Production Planning &

Control:
Inventory
 Learning Outcomes
Upon completion of this chapter, you should be
able to :
Identify or Define:
 Holding, Ordering, and Setup Costs
 Economic Order Quantity (EOQ) Model
 Production Order Quantity (POQ) Model

Describe or Explain:
 The functions of inventory and basic inventory
models
 Discussion

1. What is inventory?

2. Why we need inventories?

 What is Inventory?
 Stock of materials
 Stored capacity © 1995
Corel Corp.

 Examples

© 1984-1994 T/Maker Co. © 1984-1994 T/Maker Co.

© 1995 Corel Corp.
 Types of Inventories

 Raw materials & purchased parts

 Partially completed goods called
work in progress
 Finished-goods inventories
 (manufacturing firms)
or merchandise
(retail stores)
 Types of Inventories (Cont’d)
 Replacement parts, tools, & supplies
 Goods-in-transit to warehouses or customers
The Material Flow Cycle
 The Material Flow Cycle
Other Wait Move Queue Setup Run
Input Time Time Time Time Time Output

Cycle Time

1 Run time: Job is at machine and being worked on

2 Setup time: Job is at the work station, and the work station is being
"setup."
3 Queue time: Job is where it should be, but is not being processed
because other work precedes it.
4 Move time: The time a job spends in transit
5 Wait time: When one process is finished, but the job is waiting to be
moved to the next work area.
6 Other: "Just-in-case" inventory.
 Functions of Inventory

 To meet anticipated demand

 To smooth production requirements
 To protect against stock-outs
Functions of Inventory (Cont’d)

 To take advantage of order cycles

 To help hedge against price increases
 To take advantage of quantity discounts
 Disadvantages of Inventory

 Higher costs
 Item cost (if purchased)
 Ordering (or setup) cost
 Costs of forms, clerks’ wages etc.
 Holding (or carrying) cost
 Building lease, insurance, taxes etc.

 Difficult to control
 Hides production problems
 Inventory Costs

 Holding costs - associated with holding or

“carrying” inventory over time
 Ordering costs - associated with costs of placing
order and receiving goods
 Setup costs - cost to prepare a machine or
process for manufacturing an order
 Holding (Carrying) Costs
 Obsolescence
 Insurance
 Extra staffing
 Interest
 Pilferage
 Damage
 Warehousing
 Etc.
 Inventory Holding Costs
(Approximate Ranges)
Cost as a
Category % of Inventory Value
Housing costs (building rent, depreciation, 6%
operating cost, taxes, insurance) (3 - 10%)

Material handling costs (equipment, lease 3%

or depreciation, power, operating cost) (1 - 3.5%)
Labor cost from extra handling 3%
(3 - 5%)
Investment costs (borrowing costs, taxes, 11%
and insurance on inventory) (6 - 24%)

Pilferage, scrap, and obsolescence 3%

(2 - 5%)
Overall carrying cost 26%
 Ordering Costs

 Supplies
 Forms
 Order processing
 Clerical support
 Etc.
 Setup Costs

 Clean-up costs
 Re-tooling costs
 Adjustment costs
 Etc.
 Inventory Models

 Fixed order-quantity models Help answer the

inventory planning
 Economic order quantity questions!
 Production order quantity
 Quantity discount

 Probabilistic models
 Fixed order-period models

© 1984-1994
T/Maker Co.
 EOQ Assumptions

 Known and constant demand

 Known and constant lead time
 Instantaneous receipt of material
 No quantity discounts
 Only order (setup) cost and holding cost
 No stockouts
 Inventory Usage Over Time

Order quantity = Q Usage Rate

(maximum Average
inventory level) Inventory
(Q*/2)
Inventory Level

Minimum
inventory 0
Time
 EOQ Model
How Much to Order?
Annual Cost

Minimum
total cost

Order (Setup) Cost Curve

Optimal Order quantity

Order Quantity (Q*)
 Why Holding Costs Increase

 More units must be stored if more are ordered

Purchase Order Purchase Order

Description Qty. Description Qty.
Microwave 1 Microwave 1000

Order quantity Order quantity

 Why Order Costs Decrease
Cost is spread over more units
Example: You need 1000 microwave ovens
1 Order (Postage $ 0.33) 1000 Orders (Postage $330)

Purchase Order PurchaseOrder

Purchase Order
Description
PurchaseOrder
OrderQty.
Description
Purchase
Qty. Description Qty.
Qty.
Microwave 1000 Description
Microwave Qty. 11
Description
Microwave
Microwave
Microwave 11
Order quantity
 Deriving an EOQ

