Module-IV

Inventory Control
 Field and scope of inventory control,
 inventory types and classification,
 Inventory control models,
 static model,
 dynamic model both deterministic and stochastic,
 Economic lot size,
 reorder point and their application,
 ABC analysis,
 VED analysis,
 modern practices in purchasing and store Management.
Meaning of Inventory

• Inventory generally refers to the materials in stock.

• It is also called the idle resource of an enterprise.
• Inventories represent those items which are either stocked for sale or
they are in the process of manufacturing.
Functions of Inventory
1. To decouple or separate various parts of the production process by
covering delays. For example, if a firm’s supplies fluctuate, extra inventory
may be necessary to decouple the production process from suppliers.
2. To protect the company against fluctuations in demand
3. To provide a selection for customers by providing stock of goods. Such
inventories are typical in retail establishments.
4. To take advantage of quantity discounts, because purchases in larger
quantities may reduce the cost of goods or their delivery.
5. To hedge against inflation and upward price changes
Problems Caused by Inventory

• Inventory ties up working capital

• Inventory takes up space
• Inventory is prone to Damage, Pilferage and Obsolescence
• Inventory hides problems such as long setup time, poor maintenance
practices, unreliable suppliers, and improper production control policies.
• Therefore, excessive inventory can be viewed as an indicator of problem
rather than as a problem itself.
 The River Analogy

Defects
Defective Materials Machine Breakdowns Long Set ups

Long Lead times Unsuitable Equipment Uneven Schedules

Unreliable Suppliers Inefficient Layouts Absenteeism

Rigid Work Rules
The Material Flow Cycle

Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time
 Types of Inventories

• Raw material inventory has been purchased but not processed. This
inventory can be used to decouple (i.e., separate) suppliers from the
production process.

• Work-in-process (WIP) inventory is components or raw material that

have undergone some change but are not completed. WIP exists because
of the time it takes for a product to be made (called cycle time). Reducing
cycle time reduces inventory.

• MROs are inventories devoted to maintenance/repair/operating supplies

necessary to keep machinery and processes productive. They exist
because the need and timing for maintenance and repair of some
equipment are unknown.
• Finished-goods inventories is completed product awaiting shipment.
Finished goods may be inventoried because future customer demands are
unknown.

• Goods-in-transit to warehouses or customers

Inventory Control

Inventory control is a planned approach of determining what to order, when to order

and how much to order and how much to stock so that costs associated with buying
and storing are optimal without interrupting production and sales.

Inventory control basically deals with two problems:

(i) When should an order be placed? (Order level), and
(ii) How much should be ordered? (Order quantity).

• The scientific inventory control system strikes the balance between the loss due
to non-availability of an item and cost of carrying the stock of an item.

• Scientific inventory control aims at maintaining optimum level of stock of goods

required by the company at minimum cost to the company.
Objectives of Inventory Control

1. To ensure adequate supply of products to customer and avoid shortages as far

as possible.
2. To make sure that the financial investment in inventories is minimum (i.e., to
see that the working capital is blocked to the minimum possible extent).
3. Efficient purchasing, storing, consumption and accounting for materials is an
important objective.
4. To maintain timely record of inventories of all the items and to maintain the
stock within the desired limits.
5. To ensure timely action for replenishment.
6. To provide a reserve stock for variations in lead times of delivery of materials.
7. To provide a scientific base for both short-term and long-term planning of
materials.
 Benefits of Inventory Control

1. Improvement in customer’s relationship because of the timely delivery of goods and

service.
2. Smooth and uninterrupted production and, hence, no stock out.
3. Efficient utilisation of working capital.
4. Helps in minimising loss due to deterioration, obsolescence damage and pilferage.
5. Economy in purchasing.
6. Eliminates the possibility of duplicate ordering
 INVENTORY MODELS

Inventory control models assume that demand for an item is either

independent of or dependent on the demand for other items.

