Modeling and Simulation

(IS331)

Assoc. Prof. Laila Abd-Ellatif

Chapter 6

Inventory Control Models

Quantitative Analysis for Management, Eleventh Edition, Global Edition

by Render, Stair, and Hanna
Power Point slides created by Brian Peterson
Introduction
◼ Inventory is an expensive and important
asset to many companies.
◼ Inventory is any stored resource used to
satisfy a current or future need.
◼ Common examples are raw materials, work-
in-process, and finished goods.
◼ Most companies try to balance high and low
inventory levels with cost minimization as a
goal.
◼ Lower inventory levels can reduce costs.
◼ Low inventory levels may result in stockouts and
dissatisfied customers.

Copyright © 2012 Pearson Education 6-3

Introduction
◼ All organizations have some type of inventory
control system.
◼ Inventory planning helps determine what
goods and/or services need to be produced.
◼ Inventory planning helps determine whether
the organization produces the goods or
services or whether they are purchased from
another organization.
◼ Inventory planning also involves demand
forecasting.

Copyright © 2012 Pearson Education 6-4

Introduction
Inventory planning and control

Planning on What
Forecasting Controlling
Inventory to Stock
Parts/Product Inventory
and How to Acquire
Demand Levels
It

Feedback Measurements
to Revise Plans and
Forecasts

Figure 6.1

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Importance of Inventory Control

◼ Five uses of inventory:

◼ The decoupling function
◼ Storing resources
◼ Irregular supply and demand
◼ Quantity discounts
◼ Avoiding stockouts and shortages

◼ Decouple manufacturing processes.

◼ Inventory is used as a buffer between stages
in a manufacturing process.
◼ This reduces delays and improves efficiency.

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Importance of Inventory Control

◼ Storing resources.
◼ Seasonal products may be stored to satisfy
off-season demand.
◼ Materials can be stored as raw materials, work-
in-process, or finished goods.
◼ Labor can be stored as a component of
partially completed subassemblies.
◼ Compensate for irregular supply and
demand.
◼ Demand and supply may not be constant over
time.
◼ Inventory can be used to buffer the variability.
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Importance of Inventory Control

◼ Take advantage of quantity discounts.

◼ Lower prices may be available for larger
orders.
◼ Extra costs associated with holding more
inventory must be balanced against lower
purchase price.
◼ Avoid stockouts and shortages.
◼ Stockouts may result in lost sales.
◼ Dissatisfied customers may choose to buy
from another supplier.

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Inventory Decisions
◼ There are two fundamental decisions in
controlling inventory:
◼ How much to order.
◼ When to order.
◼ The major objective is to minimize total
inventory costs.
◼ Common inventory costs are:
◼ Cost of the items (purchase or material cost).
◼ Cost of ordering.
◼ Cost of carrying, or holding, inventory.
◼ Cost of stockouts.

Copyright © 2012 Pearson Education 6-9

Inventory Cost Factors
ORDERING COST FACTORS CARRYING COST FACTORS
Developing and sending purchase orders Cost of capital
Processing and inspecting incoming
Taxes
inventory
Bill paying Insurance

Inventory inquiries Spoilage

Utilities, phone bills, and so on, for the
Theft
purchasing department
Salaries and wages for the purchasing
Obsolescence
department employees
Supplies, such as forms and paper, for the Salaries and wages for warehouse
purchasing department employees
Utilities and building costs for the
warehouse
Supplies, such as forms and paper, for the
warehouse

Table 6.1
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Inventory Cost Factors
◼ Ordering costs are generally independent of
order quantity.
◼ Many involve personnel time.
◼ The amount of work is the same no matter the
size of the order.
◼ Carrying costs generally varies with the
amount of inventory, or the order size.
◼ The labor, space, and other costs increase as the
order size increases.
◼ The actual cost of items purchased can vary
if there are quantity discounts available.

