Management II

Part 3: Inventory control

Typical problems in groceries
• High average inventories
• High manual planning effort
• High transportation costs
• High effort in stores
• Regular recourse actions
• Stockouts

2
Typical reasons for these problems
• Poor inventory control subject to uncertain demand
• Ineffective internal processes
• Poor supplier coordination

3
The nature of randomness
The nature of randomness
• Mac owns a local newsstand and buys a number of copies of
„The Computer Journal“ each Sunday for 25 Cents to sell
them during the following week for 75 Cents. He kept track
of the demand (actual sales plus unsatisfied requests) over
the past 52 weeks:
15 19 9 12 9 22 4 7 8 11
14 11 6 11 9 18 10 0 14 12
8 9 5 4 4 17 18 14 15 8
6 7 12 15 15 19 9 10 9 16
8 11 11 18 15 17 19 14 14 17
13 12 5
The nature of randomness
• There is no obvious pattern, so a frequency histogram can
help: 7

5
Observed frequency

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22
Number of sales
6
The nature of randomness
• The histogram can now be used to estimate the probability that the
number of copies of the journal sold in any week is a specific value.
• These estimates are obtained by dividing the number of times a
demand occurrence was observed during the year by 52.
2
𝑃𝑃 𝑑𝑑 = 10 = = 0.0385
52
5
𝑃𝑃 𝑑𝑑 = 15 = = 0.0962
52
1+0+0+0+3+1+2+2+4+6 19
𝑃𝑃 𝑑𝑑 ≤ 9 = = = 0.3654
52 52

7
The nature of randomness
• Such empirical probabilities have several drawbacks
»they require maintaining a record of the demand history of every
item – this can be costly and cumbersome
»the distribution must be expressed as individual probability for
each possible past value (23 in the previous example)
»computing optimal inventory policies with empirical distributions
is more difficult

8
The nature of randomness
• For these reasons, demand history is generally approximated
using a continuous distribution
»the form of the distribution is chosen depending on the history of
past demand and its ease of use
»in many cases, the normal distribution is chosen for this purpose
(it often models demand reasonably well and is very easy to use)
»the normal model, however, must be used with care as it admits
the possibility of negative values

9
The nature of randomness
• A normal distribution is determined by the mean 𝜇𝜇 and the
� and sample variance 𝑠𝑠 2 can
variance 𝜎𝜎 2 . The sample mean 𝐷𝐷
be estimated from past observations 𝐷𝐷1 , 𝐷𝐷2 , … , 𝐷𝐷𝑛𝑛 :
𝑛𝑛
1
� = � 𝐷𝐷𝑖𝑖
𝐷𝐷
𝑛𝑛
𝑖𝑖=1
𝑛𝑛
1
𝑠𝑠 2 = �
� 𝐷𝐷𝑖𝑖 − 𝐷𝐷 2
𝑛𝑛 − 1
𝑖𝑖=1

10
The nature of randomness
� = 11.7 and s = 4.74
• For our example, we obtain 𝐷𝐷
0.14

0.12

0.1
Relative frequency

0.08

0.06

0.04

0.02

0
-6 -4 -2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28
Number of sales
11
The nature of randomness
• Exponential smoothing used to update the estimates after
observing the new values in period 𝑡𝑡. The standard deviation is
estimated using the mean absolute deviation (MAD):

