INDEPENDENT DEMAND SYSTEMS: DETERMINISTIC MODELS

A major reason for having inventory is to enable an organization to buy or produce items in economic lot sizes Economic lot sizing often applied when organization want to maintain a regular inventory of items which have a fairly uniform, independent demand To determine an optimum inventory policy, information on the following parameters is required Demands, Appropriate inventory costs and Lead times Inventory policy find answers for - how many and when to order FIXED ORDER SIZE SYSTEMS The stock level is reviewed with each transaction Whenever the inventory position reaches a predetermined point, an order for a fixed number of units is placed The two parameters of the system are Reorder point and Size of the order This system also is termed a Q-system

Stock available

Stock receipt

Demand occurs (units withdrawn)

Determine stock position (on hand + on order-back order)

No

Is stock position Reorder point?

Yes Issue replenishment order Fig. 1 Fixed Order Quantity System

37
National Institute of Technology Calicut Department of Mechanical Engineering

Economic Order Quantity (EOQ) Single Item EOQ - The order quantity that minimizes the total inventory cost

Notations Used R annual demand in units P purchase cost of an item C ordering cost per order H = PF holding cost per unit per year Q lot size or order quantity in units F annual holding costs as a fraction of unit cost TC total annual cost
60

50

Inventory

40

30

20

10

4 Time

Fig. 2 Inventory Variation graph

2.5 x 10
4

1.5 Total Costdata1 Annual order Cost Annual Carrying Cost Purchase Cost

Cost
1 0.5 0 0

100

200

300

400

500

600

700

800

Order Quantity

Fig. 3 Annual Inventory Cost 38

National Institute of Technology Calicut Department of Mechanical Engineering

Total annual cost = purchase cost + order cost + holding cost

Q0 =

2CR 2CR = H PF

Number of order per year = m = Order interval = T =

R HR = Q0 2C

1 Q0 2C = = m R HR RL Reorder level = B = 12

Replenishment order arrives just as the last item leaves the inventory which restores the inventory level to the amount ordered B < Q -never more than one order outstanding B > Q at least one order outstanding always

Assumptions Demand rate known, constant and continuous Lead time known and constant Entire lot size is added to inventory at the same time No stockouts are permitted Cost structure is fixed There is sufficient space and capital to procure the desired quantity The item is a single product; it does not interact with any other inventory item

EOQ SENSITIVITY Determines how the output of a model will be influenced by changes or errors in the input data Insensitive input can assume a wide range of values without appreciably affecting the output Analyses the errors in determining the parameters R, H, C effect in the output

Usefulness How errors in estimation could affect decisions and resulting cost Input parameters may change over time, so sensitivity analysis can help in deciding at what point it will be necessary to revise inventory decisions 39
National Institute of Technology Calicut Department of Mechanical Engineering

The effect of adjusting the order quantity to above or below EOQ to take account of factors such as capacity limitations, transportation efficiencies or packaging restrictions

Analysis Notations TVC total annual variable cost or total relevant cost Q - order quantity with parameter errors Q0 economic order quantity Input Error Factor Estimation estimated demand = demand error factor XR = actual demand

estimated order cost = order cost error factor actual order cost estimated holding cost Xh = = holding cost error factor actual holding cost Xc =

TVC(Q) =

CR HQ + Q 2

(General total variable cost equation)

TVC (Q0 ) =

CR HQ 0 + = HQ0 Q0 2

(Total variable cost at optimum order quantity)

Error in EOQ due to error in input factor

Q=

X c X R Q0 X c X R X h 2CR X c X R = Q0 = H Xh Xh Xh
XcXR 1 = order quantity error fraction Xh

Q Q0 = Q0

Sensitivity of the total variable cost per year to errors in input parameters

TVC(Q) =

CR HQ + Q 2

When the inputs are measured erroneously, the above equation becomes

40
National Institute of Technology Calicut Department of Mechanical Engineering

TVC(Q) =

CX c RX R
Q0 Xc XR Xh Xh

HX hQ0

Xc X R Xh Xh 2

= TVC (Q0 ) X c X R X h
TVC (Q) TVC (Q0 ) = X c X R X h 1 = TVC error fraction TVC (Q0 )

This shows that for single parameter variations, the effect on total cost is the same irrespective of the parameter (C, R, or H) Errors in parameters are dampened when translated into their impact on total incremental cost For example, if the ordering cost is in error by 40% on the high side ( X c = 1.4) it results in only an 18.3% increase over the theoretically possible minimum total variable cost

(Refer Fig. 4 for errors in input factor estimation and the corresponding effect in TVC. Also refer Table 1) Sensitivity of the total variable cost per year to rounding in EOQ

TVC (Q0 ) =

CR HQ 0 + = HQ0 Q0 2

TVC ( Q ) =
XQ =

HQ 0 X Q CR + Q0 X Q 2

estimated EOQ = EOQ error factor actual EOQ

TVC (Q ) TVC (Q0 ) = TVC (Q0 )

=

2 X Q 2X Q +1

HQ0 X Q CR + HQ0 Q0 X Q 2
1)

2X Q

(X

HQ0
= TVC error factor

2X Q

Fairly sizable lot size errors result in comparatively small increases in total variable costs

(Refer Fig. 4 for rounding errors in the EOQ and the corresponding effect in TVC. Also refer 41
National Institute of Technology Calicut Department of Mechanical Engineering

Table 1)

400

Table 1 Error factor and Error in TVC

Error Factor Error in TVC(Q0) Error in TVC(Q0) (Xi or XQ) due to XQ due to Xi 0.1 -68.4 405 0.2 -55.3 160 0.3 -45.2 81.7 0.4 -36.8 45 0.5 -29.3 25 0.6 -22.5 13.4 0.7 -16.3 6.4 0.8 -10.6 2.5 0.9 -5.1 0.6 1 0 0 1.2 9.5 1.7 1.4 18.3 5.7 1.6 26.5 11.3 1.8 34.2 17.8 2 41.4 25 2.2 48.3 32.8 2.4 54.9 40.9 2.6 61.2 49.3 2.8 67.3 57.9 3 73.2 66.7 4 100 112.5

350

300 Absolute TVC error

250

200

150

100

EOQ Error C, R, or H Error

50

0
0. 7 1. 6 2. 2 0. 1 0. 4 2. 8 1

Error Factor

Fig. 4 Effect of errors in C, R, H, or TVC(Q0)

Xi = (estimated i)/(actual i), where i is any of the three parameters and there are no errors in the other two. Thus, if i were C, then R and H would have no errors.

As shown in fig. 4, the cost penalty is greater for errors of underestimation than errors of overestimation This indicates the general desirability for estimates to be on the high side to avoid the larger cost penalty for low estimates

EOQ Sensitivity and Inventory Turnover EOQ formula indicates that inventory should increase only with the square root of demand Thus, a constant inventory turnover is not justified as demand (sales) increases As demand increases, a higher turnover rate should be expected Inventory turnover is the ratio of the annual cost of goods sold to the average or current inventory investment

42
National Institute of Technology Calicut Department of Mechanical Engineering