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5/ 30/ 02

Inventory Theory

Inventories are materials stored, waiting for processing, or experiencing processing.

They are ubiquitous throughout all sectors of the economy. Observation of almost any

company balance sheet, for example, reveals that a significant portion of its assets

comprises inventories of raw materials, components and subassemblies within the

production process, and finished goods. Most managers don't like inventories because

they are like money placed in a drawer, assets tied up in investments that are not

producing any return and, in fact, incurring a borrowing cost. They also incur costs for

the care of the stored material and are subject to spoilage and obsolescence. In the last

two decades their have been a spate of programs developed by industry, all aimed at

reducing inventory levels and increasing efficiency on the shop floor. Some of the most

popular are conwip, kanban, just-in-time manufacturing, lean manufacturing, and flexible

manufacturing.

Nevertheless, in spite of the bad features associated with inventories, they do have

positive purposes. Raw material inventories provide a stable source of input required for

production. A large inventory requires fewer replenishments and may reduce ordering

costs because of economies of scale. In-process inventories reduce the impacts of the

variability of the production rates in a plant and protect against failures in the processes.

Final goods inventories provide for better customer service. The variety and easy

availability of the product is an important marketing consideration. There are other kinds

of inventories, including spare parts inventories for maintenance and excess capacity built

into facilities to take advantage of the economies of scale of construction.

Because of their practical and economic importance, the subject of inventory

control is a major consideration in many situations. Questions must be constantly

answered as to when and how much raw material should be ordered, when a production

order should be released to the plant, what level of safety stock should be maintained at a

retail outlet, or how in-process inventory is to be maintained in a production process.

These questions are amenable to quantitative analysis with the help of inventory theory.

25.1 Inventory Models

In this chapter, we will consider several types of models starting with the deterministic

case in the next section. Even though many features of an inventory system involve

uncertainty of some kind, it is common to assume much simpler deterministic models for

which solutions are found using calculus. Deterministic models also provide a base on

which to incorporate assumptions concerning uncertainty. Section 25.3 adds a stochastic

dimension to the model with random product demand. Section 25.4 begins discussion of

stochastic inventory systems with the single period stochastic model. The model has

applications for products for which the ordering process is nonrepeating. The remainder

of the chapter addresses models with an infinite time horizon and several assumptions

2 Inventory Theory

regarding the costs of operation. Sections 25.5 and 25.6 derive optimal solutions for the

(s, S) policy under a variety of conditions. This policy places an order up to level S when

the inventory level falls to the reorder point s. Section 25.7 extends these results to the

(R, S) policy. In this case, the inventory is observed periodically (with a time interval R),

and is replenished to level S.

Flow, Inventory and Time

An inventory is represented in the simple diagram of Fig. 1. Items flow

into the system, remain for a time and then flow out. Inventories occur

whenever the time an individual enters is different than when it leaves.

During the intervening interval the item is part of the inventory.

Flow In

Inventory Level

(Residence Time)

Flow Out

Figure 1. A system component with inventory

For example, say the box in Fig. 1 represents a manufacturing

process that takes a fixed amount of time. A product entering the box at

one moment leaves the box one hour later. Products arrive at a rate of 100

per hour. Clearly, if we look in the box, we will find some number of

items. That number is the inventory level. The relation between flow,

time and inventory level that is basic to all systems is

Inventory level = (Flow rate )(Residence time) (1)

where the flow rate is expressed in the same time units as the residence

time. For the example, we have

Inventory Level = (100 products/hour )(1 hour) = 100 products.

When the factors in Eq. (1) are not constant in time, we typically use their

mean values.

Whenever two of the factors in the above expression are given, the

third is easily computed. Consider a queueing system for which customers

are observed to arrive at an average rate of 10 per hour. When the

customer finds the servers busy, he or she must wait. Customers in the

system, either waiting or be served, are the inventory for this system.

Using a sampling procedure we determine that the average number of

customers in the inventory is 5. We ask, how long on the average is each

customer in the system? Using the relation between the flow, time and

Inventory Models 3

inventory, we determine the answer as 0.5 hours. As we saw in the

Chapter 16, Queueing Models, Eq (1) is called Little's Law.

The relation between time and inventory is significant, because

very often reducing the throughput time for a system is just as important

as reducing the inventory level. Since they are proportional, changing one

factor inevitably changes the other.

The Inventory Level

The inventory level depends on the relative rates of flow in and out of the

system. Define y(t) as the rate of input flow at time t and Y(t) the

cumulative flow into the system. Define z(t) as the rate of output flow at

time t and Z(t) as the cumulative flow out of the system. The inventory

level, I(t) is the cumulative input less the cumulative output.

I(t) = Y(t) – Z(t) =

⌡

⌠

0

t

y(x)dx -

⌡

⌠

0

t

z(x)dx (2)

Figure 2 represents the inventory for a system when the rates vary with

time.

Time

Inventory Level

0

0

Figure 2. Inventory fluctuations as a function of time

The figure might represent a raw material inventory. The flow out

of inventory is a relatively continuous activity where individual items are

placed into the production system for processing. To replenish the

inventory, an order is placed to a supplier. After some delay time, called

the lead time, the raw material is delivered in a lot of a specified amount.

At the moment of delivery, the rate of input is infinite and at other times it

is zero. Whenever the instantaneous rates of input and output to a

component are not the same, the inventory level changes. When the input

rate is higher, inventory grows; when output rate is higher, inventory

declines.

Usually the inventory level remains positive. This corresponds to

the presence of on hand inventory. In cases where the cumulative output

4 Inventory Theory

exceeds the cumulative input, the inventory level is negative. We call this

a backorder or shortage condition. A backorder is a stored output

requirement that is delivered when the inventory finally becomes positive.

Backorders may only be possible for some systems. For example, if the

item is not immediately available the customer may go elsewhere;

alternatively, some items may have an expiration date like an airline seat

and can only be backordered up to the day of departure. In cases where

backorders are impossible, the inventory level is not allowed to become

negative. The demands on the inventory that occur while the inventory

level is zero are called lost sales.

Variability, Uncertainty and Complexity

The are many reasons for variability and uncertainty in inventory systems.

The rates of withdrawal from the system may depend on customer demand

which is variable in time and uncertain in amount. There may be returns

from customers. Lots may be delivered with defects causing uncertainty

in quantities delivered. The lead time associated with an order for

replenishment depends on the capabilities of the supplier which is usually

variable and not known with certainty. The response of a customer to a

shortage condition may be uncertain.

Inventory systems are often complex with one component of the

system feeding another. Figure 3 shows a simple serial manufacturing

system producing a single product.

1

2 3 5

10

Raw

Material

Finished

Goods

4 6 7 9

8

Delay Delay Delay Delay Oper. Oper. Inspect Inspect

Figure 3. A manufacturing system with several locations for inventories

We identify planned inventories in Fig. 3 as inverted triangles,

particularly the raw material and finished goods inventories. Material

passing through the production process is often called work in process

(WIP). These are materials waiting for processing as in the delay blocks

of the figure, materials undergoing processing in the operation blocks, or

materials undergoing inspection in the inspection blocks. All the

components of inventory contribute to the cost of production in terms of

handling and investment costs, and all require management attention.

For our analysis, we will often consider one component of the

system separate from the remainder, particularly the raw material or

finished goods inventories. In reality, rarely can these be managed

independently. The material leaving a raw material inventory does not

leave the system, rather it flows into the remainder of the production

Inventory Models 5

system. Similarly, material entering a finished goods inventory comes

from the system. Any analysis that optimizes one inventory independent

of the others must provide less than an optimal solution for the system as a

whole.