�𝑡𝑡−1
�𝑡𝑡 = 𝛼𝛼𝐷𝐷𝑡𝑡 + 1 − 𝛼𝛼 𝐷𝐷
𝐷𝐷

�𝑡𝑡−1 + 1 − 𝛼𝛼 𝑀𝑀𝑀𝑀𝑀𝑀𝑡𝑡−1
𝑀𝑀𝑀𝑀𝑀𝑀𝑡𝑡 = 𝛼𝛼 𝐷𝐷𝑡𝑡 − 𝐷𝐷

• For normally distributed demand, 𝜎𝜎𝑡𝑡 ≈ 1.25𝑀𝑀𝑀𝑀𝑀𝑀𝑡𝑡

• 𝛼𝛼 = 0.1 is generally used to ensure stability in the estimates

12
The optimization criterion
• Generally, optimization in production problems means finding a
control rule that minimizes costs. When demand is random, the
cost incurred is random itself.
• Almost all optimization techniques applied to inventory control
assume that the goal is to minimize expected costs as inventory
control problems are generally ongoing (i.e., decisions are made
repetitively).
• The law of large numbers says that the average of many
observations of a random variable will converge to the expected
value of that random variable.

13
The newsvendor model
The newsvendor model
• How many copies of the journal should Mac buy, if unsold
copies can be returned to his supplier for 10 Cents?
»An obvious solution would be to buy enough to satisfy the mean
demand of approximately 12 copies.
»But there is a higher penalty on not having enough copies than on
having too many copies:
25 Cents – 10 Cents = 15 Cents for each unsold copy
75 Cents – 25 Cents = 50 Cents for each unit of unmet demand
»Intuition tells us to buy more than the mean – but how much?

15
The newsvendor model
• Generally, the newsvendor model consists of a single product
» that is ordered once at the beginning of a period and
» that can be used only to satisfy the demand during that period
• All relevant costs can be determined based on the final inventory
» 𝑐𝑐𝑜𝑜 … “overage costs” per unit of positive remaining inventory
» 𝑐𝑐𝑢𝑢 … ”underage costs” per unit of unsatisfied demand
• Demand 𝐷𝐷 is a continuous nonnegative random variable with
density function 𝑓𝑓 𝑥𝑥 and cumulative distribution function 𝐹𝐹 𝑥𝑥
• Objective is to determine the optimal number of units 𝑄𝑄∗ to
minimize the expected costs incurred at the end of the period

16
The newsvendor model
• The optimal number of units has to satisfy a critical ratio,
which is the probability of satisfying all the weekly demand:
∗
𝑐𝑐𝑢𝑢
𝐹𝐹 𝑄𝑄 =
𝑐𝑐𝑜𝑜 + 𝑐𝑐𝑢𝑢
• The actual number of units 𝑄𝑄 ∗ can be determined as follows
𝑄𝑄 ∗ = 𝜎𝜎𝜎𝜎 + 𝜇𝜇
• The value 𝑧𝑧 can be found in a Table for the normal
distribution (e.g., Table A-4 in the text book)

17
The newsvendor model - Example
• How many copies of the journal should Mac buy, if unsold copies can
be returned to his supplier for 10 Cents?
𝑐𝑐𝑜𝑜 = 0.25€ − 0.10€ = 0.15€

𝑐𝑐𝑢𝑢 = 0.75€ − 0.25€ = 0.50€

𝑐𝑐𝑢𝑢 0.50€
= = 0.77
𝑐𝑐𝑜𝑜 + 𝑐𝑐𝑢𝑢 0.15€ + 0.50€

𝐹𝐹 𝑧𝑧 = 0.77 → 𝑧𝑧 = 0.74

Q∗ = 𝜎𝜎𝜎𝜎 + 𝜇𝜇 = 4.74 � 0.74 + 11.73 = 15.24 ≈ 15 units

18
The newsvendor model – discrete demand
• In some cases – especially if the observed mean demand is
small – it may not be possible to obtain an accurate
representation of the observed pattern of demand using a
continuous function.
• The solution process is similar to the one with continuous
demand function
»determine the critical ratio
»find the value of 𝑄𝑄 that corresponds to the first value of 𝐹𝐹 𝑄𝑄 that
is larger than the critical ratio