For example, the demand for refrigerators is independent of the demand for
toaster ovens. However, the demand for toaster oven components is dependent
on the requirements of toaster ovens.

• Independent demand – finished goods, items that are ready to be sold

such as computers, cars.
• Forecasts are used to develop production and purchase schedules for
finished goods.
• Dependent demand – components of finished products (computers, cars)
such as chips, tires and engine
• Dependent demand inventory control techniques utilize material
requirements planning (MRP) logic to develop production and
purchase schedules.
 Inventory Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain. That is why it is forecasted.

Dependent demand is certain and it is calculated.

13
Regardless of the nature of demand (independent,
dependent) two fundamental issues underlie all inventory
planning:

How Much to Order?

When to order?

14
Inventory Costs
1. Purchase cost is the amount paid to a vendor or supplier to buy the inventory.
It is typically the largest of all inventory costs.

2. Holding (carrying) cost. Cost to carry an item in inventory for a length of time,
usually a year.
o Costs include interest, insurance, taxes (in some states), depreciation,
obsolescence, deterioration, spoilage, pilferage, breakage, tracking,
picking, and warehousing costs (heat, light, rent, workers, equipment,
security).
o They also include opportunity costs associated with having funds that
could be used elsewhere tied up in inventory.

3. Ordering costs are the costs of ordering and receiving inventory.

o They include determining how much is needed, preparing invoices,
inspecting goods upon arrival for quality and quantity, and moving the
goods to temporary storage.
o Ordering costs are generally expressed as a fixed dollar amount per order,
regardless of order size
 o When a firm produces its own inventory instead of ordering it from a
supplier, machine setup costs (e.g., preparing equipment for the job by
adjusting the machine, changing cutting tools) are analogous to ordering
costs; that is, they are expressed as a fixed charge per production run,
regardless of the size of the run.

4. Shortage costs result when demand exceeds the supply of inventory on hand.
o These costs can include the opportunity cost of not making a sale, loss of
customer goodwill, late charges, backorder costs, and similar costs.
o Furthermore, if the shortage occurs in an item carried for internal use (e.g.,
to supply an assembly line), the cost of lost production or downtime is
considered a shortage cost.
o Such costs can easily run into hundreds of dollars a minute or more.
o Shortage costs are sometimes difficult to measure, and they may be
subjectively estimated.

Lead time: time interval between ordering and receiving the order
INVENTORY MODELS FOR INDEPENDENT DEMAND

1. Basic economic order quantity (EOQ) model

2. Production order quantity model

3. Quantity discount model

The Basic Economic Order Quantity
(EOQ) Model
An inventory-control technique that minimizes the total of ordering and holding
costs. Technique is relatively easy to use but is based on several assumptions:
1. Demand for an item is known, constant, and independent of decisions for
other items.

2. Lead time—that is, the time between placement and receipt of the order—is
known and consistent.

3. Receipt of inventory is instantaneous and complete. In other words, the

inventory from an order arrives in one batch at one time.

4. Quantity discounts are not possible.

5. The only variable costs are the cost of setting up or placing an order (setup or
ordering cost) and the cost of holding or storing inventory over time (holding or
carrying cost). These costs were discussed in the previous section.

6. Stockouts (shortages) can be completely avoided if orders are placed at the

right time.
 Usage rate Average
Order inventory
quantity = Q
Inventory level

on hand
(maximum
Q
inventory
level) 2

Minimum
inventory

0
Time
The Inventory Cycle

Q Usage
Quantity rate
on hand
(maximum
İnventory)

Reorder
point

Receive Place Receive Place Receive Time

order order order order order
Lead time
• The objective of most inventory models is to minimize total costs.
• Significant costs are setup (or ordering) cost and holding (or carrying) cost.
• All other costs, such as the cost of the inventory itself, are constant.
• Thus, if we minimize the sum of setup and holding costs, we will also be
minimizing total costs.
• The optimal order size, Q*, will be the quantity that minimizes the total costs.
 Annual cost

