Dr Adolf Acquaye

Department of Industrial Engineering

Introduction to Inventory Management

TOPIC 9
Defining Inventory

Inventory is an idle stock of physical goods that contain

economic value, and are held in various forms by an
organization in its custody, awaiting packing, processing,
transformation, use or sale in a future point of time.

2
Inventory Management

Inventory Management refers to the process of ordering, storing,

and using a company's inventory. These include the
management of raw materials, components, and finished
products, as well as warehousing and processing such items.

3
Why Inventory Planning

• Run out of stock too often?

• Have too much inventory for many products?

• Have too little inventory for some products?

• Have trouble forecasting your demand?

• Have a warehouse that is too small?

• Lack manufacturing capacity?

• Suffer from low inventory turns?

• Have competitors who give higher service?

4
Inventory Planning within a Firm

Inventory

Production Customer Service

• Raw materials Supporting Activities • Finished goods

• Work-in-process • Spare parts
items

• Maintenance
• Repair
• Operating supplies
Inventory Management Roles

Purchasing and Materials Management: adequate raw

materials at low inventory cost

Manufacturing and Finance: efficient and low-cost

production balanced against low inventory cost

Sales and Marketing: sufficient inventory to meet customer

delivery requests and service levels
Inventory Management KPIs

Hit Customer Service

Targets
(RESPONSIVENESS)
Reduce Quality
Inventory Costs
Availability
(EFFICIENCY)
On-time delivery
Holding
Ordering
Transporting
Inventory Management KPIs
❖ Inventory can play a substantial role in the health of a business—
having too much can cause problems, as can having too
little. Ineffective Inventory Management can result in increased costs,
missed sales and frustrated customers.
❖ Important Inventory Management KPIs:
✓ Inventory Turnover or Days on Hand.
✓ Average Days to Sell Inventory (DSI)
✓ Average Inventory.
✓ Holding Costs.
✓ Stock-out.
✓ Service Level.
✓ Lead Time. .
✓ Rate of Return.
Inventory Management KPIs
✓ Inventory Turnover or Days on Hand: This KPI examines how many
times inventory has been sold and replaced in a given time period. If the
turnover is low, the company either has too much stock or too few sales.

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝑆𝑎𝑙𝑒𝑠

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛 𝑂𝑣𝑒𝑟 = or
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
✓ Average Days to Sell Inventory (DSI) This KPI is a measure of how long it
takes your company to turn its inventory into sales. This KPI varies from
industry to industry depending on what you’re selling. Generally, a lower
DSI is preferred as it indicates a shorter duration to clear off the inventory.
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐷𝑆𝐼 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠 𝑥 365
❖ Cost of Sales= beginning inventory + purchases - ending inventory
Inventory Management KPIs
✓ Average Inventory: This KPI is used to estimate the amount of inventory
your company has on hand during a particular time frame. The goal here
is to avoid spikes or unanticipated drops in inventory, and to keep a
relatively constant flow of inventory in and out, based on the needs of the
business.

𝐵𝑒𝑔𝑖𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝐸𝑛𝑑 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
2

✓ Holding Costs This KPI measures the costs related to storing unsold
inventory. This includes the cost of damaged and spoiled goods, as well as
the cost of storage space, labor and insurance.
Inventory Management KPIs
✓ Stock-Out: This KPI represents the amount of times demand cannot be
met due to the absence of required inventory. Stock-Out results in lost
sales, missed opportunities, and frustrated clients. It provides a big
picture view of how effective a business is at purchasing and production.

✓ Service level: This KPI is used to compute the amount of stock required to
avoid a stock-out. Service level denotes a compromise between the cost of
inventory and the cost of a stock-out.
Inventory Management KPIs
✓ Lead-Time: This KPI is an important element of supply chain
management and the inventory control process. It is the time from the
moment the customer places an order (the moment the supplier learns of
the customer’s requirement) to the moment it is ready for delivery.

✓ Rate of Return: This KPI tracks and rates the percentage of orders that are
returned and need to be restocked. Equally important is tracking the
reason for the returns so that you can address any problems in the supply
chain. This will also help identify key trends that might prevent future
costly returns..
Inventory Management KPIs
✓ Inventory Accuracy: If what’s on your shelves doesn’t match what’s in
your books—or, more likely, databases—you’ll experience poor order
accuracy rates and higher costs. Inventory accuracy helps prevent this
scenario by requiring the performance of an inventory headcount to verify
that your internal data is accurate..