19
The newsvendor model - Example
• How many copies of the journal should Mac buy, if unsold
copies can be returned to his supplier for 10 Cents?
𝑸𝑸 𝒇𝒇(𝑸𝑸) 𝑭𝑭(𝑸𝑸) 𝑸𝑸 𝒇𝒇(𝑸𝑸) 𝑭𝑭(𝑸𝑸)
0 1/52 0.0192 12 4/52 0.5769
𝑐𝑐𝑢𝑢
= 0.77 1 0 0.0192 13 1/52 0.5962
𝑐𝑐𝑜𝑜 + 𝑐𝑐𝑢𝑢 2 0 0.0192 14 5/52 0.6923
3 0 0.0192 15 5/52 0.7885
4 3/52 0.0769 16 1/52 0.8077
5 1/52 0.0962 17 3/52 0.8654
6 2/52 0.1346 18 3/52 0.9231
7 2/52 0.1731 19 3/52 0.9808
8 4/52 0.2500 20 0 0.9808
9 6/52 0.3654 21 0 0.9808
10 2/52 0.4038 22 1/52 1.000
11 5/52 0.5000 20
The newsvendor model – existing inventory
• Special case: existing starting inventory 𝑢𝑢 > 0
» Given that the target inventory should still be 𝑄𝑄 ∗ in order to minimize the
expected costs, an existing positive initial inventory reduces the optimal
order size
» So we should order
𝑄𝑄∗ − 𝑢𝑢 if 𝑢𝑢 < 𝑄𝑄∗
0 if 𝑢𝑢 ≥ 𝑄𝑄∗
» 𝑄𝑄∗ should be interpreted as an order-up-to point rather than the order
quantity if 𝑢𝑢 > 0 (a.k.a. target stock level or base stock level)
» This only applies for products with a shelf-life that exceeds one period

21
Lot size-reorder point systems
Lot size-reorder point systems
• Extending the newsvendor model to multiple periods would
assume that there is no setup cost for placing an order and
that there is no positive lead time – both is rather unrealistic
»So can the EOQ model be modified, to allow for random demand?
»The optimal solution for the EOQ model with positive lead time
was, to place an order of 𝑄𝑄 units when the level of on-hand
inventory hits 𝑅𝑅.

23
Lot size-reorder point systems
• We make the following assumptions
» The inventory is continuously reviewed and demands are recorded as
they occur
» Demand is random and stationary (i.e., we cannot predict the value of
demand, but the expected value of demand 𝜆𝜆 is constant over any fixed
length time interval)
» There is a fixed positive lead time 𝜏𝜏 for placing an order
» The following costs are assumed:
• 𝐾𝐾 … setup costs per order
• ℎ … holding costs per unit of product and per unit of time
• 𝑐𝑐 … proportional order costs per item
• 𝑝𝑝 … stock-out costs per unit of unsatisfied demand

24
Lot size-reorder point systems
• Describing demand
»In the newsvendor model the demand during one period was
relevant, as this defined the final inventory level. Here, the
demand during the reorder lead time is the relevant variable.
• Decision variables
»The lot size 𝑄𝑄 and the reorder level 𝑅𝑅 have to be determined
»Unlike in the EOQ model, these two variables are independent
»An order of 𝑄𝑄 units is placed when the level of on-hand inventory
reaches 𝑅𝑅 and arrives 𝜏𝜏 units of time later

25
Lot size-reorder point systems

Inventory

𝑅𝑅
𝑄𝑄

order order Time

placed arrives
26
Lot size-reorder point systems

expected inventory level

𝑄𝑄 Slope = −𝜆𝜆

𝑄𝑄
𝑠𝑠 𝑇𝑇 =
𝜆𝜆

Time

27
Lot size-reorder point systems
• Holding costs
»Mean rate of demand is 𝜆𝜆 units per year, expected inventory varies
linearly between 𝑠𝑠 and 𝑠𝑠 + 𝑄𝑄
»We call 𝑠𝑠 the safety stock (i.e., the expected level of on-hand
inventory just before an order arrives)
»Estimated holding costs:
𝑄𝑄 𝑄𝑄
ℎ 𝑠𝑠 + = ℎ 𝑅𝑅 − 𝜆𝜆𝜆𝜆 +
2 2