6 Inventory Theory

25.2 The Deterministic Model

An abstraction to the chaotic behavior of Fig. 2 is to assume that items are withdrawn

from the inventory at an even rate a, lots are of a fixed size Q, and lead time is zero or a

constant. The resulting behavior of the inventory is shown in Fig. 4. We use this

deterministic model of the system to explain some of the notation associated with

inventory. Because of its simplicity, we are able to find an optimal solutions to the

deterministic model for several operating assumptions.

s

s+Q

Q/a 2Q/a 3Q/a 4Q/a 5Q/a 6Q/a Time

Inventory Level

0

0

Figure 4. The inventory pattern without uncertainty

Notation

This section lists the factors that are important in making decisions related

to inventories and establishes some of the notation that is used in this

section. Dimensional analysis is sometimes useful for modeling inventory

systems, so we provide the dimensions of each factor. Additional model

dependent notation is introduced later.

• Ordering cost (c(z)): This is the cost of placing an order to an

outside supplier or releasing a production order to a manufacturing

shop. The amount ordered is z and the function c(z) is often

nonlinear. The dimension of ordering cost is ($).

• Setup cost (K): A common assumption is that the ordering cost

consists of a fixed cost, that is independent of the amount ordered,

and a variable cost that depends on the amount ordered. The fixed

cost is called the setup cost and given in ($).

• Product cost (c): This is the unit cost of purchasing the product as

part of an order. If the cost is independent of the amount ordered,

the total cost is cz, where c is the unit cost and z is the amount

ordered. Alternatively, the product cost may be a decreasing

function of the amount ordered. ($/unit)

The Deterministic Model 7

• Holding cost (h): This is the cost of holding an item in inventory

for some given unit of time. It usually includes the lost investment

income caused by having the asset tied up in inventory. This is not

a real cash flow, but it is an important component of the cost of

inventory. If c is the unit cost of the product, this component of the

cost is c , where is the discount or interest rate. The holding cost

may also include the cost of storage, insurance, and other factors

that are proportional to the amount stored in inventory. ($/unit-

time)

• Shortage cost (p): When a customer seeks the product and finds the

inventory empty, the demand can either go unfulfilled or be

satisfied later when the product becomes available. The former

case is called a lost sale, and the latter is called a backorder.

Although lost sales are often important in inventory analysis, they

are not considered in this section, so no notation is assigned to it.

The total backorder cost is assumed to be proportional to the num-

ber of units backordered and the time the customer must wait. The

constant of proportionality is p, the per unit backorder cost per unit

of time. ($/unit-time)

• Demand rate (a): This is the constant rate at which the product is

withdrawn from inventory. (units / time)

• Lot Size (Q): This is the fixed quantity received at each inventory

replenishment. (units)

• Order level (S): The maximum level reached by the inventory is

the order level. When backorders are not allowed, this quantity is

the same as Q. When backorders are allowed, it is less than Q.

(units)

• Cycle time ( ): The time between consecutive inventory

replenishments is the cycle time. For the models of this section =

Q/a. (time)

• Cost per time (T): This is the total of all costs related to the

inventory system that are affected by the decision under

consideration. ($/time)

• Optimal Quantities (Q

*

, S

*

,

*

, T

*

): The quantities defined above

that maximize profit or minimize cost for a given model are the

optimal solution.

Lot Size Model with no Shortages

The assumptions of the model are described in part by Fig. 5, which shows

a plot of inventory level as a function of time. The inventory level ranges

between 0 and the amount Q. The fact that it never goes below 0 indicates

8 Inventory Theory

that no shortages are allowed. Periodically an order is placed for

replenishment of the inventory. The order quantity is Q. The arrival of

the order is assumed to occur instantaneously, causing the inventory level

to shoot from 0 to the amount Q. Between orders the inventory decreases

at a constant rate a. The time between orders is called the cycle time, ,

and is the time required to use up the amount of the order quantity, or Q/a.

Figure 5. Lot size model with no shortages

The total cost expressed per unit time is

Cost/unit time = Setup cost + Product cost + Holding cost

T =

aK

Q

+ ac +

hQ

2

. (3)

In Eq. (3),

a

Q

is the number of orders per unit time. The factor

Q

2

is the

average inventory level. Setting to zero the derivative of T with respect to

Q we obtain

dT

dQ

= –

aK

Q

2

+

h

2

= 0.

Solving for the optimal policy,

Q

*

=

2aK

h

(4)

and

*

=

Q*

a

(5)

Substituting the optimal lot size into the total cost expression, Eq. (3), and

preserving the breakdown between the cost components we see that

T

*

=

ahK

2

+ ac +

ahK

2

= ac + 2ahK (6)

The Deterministic Model 9

At the optimum, the holding cost is equal to the setup cost. We see

that optimal inventory cost is a concave function of product flow through

the inventory (a), indicating that there is an economy of scale associated

with the flow through inventory. For this model, the optimal policy does

not depend on the unit product cost. The optimal lot size increases with

increasing setup cost and flow rate and decreases with increasing holding

cost.

Example 1

A product has a constant demand of 100 units per week. The cost to

place an order for inventory replenishment is $1000. The holding cost for

a unit in inventory is $0.40 per week. No shortages are allowed. Find the

optimal lot size and the corresponding cost of maintaining the inventory.

The optimal lot size from Eq. (4) is

Q

*

=

2(100)(1000)

0.4

= 707.

The total cost of operating the inventory from Eq. (6) is

T

*

= $282.84 per week.

From Q

*

and Eq. (5), we compute the cycle time,

t

*

= 7.07 weeks.

The unit cost of the product was not given in this problem because

it is irrelevant to the determination of the optimal lot size. The product

cost is, therefore, not included in T

*

.

Although these results are easy to apply, a frequent mistake is to

use inconsistent time dimensions for the various factors. Demand may be

measured in units per week, while holding cost may be measured in

dollars per year. The results do not depend on the time dimension that is

used; however, it is necessary that demand be translated to an annual basis

or holding cost translated to a weekly basis.

Shortages Backordered

A deterministic model considered in this section allows shortages to be

backordered. This situation is illustrated in Fig. 6. In this model the

inventory level decreases below the 0 level. This implies that a portion of

the demand is backlogged. The maximum inventory level is S and occurs

when the order arrives. The maximum backorder level is Q – S. A

backorder is represented in the figure by a negative inventory level.

10 Inventory Theory

Figure 6 Lot-size model with shortages allowed

The total cost per unit time is

Cost/time = Setup cost + Product cost + Holding cost + Backorder cost

T =

aK

Q

+ ac +

hS

2

2Q

+

p(Q - S)

2

2Q

(7)

The factor multiplying h in this expression is the average on-hand

inventory level. This is the positive part of the inventory curve shown in

Fig. 6. Because all cycles are the same, the average on-hand inventory

computed for the first cycle is the same as for all time. We see the first

cycle in Fig. 7.

S

0

S-Q

On-Hand

Area

Backorder

Area

Figure 7. The first cycle of the lot size with backorders model

Defining O(t) as the on-hand inventory level and O as the average

on-hand inventory

The Deterministic Model 11

O = (1/ )

⌡

⌠

0

O(t)dt = (1/ )[On -hand Area]

=

a

Q

¸

¸

_

,

S

2

2a

¸

¸

_

,

=

S

2

2Q

Similarly the factor multiplying p is the average backorder level, B ,

where

B = (1/ )(Backorder Area) =

(Q− S)

2

2Q

.

Setting to zero the partial derivatives of T with respect to Q and S yields

S

*

=

2aK

h

p

p + h

(8)

Q

*

=

2aK

h

p + h

p

(9)

and

*

=

Q

*

a

(10)

Comparing these results to the no shortage case, we see that the optimal

lot size and the cycle times are increased by the factor

[(p + h)/h]

1/2

.

The ratio between the order level and the lot size depends only on the

relative values of holding and backorder cost.

S

*

/Q

*

=

ph

p + h

(11)

This factor is 1/2 when the two costs are equal, indicating that the inven-

tory is in a shortage position one half of the time.

