INVENTORY AND ECONOMIC ORDER QUANTITY MODELS Types of Demand Retailers and distributors must manage independent demand

items-that is, items for which demand is influenced by market conditions and isnt related to the inventory decisions for any other item held in stock. Independent demand inventory includes: 1. . !. ". wholesale and retail merchandise service industry inventory end-item and replacement part distribution inventories maintenance, repair and operating #$R%& supplies

$anufacturers and service providers must manage dependent demand items-that is, items that are re'uired as components or inputs to a product or service. Accountin Cate o!ies of In"ento!y Inventory e(ists in three aggregate categories, which are useful for accounting purposes. Ra# mate!ia$s are inventories needed for the production of good or services. )hile they have arrived from the supplier, no processing has yet been applied to them. %o!&'in' p!ocess consists of components or sub assemblies used in the manufacture of final products. )I* is also present in service industries. In both cases, one or more phases of processing have been completed. (inis)ed oods in manufacturing plants, warehouses, and retail outlets are items sold to the firms customers. Types of In"ento!y +nother way to look at inventory is to consider how or why it comes into being. Cycle inventory* ,he portion of total inventory that varies directly with the lot si-e is called cycle inventory. .etermining how much to order and how often is called $ot si+in . ,he lot si-e and therefore the cycle inventory vary directly with the elapsed time between orders. /or e(ample, if orders are placed every three weeks, the average lot si-e must e'ual ! weeks of demand and the average cycle inventory will be 1-0 weeks of demand. Safety stock inventory. ,o provide ade'uate customer service and avoid costs of unavailable components, companies hold safety stock. 1afety stock inventory protects against uncertainties in demand, lead-time and supply. ,o create safety stock, a firm places an order for an item earlier than when the items is e(pected to be needed. Anticipation inventory. Inventory used to absorb uneven rates of demand or supply is called anticipation inventory. It is often an attractive alternative to changing the si-e of the workforce and the use of overtime. + common e(ample is building an inventory for a peak sales season.

Pipeline inventory. Inventory moving from point to point in the materials flow system is called pipeline inventory. *ipeline inventory between two points is determined by the corresponding lead-time. Decoupling inventory. Inventory thats serves as a buffer between stages in a production process that have significantly different operating characteristics #e.g., set up times, lot si-es, run lengths, product fle(ibility, etc.&. It also is used to buffer production from distribution. A,C In"ento!y C$assification Inventories are often classified in order to allocate the appropriate e(tent of management review. + typical approach is the +23 classification. C$ass A items typically represent 145 to 45 of the items types or stock keeping units #167& and as much as 845 of the dollar value of the inventory. ,hese items are identified for top management attention. C$ass , items typically represent about !45 of the items types or 167s and 145 to 45 of the dollar value of the inventory. ,hese items receive management attention by e(ception and typically are handled by computer systems. C$ass C items typically represent about 945 of the items types or 167s and as little as 95 of the dollar value of the inventory. ,hese items are handled by crude systems and seldom receive management attention. In"ento!y -$acement + critical decision in the design of supply chains is where to locate the inventories of finished goods. ,ac&#a!d p$acement refers to the strategy of placing inventory back in the supply chain. ,he e(treme case is to hold no finished goods inventory and to assemble to order or build to order. +nother somewhat less e(treme case is to hold inventory in a single centrali-ed facility. 2ackwards placement provides the benefits of pooling which reduces risk and the levels of safety stock re'uired. (o!#a!d p$acement is the opposite strategy of placing inventory backward in the supply chain, i.e., nearer the customer. ,he advantages include faster response time to customers and, sometimes, reduced transportation costs, both of which can lead to enhanced sales. In"ento!y Re"ie# Systems Inventory levels are reviewed or measured either continuously or periodically.

Continuous Re"ie# .Q/ Systems, sometimes called !eo!de! point .RO-/ systems0 track the inventory level each time a withdrawal is made to determine if it is time to reorder. )henever the inventory level falls to or below a !eo!de! point .R/, an order for a fi(ed 'uantity #:& is made. +lthough the order si-e is fi(ed, the time 1et#een o!de!s .T,O/ will change. -e!iodic Re"ie# .-/ Systems, review the inventory level at fi(ed periods #e.g., weekly, monthly& in order to determine how large an order to place. +n order is placed to take the inventory position #on hand inventory ; schedules receipts < backorders& up to a predetermined target level #,&. ,hus in a * system the ,2% is constant but the order 'uantity will change. ECONOMIC ORDER QUANTITY In a continuous review system, ordering too often #in 'uantities too small& increases the annual cost of placing orders. %rdering too infre'uently #in 'uantities too large& increases the annual cost of holding inventory. ,he economic o!de! 2uantity .EOQ/ is the 'uantity that minimi-es the sum of these two costs. It is based on the following assumptions: 1. . !. ". 9. ?. ,he demand for the item is constant and known with certainty. ,here are no upper or lower limits on the order 'uantity #lot si-e&. 1tockouts are not permitted. ,here are no 'uantity discounts. =ead time and supply are known with certainty> lead time is constant. %rder 'uantities for individual items are made independently.