28
Lot size-reorder point systems
• Setup costs
»The expected cycle length 𝑇𝑇 is the expected time between the
arrival of successive orders of size 𝑄𝑄
»Setup costs are incurred exactly once each cycle
»As 𝑇𝑇 = 𝑄𝑄/𝜆𝜆, the average setup cost incurred per unit time is
𝐾𝐾 𝐾𝐾𝐾𝐾
=
𝑇𝑇 𝑄𝑄

29
Lot size-reorder point systems
• Penalty costs
» The system is only exposed to shortages between the time an order is
placed and the time that it arrives (the lead time)
» The number of units of excess demand is the amount by which the
demand over the lead time, 𝐷𝐷, exceeds the reorder level 𝑅𝑅
» The expected number of shortages that occur per cycle is
∞
𝑛𝑛 𝑅𝑅 = 𝐸𝐸 max 𝐷𝐷 − 𝑅𝑅, 0 =� 𝑥𝑥 − 𝑅𝑅 𝑓𝑓 𝑥𝑥 𝑑𝑑𝑑𝑑
𝑅𝑅
» The expected number of shortages per unit of time that is penalized with
a cost factor 𝑝𝑝 is thus:
𝑛𝑛 𝑅𝑅 𝜆𝜆𝜆𝜆 𝑅𝑅
𝑝𝑝 = 𝑝𝑝
𝑇𝑇 𝑄𝑄

30
Lot size-reorder point systems
• The total cost function
»The expected average annual cost is therefore
𝑄𝑄 𝐾𝐾𝐾𝐾 𝑝𝑝𝑝𝑝𝑝𝑝 𝑅𝑅
𝐺𝐺 𝑄𝑄, 𝑅𝑅 = ℎ + 𝑅𝑅 − 𝜆𝜆𝜆𝜆 + +
2 𝑄𝑄 𝑄𝑄
»The objective is to choose 𝑄𝑄 and 𝑅𝑅 such that 𝐺𝐺 𝑄𝑄, 𝑅𝑅 is minimal
»When demand is normally distributed, 𝑛𝑛 𝑅𝑅 is computed using the
standardized loss function
𝑅𝑅 − 𝜇𝜇
𝑛𝑛 𝑅𝑅 = 𝜎𝜎𝜎𝜎 = 𝜎𝜎𝜎𝜎 𝑧𝑧
𝜎𝜎

31
Lot size-reorder point systems
• Solution process (given a tolerance Δ, e.g., Δ = 1)
2𝐾𝐾𝐾𝐾
1. Start with the EOQ solution 𝑄𝑄0 = and determine 𝑅𝑅0 using
ℎ
𝑄𝑄0 ℎ
1 − 𝐹𝐹 𝑅𝑅0 = → find 𝑧𝑧 from table → 𝑅𝑅0 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇
𝑝𝑝𝑝𝑝
2. Use 𝑧𝑧 to find 𝐿𝐿 𝑧𝑧 , calculate 𝑛𝑛 𝑅𝑅𝑛𝑛−1 , and find
2𝜆𝜆 𝐾𝐾+𝑝𝑝𝑝𝑝 𝑅𝑅𝑛𝑛−1 𝑄𝑄𝑛𝑛 ℎ
𝑄𝑄𝑛𝑛 = and 1 − 𝐹𝐹 𝑅𝑅𝑛𝑛 = → 𝑅𝑅𝑛𝑛 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇
ℎ 𝑝𝑝𝑝𝑝
3. Repeat step 2 as long as
𝑄𝑄𝑛𝑛 − 𝑄𝑄𝑛𝑛−1 > Δ or 𝑅𝑅𝑛𝑛 − 𝑅𝑅𝑛𝑛−1 > Δ

32
Lot size-reorder point systems - Example
• Harvey’s Specialty Shop
»10$ cost per jar of mustard
»6 months lead time
»20% annual interest rate for holding costs
»$25 loss of goodwill cost per jar
»50$ cost for placing an order
»Demand during lead time is normally distributed with
𝜇𝜇 = 100 and 𝜎𝜎 = 25
»What are the optimal values for 𝑄𝑄 and 𝑅𝑅 if Δ = 1?

