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OPIM 201 OPERATIONS MANAGEMENT

INVENTORY MANAGEMENT – EOQ MODELS

(C&T CH. 5)

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Amazon.com
 Amazon.com started as a “virtual’ retailer – no inventory, no warehouses,
no overhead; just computers taking orders to be filled by others

 Amazon now stocks millions of items of inventory in 69 warehouses around

the world

 Growth has forced Amazon.com to become a world leader in warehousing

and inventory management

 Amazon.com obtains competitive advantage through inventory

management

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Why is Inventory Management Important?

 Inventory is the stock of any item or resource used in an organization
 It includes: Raw Materials, Finished Goods, Work-In-Process, Pipeline
inventory (goods-in-transit to warehouses or customers), and, MRO
(maintenance, repair, operations)
 Inventory: major form of assets
 Toys R Us
– 80% current assets
– 25% total assets
 Wal-Mart, GM, IBM, McDonald’s
 Cost of inventory: 30 - 35% of value

Dr. Wee Kwan Eng Slide 3 OPIM 201, SMU

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Inventory Example

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Purpose of Inventory
 To protect against uncertainty in demand or supply
 Safety stock (buffer) inventory
 To allow flexibility in production scheduling
 Seasonal inventory
 To take advantage of order cycles (due to set up cost)
 Cycle inventory
 To facilitate operations
 Pipeline inventory
 To help hedge against price increases or to take advantage of quantity
discounts

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Inventory Policy
 An Inventory Policy determines when stock should be replenished, and how
large orders should be.
 Order Timing: when to order
 Order Quantity: how much to order

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Components of Inventory Cost

 Holding costs
 e.g., storage facilities, handling, insurance, tax, pilferage, obsolescence,
cost of capital, etc.
 Include any cost components that are proportional to the amount of
time a flow unit spends in the system.
Typically proportional to the value of the inventory, i.e., can be

expressed as a percentage of the acquisition cost of the units.
 Backordering costs or Shortage costs
 Costs of canceling or delaying an order, dissatisfied customer etc.
 Production or Procurement costs (in general acquisition costs)
 Fixed costs
– Ordering or setup (e.g., clerical, equipment setups, transportation)
– Independent of the amount you produce or procure
– Incur only if you produce or place an order (unlike sunk costs)
 Variable purchase or production cost
– Proportional to the amount you acquire
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Example 1: Ordering Handle Caps for the Xootr

Novacruz, a kick scooter producer, sources handle caps for its scooters from a
Taiwan supplier for $2 per unit. Currently, the inventory is depleted at the
rate of the assembly operations, that is, at a flow rate of 500 units per week.
A shipping company charges Novacruz a fixed price of $1000 for shipping any
amount up to 15000 units. The annual unit holding cost is 40% of the unit
purchase price. Assuming there are no other costs, how many handle caps
should they order each time they order from their supplier?

 $2 = cost to Nova Cruz to purchase

each handle cap (a pair) from its
supplier in Taiwan.
 $1000 = fixed shipping fee (including
customs fee) for each shipment,
independent of the amount ordered.
 500 = demand for handle caps per week.
 40% = Nova Cruz’s annual inventory holding
cost

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Economic Order Quantity (EOQ) Model

Assumptions:
 Constant & known demand rate / flow rate (e.g., R units per year)
 Inventory never spoils, degrades or is lost; everything is eventually sold
 Orders are delivered with a reliable lead time
• Lead time (LT): time between when an order is placed & when it is
received
 Unit purchase price is independent of the quantity purchased

Costs:
 Unit variable acquisition (procurement or production) cost: p
 Unit holding cost per unit of time: h (typically expressed as % of p)
 Fixed costs per order: K

Decision: Order Quantity Q

(What about Order Timing?)
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Trade-Off: Fixed Costs vs. Cycle Inventory Costs

: Fixed cost (K)
Q Q Q T : Order Cycle Length
inventory level
Slope: –R
(demand rate)

Average Cycle Inventory =

LT time

place order T=

 As Q , inventory costs  but fixed cost .

 The optimal Q (or T) balances inventory holding costs and ordering costs.
 For positive lead time (LT>0), order LT periods before inventory level becomes zero.