Example 2

We continue Example 1, but now we allow backorders. The backorder

cost is $1 per unit-week. The optimal policy for this situation is found

with Eqs. (8), (9) and (10).

S

*

=

2(100)(1000)

0.4

1

1 + 0.4

= 597.61

Q

*

=

2(100)(1000)

0.4

1 + 0.4

1

= 836.66

12 Inventory Theory

t

*

=

836.66

100

= 8.36 weeks.

Again neglecting the product cost, we find from Eq. (7)

T

*

= $239.04 per week.

The cost of operation has decreased since we have removed the

prohibition against backorders. There backorder level is 239 during each

cycle.

Quantity Discounts

The third deterministic model considered incorporates quantity discount

prices that depend on the amount ordered. For this model no shortages are

allowed, so the inventory pattern appears as in Fig. 5. The discounts will

affect the optimal order quantity. For this model we assume there are N

different prices: c

1

, c

2

, …, c

N

, with the prices decreasing with the index.

The quantity level at which the kth price becomes effective is q

k

, with q

1

equal zero. For purposes of analysis define q

(N+1)

equal to infinity,

indicating that the price c

N

holds for any amount greater than q

N

. Since

the price decreases as quantity increases the values of q

k

increase with the

index k.

To determine the optimal policy for this model we observe that the

optimal order quantity for the no backorder case is not affected by the

product price, c. The value of Q

k

*

would be the same for all price levels if

not for the ranges of order size over which the prices are effective.

Therefore we compute the optimal lot size Q

*

using the parameters of the

problem.

Q* =

2aK

h

. (12)

We then find the optimal order quantity for each price range.

Find for each k the value of Q

k

*

such that

if Q

*

> q

k+1

then Q

k

*

= q

k+1

,

if Q

*

< q

k

then Q

k

*

= q

k

,

if q

k

≤ Q

*

< q

k+1

then Q

k

*

= Q

*

The Deterministic Model 13

Optimal Order Quantity (Q

**

)

a. Find the price level for which Q

*

lies within the quantity range (the

last of the conditions above is true). Let this be level n*. Compute

the total cost for this lot size

T

n*

=

aK

Q*

+ ac

n*

+

hQ*

2

. (13)

b. For each level k > n*, compute the total cost T

k

for the lot size Q

k

*

.

T

k

=

aK

Q

k

*

+ ac

k

+

hQ

k

*

2

(14)

c. Let k

*

be the level that has the smallest value of T

k

. The optimal lot

size Q

**

is the lot size giving the least total cost as calculated in

Steps b and c.

Example 3

We return to the situation of Example 1, but now assume quantity

discounts. The company from which the inventory is purchased hopes to

increase sales by offering a break on the price of the product for larger

orders. For an amount purchased from 0 to 500 units, the unit price is

$100. For orders at or above 500 but less than 1000, the unit price is $90.

This price applies to all units purchased. For orders at or greater than

1000 units, the unit price is $85.

From this data we establish that N = 3. Also

q

1

= 0 and c

1

= 100,

q

2

= 500 and c

2

= 90,

q

3

= 1000 and c

3

= 85,

q

4

= ∞.

Neglecting the quantity ranges, from Eq. (12) we find the optimal lot size

is 707 regardless of price. We observe that this quantity falls in the

second price range. All lower ranges are then excluded. We must then

compare the cost at Q = 707 and c

2

= 90, with the cost at Q = 1000 and c

3

= 85. For the cost c

2

we use Eq. (13).

T

2

= $9282 (for Q

2

*

= 707 and c

2

= 90)

For the cost c

3

we use Eq. (14).

14 Inventory Theory

T

3

= $8,800 (for Q

3

*

= 1000 and c

3

= 85).

Comparing the two costs, we find the optimal policy is to order 1000 for

each replenishment. The cycle time associated with this policy is 10

weeks.

Modeling

The inventory analyst has three principal tasks: constructing the

mathematical model, specifying the values of the model parameters, and

finding the optimal solution. This section has presented only the simplest

cases, with the model specified as the total cost function. The model can

be varied in a number of important aspects. For example, non-

instantaneous replenishment rate, multiple products, and constraints on

maximum inventory are easily incorporated.

When a deterministic model contains a nonlinear total cost

function with only a few variables, the tools of calculus can often be used

find the optimal solution. Some assumptions, however, lead to complex

optimization problems requiring nonlinear programming or other

numerical methods.

The classic lot size formulas derived in this section are based on a

number of assumptions that are usually not satisfied in practice. In

addition it is often difficult to accurately estimate the parameters used in

the formulas. With the admitted difficulties of inaccurate assumptions and

parameter estimation, one might question whether the lot size formulas

should be used at all. We should point out that whether or not the

formulas are used, lot size decisions are frequently required. However

abstract the models are, they do recognize important relationships between

the various cost factors and the lot size, and they do provide answers to lot

sizing questions.

Stochastic Inventory Models 15

25.3 Stochastic Inventory Models

There is no question that uncertainty plays a role in most inventory management

situations. The retail merchant wants enough supply to satisfy customer demands, but

ordering too much increases holding costs and the risk of losses through obsolescence or

spoilage. An order too small increases the risk of lost sales and unsatisfied customers.

The water resources manager must set the amount of water stored in a reservoir at a level

that balances the risk of flooding and the risk of shortages. The operations manager sets

a master production schedule considering the imprecise nature of forecasts of future

demands and the uncertain lead time of the manufacturing process. These situations are

common, and the answers one gets from a deterministic analysis very often are not

satisfactory when uncertainty is present. The decision maker faced with uncertainty does

not act in the same way as the one who operates with perfect knowledge of the future.

In this section we deal with inventory models in which the stochastic nature of

demand is explicitly recognized. Several models are presented that again are only

abstractions of the real world, but whose answers can provide guidance and insight to the

inventory manager.

Probability Distribution for Demand

The one feature of uncertainty considered in this section is the demand for

products from the inventory. We assume that demand is unknown, but

that the probability distribution of demand is known. Mathematical

derivations will determine optimal policies in terms of the distribution.

• Random Variable for Demand (x): This is a random variable that is

the demand for a given period of time. Care must be taken to

recognize the period for which the random variable is defined

because it differs among the models considered.

• Discrete Demand Probability Distribution Function (P(x)): When

demand is assumed to be a discrete random variable, P(x) gives the

probability that the demand equals x.

• Discrete Cumulative Distribution Function (F(b)): The probability

that demand is less than or equal to b is F(b) when demand is

discrete.

F(b) = P(x)

x·0

b

∑

• Continuous Demand Probability Density Function (f(x)): When

demand is assumed to be continuous, f(x) is its density function. The

probability that the demand is between a and b is

P(a ≤ X ≤ b) = f (x)dx

a

b

∫

.

16 Inventory Theory

We assume that demand is nonnegative, so f(x) is zero for negative

values.

• Continuous Cumulative Distribution Function (F(b)): The

probability that demand is less than or equal to b when demand is

continuous.

F(b) = f (x)dx

0

b

∫

• Standard Normal Distribution Function ( (x) and (x)): These are

the density function and cumulative distribution function for the

standard normal distribution.

• Abbreviations: In the following we abbreviate probability

distribution function or probability density function as pdf. We

abbreviate the cumulative distribution function as CDF.

Selecting a Distribution

An important modeling decision concerns which distribution to use for

demand. A common assumption is that individual demand events occur

independently. This assumption leads to the Poisson distribution when the

expected demand in a time interval is small and the normal distribution

when the expected demand is large. Let a be the average demand rate.

Then for an interval of time t the expected demand is at. The Poisson

distribution is then

P(x) =

(at)

x

e

−(at)

x!

.

When at is large the Poisson distribution can be approximated with

a normal distribution with mean and standard deviation

= at , and = at .

Values of F(b) are evaluated using tables for the standard normal

distribution. We include these tables at the end of this chapter.

