Special Inventory

Management & Control

Models
Non-instantaneous replacement
Quantity discount (Price break model)
One period decision (Single period model)
Noninstantaneous
Replenishment
Maximum cycle inventory to be decided!
Item used or sold as it is completed
Usually production rate, p, exceeds the demand
rate, d, so there is a buildup of (p d) units per
time period
Both p and d expressed in same time interval
Buildup continues for Q/p days to reach the
maxm cycle inventory
Noninstantaneous
Replenishment
Production quantity
Q
Maximum inventory
I
max

Production
and demand
Demand or
Consumption
only
TBO
p d
Demand during
production interval
O
n
-
h
a
n
d

i
n
v
e
n
t
o
r
y

Time
Lot Sizing with Noninstantaneous Replenishment
p
d
Noninstantaneous
Replenishment
Maximum cycle inventory is:
Cycle inventory is no longer Q/2, it is I
max
/2
where
p = production rate
d = demand rate
Q = lot size
( ) |
.
|

\
|
= =
p
d p
Q d p
p
Q
I
max
Noninstantaneous
Replenishment
Total annual cost = Annual holding cost
+ Annual ordering or setup cost
D is annual demand and Q is lot size
d is daily demand; p is daily production rate
( ) ( ) ( ) ( ) S
Q
D
H
p
d p Q
S
Q
D
H
I
C + |
.
|

\
|
= + =
2 2
max
Noninstantaneous
Replenishment
Economic Production Lot Size (ELS): optimal lot size
Derived by calculus
Because the second term is greater than 1,
the ELS results in a larger lot size than the
EOQ
d p
p
H
DS
ELS

=
2
Finding the Economic Production Lot
Size
EXAMPLE D.1
A plant manager of a chemical plant must determine the lot
size for a particular chemical that has a steady demand of
30 barrels per day. The production rate is 190 barrels per
day, annual demand is 10,500 barrels, setup cost is $200,
annual holding cost is $0.21 per barrel, and the plant
operates 350 days per year.
a. Determine the economic production lot size (ELS)
b. Determine the total annual setup and inventory
holding cost for this item
c. Determine the time between orders (TBO), or cycle
length, for the ELS
d. Determine the production time per lot
What are the advantages of reducing the setup time by 10
percent?
Finding the Economic Production
Lot Size
SOLUTION
a. Solving first for the ELS, we get
d p
p
H
DS

=
2
ELS
( )( )
barrels 4,873.4
30 190
190
21 0
200 500 10 2
=

=
. $
$ ,
b. The total annual cost with the ELS is
( ) ( ) S
Q
D
H
p
d p Q
C + |
.
|

\
|
=
2
( ) ( ) 200
4 873 4
500 10
21 0
190
30 190
2
4 873 4
$
. ,
,
. $
. ,
+
|
.
|

\
|

=
82 861 91 430 91 430 . $ . $ . $ = + =
Finding the Economic Production
Lot Size
c. Applying the TBO formula to the ELS, we get
( ) = = days/year 350
ELS
TBO
ELS
D
days 162 or 162.4 =
d. The production time during each cycle is the lot size divided
by the production rate:
=
p
ELS
( ) 350
500 10
4 873 4
,
. ,
days 26 or 25.6
190
4 873 4
=
. ,
Application D.1
A domestic automobile manufacturer schedules 12 two-
person teams to assemble 4.6 liter DOHC V-8 engines per
work day. Each team can assemble 5 engines per day. The
automobile final assembly line creates an annual demand for
the DOHC engine at 10,080 units per year. The engine and
automobile assembly plants operate 6 days per week, 48
weeks per year. The engine assembly line also produces
SOHC V-8 engines. The cost to switch the production line
from one type of engine to the other is $100,000. It costs
$2,000 to store one DOHC V-8 for one year.
a. What is the economic lot size?
b. How long is the production run?
c. What is the average quantity in inventory?
d. What is the total annual cost?
Application D.1
SOLUTION
a. Demand per day = d = 10,080/[(48)(6)] = 35
d p
p
H
DS

