# Chapter 11, Part B Inventory Models: Probabilistic Demand

Lecture Outline • Single-Period Inventory Model with Probabilistic Demand Single• Order-Quantity, Reorder-Point Model with Probabilistic OrderReorderDemand • Periodic-Review Model with Probabilistic Demand Periodic-

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Probabilistic Models
In many cases demand (or some other factor) is not known with a high degree of certainty and a probabilistic inventory model should actually be used. These models tend to be more complex than deterministic models. The probabilistic models covered in this chapter are: • single-period order quantity single• reorder-point quantity reorder• periodic-review order quantity periodic-

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If they can’t buy it first week can’ they don’t want to buy it . don’ The publishers were under pressure to produce the required amount of books Slide 5 Newsboy problem: Single-Period Order Quantity SingleA single-period order quantity model (sometimes singlecalled the newsboy problem) deals with a situation in which only one order is placed for the item and the demand is probabilistic. D < Q If demand is less than the order quantity. lost. the demand is not backordered and revenue (profit) will be lost. D > Q If the period's demand exceeds the order quantity. the surplus stock is sold at the end of the period (usually for less than the original purchase price). Ten million copies were sold in the first 3 days (English version alone). probabilistic.Harry Potter and the Order of the Phoenix by JK Rowling 5th This book sold over a million copies in 1 day through Amazon alone. long queues of millions waiting for the opening of bookstores. Slide 6 3 .

Single-Period Order Quantity When To use Single-period inventory model with SingleProbabilistic Demand. Can’ • Can’t be sold in the future Can’ Ex: • News Papers • Fashions • Computer books • Gadgets • Harry Potter Books Slide 7 Single-Period Order Quantity One question only is in place • How much of the products should we order • There is no question such as when we should reorder. • Can’t be carried in the inventory. • Seasonal or perishable items. Slide 8 4 .

Slide 9 Shoe Company Men’s shoe shop Men’ Summer season The shoe cost 40€ 40€ If sold before 31 July price= 60€ 60€ After 31 July (SALES) 30€ 30€ D demand is between 350 to 650 pairs The probability distribution is uniform distribution Slide 10 5 . maximum is b • Cost of overestimating demand: €co • Cost of underestimating demand: €cu • Shortages are not backordered.Single-Period Order Quantity Assumptions • Period demand follows a known probability distribution (historical Data): • normal: mean is µ. • Period-end stock is sold for salvage (not held in Periodinventory). standard deviation is σ • uniform: minimum is a.

in the following options Increase our order quantity by 1 Q=501 Our losses will be in our inability to sell the additional unit ( we over estimated our demand) we sell it in cheaper price Co =10€. what are our expected losses Slide 11 What are our losses. =60. Cu=20€ =20€ P(D>500)=150/300 EL( Q=500) = P* Cu = .40=20€ Loss because we lose the opportunity to win Co =30-40=10€.Cu=60-40=20€. =10€ P(D<501)=P(D<500)=150/300 P(D<501)=P(D< EL(Q=501) = P* Co = . =30.40=10€ Loss because we sell in cheaper price The big question is if we assume are selling 500 Is it worth to sell 501.5 *10= Stay at 500 order Q=500 Our Losses will be in our inability to fulfil our demand losing the opportunity to win.5 *20= 5 10 Slide 12 6 .

933 Slide 13 What are our losses.What are our losses. Cu=20€ =20€ P(D>600)=50/300 EL( Q=500) = P* Cu = .33 3.1667 *20= 8.33 Slide 14 7 . Cu=20€ =20€ P(D>501)=149/300 EL( Q=500) = P* Cu = .4966 *20= 5. in the following options Increase our order quantity by 1 Q=502 Our losses will be in our inability to sell the additional unit ( we over estimated our demand) we sell it in cheaper price Co =10€.5033 *10= Stay at 501 order Q=501 Our Losses will be in our inability to fulfil our demand losing the opportunity to win.033 9. in the following options Increase our order quantity by 1 Q=601 Our losses will be in our inability to sell the additional unit ( we over estimated our demand) we sell it in cheaper price Co =10€.8333 *10= Stay at 500 order Q=600 Our Losses will be in our inability to fulfil our demand losing the opportunity to win. =10€ P(D<601)=P(D<600)=250/300 P(D<601)=P(D< EL(Q=501) = P* Co = . =10€ P(D<502)=P(D<501)=151/300 P(D<502)=P(D< EL(Q=501) = P* Co = .

That will be when the expected losses would be the same EL (Q* +1)=EL (Q*) Co P(demand < Q *) = Cu P(demand > Q *) P(demand > Q *) + P(demand < Q *) =1 P(demand < Q *) = cu/(cu+co) /(c Slide 16 8 .Slide 15 Optimal solution would be when we stop increasing the level of our order and our losses form increasing will be more from status co.

