Basic EOQ Model

- EOQ model is based on deriving the optimal ordering quantity that minimises the ordering and
holding costs.

Assumptions:
1. Demand is known, constant and independent.
2. Lead time is known and constant.
3. Only variable costs are holding and ordering costs.

- Increasing Q ordering quantity would result in a

trade-off between lowering ordering cost and higher
inventory holding cost.
- Q* is the point in which ordering cost = holding
cost.

Re-Order Point (constant lead time scenario):

- Point of inventory level which tells “when” to
make the next order.
- Point which ensures that demand is met within
the lead time

𝑅 (𝑢𝑛𝑖𝑡𝑠 𝑙𝑒𝑣𝑒𝑙) = 𝐷 × 𝐿

𝑢𝑛𝑖𝑡𝑠 𝑥 𝑤𝑒𝑒𝑘𝑠 𝑥 𝑑𝑎𝑦𝑠

𝑤ℎ𝑒𝑟𝑒 𝐷 = , 𝐿 = 𝑦𝑒𝑎𝑟𝑠 = =
𝑦𝑒𝑎𝑟 52 365
EOQ Calculations:

Only for EOQ:

Total Cost= Inventory-Holding Cost + Product Cost (D*C)

Finite Production Rate: Why does the EOQ increase?

The manufacturer takes time to produce the goods. R (constant production rate) > Demand. If R is lesser
than D, there will not be any inventory available to hold as demand keeps taking in.

T1 is the time required to do the production (running the factory). T2 is the time that the factory pauses.
During the T1, there is both production and consumption. (R-D). During the T2, there is only
consumption (D).

H = max inventory on hand, does not refer to the order quantity. What we’re trying to do is to express H
as a function of q.

h* instead of h. The h* is less than h. If R equals to D, it means that the demand and supply is almost the
same. Toyota Production System, basically the demand and supply are equal. When there is a demand,
you produce directly for it. There is not inventory holding cost due to the direct flow of goods. Inventory
belongs to the supplier.

- The trade-off between inventory or holding cost and ordering cost is a higher quantity at a lower
inventory cost.
- If R goes closer to D, the EOQ can be very big. Flow through the system, means that the supply
and demand are equal. Minimum inventory cost as the goods flow through.
- Vendor Management Inventory: Supplier holds the inventory until the manufacturer needs it.
News Vendor Model

Critical Ratio: Optimal compromise between the two competing risks of Underage & Overage costs.

If the underage costs go up (R-C, gross margin (buy @ C, sell @ R)), the order quantity, example: You
have a highly profitable business, you want to sell as much as possible. You want to reduce the
probability of not holding the inventory. Hence, in order to increase the sales, should increase the quantity
of order. In case there is no sales, the overage costs will be lower.

Overage Cost: the cost of losing profit when you have to sell again at a discount. If the risk is too high to
sell afterwards, then reduce the need to have large quantities of stock available at the beginning.

The standard deviation measures the dispersion or variation of the values of a variable around its
mean value (arithmetic mean). Put simply, the standard deviation is the average distance from the mean
value of all values in a set of data.
An example:
1,000 people were questioned about their monthly phone bill. The mean value is $40 and the standard
deviation 27. Which means that the average distance of all answers (=values) to the mean is $27.
We calculate the standard deviation with the help of the square root of the variance. The symbol of the
standard deviation of a random variable is "σ“, the symbol for a sample is "s". The standard deviation is
always represented by the same unit of measurement as the variable in question. This makes
its interpretation easier, compared to the variance.
A lower standard deviation generally indicates that the measured values of a variable are distributed
closer to the mean; a higher standard deviation indicates that the data points a spread more widely.
For normally distributed variables, the rule of thumb is that about 68 percent of all data points are spread
from the mean within the standard deviation. Within two standard deviations that would include around
95 percent of all data points. Deviations higher than this average are called outliers.