Inventory Control Models 5

SIMULATION SYSTEMS
INVENTORY CONTROL MODELS 5

INVENTORY CONTROL MODELS
• Many companies fail each year due to the

lack of adequate control of inventory in
their stores.
• Whether it is raw material used for

manufacturing a product or products
waiting for sale, problem arises when, too
few or too many items are stored in the
inventory.
INVENTORY CONTROL MODELS
• If the number of items stored are more than

what are required, it is a loss of investment
and wastage of storage space which again
results in the loss of investments.
• In the case of excess inventory, items may
depreciate, deteriorate, or become
obsolete.
• If less number of items are kept in store, it
can result in the loss of sale, which ultimately
results in the loss of business.
HOW MUCH TO STORE IN THE INVENTORY
AT A GIVEN SPAN OF TIME?
• This in turn depends on what is the annual

demand and how much time it takes to
replenish the inventory by the supplier.
• There can be uncertainties, such as strike,

weather calamities, price hikes and so on, in
replenishment of inventory.
• While computing the inventory for storage,

all these factors are to be taken into
account.
INVENTORY CONTROL BASIC PROBLEM
The basic problem in inventory

control is to optimize the sum
of the costs involved in
maintaining an inventory.
BACKORDERING
• Backordering is the case when inventory

goes to zero and orders are received for the
sale of item, or raw material is required for
production.
• When fresh inventory arrives, first back orders
are completed and then regular orders are
entertained.
• In this case, raw material is required for
production purpose and inventory goes to
zero, production stops, which is a loss to firm.
BACKORDERING
• If inventory is of items, which are for the sale,

goodwill of customer is lost in this case and
even there is a possibility that customer will
also be lost.
• Thus backordering case should always be

avoided.
MATHEMATICAL INVENTORY MODELS
• The mathematical inventory models can be

divided into two broad categories :-
• deterministic models and
• stochastic models, according to the
predictability of demand involved.
DETERMINISTIC INVENTORY
• If the demand in future period can be

predicted with considerable precision, it is
reasonable to use an inventory policy that
assumes that all forecasts will always be
completely accurate.
• This is the case of known demand where a

deterministic inventory model would be
used.
STOCHASTIC INVENTORY
• When demand can not be predicted very

well, then in this case stochastic inventory
model will be required to be used, where
demand in any period is a random variable
rather than a known constant.
INVENTORY CONTROL
MODELS
INFINITE DELIVERY RATE WITH NO BACKORDERING 1
INFINITE DELIVERY RATE WITH NO
BACKORDERING
• The simplest case when there is no back

ordering and demand is deterministic.
• Costs involved in maintaining an inventory

are:-
• c0 = costs associated with placing an order or
setting up for a production run i.e., ordering cost.
• c1 = inventory holding cost (sometimes called
storage costs).
BACKORDERING
• The key to minimizing inventory costs is for

deciding, when to order, how to order, and
how much to order, and how much back
ordering to allow (if applicable).
• If the demand is known and the time to

receive an order (lead time) is constant then
when to order is not a problem.
BACKORDERING
• Assumptions while modeling the inventory

problem:
1. A single type of product is analyzed even

though many types are held in inventory
for use or sale.
2. The planning period is 1 year.
3. The demand for the product is known and
constant throughout the year.
BACKORDERING
4. The lead time is known and is constant

(time between the order and receipt of
the order).
5. Complete orders are delivered at one time
(infinite delivery rate).
6. Unfilled orders are lost sales (no
backordering allowed).
Thus only two costs are involved in this model

i.e., ordering cost and inventory holding cost.
BACKORDERING
• Generally two types of products are kept in

the inventory:-
1. for manufacturing of some item and
2. for direct sale.
• Inventory which is stocked for the use in

manufacturing will be called raw materials.
BACKORDERING
• If management allows the stock of raw material to

