Inventory Control Models

Inventory control is the technique of maintaining stock items at desired levels. In other words, it is
concerned with the acquisition, storage, and handling of inventories so that the inventory is available
whenever needed.
factors that affect Inventory levels
1. Inventory related costs
o Purchase (or production) cost. It is the cost at which an item is purchased, or if an item is
produced, it is the direct manufacturing cost.
o Ordering (or replenishment or set up) cost. The cost incurred in replenishing the
inventory is known as ordering cost. It includes all the costs relating to administration
(such as salaries of the persons working for purchasing, telephone calls, computer costs,
postage, etc.), transportation, receiving and inspection of goods, processing payments,
etc. This cost is expressed as the cost per order or per set up. It is denoted by Co.
o Carrying (or holding) cost. The cost associated with maintaining the inventory level is
known as holding cost. It is directly proportional to the quantity to be kept in stock and
the time for which an item is held in stock. It includes handling cost, maintenance cost,
depreciation, insurance, warehouse rent, taxes, etc. It is denoted by Ch.
o Shortage (or stock out) cost. It is the cost, which arises due to running out of stock (i.e.,
when an item can not be supplied on the customer's demand). It includes the cost of
production stoppage, loss of goodwill, loss of profitability, special orders at higher price,
overtime/idle time payments, expediting, loss of opportunity to sell, etc. It is denoted
by Cs.
2. Demand
It is an effective desire which is related with a particular time, price, and quantity. The demand
pattern of a commodity may be either deterministic or probabilistic. In case of deterministic, it is
assumed that the quantities needed in future are known with certainty. This can be fixed (static)
or can vary (dynamic) from time to time. To the contrary, in case of probabilistic, the demand over
a certain period of time is uncertain, but its pattern can be described by a known probability
distribution.
3. Ordering cycle
An ordering cycle is defined as the time period between two successive placement of orders. The
order may be placed on the basis of following two types of inventory review systems:
o Continuous review: In this case, record of the inventory level is updated continuously until
a specified point (known as reorder point) is reached, at this point a new order is placed.
Sometimes, this is referred to as the two-bin system. The inventory is divided into two
parts (two bins). Initially, items are used only from one bin, and when it becomes empty,
a new order is placed. Demand is then satisfied from the second bin until the order is
received. After receiving the order, the second bin is filled to make up the earlier total.
The remaining items are placed in the first bin.
o Periodic review: In this case, the orders are placed at equally spaced intervals of time. The
quantity ordered each time depends on the available inventory level at the time of review.
4. Time horizon
This is also known as planning period over which the inventory level is to be controlled. This can
be finite or infinite depending on the nature of demand.
5. Lead time or delivery lag
The time gap between the moment of placing an order and actually receiving the order is referred
to as lead time. The lead time can be deterministic, constant or variable, or probabilistic. If there

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 is no such gap, then we say that lead time is zero. If the lead time exists (i.e., it is not zero), then
it is required to place an order in advance by an amount of time equal to the lead time.
6. Buffer (or safety) stock
Normally, demand and lead time are uncertain and cannot be predetermined completely. So to
absorb the variation in demand and supply, some extra stock is kept. This extra stock is known as
buffer stock.
7. Number of items
Generally, an inventory system involves more than one commodity. The number of items held in
inventory affect the situation when these items compete for limited floor space or limited total
capital.
8. Government's policy
For items to be imported as well as for other items like explosive, highly inflammable, and other
essential items, the Government has laid down some policy norms. All these affect the level of
inventories in an organization.
Objectives of Inventory Control
• To minimize the possibility of delays in production through regular supply of raw materials.
• To keep inactive, waste, surplus, scrap and obsolete items at the minimum level.
• To maintain the overall investment in inventory at the lowest level, consistent with operating
requirements.
• To exercise economies in ordering, obtaining, and storing of the materials.
VED analysis
This analysis consists of separating the inventory items into three groups according to their critically as
under:
• Vital items (or V items) – These items are considered vital for smooth running of the system and
without these items the whole system becomes inoperative. Thus, close attention is paid to V
items.
• Essential items (or E items) – These items are considered essential for efficient running of the
system.
• Desirable items (or D items) – The availability of these items help in increasing the efficiency.
The criticality of the item may either be on technical grounds or on environmental grounds or on both.
the notations used in inventory models are:
Q = Number of units ordered per order.
D = Rate of demand.
N = Number of orders placed per year.
TC = Total inventory cost
Co = Cost of ordering per order
C = Purchase or manufacturing price per unit
Ch = Cost of holding stock per unit per period of time.
Cs = Shortage cost per unit.
R = Reorder point
L = Lead time (weeks or months)
t = The elapsed time between placement of two successive orders.

