Inventory Management

Production & Operations Management

INVENTORY MANAGEMENT
Reorder Point
Lead Time Demand, Service Level, Safety Stock

Prof. Ajith Kumar, XLRI Jamshedpur

XLRI, Jamshedpur Prof. Ajith Kumar

Inventory Management

Two key decision points for replenishment

Production & Operations Management

1. How much should be ordered (produced)?

Economic Order Quantity (EOQ) &
related models
2. When should it be ordered (produced)?
Lead time demand (LD) & related
models

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

HOW INVENTORY VARIES WITH TIME

Production & Operations Management

Inventory level

r1

r4
r3
r2

L1 L2 L3 L4 Time (t)

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Inventory Management

REORDER POINT (r)

Production & Operations Management

❖ The level of inventory at (or below)

which an order is placed for
replenishment.
❖ Generally, 𝑟1 ≠ 𝑟2 ≠ 𝑟3 ≠ 𝑎𝑛𝑑 𝑠𝑜 𝑜𝑛.

LEAD TIME (L)

❖ Is the time that elapses between placing the order and
receiving the ordered quantity at the location of the inventory.
❖ Generally, 𝐿1 ≠ 𝐿2 ≠ 𝐿3 ≠ 𝐿4 … . 𝑎𝑛𝑑 𝑠𝑜 𝑜𝑛.

If the variation is small, r or L may be taken as a

constant for modelling convenience.
XLRI, Jamshedpur Prof. Ajith Kumar
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Inventory Management

DEMAND (D)
Production & Operations Management

❖ Demand is the rate at which the

inventory is consumed.
❖ Generally, demand is not a constant
but varies with time (see the graph).
❖ Is ongoing and exists during the lead
time too.

LEAD TIME DEMAND (LD)

❖ Is the total quantity demanded from the inventory during the
lead time.
❖ Is not a “rate” unlike demand but is a quantity (of the item).
XLRI, Jamshedpur Prof. Ajith Kumar
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Inventory Management

HIGHER vs. LOWER r

Production & Operations Management

❖ Higher r ⇒
❖ greater inventory levels,
❖ better chances of meeting lead
time demand,
❖ but more holding costs.
❖ Lower reorder point ⇒
❖ lower inventory levels,
❖ lower holding costs,
❖ but greater chances of
stockout.

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

r and LD
Production & Operations Management

❖ Suppose lead time (L) and demand (D) are both constant,

❖ Then, lead time demand (LD) is also constant

The lead time demand (LD) is the same

𝐿𝐷 = 𝐿 ∗ 𝐷 during each order, that is, it is a constant.

❖ In that situation, our best reorder point (r) would be:

When r = LD, then we will have neither
𝑟 = 𝐿𝐷 = 𝐿 ∗ 𝐷 excess inventory, nor a stockout .

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

r and LD
Production & Operations Management

Tennis balls are sold at a sports store in central Delhi. 8 tennis

balls are sold daily. The store owner always purchases a carton
of 160 tennis balls from the supplier. If the lead time to
replenish is 7.5 days, what should the store’s reorder point be?

Inv
𝑟 = 𝐿𝐷 = 𝐿 ∗ 𝐷 level
160 160 160
= 8 ∗ 7.5 = 60

An order for tennis balls is

r = 60
placed whenever the
inventory level touches (or 0
Time (t)
crosses) 60. 7.5 7.5

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

r and LD
Production & Operations Management

❖ Generally, lead time (L) and demand (D) are variable.

❖ Modeled as probability distributions, using 𝜇𝐿 , 𝜎𝐿2 for lead

time and 𝜇𝐷 , 𝜎𝐷2 for demand.
❖ Then lead time demand (LD) is also a distribution, with:

𝜇𝐿𝐷 = 𝜇𝐿 ∗ 𝜇𝐷 LD varies over the order cycles.