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Economic Order Quantity

◼ The economic order quantity (EOQ) model

is one of the oldest and most commonly
known inventory control techniques.
◼ It is easy to use but has a number of
important assumptions.
◼ Objective is to minimize total cost of
inventory.

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Economic Order Quantity
Assumptions:
1. Demand is known and constant.
2. Lead time is known and constant.
3. Receipt of inventory is instantaneous.
4. Purchase cost per unit is constant
throughout the year.
5. The only variable costs are the cost of
placing an order, ordering cost, and the cost
of holding or storing inventory over time,
holding or carrying cost, and these are
constant throughout the year.
6. Orders are placed so that stockouts or
shortages are avoided completely.
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Inventory Usage Over Time

Inventory
Level
Order Quantity = Q =
Maximum Inventory Level

Minimum
Inventory

0
Time
Figure 6.2

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Inventory Costs in the EOQ Situation

Computing Average Inventory

Q
Average inventory level =
2

INVENTORY LEVEL
DAY BEGINNING ENDING AVERAGE
April 1 (order received) 10 8 9
April 2 8 6 7
April 3 6 4 5
April 4 4 2 3
April 5 2 0 1
Maximum level April 1 = 10 units
Total of daily averages = 9 + 7 + 5 + 3 + 1 = 25
Number of days = 5 Table 6.2
Average inventory level = 25/5 = 5 units

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Inventory Costs in the EOQ Situation

Mathematical equations can be developed using:

Q = number of pieces to order
EOQ = Q* = optimal number of pieces to order
D = annual demand in units for the inventory item
Co = ordering cost of each order
Ch = holding or carrying cost per unit per year

Number of Ordering
Annual ordering cost = orders placed  cost per
per year order
D
= Co
Q

Copyright © 2012 Pearson Education 6-16

Inventory Costs in the EOQ Situation

Mathematical equations can be developed using:

Q = number of pieces to order
EOQ = Q* = optimal number of pieces to order
D = annual demand in units for the inventory item
Co = ordering cost of each order
Ch = holding or carrying cost per unit per year

Average Carrying
Annual holding cost = inventory  cost per unit
per year

Q
= Ch
2

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Inventory Costs in the EOQ Situation

Total Cost as a Function of Order Quantity

Cost
Curve of Total Cost
of Carrying
Minimum and Ordering
Total
Cost

Carrying Cost Curve

Ordering Cost Curve

Figure 6.3
Optimal Order Quantity
Order
Copyright © 2012 Pearson Education Quantity 6-18
Finding the EOQ
According to the graph, when the EOQ assumptions
are met, total cost is minimized when annual
ordering cost equals annual holding cost.
D Q
Co = Ch
Q 2
Solving for Q
2 DC o = Q 2C h
2 DC o
= Q2
Ch
2 DC o
= Q = EOQ = Q *
Ch
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Economic Order Quantity (EOQ) Model

Summary of equations:

D
Annual ordering cost = C o
Q

Q
Annual holding cost = C h
2

2 DC o
EOQ = Q * =
Ch

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Sumco Pump Company

◼ Sumco Pump Company sells pump housings to

other companies.
◼ The firm would like to reduce inventory costs by
finding optimal order quantity.
◼ Annual demand = 1,000 units
◼ Ordering cost = $10 per order
◼ Average carrying cost per unit per year = $0.50

2 DC o 2(1,000 )(10)
Q = *
= = 40,000 = 200 units
Ch 0.50

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Sumco Pump Company

Total annual cost = Order cost + Holding cost

D Q
TC = C o + C h
Q 2
1,000 200
= (10 ) + (0.5 )
200 2
= $50 + $50 = $100

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Purchase Cost of Inventory Items
◼ Total inventory cost can be written to include the
cost of purchased items.
◼ Given the EOQ assumptions, the annual purchase
cost is constant at D  C no matter the order
policy, where
◼ C is the purchase cost per unit.
◼ D is the annual demand in units.
◼ At times it may be useful to know the average
dollar level of inventory:

(CQ )
Average dollar level =
2
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Purchase Cost of Inventory Items
◼ Inventory carrying cost is often expressed as an
annual percentage of the unit cost or price of the
inventory.
◼ This requires a new variable.