=
2
ELS
( )( )
38 555 1
35 60
60
000 2
000 100 080 10 2
. ,
,
, ,
=

=
or 1,555 engines
b. The production run
=
p
Q
days production 26 or 25.91
60
555 1
=
,
Application D.1
c. Average inventory
d. Total annual cost
engines 324
60
35 60
2
555 1
=
|
.
|

\
|
,
( ) ( ) ( ) ( ) S
Q
D
H
p
d p Q
S
Q
D
H
I
C + |
.
|

\
|
= + =
2 2
max
( ) ( ) 000 100
555 1
080 10
000 2
60
35 60
2
555 1
, $
,
,
, $
,
+
|
.
|

\
|

=
148 296 1
231 648 917 647
, , $
, $ , $
=
+ =
= |
.
|

\
|
=
p
d p Q I
2 2
max
Quantity Discounts
Price incentives to purchase large quantities create
pressure to maintain a large inventory
Items price is no longer fixed
If the order quantity is increased enough, then the price
per unit is discounted
A new approach is needed to find the best lot size that
balances:
Advantages of lower prices for purchased materials
and fewer orders
Disadvantages of the increased cost of holding more
inventory
Quantity Discounts
Total annual cost = Annual holding cost
+ Annual ordering or setup cost
+ Annual cost of materials
where P = price per unit, and
D = annual demand (consumption)
( ) ( ) PD S
Q
D
H
Q
C + + =
2
Quantity Discounts
Unit holding cost (H) is usually expressed as a
percentage of unit price
The lower the unit price (P) is, the lower the unit
holding cost (H) is
The total cost equation yields U-shape total cost
curves
There are cost curves for each price level
The feasible total cost begins with the top curve, then
drops down, curve by curve, at the price breaks
EOQs do not necessarily produce the best lot size
The EOQ at a particular price level may not be feasible
The EOQ at a particular price level may be feasible but
may not be the best lot size
Two-Step Solution Procedure
Step 1. Beginning with lowest price, calculate the EOQ
for each price level until a feasible EOQ is
found. It is feasible if it lies in the range
corresponding to its price. Each subsequent
EOQ is smaller than the previous one,
because P, and thus H, gets larger and
because the larger H is in the denominator of
the EOQ formula.
Step 2. If the first feasible EOQ found is for the
lowest price level, this quantity is the best
lot size. Otherwise, calculate the total cost
for the first feasible EOQ and for the larger
price break quantity at each lower price
level. The quantity with the lowest total cost
is optimal.
Quantity Discounts
(a) Total cost curves with purchased
materials added
(b) EOQs and price break quantities
PD for
P = $4.00
PD for
P = $3.50
PD for
P = $3.00
EOQ
4.00

EOQ
3.50

EOQ
3.00

T
o
t
a
l

c
o
s
t

(
d
o
l
l
a
r
s
)

Purchase quantity (Q)
0 100 200 300
First
price
break
Second
price
break
T
o
t
a
l

c
o
s
t

(
d
o
l
l
a
r
s
)