Single-Period Order Quantity Formulas Optimal probability of no shortage: P(demand < Q *) = cu/(cu+co) /(c P(demand < Q *) =20/(10+20) = 2/3 Q*= 550 Slide 17 Slide 18 9 .

55 loss. Slide 20 10 . • Any unsold copies of the book can be sold at salvage at a \$.45. based on demand distribution: normal: Q * = µ + zσ uniform: Q * = a + P(demand < Q *)(b-a) *)(b Slide 19 Example: McHardee Press Single-Period Order Quantity Single• McHardee Press publishes the Fast Food Menu Book and wishes to determine how many copies to print.Single-Period Order Quantity Formulas Optimal probability of no shortage: P(demand < Q *) = cu/(cu+co) /(c Optimal order quantity. • the incremental profit per copy is \$0.

Example: McHardee Press Single-Period Order Quantity SingleSales for this edition are estimated to be normally distributed. The most likely sales volume is 12.65σ or σ = 4848 11.45/(.000) = 1.000 . with standard deviation 4848..45 • Q* = µ +zσ : µ = 12. How many copies should be printed? Slide 21 Example: McHardee Press Single-Period Order Quantity Single• Using incremental analysis with Co = . The P(D probability of 0. • P (demand < Q *) =(Cu/(Cu+Co)) = .12.55) = =(C /(C .45 corresponds to z = -.55 and Cu = .12.000 . z=? σ =4848 +zσ • z: Find Q * such that P(D < Q *) = .45. • Q * = µ +zσ= 12.45+.418 books Slide 22 11 .000.45.000 copies .12(4848) = +zσ – Therefore. (20.45 • What is Q* for a P of 0.

Thus. (Cu/(Cu + Co)) = . no copies should be printed because if the company produced only 10.45/(.885 copies it will not recoup its \$5. how many copies should be printed? Co = .45 + .885 books Slide 23 If There is a fixed cost of \$5..65) = .000 .65 loss.000 to produce the book Since 10.4091.23(4848) = 10.45).000 fixed cost.23 P(D gives this probability.4091 (C /(C Find Q * such that P(D < Q *) = . Slide 24 12 .111 books (= 5000/.65. z = -.Example: McHardee Press Single-Period Order Quantity (revised) SingleIf any unsold copies can be sold at salvage at a \$. Q * = 12.885 books are less than the breakeven volume of 11.

referred to as the reorder point.65 σ +zσ • σ =4848 Slide 25 Reorder Point Quantity Model A firm's inventory position consists of the on-hand inventory onplus on-order inventory (all amounts previously ordered but onnot yet received).000=12.000.65 corresponds to a 5% tail probability.000+1. An inventory item is reordered when the item's inventory position reaches a predetermined value.000 copies and they believe there is a 5% chance that sales will exceed 20. • x = µ +zσ 20.If we don’t know the standard deviation The most likely sales volume is 12. Slide 26 13 . σ : note that z = 1. point.

The reorder point represents the quantity available to meet demand during lead time. the reorder point associated with EOQ-based models is set equal to EOQlead time demand. time. Slide 27 Reorder Point Quantity Under deterministic conditions. Under probabilistic conditions. the reorder point often includes safety stock. when demand and/or lead time varies. Safety stock is the amount by which the reorder point exceeds the expected (average) lead time demand. Slide 28 14 . Lead time is the time span starting when the replenishment order is placed and ending when the order arrives. when both demand and lead time are constant.

in this context. also is the long-run longproportion of lead times in which no stockouts occur. Service level. Slide 30 15 . is defined as the level. The complement of this chance is called the service level. Service level. in this context. probability of not incurring a stockout during any one lead time.Slide 29 Safety Stock and Service Level The amount of safety stock in a reorder point determines the chance of a stockout during lead time.

Slide 32 16 . Slide 31 Example: Robert’s Drug Reorder Point Model • Robert's Drugs is a drug wholesaler supplying 55 independent drug stores. • • Sales of Comfort are relatively constant as the past 10 weeks of data (on next slide) indicate. • Inventory position is reviewed continuously. • Approximate optimal order quantity: EOQ • Service level is defined in terms of the probability of no stockouts during lead time and is reflected in z. • Roberts wishes to determine an optimal inventory policy for Comfort brand headache remedy. • Shortages are not backordered.Reorder Point Model Assumptions • Lead-time demand is normally distributed Leadwith mean µ and standard deviation σ.

45 Week 1 2 3 4 5 Sales (cases) 110 115 125 120 125 Week 6 7 8 9 10 Sales (cases) 120 130 115 110 130 Slide 33 Example: Robert’s Drug Each case of Comfort costs Roberts \$10 Roberts uses a 14% annual holding cost rate for its inventory. What is Roberts’ optimal order quantity? Roberts’ Slide 34 17 .Example: Robert’s Drug Reorder Point Model Average=120. The cost to prepare a purchase order for Comfort is \$12.45 Sd=7. Sd=7.