1. Develop an expression for setup or ordering

costs
2. Develop an expression for holding cost
3. Set setup cost equal to holding cost
4. Solve the resulting equation for the best order
quantity
 EOQ Model
When To Order
Inventory Level
Optimal Average
Order Inventory
Quantity (Q*/2)
(Q*)

Reorder
Point
(ROP)

Time
Lead Time
 EOQ Model Equations
Annual setup cost = (Number of order placed per year) x
(Setup or order cost per order)

=( Annual demand ) (setup or cost per order)

( Number of units in each order)
= ( D/Q) S
Annual holding cost = (Average inventory level) x (Holding cost per unit per year)
= (Order qty /2) (Holding cost per unit per year)
=(Q/2)(H)
 EOQ Model Equations
Optimal Order Quantity 2 ×D ×S
= Q* =
H
D
Expected Number of Orders =N =
Q*
Expected Time Between Orders Working Days / Year
=T =
N
D D = Demand per year
d =
Working Days / Year S = Setup (order) cost per order
H = Holding (carrying) cost
ROP = d × L d = Demand per day
L = Lead time in days
Total cost

D Q
TC  S  H
Q 2

D = Demand per year

Q = Optimal order quantity
S = Setup (order) cost per order
H = Holding (carrying) cost
 The Reorder Point (ROP)

ROP = Demand per day x Lead time for a new order in days
= dxL
# This equation for ROP assumes that demand during lead time
and lead time itself are constant
 The Reorder Point (ROP) Curve
Q*

Slope = units/day = d
Inventory level (units)

ROP
(Units)

Time (days)
Lead time = L
 EOQ Model Problem 1
 ABC Company supplies needles to hospitals.
 The annual demand is 1,000 units.
 The setup or ordering cost is $10 per order.
 The holding cost per unit per year is $0.50
 Determine the optimal number of units per order.

2 DS 2(1,000)(10)
Q*    40,000  200 units
H 0.5
 EOQ Model Problem 2
 D = 1,000 units per year.
 S = $10 per order, H = $0.50 per unit per year.
 Total working day per year = 250.
 Determine the optimal number of orders(N) per year and the
expected time between orders(T).

2 DS 2(1,000)(10)
Q*    40,000  200 units
H 0.5

Demand 1,000
N   5 orders per year
Order quantity 200

working days 250

T   50 days between orders
number of orders 5
 EOQ Model Problem 3
 D = 1,000 units per year.
 S = $10 per order, H = $0.50 per unit per year.
 Determine the optimal total annual inventory cost.

2 DS 2(1,000)(10)
Q*    40,000  200 units
H 0.5

D Q 1,000 200
TC  S H  ($10)  ($0.50)
Q 2 200 2

 $50  $50  $100

 EOQ Model Problem 4
 D = 8,000 units per year, working days = 250 per year.
 On average, delivery of an order takes 3 working days.
 Calculate the reorder point.

D 8,000
Demand per day, d    32 units
working day per year 250

unit
Reorder point, ROP  d  L  32  3 day  96 unit
day

Thus, when inventory stock drops to 96, an order should be placed.

The order will arrive 3 days later, just as the firm' s stock is depleted.
Production Order Quantity Model
(POQ)

 EOQ we assumed the  POQ applicable under

entire inventory was situations:
received at 1 time  Inventory continuously
 POQ inventory receive flows or build up over
over a period of time a period of time after
order
 Units are produced
and sold
simultaneously
Production Order Quantity Model
 Answers how much to order and when to order
 Allows partial receipt of material
 Other EOQ assumptions apply
 Suited for production environment
 Material produced, used immediately
 Provides production lot size

 Lower holding cost than EOQ model

 POQ Model
When To Order
Both production
and usage take Usage only takes
Maximum place
place
inventory
level
Inventory Level

Time
 POQ Model Equations
Annual inventory holding cost:
= (Average inventory level) x (Holding Cost per unit per year)

Average inventory level = (Maximum inventory level)/2

Maximum inventory level = (Total production during the production run)

