Inventory Control and MRP: Economic Order Quantity (Eoq)

SCI3133
Inventory Control and MRP
Lecture 3: ECONOMIC ORDER QUANTITY (EOQ)
SCI3133 Inventory Control and MRP
Prof. Mohammad Ishak Desa FSKSM, UTM
Page 1
LEARNING OUTCOMES
1. 2. 3. 4. Discuss the reasoning behind EOQ Derive the EOQ model Calculate EOQ for an item Calculate the reorder level
Page 2
Introduction
An inventory problem exist when it is necessary to stock physical items to satisfy future demands.
Typical decision of every inventory problem (in order to avoid over or under stocking) How much to order? When to Order?
The above two questions are normally answered (determined) through inventory modeling (eg minimizing the Total Inventory Costs (TC)): TC = (Purchasing Cost) + (Setup Cost) + (Holding Cost) + (Shortage Cost)
Page 3
Purpose of Inventory Modeling

Annual cost ($) Slope = 0 Minimum total cost Total Cost
Holding Cost
Purchasing Cost Setup Cost Shortage Cost Optimal order Qopt

SCI3133 Inventory Control and MRP Prof. Mohammad Ishak Desa FSKSM, UTM
Order Quantity, Q
Page 4
Dimensions of Inventory Modeling

DEMAND:
Constant vs Variable (Static vs Dynamic) Known vs Random (Deterministic vs Probabilistic) Stationary vs Nonstationary (in the case of Probabilistic) Continuous vs Discrete
LEAD TIME:
Instantaneous Constant or Variable
REVIEW TIME:
Continuous vs Periodic
SCI3133 Inventory Control and MRP Prof. Mohammad Ishak Desa FSKSM, UTM Page 5
Dimensions of Inventory Modeling

DISCOUNTS:
None All Units or Incremental
PLANNING HORIZON:
Single Time Period Finite Time Period Infinite Time
Page 6
BASIC EOQ MODEL
1. 2.
ASSUMPTIONS
Demand is known, constant and continuous. Lead time (the time between the placement and receipt of an order) is zero.
3.
Receipt of inventory is instantaneous (inventory from an order arrives in one batch, at one point in time)
4. 5.
Purchase cost is constant; no quantity discounts. The only variable costs: set-up or placing an order (ordering cost) and holding or storing inventory over time (holding or carrying cost).
6.
No shortage/stockout
Prof. Mohammad Ishak Desa FSKSM, UTM Page 7
Inventory Order Cycle (EOQ Model)

Order quantity, Q Inventory Level
Demand rate (D)
Reorder point, R
Lead time Order Order placed receipt
Lead time Order Order placed receipt
Time
Page 8
Variables
Q T D UC RC HC : : : : : : Quantity Ordered (Order Quantity) Cycle Time (time between two consecutive replenishments - Period) Demand (numbers of units to be supplied from stock in a given time period) Unit Cost (the price for one unit item) Reorder Cost (Ordering cost or Setup Cost the cost of placing a routine order) Holding Cost (cost of holding one unit item in stock for one period time)
Page 9
DERIVATION EOQ MODEL
Find the total cost of one cycle Divide the total cost by the cycle length Minimize this cost per unit time.
Page 10
BASIC EOQ MODEL (TC FUNCTION)

Total Inventory Cost Per Cycle Unit + Cost Per Cycle Holding Ordering + Cost Cost Per Cycle Per Cycle
TC per cycle TC per unit time

Given Q = D x T
= = =
UC x Q + RC + HC x Q/2 x T (UC x Q)/T + RC/T + HC x Q/2 UC x D + RC x D + HC x Q Q 2

TC per unit time
BASIC EOQ MODEL
TC = UC x D + RC x D + HC x Q Q 2
d(TC) = - RC x D + dQ Q2 HC 2
2 x RC x D HC
Optimal EOQ, Qo =
Page 12
BASIC EOQ MODELS