Annual inventory holding charge as

I= a percentage of unit price or cost
◼ The cost of storing inventory for one year is then

C h = IC

2 DC o
thus, Q =
*

IC
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Reorder Point:
Determining When To Order
◼ Once the order quantity is determined, the
next decision is when to order.
◼ The time between placing an order and its
receipt is called the lead time (L) or
delivery time.
◼ When to order is generally expressed as a
reorder point (ROP).

Demand Lead time for a

ROP = per day  new order in days

=dL
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Procomp’s Computer Chips

◼ Demand for the computer chip is 8,000 per year.

◼ Daily demand is 40 units.
◼ Delivery takes three working days.

ROP = d  L = 40 units per day  3 days

= 120 units

◼ An order based on the EOQ calculation is placed

when the inventory reaches 120 units.
◼ The order arrives 3 days later just as the
inventory is depleted.

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Reorder Point Graphs

Figure 6.4

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EOQ Without The Instantaneous
Receipt Assumption
◼ When inventory accumulates over time, the
instantaneous receipt assumption does not apply.
◼ Daily demand rate must be taken into account.
◼ The revised model is often called the production
run model.

Copyright © 2012 Pearson Education Figure 6.5 6-28

Annual Carrying Cost for
Production Run Model
◼ In production runs, setup cost replaces ordering
cost.
◼ The model uses the following variables:

Q = number of pieces per order, or

production run
Cs = setup cost
Ch = holding or carrying cost per unit per
year
p = daily production rate
d = daily demand rate
t = length of production run in days

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Annual Carrying Cost for
Production Run Model
Maximum inventory level
= (Total produced during the production run)
– (Total used during the production run)
= (Daily production rate)(Number of days production)
– (Daily demand)(Number of days production)
= (pt) – (dt)

since Total produced = Q = pt

Q
we know t=
p
Maximum Q Q  d
inventory = pt − dt = p − d = Q 1 − 
level p p  p
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Annual Carrying Cost for
Production Run Model
Since the average inventory is one-half the maximum:

Q d 
Average inventory =  1 − 
2 p

and

Q d 
Annual holding cost =  1 − C h
2 p

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Annual Setup Cost for
Production Run Model
Setup cost replaces ordering cost when a product is
produced over time.

D
Annual setup cost = C s
Q

replaces
D
Annual ordering cost = C o
Q

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Determining the Optimal
Production Quantity
By setting setup costs equal to holding costs, we
can solve for the optimal order quantity

Annual holding cost = Annual setup cost

Q d  D
 1 − C h = C s
2 p Q

Solving for Q, we get

2 DC s
Q* =
 d
C h  1− 
 p
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Production Run Model

Summary of equations

Q d 
Annual holding cost =  1 − C h
2 p

D
Annual setup cost = C s
Q

2 DC s
Optimal production quantity Q * =
 d
C h  1− 
 p

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Brown Manufacturing

Brown Manufacturing produces commercial

refrigeration units in batches.

Annual demand = D = 10,000 units

Setup cost = Cs = $100
Carrying cost = Ch = $0.50 per unit per year
Daily production rate = p = 80 units daily
Daily demand rate = d = 60 units daily

1. How many units should Brown produce in each batch?

2. How long should the production part of the cycle last?

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Brown Manufacturing Example

2 DC s Q
1. Q = *
2. Production cycle =
 d p
C h  1− 
 p 4,000
= = 50 days
80
2  10,000  100
Q = *

 60 
0 .5  1 − 
 80 
2,000 ,000
= = 16,000 ,000
( )
0.5 1
4
= 4,000 units
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Quantity Discount Models
◼ Quantity discounts are commonly available.
◼ The basic EOQ model is adjusted by adding in the
purchase or materials cost.

