Optimize Inventory Costs with EOQ and EPQ Models

11-1
Inventory Management
Operations Management
William J. Stevenson
8th edition
11-2
Chapter Contents
1)
2)
3)
4)
5)
6)
7)
Introduction
Functions
Objectives
Requirements
of
effective
management
EOQ models: EOQ quantity model
Quantity discounts
When to reorder with EOQ ordering.
inventory
11-3
Inventory: a stock or store of goods
Dependent Demand
C(2)
B(4)
D(2)
Independent Demand
E(1)
D(3)
F(2)
Independent demand is uncertain.

Dependent demand is certain.
11-4
Types of Inventories
Raw materials & purchased parts
Partially completed goods called
work in progress
Finished-goods inventories
(manufacturing firms)
or merchandise
(retail stores)
11-5
Types of Inventories (Contd)
Replacement parts, tools, & supplies
Goods-in-transit to warehouses or customers
11-6
Q. Functions of Inventory
To meet anticipated demand
To smooth production requirements
To decouple operations
To protect against stock-outs
11-7
Functions of Inventory (Contd)
To take advantage of order cycles
To help hedge against price increases
To permit operations
To take advantage of quantity discounts
11-8
Q. Objectives of Inventory Control
To achieve satisfactory levels of customer

service while keeping inventory costs within
reasonable bounds
Level of customer service
Costs of ordering and carrying inventory
11-9
Q. Effective Inventory Management
A system to keep track of inventory
A reliable forecast of demand
Knowledge of lead times (time interval

between ordering and receiving the order)
Reasonable estimates of
Holding costs
Ordering costs
Shortage costs
A classification system
11-10 Inventory Management
Key Inventory Terms

Lead time: time interval between ordering
and receiving the order
Holding (carrying) costs: cost to carry an
item in inventory for a length of time,
usually a year
Ordering costs: costs of ordering and
receiving inventory
Shortage costs: costs when demand exceeds
supply
Q. Economic Order Quantity Models
Economic order quantity model
Economic production model
Quantity discount model
Assumptions of EOQ Model

a)
Only one product is involved
b)
Annual demand requirements known
c)
Demand is even throughout the year
d)
Lead time does not vary
e)
Each order is received in a single delivery
f)
There are no quantity discounts
The Inventory Cycle

Figure 11.2
Profile of Inventory Level Over Time
Q
Quantity
on hand
Usage
rate
Reorder
point
Receive
order
Place Receive
order order
Lead time
Place Receive
order order
Time
Total Cost
Annual
Annual
Total cost = carrying + ordering
cost
cost
TC =
Q
H
2
DS
Q
Cost Minimization Goal

Figure 11.4C
Annual Cost
The Total-Cost Curve is U-Shaped

TC
D
H S
Q
Ordering Costs
QO (optimal order quantity)
Order Quantity
(Q)
Deriving the EOQ

Using calculus, we take the derivative of the
total cost function and set the derivative
(slope) equal to zero and solve for Q.
Q OPT =
2DS
=
H
2(Annual Demand )(Order or Setup Cost )

Annual Holding Cost
Minimum Total Cost

The total cost curve reaches its minimum
where the carrying and ordering costs are
equal.
Q OPT =
2DS
=
H
2(Annual Demand )(Order or Setup Cost )

Annual Holding Cost
Economic Production Quantity (EPQ)

Production done in batches or lots
Capacity to produce a part exceeds the parts
usage or demand rate
Assumptions of EPQ are similar to EOQ
except orders are received incrementally
during production
Problem 01
A local distributor for a national tire company expects to
sell approximately 9600 steel- belted radial tires of a
certain size and tread design next year. Annual carrying
cost is &16 per tire and ordering cost is $75. The
distributor operates 288 days a year.
1) What is EOQ?
2) How many times per year does the store reorder?
3) What is the length of an order cycle?
4) What is the total annual cost if the EOQ quantity is
ordered?
Solution-01
D= 9600 tires per year

H = $ 16 per unit per year
S= $ 75
1)
Q OPT =
=
2DS
=
H
2(Annual Demand)(Or der or Setup Cost)

Annual Holding Cost
2(9600)(75 )
= 300 tires
16
2) Number of order per year= D/Qo=9600/300=32