- (Total used during the production run)
= pt - dt
 POQ Model Equations

However Q = Total product = pt , and thus t = Q/p therefore

Maximum inventory level = p (Q/p) – d (Q/p) = Q- (d/p)Q

= Q(1- d/p)
D = Demand per year
Annual inventory holding cost : S = Setup cost
Max inventory level x H = Q/2 [ 1 – (d/p)] x H H = Holding cost
2 d = Demand per day
Use EOQ equi: p = Production per day
Setup cost = (D/Q)S t = Length of production
run in days
Holding Cost = ½ HQ[1-(d/p)]
 POQ Model Equations

Set ordering cost equal to holding cost Q* p

(D/Q)S= ½ HQ[1-(d/p)]
Q2 = 2DS
H[1-(d/p)]

Q* p = √ 2DS
H[1-(d/p)]
 POQ Model Equations

= Q* = 2*D*S
Optimal Order Quantity

( )
p d
H* 1 -
p

Maximum inventory level = Q* ( 1 -

d
p )
D D = Demand per year
Setup Cost = * S
Q S = Setup cost
H = Holding cost
Holding Cost = 0.5 * H * Q
( )
1-
d
p
d = Demand per day
p = Production per day
 POQ Model Inventory Levels
Inventory Level
Inventory level with no demand

Production Max. Inventory

Portion of Cycle Q·(1- d/p)
Q*

Time
Supply Supply Demand portion of cycle
Begins Ends with no supply
Run Time

Cycle Time
Reasons for Variability in Production

Most variability is caused by waste or by poor

management. Specific causes include:
q employees, machines, and suppliers produce units that do
not conform to standards, are late or are not the proper
quantity
q inaccurate engineering drawings or specifications
q production personnel try to produce before drawings or
specifications are complete
q customer demands are unknown
 POQ Model Problem 1
 Demand = 1,000 units per year, Setup = $10, Holding = $0.50 per unit per
year, average daily demand = 4 units.
 Optimum production rate = 8 units per day. Total working days per year = 250
 Calculate the optimum number of units per order.

D  1000 units , S  $10, H  $0.50, p  8 units perday, d  4 units perday

2 DS 2(1,000)(10)
Q*p  
d 4
H [1  ( )] 0.5[1  ( )]
p 8

20,000
  80,000  282.8  283 units
0.5(0.5)
 Tutorial 1
XYZ Computer Company uses 1,000 transistors each month for its computers assembly. The
unit cost of each transistor is $10, and the cost of carrying one transistor in inventory for
a year is $3. Ordering cost is $30 per order. Compute:
(a) The optimal order quantity.
(b) The expected number of orders placed each year.
(c) The expected time between orders. (Assume 200 working day per year)
 Tutorial 1
XYZ Computer Company uses 1,000 transistors each month for its computers assembly. The
unit cost of each transistor is $10, and the cost of carrying one transistor in inventory for
a year is $3. Ordering cost is $30 per order. Compute:
(a) The optimal order quantity.
(b) The expected number of orders placed each year.
(c) The expected time between orders. (Assume 200 working day per year)

D  1000(12) units , S  $30, H  $3

2 DS 2(1,000 12)(30)
(a ) Q*    489.9  490 units
H 3

D 12,000
(b) N    24.5  25 orders per year
Q* 490

working day per year 200

(c) Time between orders, T    8 days
N 25
 Tutorial 2
Annual demand for notebook binders at Salina Stationery Shop is
10,000 units. The shop is operating 300 days per year and finds that
deliveries from supplier generally takes 5 working days. Calculate
the reorder point for the notebook binders.
 Tutorial 2
Annual demand for notebook binders at Salina Stationery Shop is
10,000 units. The shop is operating 300 days per year and finds that
deliveries from supplier generally takes 5 working days. Calculate
the reorder point for the notebook binders.

L  5 days

10,000
d  33.33 units per day
300

unit
ROP  d  L  33.33  5 day  166.7 units
day

Salina Stationery Shop should reorder when her stock reaches 167 units
 Tutorial 3
Leonard Presby Inc. has an annual demand rate of 1,000 units but can
produce at average production rate of 2,000 units. Setup cost is
$10; carrying cost is $1. What is the optimal number of units to be
produced each time.
 Tutorial 3
Leonard Presby Inc. has an annual demand rate of 1,000 units but can
produce at average production rate of 2,000 units. Setup cost is
$10; carrying cost is $1. What is the optimal number of units to be
produced each time.

D  1000 units , S  $10, H  $1, p  2,000 units peryear , d  1,000 units peryear

2 DS 2(1,000)(10)
Q*p  
d 1,000
H [1  ( )] 1[1  ( )]
p 2,000

20,000
  40,000  200 units
0.5