✓ Perfect Order Rate: The right delivery place, the right product, the right
package, the right quantity, and the right documentation. A high perfect
order rate can lead to increased customer satisfaction.
Class Discussion

What is the purpose of having inventory policies?

What do they specify?
What is the purpose of having inventory
policies? What do they specify?

Potential Responses:
Inventory policy is a way of formalizing the results of strategic inventory
decisions so that they can be implemented consistently and coherently.
Policies can specify:
• Centralized or decentralized inventory planning and/or warehousing,
frequency of communications and coordination, or a geographical
inventory positioning strategy such as postponement
• Rules for order quantities, order timing, when to act on exceptions to
rules, and amounts of specific items to purchase versus produce.
Types of Inventory

(1) Raw (2) Work-in- (3) Finished

Materials Process (WIP) Goods (FG)

(4) Maintenance, Repair, and Operating (MRO)

Raw
Manufacturer Distributor Retailer End
materials
customer
supplier

(5) In-transit
Role of Inventory in the Supply Chain
Improve Matching of
Supply and Demand

Improved Forecasting

Cost Reduce Material Flow Time Availability

Efficiency Responsiveness

Reduce Waiting Time

Reduce Buffer Inventory

Supply / Demand
Economies of Scale Seasonal Variability
Variability

Cycle Inventory Safety Inventory Seasonal Inventory

The Purpose of Inventory
• Why does inventory exist?
Difficulties in synchronizing supply and demand
®

• Decouple suppliers from production and production from distribution (Buffer stock)

Supplier Manufacturing Retailer Consumer

Supplier Wholesaler Retailer

• Provide a stock of goods to meet anticipated customer demand
• Allow one to take advantage of quantity discounts
• Provide a hedge against inflation
• Protect against shortages due to delivery variation
Inventory Costs

Item

Carrying

Ordering

Stockout

Capacity-
Related
Item Costs
Purchased Items ®
Manufactured Items

Product Direct Material

Transportation Direct Labor

Customs Duties Factory Overhead

Insurance
Carrying Costs
20% - 40% 5% – 15%

Capital Storage
Risk Costs
Costs ® Costs

Obsolescence

Space Damage

Opportunity Cost Personnel Pilferage

Equipment Insurance

Deterioration
Ordering Costs

Purchasing ®
Factory

Production
Control Cost

Purchasing Cost
Set up and Tear-
down Cost

Lost Capacity Cost

Stock-Out Costs
CAUSES OF STOCKOUTS STOCKOUT COSTS

Backorder costs
Demand during lead time
exceeds forecast and Lost sales
available inventory

Lost customers

Production and supplier Expediting costs

problems
cause inventory shortages Additional manufacturing
and purchasing costs
Capacity-Related Costs

Overtime
®

Shift
Hiring
Premiums Capacity-
related Costs

Training Layoff
Class Discussion

Discuss the role of Inventory in Supply Chain

Management.
Classification of Inventory
Classification of Inventory

1 ABC system

2 FSN: Fast, Slow and non-Moving

Inventory 3 VED: Vital, Essential, Desirable
Classifications
4 GoLF: Government, Local, Foreign

5 SDE: Scarce, Deficient, Easily Available

Classification of Inventory
✓ Classifying inventory according to some measure of importance
and allocating control efforts accordingly.

✓ Helps to divide inventory into 3 parts according to Usage Value.

