Economic Production Quantity

(EPQ)
Production done in batches or lots
production capacity > usage or demand rate
for a part for the part
1
Assumptions of EPQ
similar to EOQ
except orders are received
incrementally during production
Economic Production Quantity
(EPQ)
2
Economic Production Quantity
(EPQ)
3
( ) d p
p
Q
I
p
Q
d
Q
S
Q
D
H
I
= = =
|
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.
|

\
|
+
|
.
|

\
|
=
|
|
|
.
|

\
|
+
|
|
|
.
|

\
|
=
max
max
; length Run ; length Cycle
2
Cost
Setup
Annual
Cost
Holding
Annual
TC
|
|
.
|

\
|

=
d p
p
H
DS
Q
2
0
TC = Total annual cost
Q = Order quantity (units)
H = Annual holding cost
per unit
D = Annual Demand
S = Ordering (or setup)
cost per order
Q
0
= Optimal run or order quantity
p = Production rate
d = Usage or demand rate
I
max
= Maximum inventory level
EPQ Example
Holdit Inc. produces reusable shopping bags. Demand is 20,000 bags per
day, 5 days per week, 50 weeks per year. Production is 50,000 per day. The
setup cost is $200 and the annual holding cost rate is $.55 per bag.
Calculate the EPQ, the total cost, the cycle length and optimal production
run length.
4
H = $0.55 per bag S = $200 D = 20,000 bags x 50 wks x 5 days
d = 20,000 bags per day p = 50,000 bags per day
|
|
.
|

\
|

=
d p
p
H
DS
Q
2
0
850 , 77
20 50
50
55 .
) 200 )( 000 , 000 , 5 ( 2
0
=
|
.
|

\
|

=
G G
G
Q
EPQ Example
5
H = $0.55 per bag d = 20,000 bags per day p = 50,000 bags per day
S = $200 D = 20,000 bags x 50 wks x 5 days
( ) d p
p
Q
I S
Q
D
H
I
=
|
|
.
|

\
|
+
|
.
|

\
|
=
max
max

2
TC
( ) bags 46,710 30000
000 , 50
850 , 77
max
= = I
$25,690 00 2
850 , 77
5
) 55 (.
2
710 , 46
TC = |
.
|

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+
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.
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=
million
Holdit Inc. produces reusable shopping bags. Demand is 20,000 bags per
day, 5 days per wk, 50 wks per yr. Production is 50,000 per day. Setup cost
is $200 and annual holding cost rate is $.55 per bag. Calculate total cost.
EPQ Example
Holdit Inc. produces reusable shopping bags. Demand is 20,000 bags per
day, 5 days per week, 50 weeks per year. Production is 50,000 per
day. The setup cost is $200 and the annual holding cost rate is $.55 per
bag. Calculate cycle length and optimal production run length.
6
H = $0.55 per bag S = $200 D = 20,000 bags x 50 wks x 5 days
d = 20,000 bags per day p = 50,000 bags per day
p
Q
d
Q
= = length Run ; length Cycle
days 3.89 every
000 , 20
850 , 77
length Cycle = =
order per days 56 . 1
000 , 50
850 , 77
length Run = =
EOQ with Quantity Discounts
Price reductions are often offered as incentive to buy
larger quantities
Weigh benefits of reduced purchase price against
increased holding cost

R = per unit price of the item
D = annual demand
Annual
holding
cost
Purchasing
cost
TC = +
Q
2
H
D
Q
S
TC =
+
+
Annual
ordering
cost
RD +
Total Cost with Purchase
Cost

8
C
o
s
t

EOQ
TC with PD
TC without PD
PD
0
Quantity
Adding Purchasing cost
doesnt change EOQ
Total Cost with Quantity
Discounts
9
Best Purchase Quantity
Procedure
begin with the
lowest unit price
compute the EOQ for each
price range
stop when find a
feasible EOQ
Is EOQ for the
lowest unit price feasible?
Yes:
it is the optimal order
quantity
No:
compare total cost at all
break quantities larger
than feasible EOQ
10
The quantity that yields the
lowest total cost is optimum

Carrying Cost are Constant

There will be a single minimum point.
All curves will have their minimum point
at the same quantity.

1. Compute the minimum point.
2. Only one of the unit prices will have
the minimum point in its feasible range
since ranges do not overlap. Identify
the range.
a) If the feasible minimum point is on the lowest
price range, that is the optimal order quantity
b) If on any other range, compute the total cost
for the minimum point and for the price
breaks of all lower unit costs.
Example: Fixed Carrying Cost
The maintenance department of a large hospital uses
about 816 cases of liquid cleanser annually.
Ordering costs are $12, carrying costs are $4 per
case a year, and the new price schedule indicates
that orders of less than 50 cases will cost $20 per
case, 50 to 79 case will cost $18 per case, 80 to 99
cases will cost $17 per case, and larger orders will
cost $16 per case. Determine the optimal order
quantity and the total cost.
Order Quantity(units) Price/unit($)
0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
D = 816 S = $12 H = $4 case per year
1. Compute the common minimum


cases 70 69.97 =
4
2(816)(12)
=
H
2DS
= Q
O
~
2.
TC (70) = (70/2)4 + (816/70)12 + 18(816) = $14 968
Since there are lower cost ranges, each must be checked against
the minimum cost generated by 70 cases at $18.