Setup (or order)

cost

Order quantity

• As the quantity ordered increases, the total number of orders placed per year will
decrease.
• Thus, as the quantity ordered increases, the annual setup or ordering cost will
decrease.
 Annual cost

Holding cost

Order quantity

As the order quantity increases, the holding cost will increase due to the larger average
inventories that are maintained.
 Objective is to minimize total costs

Total cost of
holding and
setup (order)

Minimum
total cost
Annual cost

Holding cost

Setup (or order)

cost

Optimal order Order quantity

quantity (Q*)

• A reduction in either holding or setup cost will reduce the total cost curve.
• A reduction in the setup cost curve also reduces the optimal order quantity (lot size).
• In addition, smaller lot sizes have a positive impact on quality and production
flexibility.
The EOQ Model D
Annual setup cost = Q S

Q = Order Quantity
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)

Annual demand Setup or order

=
Order Quantity cost per order

D
= (S)
Q
 Q = Order Quantity
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
Q
H = Holding or carrying cost per unit per year Annual holding cost = H
2

Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2

Q
= (H)
2
 The EOQ Model Annual setup cost =
D
Q
S
Q
Annual holding cost = H
2

Optimal order quantity is found when annual setup cost equals annual
holding cost or we take the derivative of the total cost function and set the
derivative (slope) equal to zero and solve for Q

D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
2DS
Q* =
H
Inventory costs may also be expressed to include the actual cost of the material
purchased. D is annual demand and P is price per unit.

The formula for the economic order quantity (Q*) can also be determined by finding
where the total cost curve is at a minimum (i.e., where the slope of the total cost
curve is zero).
Using calculus, we set the derivative of the total cost with respect to Q* equal to 0.
An EOQ Example
Determine optimal number of needles to order (Q)
D = 1,000 units per year
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
An EOQ Example
Determine expected number orders per year (N)
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected Demand D
number of = N = =
orders Order quantity Q*
1,000
N= = 5 orders per year
200
An EOQ Example
Determine expected time between orders (T)
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year

Number of working
Expected days per year
time between = T =
orders N
250
T= = 50 days between orders
5
An EOQ Example
Determine total annual cost:
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
1,000 200
TC = ($10) + ($.50)
200 2

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

Robust Model
 The EOQ model is robust it gives satisfactory answers even with
substantial variation in its parameters.

 Determining accurate ordering costs and holding costs for inventory is

often difficult. Consequently, a robust model is advantageous.

 Total cost of the EOQ changes little in the neighborhood of the minimum.
Because the total cost curve is relatively flat in the area of the EOQ.

 Variations in setup costs, holding costs, demand, or even EOQ make

relatively modest differences in total cost.
Minimizing Costs
Objective is to minimize total costs
Total cost of
holding and
setup (order)

Minimum
total cost
Annual cost

Holding cost

Setup (or order)

cost
Optimal order Order quantity
quantity (Q*)
An EOQ Example
Suppose Management underestimates demand by 50%
D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2
1,500 200
TC = ($10) + ($.50) = $75 + $50 = $125
200 2
An EOQ Example
Actual EOQ for new demand is 244.9 units
D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2 Only 2% less
1,500 244.9 than the total
TC = ($10) + ($.50) cost of $125
244.9 2
when the
TC = $61.24 + $61.24 = $122.48 order quantity
was 200
Reorder Points
Now that we have decided how much to order, we will look at the second inventory
question, when to order.
Simple inventory models assume that
1. a firm will place an order when the inventory level for that particular item
reaches zero and
2. it will receive the ordered items immediately.
However, the time between placement and receipt of an order, called lead time, or
delivery time, can be as short as a few hours or as long as months.
Thus, the when-to-order decision is usually expressed in terms of a reorder point
(ROP)—the inventory level at which an order should be placed.

