UNIT 8 INVENTORY MODELS

Structure
8.1 Introduction
Objectives
8.2 Inventory Control
8.3 Economic Order Quantity (EOQ) Model with Uniform Demand
8.4 EOQ Model with Different Rates of Demand in Different Cycles
8.5 EOQ Model when Shortages are Allowed
8.6 EOQ Model with Uniform Replenishment
8.7 EOQ Model with Price (or Quantity) Discounts
8.8 Summary
8.9 Solutions/Answers

8.1 INTRODUCTION
In Unit 7, you have studied the sequencing problem, which involves
determining the optimum order or sequence of jobs for a process to optimise
the total time. We have discussed two types of sequencing problems: the ones
with n number of jobs to be completed through 2 machines and those with 2
jobs to be completed through m number of machines, in some pre-assigned
order.
In this unit, we discuss various inventory models. Inventory refers to a stock of
goods, materials, human resources or financial resources or any other idle
resource having some economic value, which is stocked in order to meet the
demand expected in future. Almost every business must maintain an inventory
for running its operations efficiently and smoothly.
Although inventories are essential for business, maintenance of inventories
also costs money by way of expenses on stores, equipment, personnel,
insurance, etc. Thus, excess inventories are undesirable. This calls for
controlling the inventories in the most profitable way. In the present unit, we
discuss the models for inventory control known as economic order quantity
models. These models help in deciding as to how much quantity should be
kept in stock in order to balance the costs of holding too much stock vis-à-vis
the costs of ordering in small quantities.
In this unit, we discuss inventory control and various factors involved in
inventory analysis in Sec. 8.2. In Secs. 8.3 to 8.7, we describe five models for
determining the economic order quantity: i) when demand is uniform; ii)
when rates of demand are different in different cycles; iii) when shortages are
allowed; iv) when replenishment is uniform; and v) when price (or quantity)
discounts are given.

Objectives
After studying this unit, you should be able to:
 explain the concept of inventory control;
 determine the economic order quantity when demand is uniform;
 determine the economic order quantity when rates of demand are different
in different cycles;
57
Optimisation Techniques-II  determine the economic order quantity when shortages are allowed;
 determine the economic order quantity when replenishment is uniform; and
 determine the economic order quantity when there are price discounts.

