MRS3205 - Enterprise System and Optimization Lab

Module IV

SIMULATION OF INVENTORY SYSTEM

1. Introduction
Inventory or stock (in common terms) is considered to be the central theme in man aging materials. It is
necessary to have physical stock in the system to take care of the anticipated demand because no availability
of materials when needed will lead to delays in production or projects or services delivered. However,
keeping inventory is not free because there are opportunity costs of “carrying” or “holding” inventory in
the organization. Thus, the paradox is that we need inventory, but it is not desirable to have inventory. It is
this paradoxical situation that makes inventory management a challenging problem area in materials
management. If a more exact solution is required, simulation should be used. Simulation is also used to
illustrate the behavior of the system over time so that the decision maker can gain insight/ confidence in it.
Simulation is not an optimizing technique. It does not produce a solution per se. Instead, simulation
enables decision makers to test their solutions on a model that reasonably duplicates a real process.

2. Theoretical Basic
Inventory system is one of the important classes of simulation problems. There are two decision variables:
order quantity and reorder point and two probabilistic components: daily
demand and reorder lead time. The main purpose of simulation runs is to try out various schemes of order
quantities and reorder point and to find (to minimize) the smallest total inventory cost. That means that
inventory cost includes ordering cost, holding cost and stock out costs. To avoid shortages, a buffer, or
safety, stock would need to be carried.

Carrying stock in inventory might affect the cost attribute. Some of the scenarios are

 The costs can be interest paid on the funds borrowed to buy the items, renting of storage space,
hiring guards etc.
 Carrying high inventory causes more frequent reviews and consequently, more frequent purchases
which lead to ordering cost.
 Carrying short inventory may cause loss of good will to customers.

Larger inventories decreases the possibilities of shortages but these costs must be traded off in order to
minimize the total cost of an inventory system. The total cost (profit) of an inventory system is the measure
of performance which is affected by changing order quantity and reorder point.

Monte Carlo simulations are used to construct theories for observed behavior of complicated systems,
predict future behavior of a system, and study effects on final results based upon input and parameter
changes within a system. The stochastic simulation is a way of experimenting with a system to find ways
to improve or better understand the system behavior. Monte Carlo methods use the computer together with
the generation of random numbers and mathematical models to generate statistical results that can be used
to simulate and experiment with the behavior of various business, engineering and scientific systems.

The Monte Carlo method may be used when the model contains elements that exhibit chance in their
behavior. The steps are:

1. Set up probability distributions for important variables

2. Build a cumulative probability distribution for each variable

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3. Establish an interval of random numbers for each variable

4. Generate random numbers
5. Simulate a series of trials

3. Purposes
After this practical, students are able to:

1. Try out various schemes of order quantities and reorder point and
2. Find (to minimize) the smallest total inventory cost. That means that inventory cost includes
ordering cost, holding cost and stock out costs.

4. Equipment
You will need a PC/Laptop with Microsoft Excel Installed.

5. Application of Monte Carlo Simulations

a. Probability of Demand

The daily demand for radial tires over the past 200 days is in the table 1. The manager wants to estimate
demand for tires for 10 days by using Monte Carlo simulation.

Daily Frequency
Demand (Day)
0 10
1 20
2 40
3 60
4 40
5 30
Total 200
Table 1 Daily demand frequency

for tires

Solution.
Step 1: Set up probability distributions for important variables

Daily
Probability
Demand
0 10/200 = 0,05
1 20/200 = 0,10
2 40/200 = 0,20
3 60/200 = 0,30
4 40/200 = 0,20
5 30/200 = 0,15
Total 200/200 =1,00

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Table 2 Probaility of daily demand

Step 2: Build a cumulative probability distribution for each variable

Daily Cumulative
Demand Probability
Probability

0 10/200 = 0,05 0,05

1 20/200 = 0,10 0,15
2 40/200 = 0,20 0,35
3 60/200 = 0,30 0,65
4 40/200 = 0,20 0,85
5 30/200 = 0,15 1,00
Table 3 Cumulative probability of daily demand

