STOCHASTIC

INVENTORY MODELS
INOPER3 Notes
 Single Period Model
(Newsboy Problem)
 Parameters:
› a = ordering cost
› s = selling price
› c = purchase cost
› v = salvage value
› p = stock-out cost
 Decision Variable
› Q = order quantity
 Random Variable
› x = demand (per period)
› f(x) = demand density function
 Single Period Model
(Newsboy Problem)
 Expected profit = E(P)
 If x < Q:
P1  s * x  v(Q  x)  cQ  a
 If x > Q:
P2  s * Q  p( x  Q)  cQ  a
 Single Period Model
(Newsboy Problem)
 Expected Profit
Q 
E ( P )  [ sx  v(Q  x)  cQ  a ] f ( x )dx  [ sQ  p ( x  Q )  cQ  a ] f ( x)dx
 Q
Q 
 [ sx  v(Q  x)] f ( x)dx  [ sQ  p ( x  Q)] f ( x)dx  cQ  a
 Q
 Single Period Model
(Newsboy Problem)
 Applying Leibniz Rule:
Q 
dE ( P)
1[ sQ  0] f (Q)  0  v( fx )dx  0  1[ sQ  0] f (Q)  [ s  p] f ( x)dx  c 0
dQ  Q
 
v[1  f ( x)dx]  (s  p)f ( x)dx  c 0
Q Q

v  ( s  p  v) f ( x)dx  c 0
Q

c v
f ( x)dx  s p v
(critical ratio )
Q*
 Single Period Model
(Newsboy Problem)
 If x is discrete, the critical ratio
becomes:  c v
 f ( x)  s  p  v
Q*

 If B = beginning inventory,
› Q* < B, then order zero (0)
› Q* > B, then order Q* - B
 Example 1
 A small grocery store has the problem of
determining the number of trays of bread to
stock each day. A tray costs Php125 and sells for
Php150. The leftover trays at the end of the day
can be sold as day-old bread at Php112.50. The
probability distribution of demand is given below.
Find the optimal order quantity.

x 10 11 12 13 14 15
f(x) 0.15 0.20 0.19 0.18 0.17 0.11
 Example 2
 Given the same problem, find the
optimal order quantity if the demand
has the following density function:
1
f ( x)  ; 10  x 15
5
0 ; elsewhere
 Example 3
 A company is trying to determine the
amount of particular part to manufacture as
replacements before shutting down the
production lines of this model. No future
runs will be considered. The parts sell for
Php10, cost Php6 to manufacture and can
be scrapped at Php2 if not sold. The
demand for the product is exponential with
a mean of 50 units. At present, there are
twenty parts in the inventory. How many
should be produced?
 Example 4
 A book store orders copies of popular
magazine at a cost of Php7.50 per copy.
The magazine can be sold at Php15.00 per
copy. At the end of the month, when the
next issue is delivered, any leftovers can be
returned to distributor for a credit of
Php2.50. Monthly demand for the
magazine can be regarded as normal with a
mean of 50 and a standard deviation of 15.
How many copies should the store order?
 Example 5
 A certain vending machine dispenses
sandwiches. Each morning new sandwiches
are put in, and the excess, if any, from the
previous day are removed. Sandwiches cost
the vendor PhP3.50, and are sold for
PhP8.50. Day old sandwiches are sold for
PhP1.20 a piece to a skid-row soup kitchen.
Assuming that daily demand is Poisson
distributed with a mean of 25, determine the
number of sandwiches to put into the
machine each day.
 Continuous Review Models: Lot
Size, Reorder Point Models
 Back order Case
 Stock out Case
 Back Order Case
 Parameters
› a = fixed ordering cost
› h = holding cost per unit
› p = back-order cost per unit
› d = expected demand per planning horizon
 Decision Variable
› Q = order quantity
› r = reorder point
 Random Variable
› x = demand during lead time
› f(x) = density function of demand during lead time
› µ = mean demand during lead time
Back Order Case

Inventory

Time
 Back Order Case
 EAC (Q, r) = Total Expected Annual
Cost
= ordering cost + holding cost +
back order cost
= OC + HC + BC
 Ordering cost: d
OC a
Q
 Back Order Case
 Holding cost:
HC h * I ave
I max  I min
I ave 
2
› Expected inventory level just before arrival
of Q = r - µ (can be negative)
› Expected inventory level just after arrival
of Q = Q + r - µ
 Back Order Case
 Holding cost (cont.) :
Qr   r   Q
I ave   r  
2 2

Q 
HC h   r   
2 
 Back order cost:
› Let B(r) = number of back ordered units
› B(r) = 0 ; x < r
› B(r) = x - r ; x > r
 Back Order Case
 Back order cost (cont.):
r 
B( r )  0 * f ( x) dx  ( x  r ) f ( x) dx
 r

 ( x  r ) f ( x)dx
r

d
BC  p * B(r )
Q
 Back Order Case
 Total Expected Annual Cost (EAC):
ad Q pd
EAC (Q, r )   h[  r   ]  B(r )
Q 2 Q

 Applying partial derivative:

EAC ad h pd
   2 B ( r ) 0
Q Q 2 Q

* 2d [a  pB (r )
Q  Equation (1)
h
 Back Order Case
 Applying partial derivative:
EAC pd
0  h  B ' ( r ) 0
r Q


› Where: B(r ) ( x  r ) f ( x)dx

r
› Applying Leibniz Rule:

B' (r ) 0  (1)( r  r ) f (r )  ( 1) f ( x)dx
r

B ' (r )  f ( x)dx
r
 Back Order Case
 (cont.) EAC pd

h  f ( x)dx 0
r Q r


hQ
f ( x)dx 
r
pd Equation (2)