8.2 INVENTORY CONTROL

An inventory means a physical stock of idle resources of any kind having
some economic value kept for the purpose of meeting future demand. It
indicates the raw material required before production, the finished goods after
production ready for delivery to consumers, human resources, financial
resources, etc., which are stocked in order to meet an expected demand in the
future. Almost every business must maintain an inventory for running its
operations efficiently and smoothly. If an enterprise does not maintain an
inventory, it may suddenly find at some point in its operations that it has no
materials or goods to supply to its customers. Then on receiving a sales order,
it will first have to place order for purchase of raw materials, wait for their
receipt and then start production. The customer will, thus, have to wait for a
long time for the delivery of the goods and may turn to other suppliers,
resulting in loss of business/goodwill for the enterprise.
Maintaining an inventory is necessary because of the following reasons:
i) It helps in smooth and efficient running of an enterprise.
ii) It provides service to the customer at short notice. Timely delivery can
fetch more goodwill and orders.
iii) In the absence of the inventory, an enterprise may have to pay high prices
because of piecemeal purchasing. Maintaining an inventory may earn price
discounts because of bulk purchasing. Such purchases entail less orders
and, therefore, less clerical costs.
iv) It also takes advantage of favourable market.
v) It acts as a buffer stock when raw materials are received late and shop
rejections are too many.
vi) Process and movement inventories (also called pipeline stocks) are quite
necessary in big enterprises wherein a significant amount of time is
required to ship items from one location to another.
Though inventories are essential, their maintenance also costs money by way
of expenses on stores, equipment, personnel, insurance, etc. Thus, excess
inventories are undesirable. So, only that quantity should be kept in stock,
which balances the costs of holding too much stock vis-à-vis the costs of
ordering in small quantities. This calls for controlling the inventories in the
most profitable way and that is why we need inventory analysis. We now
discuss various factors involved in inventory analysis.
1. Inventory related costs
Various costs associated with inventory control are often classified as
follows:
i) Set-up cost: This is the cost associated with the setting up of
machinery before starting production. The set-up cost is generally
assumed to be independent of the quantity ordered for.
ii) Ordering cost: This is the cost incurred each time an order is placed.
This cost includes the administrative costs (paper work, telephone
calls, postage), transportation, receiving and inspection of goods, etc.
58
 iii) Purchase (or production) cost: It is the actual price at which an item Inventory Models
is purchased (or produced). It may be constant or variable. It becomes
variable when quantity discounts are allowed for purchases above a
certain quantity.
iv) Carrying (or holding) cost: The cost includes the following costs for
maintaining the inventory: i) Rent for the space; ii) cost of equipment
or any other special arrangement for storage; iii) interest of the money
blocked; iv) the expenses on stationery; v) wages of the staff required
for the purpose; vi) insurance and depreciation; and vii) deterioration
and obsolescence, etc.
v) Shortage (or Stock-out) cost: This is the penalty cost for running out of
stock, i.e., when an item cannot be supplied on the customer’s demand.
These costs include the loss of potential profit through sales of items
demanded and loss of goodwill in terms of permanent loss of the customer.
2. Demand
Demand is the number of units required per period and may either be
known exactly or known in terms of probabilities. Problems in which
demand is known and fixed are called deterministic problems whereas
problems in which demand is known in terms of probabilities are called
probabilistic problems.
3. Selling Price
The amount which one gets on selling an item is called its selling price.
The unit selling price may be constant or variable, depending upon
whether quantity discount is allowed or not.
4. Order Cycle
The period between placement of two successive orders is referred to as
an order cycle. The order may be placed on the basis of either of the
following two types of inventory review systems:
a) The record of the inventory level is checked continuously until a
specified point is reached where a new order is placed. This is called
continuous review.
b) The inventory levels are reviewed at equal intervals of time and orders
are placed accordingly at such levels. This is called periodic review.
5. Time Horizon
The period over which the time cost will be minimised and inventory
level will be controlled is termed as time horizon. This can be finite or
infinite depending on the nature of demand.
6. Stock Replenishment
The rate at which items are added to the inventory is called the rate of
replenishment. The actual replenishment of items may occur at a uniform
rate or be instantaneous over time. Usually uniform replacement occurs in
cases when the item is manufactured within the factory while
instantaneous replacement occurs in cases when the items are purchased
from outside sources.
7. Lead Time
The time gap between placing an order for an item and actually receiving
the item into the inventory is referred to as lead time.
59
Optimisation Techniques-II 8. Reorder Level
The lower limit for the stock is fixed at which the purchasing activities
must be started for replenishment. With this replenishment, the stock
reached at a level is known as maximum stock. The level between
maximum and minimum stock is known as the reorder level.
9. Economic Order Quantity (EOQ)
The order in quantity that balances the costs of holding too much stock
vis-à-vis the costs of ordering in small quantities too frequently is called
Economic Order Quantity (or Economic lot size).
10. Reorder Quantity
The quantity ordered at the level of minimum stock is known as the
reorder quantity. In certain cases it is the ‘Economic Order Quantity’.
In Secs. 8.3 to 8.7, we shall discuss the following inventory models for
obtaining economic order quantity:
i) EOQ Model with Uniform Demand
ii) EOQ Model with Different Rates of Demand in Different Cycles
iii) EOQ Model when Shortages are Allowed
iv) EOQ Model with Uniform Replenishment
v) EOQ Model with Price (or Quantity) Discounts
However, before discussing these models, we give the notations that we shall
use in the development of the models.
The notation used in the Models
Q = Number of units ordered (supplied) per order
D = Demand in units of inventory per year
N = Number of orders placed per year
TC = Total Inventory cost
C O = Ordering cost per order
C = Purchase or manufacturing price per unit inventory
Ch = Carrying or holding cost per unit per period of time the inventory is kept

Cs = Shortage cost per unit of inventory

t = The elapsed time between placement of two successive orders
rp = Replenishment rate at which lot size Q is added to inventory.