Step 3: Establish an interval of random numbers for each variable

Interval Of Random
Numbers
0 10/200 = 0,05 0,05 00 – 05
1 20/200 = 0,10 0,15 06 – 15
2 40/200 = 0,20 0,35 16 – 35
3 60/200 = 0,30 0,65 36 – 65
4 40/200 = 0,20 0,85 66 – 85
5 30/200 = 0,15 1,00 86 - 100
Table 4 Interval of Random Numbers

Step 4: Generate random numbers (can use RANDBETWEEN(0,100) in Ms.Excel)

1 2 3 4 5 6 7 8 9 10
52 37 82 69 98 96 33 50 88 90
Table 5 Random Numbers

Step 5: Simulate a series of trials

Day Random Simulated Daily

Number Number Demand
1 52 3
2 37 3
3 82 4
4 69 4
5 98 5
6 96 5
7 33 2
8 50 3
9 88 5
10 90 5
Total 39

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Table 6 Simulated Daily Demand foe 10 days

Conclusion.

Number demand for tires is 3.9 per day

The formula for each cell is shown below

Cell Formula
Probability C4 =B5/200
Cumulative D5 =C6+D5
Probability
Boundary E4 =D5*100
Random H4 =RANDBETWEEN(0;100)
Number
Demand I4 =IF(H5<=$E$5;$A$5;IF(H5<=$E$6;$A$6;IF(H5<=$E$7;$A$7;IF(H5<=$E$8;$A$8;
IF(H5<=$E$9;$A$9;$A$10)))))

b. Simulation of Inventory System. Example The Newspaper Seller’s Problem

A classical inventory problem concerns the purchase and sale of newspapers. The paper seller buys the
papers for 33 cents each and sells them for 50 cents each. Newspapers not sold at the end of the day are
sold as scrap for 5 cents each. Newspapers can be purchased in bundles of 10. Thus, the paper seller can
buy 50, 60, and so on. There are three types of Newsday, “good,” “fair,” and “poor,” with probabilities of
0.35, 0.45, and 0.20, respectively. The distribution of papers demanded on each of these days is given in
Table 8. The problem is to determine the optimal number of papers the newspaper seller should
purchase. This will be accomplished by simulating demands for 20 days and recording profits from sales
each day.

The profits are given by the following relationship :Profit = (Revenue from sales) – (cost of newspapers) –
(lost profit from excess demand) + (salvage from sale of scrap papers)

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Demand Good Fair Poor

40 0.03 0.10 0.44
50 0.05 0.18 0.22
60 0.15 0.40 0.16
70 0.20 0.20 0.12
80 0.35 0.08 0.06
90 0.15 0.04 0.00
100 0.07 0.00 0.00
Table 7 Demand for three types of Newsday

Types of Cumulative Random - Digit

Probability
Newsday Probability Assignment
Good 0.35 0.35 01 - 35
Fair 0.45 0.8 36 - 80
Poor 0.2 1 80 - 00
Table 8 Random – digit assignments for three types of Newsday

Note→ 1$ = 100 cents

 The revenue from sales is 50 cents for each paper sold. The cost of newspapers is 33 cents for each
paper purchased.
 The lost profit from excess demand is 50 – 33 = 17 cents for each paper demanded that could not
be provided.
 The salvage value of scrap papers is 5 cents each.
 Tables 9 and 19 provide the random digits for the types of Newsday and the demands for those
days.
 To solve this problem by simulation, requires setting a policy of buying a certain number of papers
each day, then simulating the demands for papers over the 20-day time period to determine the total
profit.
 Here simulation is carried out for 70 newspapers and is shown in the table 11

Cumulative Random-digit
Type of Newsday Probability
probability assignment
Good 0.35 0.35 01-35
Fair 0.45 0.80 36-80
Poor 0.20 1.00 81-00
Table 9 Random - digit assignment for type of Newsday

Cumulative Distribution Random – Digit assignment

Demand
Good Fair Poor Good Fair Poor
40 0.03 0.10 0.44 01-03 01-10 01-44
50 0.08 0.28 0.66 04-08 11-28 45-66
60 0.23 0.68 0.82 09-23 29-68 67-82
70 0.43 0.88 0.94 24-43 69-88 83-94
80 0.78 0.96 1.00 44-78 89-96 95-00
90 0.93 1.00 1.00 79-93 97-00
100 1.00 1.00 1.00 94-00
Table 10 Random – Digit assignments for newspapers demanded

