CHAPTER 2:

INVENTORY MANAGEMENT AND RISK POOLING

Stef Lemmens
WEEK 2

RSM - a force for positive change

Introduction to Inventory
Stef Lemmens

RSM - a force for positive change

Types of inventory

INPUTS TRANSFORMATIONS OUTPUTS

Vendors
Distributors
Purchasing
Shipping
Raw Materials Customers

Conversion
Processes Customers

Customers

FGI Warehouse
Receiving
Inventory

WIP
Why do we hold inventory?

1. to hedge against uncertainty in supply and demand

2. to make use of economies of scale
3. to hedge against lead time
4. because of capacity limitations
Inventory Cost structure

• Order cost (straightforward computation)

- product cost
- transportation cost
• Holding cost (straightforward computation)
- capital tied up
- physical cost: warehouse space, storage tax, insurance, breakage, spoilage
• Component devaluation cost (life cycle dependent)
• Obsolescence costs (FG inventory + components in the pipeline +
probable discount/marketing)
• Out-of-stock cost (difficult to estimate)
Stock out versus obsolescence
Percentage of
manufacturer’s selling price
Tendency to overstock
Balancing act
Tendency to understock

100

Cost of stock outs (%)

75

Where in this box would

50
you position the labels?
25

0
10 20 30
Cost of obsolescence (%)
Inventory control policies

• Decisions:
- how often should the inventory status be checked?
- when to place a replenishment order? (herbevoorrading)
- how large should the order size be?

• Objective:
- minimize total inventory costs while meeting a certain service level

• Service level:
- cycle service level (P1) = fraction of replenishment cycles with no stock out
- fill rate (P2) = fraction of demand satisfied from stock on hand
CSL and FR: the difference

inventory

A) CSL is 0%
FR is almost 100%

time
0 1 2 3
inventory

time
CSL is 0%
B) FR is almost 0%

0 1 2 3
CSL higher than FL

inventory

0 1 2 3

time
Economic Lot Size Model
Stef Lemmens

RSM - a force for positive change

The Setting

• demand is known and constant at a rate of D items / time unit

• order quantity is fixed at Q items per order
• fixed order cost K per order
• inventory holding cost h per unit
• inventory is received instantaneous
• no discounts
• no stock outs
Economic lot size

Total cost = holding cost + fixed order cost

Q
Holding cost = ℎ
2

Order cost = K *N (with N = D/Q)

hQ KD
Total cost = +
2 Q

Note that T = 1/N

How should we
determine Q?

T = Cycle time Q = Order quantity

K = Ordering costs D = Demand
h = holding costs
Economic lot size

Total cost = holding cost + fixed order cost

Q
Holding cost = ℎ
2

Order cost = K *N (with N = D/Q)

hQ KD
Total cost = + Take the derivative w.r.t. Q
2 Q
KD h
Note that T = 1/N − 2+ =0
How Q 2 we
should
determine Q?

T = Cycle time Q = Order quantity 2KD

Q∗ =
K = Ordering costs D = Demand h
h = holding costs
Example - Economic lot size model

Consider a hardware supply warehouse that made a demand forecast for a

cleaning product of 1,125 units per week. Each time the warehouse places
an order for these items from its supplier, an ordering and transportation fee
of $20 is charged to the warehouse. The warehouse pays $1 for each
product. The annual holding cost is 25 percent of the inventory value. The
warehouse manager would like to know how much to order when the
inventory is zero.
Assume that one year consists of 50 weeks, and the items are delivered
immediately to the warehouse.
2KD
remember from the previous slide: Q∗ =
h
Example - Economic lot size model

• D = 1,125 × 50 = 56,250 per year

• K = $20
• h = $0.25 per item per year

2KD 2 × 20 × 56,250
Q∗= = = 3,000 units
h 0.25
Example - Economic lot size model

• D = 1,125 × 50 = 56,250 per year 2000

inventory cost ($)

total cost
1600
• K = $20
1200
• h = $0.25 per item per year
800 holding cost
• Q* = 3000 units 400 order cost

0
0 2000 4000 6000 8000 10000
• What are the average costs? Q∗
C(Q) = order cost + holding cost order size Q
KD hQ
= +
Q 2
20 × 56,250 0.25 × 3,000
= +
3,000 2
= 375 + 375 = $750
Economic lot size – sensitivity