be depleted, several conditions may arise i.e.,
1. Substituted or borrowed raw material will be used.
2. Emergency measures may be taken for the supply
of raw material.
3. The company may switch to the manufacturing of
different product.
4. The manufacturing process may shut down
completely.
• If management allows product to be depleted, loss

of profit will result. In case of depletion of material
for sale, firm may lose the customer permanently.
BACKORDERING
• It is assumed that lead time, that is time gap

between the requisition and receipt of inventory, is
constant.
• Let us define some parameters related with
inventory as:
• a = rate of depletion of inventory,
• c = cost of purchase of one unit,
• h = holding cost per unit per unit of time held in inventory,
• Q = quantity which is ordered each time (Economic Order Quantity
(EOQ)),
• D = annual demand for the product,
• c0 = set-up cost involved per order (ordering cost),
• Q/2 = annual inventory level,
• N = D/Q = number of orders per year,
• AIHC = annual inventory holding cost.
BACKORDERING
• Annual Ordering Cost (AOC) is given by

AOC = c0 . (D/Q) …(1)
• It is to be noted that c0 is the cost per order, and

does not include the cost of material to be ordered.
• Annual inventory holding cost is given as,

AIHC = h.(Q/2) .(Q/a) = hQ2/2a ...(2)
where Q/a is the time period after which order is to
be placed.
BACKORDERING
• Therefore total inventory cost per cycle is given by

Total cost per cycle = c0 + hQ2/2a + c.Q ...(3)
which is sum of ordering, holding and material costs.
• Therefore total cost per unit time is:

T = c0a/Q + hQ/2 + c . A
• Our aim is to minimize T.

BACKORDERING
• For T to be minimum, we use the concept of

maxima-minima theorem, which says, for a function
to be minimum, its first derivative is equal to zero
whereas second derivative is positive, Thus:
dT/dQ = 0
and
d2T/dQ2 > 0 ...(4)
• First of equation (4) gives,

-(aC0)/Q2 + h/2 = 0 ...(5)
BACKORDERING
• or Q = √2ac0/h
• Second of equation (4) gives

d2T/dQ2=2ac0/Q3> 0
• Thus value of Q given in equation (5) gives the

minimum value of T.
BACKORDERING
• Equation (5) is the well known Economic Order Quantity
(EOQ) formula.
• Figure 1 gives the graphic representation of inventory
depletion and replenishment.
• The corresponding cycle time, t, is given by:-

Q/a = √2c0/ah
BACKORDERING
Example1:
Calculate the EOQ from the following:
Annual requirement = 50 units/month
Ordering cost/order = 10.00 EGP.
Material cost/unit = 6.00 EGP.
Inventory holding cost/unit = 20% of unit cost.
Solution:
We take unit of time as one year. Total annual
requirement is 600 units/year, which is equal to a.
Cost c0 is 10.00/unit EGP.
Holding cost h is EGP. 1.20/unit/time, thus,
EOQ = Q = √2ac0/h = √2×600×10/1.20 = 100 units.
BACKORDERING
Example 2:
The demand for a particular item is 18000 units per
year. The holding cost per Unit is EGP.1.20 per year
and the cost of one procurement is EGP.400.00. No
shortage is allowed, and The replacement rate is
instantaneous. Determine:-
• (a) Optimum order quantity,
• (b) Number of orders per year,
• (c) Time between orders
• (d) Total cost per year when the cost of one unit is
EGP.1.00
BACKORDERING
Solution
Here a = 18000 units per year, h = EGP.1.20 /year, c0 =
EGP. 400/order. We take one year as the unit of time.
a) Optimum order quantity Q = √2ac0/h = √2×18000×

