D Special Inventory Models

For Operations Management, 9e by

PowerPoint Slides
Krajewski/Ritzman/Malhotra
by Jeff Heyl © 2010 Pearson Education
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. D–1
Noninstantaneous Replenishment

 Maximum cycle inventory

 Item used or sold as it is completed
 Usually production rate, p, exceeds the demand
rate, d, so there is a buildup of (p – d) units per
time period
 Both p and d expressed in same time interval
 Buildup continues for Q/p days

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Noninstantaneous Replenishment

Production quantity
Q
On-hand inventory

Demand during
production interval
Imax
Maximum inventory

p–d

Time
Production Demand
and demand only
TBO

Figure D.1 – Lot Sizing with Noninstantaneous Replenishment

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Noninstantaneous Replenishment

 Maximum cycle inventory is:

Q  pd 
I max   p  d   Q 
p  p 

where
p = production rate
d = demand rate
Q = lot size

 Cycle inventory is no longer Q/2, it is Imax /2

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Noninstantaneous Replenishment

Total annual cost = Annual holding cost

+ Annual ordering or setup cost

D is annual demand and Q is lot size

d is daily demand; p is daily production rate

Q pd 
 H    S   
I max D D
C   H   S 
2 Q 2 p  Q

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Noninstantaneous Replenishment

 Economic Production Lot Size (ELS): optimal lot

size
 Derived by calculus
 Because the second term is greater than 1, the
ELS results in a larger lot size than the EOQ

2 DS p
ELS 
H pd

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Finding the Economic Production
Lot Size
EXAMPLE D.1
A plant manager of a chemical plant must determine the lot size
for a particular chemical that has a steady demand of 30 barrels
per day. The production rate is 190 barrels per day, annual
demand is 10,500 barrels, setup cost is $200, annual holding
cost is $0.21 per barrel, and the plant operates 350 days per
year.
a. Determine the economic production lot size (ELS)
b. Determine the total annual setup and inventory holding cost
for this item
c. Determine the time between orders (TBO), or cycle length,
for the ELS
d. Determine the production time per lot
What are the advantages of reducing the setup time by 10
percent?

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Finding the Economic Production
Lot Size
SOLUTION
a. Solving first for the ELS, we get

2 DS p 210,500 $200  190

ELS    4,873.4 barrels
H pd $0 .21 190  30

b. The total annual cost with the ELS is

Q pd  D
C   H    S 
2 p  Q

4,873.4  190  30  10,500

  $0.21  $200
2  190  4,873.4

 $430.91 $430.91  $861.82

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Finding the Economic Production
Lot Size
c. Applying the TBO formula to the ELS, we get

ELS 4,873.4
TBOELS   
350 days/year  350 
D 10,500

 162.4 or 162 days

d. The production time during each cycle is the lot size divided
by the production rate:

ELS 4,873.4
  25.6 or 26 days
p 190

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Finding the Economic Production
Lot Size

Figure D.2 – OM Explorer Solver for the Economic Production Lot Size Showing the
Effect of a 10 Percent Reduction in Setup Cost

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Application D.1
A domestic automobile manufacturer schedules 12 two-person
teams to assemble 4.6 liter DOHC V-8 engines per work day.
Each team can assemble 5 engines per day. The automobile
final assembly line creates an annual demand for the DOHC
engine at 10,080 units per year. The engine and automobile
assembly plants operate 6 days per week, 48 weeks per year.
The engine assembly line also produces SOHC V-8 engines.
The cost to switch the production line from one type of engine
to the other is $100,000. It costs $2,000 to store one DOHC V-8
for one year.

a. What is the economic lot size?

b. How long is the production run?
c. What is the average quantity in inventory?
d. What is the total annual cost?

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Application D.1
SOLUTION
a. Demand per day = d = 10,080/[(48)(6)] = 35

2 DS p 210,080 100,000  60
ELS    1,555.38
H pd 2,000 60  35

or 1,555 engines

b. The production run

Q 1,555
  25.91 or 26 production days
p 60

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Application D.1
c. Average inventory

I max Q  p  d  1,555  60  35 
      324 engines
2 2 p  2  60 

d. Total annual cost

Q pd 
 H    S   
I max D D
C  H    S 
2 Q 2 p  Q

1,555  60  35  10,080
  $2,000  $100,000
2  60  1,555
 $647,917  $648,231
 $1,296,148

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Quantity Discounts

 Price incentives to purchase large

quantities create pressure to maintain a
large inventory
 Item’s price is no longer fixed
 If the order quantity is increased enough, then
the price per unit is discounted
A new approach is needed to find the best lot
size that balances:
 Advantages of lower prices for purchased materials
and fewer orders
 Disadvantages of the increased cost of holding more
inventory