A - very important
B – moderate important High
A
C - least important Annual
$ value B
of items

Low C
Few Many
Number of Items
ABC Inventory Analysis

A B C
80 80% of 15% of
Percentage 5% of
70 revenue revenue
of Annual A revenue
60
Revenue Items comes from comes from comes from
50
Generation 20% of 30% of 50% of
40
inventory inventory inventory
30
20
items. items. items.
10
0 B Items C Items
10 20 30 40 50 60 70 80 90 100

Percentage of inventory items

Class Discussion

The annual dollar value of 12 items has been calculated based on

annual demand and unit cost. The annual dollar values were then
arrayed from highest to lowest to simplify classification of items.
Reasonably classify the 12 items using the ABS Inventory System.
ABC Inventory Analysis
Item number Annual demand Unit cost Dollar value
1 2500 330 825,000
2 1000 70 70,000
3 1900 500 950,000
4 1500 100 150,000
5 3900 700 2,730,000
6 1000 915 915,000
7 200 210 42,000
8 1000 4000 4,000,000
9 8000 10 80,000
10 9000 2 18,000
11 500 200 100,000
12 400 300 120,000
total 10,000,000
ABC Inventory Analysis

Item number Annual demand Unit cost Dollar value % of Total Value

8 1000 4000 4,000,000 40.0%

5 3900 700 2,730,000 27.3%
3 1900 500 950,000 9.5%
6 1000 915 915,000 9.2%
1 2500 330 825,000 8.3%
4 1500 100 150,000 1.5%
12 400 300 120,000 1.2%
11 500 200 100,000 1.0%
9 8000 10 80,000 0.8%
2 1000 70 70,000 0.7%
7 200 210 42,000 0.4%
10 9000 2 18,000 0.2%
total 10,000,000
ABC Inventory Analysis
% of % Value of
Item number Dollar value % of Total Value Cumulative % Classification
Inventory usage
8 4,000,000 40.0% 40.0%
5 2,730,000 27.3% 67.3% A 25% 76.8%
3 950,000 9.5% 76.8% (~20%)

6 915,000 9.2% 86.0%

1 825,000 8.3% 94.2% B 25% 18.9%
4 150,000 1.5% 95.7%
12 120,000 1.2% 96.9%
11 100,000 1.0% 97.9%
9 80,000 0.8% 98.7%
2 70,000 0.7% 99.4%
C 50% 4.3%
7 42,000 0.4% 99.8%
10 18,000 0.2% 100.0%
total 10,000,000

✓ Focus and control A-class items because of high value of inventory.

✓ Based on the 80~20 Pareto Rule

4 Types of Inventory Systems
Decision Making: Inventory Mgt
❖ There are two important decisions in Inventory Management:
1. How much to Order?
2. When to Order?

Economic Order Quantity Periodic Systems

Fixed
✓ Applicable in highly reliable supply ✓ Applicable in Highly reliable supply

When to Order
and demand systems and demand systems

Re-Order Point Discrete Order Quantity

Variable
✓ Also known as Lot-for-Lot Systems
✓ A set inventory level triggers
✓ Order what ever you need when you
replenishment.
need it. Highly suitable for JIT and
Lean usage.
Fixed
Variable
How Much to Order
Re-Order Point Inventory System

❖ This is used when “How much to Order” is fixed and “When to

Order” is variable.
❖ Used-Up Inventory
Order is Placed

Inventory

Max Level (Fixed)

Re-Order Point Level

Minimum Level

Order Cycle Safety

Stock

Lead Time before Inventory is received Time

Re-Order Point Inventory System
❖ A Re-Order Point (ROP) is the unit quantity on hand that triggers the
purchase of a predetermined amount of replenishment inventory.
❖ The ROP should result in the replenishment inventory arriving just as the
last of the on-hand inventory is used up. The result is no interruption in
production and fulfillment activities, while minimizing the total amount
of inventory on hand.
❖ The maximum level of inventory equals the sum of safety stock and order
quantity.

𝑅𝑒 − 𝑂𝑟𝑑𝑒𝑟 𝑃𝑜𝑛𝑡 (𝑅𝑂𝑃) = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑈𝑠𝑎𝑔𝑒 𝑅𝑎𝑡𝑒 𝑥 𝐿𝑒𝑎𝑑 − 𝑇𝑖𝑚𝑒 + 𝑆𝑎𝑓𝑒𝑡𝑦 𝑆𝑡𝑜𝑐𝑘

Use Max Inventory if

inventory’s usage rate is Guards against Stock-Out if needed
IRREGULAR
Re-Order Point Inventory System
1. ABC Inc. retails cement to the construction industry. The average daily sales of
cement is 250 bags. The inventory’s daily consumption rate is constant, and the
lead time of 7 days is also constant. The management of ABS Inc. has refused to
hold safety stock. Compute the Re-Order Point

2. Assume ABS has irregular sales of cement with minimum daily sales rate of 150
bags, average usage of 250 bags and maximum usage of 400 bags. The lead time
also varies between 5-9 days. Re-calculate the ROP.

