Inventory Control

Models
Ch 5 (Uncertainty of Demand)
R. R. Lindeke
IE 3265, Production And
Operations Management

Lets do a QUICK Exploration of

Stochastic Inventory Control (Ch 5)
We will examine underlying ideas
We base our approaches on Probability Density
Functions (means & std. deviations)
We are concerned with two competing ideas: Q
and R
Q (as earlier) an order quantity and R a
stochastic estimate of reordering time and level
Finally we are concerned with Servicing ideas
how often can we supply vs. not supply a
demand (adds stockout costs to simple EOQ
models)

The Nature of Uncertainty

Suppose that we represent demand as:

D = Ddeterministic + Drandom
If the random component is small compared to
the deterministic component, the models of
chapter 4 will be accurate. If not, randomness
must be explicitly accounted for in the model.
In this chapter, assume that demand is a random
variable with cumulative probability distribution
F(t) and probability density function f(t).

Single Period Stochastic

Inventory Models

These models have the objective of properly

balancing the cost of Underage having not
ordered enough products vs. Overage having
ordered more than we can sell
These models apply to problems like:

Planning initial shipments of High-Fashion items

Amount of perishable food products
Item with short shelf life (like the daily newspaper)

Because of this last problem type, this class of

problems is typically called the Newsboy problem

The Newsboy Model

At the start of each day, a newsboy must decide

on the number of papers to purchase. Daily sales
cannot be predicted exactly, and are represented
by the random variable, D.
The newsboy must carefully consider these costs:
co = unit cost of overage
cu = unit cost of underage

It can be shown that the optimal number of papers

to purchase is the fractile of the demand
distribution given by F(Q*) = cu / (cu + co).

Determination of the Optimal

Order Quantity for Newsboy Example

Computing the Critical Fractile:

We wish to minimize competing costs (Co & Cu):

G(Q,D) = Co*MAX(0, Q-D) + Cu*MAX(0, D-Q)

D is actual (potential) Demand

G(Q) = E(G(Q,D)) (an expected value)

Therefore:

G (Q) Co MAX (0, Q x) f x dx Cu MAX (0, x Q ) f x dx

Q

G (Q) Co Q x) f x dx Cu x Q ) f x dx
Here: f(x) is a probability density function
controlling the behavior of ordering

Applying Leibnizs Rule:

d(G(Q))/dQ
F(Q)

= CoF(Q) Cu(1 F(Q))

is a cumulative Prob. Density Function

(as earlier of the quantity ordered)
Thus: G(Q*) = (Cu)/(Co + Cu)
This is the critical fractile for the order
variable as stated earlier

Lets see about this: Prob 5 pg 241

Observed

sales given as a number

purchased during a week (grouped)
Lets assume some data was supplied:

Make Cost: $1.25

Selling Price: $3.50
Salvageable Parts: $0.80

Co

= overage cost = $1.25 - $0.80 = $0.45

Cu = underage cost = $3.50 - $1.25 = $2.25

Continuing:

Compute Critical Ratio:

CR = Cu/(Co + Cu) = 2.25/(.45 + 2.25) = .8333

If we assume a continuous Probability Density

Function (lets choose a normal distribution):

Z(CR) 0.967 when F(Z) = .8333 (from Std. Normal

Tables!)
Z = (Q* - )/)
From the problem data set, we compute
Mean = 9856
St.Dev. = 4813.5

Continuing:
Q*

= Z + = 4813.5*.967 + 9856 = 14511

Our best guess economic order quantity is
14511
(We really should have done it as a Discrete
problem -- Taking this approach we would
find that Q* is only 12898)

Newsboys Extensions
Assuming

we have a certain number of parts

on hand, u > 0

This extends the problem compared to our initial u = 0

assumption for the single period case

This

is true only if the product under study

has a shelf life that extends beyond one
period
Here we still compute Q* will order only Q* - u
(or 0 if u > Q*)

Try one (in your Engineering Teams) :

Do

Problem 11a & 11b (pg 249)

Lot Size Reorder Point Systems

Earlier we considered reorder points (number of
parts on hand when we placed an order) they
were dependent on lead times as a dependent
variable on Q, now we will consider R as an
independent variable just like Q
Assumptions:

Inventory levels are reviewed continuously (the level

of on-hand inventory is known at all times)
Demand is random but the mean and variance of
demand are constant. (stationary demand)

Lot Size Reorder Point Systems

Additional Assumptions:
There is a positive leadtime, . This is the time
that elapses from the time an order is placed
until it arrives.
The costs are:

Set-up cost each time an order is placed at $K per order

Unit order cost at $C for each unit ordered
Holding at $H per unit held per unit time (i.e., per year)
Penalty cost of $P per unit of unsatisfied demand

Describing Demand

The response time of the system (in this case) is the

time that elapses from the point an order is placed
until it arrives. Hence,
The uncertainty that must be protected against is
the uncertainty of demand during the lead time.
We assume that D represents the demand during
the lead time and has probability distribution F(t).
Although the theory applies to any form of F(t), we
assume that it follows a normal distribution for
calculation purposes.