The reorder point (ROP) is given as:

ROP = (Demand per day) * (Lead time for a new order in days)

=d*L
The Inventory Cycle

Q Resupply takes place as

Quantity order arrives
on hand
(maximum Slope = unit per day = d
İnventory)

d = D/number of working days in a year

Reorder
point

Place Receive
Time (Day)
Receive
order order
order
Lead time = L
Production Order Quantity Model

• In the previous inventory model, we assumed that the entire inventory order was
received at one time. However, there are times, when the firm may receive its
inventory over a period of time.

• Such cases require a different model. This model is applicable under two
situations:
1. when inventory continuously flows or builds up over a period of time after
an order has been placed or
2. when units are produced and sold simultaneously.

• Under these circumstances, we take into account daily production rate (or
inventory-flow) and daily demand rate.
 Because this model is especially suitable for the production
environment, it is commonly called the production order quantity
model.
 The third assumption of EOQ model is relaxed: Receipt of inventory is
not instantaneous and complete
 Units are produced and used/or sold simultaneously
 Production is done in batches or lots
 Capacity to produce a part exceeds the part’s usage or demand rate
 Hence, inventory builds up over a period of time after an order is
placed
 Production Order Quantity Model

Part of inventory cycle during

which production (and usage)
is taking place
Inventory level

Demand part of cycle

with no production
Maximum
inventory

t Time
Production Order Quantity Model
Qp = Order Quantity p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Annual inventory Holding cost

= (Average inventory level) x
holding cost per unit per year

Average
= (Maximum inventory level)/2
inventory level
𝒎𝒂𝒙
𝑨𝒗𝒆𝒓𝒂𝒈𝒆

Maximum Total produced during Total used during

inventory level = the production run – the production run

= pt – dt
 Production Order Quantity Model…….

However, Q = total produced = pt ; thus t = Q/p

Maximum Q Q d
inventory level = p –d =Q 1–
p p p

(p-d)

Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p
Setup cost = (D/Qp)S

𝐦𝐚𝐱
𝐩

1
(D/Qp)S = 2 HQp[1 - (d/p)]

2DS
Qp 2 = H[1 - (d/p)]
The cycle time (the time between setups of consecutive runs) for the economic run
size model is a function of the run size and usage (demand) rate:
𝒑

Similarly, the run time (the production phase of the cycle) is a function of the
run (lot) size and the production rate:

𝒑
Q. Nathan Manufacturing, Inc., makes and sells specialty hubcaps for the
retail automobile aftermarket. Nathan’s forecast for its wire-wheel
hubcap is 1,000 units next year, with an average daily demand of 4
units. However, the production process is most efficient at 8 units per
day. So the company produces 8 per day but uses only 4 per day. The
company wants to solve for the optimum number of units per order.
(Note: Holding cost is $0.50 per unit per year and ordering cost is $10
per order.

D = 1,000 units p = 8 units per day

S = $10 d = 4 units per day
H = $0.50 per unit per year # of days plant is open=250

2DS
Q* =
H[1 - (d/p)]

2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]

= 282.8 or 283 hubcaps

Q. A toy manufacturer uses 48,000 rubber wheels per year for its popular dump truck
series. The firm makes its own wheels, which it can produce at a rate of 800 per day.
The toy trucks are assembled uniformly over the entire year. Carrying cost is $1 per
wheel a year. Setup cost for a production run of wheels is $45. The firm operates 240
days per year. Determine the following:
a. Optimal run size
b. Minimum total annual cost for carrying and setup
c. Cycle time for the optimal run size
d. Run time

Solution:
D = 48,000 wheels per year S = $45 H = $1 p er wheel per year
P = 800 wheels per day u =d = 48,000 wheels per 240 days, or 200 wheels per day
Q. The Dine Corporation is both a producer and a user of brass couplings. The firm
operates 220 days a year and uses the couplings at a steady rate of 50 per day. Couplings
can be produced at a rate of 200 per day. Annual storage cost is $2 per coupling, and
machine setup cost is $70 per run.
a. Determine the economic run quantity.
b. Approximately how many runs per year will there be?
c. Compute the maximum inventory level.
d. What is the average inventory on hand?
e. Determine the length of the pure consumption portion of the cycle.

