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Operations Research Lesson 6

The document discusses inventory control models, specifically focusing on the Quantity Discount Model and the Probabilitized EOQ Model. It explains how to adjust the Economic Order Quantity (EOQ) when quantity discounts are available and outlines the importance of safety stock in uncertain demand scenarios. Examples are provided to illustrate the application of these models in real-world inventory management situations.

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Ahmed Mithila
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© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
2 views

Operations Research Lesson 6

The document discusses inventory control models, specifically focusing on the Quantity Discount Model and the Probabilitized EOQ Model. It explains how to adjust the Economic Order Quantity (EOQ) when quantity discounts are available and outlines the importance of safety stock in uncertain demand scenarios. Examples are provided to illustrate the application of these models in real-world inventory management situations.

Uploaded by

Ahmed Mithila
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 23

Inventory Control Models:

Extension
Md. Thasinul Abedin
MBA(Accounting); MSc (Economics and Finance)
Assistant Professor of Accounting and Finance
University of Chittagong

February 23, 2025

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Quantity Discount Model [1]

In developing the EOQ model, we assumed that


quantity discounts were not available. However,
many companies do offer quantity discounts.
If such a discount is possible, and all of the other
EOQ assumptions are met, it is possible to find the
quantity that minimizes the total inventory cost by
using the EOQ model and making some
adjustments.

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Quantity Discount Model [2]

When quantity discounts are available, the


purchase cost or material cost becomes a relevant
cost, as it changes based on the order quantity.
The total relevant costs are as follows:
Total Costs (TC) = Material Costs + Ordering
Costs + Carrying Costs
Q
Hence, T C = DC + D
Q Co + 2 Ch

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Quantity Discount Model [3]

Here,
D = Annual Demand in Units
Co = Ordering Cost Per Order
C = Cost Per Unit
Ch = Carrying Cost Per Unit Per Year
Since the holding cost per unit per year is based on
the cost of the item, it is convenient to write it as
Ch = IC, where, I = Holding cost as a percentage
of the unit cost (C).

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Quantity Discount Model [4]

Figure: Quantity Discount Schedule

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Quantity Discount Model [5]

Figure: Total Cost (TC) Curve for the Quantity Discount


Model
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Quantity Discount Model [6]

1. For each q
discount price (C), compute
EOQ = 2DC IC
o

2. If EOQ < Minimum quantity for the


discount, adjust EOQ = Minimum quantity
for discount.
3. For each EOQ or adjusted EOQ, compute
Q
T C = DC + D Q Co + 2 Ch .
4. Choose the lowest-cost quantity.

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Example-1[1]

Brass Department Store stocks toy race cars.


Recently, the store was given a quantity discount
schedule for the cars. The normal cost for the toy
race cars is $5. For orders between 1,000 and 1,999
units, the unit cost is $4.80, and for orders of 2,000
or more units, the unit cost is $4.75. Furthermore,
the ordering cost is $49 per order, the annual
demand is 5,000 race cars, and the inventory
carrying charge as a percentage of cost, I, is 20%
or 0.2. What order quantity will minimize the
total inventory cost?

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Example-1[2]

q
2×5000×49
1. EOQ1 = 0.2×5 = 700 Units
q
2×5000×49
2. EOQ2 = 0.2×4.8 = 714 Units
q
2×5000×49
3. EOQ3 = 0.2×4.75 = 718 Units

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Example-1[3]

Since EOQ1 is between 0 and 999, it does not have


to be adjusted. EOQ2 is below the allowable range
of 1,000 to 1,999, and therefore it must be adjusted
to 1,000 units. The same is true for EOQ3 ; it must
be adjusted to 2,000 units. Therefore,
EOQ1 = 700 Units
EOQ2 = 1000 Units
EOQ3 = 2000 Units

10 / 23
Example-1[4]

Figure: Total Costs

Therefore, EOQ∗ = 1000 Units

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Probabilitized EOQ Model [1]

When the EOQ assumptions are met, it is possible


to schedule orders to arrive so that stock-outs are
completely avoided. However, if the demand or the
lead time is uncertain, the exact demand during
the lead time (which is the ROP in the EOQ
situation) will not be known with certainty.
Therefore, to prevent stock-outs, it is necessary to
carry additional inventory called safety stock.

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Probabilitized EOQ Model [2]

When demand is unusually high during the lead


time, you dip into the safety stock instead of
encountering a stock-out. Thus, the main purpose
of safety stock is to avoid stock-outs when the
demand is higher than expected.
Note that although stock-outs can often be avoided
by using safety stock, there is still a chance that
they may occur. The demand may be so high that
all the safety stock is used up, and thus there is
still a stock-out.

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Probabilitized EOQ Model [3]

One of the best ways to implement a safety stock


policy is to adjust the reorder point. In the EOQ
situation where the demand and lead time are
constant, the reorder point is simply the amount of
inventory that would be used during the lead time
(i.e., the daily demand times the lead time in
days). This is assumed to be known with certainty,
so there is no need to place an order when the
inventory position is more than this.

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Probabilitized EOQ Model [4]

Figure: Stock-Out

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Probabilitized EOQ Model [4]

The critical period during the inventory cycle


occurs between placing and receiving orders. This
is the time period when shortage (running out of
stock) could occur. The idea then is to maintain a
constant buffer stock that will put a cap on the
probability of shortage. Intuitively, lower shortage
probability entails larger buffer stock, and vice
versa.

16 / 23
Probabilitized EOQ Model [5]
The size of the buffer (B) is determined such that
the probability of running out of stock during lead
time does not exceed a pre-specified value. Now let
us define,
L = Lead time
XL = Random variable representing demand
during lead time
µL = Average demand during the lead time
σL = Standard deviation of demand during the
lead time
α = Maximum allowable probability of running
out of stock during lead time
B = Buffer stock size
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Probabilitized EOQ Model [6]
Therefore, we can write, P r{XL ≥ B + µL } ≤ α

Figure: Buffer imposed on classical EOQ, where y ∗ = EOQ

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Probabilitized EOQ Model [7]
Now, XL ∼ N (µL , σL )
XL −µL
Then, Z ∼ N (0, 1), where, Z = σL
Therefore, P r{Z ≥ σBL } ≤ α

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Probabilitized EOQ Model [8]

Now, we can write P r{Z ≥ Kα } = α


Hence, It must hold that σBL ≥ Kα
Therefore, B ≥ σL Kα
So buffer size must satisfy, B ≥ σL Kα

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Probabilitized EOQ Model [8]

Now assume that daily demand d is normal with


mean, d and variance, σd2 .
Therefore, µL = dL
and, σL2 = Lσd2 √
(Time Conversion)
Hence, σL = σd L
Note: Here, σd2 = Variance of per day demand.
Hence, for 5-day variance (L = 5), we need to
multiply 5 with σd2 .

21 / 23
Example-2 [1]

To determine the inventory policy of neon lights,


the EOQ is 1000 units. Assume that the daily
demand is N (100, 10),that is, d = 100 units and
standard deviation σd = 10 units. Determine the
buffer size, B, using α = 0.05 and L = 2 days.

22 / 23
Example-2 [2]

Here, µL = 100 × 2 = 200 Units


√
and σL = 2 × 10 = 14.14 Units
Here, K0.05 = 1.645. Hence,
B ≥ 14.14 × 1.645 ≈ 23 Units.
ROP = dL + B = 200 + 23 = 223 Units.
Hence, neon lights should place an order wheneven
inventory level drops to 223 Units.

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