• If you order Q’ rather than Q*, the relative cost increase equals
C(Q′) 1 Q′ Q∗
= +
C(Q∗ ) 2 Q∗ Q′

• If you take b% of your order size, the relative cost increase equals
C(bQ∗) 1 bQ∗ Q∗ 1 1
= + = b +
C(Q∗ ) 2 Q∗ bQ∗ 2 b

EOQ is very robust  is used when demand is stochastic

Newsvendor Model

RSM - a force for positive change

Single period model

• Selling Christmas trees

• Cost per tree: $45

• Sales price: $80
• Loss of goodwill: $10
• Salvage price: $25
Single period model

• Selling Christmas trees

$600 profit (Q=80)

sell 40 units with a profit of $80 - $45 = $35

remain 40 units with a profit of $25 - $45 = $-20
Single period model

• Selling Christmas trees

$600 $1,700 $2,800 $2,600 $2,400 $2,200 $2,000 profit (Q=80)

sell 80 units with a profit of $80 - $45 = $35

shortage 80 units with a loss of goodwill $-10
Single period model

• Selling Christmas trees

$600 $1,700 $2,800 $2,600 $2,400 $2,200 $2,000 $2,357

EXPECTED VALUE = 0.04 × $600 + 0.11 × $1,700 + …

Single period model

• Selling Christmas trees

VERY TEDIOUS
APPROACH

$600 $1,700 $2,800 $2,600 $2,400 $2,200 $2,000 $2,357 : profit (Q=80)
$200 $1,300 $2,400 $3,500 $3,300 $3,100 $2,900 $2,789 : profit (Q=100)
$-200 $900 $2,000 $3,100 $4,200 $4,000 $3,800 $2,857 : profit (Q=120)
$-600 $500 $1,600 $2,700 $3,800 $4,900 $4,700 $2,626 : profit (Q=140)
Single period model

Notation
• c = variable cost per unit
• p = selling price per unit
• v = salvage value per unit
• s = shortage penalty cost per unit
• D = demand  random variable -> F(D)
• Q = order quantity  decision variable = we need to determine Q

• Single selling period

• Only 1 ordering option
Single period model

AFTER we chose Q, what are the possible outcomes?

1. Q was not enough  there was more demand than Q

2. Q was exactly equal to the demand, none too much, none too less

3. Q was too much  there are leftovers

Single period model – Marginal Cost

Marginal costs:
• 𝐶𝐶𝑢𝑢 = cost of underage (shortage) =
= sales price per unit − cost per unit + penalty cost (if any)
= 𝑝𝑝 − 𝑐𝑐 + 𝑠𝑠
• 𝐶𝐶𝑜𝑜 = cost of overage (overstocking) =
= cost per unit − salvage value per unit (if any)
= 𝑐𝑐 − v
Single period model – The optimal solution

(Cycle) Service level = probability of not stocking out

𝐶𝐶𝑢𝑢 𝑝𝑝 − 𝑐𝑐 + 𝑠𝑠
𝑃𝑃 𝐷𝐷 ≤ 𝑄𝑄 = =
𝐶𝐶𝑢𝑢 + 𝐶𝐶𝑜𝑜 𝑝𝑝 − 𝑣𝑣 + 𝑠𝑠

with 𝐶𝐶𝑢𝑢 = 𝑝𝑝 − 𝑐𝑐 + 𝑠𝑠 and 𝐶𝐶𝑜𝑜 = 𝑐𝑐 − 𝑣𝑣

What happens if 𝐶𝐶𝑢𝑢 increases?

What happens if 𝐶𝐶𝑜𝑜 increases?
Single period model – determine Q

Selling Christmas trees (continued)

• Cost per tree (c) : $45 𝑝𝑝 − 𝑐𝑐 + 𝑠𝑠

𝑃𝑃(𝐷𝐷 ≤ 𝑄𝑄) =
• Sales price (p) : $80 𝑝𝑝 − 𝑣𝑣 + 𝑠𝑠
• Loss of goodwill (s) : $10 = 0.6923
• Salvage price (v) : $25 𝑸𝑸∗ = 𝟏𝟏𝟏𝟏𝟏𝟏 units
Optimal Q for Normally distributed demand

