Charter 2


INVENTORY MANAGEMENT
Mã MH : 704015
Bộ môn: KDQT- K.QTKD
GV : Mai Thuỳ Dung
 Contents
2.1 What is inventory?
2.2. EOQ model
2.3. The effects of demand uncertainty
2.3.1. Single period model
2.3.2. Multiple order opportunities
2.3.3. Continuous review policy
2.3.4. Variable lead time
2.3.5. Period review policy
2.4. Risk Pool
704015- Chapter 2 Inventory
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Management
 2.1 What is inventory?
❖Inventory is stock of items kept to meet future demand;
❖3 forms:
• Raw material inventory;
• Work-in-process inventory;
• Finished product inventory

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 Inventory management
❖The objective of inventory management is to strike a
balance between inventory investment and customer
service;
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 2.2. EOQ model
❖Economic order quantity (EOQ) is the order quantity that minimizes
the total holding costs and ordering costs.
❖Assumptions:
• Demand is constant at the rate of D items/day;
• Order quantity is fixed at Q items/order;
• A fixed cost (setup/order cost), K, is incurred when an order is placed;
• An inventory carrying cost (holding cost), h, is accrued per unit held
in inventory per holding day;
• The lead time = 0; Initial inventory = 0;
• The planning horizon is infinite.

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 EOQ model (cont)

A cycle time T
Order
quantity = Q Usage rate

Average
inventory
Inventory level z on hand
Q
2
Initial inventory
0
Time
Q
Inventory cost in a cycle time: K
# + hT
2
Demand in a cycle time: TD# =Q
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 EOQ model (cont)
Objective is to minimize total costs
Cost
Total cost of Average inventory per day:
K Q KD Q
holding and
setup (order)

# +h = +h
T 2 Q 2
Minimum
total cost

Holding cost
The order quantity minimizes
the above cost function
Setup (or order)
cost
(EOQ):
Optimal order Order 2KD
quantity (Q*) quantity
!Q* =
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h7
 EOQ model (an example)

Determine optimal number of needles to order

D = 2,000 units
K = $20 per order
h = $.50 per unit per year

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 EOQ model (an example)

Calculate expected numbers of orders per year

D = 2,000 units Q* = 400 units
K = $20 per order
h = $.50 per unit per year

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 EOQ model (an example)

Calculate expected time between orders

D = 2,000 units Q* = 400 units
K = $20 per order N = 5 orders per year
h = $.50 per unit per year

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 EOQ model (an example)
Calculate total annual cost
D = 2,000 units Q* = 400 units
K = $20 per order N = 5 orders per year
h = $.50 per unit per year T = 50 days

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 EOQ model (cont.)

❖ The EOQ model is robust, illustrating the trade-offs between

set-up costs and inventory holding costs
❖ The total cost is insensitive to order quantities
Calculate total cost when actual EOQ for new demand is 500 units
D = 2,000 units Q = 500 units
K = $20 per order N = 5 orders per year
h = $.50 per unit per year T = 50 days

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 2.3. The Effect of Demand Uncertainty

❖ Most companies treat the world as if it were predictable.

Production and inventory planning are based on forecasts
of demand made far in advance of the selling season;
• Short product life-cycle adds more uncertainties.
❖ Rules of thumb for all forecasts:
• The forecast is always wrong;
• The longer the forecast horizon, the worse the forecast;
• Aggregate forecasts are more accurate.

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 2.3.1. Single Period Model
❖ Assumptions:
• Product has a short life-cycle, that the firm only has 1
ordering opportunity
❖ SnowTime Sporting goods example:
– New designs are completed and One production opportunity
– Based on past sales, knowledge of the industry, and
economic conditions, the marketing department has a
probabilistic forecast

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 SnowTime Demand Scenarios(cont)
Demand Scenarios
28%

21%

Probability
14% 28%
22% 18%
7%
11% 11% 10%
0%
00

0
00

00

00

00

00
80

10

12

14

16

18
Sales

• Variable cost (C): $80/unit • Salvage value for excessive

• Selling price (P): $125/unit inventory (V): $20
• Fixed production cost (F):
$100,000 15
 SnowTime Demand Scenarios(cont)
• Scenario 1: Suppose you make 12,000 jackets and demand
ends up being 13,000 jackets.
• Scenario 2: Suppose you make 12,000 jackets and demand
ends up being 11,000 jackets.