33
Lot size-reorder point systems - Example
• Mean annual demand is 𝜆𝜆 = 2𝜇𝜇 = 200
• Step 1:
2𝐾𝐾𝐾𝐾 2 � 50 � 200
𝑄𝑄0 = 𝐸𝐸𝐸𝐸𝐸𝐸 = = = 100
ℎ 0.2 � 10

𝑄𝑄0 ℎ 100 � 2
1 − 𝐹𝐹 𝑅𝑅0 = = = 0.04 → 𝑧𝑧 = 1.76
𝑝𝑝𝑝𝑝 25 � 200

𝑅𝑅0 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇 = 25 � 1.76 + 100 = 144

34
Lot size-reorder point systems - Example
• Step 2:
𝐿𝐿 𝑧𝑧 = 0.0158 → 𝑛𝑛 𝑅𝑅0 = 𝜎𝜎𝜎𝜎 𝑧𝑧 = 25 � 0.0158 = 0.395

2𝜆𝜆 𝐾𝐾 + 𝑝𝑝𝑝𝑝 𝑅𝑅0 2 � 200 � 50 + 25 � 0.395

𝑄𝑄1 = = = 109.43 ≈ 109
ℎ 2

𝑄𝑄1 ℎ 109 � 2
1 − 𝐹𝐹 𝑅𝑅1 = = = 0.0436 → 𝑧𝑧 = 1.71
𝑝𝑝𝑝𝑝 25 � 200

𝑅𝑅1 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇 = 25 � 1.71 + 100 = 142.75 ≈ 143

𝑄𝑄1 − 𝑄𝑄0 > 1  Repeat step 2

35
Lot size-reorder point systems - Example
• Step 2:
𝐿𝐿 𝑧𝑧 = 0.0178 → 𝑛𝑛 𝑅𝑅1 = 𝜎𝜎𝜎𝜎 𝑧𝑧 = 25 � 0.0178 = 0.445

2𝜆𝜆 𝐾𝐾 + 𝑝𝑝𝑝𝑝 𝑅𝑅1 2 � 200 � 50 + 25 � 0.445

𝑄𝑄2 = = = 110.567 ≈ 111
ℎ 2

𝑄𝑄2 ℎ 111 � 2
1 − 𝐹𝐹 𝑅𝑅2 = = = 0.0444 → 𝑧𝑧 = 1.71
𝑝𝑝𝑝𝑝 25 � 200

𝑅𝑅2 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇 = 25 � 1.71 + 100 = 142.75 ≈ 143

𝑄𝑄2 − 𝑄𝑄1 > 1  Repeat step 2

36
Lot size-reorder point systems - Example
• Step 2:
𝐿𝐿 𝑧𝑧 = 0.0178 → 𝑛𝑛 𝑅𝑅2 = 𝜎𝜎𝜎𝜎 𝑧𝑧 = 25 � 0.0178 = 0.445

2𝜆𝜆 𝐾𝐾 + 𝑝𝑝𝑝𝑝 𝑅𝑅2 2 � 200 � 50 + 25 � 0.445

𝑄𝑄3 = = = 110.567 ≈ 111
ℎ 2

𝑄𝑄3 ℎ 111 � 2
1 − 𝐹𝐹 𝑅𝑅3 = = = 0.0444 → 𝑧𝑧 = 1.71
𝑝𝑝𝑝𝑝 25 � 200

𝑅𝑅3 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇 = 25 � 1.71 + 100 = 142.75 ≈ 143