• All normal distributions (ND’s) are characterized by two parameters,

mean = 𝜇𝜇 and standard deviation = 𝜎𝜎
• All ND’s are related to the standard normal 𝒁𝒁 with 𝜇𝜇 = 0 and 𝜎𝜎 = 1
Recipe:
𝑢𝑢 𝐶𝐶
1. Compute P(D ≤ Q) = 𝐶𝐶 +
𝑢𝑢 𝐶𝐶𝑜𝑜
2. Look up the Z-value for the outcome of 𝑃𝑃(𝐷𝐷 ≤ 𝑄𝑄) for the Standard Normal
Distribution
3. Transform to Normal with 𝑄𝑄 = 𝜇𝜇 + 𝑍𝑍 � 𝜎𝜎

𝑄𝑄−𝜇𝜇
(because 𝑃𝑃 𝐷𝐷 ≤ 𝑄𝑄 = 𝑃𝑃 𝜇𝜇 + 𝑍𝑍 ⋅ 𝜎𝜎 ≤ 𝑄𝑄 = 𝑃𝑃 𝑍𝑍 ≤
𝜎𝜎
Look-up table standard normal distributions
z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
The Q for the “Normal” Christmas trees

1. Let 𝑄𝑄 be the order quantity, and 1. Q = ?, 𝜇𝜇 = 100, 𝜎𝜎 = 40

(𝜇𝜇, 𝜎𝜎) the parameters of the 2. P = 0.6923
normal demand forecast 𝐷𝐷. 3. Z=?
2. Compute 𝑃𝑃 𝐷𝐷 ≤ 𝑄𝑄 4.
3. Look up the Z score for the
outcome of 𝑃𝑃(𝐷𝐷 ≤ 𝑄𝑄) in the
Standard Normal Distribution
Function Table.
4. Set 𝑄𝑄 = 𝜇𝜇 + 𝑍𝑍 � 𝜎𝜎
Look-up table standard normal distributions
z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
The Q for the “Normal” Christmas trees

1. Let 𝑄𝑄 be the order quantity, and 1. Q = ?, 𝜇𝜇 = 100, 𝜎𝜎 = 40

(𝜇𝜇, 𝜎𝜎) the parameters of the 2. P = 0.6923
normal demand forecast 𝐷𝐷. 3. Z = 0.51
2. Compute 𝑃𝑃 𝐷𝐷 ≤ 𝑄𝑄 4. 𝑄𝑄 = 𝜇𝜇 + 𝑧𝑧 � 𝜎𝜎 = 100 +0.51 � 40 =
3. Look up the Z score for the 120.4
outcome of 𝑃𝑃(𝐷𝐷 ≤ 𝑄𝑄) in the
Standard Normal Distribution
Function Table.
4. Set 𝑄𝑄 = 𝜇𝜇 + 𝑍𝑍 � 𝜎𝜎
Multi-period models: R,Q Policy
Stef Lemmens

RSM - a force for positive change

Continuous (R,Q) policy

• When do you order if demand is deterministic?

• When do you order if demand is stochastic?

reorder point =
inventory level

average demand during lead

time
+ safety stock

reorder
point
R
pipeline stock

safety stock

L time
Safety Stock

R = expected demand during lead time + safety stock

(1-α)% area
of normal curve
inventory level

safety stock reorder

point
R
pipeline stock

safety stock

L time
Safety stock and Uncertainty

Expected demand is NOT actual demand. A non-zero standard deviation

means demand uncertainty. Hence, safety stock must have a direct relation
with STD.
(1-α)% area
of normal curve
inventory level

safety stock reorder

point
R
pipeline stock

safety stock

L time
Safety stock and Service Level

Safety stock is the tool to realize the required service level: that is why the
safety stock also needs to be in direct relation with the service level α

(1-α)% area
of normal curve
inventory level

safety stock reorder

point
R
pipeline stock

safety stock

L time
Determining the safety stock

So what do we have?
STD

safety stock
service level α

𝑹𝑹 = 𝝁𝝁𝑳𝑳 + 𝒛𝒛 × 𝝈𝝈𝑳𝑳 = 𝑨𝑨𝑨𝑨𝑨𝑨 × 𝑳𝑳 + 𝒛𝒛 × 𝑺𝑺𝑺𝑺𝑺𝑺 × 𝑳𝑳

safety stock = 𝒛𝒛 × 𝑺𝑺𝑺𝑺𝑺𝑺 × 𝑳𝑳

Summing random demand (scaling)
The mean (expected value, average) of the demand can be scaled ‘directly’:
𝐷𝐷 ⇒ 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝐷𝐷
“if the expected daily demand is 𝐷𝐷, then the expected weekly demand is 7 ∗ 𝐷𝐷”

The standard deviation of the demand can only be scaled ‘indirectly’:

𝑆𝑆𝑆𝑆𝑆𝑆 ⇒ 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 ⇒ 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 ⇒ 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑆𝑆𝑆𝑆𝑆𝑆

“if STD of the daily demand is 0,5, then STD of the weekly demand is 0,5* 7.”