Solution.
D = 50 units per day × 220 days per year = 11,000 units per year Solution
S = $70 per order H = $2 per unit per year
p = 200 units per day u = 50 units per day
Quantity Discount Models
 These models are used where the price of the item ordered varies
with the order size.

 Reduced prices are often available when larger quantities are ordered.

 The buyer must weigh the potential benefits of reduced purchase

price and fewer orders that will result from buying in large quantities
against the increase in carrying cost caused by higher average
inventories.

 Hence, there is trade-off between reduced product cost and increased

holding cost
Total Costs with Purchasing Cost
Total cost = Ordering (setup) cost + Holding cost + Product cost

Where P is the unit price.

Remember that the basic EOQ model does not take into consideration the
purchasing cost. Because this model works under the assumption of no quantity
discounts, price per unit is the same for all order size.
Note that including purchasing cost would merely increase the total cost by the
amount P times the demand (D). See the following graph.
Total Costs with Purchasing Cost
Cost

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without PD

PD

0 EOQ Quantity
Quantity Discount Models
• There are two general cases of quantity discount models:
1. Carrying costs are constant (e.g. $2 per unit).
2. Carrying costs are stated as a percentage of purchase price (20% of
unit price)
Total Cost with Constant Carrying Costs
In this case there is a
single minimum point;
all curves will have
TCa their minimum point at
the same quantity
Total Cost

TCb
Decreasing
TCc Price

CC a,b,c

OC

EOQ Quantity
 EOQ when carrying cost is constant
1. Compute the common minimum point by using the basic economic
order quantity model.

2. Only one of the unit prices will have the minimum point in its feasible
range since the ranges do not overlap. Identify that range:
a. if the feasible minimum point is on the lowest price range, that is the
optimal order quantity.
b. if the feasible minimum point is any other range, compute the total cost for
the minimum point and for the price breaks of all lower unit cost.
Compare the total costs; the quantity that yields the lowest cost is the
optimal order quantity.
 Quantity Discount Model with Constant
Carrying Cost
QUANTITY PRICE
S = $2,500
1 - 49 $1,400 H = $190 per computer
50 - 89 1,100 D = 200
90+ 900

2SD 2(2500)(200)
Qopt = = = 72.5 PCs
H 190

For Q = 72.5 SD H Qopt

TC = + 2 + PD = $233,784
Qopt

For Q = 90 SD HQ
TC = + 2 + PD = $194,105
Q
Q. The maintenance department of a large hospital uses about 816 cases of liquid
cleanser annually. Ordering costs are $12, carrying costs are $4 per case a year, and
the new price schedule indicates that orders of less than 50 cases will cost $20 per
case, 50 to 79 cases will cost $18 per case, 80 to 99 cases will cost $17 per case, and
larger orders will cost $16 per case. Determine the optimal order quantity and the
total cost.

Solution:
D = 816 cases per year S = $12 H = $4 per case per year
Range Price
1 to 49 $20
50 to 79 $18
80 to 99 $17
100 or more $16
Because lower cost ranges exist, each must be checked against the minimum cost
generated by 70 cases at $18 each.

In order to buy at $17 per case, at least 80 cases must be purchased.

