inventory control

Lot Sizing for a Single Product (Economic Order Quantity)

As Best Buy sells its current inventory of HP computers, the purchasing manager places a replenishment order for a new lot of Q computers. Including the cost of transportation, Best Buy incurs a fixed cost of $S per order. The purchasing manager must decide on the number of computers to order from HP in a lot. For this decision, we assume the following inputs:

D = Annual demand of the product
S = Fixed cost incurred per order
C = Cost per unit of product
h = Holding cost per year as a fraction of product cost

Assume that HP does not offer any discounts, and each unit costs $C no matter how large
an order is. The holding cost is thus given by H = hC (using Equation 11.2). The model is developed
using the following basic assumptions:

1. Demand is steady at D units per unit time.
2. No shortages are allowed—that is, all demand must be supplied from stock.
3. Replenishment lead time is fixed (initially assumed to be zero).
   The purchasing manager makes the lot-sizing decision to minimize the total cost for the
   store. He or she must consider three costs when deciding on the lot size:
   • Annual material cost
   • Annual ordering cost
   • Annual holding cost
   Because purchase price is independent of lot size, we have
   Annual material cost = C D
   The number of orders must suffice to meet the annual demand D. Given a lot size of Q, we thus have
   $$\text{Number of orders per year}=D/Q$$(11.3)
   Because an order cost of S is incurred for each order placed, we infer that
   $$\text{Annual ordering cost }=(\frac{D}{Q})S$$ (11.4)
   Given a lot size of Q, we have an average inventory of Q/2. The annual holding cost is thus the
   cost of holding Q/2 units in inventory for one year and is given as

Annual holding cost = $Q/2\times H=Q/2\times h\times C$

The total annual cost, TC, is the sum of all three costs and is given as
$$\text{Total annual cost, TC}=CD+D/Q\times S+Q/2\times h\times C$$

the optimal lot size is one that minimizes
the total cost to Best Buy. It is obtained by taking the first derivative of the total cost with respect
to Q and setting it equal to 0,The optimal lot size is referred to as the economic order quantity (EOQ). It is denoted by Q* and is given by the following equation:

$$\text{ optimal lot size,}{Q}^{\ast }=\sqrt{\frac{2DS}{hC}}$$

For this formula, it is important to use the same time units for the holding cost rate h and the demand D. With each lot or batch of size Q*, the cycle inventory in the system is given by Q*/2. The flow time spent by each unit in the system is given by Q*/(2D). As the optimal lot size increases, so does the cycle inventory and the flow time. The optimal ordering frequency is given by n*, where.

$$n^{\ast }=\frac{D}{Q^{\ast }}=\sqrt{\frac{Dhc}{2S}}$$