• 𝜎𝜎 = Var ⟹ Var = 0,52 ⟹ 7 ∗ Var = 7 ∗ 0,52 ⟹ 7 ∗ 0,52 = 1,322

If demands are independent!

• Generally:
Back to continuous (R,Q) policy

Given is the service level 𝛼𝛼,

• the probability of stock-out during lead-time should be 1 − 𝛼𝛼.
• So, demand 𝑃𝑃(𝐷𝐷𝐿𝐿 ≤ 𝑅𝑅) ≥ 𝛼𝛼, where 𝐷𝐷𝐿𝐿 is 𝑁𝑁(𝜇𝜇𝐿𝐿 , 𝜎𝜎𝐿𝐿 )

𝑅𝑅−𝜇𝜇𝐿𝐿
𝑃𝑃 𝐷𝐷𝐿𝐿 ≤ 𝑅𝑅 = 𝑃𝑃 𝜇𝜇𝐿𝐿 + 𝑍𝑍 ⋅ 𝜎𝜎𝐿𝐿 ≤ 𝑅𝑅 = 𝑃𝑃 𝑍𝑍 ≤ ≥ 𝛼𝛼,
𝜎𝜎𝐿𝐿

⇒ 𝑅𝑅 ≥ 𝜇𝜇𝐿𝐿 + 𝑍𝑍 ⋅ 𝜎𝜎𝐿𝐿 ,
• where 𝑍𝑍 is the safety factor (Look up in the standard normal table)

If demand is normally distributed 𝑁𝑁(AVG, STD)

σ2 𝐿𝐿 = 𝑆𝑆𝑆𝑆𝑆𝑆2 × L and 𝜎𝜎𝐿𝐿 = STD × L
Example – Continuous (R,Q) policy

Consider again the hardware supply warehouse that wants to guarantee a

service level of 95% to its retail stores. The weekly demand of the stores follows
a normal distribution with an average of 1,445 units and a standard deviation of
300 units. The lead time of the supplier is 3.5 days. What should the reorder
level be?
remember from the previous slide: R = AVG × L + z × STD × L

• AVG = 1,445 units

• STD = 300 units
• L = 0.5 week
• Safety factor z = ? CSL = 95%
Look-up table standard normal distributions
z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
Example – Continuous (R,Q) policy

• AVG = 1,445 units

• STD = 300 units
• L = 0.5 week
• Safety factor z = 1.65 → found in look-up table
• R = AVG × L + z × STD × L
= 1,445 × 0.5 + 1.65 × 300 × 0.5
= 1,072.52 → always round up!
• The reorder level should be 1,073 units.
Continuous (R,Q) policy

R+Q
inventory level

reorder
point
R
pipeline
actual lead
stock
time
demand safety
stock
L t t+1 time
Q
average on-hand inventory: + z × STD × L
2
Continuous (R,Q) policy

Besides cycle service level, we can also consider the fill rate
inventory level

safety stock
reorder
point
R
pipeline stock

safety stock

L time
Continuous (R,Q) policy

expected shortage in a replenishment cycle

fill rate = 1 −
expected demand in a replenishment cycle
inventory level

safety stock
reorder
point
R
pipeline stock

safety stock

L time
Continuous (R,Q) policy

STD × L × L(z)
fill rate = 1 −
Q
inventory level

safety stock
reorder
point
R
pipeline stock

safety stock

L time
Example – Continuous (R,Q) policy

Consider again the hardware supply warehouse where R = 1,073 and Q =

3,400.

AVG = 1,445 units

STD = 300 units
L = 0.5 week
remember that R = AVG × L + z × STD × L
R − AVG × L
such that z=
STD × L
z = ??
L(z) = ??
Example – Continuous (R,Q) policy

Consider again the hardware supply warehouse where R = 1,073 and Q =

3,400.