Hence D = 120 X 52 = 6.14)(10) = 1.Example: Robert’s Drug Optimal Order Quantity The average weekly sales over the 10 week period is 120 cases. (week = 6 working days) Lead time demand has therefore been estimated as having a normal distribution with a mean of 80 cases and a standard deviation of 10 cases. Ch = (. What reorder point should Roberts use? Slide 36 18 . Co = 12. (see later) Roberts wants at most a 2% probability of selling out of Comfort during this lead time.40.240 cases per year. Q * = 2 DC o /C h = (2(6240)(12))/1.40 = 327 Slide 35 Example: Robert’s Drug The lead time for a delivery of Comfort has averaged four working days.

• Hence Roberts should reorder Comfort when supply reaches r = μ + zσ = 80 + 2. • The safety stock is zσ = 21 cases. Slide 37 Slide 38 19 .Example: Robert’s Drug Optimal Reorder Point • Hence Roberts should reorder Comfort when supply reaches • r = μ + zσ • Lead time demand is normally distributed with μ= m = 80.06(10) = 101 cases.06) = . σ = 10 cases • Z: Since Roberts wants at most a 2% probability of selling out of Comfort.0197 (about . Comfort. That is. P (z > 2. the corresponding z value is 2.06.02).

(normal) + hold.(safety) + ordering) Slide 39 Example: Robert’s Drug Total Annual Inventory Cost Ordering: (DCo/Q *) = ((6240)(12)/327) = \$229 (DC Holding-Normal: (1/2)Q *Co = (1/2)(327)(1.40) = 229 Holding(1/2)Q Holding-Safety Stock: Ch(21) = (1.Reorder Point Formulas Reorder point: Safety stock: Average inventory: Total annual cost: r = µ + zσ zσ ½ ( Q ) + zσ [( ½ )Q *Ch] + [zσ Ch] + [DCo/Q *] (hold.40)(21) = 29 HoldingTOTAL = \$487 Slide 40 20 .

the order quantity varies. At the time the order quantity is being decided. the concern is that the on-hand inventory and the onquantity being ordered is enough to satisfy demand from the time the order is placed until the next order is received (not placed).Periodic Review Model A periodic review system is one in which the inventory level is checked and reordering is done only at specified points in time (at fixed intervals usually). Assuming the demand rate varies. will vary from one review period to another. Slide 41 Slide 42 21 .

• On-hand inventory at ordering time: H On• Shortages are not backordered. Slide 43 Periodic Review Order Quantity Formulas Replenishment level: Order quantity: M = µ + zσ Q=M–H H: inventory on hand at the review period Slide 44 22 .Periodic Review Order Quantity Assumptions • Inventory position is reviewed at constant intervals. length. • Demand during review period plus lead time period is normally distributed with mean µ and standard deviation σ. • Service level is defined in terms of the probability of no stockouts during a review period plus lead time period and is reflected in z. • Lead time is less than the review period length.

Slide 45 Example: Ace Brush Periodic Review Order Quantity Model Once Joe submits an order. the lead time until Dollar receives the brushes is one week. week. Dollar would like at most a 2% chance of running out of stock during any replenishment period. • Weekly demand for Ace brushes at Dollar approximately follows a normal distribution with a mean of 60 brushes and a standard deviation of 9 brushes per week. • Every three weeks he contacts Dollar Department Store so that they may place an order to replenish their stock. how many should they order? Slide 46 23 .Example: Ace Brush Periodic Review Order Quantity Model • Joe Walsh is a salesman for the Ace Brush Company. If Dollar has 75 brushes in stock when Joe contacts them.

This is the amount of time that will elapse before the next shipment shipment of brushes will arrive. µ = 4 x 60 = 240 σ 2 =n σ ‘2 Variance of demand over 4 weeks. σ 2 = 4 x 81 = 324 Standard deviation over 4 weeks. Weekly demand is normally distributed with: Mean weekly demand. σ Weekly variance. µ = 60 = 9 Weekly standard deviation. σ 2 = 81 Demand for 4 weeks is normally distributed with: Mean demand over 4 weeks.Satisfying 3+1=4 weeks of demand Slide 47 Example: Ace Brush Demand During Uncertainty Period The review period plus the following lead time totals 4 weeks. σ = (324)1/2 = 18 Slide 48 24 .

For a 2% stockout probability (2% tail area).05)(18) = 37 brushes Slide 49 25 . Dollar should order: 277 .05. σ determined in the previous slide M = 240 + 2. • µ.Example: Ace Brush Replenishment Level M = µ + zσ • z: where z is determined by the desired stockout probability. z = 2.05(18) = 277 brushes As the store currently has 75 brushes in stock.75 = 202 brushes The safety stock is: zσ = (2.