INVENTORY AND ECONOMIC ORDER QUANTITY MODELS

Types of Demand
Retailers and distributors must manage independent demand items-that is, items for
which demand is influenced by market conditions and isnt related to the inventory
decisions for any other item held in stock. Independent demand inventory includes:
1.
2.
3.
4.

wholesale and retail merchandise

service industry inventory
end-item and replacement part distribution inventories
maintenance, repair and operating (MRO) supplies

Manufacturers and service providers must manage dependent demand items-that is,
items that are required as components or inputs to a product or service.
Accounting Categories of Inventory
Inventory exists in three aggregate categories, which are useful for accounting purposes.
Raw materials are inventories needed for the production of good or services. While they
have arrived from the supplier, no processing has yet been applied to them. Work-inprocess consists of components or sub assemblies used in the manufacture of final
products. WIP is also present in service industries. In both cases, one or more phases of
processing have been completed. Finished goods in manufacturing plants, warehouses,
and retail outlets are items sold to the firms customers.
Types of Inventory
Another way to look at inventory is to consider how or why it comes into being.
Cycle inventory. The portion of total inventory that varies directly with the lot size is
called cycle inventory. Determining how much to order and how often is called lot
sizing. The lot size and therefore the cycle inventory vary directly with the elapsed time
between orders. For example, if orders are placed every three weeks, the average lot size
must equal 3 weeks of demand and the average cycle inventory will be 1- weeks of
demand.
Safety stock inventory. To provide adequate customer service and avoid costs of
unavailable components, companies hold safety stock. Safety stock inventory protects
against uncertainties in demand, lead-time and supply. To create safety stock, a firm
places an order for an item earlier than when the items is expected to be needed.
Anticipation inventory. Inventory used to absorb uneven rates of demand or supply is
called anticipation inventory. It is often an attractive alternative to changing the size of
the workforce and the use of overtime. A common example is building an inventory for a
peak sales season.

Pipeline inventory. Inventory moving from point to point in the materials flow system is
called pipeline inventory. Pipeline inventory between two points is determined by the
corresponding lead-time.
Decoupling inventory. Inventory thats serves as a buffer between stages in a production
process that have significantly different operating characteristics (e.g., set up times, lot
sizes, run lengths, product flexibility, etc.). It also is used to buffer production from
distribution.
ABC Inventory Classification
Inventories are often classified in order to allocate the appropriate extent of management
review. A typical approach is the ABC classification.
Class A items typically represent 10% to 20% of the items types or stock keeping units
(SKU) and as much as 80% of the dollar value of the inventory. These items are
identified for top management attention.
Class B items typically represent about 30% of the items types or SKUs and 10% to
20% of the dollar value of the inventory. These items receive management attention by
exception and typically are handled by computer systems.
Class C items typically represent about 50% of the items types or SKUs and as little as
5% of the dollar value of the inventory. These items are handled by crude systems and
seldom receive management attention.
Inventory Placement
A critical decision in the design of supply chains is where to locate the inventories of
finished goods.
Backward placement refers to the strategy of placing inventory back in the supply
chain. The extreme case is to hold no finished goods inventory and to assemble to order
or build to order. Another somewhat less extreme case is to hold inventory in a single
centralized facility. Backwards placement provides the benefits of pooling which reduces
risk and the levels of safety stock required.
Forward placement is the opposite strategy of placing inventory backward in the supply
chain, i.e., nearer the customer. The advantages include faster response time to customers
and, sometimes, reduced transportation costs, both of which can lead to enhanced sales.
Inventory Review Systems
Inventory levels are reviewed or measured either continuously or periodically.

Continuous Review (Q) Systems, sometimes called reorder point (ROP) systems,
track the inventory level each time a withdrawal is made to determine if it is time to
reorder. Whenever the inventory level falls to or below a reorder point (R), an order for
a fixed quantity (Q) is made. Although the order size is fixed, the time between orders
(TBO) will change.
Periodic Review (P) Systems, review the inventory level at fixed periods (e.g., weekly,
monthly) in order to determine how large an order to place. An order is placed to take the
inventory position (on hand inventory + schedules receipts backorders) up to a
predetermined target level (T). Thus in a P system the TBO is constant but the order
quantity will change.
ECONOMIC ORDER QUANTITY
In a continuous review system, ordering too often (in quantities too small) increases the
annual cost of placing orders. Ordering too infrequently (in quantities too large)
increases the annual cost of holding inventory. The economic order quantity (EOQ) is
the quantity that minimizes the sum of these two costs. It is based on the following
assumptions:
1.
2.
3.
4.
5.
6.