Purchase quantity (Q)
0 100 200 300
First
price
break
Second
price
break
C for P = $4.00
C for P = $3.50
C for P = $3.00
Total Cost Curves with Quantity Discounts
Find Q with Quantity
Discounts
EXAMPLE D.2
A supplier for St. LeRoy Hospital has introduced quantity
discounts to encourage larger order quantities of a
special catheter. The price schedule is
Order Quantity Price per Unit
0 to 299 $60.00
300 to 499 $58.80
500 or more $57.00
The hospital estimates that its annual demand for this item is
936 units, its ordering cost is $45.00 per order, and its annual
holding cost is 25 percent of the catheters unit price. What
quantity of this catheter should the hospital order to minimize
total costs? Suppose the price for quantities between 300 and
499 is reduced to $58.00. Should the order quantity change?
Find Q with Quantity
Discounts
SOLUTION
Step 1: Find the first feasible EOQ, starting with the lowest price
level:
= =
H
DS 2
EOQ
00 57.
( )( )
( )
units 77
00 57 25 0
00 45 936 2
=
. $ .
. $
A 77-unit order actually costs $60.00 per unit, instead of the
$57.00 per unit used in the EOQ calculation, so this EOQ is
infeasible. Now try the $58.80 level:
= =
H
DS 2
EOQ
80 58.
( )( )
( )
units 76
80 58 25 0
00 45 936 2
=
. $ .
. $
This quantity also is infeasible because a 76-unit order is too
small to qualify for the $58.80 price. Try the highest price level:
Find Q with Quantity
Discounts
This quantity is feasible because it lies in the range
corresponding to its price, P = $60.00
= =
H
DS 2
EOQ
00 60.
( )( )
( )
units 75
00 60 25 0
00 45 936 2
=
. $ .
. $
Step 2: The first feasible EOQ of 75 does not correspond to
the lowest price level. Hence, we must compare its
total cost with the price break quantities (300 and 500
units) at the lower price levels ($58.80 and $57.00):
Find Q with Quantity Discounts
( ) ( ) PD S
Q
D
H
Q
C + + =
2
( )( ) | | ( ) ( ) 284 57 936 00 60 00 45
75
936
00 60 25 0
2
75
75
, $ . $ . $ . $ . = + + = C
( )( ) | | ( ) ( ) 382 57 936 80 58 00 45
300
936
80 58 25 0
2
300
300
, $ . $ . $ . $ . = + + = C
( )( ) | | ( ) ( ) 999 56 936 00 57 00 45
500
936
00 57 25 0
2
500
500
, $ . $ . $ . $ . = + + = C
The best purchase quantity is 500 units, which qualifies for the
deepest discount
Application D.2
A suppliers price schedule is:
Order Quantity Price per Unit
099 $50
100 or more $45
If ordering cost is $16 per order, annual holding cost is 20
percent of the purchase price, and annual demand is 1,800
items, what is the best order quantity?
Application D.2
SOLUTION
Step 1:
= =
H
DS 2
EOQ
00 45.
( )( )
( )( )
e) (infeasibl units 80
2 0 45
16 800 1 2
=
.
,
= =
H
DS 2
EOQ
00 50.
( )( )
( )( )
(feasible) units 76
2 0 50
16 800 1 2
=
.
,
Step 2:
=
76
C ( ) ( ) ( ) 759 90 800 1 50 16
76
800 1
2 0 50
2
76
, $ ,
,
. = + +
=
100
C ( ) ( ) ( ) 738 81 800 1 45 16
100
800 1
2 0 45
2
100
, $ ,
,
. = + +
The best order quantity is 100 units
One-Period Decisions
Seasonal goods are a dilemma facing many
retailers.
Newsboy problem
Step 1: List different demand levels and
probabilities.
Step 2: Develop a payoff table that shows the profit
for each purchase quantity, Q, at each
assumed demand level, D.
Each row represents a different order
quantity and each column represents a
different demand.
The payoff depends on whether all units are
sold at the regular profit margin which
results in two possible cases.
One-Period Decisions
If demand is high enough (Q D), then all of the cases
are sold at the full profit margin, p, during the regular
season
If the purchase quantity exceeds the eventual demand
(Q > D), only D units are sold at the full profit margin,
and the remaining units purchased must be disposed
of at a loss, l, after the season
Payoff = (Profit per unit)(Purchase quantity) = pQ