TC (80) = (80/2)4 + (816/80)12 + 17(816) = $14 154


TC (100) = (100/2)4 + (816/100)2 + 16(816) = $13 354
Example: Quantity Discounts
Below is a quantity discount schedule for an item with
an annual demand of 10,000 units that a company
orders regularly at an ordering cost of $4. The
annual holding cost is 2% of the purchase price per
year. Determine the optimal order quantity.
17
Order Quantity(units) Price/unit($)
0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
D = 10,000 units S = $4
units 2,000 =
0.02(1.00)
4) 2(10,000)(
=
H
2DS
= Q
O
units 2,020 =
0.02(0.98)
4) 2(10,000)(
=
H
2DS
= Q
O
H = .02R R = $1.20, 1.00, 0.98
Interval from 0 to 2499,
the Q
o
value is feasible
Interval from 2500-3999,
Q
o
value is NOT feasible
Interval from 4000 & up,
Q
o
value is NOT feasible
Example: Quantity Discounts
18
Order Quantity Price/unit($)
0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
units 1,826 =
0.02(1.20)
4) 2(10,000)(
=
H
2DS
= Q
O
Quantity Discount Models

19
2500
4000
A
n
n
u
a
l

c
o
s
t


0
Quantity
EOQs (not feasible)
1
st
break
quantity
2
nd
break
quantity
1
st
range
total cost
curve
2
nd
range total cost curve
3
rd
range total cost curve
EOQ
TC(0-2499) = (1826/2)(0.02*1.20) + (10000/1826)*4+(10000*1.20)
= $12,043.82

TC(2500-3999)= $10,041

TC(4000&more)= $9,949.20
Therefore the optimal order quantity is 4000 units
Example: Quantity Discounts
20
Q
2
H
D
Q
S
TC =
+ RD
+
Concept Check
Which of the following is FALSE about EOQ?

A. It determines how many to order.
B. The EOQ always results in the lowest total
cost.
C. The model minimizes total cost by
balancing carrying and order costs.
D. The model is robust and works even if all
assumptions are not exact.


21
Concept Check
Which is NOT a difference between EOQ and
EPQ?

A. A different formula is used.
B. EPQ is used mainly for producing batches,
and EOQ is for receiving orders.
C. Quantity is received gradually in EPQ.
D. Demand can be variable for EPQ but not for
EOQ.


22
Concept Check
Which is NOT an assumption of both EOQ and EPQ?

A. Demand is known with certainty
and is constant over time
B. No shortages are allowed
C. Order quantity is received all at once
D. Lead time for the receipt of orders is constant

23
Whats next?
EOQ models give HOW MANY to order
Now look at WHEN to order
Reorder Point (ROP)
24
d = Demand rate (units per day or week)
LT = Lead time (in days or weeks)
Note: Demand and lead time must have the same time units.
ROP = d LT
Example: ROP
Annual Demand = 1,000 units
Days per year = 365
Lead time = 7 days

25
units/day 2.74 =
days/year 365
units/year 1,000
= d
units 20 or 19.18 = (7days) units/day 2.74 = L = ROP d
When inventory level reaches 20 units, place the next order.
Fixed Order Quantity/Reorder Point
Model
Safety Stock
1. Variability of
demand and lead time
2. Service Level
2a. Lead time
service level
2b. Annual
service level
26
Reorder Point = Expected demand + Safety Stock
(ROP) during lead time
When to Reorder with EOQ
Ordering
Reorder Point When inventory level drops to this
amount, the item is reordered.

Safety Stock - Stock that is held in excess of expected
demand due to variability of demand and/or lead time.