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Trade-Off: Fixed Costs vs. Cycle Inventory Costs

: Fixed cost (K)
Q = 100 Q = 100 Q = 100 T : Order Cycle Length
inventory level

Too much cycle inventory

time

T long

Q=20
time

T short Too much ordering costs

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Trade-Off: Fixed Costs vs. Cycle Inventory Costs

 Very often, employees focus on one cost (perhaps due to limitation of their
role/position or the incentive system), say fixed costs and end up ordering
too much and too infrequently (to reduce ordering cost).
 They should balance the two costs by assessing how their order quantity
impact these two costs. How?

Dr. Wee Kwan Eng Slide 12 OPIM 201, SMU

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The Economic Order Quantity (EOQ), Q*

R : Flow Rate or demand rate
h : unit holding cost per unit of time
Inventory
K : Fixed costs per order
Q
1
R
Avg. Cycle Inventory =

0
T= Time
Shipment arrives Shipment arrives

Goal: Determine the economic order quantity Q* that minimizes inventory

holding cost and fixed cost per unit time, C(Q)
C(Q) = Inventory holding costs per unit time + Fixed costs per unit time
= h +K Number of orders per unit time

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Understanding the Computation of Fixed Costs

Number of orders per unit time
 Fixed costs per unit time = K 

OR K = K/T

Example
 R = 100 units/month (= 1200 units/yr.)
 Q = 200
 T = Q/R = 200/100 = 2 month (or 200/1200 = 1/6 yr.)
 Number of orders per year = 1/T = = 1200/200 = 6 times per year (or
100/200 = ½ times per month). Hence fixed costs per year is K =6K
 Alternatively, since a fixed cost K is assessed once per order cycle, it is
charged to the duration of the order cycle, T, which is 2 months or 1/6 year.
Hence the fixed cost per unit time (during each order cycle) is K/T =
K/( ). In particular, the fixed cost per year is K/( ) = 6 K.

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The Economic Order Quantity (EOQ), Q*

 Objective: Choose Q to minimize C(Q) = h  +K

• Purchasing cost (  ) is independent of the order decision
• The total cost, TC(Q) =  + h  

 Solution: Order the Economic Order Quantity, Q*:

× ×
Q* 
∗ C(Q)
C(Q*)  ∗

 Holding costs,
h ⁄

Fixed costs, K  ⁄

Q*
Order Quantity

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Check Your Understanding – Example 1

 Purchase costs:
$2 per unit x 500 per week = $1000 per week
 Q cannot influence our weekly purchase cost!
 h = Inventory holding cost per unit time:
 40% annual holding cost, so …
 0.4 x $2 = $0.80 = cost to hold a unit for one year…
 h = $0.80 / 52 = $0.01538 = cost to hold a unit for one week.
 K = Ordering cost:
 K = $1000; this is the fixed shipping fee per order that is independent of
the amount ordered as long as it does not exceed 15000.
× × × ×
 = = = 8062
.

= = = $124.03 per week

= = 8062/500  16 weeks or 4 months

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Discuss: Challenges in Applying EOQ in Practice

 Suppliers impose Minimum Order Quantity (MOQ)
 Reason: fixed cost incurred by suppliers or to facilitate storage and
transportation (e.g., inventory measured in pallet rather than in unit)
 Lead to high inventory cost at customers
 Infrequent order from customer can also cause problem in capacity
planning for upstream suppliers – constant continuous consumer
demand translates into lumpy infrequent demand for suppliers
 Could be resolved via collaboration and technology
 Demand is uncertain
 Difficult to estimate cost parameters (h and K)

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Addressing Demand Uncertainty

 EOQ are usually used in the mature stage of product life cycle due to lower
risk of obsolescence
 In the case when demand uncertainty is significant, EOQ are used together
with ROP system (where safety stock inventory may be incorporated in the
ROP)

EOQ
Sales

MOQ
MOQ

Development Introduction Growth Mature Decline

Time

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A Different Perspective of EOQ Model:

The Reorder Point (ROP) System
INVENTORY Suppose LT = 2 weeks,
R = 10 per week
Then ROP = 2×10 = 20
EOQ
Inventory
level

ROP
lead time
demand
0
LT LT TIME
place order

 Place an order when inventory reaches a reorder point, ROP

ROP = demand during lead-time = R  LT
where R = demand rate; LT = supply lead-time
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Example 1 – Revisit

 Suppose the original conditions in Example 1 continue to hold. Moreover,

it takes two weeks for an order to arrive from Taiwan. What is the
ordering policy, that is, order-size and reorder point?
× × × ×
Order EOQ = = = 8062
.