Payoff = (Demand)
Loss
per
unit
Profit per
unit sold
during
season
Amount
disposed
of after
season
= p X D l X (Q D)
One-Period Decisions
Step 3: Calculate the expected payoff of each Q by
using the expected value decision rule. For
a specific Q, first multiply each payoff by its
demand probability, and then add the
products.
Step 4: Choose the order quantity Q with the
highest expected payoff.
Finding Q for One-Period
Decisions
EXAMPLE D.3
One of many items sold at a museum of natural history is a
Christmas ornament carved from wood. The gift shop makes a
$10 profit per unit sold during the season, but it takes a $5
loss per unit after the season is over. The following discrete
probability distribution for the seasons demand has been
identified:
Demand 10 20 30 40 50
Demand Probability 0.2 0.3 0.3 0.1 0.1
How many ornaments should the museums buyer order?
Finding Q for One-Period
Decisions
SOLUTION
Each demand level is a candidate for best order quantity,
so the payoff table should have five rows. For the first
row, where Q = 10, demand is at least as great as the
purchase quantity. Thus, all five payoffs in this row are
This formula can be used in other rows but only for those
quantitydemand combinations where all units are sold
during the season. These combinations lie in the upper-
right portion of the payoff table, where Q D. For example,
the payoff when Q = 40 and D = 50 is
Payoff = pQ = ($10)(10) = $100
Payoff = pQ = ($10)(40) = $400
Finding Q for One-Period
Decisions
The payoffs in the lower-left portion of the table represent
quantitydemand combinations where some units must be
disposed of after the season (Q > D). For this case, the payoff
must be calculated with the second formula. For example,
when Q = 40 and D = 30,
Using OM Explorer, we obtain the payoff table in Figure D.5
Payoff = pD l(Q D) = ($10)(30) ($5)(40 30) = $250
Now we calculate the expected payoff for each Q by multiplying
the payoff for each demand quantity by the probability of that
demand and then adding the results. For example, for Q = 30,
Payoff = 0.2($0) + 0.3($150) + 0.3($300) + 0.1($300) + 0.1($300)
= $195
Application D.3
For one item, p = $10 and l = $5. The probability distribution for the
seasons demand is:
Demand Demand
(D) Probability
10 0.2
20 0.3
30 0.3
40 0.1
50 0.1
Complete the following payoff matrix, as well as the column on
the right showing expected payoff. What is the best choice for
Q?
Application D.3
D
Expected
Payoff Q 10 20 30 40 50
10 $100 $100 $100 $100 $100 $100
20 50 200 200 200 200 170
30 0 300 300
40 50 100 250 400 400 175
50 100 50 200 350 500 140
Application D.3
Payoff if Q = 30 and D = 20:
pD l(Q D) = 10(20) 5(30 20) = $150
Payoff if Q = 30 and D = 40:
Expected payoff if Q = 30:
pD = 10(30) = $300
0(0.2) + 150(0.3) + 300(0.3 + 0.1 + 0.1) = $195
Q = 30 has the highest payoff at $195.00
D
Expected
Payoff Q 10 20 30 40 50
10 $100 $100 $100 $100 $100 $100
20 50 200 200 200 200 170
30 0 300 300
40 50 100 250 400 400 175
50 100 50 200 350 500 140
150 300 195
Solved Problem 1
Peachy Keen, Inc., makes mohair sweaters, blouses with
Peter Pan collars, pedal pushers, poodle skirts, and other
popular clothing styles of the 1950s. The average demand
for mohair sweaters is 100 per week. Peachys production
facility has the capacity to sew 400 sweaters per week.
Setup cost is $351. The value of finished goods inventory
is $40 per sweater. The annual per-unit inventory holding
cost is 20 percent of the items value.
a. What is the economic production lot size (ELS)?
b. What is the average time between orders (TBO)?
c. What is the total of the annual holding cost and setup cost?
Solved Problem 1
SOLUTION
a. The production lot size that minimizes total cost is
d p
p
H
DS