Total cost = Material cost + Ordering cost + Holding cost

D Q
Total cost = DC + C o + C h
Q 2
where
D = annual demand in units
Co = ordering cost of each order
C = cost per unit
Ch = holding or carrying cost per unit per year
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Quantity Discount Models
◼ Quantity discounts
Because unit are
costcommonly available.
is now variable,
◼ The basic EOQ model is adjusted by adding in the
Holding cost = Ch = IC
purchase or materials cost.
I = holding cost as a percentage of the unit cost (C)
Total cost = Material cost + Ordering cost + Holding cost
D Q
Total cost = DC + C o + C h
Q 2
where
D = annual demand in units
Co = ordering cost of each order
C = cost per unit
Ch = holding or carrying cost per unit per year
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Quantity Discount Models
◼ A typical quantity discount schedule can look like
the table below.
◼ However, buying at the lowest unit cost is not
always the best choice.

DISCOUNT DISCOUNT DISCOUNT

NUMBER QUANTITY DISCOUNT (%) COST ($)
1 0 to 999 0 5.00

2 1,000 to 1,999 4 4.80

3 2,000 and over 5 4.75

Table 6.3

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Quantity Discount Models
Total cost curve for the quantity discount model
Total TC Curve for Discount 3
Cost
$ TC Curve for
Discount 1

TC Curve for Discount 2

EOQ for Discount 2

Figure 6.6
0 1,000 2,000
Order Quantity
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Brass Department Store
◼ Brass Department Store stocks toy race cars.
◼ Their supplier has given them the quantity
discount schedule shown in Table 6.3.
◼ Annual demand is 5,000 cars, ordering cost is $49, and
holding cost is 20% of the cost of the car
◼ The first step is to compute EOQ values for each
discount.
(2)(5,000 )( 49 )
EOQ1 = = 700 cars per order
(0.2)(5.00 )
(2)(5,000 )(49 )
EOQ 2 = = 714 cars per order
(0.2)(4.80 )
(2)(5,000 )(49 )
EOQ 3 = = 718 cars per order
(0.2)(4.75 )
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Brass Department Store Example

◼ The second step is adjust quantities below the

allowable discount range.
◼ The EOQ for discount 1 is allowable.
◼ The EOQs for discounts 2 and 3 are outside the
allowable range and have to be adjusted to the
smallest quantity possible to purchase and
receive the discount:

Q1 = 700
Q2 = 1,000
Q3 = 2,000

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Brass Department Store

The third step is to compute the total cost for each

quantity.
ANNUAL ANNUAL ANNUAL
UNIT ORDER MATERIAL ORDERING CARRYING
DISCOUNT PRICE QUANTITY COST ($) COST ($) COST ($)
NUMBER (C) (Q) = DC = (D/Q)Co = (Q/2)Ch TOTAL ($)

1 $5.00 700 25,000 350.00 350.00 25,700.00

2 4.80 1,000 24,000 245.00 480.00 24,725.00

3 4.75 2,000 23,750 122.50 950.00 24,822.50

The final step is to choose the alternative with the

lowest total cost.
Table 6.4
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Use of Safety Stock

◼ If demand or the lead time are uncertain,

the exact ROP will not be known with
certainty.
◼ To prevent stockouts, it is necessary to
carry extra inventory called safety stock.
◼ Safety stock can prevent stockouts when
demand is unusually high.
◼ Safety stock can be implemented by
adjusting the ROP.

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Use of Safety Stock
◼ The basic ROP equation is
ROP = d  L
d = daily demand (or average daily demand)
L = order lead time or the number of
working days it takes to deliver an order
(or average lead time)

◼ A safety stock variable is added to the equation

to accommodate uncertain demand during lead
time
ROP = d  L + SS
where
SS = safety stock
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Use of Safety Stock

Figure 6.7

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Calculating Lead Time Demand
and Standard Deviation
◼ There are three situations to
consider:
◼ Demand is variable but lead time is
constant.
◼ Demand is constant but lead time is
variable.
◼ Both demand and lead time are variable.

