Stochastic Inventory Modeling

Chapter 16

Assumptions in Deterministic Models

1.
2.
3.
4.

Demand is known and constant

Lead time is known and constant
Order quantity does not depend on price
Order quantity arrives all at once when
needed
5. Planned shortages are not allowed
Relaxed the 3rd, 4th and 5th assumption

Independent Demand
Inventory exists to meet the demand of customers.
Customers can be external (purchasers of products) or
internal (workers using material).
Management needs accurate forecast of demand.
Items that are used internally to produce a final product are
referred to as dependent demand items.
Items that are final products demanded by an external
customer are independent demand items.

Deterministic and Stochastic

Models
If demand and lead time are known
(constant), they are called deterministic
models
If they are treated as random (unknown),
they are stochastic
Each random variable can have a
probability distribution
Attention is focused on the distribution of
demand during the lead time

Inventory Control Systems

Three basic types of systems:
continuous model (fixed-order quantity), periodic
model (fixed-time), and Single-Period model
Continuous system: an order is placed for the
same constant amount when inventory decreases
to a specified level.
Periodic system: an order is placed for a variable
amount after a specified period of time.
Single-period system: an order is placed just for
one period

Continuous Inventory Systems

Continual record of inventory level is maintained.
Whenever inventory decreases to a predetermined
level, the reorder point, an order is placed for a
fixed amount
Management must be aware of status of inventory
level
System is relatively expensive to maintain

Continuous System: Deterministic Model

Reorder Point
The reorder point is the inventory level at which a new
order is placed.
Order must be made while there is enough stock in place to
cover demand during lead time.
Formulation:
R = dL
where d = demand rate per time period

L = lead time

Ideal Deterministic Model

Q+S

Continuous System: Stochastic Model

Inventory level might be depleted at slower or faster rate
during lead time.
When demand is uncertain, safety stock is added as a
hedge against stockout.
Focus must be on demand distribution during the lead time

Reorder Point and Safety Stock

Reorder Point Quantity

Under deterministic conditions, when both

demand and lead time are constant, the
reorder point is set equal to lead time
demand.
Under probabilistic conditions, when
demand and/or lead time varies, the reorder
point often includes safety stock
Safety stock is the amount by which the
reorder point exceeds the expected
(average) lead time demand.

Safety Stock and Service Level

Safety stock determines the chance of a stockout
during lead time
The complement of this chance is called the
service level
Service level is defined as the probability of not
incurring a stockout during any one lead time
The higher the probability inventory will be on hand,
the more likely customer demand will be met.
Service level of 90% means there is a .90
probability that demand will be met during lead time
and .10 probability of a stockout.

Safety Stock and Service Level

S

Service Level

0.5
0.5

1.0

Reorder Point

Assumptions

Lead-time demand is normally distributed

with mean and standard deviation .

Approximate optimal order quantity: EOQ
Service level is defined in terms of the
probability of no stockouts during lead time
and is reflected in z.
Shortages are not backordered.
Inventory position is reviewed continuously.

Reorder Point with Variable Demand

Reorder Point with Variable Demand

R d L Z d L
where:
R reorder point
d average daily demand
L lead time

d the standard deviation of daily demand

Z number of standard deviations corresponding
to service level probability
Z d L safety stock

Reorder Point with Variable Demand Example

For following data, determine reorder point and safety stock
for service level of 95%.
d 30 yd per day
L 10 days
d 5 yd per day
For 95% service level, Z 1.65 (Table A -1, appendix A )
R d L Zd L 30(10) (1.65)(5)( 10 ) 300 26.1
326.1 yd
Safety stock is second term in reorder point formula : 26.1.

Reorder Point with Variable Lead Time

For constant demand and variable lead time:
R d L Zd L
where:
d constant daily demand
L average lead time
L standard deviation of lead time
d L standard deviation of demand during lead time
Zd L safety stock

Reorder Point with Variable Lead Time Example

Carpet Discount Store:
d 30 yd per day
L 10 days

L 3 days
Z 1.65 for a 95% service level
R d L Zd L (30)(10) (1.65)(30)(3) 300 148.5 448.5 yd

Reorder Point
Variable Demand and Lead Time
When both demand and lead time are variable:
2

2 2
R d L Z ( d ) L ( L) d
where:
d average daily demand
L average lead time
2

2 2
( d ) L ( L ) d standard deviation of demand during lead time
2

2 2
Z ( d ) L ( L) d safety stock

Reorder Point
Variable Demand and Lead Time Example
Carpet Discount Store:
d 30 yd per day
d 5 yd per day

L 10 days
L 3 days
Z 1.65 for 95% service level
2

2 2
R d L Z ( d ) L ( L ) d
(30)(10) (1.65) (5)(5)(10) (3)(3)(30)(30)
300 150.8
450.8 yds

Periodic Inventory Systems

Inventory level (on hand) is counted at specific time
intervals
An order placed that brings inventory up to a specified level
Less costly to track of inventory level
Requires a new order quantity each time an order is placed
Used in smaller retail stores, drugstores, grocery stores and
offices

Periodic Review Order Quantity

Assumptions

Inventory position is reviewed at constant intervals.