=
2
ELS
( )( )
( ) 100 400
400
40 20 0
351 52 100 2

=
$ .
$
sweaters 780
3
4
300 456 = = ,
b. The average time between orders is
= =
D
ELS
O TB
ELS
year 0.15
200 5
780
=
,
Converting to weeks, we get
( )( ) weeks 7.8 r weeks/yea 52 year 0.15 TBO
ELS
= =
Solved Problem 1
c. The minimum total of setup and holding costs is
( ) ( ) S
Q
D
H
p
d p Q
C + |
.
|

\
|
=
2
( ) ( ) 351
780
200 5
40 20 0
400
100 400
2
780
$
,
$ . +
|
.
|

\
|

=
r $4,680/yea r $2,340/yea r $2,340/yea = + =
Solved Problem 2
A hospital buys disposable surgical packages from Pfisher, Inc.
Pfishers price schedule is $50.25 per package on orders of 1 to 199
packages and $49.00 per package on orders of 200 or more
packages. Ordering cost is $64 per order, and annual holding cost is
20 percent of the per unit purchase price. Annual demand is 490
packages. What is the best purchase quantity?
SOLUTION
We first calculate the EOQ at the lowest price:
= =
H
DS 2
EOQ
00 49.
( )( )
( )
packages 80 400 6
00 49 20 0
00 64 490 2
= = ,
. $ .
. $
Solved Problem 2
This solution is infeasible because, according to the price
schedule, we cannot purchase 80 packages at a price of
$49.00 each. Therefore, we calculate the EOQ at the next
lowest price ($50.25):
= =
H
DS 2
EOQ
25 50.
( )( )
( )
packages 79 241 6
25 50 20 0
00 64 490 2
= = ,
. $ .
. $
This EOQ is feasible, but $50.25 per package is not the lowest
price. Hence, we have to determine whether total costs can be
reduced by purchasing 200 units and thereby obtaining a
quantity discount.
Solved Problem 2
( ) ( ) PD S
Q
D
H
Q
C + + =
2
( ) ( ) ( ) 490 25 50 00 64
79
490
25 50 20 0
2
79
79
. $ . $ . $ . + + = C
( ) ( ) ( ) 490 00 49 00 64
200
490
00 49 20 0
2
200
200
. $ . $ . $ . + + = C
/year $25,416.44 $24,622.50 ar $396.68/ye ar $396.98/ye = + + =
/year $25,146.80 $24,010.00 ar $156.80/ye ar $980.00/ye = + + =
Purchasing 200 units per order will save $269.64/year,
compared to buying 79 units at a time.
Solved Problem 3
Swell Productions is sponsoring an outdoor conclave for
owners of collectible and classic Fords. The concession stand
in the T-Bird area will sell clothing such as T-shirts and official
Thunderbird racing jerseys. Jerseys are purchased from
Columbia Products for $40 each and are sold during the event
for $75 each. If any jerseys are left over, they can be returned
to Columbia for a refund of $30 each. Jersey sales depend on
the weather, attendance, and other variables. The following
table shows the probability of various sales quantities. How
many jerseys should Swell Productions order from Columbia
for this one-time event?
Sales Quantity Probability Quantity Sales Probability
100 0.05 400 0.34
200 0.11 500 0.11
300 0.34 600 0.05
Solved Problem 3
SOLUTION
Table next slide is the payoff table that describes this one-
period inventory decision. The upper right portion of the table
shows the payoffs when the demand, D, is greater than or
equal to the order quantity, Q. The payoff is equal to the per-
unit profit (the difference between price and cost) multiplied by
the order quantity. For example, when the order quantity is
100 and the demand is 200,
Payoff = (p c)Q = ($75 - $40)100 = $3,500
Solved Problem 3
PAYOFFS table
Demand, D
Expected
Payoff Q 100 200 300 400 500 600
100 $3,500 $3,500 $3,500 $3,500 $3,500 $3,500 $3,500
200 $2,500 $7,000 $7,000 $7,000 $7,000 $7,000 $6,775
300 $1,500 $6,000 $10,500 $10,500 $10,500 $10,500 $9,555
400 $500 $5,000 $9,500 $14,000 $14,000 $14,000 $10,805
500 ($500) $4,000 $8,500 $13,000 $17,500 $17,500 $10,525
600 ($1,500) $3,000 $7,000 $12,000 $16,500 $21,000 $9,750
Solved Problem 3
The lower-left portion of the payoff table shows the payoffs
when the order quantity exceeds the demand. Here the
payoff is the profit from sales, pD, minus the loss
associated with returning overstock, l(Q D), where l is the
difference between the cost and the amount refunded for
each jersey returned and Q D is the number of jerseys
returned. For example, when the order quantity is 500 and
the demand is 200,
Payoff = pD l(Q D) = ($75 - $40)200 ($40 $30)(500 200)
= $4,000
The highest expected payoff occurs when 400 jerseys are
ordered:
Expected payoff
400
= ($500 0.05) + ($5,000 0.11)
+ ($9,500 0.34) + ($14,000 0.34)
+ ($14,000 0.11) + ($14,000 0.05)
= $10,805