Optimal Cycle Length, To = Qo/D Optimal Variable Cost Per Unit Time, VCo = HC x Qo Optimal Cost Per Unit Time, TCo = UC x D + VCo
Page 13
BASIC EOQ MODELS Example 1
Demand for an item is constant at 1,000 units a year. Unit cost is $50, reorder cost is $100, holding cost is 25 per cent of value a year and no shortages are allowed. Determine an optimal inventory policy for the item.
Page 14

Listing the variable given in consistent units: D = 1,000 units a year UC = $50 a unit RC = $100 an order HC = 0.25 50 = 12.50 a unit a year Optimal order quantity: Qo = (2 RC D/HC) = (2 100 1,000/12.50) = 126.5 units Cycle length: To = Qo/D = 126.5/1,000 = 0.126 years or 6.6 weeks Variable cost: VCo = HC Qo = 12.50 126.5 = $1,581 a year Total cost: TCo = UC D + VCo = 50 1,000 + 1,581 = $51,581 a year
SCI3133 Inventory Control and MRP Prof. Mohammad Ishak Desa FSKSM, UTM Page 15
BASIC EOQ MODELS Exercise
X company buys 6,000 units of an item EvEry yEar with a unit cost of RM 30. It costs RM125 to process an order an arrange delivery, while interest and storage costs amount to Rm6 a year for each unit held. What is the best ordering policy for the item?
Page 16
Sensitivity Analysis
Change of variable cost moving away from the EOQ: VC ---VCo 1 --2 | Qo Q | | ---- + ---- | | Q Qo|
Page 17
Variable Cost Curve Around the EOQ
1.1 VCo 1.05 VCo VCo
Page 18

To keep variable costs within 10 per cent of the minimum, the order size must be between 0,64 and 1.56 times the EOQ, or between: 0.64 126.5 = 81 units and 1.56 125.5 = 197 units
For deliveries of 200 units the variable cost is
VC = RC DQ +HC Q2 =100 1,000200 + 12.50 200 2 = $1,750 a year TC = UC D + VC = 50 1,000 + 1,750 = $51,750 a year.
Page 19
Orders for Discrete Items

If the EOQ suggest an order for 5.5 computers, we must order either 5 or 6. For expensive item, which one is better, to round up or round down, ie Q which the first integer above the Qo, or Q-1 which is the integer below the Qo. Selection Procedure:
1. 2. 3. Calculate the EOQ, Qo Find the integers Q and Q-1 If Q x (Q-1) is less than or equal to Qo2, order Q. Else order Q-1.
Page 20
Uncertainty in Demand and Costs

In Basic EOQ model, demand and costs were known with certainty. Not likely true in practice
Suppose there is an error of E in forecasting the demand D. Then the actual D = D x (1+E).
The resulting error in the variable cost
VC ---VCo 1 --2 | 1 | ---- + | (1+E)1/2 (1+E)1/2 | ---| 1 |
Page 21
Uncertainty in Demand and Costs

Suppose there is an error of E1 in estimating the RC, and an error of E2 in HC . Then Qo = SQRT ((2 x RC (1 +E1) x D)/HC x (1 + E2)
The resulting error in the variable cost

VC ---VCo 1 --2 | (1+E1)1/2 (1+E2)1/2 | | ---+ ---| | (1+E2)1/2 (1+E1)1/2 |
Page 22
Lead Time - Causes

Def: Total time between placing order and receiving the order. The Lead Time occurs because of:
Time for order preparation Time to get the order to right place in suppliers Time at the supplier (process and prepare for deliveries) Time to get materials delivered from suppliers Time to process the delivery.
Ways to reduce Lead Time

E-business Mode of transportation Get near suppliers
Reorder Level for Basic EOQ Model

Because Demand and Lead Time are Constant, the Reorder Level (ROL) which indicate the time to place an order is given by, ROL = = Lead Time x Demand per Unit Time LT x D
The rule is to order a batch of size Qo whenever the stock level falls to LT x D.
Page 24
Longer Lead Times

Lead Time LT > Cycle Time T Eg: D = 100 units per week Qo = 250 units T= Qo/D = 2.5 weeks Suppose LT = 2 weeks, then ROL = 200 units
When LT =3, ROL = 300 units which is greater than the maximum stock level!. What to do?
Page 25
Longer Lead Times (cont.)