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Quantity Discounts

Total annual cost = Annual holding cost

+ Annual ordering or setup cost
+ Annual cost of materials

Q D
C   H    S   PD
2 Q

where P = price per unit

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Quantity Discounts

 Unit holding cost (H) is usually expressed as a

percentage of unit price
 The lower the unit price (P) is, the lower the unit
holding cost (H) is
 The total cost equation yields U-shape total cost
curves
 There are cost curves for each price level
 The feasible total cost begins with the top curve, then
drops down, curve by curve, at the price breaks
 EOQs do not necessarily produce the best lot size
 The EOQ at a particular price level may not be feasible
 The EOQ at a particular price level may be feasible but may
not be the best lot size

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Two-Step Solution Procedure
Step 1. Beginning with lowest price, calculate the
EOQ for each price level until a feasible EOQ
is found. It is feasible if it lies in the range
corresponding to its price. Each subsequent
EOQ is smaller than the previous one,
because P, and thus H, gets larger and
because the larger H is in the denominator of
the EOQ formula.
Step 2. If the first feasible EOQ found is for the
lowest price level, this quantity is the best lot
size. Otherwise, calculate the total cost for
the first feasible EOQ and for the larger price
break quantity at each lower price level. The
quantity with the lowest total cost is optimal.

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Quantity Discounts
C for P = $4.00 EOQ 4.00
C for P = $3.50 EOQ 3.50
C for P = $3.00 EOQ 3.00
Total cost (dollars)

Total cost (dollars)

PD for
P = $4.00 PD for
P = $3.50 PD for
P = $3.00

First Second First Second

price price price price
break break break break

0 100 200 300 0 100 200 300

Purchase quantity (Q) Purchase quantity (Q)

(a) Total cost curves with purchased (b) EOQs and price break quantities
materials added
Figure D.3 – Total Cost Curves with Quantity Discounts

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Find Q with Quantity Discounts

EXAMPLE D.2
A supplier for St. LeRoy Hospital has introduced quantity
discounts to encourage larger order quantities of a special
catheter. The price schedule is

Order Quantity Price per Unit

0 to 299 $60.00
300 to 499 $58.80
500 or more $57.00

The hospital estimates that its annual demand for this item is
936 units, its ordering cost is $45.00 per order, and its annual
holding cost is 25 percent of the catheter’s unit price. What
quantity of this catheter should the hospital order to minimize
total costs? Suppose the price for quantities between 300 and
499 is reduced to $58.00. Should the order quantity change?

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Find Q with Quantity Discounts

SOLUTION
Step 1: Find the first feasible EOQ, starting with the lowest price
level:
2 DS 2936 $45.00 
EOQ 57.00    77 units
H 0.25$57.00 

A 77-unit order actually costs $60.00 per unit, instead of the

$57.00 per unit used in the EOQ calculation, so this EOQ is
infeasible. Now try the $58.80 level:

2 DS 2936 $45.00 
EOQ 58.80    76 units
H 0.25$58.80 

This quantity also is infeasible because a 76-unit order is too

small to qualify for the $58.80 price. Try the highest price level:

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Find Q with Quantity Discounts

2 DS 2936 $45.00 
EOQ 60.00    75 units
H 0.25$60.00 

This quantity is feasible because it lies in the range

corresponding to its price, P = $60.00

Step 2: The first feasible EOQ of 75 does not correspond to

the lowest price level. Hence, we must compare its
total cost with the price break quantities (300 and 500
units) at the lower price levels ($58.80 and $57.00):

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Find Q with Quantity Discounts

Q D
C   H    S   PD
2 Q

75
C 75  0.25 $60.00  936 $45.00  $60.00936  $57,284
2 75

300
C 300  0.25 $58.80  936 $45.00  $58.80936  $57,382
2 300

500
C 500  0.25 $57.00  936 $45.00  $57.00936  $56,999
2 500

The best purchase quantity is 500 units, which qualifies for the
deepest discount

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Find Q with Quantity Discounts

Figure D.4 – OM Explorer Solver for Quantity Discounts Showing the Best Order Quantity

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Application D.2
A supplier’s price schedule is:

Order Quantity Price per Unit

0–99 $50
100 or more $45

If ordering cost is $16 per order, annual holding cost is 20

percent of the purchase price, and annual demand is 1,800
items, what is the best order quantity?

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Application D.2
SOLUTION
Step 1:
2 DS 21,800 16 
EOQ 45.00    80 units (infeasible)
H 45 0.2 
2 DS 21,800 16 
EOQ 50.00    76 units (feasible)
H 500.2 
Step 2:
76 1,800
C 76  50  0.2  16  501,800  $90,759
2 76
100 1,800
C100  45  0.2  16  451,800  $81,738
2 100
The best order quantity is 100 units

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One-Period Decisions

 Seasonal goods are a dilemma facing many

retailers.
 Newsboy problem
Step 1: List different demand levels and
probabilities.
Step 2: Develop a payoff table that shows the
profit for each purchase quantity, Q, at
each assumed demand level, D.
Each row represents a different order
quantity and each column represents a
different demand.
The payoff depends on whether all units
are sold at the regular profit margin
which results in two possible cases.