𝑄𝑄3 − 𝑄𝑄2 ≤ 1 and 𝑅𝑅3 − 𝑅𝑅2 ≤ 1  Stop

37
Service levels in (Q, R) systems
Service levels in (Q, R) systems
• Type 1 service level 𝛼𝛼
»The probability of not stocking out in the lead time
»Appropriate only when a shortage occurrence has the same
consequence independent of its time or amount (e.g., a
production line is stopped whether 1 or 100 units are short)
»Optimal solution:
• Determine 𝑅𝑅 to satisfy 𝐹𝐹 𝑅𝑅 = 𝛼𝛼
• Set 𝑄𝑄 = 𝐸𝐸𝐸𝐸𝐸𝐸

39
Service levels in (Q, R) systems
• Type 2 service level 𝛽𝛽
»The proportion of demands that are met from stock
»Also known as “fill rate” – this is what most managers generally
mean by service
»EOQ is not optimal in this case, but usually gives good results:
• Set 𝑄𝑄 = 𝐸𝐸𝐸𝐸𝐸𝐸
• Determine 𝑅𝑅 such that 𝑛𝑛 𝑅𝑅 = 1 − 𝛽𝛽 𝑄𝑄

40
Service levels in (Q, R) systems - Example
• Harvey’s Specialty Shop
»What are the optimal values for 𝑄𝑄 and 𝑅𝑅 if 𝛼𝛼 = 0.98?

𝐹𝐹 𝑅𝑅 = 0.98 → 𝑧𝑧 = 2.06 → 𝑅𝑅 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇 ≈ 152

2𝐾𝐾𝐾𝐾 2 � 50 � 200
Q= = = 100
ℎ 0.2 � 10

41
Service levels in (Q, R) systems - Example
• Harvey’s Specialty Shop
» What are approximate values for 𝑄𝑄 and 𝑅𝑅 if 𝛽𝛽 = 0.98?

𝑛𝑛 𝑅𝑅 = 1 − 𝛽𝛽 𝑄𝑄

→ 𝐿𝐿 𝑧𝑧 � 𝜎𝜎 = 1 − 𝛽𝛽 𝑄𝑄

1 − 𝛽𝛽 𝑄𝑄 1 − 0.98 � 100
→ 𝐿𝐿 𝑧𝑧 = = = 0.08 → 𝑧𝑧 = 1.03
𝜎𝜎 25

𝑅𝑅 = 𝑧𝑧𝑧𝑧 + 𝜇𝜇 ≈ 126

42
Service levels in (Q, R) systems
• Optimal policy for β service level: Service Level Order Quantity (SOQ)
2𝐾𝐾𝐾𝐾
1. Start with the EOQ solution 𝑄𝑄0 = and determine 𝑛𝑛 𝑅𝑅0 = 1 − 𝛽𝛽 𝑄𝑄0
ℎ
to find 𝑧𝑧 and 𝑅𝑅0 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇
2. Use 𝑧𝑧 to find 𝐿𝐿 𝑧𝑧 , calculate 𝑛𝑛 𝑅𝑅𝑛𝑛−1 , and find
2
𝑛𝑛 𝑅𝑅𝑛𝑛−1 2𝐾𝐾𝐾𝐾 𝑛𝑛 𝑅𝑅𝑛𝑛−1
𝑄𝑄𝑛𝑛 = + +
1 − 𝐹𝐹 𝑅𝑅𝑛𝑛−1 ℎ 1 − 𝐹𝐹 𝑅𝑅𝑛𝑛−1
1 − 𝛽𝛽 𝑄𝑄𝑛𝑛
𝑛𝑛 𝑅𝑅𝑛𝑛 = 1 − 𝛽𝛽 𝑄𝑄𝑛𝑛 → 𝐿𝐿 𝑧𝑧 = → 𝑅𝑅𝑛𝑛 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇
𝜎𝜎
3. Repeat step 2 as long as
𝑄𝑄𝑛𝑛 − 𝑄𝑄𝑛𝑛−1 > Δ or 𝑅𝑅𝑛𝑛 − 𝑅𝑅𝑛𝑛−1 > Δ