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 SnowTime Demand Scenarios(cont)
Weighted Profit as per Demand scenarios
500000

375000
Profit

250000

125000

0
5000 6000 7000 8000 9000 10000 11000 12000 13000 14000 15000 16000

Production Quantity

➡The optimal order quantity is NOT necessarily equal to

forecast/average demand
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 2.3.2 Multiple Order Opportunities
• Initial inventory
– Can be used to meet demand;
– Avoids fixed costs for a new order/production
• (s, S) policy, or min-max policy
– When the inventory falls below a certain value, say s, we
order/produce to increase the inventory to level S.

s: reorder point (the min) S: order-up-to level (the max)

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 Multiple Order Opportunities (cont.)
• Besides fashion industry, the decision maker may:
– Order products repeatedly at any time during the year;
– Wait for a delivery lead time to have his order fulfilled.
• 2 types of inventory policies
– Continuous review policy, in which inventory is reviewed
continuously, and an order is placed when the inventory reaches
the reorder point.
– Periodic review policy, in which inventory is reviewed at regular
intervals, and an appropriate quantity is ordered after each review
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 Normal distribution (extension)
• In probability theory and statistics, a probability distribution is a
mathematical function that provides the probabilities of occurrence of different
possible outcomes in an experiment.
Eg: X = outcomes of a coin toss, what is the probability distribution of X?
• A probability distribution is generally divided into 2 classes:
- Discrete probability distribution: is applicable to the scenarios where
the set of possible outcomes is discrete. Eg: a coin toss, a roll of dice
- Continuous probability distribution: is applicable to the scenarios
where the set of possible outcomes takes on values in a continuous range.
Eg: Temperature on a day
• If the probability of X is continuous, X is called a continuous random variable

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 Normal distribution (extension)
• If continuous random variable X has
a probability density function
# f(X) , the probability of falling into an
interval [a,
# b] is given by the
integral:
b

∫a
# P[a ≤ X ≤ b] = f(x)dx
•Normal distribution is used in the
natural and social science to present
real-valued random variables whose Probability density function of normal distribution
distribution is unknown;
21
 Normal distribution (extension)
μ
# : mean/ average of the distribution σ# : standard deviation,
where μ # is estimated from the arithmetic mean x̄
# of a sample #x1, x2, . . . , xn:
x1 + x2 + . . . + xn
#μ ≡ x̄ =
n
N
1
N−1∑
and #σ = (xi − x̄)
i=1

Calculate Average & Standard deviation of monthly demand

Month Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
Sales 200 152 100 221 287 176 151 198 246 309 98 156
22
 2.3.3.Continuous Review Policy
Assumptions:
• Daily demand is random, and follow a normal distribution, which is
characterized with average demand AVG, and standard deviation STD;
• A fixed cost (setup/order cost), K, is incurred when an order is placed;
• An inventory carrying cost (holding cost), h, is charged per unit held in inventory
per unit time;
• It takes a lead time, L, to fulfill the order after the order is placed;
• The distributor commits a service level, α
# , which implies the probability of not
stocking out during lead time
• Inventory Position = actual inventory + items already ordered but not delivered
- items backordered

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 Continuous Review Policy (cont.)
• Continuous review policy is known as (Q, R) policy:
R: reorder point Q: order quantity
• R has two components:
– To account for average demand during lead time:

L∗AVG
– To account for deviations from average (we call this safety stock)

z*STD*
# L

where z is referred as safety factor to ensure that the probability of
stock-out during lead time is exactly 1
# − α.
➡R
# = L*AVG + z*STD* L
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 Continuous Review Policy (cont.)
Inventory level as a function of time in a (Q, R) policy

Inventory level before receiving an order = z*STD*

# L
Inventory level after receiving an order = #Q + z*STD* L
Q
➡ Average inventory= # + z*STD* L 25
 Continuous Review Policy (cont)
In summary:
• Reorder Level: !R = L*AVG + z*STD* L
2*K*AVG
• Order Quantity (recall from EOQ model): !Q =
h
Table 1: Service level and service factor, z
Service level 90% 91% 92% 93% 94% 95% 96% 97% 98% 99% 99.9%

z 1.29 1.34 1.41 1.48 1.56 1.65 1.75 1.88 2.05 2.33 3.08

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 Continuous Review Policy example
A distributor of TV sets is trying to set inventory policies for one of
the TV models. The cost of a TV set to the distributor is $250, and
annual inventory holding cost is about 18% of the product cost. K
= $4,500; L= 2 weeks. Given that the distributor would like to
ensure 97% of service level, what is Q and R that the distributor
should use?
Table 2: Historical data
Month Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
Sales 200 152 100 221 287 176 151 198 246 309 98 156