8.3 ECONOMIC ORDER QUANTITY (EOQ)

MODEL WITH UNIFORM DEMAND
The objective of the EOQ model with uniform demand is to determine an
optimum economic order quantity such that the total inventory cost is
minimised. We make the following assumptions for this model:
1. Demand rate (D) is constant and known;
2. Replenishment rate (rp) is instantaneous;
60 3. Lead time is constant and zero;
4. Purchase price is constant, i.e., discounts are not allowed; Inventory Models

5. Carrying cost and ordering cost are known and constant; and
6. Shortages are not allowed.
The situation can be graphically represented as shown in Fig. 8.1.

Inventory
A C E
Level

O B D F Time Period
Fig. 8.1

The graph in Fig. 8.1 shows that initially there were Q units in the stock. The
number of units goes on decreasing with respect to time to meet the demand
and this is represented by the line AB in the graph. When the stock vanishes,
i.e., the point B is reached, the stock level rises to Q instantaneously as the
replenishment is instantaneous. Since the demand is uniform, the rate of
decrease of the quantity remains the same as earlier. Therefore, this is
represented by the line CD in the graph, which is parallel to AB. Similarly, EF
is parallel to AB and CD due to uniform demand, and so on.

Since the demand is uniform, the average inventory is simply the arithmetic
mean of the maximum and the minimum levels of inventory. Let Q be the
quantity ordered (or replenished) when the minimum level, i.e., zero is
reached.
Q0 Q
Therefore, the average inventory = 
2 2
The ordering cost = Number of orders per year  ordering cost per order
D
= N  CO =  CO
Q
The carrying cost = Average units in inventory  carrying cost per unit
Q
=  Ch
2
The total inventory cost is the ordering cost plus the carrying cost. Therefore,

D Q
TC  CO  C h
Q 2
The total inventory cost (TC) is minimum at that value of Q where the
derivative of TC with respect to Q is zero. Differentiating TC with respect to
Q and then equating it to zero, we get

D 1
 2
CO  Ch  0
Q 2
61
Optimisation Techniques-II D Q
 CO  Ch (i.e., ordering cost = carrying cost)
Q 2
2D C O 2 DCO
 Q2  Q
Ch Ch
This value of Q minimises the total inventory cost (TC) and hence it is the
economic order quantity. Let us denote it by Q*. Thus, the EOQ for this model
is
2 D CO
Q* 
Ch
D
Hence, the optimum number of orders placed per year  N * 
Q*
The minimum total yearly inventory cost

D Q* 2DC O + (Q*)2 C h
(TC*) = Q * C O +
2
Ch =
2Q *

= 2 D COCh (on simplification)

and the total minimum cost = TC *  cost of material.

Let us consider an example to obtain the total minimum cost in this model.
Example 1: An enterprise requires 1000 units per month. The ordering cost is
estimated to be ` 50 per order. In addition to ` 1, the carrying costs are 5% per
unit of average inventory per year. The purchase price is ` 20 per unit. Find the
economic lot size to be ordered and the total minimum cost.
Solution: We are given that
D = Monthly demand  12
= 1000  12 = 12000 units per year
C O  ` 50 per order; C = ` 20 per unit
C h  1  5% of ` 20
= 1 + 1 = ` 2 per unit of average inventory

The economic lot size, therefore, is given by

2 D CO 2 12000  50
Q*    775 units
Ch 2
Total minimum cost = TC* + Cost of material

= 2 D CO Ch  12000  20 

= 2  12000  50  2  240000
= 2400000  240000 = 240  100  240000
= 15.5  100 + 240000 = ` 241550

You may now like to solve the following problems to assess your
understanding.
62
 Inventory Models
E1) The XYZ manufacturing company uses 12000 units of raw material
annually, which costs `1.25 per unit. Placing each order costs
`15 and the carrying costs are 15% per year per unit of the average
inventory. Find the economic order quantity.
E2) The XYZ manufacturing company has determined from an analysis of its
accounting and production data for a part, that its cost to purchase is
`36 per order and `2 per part. Its inventory carrying charge is 18% of the
average inventory. The demand of this part is 10000 units per annum.
a) What should the economic order quantity be?
b) What is the optimum number of days supply per optimum order?