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Calculating Annual Holding
Cost with Safety Stock
◼ Under standard assumptions of EOQ,
average inventory is just Q/2.
◼ So annual holding cost is: (Q/2)*Ch.
◼ This is not the case with safety stock
because safety stock is not meant to
be drawn down.

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Calculating Annual Holding
Cost with Safety Stock
Total annual holding cost = holding
cost of regular inventory + holding
cost of safety stock

Where:
THC = total annual holding cost
Q = order quantity
Ch = holding cost per unit per year
SS = safety stock

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ABC Analysis
◼ The purpose of ABC analysis is to divide the
inventory into three groups based on the overall
inventory value of the items.
◼ Group A items account for the major portion of
inventory costs.
◼ Typically about 70% of the dollar value but only 10% of
the quantity of items.
◼ Forecasting and inventory management must be done
carefully.
◼ Group B items are more moderately priced.
◼ May represent 20% of the cost and 20% of the quantity.
◼ Group C items are very low cost but high volume.
◼ It is not cost effective to spend a lot of time managing
these items.
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Summary of ABC Analysis

INVENTORY DOLLAR INVENTORY ARE QUANTITATIVE CONTROL

GROUP USAGE (%) ITEMS (%) TECHNIQUES USED?

A 70 10 Yes

B 20 20 In some cases

C 10 70 No

Table 6.8

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Just-in-Time (JIT) Inventory
Control
◼ To achieve greater efficiency in the
production process, organizations have
tried to have less in-process inventory on
hand.
◼ This is known as JIT inventory.
◼ The inventory arrives just in time to be
used during the manufacturing process.
◼ One technique of implementing JIT is a
manual procedure called kanban.

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Just-in-Time Inventory Control

◼ Kanban in Japanese means “card.”

◼ With a dual-card kanban system, there is a
conveyance kanban, or C-kanban, and a
production kanban, or P-kanban.
◼ Kanban systems are quite simple, but they
require considerable discipline.
◼ As there is little inventory to cover
variability, the schedule must be followed
exactly.

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4 Steps of Kanban
1. A user takes a container of parts or inventory
along with its C-kanban to his or her work area.
When there are no more parts or the container is
empty, the user returns the container along with
the C-kanban to the producer area.
2. At the producer area, there is a full container of
parts along with a P-kanban.
The user detaches the P-kanban from the full
container and takes the container and the C-
kanban back to his or her area for immediate
use.

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4 Steps of Kanban
3. The detached P-kanban goes back to the
producer area along with the empty container
The P-kanban is a signal that new parts are to be
manufactured or that new parts are to be placed
in the container and is attached to the container
when it is filled .
4. This process repeats itself during the typical
workday.

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The Kanban System

P-kanban C-kanban
and and
Container Container

4 1

Producer Storage User

Area Area Area

3 2

Figure 6.16

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Enterprise Resource Planning

◼ MRP has evolved to include not only the materials

required in production, but also the labor hours,
material cost, and other resources related to
production.
◼ In this approach the term MRP II is often used and
the word resource replaces the word requirements.
◼ As this concept evolved and sophisticated software
was developed, these systems became known as
enterprise resource planning (ERP) systems.

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Enterprise Resource Planning

◼ The objective of an ERP System is to reduce costs

by integrating all of the operations of a firm.
◼ Starts with the supplier of materials needed and
flows through the organization to include
invoicing the customer of the final product.
◼ Data are entered only once into a database where
it can be quickly and easily accessed by anyone in
the organization.
◼ Benefits include:
◼ Reduced transaction costs.
◼ Increased speed and accuracy of information.

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Enterprise Resource Planning

◼ Drawbacks to ERP:
◼ The software is expensive to buy and costly to
customize.
◼ Small systems can cost hundreds of thousands of
dollars.
◼ Large systems can cost hundreds of millions.
◼ The implementation of an ERP system may
require a company to change its normal
operations.
◼ Employees are often resistant to change.
◼ Training employees on the use of the new
software can be expensive.

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