The demand for the item is constant and known with certainty.
There are no upper or lower limits on the order quantity (lot size).
Stockouts are not permitted.
There are no quantity discounts.
Lead time and supply are known with certainty; lead time is constant.
Order quantities for individual items are made independently.

The classic saw tooth diagram of inventory level over time is illustrated in Figure 1.

Figure 1. Inventory levels over time.

If we define

C - total annual (period) cost

S - fixed cost of placing an order
D - annual (period) demand
H - annual (period) unit cost of holding inventory
Q order quantity (to be determined)
then

SD HQ

.
Q
2

The Figure 2 displays the cost relationships involved in the model:

Figure 2. Inventory cost versus order size Q.

The economic order quantity is calculated by
EOQ

2 SD
.
H

MINIMUM ORDER SIZES AND ORDER BLOCK SIZES

Dealing with minimum order sizes and order block sizes (a number which all order sizes
must be a multiple of) is quite easy. We Round EOQ to AOQ (allowable order quantity)
by choosing the multiple of the order block size that is closest to EOQ and at least equal
to minimum order size
QUANTITY DISCOUNTS
In many instances, a vendor offers an item at a unit price, which we will call the normal
cost and denote by Pn, but will make the item available at a reduced unit cost, which we

will call the discount cost and denote by Pd, as long as the order size is at least equal to
the discount volume (DV). In such a case we begin by calculating EOQ and rounding to
AOQ. The cost relationships for the quantity discount problem are illustrated in Figure 3.

Figure 3. Cost relationships for quantity discounts.

Therefore, we must compare the total cost per period for AOQ and DV and use
whichever produces the smaller cost. This total cost adds the purchase cost per period to
the order plus holding cost specified previously. Thus we calculate
(1)

Daily Cost at AOQ

SD
H * AOQ

D * Pn , IF AOQ DV
AOQ
2

OR

Daily Cost at AOQ

SD
H * AOQ

D * Pd , IF AOQ DV
AOQ
2

AND
( 2) Daily Cost at DV

SD
H * DV

D * Pd
DV
2

However, it can be noted that whenever AOQ DV, the cost comparison will always
select AOQ.

EXAMPLES

Suppose demand for final product is as follows:

F001: 98
F002: 244
F003: 198
Consider P037 Spokes 20
Order cost (S): $ 10
Normal Cost (Pn ): $ 0.050
Discount Volume (DV): 200,000
Order block: 2,000

Holding Cost Per Day (H): $0.00009

Discount Cost (Pd ): $ 0.045
Minimum Order: 20,000

Since there are 72 P037s in each F001 and 0 in each F002 and F003, we
estimate daily volume for P037 as
D = Daily Volume = 98(72)+244(0)+198(0) = 7056
Q

2SD

2(10)(7056)
39,598
.00009

Above minimum order so round to AOQ = 40,000

Since AOQ is below DV we calculate by (1) by using the first equation
DailyCost at AOQ

10(7,056) .00009(40,000)

7,056(.050) 1.76 1.80 352.80 356.36

40,000
2

and by (2)
Daily Cost at DV

10(7,056) .00009( 200,000)

7,056(.045) 0.35 9.00 317.52 326.87

200,000
2

Then since Daily Cost at DV < Daily Cost at AOQ order quantity is set to
discount volume = 200,000.
Order cycle = DV/ D = 200,000/(7,056) = 28.3 days
Consider P043 Steel Tubing
Order cost(S): $ 45
Normal Cost (Pn ): $ 0.20

Holding Cost Per Day(H): $0.00035

Discount Cost (Pd ): $ 0.18

Discount Volume (DV): 10,000

Order block: 1000

Minimum order: 5,000

Since there are 21 P043s in each F001, 23 in each F002 and 24 in each
F003, we estimate daily volume for P043 as
D = Daily Volume = 98 (21) + 244(23) + 198(24) = 12,422
Q

2 SD

2( 45)(12,422)
56,517,51
.00035

Above minimum order so round to 57,000

Since AOQ is above DV we calculate by (1) by using the second equation
Daily Cost at AOQ

45(12,422) .00035(57,000)

12,422(.18) 9.81 9.97 2,235.96 2,255.74

57,000
2

and by (2)
Daily Cost at DV

45(12,422) .00035(10,000)

12,422(.18) 55.90 1.75 2,235.96 2,293.61

10,000
2

Then since Daily Cost at AOQ < Daily Cost at DV order quantity is set to AOQ =
57,000. This could have been anticipated since AOQ > DV.
Order cycle =AOQ/D = 57,000/12,422 = 4.6 days