,he classic @saw toothA diagram of inventory level over time is illustrated in /igure 1.

/igure 1. Inventory levels over time.

If we define 3 - total annual #period& cost 1 - fi(ed cost of placing an order . - annual #period& demand B - annual #period& unit cost of holding inventory : < order 'uantity #to be determined& then
C= SD HQ + . Q

,he /igure displays the cost relationships involved in the model: Cost Versus Order Quantity
1200 1000 800 600 400 200 0 100 200 300 400 500 Q Order Cost = (S*D)/Q Holdin Cost = (H*Q)/2 !ot"l Cost 600 700 800 900 1000

/igure . Inventory cost versus order si-e :. ,he economic order 'uantity is calculated by
EOQ = SD . H

MINIMUM ORDER SI3ES AND ORDER ,LOC4 SI3ES .ealing with minimum order si-es and order block si-es #a number which all order si-es must be a multiple of& is 'uite easy. )e Round C%: to +%: #allowable order 'uantity& by choosing the multiple of the order block si-e that is closest to C%: and at least e'ual to minimum order si-e QUANTITY DISCOUNTS

Cost

In many instances, a vendor offers an item at a unit price, which we will call the normal cost and denote by *n, but will make the item available at a reduced unit cost, which we will call the discount cost and denote by *d, as long as the order si-e is at least e'ual to the discount volume #.D&. In such a case we begin by calculating C%: and rounding to +%:. ,he cost relationships for the 'uantity discount problem are illustrated in /igure !.

/igure !. 3ost relationships for 'uantity discounts. ,herefore, we must compare the total cost per period for +%: and .D and use whichever produces the smaller cost. ,his total cost adds the purchase cost per period to the order plus holding cost specified previously. ,hus we calculate
#1&
OR

Daily Cost at AOQ =

SD H E AOQ + + D E Pn , IF AOQ < DV AOQ

Daily Cost at AOQ =

SD H E AOQ + + D E Pd , IF AOQ DV AOQ

AND
# & Daily Cost at DV = SD H E DV + + D E Pd DV

Bowever, it can be noted that whenever +%: F .D, the cost comparison will always select +%:.

E5AM-LES
1uppose demand for final product is as follows: /441: G8 /44 : "" /44!: 1G8 3onsider *4!H 1pokes 4A %rder cost #1&: I 14 Jormal 3ost #*n &: I 4.494 .iscount Dolume #.D&: 44,444 %rder block: ,444 Bolding 3ost *er .ay #B&: I4.4444G .iscount 3ost #*d &: I 4.4"9 $inimum %rder: 4,444

1ince there are H *4!Hs in each /441 and 4 in each /44 and /44!, we estimate daily volume for *4!H as . K .aily Dolume K G8#H &; ""#4&;1G8#4& K H49?
Q= SD = H #14&#H49?& = !G,9G8 .4444G

+bove minimum order so round to +%: K "4,444 1ince +%: is below .D we calculate by #1& by using the first e'uation
Daily Cost at AOQ = 14#H,49?& .4444G# "4,444& + + H,49?#.494& = 1.H? +1.84 + !9 .84 = !9?.!? "4,444

and by # &
DailyCost at DV = 14#H,49?& .4444G# 44,444& + + H,49?#.4"9& = 4.!9 + G.44 + !1H.9 = ! ?.8H 44,444

,hen since .aily 3ost at .D L .aily 3ost at +%: order 'uantity is set to discount volume K 44,444. %rder cycle K .DM . K 44,444M#H,49?& K 8.! days 3onsider *4"! 1teel ,ubing %rder cost#1&: I "9 Bolding 3ost *er .ay#B&: I4.444!9

Jormal 3ost #*n &: I 4. 4 .iscount Dolume #.D&: 14,444 %rder block: 1444

.iscount 3ost #*d &: I 4.18 $inimum order: 9,444

1ince there are 1 *4"!s in each /441, ! in each /44 and " in each /44!, we estimate daily volume for *4"! as . K .aily Dolume K G8 # 1& ; ""# !& ; 1G8# "& K 1 ,"
Q= SD = H # "9&#1 ," .444!9 & = 9?,91H,91

+bove minimum order so round to 9H,444 1ince +%: is above .D we calculate by #1& by using the second e'uation
Daily Cost at AOQ = "9#1 ," & .444!9#9H,444& + +1 ," 9H,444 #.18& = G.81 + G.GH + , !9.G? = , 99.H"

and by # &
Daily Cost at DV = "9#1 ," & .444!9#14,444& + +1 ," 14,444 #.18& = 99.G4 +1.H9 + , !9.G? = , G!.?1

,hen since .aily 3ost at +%: L .aily 3ost at .D order 'uantity is set to +%: K 9H,444. ,his could have been anticipated since +%: N .D. %rder cycle K+%:M. K 9H,444M1 ," K ".? days