8.4 EOQ MODEL WITH DIFFERENT RATES OF

DEMANDS IN DIFFERENT CYCLES
In this EOQ model, the same quantity is ordered each time when the stock
vanishes with the assumption that the replenishment is instantaneous. The
demand is not uniform and the stock vanishes in different periods of time. The
situation can be graphically represented as shown in Fig. 8.2.

Inventory
level

Time period
t1 t2 t3

Fig. 8.2

Let the demand in different periods of time t1, t2, …, tn be D1, D2, …, Dn,
respectively, so that the total demand in time T is given by

D = D1 + D2 + …+ Dn where T = t1 + t2 + … + tn
The cost of ordering in time T
= No. of orders per year  ordering cost per order
 N CO
Total Demand in time T ´ Ordering cost per order
=
No. of units ordered per order
D
  CO
Q

The carrying cost for time T

= Average unit in inventory  carrying cost per unit
63
Optimisation Techniques-II Q  t1 Q t2 Q tn
 Ch  C h  ...  Ch
2 2 2
Q QC h T
 Ch  t1  t 2  ...  t n  
2 2
 The total inventory cost (TC) = ordering cost + carrying cost
DCO QC h T
TC  
Q 2
This cost is minimum when its derivative with respect to Q is zero,
i.e., if
D 1
 2
C O  TC h  0
Q 2
D Q
 C O  TC h (i.e., ordering cost = carrying cost)
Q 2
2D C O 2D CO
 Q2  Þ Q* =
ChT Ch T

This result is similar to that of the model discussed in Sec. 8.3. The only
difference is that the uniform demand (D) is replaced by the average demand
(D/T).
D CO Q *T Ch 2DCO + (Q*)2 TC h
(TC*) = Q*
+
2
=
2Q*

= 2 D C O C h T (on simplification);

The total minimum cost = (TC*) + Cost of material

If T = 1 year, the result of this model is exactly the same as the EOQ model
with uniform demand.

8.5 EOQ MODEL WHEN SHORTAGES ARE

ALLOWED
The assumptions made for this model are the same as those for the EOQ model
with uniform demand discussed in Sec. 8.3, except that shortages are allowed,
which may occur frequently. The cost of shortages is assumed to be directly
proportional to the number of units short. The assumptions for the model are:
i) Demand is constant and known;
ii) Replenishment is instantaneous;
iii) Lead time is zero;
iv) Purchasing cost is constant and known;
v) Carrying cost and ordering cost are constant and known; and
vi) Shortage is allowed and the shortage cost is directly proportional to the
number of units short.
The situation can be represented graphically as shown in Fig. 8.3.

64
 Inventory Models
Inventory
level

Q M
t2
t1
O
F E
S = QM

C
B t
Fig. 8.3
Here,
Q = No. of units ordered per order
D = No. of units required per year
t1 = Time when there are no shortages
t2 = Time period during which there is shortage
t = Total cycle time, i.e., t = t1 + t2
S = Maximum shortage
The same quantity Q is ordered and received every time. The maximum
shortage is equal to S. The remaining quantity M is placed in the inventory as
surplus to satisfy the demand in the next cycle. Note that S units out of Q are
always in the shortage list, i.e., these are never placed in the inventory. Thus, it
results in a saving on the inventory carrying cost.
D
No. of orders placed per year = N 
Q
Ordering cost = No. of orders placed per year  ordering cost per order
D
 NCO  CO
Q
M
Average inventory =
2
M 
Carrying cost per cycle  Ch   t1 
 2 
Note from Fig. 8.3 that  ABC is similar to AOF. Therefore,
t1 M M
  t1  t
t Q Q

 M2  t 
Therefore, carrying cost    Ch
 2Q 
65
Optimisation Techniques-II
M2
Carrying cost per unit time  Ch
2Q
Shortage cost = Average no. of units short  time period of shortage
 shortage cost per unit per time period
S S 
  t 2  CS   t 2  CS
2 2 
Now, ABC is similar to CEF in Fig. 8.3. Therefore,
t2 S S
  t2  t
t Q Q
 S2  t 
Hence, shortage cost    CS
 2Q 
S2
Shortage cost per unit time  CS
2Q
Therefore, the total inventory cost is given as:
TC = ordering cost + carrying cost + shortage cost

