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The square-root law characterizing the safety stock growth under

decentralized inventory management


Spyros Reveliotis
In this document, we shall use the results developed for the (Q, r) inventory
control policy in order to show that the substitution of a centralized inventory system for a given product by n more locally operated inventory systems with the same
cost structure and fill rate level and facing independent regional demands, will increase the total safety stock maintained across these local inventory systems by a

factor of n compared to the safety stock maintained by the centralized facility.


So, first consider the n local inventory systems, each serving the demand of
a certain region. These regions are non-overlapping, and each of these inventory
systems experience the same ordering and holding costs, A and h, and the same
replenishment lead time, l. They are also operated at the same fill rate level a, and
they experience the same type of demand. In particular, for the reasons discussed
in class, we shall assume that regional demands over a replenishment interval are
normally distributed, with mean l and st. deviation l (where the subscript l stands
for local).
Based on the above information, the safety stock carried by each of these local
inventory systems can be computed as follows:
First, it is reasonable to assume that the order size Ql for each of these systems
has been optimized according to the EOQ formula. More specifically, let Dl denote
the expected annual regional demand (for any of the considered n regions). Then,
r
2ADl

Ql =
(1)
hl
From the (approximating) formulae developed in class for the fill rate of a
(Q, r)-inventory system, we have:
S(Ql , rl ) = 1

1
1
[B(rl ) B(rl + Ql )] 1 B(rl ) = a

Ql
Ql
B(rl ) = (1 a)Ql .

(2)

Also, from the assumed normality of the lead-time demand, we have that
B(rl ) = l L(

rl l
)
l

(3)

where L() is the loss function for the standardized normal distribution. From
Eqs 2 and 3, we get:
rl l
) = (1 a)Ql
l
rl l
1a
L(
)=
Q
l
l l
rl l
1a
= L1 (
Q )
l
l l

l L(

(4)

where the epression L1 ( 1a


l Ql ) denotes the inversion of the loss function L()

at the point 1a
l Ql defined by the values of a, l and Ql . From Eq. 4 we have that
the safety stock carried at each local inventory system is given by

ssl = rl l = l L1 (

1a
Q ),
l l

(5)

and total safety stock, carried across all n inventory systems is


1
sstot
l = n ssl = n l L (

1a
Q ).
l l

(6)

Next, consider the substitution of the above distributed inventory system with
a centralized inventory operation with the same ordering and holding cost A and
h. This facility has also the same replenishment lead time l and it is operated at
the same target fill rate a. On the other hand, this facility faces the cumulative demand faced by the original n inventory systems, and therefore, its expected annual
demand is Dc = n Dl and its lead-time demand is normally distributed with mean

c = n l and st. deviation c = n l . More specifically, the last two results


are obtained by (i) considering the lead-time demand for the centralized inventory
system as a random variable Xc defined by
Xc = Xl1 + . . . + Xln

(7)

where Xli is the (random) regional lead-time demand for region i = 1, . . . , n, and (ii)
further assuming that the regional demands Xli are mutually independent. Then,
E[Xc ] = E[Xl1 ] + . . . + E[Xln ]
Var[Xc ] =

Var[Xl1 ] + . . . +Var[Xln ]

(8)
(9)

From the above discussion we also have that an optimized selection for the
order size of the centralized inventory is
r
r
2ADc
2AnDl

=
= n Ql
(10)
Qc =
h
h
2

But then, the requirement for a target fill rate of a implies that
1
B(rc ) = a
Q
B(rc ) = (1 a)Qc
rc c
c L(
) = (1 a)Qc
c
rc c
1a
L(
)=
Q
c
c c
1a
rc c
)=
L(
nQl
c
nl
rc c
1a
L(
)=
Q
c
l l
1a
rc c
= L1 (
Q )
c
l l
1a
ssc = rc c = c L1 (
Q )
l l

1a
Q )
ssc = n l L1 (
l l
S(Qc , rc ) 1

(11)

Finally, from Eqs 6 and 11 we get:

sstot
l
= n
ssc

(12)

which is the desired result.


It is instructive to notice in the derivations of Eq. 11 how the final result of
Eq. 12 was shaped up by the established relations among the various corresponding
parameters of the two inventory systems. Also, consider how the above derivations
will be impacted by some correlation among the regional demands; e.g., how the
above analysis will be affected if the demands arising in (some of) these regions
are picking up or slowing down in sync?