2
𝜎𝐿𝐷 = 𝜇𝐿 ∗ 𝜎𝐷2 + 𝜎𝐿2 ∗ 𝜇𝐷2 is ≥ 0.
this formula is dimensionally consistent

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

r and LD
Production & Operations Management

The demand for cheque deposit challans in a bank has a mean

of 15 per day and standard deviation of 2.2 per day. The lead
time to replenish challans (by printing) has a mean of 6 days
with a variance of 4 day2. What are the mean and standard
deviation of the lead time demand?
𝝁𝑳𝑫 = 𝜇𝐿 ∗ 𝜇𝐷 = 15 ∗ 6 = 𝟗𝟎 challans
2
𝜎𝐿𝐷 = 𝜇𝐿 ∗ 𝜎𝐷2 + 𝜎𝐿2 ∗ 𝜇𝐷2
= 6 ∗ 2.22 + 4 ∗ 152 = 929.04
𝝈𝑳𝑫 = 929.04 = 𝟑𝟎. 𝟒𝟖 challans

The lead time demand for the challans has a mean of 90 and a
standard deviation of 30.48.
XLRI, Jamshedpur Prof. Ajith Kumar
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Inventory Management

r, LD and stockout
Production & Operations Management

❖ Generally, LD varies over order cycles.

❖ Suppose, we fix a particular reorder point r. Then,

❖ When replenishment arrives, three situations are possible:

1) 𝐿𝐷 < 𝑟: some inventory will be left.
2) 𝐿𝐷 = 𝑟: no inventory is left, but no stockout too.
3) 𝐿𝐷 > 𝑟 : no inventory is left + a stockout happens.

❖ Thus, a stockout can happen in any order cycle.

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

r, LD and stockout
Production & Operations Management

Anshu Systems is a retailer of 2 TB hard drives. It keeps a

limited stock of these drives which it replenishes by ordering
frequently from a wholesaler. The forecast of lead time demand
during the next 12 order cycles is known. If the reorder point is
4, identify the order cycles in which a stockout will occur.
Order Cycle 1 2 3 4 5 6 7 8 9 10 11 12
Lead Time
5 7 3 4 6 2 1 8 6 4 3 7
Demand (LD)

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

Service level (SL) of an inventory system

Production & Operations Management

❖ This inspires the concept of “service level” (SL).

❖ The service level (SL) is the probability of no stockout.

❖ SL = P 𝑛𝑜 𝑠𝑡𝑜𝑐𝑘𝑜𝑢𝑡 = P 𝐿𝐷 ≤ 𝑟 = 1 − P(𝐿𝐷 > 𝑟)

❖ If we need a service level 𝑋, then set 𝑟 as the lowest value of

LD that satisfies the condition:
P 𝐿𝐷 ≤ 𝑟 ≥ 𝑋.

❖ Example– for a SL of 0.9, if 300 is the lowest value of LD, which

satisfies the condition that P 𝐿𝐷 ≤ 300 ≥ 0.9, then set r = 300.

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

r, LD and SL
Production & Operations Management

Anshu Systems is a retailer of 2 TB hard drives. It keeps a

limited stock of these drives which it replenishes by ordering
frequently from a wholesaler. The forecast of lead time demand
during the next 12 order cycles is known. If the reorder point is
4, identify the order cycles in which a stockout will occur.

Order Cycle 1 2 3 4 5 6 7 8 9 10 11 12
Lead Time
5 7 3 4 6 2 1 8 6 4 3 7
Demand (LD)

What is the current service level in Anshu systems?

𝑺𝑳 = 𝟔Τ𝟏𝟐 = 𝟎. 𝟓 (𝟓𝟎%)

If r is increased to 6, what will the SL become?