AVG = 1,445 units

STD = 300 units
L = 0.5 week
remember that R = AVG × L + z × STD × L
R − AVG × L
such that z=
STD × L
z = 1.65
L(z) = ??
Look-up table standard normal distributions – L(z)
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.3989 0.3940 0.3890 0.3841 0.3793 0.3744 0.3697 0.3649 0.3602 0.3556
0.1 0.3509 0.3464 0.3418 0.3373 0.3328 0.3284 0.3240 0.3197 0.3154 0.3111
0.2 0.3069 0.3027 0.2986 0.2944 0.2904 0.2863 0.2824 0.2784 0.2745 0.2706
0.3 0.2668 0.2630 0.2592 0.2555 0.2518 0.2481 0.2445 0.2409 0.2374 0.2339
0.4 0.2304 0.2270 0.2236 0.2203 0.2169 0.2137 0.2104 0.2072 0.2040 0.2009
0.5 0.1978 0.1947 0.1917 0.1887 0.1857 0.1828 0.1799 0.1771 0.1742 0.1714
0.6 0.1687 0.1659 0.1633 0.1606 0.1580 0.1554 0.1528 0.1503 0.1478 0.1453
0.7 0.1429 0.1405 0.1381 0.1358 0.1334 0.1312 0.1289 0.1267 0.1245 0.1223
0.8 0.1202 0.1181 0.1160 0.1140 0.1120 0.1100 0.1080 0.1061 0.1042 0.1023
0.9 0.1004 0.0986 0.0968 0.0950 0.0933 0.0916 0.0899 0.0882 0.0865 0.0849
1.0 0.0833 0.0817 0.0802 0.0787 0.0772 0.0757 0.0742 0.0728 0.0714 0.0700
1.1 0.0686 0.0673 0.0659 0.0646 0.0634 0.0621 0.0609 0.0596 0.0584 0.0573
1.2 0.0561 0.0550 0.0538 0.0527 0.0517 0.0506 0.0495 0.0485 0.0475 0.0465
1.3 0.0455 0.0446 0.0436 0.0427 0.0418 0.0409 0.0400 0.0392 0.0383 0.0375
1.4 0.0367 0.0359 0.0351 0.0343 0.0336 0.0328 0.0321 0.0314 0.0307 0.0300
1.5 0.0293 0.0286 0.0280 0.0274 0.0267 0.0261 0.0255 0.0249 0.0244 0.0238
1.6 0.0232 0.0227 0.0222 0.0216 0.0211 0.0206 0.0201 0.0197 0.0192 0.0187
1.7 0.0183 0.0178 0.0174 0.0170 0.0166 0.0162 0.0158 0.0154 0.0150 0.0146
1.8 0.0143 0.0139 0.0136 0.0132 0.0129 0.0126 0.0123 0.0119 0.0116 0.0113
1.9 0.0111 0.0108 0.0105 0.0102 0.0100 0.0097 0.0094 0.0092 0.0090 0.0087
2.0 0.0085 0.0083 0.0080 0.0078 0.0076 0.0074 0.0072 0.0070 0.0068 0.0066
Example – Continuous (R,Q) policy

Consider again the hardware supply warehouse where R = 1,073 and Q =

3,400.

AVG = 1,445 units

STD = 300 units
L = 0.5 week
L(z) = 0.0206 STD × L × L(z)
fill rate = 1 −
Q
300 × 0.5 ×0.0206
=1−
3,400
= 99.87%
Multi-period models: S-1,S and s,S Policy
Stef Lemmens

RSM - a force for positive change

Periodic (S-1,S) policy
base-stock level
S
inventory inventory
on hand position S = AVG × (r + L)
+ z × STD × r+L

safety
stock

review review
time
L
r L r
Why Inventory Position?