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 On day 1 the demand is 60 newspapers. The revenue from the sale of 60 newspapers is $30. Ten
newspapers are left at the end of the day. The salvage value at 5 cents each is 50 cents. The profit
for the first day is
Profit = $30.00 - $23.10 – 0 + $0.50 = $7.40

 On 5th day the demand is greater than the supply. The revenue from sales is $35, since only 70
papers are available under this policy. An additional 20 papers could have been sold. Thus a lost
profit of $3.40 (20 * 17 cents) is assessed. The daily profit is determined as follows
Profit = $35.00 - $23.10 - $3.40 + 0 = $8.50

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Figure 1 Spreadsheet Implementation of Newsday in carried out for 70 newspaper

The formula for each cell are shown below

Cell Formula
Type of Newsday N5 =IF(M5<=$E$5;$A$5;IF(M5<=$E$6;$A$6;$A$7))
Revenue from Sales
Q5 =IF(($E$22-P5)>=0;P5*$B$24/100;$E$22*$B$24/100)
($)
Lost Profit from
R5 =IF(($E$22-P5)<0;(P5-$E$22)*$B$26/100;0)
Excess Demand ($)
Salvage from Sale of
S5 =IF(($E$22-P5)>0;($E$22-P5)*$B$25/100;0)
Scrap ($)
Daily Profit ($) T5 =(Q5-($E$22*$B$23/100)-R5+S5)
Table 11 Formula for Newsday

Conclusion.

 The profit for the 20-day period is the sum of the daily profits $174.90. It can also be computed
from the totals for the 20 days of simulation as
Total profit = $645.00 - $462.00 - $13.60 + $5.50 = $174.90.

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 This simulation is repeated by changing the values for the policy (buying number of newspapers)
like 60, 80 and so on. The best policy is obtained by comparing all the profits. The policy is changed
to other values and the simulation is repeated until the best value is found.
 The total profit por 20-day period simulation in carried out for 60 Newspaper shown in figure 2 .

Figure 2 Spreadsheet Implementation of Newsday in carried out for 70 Newspaper

 The simulation for various number of newspaper purchased is given table 12. We can make
conclusion that the optimum number of Newspaper should purchase are 70 newspapers.
Number of Newspaper Profit for 20 days
Purchased ($)
40 39.1
50 107.1
60 150.3
70 174.9
80 162.3
90 112.5
Table 12 Simulation for various number of newspaper purchased

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c. Simulation of Inventory System. Example of an Inventory Control Model

The manager of a truck dealership wants to acquire some insight into how a proposed policy for reordering
trucks from the manufacturer might result in shortage. Under the new policy, two trucks are to be ordered
whenever the number of trucks on hand at the end of the day plus number of trucks on order is two
or fewer. Assume that purchase lead time is only two full days. According to the dealer’s records, the
probability distribution for daily demand (i.e., its sales) is:

Demand x P(x)
0 0.5
1 0.4
2 0.1
Table 13 Probability Distribution for daily demand of Trucks

The problem is the manager want to estimate the probability of shortage for 10 days.

Solution:

a. Manually simulation of the inventory system for 10 days with assumption beginning inventory of
dour trucks.

Cumulative Random - Digit

Demand x Probability
Probability Assignment
0 0.5 0.5 0 - 50
1 0.4 0.9 51 - 90
2 0.1 1 91 - 100
Table 14 Random Digit Assignment for daily demand of Trucks

 On day 1 the demand is a truck. So ending inventory + on order are 3.

 On day 2, the demand is 2, so ending inventory + on order is 2. Based on the new policy that two
trucks are to be ordered whenever the number of trucks on hand at the end of the day plus number
of trucks on order is two or fewer, we reorder 2, arrival day at day 5.
 On 7th day the demand is greater than the supply. The demand is 2 and the inventory is 1, resulting
in shortage.
 The only negative ending inventory is in day 7. Therefore estimate for probability of shortage
1/10=0.1.
 This simulation is repeated by changing the values for the policy (buying number of trucks
whenever the number of trucks on the hand at the end of the day plus number of trucks on order is
a number) the best policy is obtained by comparing all the probability of shortage.