3) Length of order cycle= Qo/D =300 tires/9600tires, yr
4) Total cost ,TC = Carrying cost + Ordering cos
=(Qo/2)H+(D/Qo)S
=(300/2)16+(9600/300)75
=$2400+$2400
=$4800
Problem 02
Piddling Manufacturing assembles security
monitors. It purchases 3600 black and white
cathode ray tubes a year at $65 each. Ordering
costs are $ 31, and annual carrying costs are 20
percent of the purchase price .
Compute the optimal quantity and the total annual
cost of ordering and carrying the inventory.
Solution-02
D= 3600 cathode ray tubes per year

S =$31
H =.20($65)=$13
Q OPT =
=
2DS
=
H

Annual Holding Cost
2(3600)(31 )
= 131 cathode ray tube
13
Total cost ,TC = Carrying cost + Ordering cost

=(Qo/2)H+(D/Qo)S
=(131/2)13+(3600/131)31
=$852+$852
=$1704
Problem-3
A museum of natural history opened a gift shop two years ago. One
of the top selling items at the museums gift shop is a bird feeder.
Sales are 18 units per week and supplier charges $60 per unit. The
cost of placing an order with the supplier is $45. Annual holding
cost is 25% of a feeders value and the museum operates 52 weeks
per year. Management chooses a 390 unit lot size so that new orders
could be placed less frequently.
a. What is the annual cost of the current policy of using a 390 unit
lot size?
b. Would a lot size of 468 be better?
c. What is the EOQ?
Economic Production Quantity Assumptions

Only one item is involved
Annual demand is known
Usage rate is constant
Usage occurs continually
Production rate is constant
Lead time does not vary
No quantity discounts
Problem-04
A toy manufacturer uses 48000 rubber wheels per year for
its poplar dump truck series the firm makes its own
wheels, which it can produce at a rate of 800 per day. The
toy trucks are assembled uniformly over the entire year.
Carrying cost is $1 per wheel a year. Setup cost for a
production run of wheels is $45. the firm operates 240
days per year . Determine the
a) Optimal run size or Economic Run size
b) Minimum total annual cost for carrying and setup
c) Cycle time for the optimal run size
d) Run time
Solution-04
D( annual demand)=48000 wheels per year

S( holding cost)= $45
H( carrying cost) =$1 per wheel per year
P( Production rate) = 800 wheels per day
u( usage rate) = 48000 wheels per 240 days or 200 wheels
per day
Imax= Maximum inventory.
a)
Q0
2 DS
H
pu
2 ( 48000 )( 45 )
*
1
800
800 200
2400
Solution-04
b) TC
min=Carrying
={Imax
cost + setup cost

/2}H+(D/Qo)S
Imax ={Qo/p}(p-u)=(2400/800)(800-200)
=1800 wheels
TC
min={Imax
/2}H+(D/Qo)S
=(1800/2)$1+(48000/2400)($45)
=1800
Solution-04..
c) Cycle time = Qo/u
= 2400 wheels /200 wheels per day
=12 days (a run of wheels will be
made every 12 days)
d) Run time = Qo/p

= 2400 wheels / 800 wheels per day
=3 days ( each run will require three
days to complete)
Total Costs with Purchasing Cost

Annual
Annual
Purchasing
+
TC = carrying + ordering cost
cost
cost
Q
H
TC =
2
D S(O) +
Q
PD
Total Costs with PD

Cost
Figure 11.7
Adding Purchasing cost
doesnt change EOQ
TC with PD
TC without PD
PD
EOQ
Quantity
Total Cost with Constant Carrying Costs

Figure 11.9
Total Cost
TCa
TCb
Decreasing
Price
TCc
CC a,b,c
OC
EOQ
Quantity
Problem-o5
A small manufacturing firm uses roughly 3400 pounds of

chemical dye a year. Currently the firm purchases 300
pounds per order and pays $3 per pound. The supplier has
just an announced that orders of 1000 pounds or more will
be filled at a price of $ 2 per pound. The manufacturing
firm incurs a cost of $100 cash time it submits an order
and assigns an annual holding cost of 17 percent of the
purchase price per pound.
A) determine the order size that will minimize the total
cost.
B) if the supplier offered the discount at 1500 pounds
instead of 1000 pounds what order size would minimize
total cost?
Solusion-05
D= 3400 pounds per year
S = $100
H= .17p
A) compute the EOQ for $2 per pound
the quality range are
Range
unit price
1to 999
$3
1000+
$2
Q$2 pounds
=
2DS
=
H