TC 80 = ( 80 / 2 ) 4 + ( 816 / 80 ) 12 + 17(816) = $14,154

To obtain a cost of $16 per case, at least 100 cases per order are required, and the
total cost at that price break will be
TC 100 = ( 100 / 2 ) 4 + ( 816 / 100 ) 12 + 16(816) = $13,354

100 cases per order yields the lowest total cost, 100 cases is the overall optimal
order quantity.
 Total Cost with varying Carrying Costs
When carrying cost is expressed as a percentage of the unit price, each curve
will have different minimum point.
TCa
TCb
Cost

TCc

CCa
OC

CCb

CCc
Quantity
 EOQ when carrying cost is a percentage of the unit
price

Holding cost is expressed as a percent (I) of

2DS unit price (P) instead of as a constant cost
Q* =
IP per unit per year, H

1. Beginning with the lowest unit price, compute the minimum points for
each price range until you find a feasible minimum point (i.e., until a
minimum point falls in the quantity range of its price).
2. If the minimum point for the lowest unit price is feasible, it is the optimal
order quantity.
3. If the minimum point is not feasible in the lowest price range, compare
the total cost at the price break for all lower prices with the total cost of
the feasible minimum point. The quantity which yields the lowest total
cost is the optimum
Q. The normal price of the item is $5. Annual demand is 5000. When 1,000 to 1,999
units are ordered at one time, the price per unit drops to $4.80; when the quantity
ordered at one time is 2,000 units or more, the price is $4.75 per unit. As always,
management must decide when and how much to order. However, with an
opportunity to save money on quantity discounts, how does the operations
manager make these decisions?
A typical quantity discount schedule, Inventory Carrying cost is 20% of
unit price. Ordering cost is Rs 49 per order.

D=5000 I=0.2 S=49

Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80

3 2,000 and over 5 $4.75

When carrying costs are specified as a percentage of unit price, the total cost
curve is broken into different total cost curves for each discount range

Total cost curve for discount 2

Total cost
curve for
discount 1
Total cost $

Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a
and must be adjusted upward to 1,000 units at point b

1st price 2nd price

break break

0 1,000 2,000
Order quantity
Calculate Q* first for the lowest price range

2DS
Q* =
IP

2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80)

2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)
Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80

3 2,000 and over 5 $4.75

2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80)

2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
 Quantity Discount Example
Annual Annual Annual
Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total Cost
1 $5.00 700

2 $4.80 1,000

3 $4.75 2,000

Choose the price and quantity that gives the lowest total cost
 Quantity Discount Example
Annual Annual Annual
Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total Cost
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000

3 $4.75 2,000

Choose the price and quantity that gives the lowest total cost
 Quantity Discount Example
Annual Annual Annual
Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total Cost
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000

Choose the price and quantity that gives the lowest total cost
Quantity Discount Example
Annual Annual Annual
Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

Table 12.3
Choose the price and quantity that gives
the lowest total cost
Buy 1,000 units at $4.80 per unit
Q. Surge Electric uses 4,000 toggle switches a year. Switches are priced as follows: 1 to
499, 90 cents each; 500 to 999, 85 cents each; and 1,000 or more, 80 cents each. It
costs approximately $30 to prepare an order and receive it, and carrying costs are
40 percent of purchase price per unit on an annual basis. Determine the optimal
order quantity and the total annual cost.

Solution:
D = 4,000 switches per year S = $30 H = .40P
Range Unit Price H
1 to 499 $.90 .40(.90) = .36
500 to 999 $.85 .40(.85) = .34
1,000 or more $.80 .40(.80) = .32

Find the minimum point for each price, starting with the lowest price, until you
locate a feasible minimum point.

Because an order size of 866 switches will cost $.85 each rather than $.80 each,
866 is not a feasible minimum point for $.80 per switch. Next, try $.85 per unit.
This is feasible; it falls in the $.85 per switch range of 500 to 999.

Now compute the total cost for 840, and compare it to the total cost of the minimum
quantity necessary to obtain a price of $.80 per switch.

Thus, the minimum-cost order size is 1,000 switches.