Random Demand
Day Beginning Inventory number x Ending inventory + on order
1 4 54 1 3
2 3 73 1 2 (reorder 2, arrival days = 5)
3 2 29 0 2+2
4 2 51 1 1+2

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3 (Day 2 order
5 arrived)
6 2
7 1
1 (day 5 order
8 arrived)
9 3
3 (day 7 order
10 arrived)
Table 15 Manual Simulation for demand of Trucks in 10 days
87 1 2 (reorder 2, arrival days = 8)
51 1 1+2
-1+2 (reorder 2, arrival
99 2 days=10)
18 0 1+2
30 0 1+2
27 0 3

b. Enter the model for this problem in Excel and runs simulation for 100 days. We will estimate the
probability of shortage by counting the negative ending stocks in 100 days.

Figure 3 Spreadsheet implementation of trucks dealership

The formula for each cell below

Cell Formula
Unit Received B12 =IF(A12=I9;$H$5;0)
Beginning Stock
C12 =F11+B12
Level
Random number D12 =RANDBETWEEN(0,100)
Demand E12 =IF(D12<=$E$5;$A$5;IF(D12<=$E$6;$A$6;$A$7))

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Ending Stock F13 =C12-E12

Quantity on order G12 =IF(H11="Yes";G11+$H$5-B12;G11-B12)
Order? H12 =IF(F12+G12>$H$6;"No";"Yes")
Day of arrival I12 =IF(H12="Yes";A12+$H$7+1;"")
Shortage D8 =COUNTIF(F12:F111;"<0")
Table 16 Formula for spreadsheet

c. Conclusion
The formula in cell D8 counts the negative ending stocks for 20 days. In this case, there are 2 days
when shortage occurred. Therefore, our estimate for probability of shortage is 3/20=15%. To
increase accuracy, we should increase run length.

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d. Simulation of Inventory System. Example of an Inventory Control Model

Teguh Boutique, is a Boutique that sells special clothes T-Shirt among young people. One type of T-
Shirt sold is Hushus shirts. The number of requests for shirts per day within 300 days is as follows

Demand for Frequency

Hushus T-Shirt
0 15
1 30
2 60
3 120
4 45
5 30
300
Table 17 Daily Demands for Hushus T-Shirts

The manager make policy that the boutique will make an order if the remaining 5 t-shirts or less (include t-
shirts in order) in inventory. The order quantity is 10 pieces per order. When making an order, the supplier
has a lead time varying according to the following data.

Lead Time Frequency

1 10
2 25
3 15
Table 18 Lead time for Hushus T-Shirts

Check the policy and by using Monte Carlo, simulate in 10 days:

a. Number of shortage
b. The inventory-holding costs are $1 per unit per day, the ordering cost is $20 per order, the short
age cost is $25 per unit, and the beginning inventory is 10 units. Using an order quantity of 10
and a reorder point of 5, simulate 10 day of operation of this inventory system.

Solution.

 To solve this problem by simulation, requires setting a policy of buying a certain number of T-
shirts per order and reorder point, then simulating the demands for T-Shirts over the 20-day time
period to determine average daily cost. Assume beginning inventory are 10 t-shirts.
 Policy using an order quantity of 10 and a reorder point of 5
 On the first day, the amount of inventory is 10 and the amount of demand is 3, leaving the
remaining 7 items in the inventory. So no reservation is made.
 On the second day, the inventory amount is 7 and the total demand is 3, so at the end of the day
there are 4 items left. For that order is made with a lead time of 1 day which will arrive on day 4.

Spreadsheet implementation of Teguh Boutique inventory simulations for Hushus T-Shirts.