𝑺𝑳 = 𝟗Τ𝟏𝟐 = 𝟎. 𝟕𝟓 (𝟕𝟓%)
XLRI, Jamshedpur Prof. Ajith Kumar
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Inventory Management

SAFETY STOCK (s) IN THE INVENTORY SYSTEM

Production & Operations Management

𝑠 = 𝑟 − 𝜇𝐿𝐷 , when 𝑟 > 𝜇𝐿𝐷

= 0, when 𝑟 ≤ 𝜇𝐿𝐷

❖ The safety stock in the extra inventory maintained to keep

the probability of a stockout within a desired threshold.
• A higher reorder point (r) ⇒ more safety stock (s) ⇒ higher SL

• A lower reorder point (r) ⇒ lesser safety stock (s) ⇒ lower SL

• If reorder point (r) low enough ⇒ no safety stock (s)

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

r, LD, SL, s
Production & Operations Management

Anshu Systems is a retailer of 2 TB hard drives. It keeps a

limited stock of these drives which it replenishes by ordering
frequently from a wholesaler. The forecast of lead time demand
during the next 12 order cycles is known. If the reorder point is
4, identify the order cycles in which a stockout will occur.
Order Cycle 1 2 3 4 5 6 7 8 9 10 11 12
Lead Time
5 7 3 4 6 2 1 8 6 4 3 7
Demand (LD)

What is the current safety stock in Anshu Systems’ inventory?

𝜇𝐿𝐷 = 4.67 𝑟=4 𝑟 ≤ 𝜇𝐿𝐷 𝑠=0

If r is increased to 5, what will the safety stock be?

𝜇𝐿𝐷 = 4.67 𝑟=5 𝑟 > 𝜇𝐿𝐷 𝑠 = 𝑟 − 𝜇𝐿𝐷 = 0.33
XLRI, Jamshedpur Prof. Ajith Kumar
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Inventory Management

LD follows a discrete distribution

Production & Operations Management

LD FREQ
Greychip Electronics uses PCBs for making LCD TVs. To 1100 1
maintain high quality and low costs, Greychip has 1121 1
cultivated a set of five different vendors to supply these 1144 2
PCBs.
1158 2
To keep its relationships alive, Greychip orders from a 1174 3
different vendor every order cycle. This has meant that
1205 5
the lead time is not a constant but varies with each order.
1218 6
In recent times, there have been fluctuations in the rate of
internal consumption for the PCBs as well. 1232 7
1258 4
As a result of these two sources of fluctuations Greychip’s
statisticians recognized the given pattern in the lead time 1280 2

demand (LD) for the PCBs based on the past 36 occasions 1302 1
that a replenishment order was placed: 1327 1
1350 1

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

LD follows a discrete distribution

Production & Operations Management

LD FREQ

While Greychip wishes to minimize its total inventory 1100 1

costs, it is also concerned that its customers are not 1121 1
displeased. Compute, 1144 2
a) the mean lead time demand (𝜇𝐿𝐷 ). 1158 2
b) the minimum reorder point such that there are no 1174 3
stock-outs ever. 1205 5
c) the reorder point for a 90% service level. 1218 6
1232 7
1258 4
1280 2
1302 1
1327 1
1350 1

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management

LD follows a discrete distribution

Production & Operations Management

a) the mean lead time demand. 1218.75 LD Freq

Cumm Rel Cumm
Freq freq rel freq
b) the minimum reorder point 1100 1 1 0.03 0.03
such that there are no stock- 1350 1121 1 2 0.03 0.06
outs ever. 131.25
1144 2 4 0.06 0.11
c) the reorder point for a 90%
1280 1158 2 6 0.06 0.17
service level. 61.25 1174 3 9 0.08 0.25

1205 5 14 0.14 0.39

1218 6 20 0.17 0.56

1232 7 27 0.19 0.75

The lowest possible LD where the probability 1258 4 31 0.11 0.86

of no stockout is 0.90 or more: 1280 2 33 0.06 0.92

1302 1 34 0.03 0.94

This is the max LD possible. Hence, the 1327 1 35 0.03 0.97

minimum r, at which, there are no stockouts: 1350 1 36 0.03 1.00
1218.75 36 1
XLRI, Jamshedpur 𝜇𝐿𝐷
Prof. Ajith Kumar
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Inventory Management

LD follows a normal distribution

Production & Operations Management

Bright Systems, a Compute,

manufacturer of LED lights
acquires lamp holders from
suppliers. Recently, it has
managed to eliminate the
fluctuations in the lead time
and made it a constant 4
days.
a) the reorder point for a 95% service
level, and the safety stock.
b) the reorder point for a 98% service
level, and the safety stock.
c) the service level and safety stock at a
reorder point of 1500.

