷𝑖 𝑆𝑖
For item 𝑖 calculate 𝑄𝑖∗ = , where 𝑓𝑖 stands for the storage
ℎ𝐶𝑖 +2𝜆𝑓𝑖
space requirement per unit of item 𝑖 (and 𝜆 is a non-negative number,
start with 𝜆 = 0)

If σ𝑛𝑖=1 𝑓𝑖 𝑄𝑖∗ ≤ 𝑊 (total warehouse space needed ≤ total warehouse

space available) then stop. Otherwise recalculate 𝑄𝑖∗ based on 𝜆 = 1
and check the warehouse constraint again.

If the required space is more than what is available, increase 𝜆,

otherwise decrease λ (if desired!).

Continue iteration until satisfied.

11-16
Homework
• Make the exercises and case in this slideset

11-18
Exercise 1 - Medium

Answers: a) Q = 2000 TC = 39000, Q = 1000, TC = 25500

11-19
Exercise 2 - Hard
A small shop produces three machine parts (I, II, ad III) in
lots. The shop has only 650 𝑚2 of storage space. The data
for the three items are given below. The shop uses an
inventory charge of 20% of average inventory value per
year. Determine the optimal lot size for each item.

Item I II III
Yearly demand 5000 2000 10000
Order cost 100 200 75
Material cost 10 15 5
Floor space per unit (𝑚2 ) 0.7 0.8 0.4

Answers: 𝜆 = 6 𝑤𝑖𝑡ℎ𝑜𝑢𝑡 𝑓𝑢𝑟𝑡ℎ𝑒𝑟 𝑓𝑖𝑛𝑒𝑡𝑢𝑛𝑖𝑛𝑔 𝑄𝐼 = 310, 𝑄𝐼𝐼 = 252, 𝑄𝐼𝐼𝐼 =

509, 𝑠𝑝𝑎𝑐𝑒 = 622 m2 11-21
Exercise 3 - Insight
The total cost equation changes slightly if we assume a non-zero
lead time 𝐿 and include the pipeline inventory.
a) Give the new expression for the TC.
b) Give the new optimal value 𝑄∗

11-22
Exercise 4 - Standard
Nick's Camera Shop carries Zodiac instant print film. The
film normally costs Nick $3.20 per roll, and he sells it for
$5.25. Nick's average sales are 21 rolls per week (and there
are 52 weeks in a year). His annual inventory holding cost
rate is 30% and it costs Nick $20 to place an order with
Zodiac.
If Zodiac offers a 5% discount on orders of 800 rolls or more,
determine Nick's optimal order quantity.

Answer: Q = 213 with TC = 3699

11-24
Exercise 5 - Standard
A toy manufacturer uses 48000 rubber wheels per year. The
firm makes its own wheels at a rate of 800 per day. Carrying
cost is $1 per wheel per year. Setup cost for a production
run is $45. The firm operates 240 days per year. Determine:

• The optimal run size

• Minimum total annual cost for carrying and setup
• Cycle time for the optimal run size
• Run time for the optimal run size.

Answers: Q = 2400, 𝐼max = TC = 1800, cycle time = 12 days, run time = 3 days
11-26
Case - Medium
As the inventory control manager at Nightingale Drugstore, Robert has been experiencing
problems keeping Totalee toothbrushes in stock. He has discovered that customers are very
loyal to the Totalee brand name since Totalee holds a patent on the toothbrush endorsed by 9
out of 10 dentists. Customers are willing to wait for the toothbrushes to arrive at Nightingale
Drugstore since the drugstore sells the toothbrushes for 20 percent less than other local
stores. This demand for the toothbrushes at Nightingale means that the drugstore is often out
of Totalee toothbrushes. The store is able to receive a shipment of toothbrushes several hours
after an order is placed to the Totalee regional warehouse because the warehouse is only 20
miles away from the store. Nevertheless, the current inventory situation causes problems
because numerous emergency orders cost the store unnecessary time and paperwork and
because customers become disgruntled when they must return to the store later in the day.

The demand data for the toothbrushes is almost constant across the months. Whether in
winter or summer, customers have teeth to brush, and they need toothbrushes. Since a
toothbrush will wear out after a few months of use, customers will always return to buy
another toothbrush. The demand data shows that Nightingale Drugstore customers purchase
an average of 250 Totalee toothbrushes per month (30 days). After examining the demand
data, Robert investigates the cost data. Because Nightingale Drugstore is such a good
customer, Totalee charges its lowest wholesale price of only $1.25 per toothbrush. Robert
spends about 20 minutes to place each order with Totalee. His salary and benefits add up to
$18.75 per hour. The annual holding cost for the inventory is 12 percent of the capital tied up
in the inventory of Totalee toothbrushes.

Solution: a) order 500 every two months, TC = 75 b) order 500 when there are 50 left c) EOQ=524, Sh
= 48, ROP = 2, TC = 71,50 d) repeat analysis of c) e) order 1000 when 50 are left, TC = 3079

11-29
a) Robert decides to create an inventory policy that normally fulfills all demand since he believes that stock-outs are just
not worth the hassle of calming customers or the risk of losing future business. Since Nightingale Drugstore receives an
order several hours after it is placed, Robert makes the simplifying assumption that delivery is instantaneous. What is
the optimal inventory policy under these conditions? How many Totalee toothbrushes should Robert order each time
and how frequently? What is the total variable inventory cost per year with this policy?

b) Totalee has been experiencing financial problems because the company has lost money trying to branch into producing
other personal hygiene products, such as hairbrushes and dental floss. The company has therefore decided to close the
warehouse located 20 miles from Nightingale Drugstore. The drugstore must now place orders with a warehouse
located 350 miles away and must wait 6 days after it places an order to receive the shipment. Given this new lead
time, how many Totalee toothbrushes should Robert order each time, and when should he order?

c) Robert begins to wonder whether he would save money if he allows planned shortages to occur. Customers would wait
to buy the toothbrushes from Nightingale since they have high brand loyalty and since Nightingale sells the
toothbrushes for less. Even though customers would wait to purchase the Totalee toothbrush from Nightingale, they
would become unhappy with the prospect of having to return to the store again for the product. Robert decides that
he needs to place a dollar value on the negative ramifications from shortages. He estimates the costs of dealing with
disgruntled customers and losing customer goodwill and future sales as $1.50 per unit short per year. Given the 6-day
lead time and the shortage allowance, how many Totalee toothbrushes should Robert order each time, and when
should he order? What is the maximum shortage under this optimal inventory policy? What is the total variable
inventory cost per year?

d) Robert realizes that his estimate for the shortage cost is simply that—an estimate. He realizes that employees
sometimes must spend several minutes with each customer who wishes to purchase a toothbrush when none is
currently available. In addition, he realizes that the cost of losing customer goodwill and future sales could vary within
a wide range. He estimates that the cost of dealing with disgruntled customers and losing customer goodwill and
future sales could range from 85 cents to $25 per unit short per year. What effect would changing the estimate of the
unit shortage cost have on the inventory policy and total variable inventory cost per year found in part (c)?

e) Closing warehouses has not improved Totalee’s bottom line significantly, so the company has decided to institute a
discount policy to encourage more sales. Totalee will charge $1.25 per toothbrush for any order of up to 500
toothbrushes, $1.15 per toothbrush for orders of more than 500 but less than 1000 toothbrushes, and $1 per
toothbrush for orders of 1000 toothbrushes or more. Robert still assumes a 6-day lead time, but he does not want
planned shortages to occur. Under the new discount policy, how many Totalee toothbrushes should Robert order each
time, and when should he order? What is the total inventory cost (including purchase costs) per year? 11-30