ENIE 351

Production Planning and

Control

2nd Session:
Chapter 2:
Inventory Control
From EOQ to
ROP
 Agenda

• Chapter 2: Inventory Control From EOQ to

ROP
 Inventory Control

There is a trade-off between set-ups and

inventory.

There is a trade-off between customer service

and inventory

There is a trade-off between variability and

inventory
 The EOQ Model

To a pessimist, the glass is half empty.

to an optimist, it is half full.

– Anonymous
 EOQ History
– Introduced in 1913 by Ford W. Harris, “How Many Parts to Make
at Once”

– Interest on capital tied up in wages, material and overhead sets

a maximum limit to the quantity of parts which can be profitably
manufactured at one time; “set-up” costs on the job fix the
minimum. Experience has shown one manager a way to
determine the economical size of lots.

– Early application of mathematical modeling to Scientific

Management
 MedEquip Example
• Small manufacturer of medical diagnostic equipment.
• Purchases standard steel “racks” into which components are
mounted.
• Metal working shop can produce (and sell) racks more cheaply if
they are produced in batches due to wasted time setting up shop.
• MedEquip doesn’t want to tie up too much precious capital in
inventory.

• Question: how many racks should MedEquip order at once?

 EOQ Modeling Assumptions
1. Production is instantaneous – there is no capacity constraint
and the entire lot is produced simultaneously.
2. Delivery is immediate – there is no time lag between
production and availability to satisfy demand.
3. Demand is deterministic – there is no uncertainty about the
quantity or timing of demand.
4. Demand is constant over time – in fact, it can be represented
as a straight line, so that if annual demand is 365 units this
translates into a daily demand of one unit.
5. A production run incurs a fixed setup cost – regardless of the
size of the lot or the status of the factory, the setup cost is
constant.
6. Products can be analyzed singly – either there is only a single
product or conditions exist that ensure separability of products.
 Notation
D demand rate (units per year).

C unit production cost, not counting setup or inventory

costs (dollars per unit).
Co fixed or ordering cost to place an order.

Cc holding (carrying) cost (per year); if the holding cost

is consisting entirely of interest on money tied up in
inventory, then Cc = ic where i is an annual interest
rate.

Q the unknown size of the order or lot size. decision variable

Inventory vs Time in EOQ Model
Inventory

Q/D 2Q/D 3Q/D 4Q/D

Time
 Costs
𝑄
• Holding Cost: average inventory =
2
𝐶𝑐 𝑄
annual holding cost =
2
𝐷
number of orders per year =
𝑄

𝐶𝑜 𝐷
• Setup (Order) Cost =
𝑄

𝐶𝑐 𝑄 𝐶𝑜 𝐷
• Cost Formulation: T(Q) = +
2 𝑄
 MedEquip Example Costs

• D = 1000 racks per year

• c = $250
• Co = $500 (estimated from supplier’s
pricing)
• Ch = (0.1)($250) + $10 = $35 per unit per
year
Costs in EOQ Model
Economic Order Quantity

2Co D EOQ Square Root Formula

Q∗ =
Cc

2(500)(1000)
Q =
*
= 169 MedEquip Solution
35
Economic Production Lot (EPL)
• Harris's original formula has been extended in a
variety of ways over the years.
• One of the earliest extensions was to the case in
which replenishment is not instantaneous.
• Production rate is finite, but constant and
deterministic.
• This model is sometimes called the economic
production lot (EPL) model.
• Results in a similar square root formula to the
regular EOQ.
Economic Production Lot (EPL)
• Imagine we produce car’s transmissions:
• We can produce p = 50 transmissions a day
• We need to install d = 40 transmissions a day
• We would be accumulating p-d = 10
transmissions a day
• How many transmissions I would accumulate
after 30 days?
Economic Production Lot (EPL)
• Imagine we produce car’s transmissions:
• We can produce p = 50 transmissions a day
• We need to install d = 40 transmissions a day
• We would be accumulating p-d = 10
transmissions a day
• How many transmissions I would accumulate
after 30 days?
• (p-d)*30 = (50-40)*30 = 300 transmissions
300
• That can be consumed in = 7.5 𝑑𝑎𝑦𝑠
40
EOQ Modeling Assumptions
1. Production is instantaneous – there is no capacity constraint relax via
and the entire lot is produced simultaneously. EPL model
2. Delivery is immediate – there is no time lag between production
and availability to satisfy demand.
3. Demand is deterministic – there is no uncertainty about the
quantity or timing of demand.
4. Demand is constant over time – in fact, it can be represented as
a straight line, so that if annual demand is 365 units this
translates into a daily demand of one unit.
5. A production run incurs a fixed setup cost – regardless of the size
of the lot or the status of the factory, the setup cost is constant.
6. Products can be analyzed singly – either there is only a single
product or conditions exist that ensure separability of products.
 Notation – EPL Model
D demand rate (units per year)

