Inventory Models

Inventory is the stock of raw materials and goods required for production in a
factory or finished goods for sales. It is very useful to reduce the cost of transportation
and storage.
Objective: i) When should an order for materials be placed?
ii) How much to be produced during each period or how much to be ordered
each time ?

Costs Involved in Inventory Control

i) Holding Cost / Storage cost / Carrying cost (C 1): This is the cost associated
with holding (carrying) the inventory in the godown. It includes rent for
godown, interest for the money locked up, insurance premium, salaries for the
watchmen, deterioration (damage) cost etc.

a) Carrying cost = (Holding cost per unit for unit time) x (Average number of
units in stock)
b) Carrying cost = (Cost of storing stock of one rupee worth) x (Rupee value
of the units stored)

ii) Set-up Cost / Ordering cost (C s): Ordering cost is associated with the cost of
placing orders for procurement of materials or finished goods from suppliers.
It includes the cost of stationery, postage, telephones, travelling expenses,
handling of materials etc.
Ordering cost = (Cost per order or per set up) x (Number of orders or
Production runs)

iii) Production cost / Purchase cost: Production cost per unit item depends upon
the length of production runs. Purchase cost is less for orders of large quantity
due to quantity discounts or price breaks.

iv) Shortage cost / Stock out cost (C2): If the inventory on hand is not sufficient
to meet with the demand of materials or finished goods, then it results in
shortage of supply. There are two cases:
i) Orders are kept pending and as soon as stock is replenished back
orders are supplied
ii) Unfilled demand (order) results in lost sales and cancellation of order.

v) Total inventory cost(C):

C = ordering cost + Holding cost + Shortage cost.
If price discounts are available on purchase cost, then purchase cost is also to
be included in the total cost.
Characteristics of Inventory System

i) Demand: The nature of demand must be known for inventory control.

Demand may be deterministic or probabilistic.
In the deterministic case the quantity of material required over a period of
time is certain and known before hand. The demand may be uniform in many
cases.
In the probabilistic case the nature of demand is uncertain and is given by
some probability distribution.

ii) Order Cycle: The period of time between two consecutive placements of
orders.
iii) Lead time: When an order is placed, the supplier takes some time to supply
the item. Lead time is the time between the placement of an order and the
receipt of the material.
iv) Replenishment of stock: It may occur instantaneously without lead time or
uniform replenishment may occur when the goods are manufactured by the
factory itself.
v) Planning horizon (period): The duration of time over which a particular
inventory level will be maintained.

Deterministic Inventory Models with no shortage

Economic Lot Size model with constant demand:

In this model demand is assumed to be constant or completely pre-determined. It
is to determine the quantity to be ordered in the most economical nature. This
quantity is called Economic Order Quantity (EOQ).

Assumptions: Demand is known and uniform.

i) Q – lot size in each production run

ii) D – total number of units produced or supplied per unit period.
iii) Shortages are not allowed. As soon as the level of inventory reaches zero, the
inventory is replenished.
iv) Production or supply of materials is instantaneous.
v) Lead time is zero
vi) - Set up cost per production run
vii) - Holding cost / Storage cost

If the holding cost is expressed as a percentage I of the unit cost C of the commodity,
then
Formula for EOQ

1. Economic Order Quantity (EOQ) =

where is the optimum quantity.

2. The optimum annual inventory cost is
3. Optimal period of one run (order cycle) is

4. Number of runs per year is

Problems:

1. A factory requires 3600kg of raw material for producing an item per year. The
cost of placing an order is Rs. 36 and the holding cost of the stock is Rs. 2.50 per
kg per year. Determine the EOQ.

Solution: Given that: D = 3600 kg per year

= Rs 36 per order
= Rs. 2.50 per kg per year

Now, EOQ = = = 322 kg

Period of one run = 0.089 year = 32 days

Number of runs per year

2. The annual demand for an item is 3200 units. The unit cost is Rs. 6. The inventory
carrying cost is 25% per annum per unit. The cost of one procurement is Rs. 150.
Determine i) EOQ
ii) Number of orders per year
iii) Time between two consecutive orders
iv) Total annual cost

Solution: Given that D = 3200, C = 6, I = 0.25

= 150
= IC = 1.5

i) EOQ = = = 800 units

ii) Number of orders

iii) Time between two consecutive orders = = 3 months

iv) Total annual cost = material cost + inventory cost
 =
=
= Rs. 20400

3. A manufacturer has to supply 12000 units of a product per year to his customer.
Shortages are not permitted and there is no lead time. The inventory holding cost
is Rs. 0.20 per unit per month and the set-up cost per run is Rs. 350. Determine
i) the economic lot sizes
ii) the period of one run
iii) The minimum annual inventory cost

Solution: Given that D = 12000 units per year

= 1000 units per month
= Rs 350
= Rs. 0.20 per month

i) EOQ = = = 1870 units

ii) Period of one run = 1.87 months = 56 days

iii) Annual inventory cost =
=
= Rs 4490

4. A company has to supply 100 units of an item to the customers every week. The
item is purchased from the supplier at Rs. 60 per unit. The cost of ordering and
procurement from the supplier is Rs 150 per order. The storage cost is 15% of the
cost per year. Find the economic lot size and the optimum cost per week.