Of course other distributions can be assumed for demand.

Common assumptions are the normal distribution with other values of the

mean and standard deviation, the uniform distribution, and the exponential

distribution. The latter two are useful for their analytical simplicity.

Finding the Expected Shortage and the Expected Excess

We are often concerned about the relation of demand during some time

period relative to the inventory level at the beginning of the time period.

If the demand is less than the initial inventory level, there is inventory

remaining at the end of the interval. This is the condition of excess. If the

Stochastic Inventory Models 17

demand is greater than the initial inventory level, we have the condition of

shortage.

At some point, assume the inventory level is a positive value z.

During some interval of time, the demand is a random variable x with pdf,

f(x), and CDF, F(x). The mean and standard deviation of this distribution

are and , respectively. With the given distribution, we compute the

probability of a shortage, P

s

, and the probability of excess, P

e

. For a

continuous distribution

P

s

= P{x > z} = f (x)dx

z

∞

∫

= 1 – F(z) (15)

P

e

= P{x ≤ z} = f (x)dx

0

z

∫

= F(z) (16)

In some cases we may also be interested in the expected shortage,

E

s

. This depends on whether the demand is greater or less than z.

Items short =

¹

'

¹

0, if x ≤ z

x – z, if x > z

Then E

s

is the expected shortage and is

E

s

= (x – z) f (x)dx

z

∞

∫

. (17)

Similarly for excess, the expected excess is E

e

E

e

= (z – x) f (x)dx

0

z

∫

The expected excess is expressed in terms of E

s

E

e

= (z – x) f (x)dx

0

∞

∫

– (z – x) f (x)dx

z

∞

∫

= z – µ + E

s

. (18)

For discrete distributions, sums replace the integrals in Eqs. (15)

through (18).

P

s

= P{x ≥ z} = P(x)dx

x· z

∞

∑

= 1 – F(z), (19)

P

e

= P{x ≤ z} = P(x)dx

x·0

z

∑

= F(z). (20)

18 Inventory Theory

E

s

= (x – z)P(x)dx

x· z

∞

∑

. (21)

E

e

= (z – x)P(x)dx

x·0

z

∑

= z – µ + E

s

. (22)

When the Distribution of Demand is Normal

When the demand during the lead time has a normal distribution, tables

are used to find these quantities. Assume the demand during the lead time

has a normal distribution with mean and standard deviation . We

specify the inventory level in terms of the number of standard deviations

away from the mean.

z = + k or k =

z –

We have included at the end of this chapter, a table for the standard

normal distribution, (y), (y) and G(y). We have formerly identified

the first two of these functions as the pdf and CDF. The third is defined as

G(k) · (y − k) (y)dy

k

∞

∫

· (k) − k 1− (k) [ ].

Using the relations between the normal distribution and the standard

normal, the following relationships hold.

f(z) = (1/ ) (k) (23)

F(z) = (k) (24)

E

s

(z) = G(k) (25)

E

e

= z – µ + G(k) (26)

We have occasion to use these results in subsequent examples.

Single Period Stochastic Inventories 19

25.4 Single Period Stochastic Inventories

This section considers an inventory situation in which the current order for the

replenishment of inventory can be evaluated independently of future decisions. Such

cases occur when inventory cannot be added later (spares for a space trip, stocks for the

Christmas season), or when inventory spoils or becomes obsolete (fresh fruit, current

newspapers). The problem may have multiple periods, but the current inventory decision

must be independent of future periods. First we assume there is no setup cost for placing

a replenishment order, and then we assume that there is a setup cost.

Single Period Model with No Setup Cost

Consider an inventory situation where the merchant must purchase a

quantity of items that is offered for sale during a single interval of time.

The items are purchased for a cost c per unit and sold for a price b per

unit. If an item remains unsold at the end of the period, it has a salvage

value of a. If the demand is not satisfied during the interval, there is a cost

of d per unit of shortage. The demand during the period is a random

variable x with given pdf and CDF. The problem is to determine the

number of items to purchase. We call this the order level, S, because the

purchase brings the inventory to level S. For this section, there is no cost

for placing the order for the items.

The expression for the profit during the interval depends on

whether the demand falls above or below S. If the demand is less than S,

revenue is obtained only for the number sold, x, while the quantity

purchased is S. Salvage is obtained for the unsold amount S – x. The

profit in this case is

Profit = bx – cS + a(S – x) for x ≤ S.

If the demand is greater than S, revenue is obtained only for the number

sold, S. A shortage cost of d is expended for each item short, x – S. The

profit in this case is

Profit = bS – cS – d(x – S) for x ≥ S.

Assuming a continuous distribution and taking the expectation over all

values of the random variable, the expected profit is

E[Profit] = b xf (x)dx

0

S

∫

+ b Sf (x)dx

S

∞

∫

– cS + a (S – x) f (x)dx

0

S

∫

– d (x – S) f (x)dx

S

∞

∫

.

Rearranging and simplifying,

20 Inventory Theory

E[Profit] = b – cS + a (S – x) f (x)dx

0

S

∫

– (d + b) (x – S) f (x)dx

S

∞

∫

.

We recognize in this expression the expected excess, E

e

, and the expected

shortage, E

s

. The profit is written in these terms as

E[Profit] = b – cS + aE

e

– (d + b)E

s

(27)

To find the optimal order level, we set the derivative of profit with respect

to S equal to zero.

dE[Profit]

dS

= –c + a f (x)dx

0

S

∫

+ (d + b) f (x)dx

S

∞

∫

= 0.

or –c + aF(S) + (d + b)[1 – F(S)] = 0.

The CDF of the optimal order level, S

*

, is determined by

F(S

*

) =

b – c + d

b – a + d

. (28)

This result is sometimes expressed in terms of the purchasing cost,

c, a holding cost h, expended for every unit held at the end of the period,

and a cost p, expended for every unit of shortage at the end of the period.

In these terms the optimal expected cost is

E[Cost] = cS + hE

e

+ pE

s

.

The optimal solution has

F(S

*

) =

p – c

p + h

. (29)

The two solutions are equivalent if we identify

h = –a = negative of the salvage value

p = b + d = lost revenue per unit + shortage cost.

If the demand during the period has a normal distribution with

mean and standard deviation and , the expected profit is easily

evaluated for any given order level. The order level is expressed in terms

of the number of standard deviations from the mean, or

S = + k .

The optimality condition becomes

Single Period Stochastic Inventories 21

(k

*

) =

b – c + d

b – a + d

=

p – c

p + h

. (30)

The expected value of profit is evaluated with the expression

E[Profit] = b – cS + a[S – + G(k)] – (d + b) G(k). (31)

Call the quantity on the right of the Eq. (28) or (29) the threshold.

Optimality conditions for the order level give values for the CDF. For

continuous random variables there is a solution if the threshold is in the

range from 0 to 1. No reasonable values of the parameters will result in a

threshold less than 0 or larger than 1.

For discrete distributions the optimal value of the order level is the

smallest value of S such that

E[Profit |S + 1] ≤ E[Profit | S + 1].

By manipulation of the summation terms that define the expected profit,

we can show that the optimal order level is the smallest value of S whose

CDF equals or exceeds the threshold. That is

F(S

*

) ≥

b – c + d

b – a + d

or

p – c

p + h

. (32)

Example 4: Newsboy Problem

The classic illustration of this problem involves a newsboy who must

purchase a quantity of newspapers for the day's sale. The purchase cost of

the papers is $0.10 and they are sold to customers for a price of $0.25.

Papers unsold at the end of the day are returned to the publisher for $0.02.

The boy does not like to disappoint his customers (who might turn

elsewhere for supply), so he estimates a "good will" cost of $0.15 for each

customer who is not be satisfied if the supply of papers runs out. The boy

has kept a record of sales and shortages, and estimates that the mean

demand during the day is 250 and the standard deviation is 50. A Normal

distribution is assumed. How many papers should he purchase?