D M2 S2
or TC  CO  Ch  CS
Q 2Q 2Q

2
D M 2Ch  Q  M  CS
or TC  CO   ...(1)
Q 2Q 2Q
Now, TC is a function of two variables Q and M. Therefore, to find the
minimum inventory cost, we differentiate TC with respect to Q and M
separately and equate them to zero. Thus, we get
d DC M 2 Ch 1  2Q(Q  M)2  (Q  M)2 
0 (TC)   2O     CS
dQ Q 2Q2 2 Q2 
2 2 2
DC M Ch  Q  M 
0   2O    CS
Q 2Q 2  2Q2 

DCO M 2 C
 2
 2 (Ch  CS )  S  0
Q 2Q 2

CS Q 2 M 2
  (Ch  CS )  DCO
2 2
 C  CS  2DCO
 Q2  M 2  h  … (2)
 CS  CS
and
d MC h (Q - M)
(TC) = - CS = 0
dM Q Q
M
 (Ch  CS )  CS  0
Q
66
 Inventory Models
 CS 
M Q ….(3)
 C h  CS 
Substituting the value of M in equation (2), we get
2
2 CS   C h  CS  2 2DCO
Q    Q 
 Ch  CS   CS  CS

 CS  2DCO
Q 2 1  
 Ch  CS  CS

 CS  2DCO
 Q2 1  
 C h  CS  CS

 C h  2DCO
 Q2  
 C h  CS  CS
2DC O CS  C h
 Q2  ( )
Ch CS
Thus, the optimum value of Q is given by

2DCO æ ö
ç CS + C h ÷
Q* = ç ÷
Ch è CS ø

The optimum value of M is given by

æ C ö æ ö
M* = çç S ÷Q* = 2DCO ç CS ÷
÷ Ch çè Ch + CS ÷
è Ch + CS ø ø
Therefore, the minimum inventory cost

 CS 
TC*  2DCO C h  
 Ch  CS 

Q* 2CO æ ö
ç CS + Ch ÷
Total Cycle time = t* = = ç ÷
D DC h è CS ø

Let us explain this model with the help of an example.

Example 2: A contractor has to supply engines to a truck manufacturer at the
rate of 20 per day. The penalty in the contract is `100 per engine per day for
missing the scheduled delivery date. The cost of holding an engine in stock for
one month is `150. His production process is such that each month (30 days)
he starts producing a batch of engines through the agencies and all are
available for supply after the end of the month. Determine the maximum
inventory level at the beginning of each month.
Solution: Here we have
150
C h =` per engine per day = `5 per engine per day;
30
Cs =` 100 per day per engine; D = 20 engines per day and t* = 30 days.

67
Optimisation Techniques-II The maximum inventory level M* at the beginning of each month will be
Cs Cs
M*  Q*   D  t *
C h  Cs C h  Cs
100
  20  30  571 engines
5  100
You may now like to solve the following problem to assess your
understanding.
E3) A manufacturer has to supply his customer with 24000 units of his
product every year. The demand is fixed and known. Since the unit is
used by the customer in an assembly operation and the customer has no
storage space for units, if the manufacturer fails to supply the required
units, the shortage cost is `2 per unit per month. The inventory cost is `1
per unit per month and the set-up cost per run is ` 3500. Determine
i) the optimal run size (Q);
ii) the optimal level of inventory (M) at the beginning of any period;
iii) the optimal scheduling period; and
iv) the minimum inventory cost.