Reorder Point = 500 caps per week * 2 week = 1000

INVENTORY

8062

2 weeks 2 weeks
1000

0 TIME
Place order Place order
Shipment Shipment
arrives arrives
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Check Your Understanding: Example 2

A local distributor for Handi-Man Company expects to sell approximately
30,000 two-wheel carts of a certain size and design next year. The
distributor’s cost of placing an order with the manufacturing facility is $300
and the manufacturer’s price for each cart is $25. The annual cost for carrying
inventory is 30 percent of the item purchase price. The distributor operates
250 days per year. The manufacturer’s lead time for replenishing this product
is five working days. Answer the following questions.
(a) What is the economic order quantity (EOQ)?

(b) What is the reorder point (ROP) in units for the distributor based on the
above information?

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Discuss: Challenges in Applying EOQ in Practice

 Suppliers impose Minimum Order Quantity (MOQ)
 Reason: fixed cost incurred by suppliers or to facilitate storage and
transportation (e.g., inventory measured in pallet rather than in unit)
 Lead to high inventory cost at customers
 Infrequent order from customer can also cause problem in capacity
planning for upstream suppliers – constant continuous consumer
demand translates into lumpy infrequent demand for suppliers
 Could be resolved via collaboration and technology
 Demand is uncertain
 Difficult to estimate cost parameters (h and K)

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Robustness of EOQ
 EOQ model requires accurate estimates of parameters such as K & h. How
do inaccurate estimates of these parameters (leading to incorrect
computation of Q*) affect the system performance?

 EOQ model is very robust:

For any Q,
∗
∗ = ∗

 Example: Suppose Q = 2Q*.

∗ = =

Hence, if Q is twice as much as Q*, C(Q) only increases by 25%.

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Sensitivity Analysis

Q* 

C(Q*) 

 Q*:
 If K decreases (by n times), then Q* decreases (by times).
 If h decreases (by n times), then Q* increases (by times).

 C(Q*):
 If K decreases (by n times), then C(Q*) decreases (by times).
 If h decreases (by n times), then C(Q*) decreases (by times).

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Check Your Understanding

1) Natural is a firm that produces different flavors of jam, each with a constant
demand. Natural manages its inventory for each flavor using an EOQ model. It has
signed a three-year contract to rent a warehouse at $1000 per month. The
warehouse is used to store the jam produced. How does this contribute to the
cost structure under the EOQ model?
a) Holding Cost
b) Fixed Cost
c) Shortage Cost
d) Variable Production Cost
e) None of the above
2) Natural is highly automated and its machinery is depreciating at a rate of $100 per
day. How does the depreciating cost contribute to the cost structure under the
EOQ model?
a) Holding Cost
b) Fixed Cost
c) Shortage Cost
d) Variable Production Cost
e) None of the above

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Key Lesson
 Do not confuse cost accounting (or activity-based costing – allocating costs
for accounting purposes) with identifying relevant cost parameters for
making operational decision
 E.g., some costs such as salaries or wages are actually sunk costs and
should not be charged as fixed costs or holding costs.

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Summary
 Inventory management:
 Helps to coordinate flows across supply chain
 Keeps costs low, and keeps customers satisfied
 Ordering too much at one time:
 Reduces administrative and fixed costs of orders
 Increases inventory holding costs
 Ordering too little at one time:
Reduces inventory holding costs, but increases fixed and administrative

costs
 EOQ model
 Balances order and holding costs
 Order with moderate frequency
 Time between successive orders: depends on optimal quantity

Dr. Wee Kwan Eng Slide 27 OPIM 201, SMU