Q. A small manufacturing firm uses roughly 3,400 pounds of chemical dye a year.
Currently the firm purchases 300 pounds per order and pays $3 per pound. The
supplier has just announced that orders of 1,000 pounds or more will be filled at a
price of $2 per pound. The manufacturing firm incurs a cost of $100 each time it
submits an order and assigns an annual holding cost of 17 percent of the purchase
price per pound.
a. Determine the order size that will minimize the total cost.
b. If the supplier offered the discount at 1,500 pounds instead of 1,000 pounds,
what order size would minimize total cost?

Solution:
D = 3,400 pounds per year S = $100 per order H = .17P

a. Compute the EOQ for $2 per pound: The quantity ranges are as follows.
Range Unit Price
1 to 999 $3
1,000 + $2

Because this quantity is feasible at $2 per pound, it is the optimum.

b. When the discount is offered at 1,500 pounds, the EOQ for the $2 per pound range
is no longer feasible.
Consequently, it becomes necessary to compute the EOQ for $3 per pound and
compare the total cost for that order size with the total cost using the price break
quantity (i.e., 1,500).

Hence, because it would result in a lower total cost, 1,500 is the optimal order size.
13. A mail-order house uses 18,000 boxes a year. Carrying costs are 60 cents per box a
year, and ordering costs are $96. The following price schedule applies. Determine the
following:
a. The optimal order quantity
b. The number of orders per year
Number of Boxes Price per Box
1,000 to 1,999 $1.25
2,000 to 4,999 1.20
5,000 to 9,999 1.15
10,000 or more 1.10

14. A jewelry firm buys semiprecious stones to make bracelets and rings. The supplier
quotes a price of $8 per stone for quantities of 600 stones or more, $9 per stone for
orders of 400 to 599 stones, and $10 per stone for lesser quantities. The jewelry firm
operates 200 days per year. Usage rate is 25 stones per day, and ordering costs are $48.
a. If carrying costs are $2 per year for each stone, find the order quantity that will
minimize total annual cost.
b. If annual carrying costs are 30 percent of unit cost, what is the optimal order size?
c. If lead time is six working days, at what point should the company reorder?
15. A manufacturer of exercise equipment purchases the pulley section of the
equipment from a supplier who lists these prices: less than 1,000, $5 each; 1,000
to 3,999, $4.95 each; 4,000 to 5,999, $4.90 each; and 6,000 or more, $4.85 each.
Ordering costs are $50, annual carrying costs per unit are 40 percent of purchase
cost, and annual usage is 4,900 pulleys. Determine an order quantity that will
minimize total cost.

16. A company will begin stocking remote control devices. Expected monthly demand
is 800 units. The controllers can be purchased from either supplier A or supplier B.
Their price lists are as follows:

SUPPLIER A SUPPLIER B
Quantity Unit Price Quantity Unit Price
1–199 $14.00 1–149 $14.10
200–499 13.80 150–349 13.90
500 + 13.60 350 + 13.70

Ordering cost is $40 and annual holding cost is 25 percent of unit price per unit.
Which supplier should be used and what order quantity is optimal if the intent is
to minimize total annual costs?
17. A manager just received a new price list from a supplier. It will now cost $1.00 a
box for order quantities of 801 or more boxes, $1.10 a box for 200 to 800 boxes, and
$1.20 a box for smaller quantities. Ordering cost is $80 per order and carrying costs
are $10 per box a year. The firm uses 3,600 boxes a year. The manager has suggested a
“round number” order size of 800 boxes. The manager’s rationale is that with a U-
shaped cost curve that is fairly flat at its minimum, the difference in total annual cost
between 800 and 801 units would be small anyway. How would you reply to the
manager’s suggestion? What order size would you recommend?

18. A newspaper publisher uses roughly 800 feet of baling wire each day to secure
bundles of newspapers while they are being distributed to carriers. The paper is
published Monday through Saturday.
Lead time is six workdays. What is the appropriate reorder point quantity, given that
the company desires a service level of 95 percent, if that stockout risk for various
levels of safety stock is as follows:
1,500 feet, .10; 1,800 feet, .05; 2,100 feet, .02; and 2,400 feet, .01?