43
Service levels in (Q, R) systems - Example
• Harvey’s Specialty Shop
» What are the optimal values for 𝑄𝑄 and 𝑅𝑅 if 𝛽𝛽 = 0.98 and Δ = 1?
» Iteration 1:
Q0 = 100, 𝑅𝑅0 = 126
𝑛𝑛 𝑅𝑅0 = 1 − 𝛽𝛽 𝑄𝑄0 = 0.02 � 100 = 2
2
𝑛𝑛 𝑅𝑅0 = 𝜎𝜎𝜎𝜎 𝑧𝑧 → 𝐿𝐿 𝑧𝑧 = = 0.08 → 𝑧𝑧 = 1.03 → 1 − 𝐹𝐹 𝑅𝑅0 = 0.1515
25
2
2 2
2
𝑄𝑄1 = + 100 + ≈ 114
0.1515 0.1515
1 − 𝛽𝛽 𝑄𝑄1
𝐿𝐿 𝑧𝑧 = = 0.0912 → 𝑧𝑧 = 0.96 → 𝑅𝑅𝑛𝑛 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇 = 124
𝜎𝜎

44
Service levels in (Q, R) systems - Example
• Harvey’s Specialty Shop
» Iteration 2:
Q1 = 114, 𝑅𝑅1 = 124
𝑛𝑛 𝑅𝑅1 = 1 − 𝛽𝛽 𝑄𝑄1 = 0.02 � 114 = 2.28
𝑧𝑧 = 0.96 → 1 − 𝐹𝐹 𝑅𝑅1 = 0.1685
2
2.28 2
2.28
𝑄𝑄2 = + 100 + ≈ 114
0.1685 0.1685
1 − 𝛽𝛽 𝑄𝑄2
𝐿𝐿 𝑧𝑧 = = 0.0912 → 𝑧𝑧 = 0.96 → 𝑅𝑅𝑛𝑛 = 𝜎𝜎𝜎𝜎 + 𝜇𝜇 = 124
𝜎𝜎
𝑄𝑄𝑛𝑛 − 𝑄𝑄𝑛𝑛−1 ≤ Δ and 𝑅𝑅𝑛𝑛 − 𝑅𝑅𝑛𝑛−1 ≤ Δ Stop

45
Service levels in (Q, R) systems
• Imputed shortage costs
»Each solution for (𝑄𝑄, 𝑅𝑅) found using a service level implies a
certain value for the shortage costs 𝑝𝑝
𝑄𝑄𝑄 𝑄𝑄𝑄
»Given that 1 − 𝐹𝐹 𝑅𝑅 = , we see that 𝑝𝑝 =
𝑝𝑝𝑝𝑝 𝜆𝜆 1−𝐹𝐹 𝑅𝑅
»This imputed shortage cost is a useful way to determine, if the
chosen value for the service level is appropriate

46
Service levels in (Q, R) systems - Example
• Harvey’s Specialty Shop
»For 𝛼𝛼 = 0.98, we found 𝑄𝑄, 𝑅𝑅 = 100, 152
𝑄𝑄𝑄 100 0.2 � 10
𝑝𝑝 = = = 50$
𝜆𝜆 1 − 𝐹𝐹 𝑅𝑅 200 � 0.02