3. To avoid overstocking and an increase in cost, a firm can hold safety stock and
use it to compensate for the extra usage of inventory. Let’s consider Example 1
and assume that ABS Inc. has set up safety stock for an average usage of 5 days.
Calculate the Re-Order Point.
Re-Order Point Inventory System

𝑅𝑒 − 𝑂𝑟𝑑𝑒𝑟 𝑃𝑜𝑛𝑡 (𝑅𝑂𝑃) = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑈𝑠𝑎𝑔𝑒 𝑅𝑎𝑡𝑒 𝑥 𝐿𝑒𝑎𝑑 − 𝑇𝑖𝑚𝑒 + 𝑆𝑎𝑓𝑒𝑡𝑦 𝑆𝑡𝑜𝑐𝑘

𝑏𝑎𝑔𝑠
1. 𝑅𝑒 − 𝑂𝑟𝑑𝑒𝑟 𝑃𝑜𝑖𝑛𝑡 = 250 𝑑𝑎𝑦
× 7 𝑑𝑎𝑦𝑠 = 1750 𝑏𝑎𝑔𝑠

𝑏𝑎𝑔𝑠
2. 𝑅𝑒 − 𝑂𝑟𝑑𝑒𝑟 𝑃𝑜𝑖𝑛𝑡 = 400 × 9 𝑑𝑎𝑦𝑠 = 3600 𝑏𝑎𝑔𝑠
𝑑𝑎𝑦

𝑏𝑎𝑔𝑠
3. 𝑅𝑒 − 𝑂𝑟𝑑𝑒𝑟 𝑃𝑜𝑖𝑛𝑡 = 250 × (7 + 5) 𝑑𝑎𝑦𝑠 = 3000 𝑏𝑎𝑔𝑠
𝑑𝑎𝑦

✓ Because the company has safety stock, it can use both average daily sales and average
lead time to determine reorder point as in Example 3. Comparing Example 3 to 2, the
setup of safety stock in (3) allows holding a lower stock balance and reducing holding
costs.
Periodic Inventory System

❖ This is used when “How much to Order” is Variable and

“When to Order” is Fixed.
How much is
❖ ordered is variable.
Inventory
Max Inventory Level

Periods of Review
are fixed (weekly or
monthly)

Time
Periodic Inventory System
❖ A Periodic Inventory System determines the amount of
inventory at the end of a specified periods.
❖ Furthermore, a periodic inventory system requires a physical
count for each period.
❖ In Periodic Inventory System, there is no continual record of
the value of inventory until there is an actual physical count
of inventory at the end of the review period.
Periodic Inventory System

Calculation: Cost of Goods Sold (CoGS) under the periodic inventory

✓ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑆𝑎𝑙𝑒 – 𝐸𝑛𝑑𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
✓ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒 = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

❖ EXAMPLE: A firm has beginning inventory of 100,000 AED, has paid 170,000 AED for
purchases, and its physical inventory count reveals an ending inventory cost of 80,000
AED. Determine the Cost of Goods Sold.

✓ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑆𝑎𝑙𝑒 – 𝐸𝑛𝑑𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

= 𝐵𝑒𝑔𝑖𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 – 𝐸𝑛𝑑𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

= 100,000 + 170,000 – 80,000

= 190, 000 𝐴𝐸𝐷 𝑜𝑓 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
Discrete Order Quantity Inventory System

✓ DOQ is a method for lot sizing, where the net requirements

occurring for each period are the quantity of order.