This is a single-period problem because today's newspapers will be

obsolete tomorrow. The factors required by the analysis are

a = 0.02, the salvage value of a newspaper,

b = 0.25, the selling price of each paper,

c = 0.10, the purchase cost of each paper,

d = 0.15, the penalty cost for a shortage.

22 Inventory Theory

Because the demand distribution is normal, we have from Eq. (30),

(k

*

) =

b – c + d

b – a + d

=

0.25 – 0.10 + 0.15

0.25 – 0.02 + 0.15

= 0.7895.

From the normal distribution table, we find that

(0.80) = 0.7881 and (0.85) = 0.8022.

With linear interpolation, we determine k

*

= 0.805. Then

S

*

= (0.805)(50) + 250 = 290.2.

Rounding up, we suggest that the newsboy should purchase 291 papers for

the day. The risk of a shortage during the day is

1 – F(S

*

) = 0.211.

Interpolating in the G(k) column in Table 4, we find that

G(k

*

) = G(0.805) = 0.1192.

Then from Eqs. (25), (26) and (31),

E

e

= 46.2, E

s

= 5.96, and E[Profit] = $32.02 per day.

Example 5: Spares Provisioning

A submarine has a very critical component that has a reliability problem.

The submarine is beginning a 1-year cruise, and the supply officer must

determine how many spares of the component to stock. Analysis shows

that the time between failures of the component is 6 months. A failed

component cannot be repaired but must be replaced from the spares stock.

Only the component actually in operation may fail; components in the

spares stock do not fail. If the stock is exhausted, every additional failure

requires an expensive resupply operation with a cost of $75,000 per

component. The component has a unit cost of $10,000 if stocked at the

beginning of the cruise. Component spares also use up space and other

scarce resources. To reflect these factors a cost of $25,000 is added for

every component remaining unused at the end of the trip. There is

essentially no value to spares remaining at the end of the trip because of

technical obsolescence.

This is a single-period problem because the decision is made only

for the current trip. Failures occur at random, with an average rate of 2

per year. Thus the expected number of failures during the cruise is 2. The

number of failures has a Poisson distribution. The second form of the

solution, Eq. (29), is convenient in this case.

Single Period Stochastic Inventories 23

h = 25,000, the extra cost of storage.

c = 10,000, the purchase cost of each component.

p = 75,000 the cost of resupply.

Expressed in thousands, the threshold is

F(S

*

) =

p – c

p + h

=

7 5 – 1 0

75 + 25

= 0.65.

From the cumulative Poisson distribution using a mean of 2, we find

F(0) = 0.135, F(1) = 0.406, F(2) = 0.677, F(3) = 0.857.

Because this is a discrete distribution, we select the smallest value of S

such that the CDF exceeds 0.65. This occurs for S

*

= 2 which means,

somewhat surprisingly, that only two spares should be brought. This is in

addition to the component initially installed, so that only on the third

failure will a resupply be required. The probability of one or more

resupply operations is

1 – F(2) = 0.323.

The relevance of this model is due in part to the resupply aspect of

the problem. If the system simply stopped after the spares were exhausted

and a single cost of failure were expended, then the assumption of the

linear cost of lost sales would be violated.

Single Period Model with a Fixed Ordering Cost

When the merchant has an initial source of product and there is a fixed

cost for ordering new items, it may be less expensive to purchase no

additional items than to order up to some order level. In this section, we

assume that initially there are z items in stock. If more items are

purchased to increase the stock to a level S, a fixed ordering charge K is

expended. We want to determine a level s, called the reorder point, such

that if z is greater than s we do not purchase additional items. Such a

policy is called the reorder point, order level system, or the (s, S) system.

We consider first the case where additional product is ordered to

bring the inventory to S at the start of the period. The expression for the

expected profit is the same as developed previously, except we must

subtract the ordering charge and it is only necessary to purchase (S – z)

items.

P

O

(z, S) = b – c(S – z) + aE

e

[S] – (d + b)E

s

[S] – K (33)

24 Inventory Theory

We include the argument S with E

e

[S] and E

s

[S] to indicate that these

expected values are computed with the starting inventory level at S.

Neither z nor K affect the optimal solution, and as before

F(S

*

) =

b – c + d

b – a + d

If no addition items are purchased, the system must suffice with

the initial inventory z. The expected profit in this case is

P

N

(z)

=b + aE

e

[z] – (d + b)E

s

[z], (34)

where the expected excess and shortage depend on z.

When z equals S, P

N

is greater than P

O

by the amount K, and

certainly no additional items should be purchased. As z decreases, P

N

and

P

O

become closer. The two expressions are equal when z equals s, the

optimal reorder point. Then the optimal reorder point is s* where,

P

O

(s*, S) = P

N

(s*)

Generally it is difficult to evaluate the integrals that allow this

equation to be solved. When the demand has a normal distribution,

however, the expected profit in the two cases can be written as a function

of the distribution parameters.

Assuming a normal distribution and given the initial supply, z, the

profit when we replenish the inventory up to the level S is

P

O

(z, S) = b – c(S – z) + a[S – + G(k)] – (d + b)[ G(k)] – K (35)

Here S = + k . If we choose not to replenish the inventory, but rather

operate with the items on hand the profit is

P

N

(z) = E[Profit] = b + a[z – + G(k

z

)] – (d + b)[ G(k

z

)]. (31)

Here z = + k

z

.

We modify the newsboy problem by assuming that the boy gets a

free stock of papers each morning. The question is whether he should

order more? The cost of placing an order is $10. In Fig. 8, we have

plotted these the costs with and without an order. The profit is low when

the initial stock is low and we do not reorder. The two curves cross at

about 210. This is the reorder point for the newsboy. If he has 210 papers

or less, he should order enough papers to bring his stock to 291. If he has

more than 210 papers, he should not restock. The profit for a given day

depends on how many papers the boy starts with. The higher of the two

curves in Fig. 8 shows the daily profit if one follows the optimal policy.

As expected the profit grows with the number of free papers.

Single Period Stochastic Inventories 25

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

100 120 140 160 180 200 220 240 260 280 300

Reorder

Not reorder

Prof it

Init ial St ock

Figure 8. Determining the reorder point for the newsboy problem

Example 6: Demand with a Uniform Distribution

The demand for the next period is a random variable with a uniform

distribution ranging from 50 to 250 units. The purchase cost of an item is

$100. The selling price is $150. Items unsold at the end of the period go

"on sale" for $20. All remaining are disposed of at this price. If the

inventory is not sufficient, sales are lost, with a penalty equal to the selling

price of the item. The current level of inventory is 100 units. Additional

items may be ordered at this time; however, a delivery fee will consist of a

fixed charge of $500 plus $10 per item ordered. Should an order be

placed, and if so, how many items should be ordered?

To analyze this problem first determine the parameters of the

model.

c = $110, the purchase cost plus the variable portion of the delivery fee

K = $500, the fixed portion of the delivery fee

p = $150, the lost income associated with a lost sale

h = –$20, the negative of the salvage value of the product.

From Eq. (29), the order level is S, such that

26 Inventory Theory

F(S

*

) =

p – c

p + h

=

150 – 1 1 0

1 5 0 –20

= 0.3077.

Setting the CDF for the uniform distribution equal to this value and

solving for S,

F(S) =

S – 50

250 – 50

= 0.3077 or S = 111.5.

Rounding up, we select S

*

= 112.

`Modifying the expected cost function to include the initial stock

and the cost of placing and order.

C

O

= c(S – z) + hE

e

[S] + pE

s

[S] + K

For the uniform distribution ranging from A to B,

E

e

[S] =

1

(B – A)

⌡

⌠

A

S

(S – x)dx =

(S – A)

2

2(B – A)

E

s

[S] =

1

(B – A)

⌡

⌠

S

B

(x – S)dx =

(B – S)

2

2(B – A)

C

O

= c(S – z) + K +

h(S – A)

2

+ p(B – S)

2

2(B – A)

When no order is placed, the purchase cost and the reorder cost terms drop

out and z replaces S.