400/1.20 = 3464.10 units = 3465 units.
b) Number of orders per year = total time
period/cycle time = a/Q = 18000/3465 = 5.2 or 5
orders/year.
c) Time between orders = 365/5 = 73 days
BACKORDERING
Solution
(d) Total cost = material cost + storage cost +
ordering cost
= unit price × no. of units + (Q/2)h + (ac0)/Q
= 1×18000 + 3465×1.20/2 + 18000×400/3465
= EGP. 22157.00
INVENTORY CONTROL
MODELS
FINITE DELIVERY RATE WITH NO BACKORDERING 2
FINITE DELIVERY RATE WITH NO
BACKORDERING
• Suppose there is a case, when complete

order is not delivered in one installment, but
is sent in part deliveries.
• This may be due to non availability of raw

material, or order is so bulky that it can not
be carried in single installment.
• We also assume that arrival rate is greater

than the use or sail rate, thus there is no
depletion.
BACKORDERING
• Such case is called finite delivery rate with

no back ordering, and is modeled as
follows:-
• Let A = arrival rate of an order in units/day
• a = use or sale rate in units/day
• Q = order quantity
• Q/A = time to receive complete order of Q units
(in days)
• and A > a, which means, arrival rate is greater
than sale rate.
BACKORDERING
• Since units are sold or used while others are

arriving and being added to the inventory,
the inventory level will never reach the EOQ
level.
• Since arrival rate is A/day, total ordered

quantity is supplied in Q/A days.
• Now a number of units are used in one day,

therefore aQ/A is the number of units sold in
Q/A days, when whole order is supplied.
BACKORDERING
• Then since A > a, there are always some

items left in inventory, thus:-
Q – a(Q/A) = maximum inventory level in one cycle
(Q/A days).
1/2[Q– a(Q/A)] = average inventory level in one

cycle.
BACKORDERING
• Now total inventory cost = holding cost +

annual ordering cost + material cost, then
total cost per unit time t, is:-
• where c0 is the cost involved per order and a/Q is

number of orders per unit time, h being the cost of
holding inventory per unit time.
BACKORDERING
• Differentiating this equation with respect to

Q and equating the resulting equation to
zero as shown previously, we get:-
• which is the expression for optimum quantity to be

ordered, when arrival rate and depletion rate are
known.
BACKORDERING
Example 3:
A small manufacturing company specializes
in the production of sleeping bags. Based on
the past records, it is estimated that the
company will be able to produce 5000 bags
during the next year if the raw materials is
available, when needed. Raw material for
each bag costs EGP.50.00.
BACKORDERING
Example 3:
Assuming that bags are produced at
constant rate during the year of 300 working
days, it is estimated that the annual holding
cost of the inventory of raw material is 20% of
the raw material cost. Also each time order is
placed, company has to pay EGP. 25.00 as
reordering cost. If lead time is 7 days,
calculate total annual inventory cost (TAIC),
and total cost.
BACKORDERING
Solution:
Since manufacturer is planning to
manufacture 5000 bags in next year, this
means sale (depletion) rate per year is 5000. If
an year is taken as time unit, then a = 5000,
c0= 25.00, h = 0.2 × 50 = 10.00, therefore:-
Now
BACKORDERING
Solution:
Therefore,
where
BACKORDERING
Solution:
Therefore
total cost (TC) = cost of the material + TAIC
= 50 × 5000 + 1581.14
= 251581.14
This is the long-run average total cost since

N = a/Q = 5000/158 = 31.65 orders/year
BACKORDERING
Example 4:
In example 3, if supplier gives 5% discount to
manufacturer, on the condition that, he
purchases material, only twice in a year. Is this
proposal acceptable?
Solution:
In this case cost per bag is
Cost/bag = EGP. (50.00 – 0.05 × 50) =
EGP.47.50
BACKORDERING
Solution:
Q = 2500
a = annual requirement = 5000,
Thus total cost under this proposal is
= EGP. 250050
This cost is less than TC in first case, which is EGP.