Demand during review period plus lead time period
is normally distributed with mean and standard
deviation .
Service level is defined in terms of the probability of
no stockouts during a review period plus lead time
period and is reflected in z.
On-hand inventory at ordering time: H
Shortages are not backordered.
Lead time is less than the review period length.

Order Quantity for Variable Demand

For normally distributed variable daily demand:
Q d (tb L) Z d tb L I
where:
d average demand rate
tb the fixed time between orders
L lead time
d standard deviation of demand
Z d tb L safety stock
I inventory in stock

Order Quantity for Variable Demand Example

Corner Drug Store with periodic inventory system.
Order size to maintain 95% service level:
d 6 bottles per day
d 1.2 bottles
tb 60 days
L 5 days
I 8 bottles
Z 1.65 for 95% service level
Q d (tb L) Z d tb L I
(6)(60 5) (1.65)(1.2) 60 5 8
398 bottles

Example: Ace Brush

Joe Walsh is a salesman for the Ace Brush Company.
Every three weeks he contacts Dollar Department
Store so that they may place an order to replenish
their stock. Weekly demand for Ace brushes at Dollar
approximately follows a normal distribution with a
mean of 60 brushes and a standard deviation of 9
brushes.
Once Joe submits an order, the lead time until Dollar
receives the brushes is one week. Dollar would like at
most a 2% chance of running out of stock during any
replenishment period. If Dollar has 75 brushes in
stock when Joe contacts them, how many should they
order?

Example: Ace Brush

The review period plus the lead time totals 4 weeks

This is the amount of time that will elapse before the
next shipment of brushes will arrive
Weekly demand is normally distributed with:
Mean weekly demand,
= 60
Weekly standard deviation, = 9
Weekly variance, 2
= 81
Demand for 4 weeks is normally distributed with:
Mean demand over 4 weeks, = 4 x 60 = 240
Variance of demand over 4 weeks, 2 = 4 x 81= 324
Standard deviation over 4 weeks, = (324)1/2 = 18

Single-Period Order Quantity

A single-period order quantity model (sometimes
called the newsboy problem) deals with a
situation in which only one order is placed for the
item and the demand is probabilistic.
If the period's demand exceeds the order
quantity, the demand is not backordered and
revenue (profit) will be lost.
If demand is less than the order quantity, the
surplus stock is sold at the end of the period
(usually for less than the original purchase
price).

Single-Period Order Quantity

Assumptions

Period demand follows a known probability

distribution:
normal: mean is , standard deviation is
uniform: minimum is a, maximum is b

Cost of overestimating demand: $co

Cost of underestimating demand: $cu
Shortages are not backordered.
Period-end stock is sold for salvage (not
held in inventory).

Single-Period Order Quantity

Formulas

Optimal probability of no shortage:

P(demand < Q *) = cu/(cu+co)
Optimal probability of shortage:
P(demand > Q *) = 1 - cu/(cu+co)

Optimal order quantity, based on demand distribution:

normal:

Q * = + z

uniform:

Q * = a + P(demand < Q *)(b-a)

Example: McHardee Fashion

McHardee Fashion produces a jacket and
wishes to determine how many units to
manufacture. There is a fixed cost of $5,000
to produce the item and the incremental
profit per unit is $0.45. Any unsold items
can be sold at salvage at a $.55 loss. Sales
for this item are estimated to be normally
distributed. The most likely sales volume is
12,000 units and they believe there is a 5%
chance that sales will exceed 20,000. How
many units should be printed?

Solution

= 12,000
To find note that z = 1.65 corresponds to a 5%
tail probability
Therefore, (20,000 - 12,000) = 1.65 or = 4848
Co=.55 and Cu=.45, (Cu/(Cu+Co))=.45/(.45+.55)=.45
Find Q * such that P(D < Q *) = .45.
The probability of 0.45 corresponds to z = -.12.
Thus, Q * = 12,000 - .12(4848) = 11,418 Jackets

Solution-Cont.
If any unsold copies can be sold at salvage at a
$.65 loss, how many units should be produced?
Co=.65, (Cu/(Cu+Co))=.45/(.45+.65) = .4091
Find Q * such that P(D < Q *) = .4091. z = -.23
gives this probability.
Thus, Q * = 12,000 - .23(4848) = 10,885 units
However, since this is less than the breakeven
volume of 11,111 jackets (= 5000/.45), no item
should be produced because if the company
produced only 10,885 units it will not recoup its
$5,000 fixed cost.