C

N

=

h(z – A)

2

+ p(B – z)

2

2(B – A)

.

Evaluating C

O

with the order level equal to 112, we find that

C

O

= 19,729 – 110z.

Expressing C

N

entirely in terms of z,

C

N

= –0.05(z – 50)

2

+ 0.375(250 – z)

2

Setting C

O

equal to C

N

, substituting s for z, we solve for the optimal

reorder point.

19729 – 110s = –0.05(s – 50)

2

+ 0.375(250 – s)

2

0.325s

2

– 72.5s + 3543.3 = 0

Single Period Stochastic Inventories 27

Solving the quadratic

1

we find the solutions

s = 150.8 and s = 72.3.

The solution lying above the order level is meaningless, so we select the

reorder point of 72. At this point, for

s = 72.3, we have C

N

= C

O

= 11,814.

Because the current inventory level of 100 falls above the reorder

point, no additional inventory should be purchased. If there were no fixed

charge for delivery, the order would be for 12 units.

Example 7: Demand with an Exponential Distribution

Consider the situation of Example 6 except that demand has an

exponential distribution with a mean value = 150. At the optimal order

level

F(S

*

) = 1 – exp(–S/ ) = 0.3077.

Solving for S, we get

S = – [ln(1 – 0.3077)] = 55.17.

The difference between s and S for the exponential distribution is

approximately

∆ = S – s =

2 K

c + h

=

2(150)(500)

100 − 20

= 41

s = 56 – 41 = 15

For this distribution of demand, the current inventory of 100 is

considerably above both the reorder point and the order level. Certainly

an order should not be placed.

1

The solution to the quadratic ax

2

+ b x + c = 0 is x =

–b ± b

2

–4a c]

2a

.

28 Inventory Theory

25.5 The (s, Q) Inventory Policy

We now consider inventory systems similar to the deterministic models presented in

Section 25.2, but allow the demand to be stochastic. There are a number of ways one

might operate an inventory system with random demand. At this time, we consider the

(s, Q) inventory policy, alternatively called the reorder point, order quantity system.

Figure 9 shows the inventory pattern determined by the (s, Q) inventory policy. The

model assumes that the inventory level is observed at all times. This is called continuous

review. When the level declines to some specified reorder point, s, an order is placed for

a lot size, Q. The order arrives to replenish the inventory after a lead time, L.

Time

Inventory Level

0

0

L L L L L

Q

r

Figure 9. Inventory Operated with the reorder point-lot size Policy

Model

The values of s and Q are the two decisions required to implement the

policy. The lead time is assumed known and constant. The only

uncertainty is associated with demand. In Fig. 9, we show the decrease in

inventory level between replenishments as a straight line, but in reality the

inventory decreases in a stepwise and uneven fashion due to the discrete

and random nature of the demand process.

If we assume that L is relatively small compared to the expected

time required to exhaust the quantity Q, it is likely that only one order is

outstanding at any one time. This is the case illustrated in the figure. We

call the period between sequential order arrivals an order cycle. The cycle

begins with the receipt of the lot, it progresses as demand depletes the

inventory to the level s, and then it continues for the time L when the next

lot is received. As we see in the figure, the inventory level increases

instantaneously by the amount Q with the receipt of an order.

In the following analysis, we are most concerned with the

possibility of shortage during an order cycle, that is the event of the

inventory level falling below zero. This is also called the stockout event.

We assume shortages are backordered and are satisfied when the next

The (s, Q) Inventory Policy 29

replenishment arrives. To determine probabilities of shortages, one need

only be concerned about the random variable that is the demand during the

lead time interval. This is the random variable X with pdf, f(x), and CDF

F(x). The mean and standard deviation of the distribution are and

respectively. The random demand during the lead time gives rise to the

possibility that the inventory level will be depleted before the

replenishment arrives. With the average rate of demand equal to a, the

mean demand during the lead time is

= aL

A shortage will occur if the demand during the period L is greater

that s. This probability, defined as P

s

, is

P

s

= P{x > s} = f (x)dx

s

∞

∫

= 1 – F(s).

The service level is the probability that the inventory will not be depleted

during one order cycle, or

Service level = 1 – P

s

= F(s).

In practical instances the reorder point is significantly greater than

the mean demand during the lead time so that P

s

is quite small. The safety

stock, SS, is defined as

SS = s – .

This is the inventory maintained to protect the system against the

variability of demand. It is the expected inventory level at the end of an

order cycle (just before a replenishment arrives). This is seen in Fig. 10,

where we show the (s, Q) policy for deterministic demand. This figure

will also be useful for the cost analysis of the system.

Time

Inventory Level

0

0

L L

Q

s

L L

SS

Figure 10. The (s, Q) policy for deterministic demand

30 Inventory Theory

General Solution for the (s, Q) Policy

We develop here a general cost model for the (s, Q) policy. The model

and its optimal solution depends on the assumption we make regarding the

cost effects of shortage. The model is approximate in that we do not

explicitly model all the effects of randomness. The principal assumption

is that stockouts are rare, a practical assumption in many instances. In the

model we use the same notation as for the deterministic models of Section

25.2. Since demand is a random variable, we use a as the time averaged

demand rate per unit time.

When we assume that the event of a stockout is rare and inventory

declines in a continuous manner between replenishments, the average

inventory is approximately

Average inventory level =

Q

2

+ s – .

Because the per unit holding cost is h, the holding cost per unit time is

Expected holding cost per unit time = h(

Q

2

+ s – ).

With the backorder assumption, the time between orders is random with a

mean value of Q/a. The cost for replenishment is K, so the expected

replenishment cost per unit time is

Expected replenishment cost per unit time =

Ka

Q

.

With the (s, Q) policy and the assumption that L is relatively

smaller than the time between orders, Q/a, the shortage cost per cycle

depends only on the reorder point. We call this C

s

, and we observe that it

is a function of the reorder point s. We investigate several alternatives for

the definition of this shortage cost. Dividing this cost by the length of a

cycle we obtain

Expected Shortage cost per unit time =

a

Q

C

s

.

Combining these terms we have the general model for the expected cost of

the (s, Q) policy.

EC(s, Q) = h(

Q

2

+ s – ) Inventory cost

+

Ka

Q

Replenishment cost

The (s, Q) Inventory Policy 31

+

a

Q

C

s

Shortage cost (37)

There are two variables in this cost function, Q and s. To find the

optimal policy that minimizes cost, we take the partial derivatives of the

expected cost, Eq. (37), with respect to each variable and set them equal

to zero. First, the partial derivative with respect to Q is

∂EC

∂Q

=

h

2

–

a(K + C

s

)

Q

2

= 0

or Q

*

=

2a(K + C

s

)

h

(38)

We have a general expression for the optimal lot size that depends on the

cost due to shortages. Taking the partial derivative with respect to the

variable s,

∂EC

∂s

= h +

a

Q

¸

¸

,

_ ∂C

s

∂s

= 0,

or

∂C

s

∂s

= –

hQ

a

(39)

The solution for the optimal reorder point depends on the functional form

of the cost of shortage. We consider four different cases in the remainder

of this section

2

.

Case of a Fixed Cost per Stockout

In this case, there is a cost

1

expended whenever there is the event of a

stockout. This cost is independent of the number of items short, just on

the fact that a stockout has occurred. The expected cost per cycle is

C

s

=

1

P{x

> s} =

1

f (x)dx

s

∞

∫

¸

¸

_

,

. (40)

Now the partial derivative of Eq. (40) with respect to s is

∂C

s

∂s

= –

1

f(s).

