END 4810
INVENTORY
MODELS
The extensions of EOQ:
Extension To A Finite Production Rate
An implicit assumption of the simple EOQ model is that the items are
obtained from an outside supplier. When that is the case, it is reasonable
to assume that the entire lot is delivered at the same time.
However, if we wish to use the EOQ formula when the units are produced
internally, then we are effectively assuming that the production rate is
infinite. When the production rate is much larger than the demand rate,
this assumption is probably satisfactory as an approximation.
Assume that items are produced at a rate P during a production run. We
require that P> for feasibility. All other assumptions will be identical to
those made in the derivation of the simple EOQ. When units are produced
internally, the curve describing inventory levels as a function of time is
slightly different from the sawtooth pattern of basic EOQ model.
The extensions of EOQ:
Extension To A Finite Production Rate
Example:
Extension To A Finite Production Rate
A local company produces an erasable programmable read-only memory
(EPROM) for several industrial clients. It has experienced a relatively flat
demand of 2,500 units per year for the product. The EPROM is produced at
a rate of 10,000 units per year. The accounting department has estimated
that it costs $50 to initiate a production run, each unit costs the company
$2 to manufacture, and the cost of holding is based on a 30 percent annual
interest rate. Determine the optimal size of a production run, the length of
each production run, and the average annual cost of holding and setup.
What is the maximum level of the on-hand inventory of the EPROMs?
Example:
Extension To A Finite Production Rate
Macho Auto Company needs to produce 10,000 car chassis per year. Each
is valued at $2,000. The plant has the capacity to produce 25,000 chassis
per year. It costs $200 to set up a production run, and the annual holding
cost is 25¢, per dollar of inventory. Determine the optimal production run
size. How many production runs should be made each year?
The EOQ Model with Back Orders
Allowed
In many real-life situations, demand is not met on time, and shortages
occur. When a shortage occurs, costs are incurred (because of lost
business, the cost of placing special orders, loss of future goodwill, and so
on). We will modify the basic EOQ model to allow for the possibility of
shortages.
Let s be the cost of being short one unit for one year. In most situations, s
is very difficult to measure. We assume that all demand is backlogged and
no sales are lost. To determine the order policy that minimizes annual
costs, we define:
q order quantity
q M maximum shortage that occurs under an ordering policy.
Equivalently (assuming a zero lead time), the firm will be q M units short
each time an order is placed (when the firm’s inventory position is M q).
The EOQ Model with Back Orders
Allowed
We assume that the lead time for each order is zero. Since an order is
placed each time the firm is q M units short (or when the firm’s inventory
position is M q), the firm’s maximum inventory level will be M q + q = M.
Since purchasing costs do not depend on q and M, we can minimize annual
costs by determining the values of q and M that minimize: (holding +
shortage +ordering cost)
The EOQ Model with Back Orders
Allowed
Optimal Inventory Policy with Backordering
Nobody backorders cigarettes or gasoline.
Sales for those products are lost during shortages.
This model does not apply for them.
The shortage penalty s is not usually
known. But it may be imputed from
existing policy. The service level L is used
for that purpose:
L = proportion of time fully stocked
The imputed shortage penalty is:
hL
s =
1-L
9
Example: EOQ Model with Back
Orders
Each year, the Smalltown Optometry Clinic sells 10,000 frames for
eyeglasses. The clinic orders frames from a regional supplier, which charges
$15 per frame. Each order incurs an ordering cost of $50. Smalltown
Optometry believes that the demand for frames can be backlogged and that
the cost of being short one frame for one year is $15 (because of loss of
future business). The annual holding cost for inventory is 30¢ per dollar
value of inventory. What is the optimal order quantity (q)? What is the
maximum shortage that will occur (q M )? What is the maximum inventory
level that will occur (M)?
Example: EOQ Model with Back
Orders
A Mercedes dealer must pay $20,000 for each car purchased. The annual
holding cost is estimated to be 25% of the dollar value of inventory. The
dealer sells an average of 500 cars per year. He believes that demand is
backlogged but estimates that if he is short one car for one year he will lose
$20,000 worth of future profits. Each time the dealer places an order for
cars, ordering cost amounts to $10,000. Determine the Mercedes dealer’s
optimal ordering policy. What is the maximum shortage that will occur?
References
Silver, E. A., Pyke, D. F., & Peterson, R. Inventory management
and production planning and scheduling (4th edition). CRC Press
Nahmias, S., & Olsen, Y. Production and operations analysis (7th
edition). Waveland Press
Winston, W. L., . Operations research: applications and
algorithms