If Lead Time LT > Cycle Time T, there will be an outstanding order (or orders) when it is time to place an order. In this case, ROL = LT x D = Stock on Hand + Stock on Order. i.e the Actual ROL = LT x D Qo
In general when LT is between nT and (n+1)T, then

ROL = LT x D n x Qo
Page 26
Example 2
Demand for an item is constant at 40 units a week, and the optimal economic order quantity is calculated to be 100 units. What is the reorder level if lead time is constant at four weeks? What happens if the lead time (a) falls to two weeks; (b) rises to six weeks?
Page 27
Example 2
Qo = 100 units T= 100/40 = 2.5 weeks. LT = 4 weeks, (there will be one delivery outstanding when it is time to place another order). T < LT < 2T (i.e n=1) Then the reorder level is: LT D Qo = 4 40 100 = 160 100 units = 60 units
Example 2
If the LT falls to 2 weeks, there are no deliveries outstanding (n=0) when it is time to place another order, and the reorder level is: LT D = 2 40 = 80 units. If the LT rises to 6 weeks, there are two deliveries outstanding (n=2) when it is time to place another order, and the reorder level is: LT D 2 Qo = 6 40 2 100 = 40 units.
Summary
By making a series of assumptions we can describe a simple, or idealized, inventory system. Then we can build a model to relate the overall cost of this system to the four cost components and the order quantity. In particular, we can find the order quantity that minimizes the total cost per unit time. This order quantity, which is conventionally called the economic order quantity (EOQ). (EOQ), sets the overall features of the stocks, including length of the stock cycle, average stock level and costs.
Summary
In practice, these calculations are always done by computer and there is a wealth of software available. The use a spreadsheet is helpful. The analysis is based on a series of assumptions, but one of its strengths is that costs rise slowly around the economic order quantity. As a result, the EOQ gives good guidelines for the best order size in a variety of circumstances. It is easy to calculate the effects of moving away from the EOQ perhaps for convenience or discrete demand and to find the effects of errors and approximations in the calculations.
Summary
The lead time is the total time between ordering materials and having them delivered and available for use. We can use the lead time demand to define a reorder level which shows when to place an order.
Page 32

Inventory Control and MRP: Economic Order Quantity (Eoq)

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Inventory Control and MRP: Economic Order Quantity (Eoq)

Uploaded by

Copyright:

Available Formats

SCI3133

Inventory Control and MRP

Lecture 3: ECONOMIC ORDER QUANTITY (EOQ)

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

Purpose of Inventory Modeling

Purchasing Cost Setup Cost Shortage Cost Optimal order Qopt

Dimensions of Inventory Modeling

Dimensions of Inventory Modeling

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

BASIC EOQ MODEL

SCI3133 Inventory Control and MRP

Inventory Order Cycle (EOQ Model)

Demand rate (D)

Lead time Order Order placed receipt

Lead time Order Order placed receipt

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

DERIVATION EOQ MODEL

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

BASIC EOQ MODEL (TC FUNCTION)

TC per cycle TC per unit time

UC x Q + RC + HC x Q/2 x T (UC x Q)/T + RC/T + HC x Q/2 UC x D + RC x D + HC x Q Q 2

TC per unit time

SCI3133 Inventory Control and MRP

BASIC EOQ MODEL

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

BASIC EOQ MODELS

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

BASIC EOQ MODELS Example 1

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

BASIC EOQ MODELS Example 1

BASIC EOQ MODELS Exercise

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

Variable Cost Curve Around the EOQ

1.1 VCo 1.05 VCo VCo

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

BASIC EOQ MODELS Example 1

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

Orders for Discrete Items

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

Uncertainty in Demand and Costs

SCI3133 Inventory Control and MRP

Prof. Mohammad Ishak Desa FSKSM, UTM

Uncertainty in Demand and Costs