Period 1 2 3 4 5 6 7 8 9 10 TOTAL
Net Requirements 40 15 35 20 5 15 30 25 185
Scheduled Order 40 15 35 20 5 15 30 25 185

40

20
Discrete Order Quantity Inventory System

❖ DOQ is an approach for lot sizing, where the amount of order

each time placed is equal to the net requirements for the
product for that duration.
❖ This technique is characteristically utilized largely for
expensive products and the products whose demands are
variable and periodic (occurs intermittently).
❖ This system is very suitable for JIT and Lean usage. Its
however expensive due to the cost of monitoring
Discrete Order Quantity Inventory System

❖ Only required amount is ordered

❖ Order quantities change as requirements change
❖ No unused lot-size inventory is created
❖ Is used:
✓ For expensive components (A-type items)
✓ Perishable items

✓ In a lean or Just-in-Time (JIT) environment

Economic Order Quantity (EOQ)

Models
Economic Order Quantity (EOQ)

The Economic Order Quantity (EOQ) is the number of

units that a company should add to inventory with each
order to minimize the total costs of inventory—such as
holding costs, order costs, and shortage costs.

✓ The EOQ provides a model for calculating the appropriate reorder point and
the optimal reorder quantity to ensure the instantaneous replenishment of
inventory with no shortages.
Economic Order Quantity (EOQ)
✓ ASUMPTIONS of EOQ Model:
1) Demand is relatively constant and known

2) Items are produced or purchased in lots or batches

3) Order preparation costs and inventory carrying costs and unit cost
are constant and known

4) Replacement occurs all at once

5) Delivery is perfectly reliable and instant

Economic Order Quantity (EOQ)
✓ The objective of Inventory Management is to minimize cost:

1. Cost of having too much

2. Cost of having too little.

✓ The objective of Inventory is to minimize the two cost components.

Inventory being
used up at
uniform rate
Inventory is replenished
Inventory

Average

Time
Economic Order Quantity (EOQ)
Economic Order Quantity (EOQ)

Min at where:
Holding Cost = Handling Cost

Minimum Cost at Q = 400 Units

Economic Order Quantity (EOQ)
1) Quantity being carried is changing at any time t, in a period from
Maximum amount to zero, hence the average of the quantity is
used in the model.

2) Total Ordering Cost keep reducing, because as you increase

quantity ordered, the cost reduces.

3) Holding Cost on the other hand keep increasing with increase in

the quantity of units.
Total Cost OF Inventory
The total annual cost associated with carrying and ordering inventory
when Q units are ordered each time is:

Annual Annual
Total cost = Holding + Ordering
Cost Cost
Q + DC
TC = Ch
2 Q o
Where
Q = quantity to be ordered
Ch= holding cost per unit (carrying cost per unit)
Co = ordering (setup cost) per order
D = annual demand
Total Cost
Differentiating and Solving to determine the minimum Q for which
Total Cost is MINIMUM gives:

𝟐𝑫𝑪𝒐
Optimal Lot, Qo =
𝑪𝒉
Minimum Total Cost

The total cost curve reaches its minimum where the carrying
and ordering costs are equal. This minimum cost can be found
by substituting Q0 for Q in the Total cost (TC) formula:

𝑄𝑜 𝐷
𝑇𝐶 = 𝐶ℎ + 𝐶𝑜
2 𝑄𝑜
EOQ Example 1
A local distributor for a national tire company expects to sell approximately
9600 steel-belted radial tires of a certain size and tread design next year.
Annual carrying cost is $16 per tire, and ordering cost is $75. the distributor
operates 288 days a year.
i. What is the EOQ?

ii. How many times per year does the store reorder?

iii. What is the length of an order cycle?

iv. What is the total annual cost if the EOQ is ordered?

EOQ Example
SOLUTION
D = 9600 tires per year
H = $16 per unit per year
S = $75 per order

𝟐𝑫𝑪𝒐 𝟐 × 𝟗𝟔𝟎𝟎 × 𝟕𝟓
a) Q0 = 𝑪 = = 300 tires
𝒉 𝟏𝟔

b) Number of order per year: D/Q0 = 9600/300 = 32 orders

c) Length of order cycle: Q0/ D = 300/9600 =1/32 of a year , which is 1/32 (288 days a
year) = 9 workdays
EOQ Example 1
SOLUTION (CONT.)
d) Tc = Carrying cost + Ordering cost

𝑄𝑜 𝐷
𝑇𝐶 = 𝐶ℎ + 𝐶𝑜
2 𝑄𝑜
= (300/2) 16 + (9600/300) 75

= 2400 + 2400

= $4800
EOQ Example 2
Demand for the Deskpro computer at PC World is 1,000 units per month. PC World
incurs a fixed order placement, transportation, and receiving cost of $4,000 each
time an order is placed. Each computer costs PC World $500 and the retailer has a
holding cost of 20 percent.
1. Evaluate the number of computers that the store manager should order in each
replenishment lot.