Order 2
base-stock
level
S
inventory
on hand

Order 1
inventory
position

review
review
review

review
safety
stock

Lead time time

Periodic (s,S) policy
order-up-to level
inventory inventory
on hand position

reorder point
under-
shoot
expected
demand
lead
time
safety stock

review review review review

time
lead time

risk period
Stochastic Lead Times
Stef Lemmens

RSM - a force for positive change

The impact of stochastic lead time

R = μ 𝐿𝐿 + 𝑧𝑧 𝐿𝐿 𝜎𝜎 2 = μ 𝐿𝐿 + 𝑧𝑧 𝐿𝐿 𝜎𝜎

Expected lead time demand Demand uncertainty during lead time

With stochastic lead time:

• Expected lead time demand stays as is
• Uncertainty increases

• 𝑅𝑅 = 𝐴𝐴𝐴𝐴𝐴𝐴 × 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 + 𝑧𝑧 × 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 × 𝑆𝑆𝑆𝑆𝑆𝑆2 + 𝐴𝐴𝐴𝐴𝐴𝐴 2 × 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆2

AVG= Expected (average) demand (𝜇𝜇)
STD = Std. of demand (𝜎𝜎)
AVGL = Expected (average) Lead Time
STDL = Std. of Lead Time 88
Risk-pooling and wrap-up
Stef Lemmens

RSM - a force for positive change

Risk Pooling - aggregation

• Products with high profit margin tend to have highly variable demand
• Demand variability is reduced if one aggregates demand across
locations.
• More likely that high demand from one customer will be offset by low
demand from another.
• Reduction in variability allows a decrease in safety stock and
therefore reduces average inventory (while maintaining the same
service level) – How?
Square-root law for risk pooling

• If demand in 𝒌𝒌 different geographic locations is

- independent and
- about the same size
• Then aggregation reduces safety stock by
about a factor of 𝒌𝒌

• Disadvantages:
- Increase in response time to customer order
- Increase in transportation cost
Square-root law: Example

• Italian coffee machine company, Shanghai branch

• 4 warehouses in 4 regions or only one in Ningbo?
• Per region (north, east, south, west):
- average weekly demand 𝜇𝜇𝐷𝐷 = 1,000 units
- standard deviation 𝜎𝜎𝐷𝐷 = 300 units
- lead-time 𝐿𝐿 = 5 weeks
- price 𝑝𝑝 = $1,000 per unit
- holding cost ℎ = 20%
- transport cost 𝑡𝑡 = $10/unit within the region
𝑡𝑡 = $13/unit from centralized location
• Demand for each region is independent
Square-root law: Example

• 𝜇𝜇𝐷𝐷 = 1,000, 𝜎𝜎𝐷𝐷 = 300, 𝐿𝐿 = 5, 𝑝𝑝 = $1,000, ℎ = 20%

• 𝑡𝑡 = $10/unit within the region, 𝑡𝑡 = $13/unit centralized
• CSL = 95% (or 0.95) ⇒ 𝑍𝑍 = 1.65
• Per region (north, east, south, west: 𝑖𝑖 = 1,2,3,4):
• 𝑆𝑆𝑆𝑆𝑖𝑖 = 𝑍𝑍 ∗ 𝐿𝐿 ∗ 𝜎𝜎𝐷𝐷 = 1.65 ∗ 5 ∗ 300 = 1106.85 units
• total SS = 4 ∗ 𝑆𝑆𝑆𝑆𝑖𝑖 = 4427.41 units
SS 4427
• Reduction in total safety inventory = = 2214
4 2
• Centralized: (𝜇𝜇𝐷𝐷𝐶𝐶 = 4 ∗ 𝜇𝜇𝐷𝐷 = 4,000 𝐶𝐶
// 𝜎𝜎𝐷𝐷 = 4 ∗ 𝜎𝜎𝐷𝐷 = 600)
• SS𝐶𝐶 = 𝑍𝑍 ∗ 𝐿𝐿 ∗ 𝜎𝜎𝐷𝐷𝐶𝐶 = 1.65 ∗ 5 ∗ 600 = 2213.7
• Decrease in annual holding cost on aggregation
• amount of reduction ∗ ℎ ∗ 𝑝𝑝 = 2213.7 ∗ 200 = $442.741
Critical points

The higher the coefficient of variation, the greater the benefit

from risk pooling
• The higher the variability, the higher the safety stocks kept by the warehouses.
The variability of the demand aggregated by the single warehouse is lower

The benefits from risk pooling depend on the behavior of the

demand from one market relative to demand from another
• risk pooling benefits are higher in situations where demands observed at
warehouses are negatively correlated
Inventory control policies

• Deterministic demand (EOQ)

• Demand uncertainty – single period (Newsvendor)
• Demand uncertainty – multi-period
- reorder level: threshold level to indicate that an order should be placed
- order size: the number of units to order

order moment
continuous review periodic review
fixed (R,Q)
order size

no fixed cost: (S-1,S)

variable fixed cost: (s,S)