 Iterative Process:
1. Set B(r) = 0 and solve for Q1 using Equation (1)
2. Solve r1 using Equation (2)
3. Solve B(r1)
4. Solve Q2
5. Solve r2
6. Continue process until vales of Q and r converge.
 Back Order Case
 Note: When f(x) is complicated, the
evaluation of B(r) may not be trivial.
 When x is normal:
r  r 
B( r ) f       r  G  
     
 Where: r 
f  is the value of the function at (r- µ)/σ
  

r 
G  is the area to the right of z
  
2
1  r  
r  1  
2   
f   e
   2
 Example 6
 Items can be ordered at a cost of Php20.
It costs Php1 per week to store one unit
and Php5 is the cost incurred for every
item back-ordered. Lead time equals
one week. Find the optimal order
quantity and reorder point assuming:
(a) demand has the following distribution
X 10 11 12 13 14
f(x) 0.3 0.25 0.2 0.15 0.1

(b) demand is 1uniformly

f ( x) 
distributed
; 10  x 14
4
 Example 7
 A department sells blank tape under its own
brand name. Because of special labeling and
packaging, there is a lead time of 5.2 weeks.
Assume that the demand during lead time is
normal with a mean of 1000 tapes and
standard deviation of 250. The cost of paper
work and handling associated with placing
an order is Php100 per order. Holding cost is
Php0.5 per tape per year. The penalty is
Php1 per tape back-ordered. Find the
optimal quantity and reorder point.
 Stock-out Case
 Parameters
› a = fixed ordering cost
› h = holding cost
› p = stock-out cost per unit
› d = expected during per planning horizon
 Decision Variable
› Q = order quantity
› r = reorder point
 Random Variable
› x = demand lead time
› f(x) = density function of demand during lead time
› µ = mean demand during lead time
 Stock-out Case
 EAC (Q, r) = Expected Total Annual
Cost
= ordering cost + holding cost +
stock-out cost
= OC + HC + SC
 Ordering cost: OC a d
Q
HC h * I ave
 Holding cost: Q 
HC h   r    B(r )
2 
 Stock-out Case
 Stock-out cost:
› Let B(r) = number of stocked out units

B (r )  ( x  r ) f ( x)dx
r

d
SC  p * B (r )
Q

 Total Expected
ad Annual
Q Cost
pd
EAC (Q, r )   h[  r    B(r )]  B(r )
Q 2 Q
 Stock-out Case
 Applying partial derivative:

2d [a  pB(r ) Equation (1)

Q* 
h

hQ
f ( x)dx 
r
pd  hQ
Equation (2)

 Iterative Process:
1. Set B(r) = 0 and solve for Q1 using Equation (1)
2. Solve r1 using Equation (2)
3. Solve B(r1)
4. Solve Q2
5. Solve r2
6. Continue process until vales of Q and r converge.
 Stock-out Case
 Note: When f(x) is complicated, the
evaluation of B(r) may not be trivial.
 When x is normal:
r  r 
B(r ) f       r G  
     
 Where: r 
f  is the value of the function at (r- µ)/σ
  
r 
G  is the area to the right of z
  
2
1  r  
r  1 
2   
f   e
   2
 Example 8
 Consider Example 6. Assume Stock out
case.
 Consider Example 7. Assume Stock out
case.
Periodic Review Model for
Stochastic Demand

m-μ

tr L
 Periodic Review Model for
Stochastic Demand
 Let
› tr = elapsed time between reviews
› m = target level to which we want to restore the inventory
› Ir = inventory at the time of review
› f(x) = density function of demand during lead time
› a = combined order cost and cost of reviewing
› h = holding cost per unit per T
› p = back order cost
› μ = mean of density function of demand during lead time
› d = expected value of demand
› Beginning inventory of a cycle = m – μ
› Expected Demand during tr = d * tr
› Ending Inventory = m – μ – d * tr
 Periodic Review Model for
Stochastic Demand
a
 Total Order and Review Cost =
tr
 Total Holding Cost =
 m    m    dt r   1 
H   H  m    dt r 
 2   2 
 Total time when demand is
present = tr + L
 f(D/tr+L) = density function of demand
given a time period of tr + L
 Periodic Review Model for
Stochastic Demand
 Bm = expected back ordered units

Bm  ( D  m) f ( D / t r  L)dD
m
p
Bm
 Expected back ordered cost = tr
 Therefore,
a  1  p 
E (c )   H  m    dt r   ( D  m) f ( D / t r  L)dD
tr  2  tr m
 Using Leibniz Rule: dE (c) H  p  f ( D / t 
r  L)dD 0
dm t r
m

 Ht r
m f ( D / t r  L)dD  p
 Example 9
 Assume that an item can be ordered at
a cost of Php20. It costs Php1 per week
to store it and Php5 is incurred for every
item back ordered. The lead time is 1
week. A Php10 review cost is also
incurred. Assume that the demand per
week is normal with a mean of 12 and a
variance of 1. Find the target level of
inventory m of the review period is 2
weeks.
 Solution to Example 9
 Given: tr = 2 weeks
L = 1 week
a = 20 + 10 = 30
h = 1 per unit per week
p = 5 per unit
Normal distribution of demand with μ = 12
and σ2 = 1
tr + L = 3 weeks
 Solution to Example 9

 f(D/3) = normal with μT = 36 and σ2T =

3  f ( D / 3)dD 1(52) 0.4


P ( D  m )  0 .4
m  36
z 0.6 0.255 
3
m 36.44

 36.44  36    36.44  36  
Bm  3 f     G    36  36.44 0.4929
 3    3 

30  1  5
E (c )   1 36.44  12  (12)( 2)  (0.4929) 28.67
2  2  2
Solution to Example 9

tr E(c)
1 37.98
2 28.67
2.2 28.45
2.3 28.41
2.4 28.43
3.0 29.29