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Figure 4 Spreadsheet implementation of Hushus T-Shirts

Figure 5 Spreadsheet implementation of Hushus T-Shirts

The formula for each cell below

Cell Formula
Order Received I5 =COUNTIF($T$4:T4;H5)
Unit Received J5 =I5*$B$21
Beginning Inventory K5 =N4+J5
Random Number L4 =RANDBETWEEN(1,100)
Demand M4 =IF(L4<=$F$5;$A$5;IF(L4<=$F$6;$A$6;IF(L4<=$F$7;$A$7;IF(L4<=$
F$8;$A$8;IF(L4<=$F$9;$A$9;$A$10)))))

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Ending Inventory N4 =IF((K4-M4)>=0;(K4-M4);0)

Lost Sale O4 =IF((K4-M4)<0;ABS(K4-M4);0)
Units Received P5 =IF(Q4="Yes";P4+$B$21-M5;P4-M5)
Ending Inventory + On Q4 =IF(P4<$B$22;"Yes";"No")
order
Order? R4 =IF(Q4="Yes";RANDBETWEEN(0;100);"")
Random Number S4 =IF(R4="";"";IF(R4>$F$17;$A$17;IF(R4>$F$16;$A$16;$A$15)))
Lead Time T4 =IF(S4="";"";(H4+S4+1))
Day of arrival U4 =N4*$E$21
Hold Cost V4 =IF(Q4="Yes";$E$22;0)
Order Cost W4 =O4*$E$23
Shortage Cost X4 =SUM(U4:W4)
Table 19 Formula for spreadsheet of Hushus T-Shirts

Conclusion.

From spreadsheet implementation of Teguh Boutique inventory simulation we can analyze that :

 The number of shortage is 4 items.

 Total daily cost is summation of holding cost, shortage cost and order cost. The average daily cost
for T-Shirts is $ 19.
 We can simulate to find the minimum cost by changing the reorder point and order quantity

3.5. Example of Fixed Period Inventory Management System

Sound Systems, Inc., is a retail firm that carries high-quality audio equipment, including a popular personal
audio system. Demand for the systems is subject to variability, and it has been very difficult to anticipate
when and how much the demand for the product will be. On approximately half the days when the store is
open no one orders one. However, about one day per month, three or even four orders may occur. If variable
demand were the only source of uncertainty, the order quantity and reorder-point decision could be based
on a single-period inventory model. However, the inventory problem is further complicated by the fact that
the lead time varies between one and five days. These lead times have caused the store to run out of
inventory on several occasions, which has resulted in back orders. After an analysis of delivery charges and
other costs associated with each order, the store manager estimated an order cost of $40 per order. An
analysis of interest, insurance, and other costs of carrying inventory led to an estimate for the holding cost
of $0.20 per unit per day. Finally, the shortage cost was estimated to be $100 per unit. The total cost of the
system is given by the sum of the ordering cost, the holding cost, and the shortage cost. The objective is to
find the combination of order quantity and reorder point that will result in the lowest possible total cost. To
carry out the simulation, they develop data from the demand and lead time distributions below.

Demand Lead Time

Cumulative Cumulative
Units Frequency Probability Probability Days Frequency Probability Probability
0 150 0.5 0.5 1 6 0.2 0.2
1 75 0.25 0.75 2 3 0.1 0.3
2 45 0.15 0.9 3 12 0.4 0.7
3 15 0.05 0.95 4 6 0.2 0.9

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4 15 0.05 1 5 3 0.1 1
Sum 300 1 15 30 1
Table 20 Probability of demand and lead time for Sound Systems
Spreadsheet implementation of sound systems inventory simulations

Figure 6. Spreadsheet implementation of sound systems inventory simulations

Figure 7 Spreadsheet implementation of sound systems inventory simulations

The formula for each cell below

Cell Formula
Beginning B16 =I15
Inventory
Order Received C14 =COUNTIF($O$15:O15;A16)
Unit Received D14 =C16*$D$10
Beginning stock E14 =H15+L15
level + in order

