INVENTORY MODELING

Basic Concepts

INVENTORY MODELING

What is inventory?

Items in inventory in a store

Manufactured items waiting to be shipped
Employees in a firm
Computer information in computer files
Etc.

COMPONENTS OF AN
INVENTORY POLICY
Q = the amount to order
(the order quantity)
R = the number of items left in inventory
when an order is placed
(the reorder point)

BASIC CONCEPT
Balance the cost of having goods in
inventory (Holding Cost) to other costs
such as:
Order Cost
Purchase Costs
Shortage Costs

HOLDING COSTS
Costs of keeping goods in inventory
Cost of capital
Rent
Utilities
Insurance
Labor
Taxes
Shrinkage, Spoilage, Obsolescence

Holding Cost Rate

Annual Holding Cost Per Unit
These factors, individually are hard to
determine
Management (typically the CFO) assigns
a holding cost rate, H, which is a
percentage of the value of the item, C
Annual Holding Cost Per Unit, Ch
Ch = HC (in $/item in inv./year)

ORDER/SETUP COSTS
When purchasing items, this cost is
known as the order cost, CO (in $/order)
These are costs associated with the
ordering process that are independent of
the size of the order-- invoice processing,
check writing, e-mails, phone calls,
accounting etc.
Labor
Communication
Some transportation

ORDER/SETUP COSTS (Contd)

When these costs are associated with
producing items for sale they are called set-up
costs (still labeled CO-- in $/setup)
Costs associated with getting the process ready
for production (regardless of the production
quantity)
Readying machines
Calling in shift workers
Paperwork, communications involved

PROCUREMENT/PRODUCTION
COSTS

These are the per unit purchase costs, C,

if we are ordering the items from a
supplier
These are the per unit production costs,
C, if we are producing the items for sale

CUSTOMER SATISFACTION
COSTS
Shortage/Goodwill Costs associated
with being out of stock
goodwill
loss of future sales
labor/communication

Fixed administrative costs = C b

($/occurrence)
Annualized Customer Waiting Costs =
Cs ($/item short/year)

BASIC INVENTORY EQUATION

(Total Annual Inventory Costs) =
(Total Annual Order/Setup-Up Costs) +
(Total Annual Holding Costs) +
(Total Annual Purchase/Production Costs) +
(Total Annual Shortage/Goodwill Costs)
This is a quantity we wish to minimize!!

REVIEW SYSTEMS
Continuous Review - Items are monitored continuously
When inventory reaches some critical level,
R, an order is placed for additional items

Periodic Review - Ordering is done periodically (every day,

week, 2 weeks, etc.)
Inventory is checked just prior to ordering to
determine an order quantity

TIME HORIZONS
Infinite Time Horizon
Assumes the process has and will continue
forever

Single Period Models

Ordering for a one-time occurence

EOQ-TYPE MODELS
EOQ (Economic Order Quantity)-type
models assume:
Infinite Time Horizon
Continuous Review
Demand is relatively constant

THE BASIC EOQ MODEL

Order the same amount, Q, each time
Reordering is instantaneous
No shortages
Since reordering is instantaneous

Infinite Time Horizon

Continuous Review
Demand is relatively constant at
items/yr.

AVERAGE INVENTORY
INVENTORY VS. TIME
Q

Q/2

Average Inventory = Q/2

THE EOQ COST COMPONENTS

Total Annual Order Costs:
(Cost/order)(average # orders per year) = CO(D/Q)

Total Annual Holding Costs:

(Cost Per Item in inv./yr.)(Average inv.) = Ch(Q/2)

Total Annual Purchase Costs:

(Cost Per Item)(Average # items ordered/yr.) = CD

THE EOQ TOTAL COST

EQUATION
TC(Q) = CO(D/Q) + Ch(Q/2) + CD

D
Q
TC (Q ) Co Ch CD
Q
2
This a function in one unknown (Q) that we
wish to minimize

SOLVING FOR Q*
TC(Q) = CO(D/Q) + Ch(Q/2) + CD
Ch Q
1
TC (Q ) Co DQ
CD
2
dTC
CO D Ch

00
2
dQ
Q
2

Solving ,
2CO D
2
Q
Ch
Q
*

2CO D
The EOQ Formula
Ch

THE REORDER POINT, r*

Since reordering is instantaneous, r* = 0
MODIFICATION -- fixed lead time = L yrs.
r* = LD
But demand was only approximately constant so we
may wish to carry some safety stock (SS) to lessen
the likelihood of running out of stock
Then, r* = LD + SS