Annual Holding Cost
2(3400)(10 0)
= 1414 pounds
.17(2)
Because this quantity is feasible at $2 per pound it is the optimum
Solusion-05..
B) When the discount is offered at 1500 pounds the
EOQ for the $2 per pound range is no longer
feasible . Consequently it becomes necessary to
compute the EOQ for $3 per pound and compare
the total cost for that order size with the total cost
using the price break quantity (i.e1500)
Q$3 pounds
=
2DS
=
H

Annual Holding Cost
2(3400)(10 0)
= 1155 pounds
.17(3)
Solusion-05..
Annual
Annual
Purchasing
+
TC = carrying + ordering cost
cost
cost
Q
DS
+
+ PD
H
TC1155 =
2
Q
=1155(.17)(3)/2+3400(100)/1155+3(3400)
=$10789
Q
D S(O) + PD
+
H
TC1500 =
2
Q
=1500(.17)(2)/2+3400(100)/1500+2(3400)
=$7282( It is lowest total cost )
1500 is the optimal order size
Q. When to Reorder with EOQ Ordering
Reorder Point - When the quantity on hand

of an item drops to this amount, the item is
reordered
Safety Stock - Stock that is held in excess of

expected demand due to variable demand
rate and/or lead time.
Service Level - Probability that demand will

not exceed supply during lead time.
Determinants of the Reorder Point

The rate of demand
The lead time
Demand and/or lead time variability
Stockout risk (safety stock)
Safety Stock
Quantity
Figure 11.12
Maximum probable demand

during lead time
Expected demand
during lead time
ROP
Safety stock reduces risk of
stockout during lead time
Safety stock
LT
Time
Reorder Point
Figure 11.13
The ROP based on a normal
Distribution of lead time demand
Service level
Risk of
a stockout
Probability of
no stockout
Expected
demand
0
ROP
Quantity
Safety
stock
z
z-scale
Thanks
For
Attending this session

Optimize Inventory Costs with EOQ and EPQ Models

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11-1

Inventory: a stock or store of goods

Independent demand is uncertain.

Types of Inventories (Contd)

Replacement parts, tools, & supplies

Goods-in-transit to warehouses or customers

To meet anticipated demand

To smooth production requirements

To protect against stock-outs

Functions of Inventory (Contd)

To take advantage of order cycles

To help hedge against price increases

To take advantage of quantity discounts

Q. Objectives of Inventory Control

To achieve satisfactory levels of customer

Level of customer service

Costs of ordering and carrying inventory

Q. Effective Inventory Management

A system to keep track of inventory

A reliable forecast of demand

Knowledge of lead times (time interval

11-10 Inventory Management

Key Inventory Terms

11-11 Inventory Management

Q. Economic Order Quantity Models

Economic order quantity model

Economic production model

Quantity discount model

11-12 Inventory Management

Assumptions of EOQ Model

Only one product is involved

Annual demand requirements known

Demand is even throughout the year

Lead time does not vary

Each order is received in a single delivery

There are no quantity discounts

11-13 Inventory Management

The Inventory Cycle

11-14 Inventory Management

11-15 Inventory Management

Cost Minimization Goal

The Total-Cost Curve is U-Shaped

11-16 Inventory Management

Deriving the EOQ

2(Annual Demand )(Order or Setup Cost )

11-17 Inventory Management

Minimum Total Cost

2(Annual Demand )(Order or Setup Cost )

11-18 Inventory Management

Economic Production Quantity (EPQ)

11-19 Inventory Management

11-20 Inventory Management

D= 9600 tires per year

2(Annual Demand)(Or der or Setup Cost)

2) Number of order per year= D/Qo=9600/300=32

11-21 Inventory Management

11-22 Inventory Management

D= 3600 cathode ray tubes per year

2(Annual Demand)(Or der or Setup Cost)

Total cost ,TC = Carrying cost + Ordering cost

11-23 Inventory Management

11-24 Inventory Management

Economic Production Quantity Assumptions