8.6 EOQ MODEL WITH UNIFORM

REPLENISHMENT
For this model, it is assumed that the production run may take significant time to
complete, that is, the replenishment is not instantaneous. The stock is added at a
constant rate, i.e., the replenishment is uniform. Other assumptions are the same
as the ones made for the EOQ model with uniform demand as explained in
Sec. 8.3. The order size here is taken as the production size.
The graph representing this situation is shown in Fig. 8.4
inventory (rp  rd )

Rate of decreasing of
Rate of increasing of

inventory (rd)
Inventory

t t

t1 t2 t1 t2

time period

Fig. 8.4

68
Let rd be the demand rate in units per time period, rp , the replenishment rate Inventory Models

per unit of time, t 1 , the time of production run or time of replenishment, and
t 2 , the time required for the inventory to be exhausted. Then t1  t 2  t (say)
is the time for each order cycle.
Let Q be the number of units produced per order cycle. Then
Q
t1 
rp
Time for producing1unit  1 Rate of replenishment  1 r  p

Inventory is building up at the rate of rp  rd .

 Maximum inventory level = rp - rd t1 ( )

Average inventory =
 rp  rd  t1   rp  rd  Q 
Q  rd
1


2 2 rp 2  rp 


D Qæ r ö
Now, ordering (or set-up) cost = C O and carrying cost = çç1 - d ÷ Ch
C 2 è rp ÷ ø
 the total annual inventory cost is given by

D Q r 
TC  CO  1  d  Ch
Q 2  rp 

D Q r 
The cost will be minimum if CO  1  d  Ch
Q 2  rp 

2DCO  rp  2DCO  rp 
 Q2     Q*   
C h  rp  rd  Ch  rp  rd 
Thus, the characteristics of the model are as follows:
1. Optimum number of production runs per year:

N* 
D

DC h rp  rd 
Q* 2Co rp

2. Length of each lot size production run:

Q* 2DCO
t1  
rp 
Ch rp rp  rd 
3. The total minimum inventory cost:

D Q*æ ö 
ç1 - rd ÷ C  2DC C 1  rd

TC* = CO + ç ÷ h O h 
Q* 2 è rp ø  rp 
We take up an example to apply this model.
Example 3: A tyre producer makes 1600 tyres per day and sells them at
approximately half that rate. Accounting figures show that the production
69
Optimisation Techniques-II set-up cost is `1000 and carrying cost per unit is `5. If the annual demand is
160000 tyres, what is the optimal lot size and how many production runs
should be scheduled per year?
Solution: We are given that the annual demand (D) = 160000 tyres,
C h ` 5, CO  `1000, Production rate rp  = 1600 tyres per day and Demand
rate rd  = 800 tyres per day.

2DCO rp
 The optimal lot size Q* =
Ch rp - rd

2 160000 1000 1600

Q*    11314 tyres
5 1600  800

D 160000
Optimal production runs per year N*    14 runs/year approx.
Q* 11314
You may now like to solve the following problems to assess your
understanding.
E4) A product is manufactured at the rate of 50 items per day. The demand
occurs at the rate of 30 items per day. It is given that the set-up cost per
order is `1000 and holding cost per unit time is `0.05. Find the economic
lot size and the associated total cost per cycle assuming that no shortage
is allowed.
E5) A company uses 100000 units of a particular item per year. Each item
costs `2. The production engineering department estimates the holding
cost as 12.5% of the value of the inventory per day. The replenishment
rate is uniform at 500 units per day. Assuming 250 working days (for
replenishment purpose), calculate the
a) optimal set-up quantity;
b) total cost on the basis of optimal policy; and
c) optimal number of set-ups.

8.7 EOQ MODEL WITH PRICE (OR QUANTITY)

DISCOUNTS
If the items are purchased in bulk, some discount in price is usually offered by
the supplier. The discount is called all units discount if it is applicable for all
the units purchased. It is said to be incremental discount if discounts are
offered only for the items which are in excess of the specified amount. In the
incremental discount, the prices offered in different slabs are applicable in
finding the total cost while in ‘all units discount’, only one price at any one
slab is applicable for finding the total cost. Buying in large quantities may
result in the following advantages:
Less unit price, less ordering costs, less transportation cost, fewer stock-outs
and hence less chances of loss of goodwill, mass display by retailers and
preferential treatment by the sellers.
At the same time, large quantity buying may involve the following
disadvantages:
70
Higher carrying costs, older stocks, lower stock turnover, more capital Inventory Models
required, blocked money, less flexibility, heavier deterioration and
depreciation.
If the items are purchased with quantity discounts, the price C may vary
according to the following scheme:
C  p o if purchased quantity Q  Q 0  b1
= p1 if purchased quantity b1  Q1  b 2
….…………………………………..
……………………………………..
……………………………………..
= p n if purchased quantity b n  Qn
where p j1 is greater than p j , for j = 1, 2, …, n. Here p j is the price per unit for
the jth lot size. If the shortages are not allowed and supply is instantaneous, the
total cost per year is given by the set of relations:
CO D 1
 