Combining Eq. (39) with Eq. (40), we have for the optimal value of s

∂C

s

∂s

= –

1

f(s*) = −

hQ

a

,

2

In this article we follow the development in Peterson and Silver [1979], Chapter 7.

32 Inventory Theory

or f(s*) =

hQ

1

a

, (41)

and C

s

=

1

(1 – F(s*)). (42)

Equation (41) is a condition on the value of the pdf at the optimal reorder

point. If no values of the pdf satisfy this equality, select some minimum

safety level as prescribed by management. The pdf may satisfy this

condition at two different values. It can be shown that the cost function is

minimized when f(x) is decreasing, so for a unimodal pdf, select the

greater of the two solutions.

Equation (41) specifying the optimal s* together with the Eq. (38)

for Q

*

define the optimal control parameters. If one of the parameters are

given at a perhaps not optimal value, these equations yield the optimum

for the other parameter. If both parameters are flexible, a successive

approximation method, as illustrated in Example 13, is used to find values

of Q and s that solve the problem.

Example 8: Optimal reorder point given the order quantity (

1

Given)

The monthly demand for a product has a normal distribution with a mean

of 100 and a standard deviation of 20. We adopt a continuous review

policy in which the order quantity is the average demand for one month.

The interest rate used for time value of money calculations is 12% per

year. The purchase cost of the product is $1000. When it is necessary to

backorder, the cost of paperwork is estimated to be $200, independent of

the number backordered. Holding cost is estimated using the interest cost

of the money invested in a unit of inventory. The lead time for this

situation is 1 week. The fixed order cost is $800. Find the optimal

inventory policy.

We must first adopt a time dimension for those data items related

to time. Here we use 1 month. For this selection,

a = 100 units/month

h = 1000(0.01) = $10/unit-month, the unit cost multiplied by the

interest rate (interest rate is 12%/12 = 1% per month)

1

= $1000, the backorder cost, which is independent in time and

number

K = $800, the order cost.

We must also describe the distribution of demand during the lead time.

For convenience we assume that 1 month has 4 weeks and that the

demands in the weeks are independent and identically distributed normal

variates. With these assumptions the weekly demand has

The (s, Q) Inventory Policy 33

= 100/4 = 25, and

2

= 20

2

/4 = 100 or = 10.

The problem specifies the value of Q as 1 month's demand; thus Q = 100.

Using this value in Eq. (41), we find the associated optimal reorder point.

or f(s*) =

hQ

1

a

=

(10)(100)

(1000)(100)

= 0.01.

The pdf of the standard normal distribution is related to a general normal

distribution as

f(s) = (1/ ) (k) or (k) = f(s)

Then in terms of the standard normal we have

(k

*

) =

hQ

1

a

= (10)(0.01) = 0.1.

We look this up in the standard normal table provided at the end of this

chapter to discover k

*

= ±1.66. Taking the larger of the two possibilities

we find

s* = + (1.66) = 25 + 1.66 (10) = 41.6

or 42 (conservatively rounded up). This is the optimal reorder point for

the given value of Q.

Case of a Charge per Unit Short

In some cases, we may also be interested in the expected number of items

backordered during an order cycle, E

s

. This depends on the demand

during the lead time.

Items backordered =

¹

'

¹

0, if x ≤ s

x – s, if x > s

Therefore, the expected shortage is

E

s

= (x – s) f (x)dx

s

∞

∫

.

For this situation, we assume a cost

2

is expended for every unit

short in a stockout event. The expected cost per cycle is

C

s

=

2

E

s

.

Now the partial derivative with respect to s is

∂C

s

∂s

= –

2

f (x)dx

0

s

∞

∫

¸

¸

_

,

= –

2

(1 – F(s)).

34 Inventory Theory

From Eq. (41), the optimal value of s must satisfy

∂C

s

∂s

= –

2

(1 – F(s*)) = −

hQ

a

or F(s*) = 1 –

hQ

2

a

. (43)

In this case, we have a condition on the CDF at the optimal reorder point.

If the expression on the right is less than zero, use some minimum reorder

point specified by management.

For a given value of s, the optimal order quantity is determined

from Eq. (38) by substituting the value of C

s

.

C

s

=

2

E

s

=

2

(x – s*) f (x)dx

s

∞

∫

¸

¸

_

,

. (44)

This integral is difficult to compute except for simple distributions. It is

evaluated with tables for the normal random variable using Eq. (25).

Managers may find it difficult to specify the shortage cost

2

. It is

easier to specify that the inventory meet some service level. One might

require that the inventory meet demands from stock in 99% of the

inventory cycles. The service level is actually the value of F(s). Given

values of h, Q and a, one can compute with Eq. (43) the implied shortage

cost for the given service level.

Example 9: Optimal reorder point given the order quantity (

2

Given)

We consider again Example 8, but change the cost structure for

backorders. Now we assume that we must treat each backordered

customer separately. The cost of paperwork and good will is estimated to

be $200 per unit backordered. This is

2

. The optimal policy is governed

by Eq. (43).

F(s*) = 1 –

hQ

2

a

= 1 –

(10)(100)

(200)(100)

= 0.95.

We know that the probabilities for a normal distribution is related to the

standard normal distribution by

F(s) =

s – ¸

¸

_

,

.

(k

*

) = 0.95.

From the normal distribution table we find that this is associated with a

standard normal variate of z = 1.64. The reorder point is then

The (s, Q) Inventory Policy 35

s* = + (1.64) = 25 + 1.64 (10) = 41.4

or 42 (conservatively rounded up). This is the optimal for the given value

of Q.

Case of a Charge per Unit Short per Unit Time

When the backorder cost depends not only on the number of backorders

but the time a backorder must wait for delivery, we would like to compute

the expected unit-time of backorders for an inventory cycle. When the

number of backorders is x – s and the average demand rate is a, the

average time a customer must wait for delivery is

x – s

2a

.

The resulting unit-time measure for backorders is

(x – s)

2

2a

.

Integrating we find the expected value T

s

, where

T

s

=

1

2a

(x – s)

2

f (x)dx

s

∞

∫

. (45)

We consider here the case when a cost

3

is expended for every

unit short per unit of time. The expected cost per cycle is

C

s

=

3

T

s

. (46)

Now the partial derivative of C

s

with respect to s is

∂C

s

∂s

= –

3

a

(x – s) f (x)dx

s

∞

∫

¸

¸

_

,

= –

3

E

s

a

.

From Eq. (41), the optimal value of s must satisfy

∂C

s

∂s

= −

3

E

s

a

= –

hQ

a

or E

s

(s*) =

hQ

3

. (47)

We have added the parameter s* to the expected shortage to indicate its

value is a function of the reorder point. Note that Silver et al. [1998]

report the result E

s

(s*) =

Qh

h +

3

which is derived using a more accurate

36 Inventory Theory

representation of the average inventory. The two results are

approximately the same when

3

>> h, as assumed here.

Example 10: Optimal reorder point given the order quantity (

3

Given)

We consider again Example 8, but now we assume that $1000 is expended

per unit backorder per month. This is

3

. The optimal policy is governed

by Eq. (47).

E

s

(s*) =

hQ

3

=

(10)(100)

1000

= 1.

When the demand is governed by the normal distribution, the expected

shortage at the optimum is

E

s

(s*) = G(k

*

) = 1

where k

*

=

s * −

or G(k

*

) = 0.1

From the table at the end of the chapter

k

*

= 0.9.

The reorder point is then

s* = + (0.9) = 25 + 9 = 34

This is the optimum for the given value of Q.

Lost Sales Case

In this case sales are not backordered. A customer that arrives when there

is no inventory on hand leaves without satisfaction, and the sale is lost.