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One-Period Decisions

If demand is high enough (Q ≤ D), then all of the

cases are sold at the full profit margin, p, during the
regular season

Payoff = (Profit per unit)(Purchase quantity) = pQ

If the purchase quantity exceeds the eventual

demand (Q > D), only D units are sold at the full profit
margin, and the remaining units purchased must be
disposed of at a loss, l, after the season

Profit per Amount

Loss
unit sold disposed
Payoff = (Demand) – per
during of after
unit
season season

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One-Period Decisions

Step 3: Calculate the expected payoff of each Q by

using the expected value decision rule. For a
specific Q, first multiply each payoff by its
demand probability, and then add the
products.
Step 4: Choose the order quantity Q with the highest
expected payoff.

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Finding Q for One-Period Decisions

EXAMPLE D.3
One of many items sold at a museum of natural history is a
Christmas ornament carved from wood. The gift shop makes a
$10 profit per unit sold during the season, but it takes a $5 loss
per unit after the season is over. The following discrete
probability distribution for the season’s demand has been
identified:

Demand 10 20 30 40 50

Demand Probability 0.2 0.3 0.3 0.1 0.1

How many ornaments should the museum’s buyer order?

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Finding Q for One-Period Decisions

SOLUTION
Each demand level is a candidate for best order quantity, so
the payoff table should have five rows. For the first row,
where Q = 10, demand is at least as great as the purchase
quantity. Thus, all five payoffs in this row are

Payoff = pQ = ($10)(10) = $100

This formula can be used in other rows but only for those
quantity–demand combinations where all units are sold during
the season. These combinations lie in the upper-right portion
of the payoff table, where Q ≤ D. For example, the payoff when
Q = 40 and D = 50 is

Payoff = pQ = ($10)(40) = $400

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Finding Q for One-Period Decisions

The payoffs in the lower-left portion of the table represent

quantity–demand combinations where some units must be
disposed of after the season (Q > D). For this case, the payoff
must be calculated with the second formula. For example,
when Q = 40 and D = 30,

Payoff = pD – l(Q – D) = ($10)(30) – ($5)(40 – 30) = $250

Using OM Explorer, we obtain the payoff table in Figure D.5

Now we calculate the expected payoff for each Q by multiplying

the payoff for each demand quantity by the probability of that
demand and then adding the results. For example, for Q = 30,

Payoff = 0.2($0) + 0.3($150) + 0.3($300) + 0.1($300) + 0.1($300)

= $195

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Finding Q for One-Period Decisions

Figure D.5 – OM Explorer Solver for One-Period Inventory Decisions Showing

the Payoff Table

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Finding Q for One-Period Decisions

Using OM Explorer, Figure D.6 shows the expected payoffs

Figure D.6 – OM Explorer Solver Showing the Expected Payoffs

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Application D.3
For one item, p = $10 and l = $5. The probability distribution for
the season’s demand is:

Demand Demand
(D) Probability
10 0.2
20 0.3
30 0.3
40 0.1
50 0.1

Complete the following payoff matrix, as well as the column on

the right showing expected payoff. (Students complete
highlighted cells) What is the best choice for Q?

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Application D.3
D Expected
Q 10 20 30 40 50 Payoff
10 $100 $100 $100 $100 $100 $100
20 50 200 200 200 200 170
30 0 300 300
40 –50 100 250 400 400 175
50 –100 50 200 350 500 140

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Application D.3
D Expected
Q 10 20 30 40 50 Payoff
10 $100 $100 $100 $100 $100 $100
20 50 200 200 200 200 170
30 0 150 300 300 300 195
40 –50 100 250 400 400 175
50 –100 50 200 350 500 140

Payoff if Q = 30 and D = 20:

pD – l(Q – D) = 10(20) – 5(30 – 20) = $150
Payoff if Q = 30 and D = 40: pD = 10(30) = $300

Expected payoff if Q = 30:

0(0.2) + 150(0.3) + 300(0.3 + 0.1 + 0.1) = $195

Q = 30 has the highest payoff at $195.00

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Solved Problem 1
Peachy Keen, Inc., makes mohair sweaters, blouses with Peter
Pan collars, pedal pushers, poodle skirts, and other popular
clothing styles of the 1950s. The average demand for mohair
sweaters is 100 per week. Peachy’s production facility has the
capacity to sew 400 sweaters per week. Setup cost is $351. The
value of finished goods inventory is $40 per sweater. The
annual per-unit inventory holding cost is 20 percent of the
item’s value.
a. What is the economic production lot size (ELS)?
b. What is the average time between orders (TBO)?
c. What is the total of the annual holding cost and setup cost?