TC Q j  Dp j 
Qj
 Ch Q j , where b j  Q j  b j1
2

and C h  ip j , where i is the percentage change for j = 0, 1, 2, …., n.

We follow the procedure given below to find the overall optimum lot size:
Step 1: We find EOQ for the lowest price, i.e., we calculate
2CO D
Q*n 
ip n
* *
If Q*n ³ b n , the optimum order quantity is Qn . If Qn  bn , we go to Step 2.

2CO D
Step 2: We compute Q*n1  for the next lowest price.
ipn1

If Q*n 1  b n 1 , then we compare the total cost TCn 1 for purchasing Q*n 1 with
the total cost TC n for purchasing quantity b n and select the one that gives the
least cost.

If Q*n 1  bn 1 , we go to Step 3.

2CO D
Step 3: We compute Q*n2  . If Q*n 2  bn 2 , we compare the total
ipn 2
cost TC , TC and TC for purchase of quantities Q* , b and b ,
n2 n 1 n n 2 n 1 n
respectively, and select the optimum purchase quantity.
If Q*  n , then we go to Step 4.
n 2 n2

Step 4: We continue in this fashion until Q*n j  bn j. Then we compare total

costs TCn  j with TC n  j1 ,..., TC n 1 ,TCn for purchase quantities Q*n j ,
b n  j1, ..., b n 1, b n , respectively, and select the optimum purchase quantity.
We now apply this method to an example.
71
Optimisation Techniques-II Example 5: The annual demand for an item is 2400 units. The inventory
carrying charge is 24% of the purchase price per year. Purchase prices are:
p1 =` 10 for purchasing Q1  500
p 2 =` 9.25 for purchasing 500  Q 2  750
p3 =` 8.75 for purchasing 750  Q 3
Determine the optimum purchase quantity taking the ordering cost as
i) ` 437.5
ii) ` 87.5
Solution: To determine the optimum purchase quantity, we follow the
procedure given below:
2´ 437.5´ 2400
i) As per Step 1, Q*3 = =1000 units
(0.24)(8.75)
Since 1000 is greater than 750, the optimum purchase quantity is 1000 units.
2  87.5  2400
ii) Here Q*3   447 units
(0.24)(8.75)

Since 447  750  b3 , we next compute

2´ 87.5´ 2400
Q*2 = =435units
(0.24)(9.25)
Since 435  500  b2 , we next compute

2´ 87.5´ 2400
Q*1 = =418units>0 and<500
(0.24)(10)

We now compare the total cost for purchasing Q*1  418, b 2  500
and b 3  750 units, respectively.
87.5´ 2400 1
TC1 (for purchasing 418) = 10´ 2400+ + (0.24)´ (10)´ 418
418 2
= ` 24504
87.5 ´ 2400 1
TC 2 (for Q 2 = 500) = 9.25´ 2400 + + (0.24)´ (9.25)´ (500)
500 2
= `23175
87.5´ 2400 1
TC3 (for Q3 = 750) = 8.75´ 2400 + + (0.24)´ (8.75)´ (750)
750 2
= `22067
As the total inventory cost is minimum for Q3 = 750, therefore, the optimum
purchase quantity is 750.
You may now like to solve the following problems to assess your
understanding.
E6) Consider Example 5 and determine the optimum purchase quantity with
the ordering cost as `175.