Economic Order Quantity Model with Uniform Demand

The main problem while purchasing material is how much to buy at a time. If large quantities are bought,
the cost of carrying the inventory would be high. To the contrary, if frequent purchases are made in small
quantities, costs relating to ordering will be high.

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Economic Order Quantity (EOQ) is that size of the order for which the cost of maintaining inventories is
minimum. Therefore, the quantity to be ordered at a given time should be determined by taking into
account two factors, i.e., the acquisition cost and the cost of possessing materials. We illustrate this model
after making the following assumptions:
Assumptions
• Demand rate is uniform over time and is known with certainty.
• The inventory is replenished as soon as the level of the inventory reaches to zero. Thus shortages
are not allowed.
• Lead time is zero.
• The rate of inventory replenishment is instantaneous.
• Quantity discounts are not allowed.

The inventory costs are determined as follows:

1. Ordering cost = Number of orders per year x Ordering cost per order
= N x Co
= Total annual demand/Number of units ordered x Co
D
= ---- x Co
Q
2. Carrying cost = Average inventory x carrying cost per unit
Q
= ---- x Ch
2
The total inventory cost is the sum of ordering cost and carrying cost.
D Q
TC = ---- (Co) + ---- (Ch)
Q 2
The total cost is minimum at a point where ordering cost equals carrying cost. Thus, economic order
quantity occurs at a point where
Ordering cost = Carrying cost
D Q
---- (Co) = ---- (Ch)
Q 2

Thus, optimal Q (EOQ) is derived to be

2DCo
Q=√
Ch
The period t is given by

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 𝑄 2Co
t= =√
𝐷 Ch 𝐷
Optimal number of orders per year is given by
𝐷 1
𝑁 = =
𝑄 𝑡
Minimum total yearly inventory cost TC is given by
TC = √2DCo Ch

Example 1
Annual usage - 500 pieces
Cost per piece - KES 100
Ordering cost - KES 10 per order
Inventory holding cost - 20% of Average Inventory
Solution.
D = 500 pieces
Co = 10
Ch = 100 X 20% = KES. 20
EOQ is given by
2DCo 2×10×500
Q=√ = √ =22 pieces
Ch 20
Example 2
The Newtech Hardware Company sells hardware items. Consider the following information.
Annual sales = KES 10000
Ordering cost = KES 25 per order
Carrying cost = 12.5% of average inventory value.
Find the optimal order size, number of orders per year, and cycle period.
Solution.
D = KES 10000, Co = KES. 25, Ch = 12.5% of average inventory value/unit
EOQ is given by
2DCo 2×25×10000
Q=√ =√ =KES 2000
Ch 0.125

The period t is given by

Q 2000 1
t= = = years=73 days
D 10000 5
Optimal number of orders per year is given by
1
N=
t
1
= =5
1
(5)

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EOQ Model with Shortages
In this case, shortages are permitted which implies that shortage cost is finite or it is not large. The cost
of a shortage is assumed to be directly proportional to the mean number of units short.
Further, all the assumptions of model I hold good here also.
The economic order quantity EOQ Model with Shortages is graphed in the following figure.

where
S = Back order quantity.
M = Maximum inventory level.
t1 = Time during which stock is available.
t2 = Time during which there is a shortage.
t = Time between receipt of orders.
The cycle time t is the sum of t1 and t2.

Economic Order Quantity (EOQ)

2DCo Ch +Co
Q=√ ×
Ch Cs

Maximum inventory level (M)

2DCo Cs
M=√ ×
Ch Ch +Cs

Time between receipt of orders (t)

2Co Cs +Ch
t=√ ×
DCh Cs

Total inventory cost (TC):

Cs
TC = √2DCo Ch ×
Cs +Ch

Example
The Wartsila Diesel Company has to supply diesel engines to a truck manufacturer at a rate of 10 engines
per day. The ordering cost is Kes. 150 per order. The penalty in the contract is Kes. 90 per engine per day
late for missing the scheduled delivery date. The cost of holding an engine in stock for one month is Kes.
140. His production process is such that each month (30 days) he starts procuring a batch of engines

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through the agencies and all are available for supply after the end of the month. Determine the maximum
inventory level at the beginning of each month.

Solution.
Given
Demand (D) = 10 engines per day
Shortage cost (Cs) = Kes. 90 per day per engine
Carrying cost (Ch) = 140/30 = 14/3 per engine per day
Ordering cost (Co) = Kes. 150 per order

Maximum inventory level (M) per month

2DCo Cs
M=√ ×
Ch Ch +Cs
2×10×150 90
= 30 ×√ 14 × 14
+90
3 3

= 741.65 ≈ 742 engines