d daily demand rate

p daily production rate (units per day), where p>d

c unit production cost, not counting setup or inventory costs (dollars

per unit)

Co fixed or setup cost to place an order (dollars)

Cc holding (carrying) cost (per year); if the holding cost is consisting

entirely of interest on money tied up in inventory, then Cc = ic where i
is an annual interest rate.

Q the unknown size of the production lot size decision variable

Inventory vs Time in EPL Model
Economic Production Lot (EPL)
• We have to decide on particular production
run size.
• Do we go and produce to accumulate 300
units in 30 days?
• Should we produce for 400 days and over
that period produce 5000 transmissions and
accumulate 1000 transmissions?
Economic Production Lot (EPL)

The larger the The larger

The larger The grater
accumulating the
p the Cc
time inventory

The fewer the The lower the

The larger p
setup time Co
 Economic Production Lot (EPL)
𝑄
• EOQ: average inventory =
2
𝐼 𝑚𝑎𝑥
• EPL: average inventory =
2
𝐼 𝑚𝑎𝑥 = ⧣ 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑡ℎ𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑟𝑢𝑛𝑠 ∗
•
𝑡ℎ𝑒 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑑𝑎𝑦
𝑄
• 𝐼 𝑚𝑎𝑥 = ∗ (𝑝 − 𝑑)
𝑝
 Costs
𝐼 𝑚𝑎𝑥
• Holding Cost: average inventory =
2
𝐶𝑐 ∗ 𝐼 𝑚𝑎𝑥
annual holding cost =
2
𝐷
number of production runs/year =
𝑄

𝐶𝑜 𝐷
• Setup Cost =
𝑄

𝐶𝑐 ∗ 𝐼 𝑚𝑎𝑥 𝐶𝑜 𝐷
• Total cost = +
2 𝑄
 Economic Production Lot (EPL)
• The optimal production quantity size:

∗
2𝐷𝐶𝑜
𝑄 =
𝑑
(1 − )𝐶𝑐
𝑝
 Economic Production Lot (EPL)
• Example: • Answer:
d = 50 units
∗ 2(12,500)(200)
p = 150 units • Q = 50
1− 10
150
Co = SR200
Cc = SR10 • Q∗ = 866 units
D = 12,500 units • The optimal production
𝑄∗ = ? ? 866
interval = = 5.7 𝑑𝑎𝑦𝑠
150
• Max. inventory= 5.7 (150-50)
= 577.3 units
 The Key Insight of EOQ
There is a tradeoff between lot size and inventory

D
• Order Frequency: F=
Q

cQ cD
• Inventory Investment: I=
2
=
2F
 EOQ Tradeoff Curve
50
45
Inventory Investment

40
35
30
25
20
15
10
5
0
0 20 40 60 80 100
Order/Year
 EOQ Takeaways
• Batching causes inventory (i.e., larger lot sizes
translates into more stock).
• Smaller lot sizes translates into more frequent
orders (i.e., higher ordering cost)
• Under specific modeling assumptions the lot
size that optimally balances holding and setup
costs is given by the square root formula:
2Co D
Q∗ =
Cc