72 Let us now summarise the main points which have been covered in this unit.
 Inventory Models
8.8 SUMMARY
1. An inventory is a physical stock of idle resources of any kind having some
economic value kept for the purpose of meeting future demand. It indicates
the raw material required before production, the finished goods after
production ready for delivery to consumers, human resources, financial
resources, etc. stocked in order to meet an expected demand in the future.
2. Inventories are essential for almost all businesses for efficient and smooth
operations. Hence, inventories need to be controlled in the most profitable
way.
3. The quantity that is kept in stock in order to balance the costs of holding
too much stock vis-à-vis the costs of ordering in small quantities is called
the economic order quantity.
4. Five models have been discussed for obtaining the economic order
quantity for the following situations:
i) when demand is uniform,
ii) when rates of demand are different in different cycles,
iii) when shortages are allowed,
iv) when replenishment is uniform, and
v) when price discounts are given.

8.9 SOLUTIONS/ANSWERS

12000 12000
E1) We have D = = ´ 100 = 9600 ; C = 1.25 per unit;
1.25 125
15 125
CO = 15 and Ch = 15% of 1.25  
100 100
2DCO 2´ 9600´ 15´ 100
Q*= = = 1920000 =1385 units
Ch 15

18  2 9
E2) Here CO = 36, C = 2, D = 10000, and C h  18% of 2  
100 25
2´ 10000´ 36´ 25
Therefore, a) Q* = = 2000000 =1414 units
9
D 10000
and b)   7.072
Q* 1414
365
Thus, the optimum no. of days =  52 days
7
E3) We have D = number of units supplied per year = 24000
Ordering cost per unit = ` 3500
Shortage cost = `2 per unit per month
= `24 per unit per year
Carrying cost = `1 per unit per month
= `12 per unit per year
73
Optimisation Techniques-II
i) The optimal value of Q is

2DCO  CS  C h 
Q* 
C h  CS 
2  24000  3500  24  12 
  
12  24 

 2  1000  3500  3  210  100000

 21  1000  4.583  1000  4583 units

 CS  *  24 
ii) M*   Q   4583
 C h  CS   12  24 

2
  4583  3055 units
3

Q* 4583 4.583
iii) t*     2.29 months
D 24000 2

iv) The minimum inventory cost = TC*

 CS 
 2DCO Ch  
 C h  CS 

 24 
 2  24000  12     3500
 12  24 
æ24 ö
= 576000 ´ çç ÷ ÷´ 3500 =` 37200
è 36 ø
E4) We have D = 30 items per day, rp = 50 items per day,
CO = `1000, Ch = ` 0.05, rd = 30 items per day

2DCO  rp  2  30  1000  50 
Therefore, Q*  r r    
Ch  p d 0.05  20 

 3000000 = 1732.05081 = 1732 units

Total minimum inventory cost

 r 
TC*  2DCO C h 1  d 
 rp 

 30 
 2  30  1000  0.05  1  
 50 

5 20
 2  30  1000   = 1200 =` 34.64
100 50
E5) We are given that
rp = 500 × 250 units per year, rd = 100000 units per year, CO = 25

74
 12.5  2 1 Inventory Models
Ch = 12.5% of `2    0.25
100 4

2DCO  rp 
Q* 
a) C h  rp  rd 

2  100000  25  125000 
  
0.25  25000 
 4000000  25  10000

 r 
b) TC*  2DCO C h 1  d 
 rp 

 100000 
 2  100000  0.25  25 1  
 125000 
 250000  500
Total cost on the basis of optimal policy = TC* + 2 × 100000
= 200500
D 100000
c) Optimum number of set ups    10 set-ups
Q* 10000

2  175  2400
E6) Here Q*3   632 units
(.24)(8.75)

Since 632  750  b3 , we next compute

1/ 2
 2  175  2400 
Q*2    615units
 (.24)(9.25) 
Since 615> 500 = b 2 we compare the total costs for purchasing
Q*  615and b  750 units respectively.
2 3

100 ´ 2400 1
TC2 (for 615units) = 9.25 ´ 2400 + + ´ (0.24)´ (9.25) ´ (615)
615 2
=` 23, 273

100 ´ 2400 1
TC3 (for Q3 = 750) = 8.75´ 2400 + + ´ (0.24)´ (8.75) ´ (750)
750 2
=` 22,119.50
Therefore, the economic purchase quantity for this problem is
Q*  750 units
3

75