251581.14, hence proposal is acceptable.
INVENTORY CONTROL
MODELS
INFINITE DELIVERY RATE WITH BACKORDERING 3
INFINITE DELIVERY RATE WITH
BACKORDERING
• In the previous sections, we assumed that

unfilled demands are lost demands.
• However, unfilled demands for salable items
do not always result in lost sales.
• Quite often customers will wait for an
ordered item to arrive, or they will permit the
merchant to place an order for the item of
interest.
• An unfilled demand, that can be filled at a
later date, is known as a backorder.
BACKORDERING
• There is generally a cost associated with

backorders. Clearly, if all demands could be
backordered, and if there were no cost for
backorders, there would have been no
need for inventory.
• The merchant could take orders and then

wait until the most economical time for him
to place an order for future delivery. But this
is rarely the case.
BACKORDERING
• If an item is backordered, there are

generally costs associated with it.
• If the cost of holding the inventory is high

relative to these shortage costs, then
lowering the average inventory level by
permitting occasional brief shortage may be
a sound business decision.
BACKORDERING
• Costs due to shortage are,

• Loss of goodwill,
• Repeated delays in delivery,
• Additional book keeping, loss of cash that would
have been available for immediate use.
• The basic problem then is, to decide how much

order to be placed and how many backorders to
allow before receiving a new shipment.
BACKORDERING
• In order to model this situation, we make

following assumptions:-
1. Backorders are allowed.
2. Complete orders are delivered at one time.
3. All assumptions from INFINITE DELIVERY RATE
WITH NO BACKORDERING hold.
BACKORDERING
let
• Q = ordered quantity,
• D = annual demand for the product,
• B = number of backorders allowed before replenishing inventory,
• c0 = ordering cost/order,
• h = annual inventory holding cost/unit/time,
• p = annual backorder cost/unit/time,
• t1 = time for the receipt of an order until the inventory level is again
zero,
• t2 = time from a zero inventory level until a new order is received,
• t3 = time between consecutive orders,
• N = D/Q = number of orders/year,
• Q – B = inventory level just after a batch of Q units is added.
BACKORDERING
• Since a is the rate of depletion of inventory,

during each cycle, the inventory level is
positive for a time (Q – B)/a.
• The average inventory level during this time

is (Q – B)/2 units, and corresponding cost is
h(Q – B)/2 per unit time.
• Hence holding cost per cycle =

BACKORDERING
• Similarly shortage occurs for a time B/a. The

average amount of shortage during this
time is (0 + B)/2 units, and the corresponding
cost is pB/2 per unit time, where p is the cost
per unit short inventory per unit time short.
• Hence shortage cost per cycle =

BACKORDERING
• Reordering cost/cycle = c0, and cost of

inventory is cQ. Thus total cost/cycle (TC) is
sum of these costs i.e.,
• And the total cost per unit time is:

BACKORDERING
• The graphic representation of the model is

as follows:-
BACKORDERING
• In this model, there are two decision variables (B

and Q), so in order to find optimal values of Q and
B, we set partial derivatives and ∂T/∂Q and ∂T/∂B to
zero, and solve for Q and B.
• We get after differentiation,
• which is optimum values of Q and B.

BACKORDERING
Example 5:
Suppose a retailer has the following information
available:
• a = 350 units/year
• c0 = Rs.50 per order
• h = EGP. 13.75 per unit/time
• p = EGP. 25 per unit/time
• LT = 5 days
To minimize the total annual inventory cost when
backordering is allowed, how many units should be
ordered each time an order is placed, and how
many backorders should be allowed?
BACKORDERING
Solution:
In this case, optimum order and back order are,
Thus, the optimal policy is to allow approximately 22

backorders before replenishing the inventory with
approximately 63 units.
INVENTORY CONTROL
MODELS
FINITE DELIVERY RATE WITH BACKORDERING 4
FINITE DELIVERY RATE WITH
BACKORDERING
• we assume that each order for more stock

arrives in partial orders at a constant rate
each day until the complete order is
received.
• Thus, all assumptions from INFINITE DELIVERY