Service Level Probability demand will not exceed supply.
Lead time service level: probability that demand will not exceed
supply during lead time.
Annual service level: percentage of annual demand filled.
27
Determinants of the Reorder
Point
Rate of
demand
Lead time
Demand
and/or lead
time variability
Stockout risk
(safety stock)
28
ROP Expected demand
Safety stock
during lead time
=
+
Safety Stock
29
LT
Time
Expected demand
during lead time
Maximum probable demand
during lead time
ROP
Q
u
a
n
t
i
t
y

Safety stock
Safety stock reduces risk of
stockout during lead time
Reorder Point
30
z = Safety factor; number of standard deviations above expected demand
o
dLT
= The standard deviation of demand during lead time
Safety Stock = z.o
dLT

The ROP based on a normal
Distribution of lead time demand
Demand During Lead Time
31
ROP with Lead Time Service
Level
variable demand during a lead time
32
ROP = expected demand during lead time + safety stock
z = Safety factor; number of standard deviations above expected demand
o
dLT
= The standard deviation of demand during lead time

ROP = + z.o
dLT

ROP with Lead Time Service
Level
variable demand and constant lead time
33
ROP =
(average demand x lead time) + z x st. dev. of demand during lead time
(demand and lead time measures in same time units)
o
d
= standard deviation of demand per day
o
dLT
= o
d
LT
ROP with Lead Time Service
Level
both demand and lead time are variable
34
ROP =
(avg. demand x avg. lead time) + z x st. dev. of demand in lead time
(demand and lead time measures in same time units)
o
d
= standard deviation of demand per day
o
LT
= standard deviation of lead time
o
dLT
= (average lead time x o
d
2
)
+ (average daily demand)
2
o
LT
2


Example 1: ROP with Lead Time Service
Level
Calculate the ROP required to achieve a 95% service level
for a product with average demand of 350 units per week and
a standard deviation of demand during lead time of 10. Lead
time averages one week.

35
From Table 12-3 (p434), z for 95% = 1.65
ROP = 350 + Zo
dLT

= 350 + 1.65 (10)
= 350 + 16.5 = 366.5 367
A new order should be placed when
inventory level reaches 367 units.
Example 2: ROP with Lead Time Service
Level
Calculate the ROP and amount of safety stock required to
achieve a 90% service level for a product with variable
demand that averages 15 units per day with a standard
deviation of 5. Lead time is consistently 2 days.

36
From Table 12-3 (p434), z for 90% = 1.28
ROP = (15 units x 2 days) + Zo
dLT

= 30 + 1.28 ( 2) (5)
= 30 + 8.96 = 38.96 39
Safety stock is about 9 units and
a new order should be placed when
inventory level reaches 39 units.
Example 3: ROP with Lead Time Service
Level
Calculate the ROP for a product that has an average demand of
150 units per day and a standard deviation of 16. Lead time
averages 5 days, with a standard deviation of 2. The company
wants no more than 5% stockouts.
37
service level = 1 5% = 95%
From Table 12-3 (p434), z for 95% = 1.65
Place a new order when inventory level reaches 1004 units
ROP = (150 units x 5 days) + 1.65o
dlt

= (150 x 5) + 1.65 (5 days x 16
2
) + (150
2
x 1
2
)
= 750 + 1.65 (154) = 1,004 units
ROP Using Annual Service
Level
1. Calculate


2. Use a table to find the z value associated with E(z)
3. Use the z value in the appropriate ROP formula,

38
dLT
annual
SL Q
z E
o
) 1 (
) (

=
dLT
z ROP o + = time lead during demand expected
SL
annual
= annual service level
E(z) = standardized expected number of units short during an order cycle.
Min/Max model
similar to fixed order-quantity/reorder point
(ROP) model
difference:
if at order time, Q on hand < min (ROP),
then order quantity = max Q on hand
(max ~ EOQ + ROP)
39
Inventory Models
EOQ/ROP model
Order size constant, time between orders changes

Fixed Order Interval/Order up to Level Model
orders placed at fixed time intervals
determine how much to order to bring inventory level up
to a predetermined point (order up to level)
used widely for retail
consider expected demand during lead time, safety
stock, and amount on hand
demand or lead time can be variable
40
Comparing Inventory Models
41
EOQ/ROP
Fixed
Interval/
Order up to
Disadvantages
requires a larger safety stock
increases carrying cost
costs of periodic reviews

Fixed Order Interval: Benefits and
Disadvantages
Benefits
grouping items from same supplier
can reduce ordering/shipping costs
practical when inventories
cannot be closely monitored
42
Fixed Order Interval/Order up to Level Model
Determining the order interval
43
OI = order interval (in fraction of a year)
S = fixed ordering cost per purchase order
s = variable ordering cost per SKU included in the order (line item)
(assume s is the same for every SKU)
n = n number of SKUs purchased from the supplier
Rj = unit cost of SKUj , j = 1, , n
i = annual holding cost rate
Dj = annual demand of SKUj , j = 1, ., n
Total Annual Inventory Cost:
TC =

Optimal Order Interval:
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+ +
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|

\
|

OI
ns S i R
OI D
j
j
1
) ( .
2
.