The daily internal

consumption continues to
fluctuate and is found to
follow a normal distribution
with a mean of 400 and a
standard deviation of 30 per
day.
XLRI, Jamshedpur Prof. Ajith Kumar
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Inventory Management

LD follows a normal distribution

Production & Operations Management

Bright Systems, a ❖ L = constant = 4 days

manufacturer of LED lights ❖ D per day follows a normal distribution.
acquires lamp holders from 𝜇𝐷 = 400 𝜎𝐷 = 30
suppliers. Recently, it has
managed to eliminate the ❖ LD = demand over 4 days.
fluctuations in the lead time ❖ The distribution of LD is got by adding 4
and made it a constant 4 independent and identical normal
days. distributions. Hence,
The daily internal ❖ LD also follows a normal distribution.
consumption continues to
𝜇𝐿𝐷 = 𝜇𝐿 ∗ 𝜇𝐷 = 4 ∗ 400
fluctuate and is found to
𝝁𝑳𝑫 = 𝟏𝟔𝟎𝟎 holders
follow a normal distribution
with a mean of 400 and a 2
𝜎𝐿𝐷 = 𝜇𝐿 ∗ 𝜎𝐷2 + 𝜎𝐿2 ∗ 𝜇𝐷2
standard deviation of 30 per
= 4 ∗ 302 + 0 = 3600
day.
𝝈𝑳𝑫 = 𝟑𝟔𝟎𝟎 = 𝟔𝟎 holders
XLRI, Jamshedpur Prof. Ajith Kumar
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Inventory Management

LD follows a normal distribution

Production & Operations Management

a) the order point for a 95% service

level, and the safety stock.
SL = 0.95
z = 1.645
r = 1698.69
1.645σ s = 98.69
𝒓 = 𝝁𝑳𝑫 + 𝒛 ∗ 𝝈𝑳𝑫
a) c) the service level and safety 𝑟 = 1698.69 is the lowest value of LD that
stock at a reorder point of 1500. satisfies the condition:
𝐏 𝑳𝑫 ≤ 𝒓 ≥ 𝟎. 𝟗𝟓
r = 1500,
s = 0, – 1.667σ SL = 0.98
z = –1.667, z = 2.054,
SL = 0.048 r = 1723.23,
s = 123.23
2.054σ
a) b) the order point for a 98%
service level, and the safety stock.

-4 -3 -2 -1 0 1 2 3 4

1360 1420 1480 1540 1600 1660 1720 1780 1840

Lead time demand (LD)
XLRI, Jamshedpur Prof. Ajith Kumar
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Inventory Management

r, LD, SL and s
Production & Operations Management

Let F be the cumulative distribution function of LD, then:

❖ If LD is modelled as continuous, then 𝑟 = 𝐿𝐷: 𝐿𝐷 = 𝐹 −1 (𝑆𝐿)

❖ If LD is modelled as discrete, 𝑟 is the lowest 𝐿𝐷: 𝐿𝐷 ≥ 𝐹 −1 (𝑆𝐿)

❖ In both cases, safety stock, 𝑠 = 𝑟 − 𝜇𝐿𝐷

❖ In a special case that LD is modelled as a normal distribution,

𝑟 = 𝜇𝐿𝐷 + 𝑧𝑆𝐿 ∗ 𝜎𝐿𝐷 and

𝑠 = 𝑧𝑆𝐿 ∗ 𝜎𝐿𝐷 , when 𝑧𝑆𝐿 > 0 and

0, when 𝑧𝑆𝐿 ≤ 0

❖ If 𝑟 is not a fixed value in the inventory model, but can vary across orders,
then replace 𝑟 and 𝑠 with 𝜇𝑟 and 𝜇𝑠 respectively, in the above equations.

XLRI, Jamshedpur Prof. Ajith Kumar

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Inventory Management
Production & Operations Management

THANK YOU

XLRI, Jamshedpur Prof. Ajith Kumar