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 2.3.4. Variable Lead Time
• Assumption: Lead time is normally distributed with average lead
time, AVGL, and standard deviation, STDL
• Average demand during lead time = #AVG*AVGL;
• Safety stock = #z AVGL*STD 2 + AVG 2*STDL 2
• Reorder point,
# = AVG*AVGL + z AVGL*STD 2 + AVG 2*STDL 2
R
2*K*AVG
• Order quantity, Q
# =
h

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 2.3.5. Periodic Review Policy
• When inventory is reviewed periodically at regular
intervals, the (Q, R) policy can’t be directly implemented,
since the inventory position may fall below the reorder
point.
• Periodic Review Policy is referred as (s,S) policy, where
s=R, S= R+Q.
• Base-stock level is the target inventory level, to which
the warehouse will order enough to raise the inventory
level after each review period.
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 Periodic Review Policy (cont.)
• r is the length of the review period—> The next order
arrives after a period of r# + L days

Inventory level as a function of time in a periodic review

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 Periodic Review Policy (cont.)
• The base-stock level include two components:
- Average demand during r# + L days =#AVG*(r + L);
- Safety stock protecting against deviations from average demand
during #r + L days = z*TD*
# r + L;
• Expected inventory level after receiving an order =
r*AVG
# + z*STD* r + L
• Expected inventory level before an order arrives = #z*STD* r+L
r*AVG
➡ Average inventory level = # + z*STD* r + L
2
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 Comparing three policies

EOQ (Q, R) Policy (s, S) Policy

Inventory level
before an order 0 z*STD* L z*STD* r + L
arrives
Inventory level 2KD
after an order Q= Q + z*STD* L r*AVG + z*STD* r + L
h
arrives
Average Q Q r*AVG
+ z*STD* L + z*STD* r + L
inventory level 2 2 2

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 2.4 Risk Pooling

• Risk pooling suggests that demand variability is reduced

if one aggregates demand across locations
• Standard deviation measures how much demand tends
to vary around the average, while coefficient of variation
is the ratio of standard deviation to average demand;
Standard deviation
# oefficient of variation =
C
Average demand

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 ACME case
ACME is an electronic equip producer and distributor
Current Strategy Alternative Strategy
Market
Market
Warehouse MA One
One
Centralized
ACME ACME
Market warehouse
Warehouse NJ Market
Two
Two

LT = 1 week !K = $60 / order

! = 97%
α Transportation cost:
1500 products, 10 000 accounts - Current strategy: $1.05/ product;
h! = $0.27 / unit/ week - Alternative strategy: $1.10/ product
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 ACME’s historical Data
PRODUCT A
Week 1 2 3 4 5 6 7 8
Massachusetts 33 45 37 38 55 30 18 58
New Jersey 46 35 41 40 26 48 18 55
Total 79 80 78 78 81 78 36 113
PRODUCT B
Massachusetts 0 3 3 0 0 1 3 0
New Jersey 2 4 3 0 3 1 0 0
Total 2 6 3 0 3 2 3 0
 Critical Points about Risk Pooling

• The higher the coefficient of variation, the greater the benefit

from risk pooling
• The benefits from risk pooling depend on the behavior of the
demand from one market relative to demand from another.
Intuitively, the benefit from risk pooling decreases as the
correlation between demand from the two markets become
more positive.
• Reallocation of items from one market to another can be
more easily accomplished in centralized systems than in
decentralized systems.

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 2.5. Risk Pool Game
The Risk Pool Game (RPG) models the 2 scenarios:
Retailer Retailer
Centralized warehouse Decentralized retailers
1 1

Manufacturer Warehouse Retailer Retailer

2
Manufacturer
2
L1 = 2w
L2 = 2w Retailer
3 L = 4w
Retailer
3

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 Risk Pool Game (cont.)
• How to play: 2 games, 10 rounds/ game
Game Time (mins) Actions
Adjust settings including Initial Inventory, Demand, Cost as
5
given
1 Decide and enter Order to Supplier (box A) and Inventory
2/ round Allocation (3 boxes B) to retailers in centralized system, and
Orders to Supplier (3 boxes C) in decentralized system
15 Adjust Inventory Policy
2 Have the computer play automatically as per your set
0.5/ round
Inventory Policy
• How to grade:
- Points will be rewarded on the profit ranking after each game, with 5 points to
the team with highest profit, and decreasing along the ranking;
- A team’s grade = total grade from 2 games. 38
 Risk Pool Game (cont.)

YOUR GAME STARTS NOW

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