Production Order

Quantity Model
 Production Order
Quantity Model
 In EOQ Model, We
assumed that the
entire order was
received at one time.
 However, Some
Business Firms may
receive their orders
over a period of time.
Production Order
Quantity Model
 Such cases require a different
inventory model.
 Here, we take into account the
daily production rate and daily
demand rate.
Production Order
Quantity Model
Production Order
Quantity Model
 Since this model is especially
suitable for production
environments, It is called
Production Order Quantity Model.
 Here, we use the same approach
as we used in EOQ model.
 Lets define the following:
Production Order
Quantity Model
 p: Daily Production rate (units /
day)
 d: Daily demand rate (units / day)
 t: Length of the production in
days.
 H: Annual holding cost per unit
Production Order
Quantity Model
 Average Holding Cost =
(Average Inventory) . H

= (Max. Inventory / 2) . H
Production Order
Quantity Model
 In the period of production (until
the end of each t period):
 Max. Inventory = (Total
Produced) – (Total Used)
= p.t - d.t
Production Order
Quantity Model
 Here, Q is the total units that are
produced.
 Therefore,
 Q = p.t t = Q/p
Production Order
Quantity Model
 If we replace the values of t in the
Max. Inventory formula:
 Max. Inventory = p (Q/p) - d
(Q/p) = Q - dQ/p = Q (1 – d/p)
Production Order
Quantity Model
 Annual Holding Cost = (Max.
Inventory / 2) . H = Q/2 (1 –
d/p) . H

Annual Setup Cost = (D/Q) . S

 Production Order
Quantity Model
 Now we will set
Annual Holding Cost = Annual
Setup Cost
Q/2 (1 – d/p) . H = (D/Q) . S
Production Order
Quantity Model
Production Order
Quantity Model
 This formula gives us the optimum
production quantity for the
Production Order Quantity Model.

 It is used when inventory is

consumed as it is produced.
 Backorder Inventory
Model

In this model,
we assume that
stock outs (and
backordering)
are allowed.
Backorder Inventory
Model
 In addition to previous
assumptions, we assume that sales
will not be lost due to a stock out.
 Because, we will back order any
demand that can not be fulfilled.
Backorder Inventory
Model
B: Backordering cost per unit per
year
b: The amount backordered at the
time the next order arrives
Q – b: Remaining units after the
backorder is satisfied
Backorder Inventory
Model
Backorder Inventory
Model
 Total Annual Cost = Annual Setup
Cost + Annual Holding Cost +
Annual Backordering Cost
 Annual Setup (Ordering) Cost = (D/Q) .
S
 Annual Holding Cost = (Average
Inventory Level) . H
Backorder Inventory
Model
Backorder Inventory
Model
 By using the graphical ratios, we
know that:

 T1 / T = (Q – b) / Q Therefore, if we
replace T1/T in the above equation
we get

 Average Inventory Level = (Q – b)2 / 2Q

Backorder Inventory
Model
Backorder Inventory
Model
 By using the graphical ratios, we
know that:
 T2 / T = b / Q Therefore, if
we replace T2/T in the above
equation we get
 Average Backordering = b2 / 2Q
and
Backorder Inventory
Model
Backorder Inventory
Model
 We find optimum order quantity
(Q*) and optimum backordering
quantity (b*) by taking the
derivatives of dTC/dQ = 0 and
dTC / db = 0 and then putting the
values in their places.
Backorder Inventory
Model
Quantity Discount
Model
 A quantity discount is simply a
reduced price (P) for an item when
it is purchased in LARGER
quantities.
 A typical quantity discount
schedule is as follows:
Quantity Discount
Model
Quantity Discount
Model
 Since the unit cost for the Third discount is
the lowest, We might be tempted to order
2000 or more units.
 However, this quantity might not be the one
that minimizes the Total Cost.
 Remember that, As the quantity goes up, the
holding cost increases.
Quantity Discount
Model
 Here, there is a trade off between
reduced product price (P) and
increased holding cost (H).
 Total Cost = Setup Cost + Holding
Cost + Product Price (Cost)
 Total Cost = DS / Q + QH / 2 + PD
where P is the price per unit
Quantity Discount
Model
 To determine the minimum Total
Cost, we perform the following
process which includes 4 steps:
Quantity Discount
Model
 Step 1: Assume that
 I: is a percentage value, and
 I . P represents the holding cost as
a percentage of price per unit (P).
Quantity Discount
Model
 For each discount alternative,
calculate a value of Q* = [2DS /
IP]1/2
 Here, instead of using a value of H,
the holding cost is equal to I . P
 That is, If the item is expensive
(such as a Class A Item), Its holding
cost will be higher.
Quantity Discount
Model
 Since the price of item (P) is a
factor in Annual Holding Cost, we
can no longer assume that the
holding cost is constant (such as
H) when price changes.
Quantity Discount
Model
 Step 2: For any discount alternative,
 If the calculated optimum order quantity
(Q*) is too low to qualify for the discount
range,
 Then, Adjust the order quantity upward
to the lowest quantity that will qualify
for the particular discount alternative.
Quantity Discount
Model
 Step 3: Using the total cost (TC)
equation above, compute a total
cost for every order quantity (Q).
Use the adjusted Q values.
Quantity Discount
Model
 Step 4: Select the discount
alternative which has the minimum
Total Cost (TC).
Example
 Consider the quantity discount schedule
given in the beginning (above).
 Assume that the Ordering (Setup) Cost
(S) is $49 per each order.
 Annual Demand (D) is 5000 units, and
 Inventory carrying charge is a percentage
(I=0.20) of product cost (P).
Example
 Question: What order quantity will
minimize the total inventory cost.
 Answer:
 Step 1: Compute Q* for every
discount range.
Example
Example
 Step 2: Adjust values of Q* that are
below allowable discount ranges.
- For Q1, allowable range is 0-999.
Since Q1* = 700 is between 0 and
999, It does not have to be
adjusted.
Example
- For Q2, allowable range is 1000-1999. Since
Q2* = 714 is not in the allowed range, we
adjust it to the lowest allowable value, That
is Q2* = 1000.
- For Q3, allowable range is 2000-. Since Q3*
= 718 is not in the allowed range, we adjust
it to the lowest allowable value, That is Q3*
= 2000.
Example
 Step 3: Compute total cost for
each of the order quantities (Q*)
Example
Example
 Step 4: An Order quantity of 1000
units will minimize the total cost.
 However, if the third discount cost
is lowered to $4.65, selecting This
discount alternative (2000 units)
would be the optimum solution.
Probabilistic Models
 So far we assumed that demand is
constant and uniform.
 However, In Probabilistic models,
demand is specified as a probability
distribution.
 Uncertain demand raises the
possibility of a stock out (or
shortage). (Why?)
Probabilistic Models
 One method of reducing stock outs
is to hold extra inventory (called
Safety Stock).
 In this case, we change the ROP
formula to include that safety
stock (ss).
Probabilistic Models
ROP = d . L
d = daily demand, and
L = Order Lead Time
Now it will be as follows:
ROP = d . L + (ss)
where (ss) is the safety stock
Example
 AMP Ltd. company determined its ROP =
50 units.
 Its holding cost (H) is $5 per unit per
year.
 Its stock out cost (B) is $40 per unit.
 Probability of stock out is based on the
following probability distribution:
Example
Example
 Question: Find the Level of Safety
Stock (ss) that minimizes the total
additional holding cost and Stock
out costs (annually).

 Stock out cost is an expected cost;

That is:
Example
Example
 Possible stock outs per year is actually
the number of orders per year (D/Q).
 Since it is not known (or not given)
assume that it is 6 times / year.
 For zero safety stock, there is no
additional holding cost for extra (safety)
stock.
 But there are stock out costs for two
levels:
Example
1) If demand is 60 units at the ROP,
Then a shortage of 10 units will
occur.
(Because, ROP is 50 units)

2) If demand is 70 units at the ROP,

Then a shortage of 20 units will
occur.
Example
Example
 The safety stock with the lowest
total cost is (ss = 20) units.

 Therefore, ROP = 50 + 20 = 70
units.
Finding A Safety Stock
Level

Managers may
want to limit the
possibility of
stock out only to
a small
percentage, say
5%.
Finding A Safety Stock
Level
 If demand level is assumed to be a
normal distribution,
 By using mean and standard
deviation of the normal distribution,
 We can determine a safety stock
that is necessary for %95 service
level.
Example
 The SAC company carries an
inventory item that has a normally
distributed demand.
 The mean demand is (µ =350)
units and standard deviation is
(σ =10).
Example
Example
Example
 We use the properties of a
standardized normal curve to get a
z value that corresponds to the.95
of the curve.

 Using a standard Normal table we

find z = 1.65 for 95% confidence.
 Example

Reorder point is elevated up by 16.5

units.
Example