RATE WITH BACKORDERING hold with the
exception of the one just stated.
BACKORDERING
• Let:
• A = arrival (delivery) rate/day,
• a = use or sale rate/day,
• Q = order quantity,
• B = number of backorders allowed before replenishing
inventory,
• c0 = ordering cost/order,
• h = annual inventory holding cost/unit/time,
• c2 = annual backorder cost/unit,
• p = c2/time,
• t1 = time from zero inventory until the complete order is
received,
BACKORDERING
• Let:
• t2 = time from receipt of complete order until the inventory
level reaches zero again,
• t3 = time from when backordering starts coming in,
• t4 = time from when a new order starts coming in until all
backorders are filled (inventory
• level comes back to zero again),
• t5 = t1 + t2 + t3 + t4,
• N = D/Q = number of orders per year.
BACKORDERING
• Based on the above notations, annual order

cost is given as:
• Annual Inventory Holding Cost (AIHC),

Annual Backordering Cost (ABC), are given
by:
BACKORDERING
• (t1 + t2)/t5 is the ratio of time, for which

inventory remains positive.
• Now t5 is the total time in which inventory Q
has arrived and depleted.
• Since arrival rate A is greater than the
depletion rate a, t5 = Q/A.
BACKORDERING
• (t1 + t2) time is the time for which inventory

remained positive, while items were arriving
and were being consumed simultaneously.
• This means,
BACKORDERING
• Now t1 is the time in which full EOQ i.e., Q will

arrive i.e., t1 = Q/A. Substituting expressions
for t1, t2, t3, t4, t5 in previous equations and
adding the three costs, one gets:
BACKORDERING
• To find optimum values of Q and B for minimum

total annual inventory cost, we differentiate the
previous equation with respect to Q and B.
• After differentiation we get after some algebraic

computation,

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SIMULATION SYSTEMS

INVENTORY CONTROL MODELS 5

• Many companies fail each year due to the

• Whether it is raw material used for

• If the number of items stored are more than

• This in turn depends on what is the annual

• There can be uncertainties, such as strike,

• While computing the inventory for storage,

The basic problem in inventory

• Backordering is the case when inventory

• If inventory is of items, which are for the sale,

• Thus backordering case should always be

• The mathematical inventory models can be

• If the demand in future period can be

• This is the case of known demand where a

• When demand can not be predicted very

• The simplest case when there is no back

• Costs involved in maintaining an inventory

• The key to minimizing inventory costs is for

• If the demand is known and the time to

• Assumptions while modeling the inventory

1. A single type of product is analyzed even

4. The lead time is known and is constant

Thus only two costs are involved in this model

• Generally two types of products are kept in

• Inventory which is stocked for the use in

• If management allows the stock of raw material to

• If management allows product to be depleted, loss

• It is assumed that lead time, that is time gap

• Annual Ordering Cost (AOC) is given by

• It is to be noted that c0 is the cost per order, and

• Annual inventory holding cost is given as,

• Therefore total inventory cost per cycle is given by

• Therefore total cost per unit time is:

• Our aim is to minimize T.

• For T to be minimum, we use the concept of

• First of equation (4) gives,

• Second of equation (4) gives

• Thus value of Q given in equation (5) gives the

• The corresponding cycle time, t, is given by:-

a) Optimum order quantity Q = √2ac0/h = √2×18000×

• Suppose there is a case, when complete

• This may be due to non availability of raw

• We also assume that arrival rate is greater

• Such case is called finite delivery rate with

• Since units are sold or used while others are

• Since arrival rate is A/day, total ordered

• Now a number of units are used in one day,

• Then since A > a, there are always some

1/2[Q– a(Q/A)] = average inventory level in one

• Now total inventory cost = holding cost +

• where c0 is the cost involved per order and a/Q is

• Differentiating this equation with respect to

• which is the expression for optimum quantity to be

This is the long-run average total cost since

This cost is less than TC in first case, which is EGP.

• In the previous sections, we assumed that

• There is generally a cost associated with

• The merchant could take orders and then