Decision Variables

For the basic EOQ model discussed in Chapter 4,

there was only the single decision variable Q.
The value of the reorder level, R, was determined
by Q.
Now we treat Q and R as independent decision
variables.
Essentially, R is chosen to protect against
uncertainty of demand during the lead time, and Q
is chosen to balance the holding and set-up costs.
(Refer to Figure 5-5)

Changes in Inventory Over Time

for Continuous-Review (Q, R) System

The Cost Function

The average annual cost is given by:
G (Q, R ) h(Q / 2 R ) K / Q p n( R ) / Q

Interpret n(R) as the expected number of stockouts per

cycle given by the loss integral formula (see Table A-4
(std. values)). And note, the last term is this cost model
is a shortage cost term
The optimal values of (Q,R) that minimizes G(Q,R) can
be shown to be:

2 ( K pn( R))
Q
h
1 F ( R) Qh / p

Solution Procedure

The optimal solution procedure requires iterating

between the two equations for Q and R until
convergence occurs (which is generally quite fast)

We consider that the problem has converged if 2

consecutive calculation of Q and R are within 1 unit

A cost effective approximation is to set Q=EOQ

and find R from the second equation.
A slightly better approximation is to set Q =
max(EOQ,)

where is the standard deviation of lead time demand

when demand variance is high.

Ready to Try one? Lets!

Try

Problem 13a & 13b (pg 261)

Start by computing EOQ and then begin
iterative solution for optimal Q and R values

Service Levels in (Q,R) Systems

In many circumstances, the penalty cost, p, is
difficult to estimate. For this reason, it is
common business practice to set inventory
levels to meet a specified service objective
instead. The two most common service
objectives are:

1)

2)

Type 1 service: Choose R so that the probability of

not stocking out in the lead time is equal to a
specified value.
Type 2 service. Choose both Q and R so that the
proportion of demands satisfied from stock equals a
specified value.

Computations
For

type 1 service, if the desired service level

is then one finds R from F(R)= and
Q=EOQ.
Type 2 service requires a complex interative
solution procedure to find the best Q and R.
However, setting Q=EOQ and finding R to
satisfy n(R) = (1-)Q (which requires Table A4) will generally give good results.

Comparison of Service
Objectives
Although

the calculations are far easier for

type 1 service, type 2 service is generally the
accepted definition of service.
Note that type 1 service might be referred to
as lead time service, and type 2 service is
generally referred to as the fill rate.
Refer to the example in section 5-5 to see the
difference between these objectives in
practice (on the next slide).

Comparison (continued)
Order Cycle
1
180
2
75
3
235
4
140
5
180
6
200
7
150
8
90
9
160
10
40

Demand

Stock-Outs

0
0
45
0
0
10
0
0
0
0

For a type 1 service objective there are two cycles out of ten in which a stockout
occurs, so the type 1 service level is 80%. For type 2 service, there are a total
of 1,450 units demand and 55 stockouts (which means that 1,395 demand are
satisfied). This translates to a 96% fill rate.

Example: Type 1 Service Pr 5-16

Desire

95% Type I service Level

F(R) = .95 Z is 1.645 (Table A4)
From Problem 13: was found to be 172.8
and was 1400
Therefore: R = Z + = 172.8*1.645 + 1400
R = 1684.256 1685
Use Q = EOQ = 1265

Example: Type 2 Service Pr 5-17

Require Iterative Solution:

Q0 EOQ 1295

n( R1 ) 1 * Q0 63.25
L Z1

n( R1 )

63.25

.3673

172.8
Z1 .065 & 1 F R =.474 from Table A4
Q1

n( R1 )

1 F R

Q1 63.25

.474

n( R1 )

EOQ
2

1265 63.25
2

.474

1 F R

1405

Example: Type 2 Service Pr 5-17

(cont.)

n R2 1 Q1 .05*1405 70.25
L Z 2 70.25

0.408
172.8
Z 2 0.02 & 1 F ( R2 ) 0.508
R2 Z 2 1397
Q2 70.25

.508

1265

70.25

.508

n R3 0.05*1411 70.54
L Z 3 70.54

172.8

0.4097

Z 3 .02
R3 Z 3 1397 SAME so Stop!

Q, R = 1411, 1397

1411

(s, S) Policies

The (Q,R) policy is appropriate when inventory levels are

reviewed continuously. In the case of periodic review, a slight
alteration of this policy is required. Define two levels, s < S,
and let u be the starting inventory at the beginning of a
period. Then

If u s, order S u
If u s, don't order

(In general, computing the optimal values of s and S is much more

difficult than computing Q and R.)