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Random F14
Number
Demand G14 =IF(F16<=$J$6;$F$6;IF(F16<=$J$7;$F$7;IF(F16<=$J$8;$F$8;IF(F
16<=$J$9;$F$9;$F$10))))
Ending Stock H14 =E16-G16
level + in order
Ending I14 =I15+D16-G16
inventory
Back Order J14 =IF(I16<0;ABS(I16);0)
Order? K14 =IF(H16>$D$11;"No";"Yes")
In Order L14 =IF(K16="Yes";$D$10;0)
Random number M14 =IF(K16="Yes";RANDBETWEEN(0;100);"")
Lead time N14 =IF(M16="";"";IF(M16<=$P$6;$L$6;IF(M16<=$P$7;$L$7;IF(M16
<=$P$8;$L$8;IF(M16<=$P$9;$L$9;$L$10)))))
Day of arrival O14 =IF(K16="Yes";A16+N16+1;"")
Hold cost P14 =IF(I16>0;I16*$D$6;0)
Order cost Q14 =IF(K16="Yes";$D$5;"")
Short cost R14 =J16*$D$7
Total cost S16 =SUM(P16:R16)
Table 21 Formula for spreadsheet implementation of Sound Systems Inventory Simulation
 At the start of day 1, five units are in inventory and one order arrives. A random number using by
RANDBETWEEN in excel, this corresponds to a daily demand of one units and an ending
inventory of four. On days 2, the random numbers generates 2. By this point, the reorder point
reached, so an order is placed. The beginning stock level + in order now increases by the amount
of the order. A random number is generated for the lead time, indicating that an order will arrive in
days 6.
 On day 3, an order is placed so that beginning stock level + in order day 3 increases to 7. But, the
real beginning inventory is 2, because 5 still in order. Because ending stock level + inventory still
>reorder point, we don’t make an order.

Conclusion

 Total cost for Sound System Inc. inventory system for 20 days with policy reorder point = 5 and
order quantity = 3 are $133 with average daily cost $6.65.
 We can make simulation for various combination of the order quantity and reorder point.
 Simulation cannot guarantee an optimal solution, but can help identify near solutions for similar
inventory management problems.

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6. Exercises
a. The number of jobs received by a small machine shop is to be simulated for an eight-dayperiod.
The shop manager has collected the following data for the number of jobs received daily:

Number of jobs Frequency

2 or less 0
3 10
4 50
5 80
6 40
7 16
8 4
9 or more 0
200

Determine the average number of jobs per day for the eight day simulation period.
b. A baker is trying to determine how many dozens of bagels to bake each day. The probability
distribution of the number of bagel customers and number of dozen ordered is as follows :

Number of Number of Dozen

Probability Probability
Customers/Day ordered/Customer
8 0.35 1 0.4
10 0.3 2 0.3
12 0.25 3 0.2
14 0.1 4 0.1
Bagel sell for 5.4 dollar per dozen. They cost 3.8 dollar per dozen to make. All bagels not sold at
the end of the day are sold at half-price to a local grocery store. Based on 5 days of simulation,
how many dozen (to the nearest 10 dozen) bagels should be baked each day?
c. Demand for widgets follows the probability distribution shown :

Daily
0 1
demand 2 3 4
Probability 0.33 0.25 0.2 0.12 0.1
Stock is examined every 7 days (the plant is in operation every day) and if the stock level has
reached 6 units, or less, an order for 10 widgets is placed. The lead time (days until delivery) is
probabilistic and follows the following distribution:

Lead Time
1 2
(Days) 3
Probability 0.3 0.5 0.2
When the simulation begins, it is the beginning of the week, 12 widgets are on hand, and no orders
have been backordered (backordering is allowed). Simulate 6 weeks of operation of this system.
Analyze the system. Perform additional simulations to determine the effect on shortages if
increases or decreases occur in (1) the review period, (2) the reorder quantity, and (3) the reorder
point.

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d. Bristol Bikes, Inc. wants to develop an order-quantity and reorder-point policy that would
minimize the total costs associated with its inventory of exercise bikes. The relative frequency
distribution for retail demand on a weekly basis follows:

Demand 0 1 2 3 4 5
Probability 0.2 0.5 0.1 0.1 0.05 0.05
The relative frequency distribution for lead time follows:

Lead Time
(weeks) 1 2 3 4
Relative
Frequency 0.1 0.25 0.6 0.05

The inventory-holding costs are $1 per unit per week, the ordering cost is $20 per order, the short
age cost is $25 per unit, and the beginning invent tory is 7 units. Using an order quantity of 12 and
a reorder point of 5, simulate 10 weeks of operation of this inventory system.

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