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Solved Problem 1
SOLUTION
a. The production lot size that minimizes total cost is

2 DS p 2100  52 $351 400

ELS  
H pd 0.20$40  400  100
4
 456,300  780 sweaters
3

b. The average time between orders is

ELS 780
TBOELS    0.15 year
D 5,200
Converting to weeks, we get

TBOELS  0.15 year 52 weeks/year   7.8 weeks

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Solved Problem 1
c. The minimum total of setup and holding costs is

Q pd  D
C   H    S 
2 p  Q

780  400  100  5,200

  0.20  $40   $351
2  400  780

 $2,340/year  $2,340/year  $4,680/year

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Solved Problem 2
A hospital buys disposable surgical packages from Pfisher, Inc.
Pfisher’s price schedule is $50.25 per package on orders of 1 to
199 packages and $49.00 per package on orders of 200 or more
packages. Ordering cost is $64 per order, and annual holding
cost is 20 percent of the per unit purchase price. Annual
demand is 490 packages. What is the best purchase quantity?

SOLUTION
We first calculate the EOQ at the lowest price:

2 DS 2490 $64.00 
EOQ 49.00    6,400  80 packages
H 0.20$49.00 

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Solved Problem 2
This solution is infeasible because, according to the price
schedule, we cannot purchase 80 packages at a price of $49.00
each. Therefore, we calculate the EOQ at the next lowest price
($50.25):

2 DS 2490 $64.00 
EOQ 50.25    6,241  79 packages
H 0.20$50.25 

This EOQ is feasible, but $50.25 per package is not the lowest
price. Hence, we have to determine whether total costs can be
reduced by purchasing 200 units and thereby obtaining a
quantity discount.

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Solved Problem 2

Q D
C  H    S   PD
2 Q

79 490
C79  0.20  $50.25   $64.00  $50.25490
2 79
 $396.98/year  $396.68/year  $24,622.50  $25,416.44/year

200 490
C200  0.20  $49.00  $64.00  $49.00490
2 200
 $980.00/year  $156.80/year  $24,010.00  $25,146.80/year

Purchasing 200 units per order will save $269.64/year,

compared to buying 79 units at a time.

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Solved Problem 3
Swell Productions is sponsoring an outdoor conclave for
owners of collectible and classic Fords. The concession stand
in the T-Bird area will sell clothing such as T-shirts and official
Thunderbird racing jerseys. Jerseys are purchased from
Columbia Products for $40 each and are sold during the event
for $75 each. If any jerseys are left over, they can be returned to
Columbia for a refund of $30 each. Jersey sales depend on the
weather, attendance, and other variables. The following table
shows the probability of various sales quantities. How many
jerseys should Swell Productions order from Columbia for this
one-time event?

Sales Quantity Probability Quantity Sales Probability

100 0.05 400 0.34
200 0.11 500 0.11
300 0.34 600 0.05

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Solved Problem 3
SOLUTION
Table D.1 is the payoff table that describes this one-period
inventory decision. The upper right portion of the table shows
the payoffs when the demand, D, is greater than or equal to the
order quantity, Q. The payoff is equal to the per-unit profit (the
difference between price and cost) multiplied by the order
quantity. For example, when the order quantity is 100 and the
demand is 200,

Payoff = (p – c)Q = ($75 - $40)100 = $3,500

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Solved Problem 3

TABLE D.1 | PAYOFFS

Demand, D
Expected
Q 100 200 300 400 500 600 Payoff
100 $3,500 $3,500 $3,500 $3,500 $3,500 $3,500 $3,500
200 $2,500 $7,000 $7,000 $7,000 $7,000 $7,000 $6,775
300 $1,500 $6,000 $10,500 $10,500 $10,500 $10,500 $9,555
400 $500 $5,000 $9,500 $14,000 $14,000 $14,000 $10,805
500 ($500) $4,000 $8,500 $13,000 $17,500 $17,500 $10,525
600 ($1,500) $3,000 $7,000 $12,000 $16,500 $21,000 $9,750

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Solved Problem 3
The lower-left portion of the payoff table shows the payoffs
when the order quantity exceeds the demand. Here the payoff is
the profit from sales, pD, minus the loss associated with
returning overstock, l(Q – D), where l is the difference between
the cost and the amount refunded for each jersey returned and
Q – D is the number of jerseys returned. For example, when the
order quantity is 500 and the demand is 200,

Payoff = pD – l(Q – D) = ($75 - $40)200 – ($40 – $30)(500 – 200)

= $4,000
The highest expected payoff occurs when 400 jerseys are
ordered:
Expected payoff400 = ($500  0.05) + ($5,000  0.11)
+ ($9,500  0.34) + ($14,000  0.34)
+ ($14,000  0.11) + ($14,000  0.05)
= $10,805
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