TOTAL ANNUAL COST

The optimal policy is to order Q* when
supply reaches r*
TC(Q*) = COD/Q* + Ch (Q*/2) + CD + ChSS

Purchase Safety
Variable Costs TV(Q)
Stock
Costs
Costs

The optimal policy minimizes the total

variable cost, hence the total annual cost

TOTAL VARIABLE COST CURVE

Ignoring purchase costs and safety stock
costs:
The Total Variable Costs function

TV(Q)

Constructing the Total Annual Variable Cost

Add the two curves to one another
Total Annual
CHQ/2Holding
+ COD/Q and
Ordering
CostsCOSTS
TOTAL
VARIABLE

* *

o *

/2)
Q
(
CH
ding
l
o
H
Curve
ts
Cos

CO D/Q
Order
Costs
*
Q
Q*

Optimal Order Quantity occurs where

The optimal orderHolding

size Costs = Reorder Costs

EXAMPLE -- ALLEN
APPLIANCE COMPANY
Juicer Sales For Past 10 weeks
1. 105 6. 120
2. 115 7. 135
3. 125 8. 115
4. 120 9. 110
5. 125 10. 130
Using 10-period moving average method,
D = (105 + 115 + + 130)/10 = 120/ wk = 6240/yr

ALLEN APPLIANCE COSTS

Juicers cost $10 each and sell for $11.85

Cost of money = 10%
Other misc. inventory = 4%
Labor, postage, telephone/order = $8
Workers paid $12/hr.--20 min. to unload an order
Desires a safety stock = 13
EOQ Model
D = 6240
H = .10 + .04 = .14
CH = .14(10) = $1.40
CO = $8 + (1/3 hr.)*($12/hr.) = $8 + $4 = $12
SS = 13

OPTIMAL ORDER QUANTITY

FOR ALLEN

2CO D
2(12)(6240)
Q*

327.065
Ch
1.40
Round to Q * 327

OPTIMAL QUANTITIES
Total Order Cost = CO(D/Q*) = (12)(6240)/327 =
$228.99
Total Holding Cost = Ch(Q*/2) =
(1.40/2)(327) = $228.90
(Total Order Cost = Total Holding Cost -- except for
rounding error: actual Q* = 327.065)

# Orders Per Year = D/Q* = 6240/327 = 19.08

Time between orders (Cycle Time) =
Q*/D = 327/6240 = .0524 years = 2.72 weeks
r* = SS = 13

TOTAL ANNUAL COST

Total Variable Cost = Total Order Cost +
Total Holding Cost = $228.99 + $228.90 =
$457.89
Total Purchase Cost = CD = 10(6240) =
$62,400
Total Safety Stock Cost =ChSS =(1.40)(13) =
$18.20
Total Annual Cost = $457.89 + $62,400 + $18.20 =
$62,876.09

Using the Inventory Template

Input Parameters
Note: Ch is automatically
calculated

Optimal Quantities

WHY IS THE EOQ MODEL

IMPORTANT?
No real-life model really is an EOQ model
Many models are variants of EOQ-type models
Many situations can be approximated by EOQ
models
The EOQ model is relatively insensitive to some
pretty major errors in input parameters

INSENSIVITY IN EOQ MODELS

We cannot affect purchase costs and safety stock
cost, only variable costs: TV(Q) = COD/Q + Ch(Q/2)
Now, suppose D really = 7500 (>20% error)
We did not know this and got Q* = 327
TV(327) = ((12)(7500))/327 + (1.40/2)(327) = $504.13

Q* should have been: SQRT(2(12)(7500)/1.40) = 359

TV(359) = ((12)(7500))/359 + (1.40/2)(359) = $502.00

This is only a 0.4% increase in the TVCost

Review
Cost Components of Inventory Models
Holding, Order/Setup, Procurement, Shortage

Objective -- Minimize Total Annual Cost

Continuous Review/Infinite Time Horizon
Basic EOQ Assumptions
Basic EOQ Formula
Reorder Point and Safety Stock
Quantities of Interest
Use of Template
Importance of EOQ Models