Solution: Given that D = 100 units per week

= Rs 150
= 15% per year of the cost
=
= Rs 9 per unit per year (52 weeks)
= Rs per unit per week

i) EOQ = = = 416 units

ii) Optimum total cost = Purchase cost + Inventory cost

=
 =
= Rs 6072

Manufacturing model

In this model, the replenishment rate (manufacturing rate) is finite, say k units per
unit time and demand rate (consumption rate) is r units per unit time ( . Each
production run of length t is divided into parts and such that
i) the inventory is building up at a constant rate of (k - r) units per unit time
during .
ii) There is no production during and the inventory is decreasing at the rate of
r units per unit time ( + = t)

Formula:

1. EOQ =

2. Optimal period of a run

3. Total annual inventory cost

4. Number of runs per year

Problems

5. A contractor has to supply 10000 bearings per day to an automobile manufacturer.

He can produce 25000 bearings per day. The holding cost is Rs 2 per year and the
set-up cost is Rs 180. How frequently should the production run be made?

Solution: Given that:

= Rs 180
= Rs 2 per year = 0.0055 per day

EOQ = = = 33029 units

Period of one run = 3.3 days

6. An item is produced at the rate of 50 units per day. The demand is at the rate of 25
units per day. The set-up cost is Rs 100 and the holding cost is Rs 0.01 per unit
per day. Find the EOQ and the minimum annual inventory cost. After how many
days should production be stopped during each run?
 Solution: Given that per day, units per day
= Rs 100
= 0.01 per year

i) EOQ = = = 1000 units

ii) Inventory cost = =

= Rs 5 per day

iii) Annual inventory cost = Rs 1825

iv)

During each run of 40 days, production continues for 20 days and there
would be no production for the remaining 20 days.

Model with Price Breaks (Quantity Discounts)

In the previous model, the cost of the material (purchase cost) was not affected by
the order size since it remains constant. Quantity discounts are offered to encourage the
buyers to purchase more units of an item. There may be quantity discounts or price
breaks. Let us assume that the cost per unit commodity is if and if
where > .

Formula

1. The total annual cost is for

for

2. Ignoring the price break, EOQ =

3. Choosing the quantity such that =

The optimum quantity depends on the value of q (price break point). We can
determine as follows: = (I zone)
= (II zone)
= if (III zone)
Problems

7. The cost of a commodity is Rs 2 for an order less than 15 and Re 1 for orders
greater than or equal to 15. Holding cost per unit is Re 1 and setup cost is Rs 10
per run and the requirement is 5 units per day. Find the EOQ.

Solution: Given , , D = 5, q = 15, =10,

Ignoring the price break we have

= 10 units

Since q = 15, we find that

To find
= = 20

Let,

20 =

30 = 100 +
= 26.18 or 3.82
By definition is taken as the larger value
= 26.18, , q = 15
Therefore, (2nd zone)

Therefore, EOQ = 15

8. The price break of a product is unit cost = . Monthly demand

is 200 units. Storage cost is 2% of the unit cost per month. Find the EOQ if
i) ordering cost is Rs 350
ii) ordering cost is Rs 100

Solution:
i) Ordering cost = Rs 350,
= 10(0.02) = 0.2
D = 200

= 837

q = 500,
 Hence,

ii) = 100, = 0.2, D = 200,

= 447

Therefore,
To find
= = 2089

Let,
2089 =
= 2567 or 88.9
By definition = 2567 we find that
Therefore, (2nd zone)

Model with Shortages

Customers leave the orders with the supplier and this back order is supplied as
soon as the stock is replenished. It involves shortage cost. Shortage cost depends upon
how long the customer waits to receive supply.

Formula

1. EOQ =

2. The optimum annual cost

3. If shortages are not allowed then ,

9. A commodity is to be supplied at the rate of 200 units per day. Ordering cost is Rs
50 and the holding cost is Rs 2 per day. The delay in supply induces a penalty of
Rs 10 per unit per delay of one day. Find the optimal policy and the reorder cycle
period.

Solution: Given that: D = 200 units per day, = 50, ,

 EOQ = = 109.5 units

Reorder cycle period = day

10. The annual demand of an item is 10000 units. The ordering cost is Rs 10. The cost
of the item is Rs 20. The holding cost is 20% of the value of the inventory per
year. If the shortage cost is 25% of the value per unit per year. Find the EOQ and
the optimal annual inventory cost.

Solution: Given D = 10000 units, = 10, = 4, =

5

EOQ = = 300 units

= Rs 666.7

11. The demand of an item is uniform at the rate of 20 units per month. The fixed cost
is Rs 10 per run. The production cost is Re 1 per item and the holding cost is Re
0.25 per month. If the shortage cost is Rs 1.25 per item per month. Determine the
EOQ, the period of a run and shortage period.

Solution: Given: D = r = 20, =10,

= 44

= 2.2 months (66 days)

= =37

Therefore = 44-37 =7
= 10.5 days