+
=
j j
R D i
ns S
OI
) ( 2
*
Fixed Order Interval/Order up to Level Model
Determining the Order up to Level
44
( ) LT OI z LT OI d
d
+ + + =
=
|
|
.
|

\
|
+
|
|
|
.
|

\
|
=
=
o
Stock
Safety
interval
protection during
demand Expected
I
hand on Amount I Q
max
max
= Average daily or weekly or monthly demand
OI = Order interval (length of time between orders
LT = Lead time in days or weeks or months
z = Safety factor; # of standard deviations above expected demand
o
d
= Standard deviation of daily or weekly or monthly demand
= 20 (30 + 10) + (2.32) (4) 30 + 10
= 800 + 2.32 (25.298)
= 858.7 or 859 units stock up to level
Example: Fixed Order Interval
Model
Average daily demand for a product is 20 units, with a standard
deviation of 4 units. The order interval is 30 days, and lead time is 10
days. Desired service level is 99%. If there are currently 200 units on
hand, how many should be ordered?
45
( ) LT OI z LT OI d
d
+ + + = o
max
I
max
I
Amount to order = 859 200 = 659 units
Coordinated Periodic Review
Model
determines an order interval (OI) and order up to
level for reviewing every stock keeping unit (SKU)
calculate a multiple (m
i
) of OI for each SKU
i

use this to determine the optimal OI for each SKU
i

46
To use:
Compare on hand inventory of each SKU to its ROP
(forecast demand for next OI + lead time + safety stock)
if on hand is less: order a quantity that brings the on
hand level to SKUs order up-to level
the order up-to level is enough for the next OI + LT.
Single Period Model
Single period model
model for ordering of perishables and other items with
limited useful lives
Shortage cost C
s

generally the unrealized profits per unit
Revenue per unit Cost per unit
Excess cost C
e

cost per unit - salvage per unit
for items left over at the end of a period
47
GOAL = find order quantity (stock level) that
minimizes total excess and shortage costs.
Single Period Model
Continuous stocking levels
Identifies optimal stocking levels
Optimal stocking level balances unit
shortage and excess cost

Discrete stocking levels
Desired service level is equaled or
exceeded
Compare service level to cumulative probability of
demand
48
Optimal Stocking Level
49
Service Level
So
Quantity
Ce Cs
Balance point
Service level (SL) =
Cs
Cs + Ce
Cs = Shortage cost per unit
Ce = Excess cost per unit
So = Optimum stocking level (i.e., order quantity
Example 1: Single Period
Model
Ce = $0.20 per unit
Cs = $0.60 per unit
Service level = Cs/(Cs+Ce) = .6/(.6+.2)
Service level = .75
50
Service Level = 75%
Quantity
Ce Cs
Stockout risk = 1.00 0.75 = 0.25
Example 2: Single Period
Model

The Poisson table (App. B, Table C) C
s
is unknown C
e
= $500
provides these values for a mean of 2.0:
Number of Failures
Cumulative Probability
0 .135
1 .406
2 .677
3 .857
4 .947
5 .983
51
s
.406, so .406($500 )
$500
s
s
s
C
C C
C
= = +
+
Optimum stock
level = 2, then
SL between
C
s
= $343.17
The range of shortage cost
is $343.17 to $1,047.99.
.677, so .677($500 )
$500
s
s s
s
C
C C
C
= = +
+
C
s
= $1,047.99.
A company usually carries 2 units of a spare part that costs $500 and has
no salvage value. Part failures can be modeled by a Poisson distribution
with a mean of 2 failures during the useful life of the equipment. Estimate
the range of shortage cost for which stocking 2 units of this spare part is
optimal.
Review: Inventory Models
EOQ models used to determine order size
Simple model for many types of inventory
Trade-off between carrying and ordering costs
Quantity discount model adds purchasing costs
and compares total cost for various order sizes
(that is still a feasible EOQ)

EPQ models used to determine production
lot size
Used when producing and depleting items at
same time
Trade-off between carrying and setup costs
Consider production and usage rate

52
Review: Inventory Models
ROP (reorder point)
Determines at what quantity (when) to re-order
Consider expected demand during lead time and safety stock
Trade-off cost of carrying safety stock & risk of stockout
Fixed Order Interval Model
Used when orders placed at fixed time intervals determine
how much to order
Used widely for retail
Consider expected demand during lead time, safety stock,
and amount on hand
Demand or lead time can be variable
Need more safety stock, but not continuous monitoring
Single-Period Model
Determines at what quantity (when) to re-order
Used when cant carry goods to next period (e.g.. perishables)
Trade-off cost of shortages & of excess (wasted) inventory



53
Define the term inventory and list the major reasons
for holding inventories.
Discuss the objectives of inventory management.
List the main requirements for effective inventory
management.
Describe the A-B-C approach and perform it.
Describe Basic Inventory Control Systems
Be able to describe and solve problems using:
EOQ, EPQ, ROP,
Fixed Order Interval Model, Single Period Model.
54