2. Estimate the number of orders per year

3. What is the cycle inventory (also known as Average Inventory)?

4. Calculate the Total Annual Cost

5. What is the Lead Time?

EOQ Example 2
Demand for the Deskpro computer at PC World is 1,000 units per month. PC World
incurs a fixed order placement, transportation, and receiving cost of $4,000 each
time an order is placed. Each computer costs PC World $500 and the retailer has a
holding cost of 20 percent.

SOLUTION
In this case, the store manager has the following inputs:
✓ Annual demand, D = 1,000 * 12 = 12,000 units

✓ Order cost per lot, Co = $4,000

✓ Unit cost per computer, Cm = $500

✓ Holding cost per year as a fraction of unit cost, Ch = 20%

EOQ Example 2
SOLUTION (CONT.)
Using the EOQ Model:

𝟐𝑫𝑪𝒐 𝟐 × 𝟏𝟐𝟎𝟎𝟎 × 𝟒𝟎𝟎𝟎

Q0 = 𝑪𝒉 𝟎. 𝟐 × 𝟓𝟎𝟎 = 980 computers

𝐷 12000
Number of orders per year = = = 12.24 𝑜𝑟𝑑𝑒𝑟𝑠
𝑄 980
EOQ Example 2
SOLUTION (CONT.)
To minimize the total cost at PC World, the store manager orders a lot size of
980 computers for each replenishment order. The cycle inventory is the
average resulting inventory

𝑄 980
= = = 490 Computers
2 2

Annual Ordering and Holding Cost

𝑄 𝐷 980 12000
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝐶ℎ + 𝐶𝑂 = .(0.2 X 500)+ x 4000 = $97,000
2 𝑄 2 980
EOQ Example 2
SOLUTION (CONT.)

Average Flow or Lead Time:

𝐴𝑣𝑔.𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑄 980
𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒 = = = = 0.041 years = 0.49 months
𝐷𝑒𝑚𝑎𝑛𝑑 2𝐷 2𝑋12000

Each computer thus spends 0.49 month, on average, at PC World before it

is sold because it was purchased in a batch of 980.
EOQ: Some Observations

∗ 𝟐𝑫𝑪𝒐
Optimal Lot Q =
𝑪𝒉

RULES:
❖ If demand increases by a factor of 𝑘:

✓ the optimal lot size increases by a factor of 𝒌.

✓ The number of orders placed per year should also increase by a factor of 𝒌.
EOQ: Some Observations
Relationship Between Desired Lot Size and Ordering Cost
✓ Let us assume the store manager at PC World would like to reduce the optimal lot size from
980 to 200. For this lot size reduction to be optimal, the store manager wants to:
1. Find out the impact it would have on Total Cost
2. Evaluate how much the ordering cost per lot should be reduced in order to optimize
cost if necessary.

Q1
𝑄 𝐷 200 12000
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝐶ℎ + 𝐶𝑂 = .(0.2 X 500)+ x 4000 = $250,000
2 𝑄 2 200

Q2
𝑄 𝐷
At Optimal Solution, Ordering Cost = Holding Cost: 𝐶ℎ = 𝐶
2 𝑄 𝑂

Solving for 𝐶𝑂 , Ordering Cost = $166.7:

EOQ: Some Observations
Relationship Between Desired Lot Size and Ordering Cost
✓ Thus, the store manager at PC World would have to reduce the order cost
per lot from $4,000 to $166.7 for a lot size of 200 to be optimal

➢ [Lot Size] From 980 >>>> To 200 >>>> a factor of 4.9 reduction
➢ [Ordering Cost] From $4,000 >> To $166.7 >> a factor of 4.92 reduction

RULE:
To reduce the optimal lot size by a factor of 𝒌, the fixed
order cost 𝑪𝑶 must be reduced by a factor of 𝒌𝟐