»For 𝛽𝛽 = 0.98, we found 𝑄𝑄, 𝑅𝑅 = 114, 124

𝑄𝑄𝑄 114 0.2 � 10
𝑝𝑝 = = ≈ 6.77$
𝜆𝜆 1 − 𝐹𝐹 𝑅𝑅 200 � 0.1685

47
Multi product systems:
ABC analysis
ABC analysis
• There is a trade-off between the cost of implementing an
inventory control system and the potential benefits it brings
• Not all products are equally profitable – control costs may be
justified in some cases, but not in others
• It is important to differentiate profitable from unprofitable
items – a large proportion of the total dollar volume of sales
is often accounted for by a small number of inventory items

49
ABC analysis
• Assume that items are ranked in decreasing order of the
value of annual sales. Then the cumulative value of sales
generally looks like this:
1
95% 0.9
80% 0.8
0.7
Cumulative fraction of

0.6
value of inventory

0.5
0.4
0.3
0.2 A B C
0.1
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Proportion of inventory items
20% 50% 50
ABC analysis
• Typical situation:
»A: the top 20% of the items account for about 80% of the volume
»B: the next 30% of the items for the next 15% of sales volume
»C: the last 50% of the items for the last 5% of the sales volume
• These figures are only approximate and vary from system to
system
• If required, a finer distinction can be obtained using 4 or
more groups

51
ABC analysis
• A items
»account for the largest share of the yearly revenue
»inventory levels should be monitored continuously
»more sophisticated forecasting procedures might be used
»more care should be taken in the estimation of the various
parameters required in calculating operating policies

52
ABC analysis
• B items
»also account for a large share of the yearly revenue
»inventory levels could be reviewed periodically
»items could be ordered in groups rather than individually
»slightly less sophisticated forecasting methods could be used

53
ABC analysis
• C items
»account for a very small share of the yearly revenue
»the minimum degree of control should be applied to C items
»very cheap items with moderate demand should be ordered in
large lot sizes to minimize ordering frequency
»expensive C items with very low demand should generally not be
kept in inventory but ordered when demanded

54
ABC analysis- Example
• Harvey’s Specialty Shop
Part # Price ($) Yearly demand Volume $
5497J 2.25 260 585.00
3K62 2.85 43 122.55
88450 1.50 21 31.50
P001 0.77 388 298.76
2M993 4.45 612 2,723.40
4040 6.10 220 1,342.00
W76 3.10 110 341.00
JJ335 1.32 786 1,037.52
R077 12.80 14 179.20
70779 24.99 334 8,346.66
4J65E 7.75 24 186.00
334Y 0.68 77 52.36
8ST4 0.25 56 14.00
16113 3.89 89 346.21
45000 7.70 675 5,197.50
7878 6.22 66 410.52
6193L 0.85 148 125.80
TTR77 0.77 690 531.30
39SS5 1.23 52 63.96
93939 4.05 12 48.60
55
ABC analysis- Example
• Harvey’s Specialty Shop
Part # Price ($) Yearly demand Volume $ Cumulative Volume $
70779 24.99 334 8,346.66 8,346.66 A items:
45000 7.70 675 5,197.50 13,544.16 20% of items account for
2M993 4.45 612 2,723.40 16,267.56
80.1% of total value
4040 6.10 220 1,342.00 17,609.56
JJ335 1.32 786 1,037.52 18,647.08 B items:
5497J 2.25 260 585.00 19,232.08
TTR77 0.77 690 531.30 19,763.38
30% of items account for
7878 6.22 66 410.52 20,173.90 14.8% of total value
16113 3.89 89 346.21 20,520.11
W76 3.10 110 341.00 20,861.11
P001 0.77 388 298.76 21,159.87 C items:
4J65E 7.75 24 186.00 21,345.87
50% of items account for
R077 12.8 14 179.20 21,525.07
6193L 0.85 148 125.80 21,650.87 5.1% of total value
3K62 2.85 43 122.55 21,773.42
39SS5 1.23 52 63.96 21,837.38
334Y 0.68 77 52.36 21,889.74
93939 4.05 12 48.60 21,938.34
88450 1.50 21 31.50 21,969.84
8ST4 0.25 56 14.00 21,983.84
56