When stock is exhausted during the lead time, the inventory level rises to

the level Q when it is finally replenished. The effect of this situation is to

raise the average inventory level by the expected number of shortages in a

cycle, E

s

. We also experience a shortage cost based on the number of

shortages in a stockout event. We use

L

to indicate the cost for each lost

sale. For the case of lost sales the approximate expected cost is

EC(Q, s) = h

Q

2

+ s − + E

s

¸

¸

_

,

Inventory cost

+

aK

Q

Replenishment cost

The (s, Q) Inventory Policy 37

+

a

L

Q

E

s

Shortage cost (48)

Here we are neglecting the fact that with lost sales, not all the demand is

met. The number of orders per unit time is slightly less than a/Q. Taking

partial derivatives with respect to Q and s we find the optimal lot size is

Q

*

=

2a(K +

L

E

s

)

h

(49)

∂EC

∂s

= h 1 +

∂E

s

∂s

¸

¸

_

,

)+

a

L

Q

∂E

s

∂s

¸

¸

_

,

= 0,

or

∂E

s

∂s

= −

hQ

hQ+

L

a

or (1 – F(s*)) =

hQ

hQ+

L

a

F(s*) = 1 –

hQ

hQ+

L

a

=

L

a

hQ+

L

a

(50)

Example 11: Optimal reorder point given the order quantity (

L

Given)

We consider Example 8 again, but now we assume that the sale is lost

given a stockout. We charge $2000 for every lost sale. This is

L

. The

optimal policy is governed by Eq. (50).

F(s*) =

L

a

hQ+

L

a

=

(2000)(100)

(10)(100) + (2000)(100)

= 0.995

From the table at the end of the chapter

k

*

= 2.58.

The reorder point is then

s* = + (2.58) = 25 + 22.6 = 47.6

This is the optimum for the given value of Q.

Summary

We have found in this section solutions for several assumptions regarding

the costs due to shortages. These are summarized below for easy use. The

optimal reorder point requires one to find the value s* that corresponds to

38 Inventory Theory

f(s*), F(s*) or E

s

(s*) equaling some simple function of the problem

parameters.

The optimal order quantity for each case depends on the shortage

cost, C

s

, and is given by

Q* =

2a(K + C

s

)

h

This equation is used directly when a value of s is specified. It is used

iteratively when the optimum for both s and Q is required.

Table 1. The (s, Q) Policy for Continuous Distributions

Situation C

s

Optimal reorder point Normal solution

Fixed cost per

stockout (

1

)

1

(1 – F(s))

f(s*) =

hQ

1

a

(k

*

) =

hQ

1

a

Charge per unit

Short (

2

)

2

E

s

F(s*) = 1 –

hQ

2

a

(k

*

) = 1 –

hQ

2

a

Charge per unit

short per unit time

(

3

)

3

T

s

E

s

(s*) =

hQ

3

G(k

*

) =

hQ

3

Charge per unit of

lost sales (

L

)

L

E

s

F(s*) =

L

a

hQ+

L

a

(k

*

) =

L

a

hQ+

L

a

Determination of the Order Quantity

Up until this point, all our examples have determined the reorder point

given the order quantity. The following examples illustrate the

determination of the order quantity when the reorder point is given, and

the determination of optimal values for both variables simultaneously.

Example 12: Optimal order quantity given the reorder point

We continue from Example 9 in which the shortage cost is

2

= $200 per

unit short. The demand during the lead time is normal with µ = 25 and

= 10. If the reorder point is fixed at 50, what is the optimal order

quantity?

For a normal distribution the expected shortage cost is

C

s

=

2

G(k

s

)

The (s, Q) Inventory Policy 39

where k

s

= (s – )/ . For s = 50 and k

s

= 2.5, G(2.5) = 0.0020, E

s

=

0.020, C

s

= 4. Then the optimal order quantity is

Q

*

=

2a(K + C

s

)

h

=

2(100)(800 + 4)

10

= 126.8

or 127 (conservatively rounded up).

Example 13: Both optimal order quantity and reorder point

In the previous examples we fixed one of the decisions and found the

optimal value of the other. We need an iterative procedure to find both,

Q

*

and s*. We use the expression below sequentially.

Q =

2a(K + C

s

)

h

, (k

s

) = 1 –

hQ

2

a

, C

s

=

2

G(k

s

)

The first step is to assume C

s

= 0 and to find the corresponding

optimal order quantity.

Q

1

= 126.5.

Using this value of Q

1

, we find the optimal reorder point

k

s

= 1.53 or s = 40.3

The expected shortage per period with this reorder point is

C

s

=

2

G(1.53) = (200)(10)(0.02736) = 54.72

For this value of C

s

, we have

Q

2

= 130.7.

Using this value of Q

2

, we find the optimal reorder point

k

s

= 1.51 or s = 40.1

Computing the associated C

s

we find

Q

3

= 130.9.

It appears that the values are converging, so we adopt the policy

Q

*

= 131 and s* = 40.

40 Inventory Theory

25.6 Variations on the (s, Q) Model

Reorder Point Based on Inventory Position

In the foregoing, we have assumed that a replenishment order is to be

placed whenever the inventory level reaches the reorder point. A move

practical idea is to use the inventory position rather than the inventory

level as an indicator. The inventory position is the inventory level plus the

quantity on order. The difference is illustrated in Fig. 11. We note that

inventory level is the same as inventory position when there are no

outstanding orders. In the early cycles of the figure, the inventory level

crosses the reorder point at the same time as the inventory position, and

the same order pattern is obtained using either measure. Basing the order

on the inventory level fails, however, when there is a lead time demand

larger than the order quantity, as in the last cycle of the figure. In this case

the inventory level falls below the reorder point and never reaches it again.

Using the inventory position, however, allows two orders to be placed in

quick succession, thus keeping the inventory in control.

Inventory Position

0

0

L L L L

Q

s

Inventory Level

L

Time

Figure 11. Using inventory position as a measure for placing orders

Using the inventory position in this manner, also allows us to drop

the requirement that the lot size be very much greater than the average

demand during the lead time. The results in the table can be used even in

cases where the lot size is small in relation to the lead time demand. The

primary assumption for the derivations is that the probability of a stockout

be small. This probability depends on the reorder point and not the lot

size.

Variations on the (s, Q) Model 41

When the lot size is small, there may be many outstanding orders

at any given time, emphasizing the need to track the inventory position. A

particularly interesting case is when the lot size is 1. This implies that a

replenishment order is placed whenever an item is withdrawn from

inventory.

Discrete Demand During the Lead Time

The results of the table were derived for continuous distributions. In fact

the items in an inventory are usually discrete, and a discrete demand

distribution may be more appropriate. This is particularly true when the

reorder point is relatively small. For the discrete distribution p(x) is the

probability that the random demand during the lead time takes the value x.

F(x) is the probability that the demand is less than or equal to x. The

expected shortage and expected unit-time shortage are

E

s

= (x – s) p(x)

x ·s +1

∞

∑

(51)

T

s

=

1

2a

(x – s)

2

p(x)

x ·s +1

∞

∑

(52)

Table 2. The (s, Q) Policy for Discrete Distributions

Situation C

s

Optimal reorder point

Fixed cost per

stockout (

1

)

1

(1 – F(s))

p(s* – 1) >

hQ

1

a

≥ p(s*)

Charge per unit

short (

2

)

2

E

s

F(s*) ≤ 1 –

hQ

2

a

< F(s*+1)

Charge per unit

short per unit time

(

3

)

3

T

s

E

s

(s*–1) >

hQ

3

≥ E

s

(s*)

Charge per unit of

lost sales (

L

)

L

E

s

F(s*) ≤ 1 –

hQ

hQ+

L

a

< F(s*+1)

Lead Time a Random Variable

Previously we assumed that lead time is a constant. Indeed this is a very

desirable characteristic of an inventory system. The lead time may

actually be uncertain in duration due to variability in shipping times,

material availability and supplier processing times.

42 Inventory Theory

Let lead time be a random variable Y with pdf h(y), and let demand

be the random variable X with joint pdf g(x, y) -- that is, the demand

distribution depends on the lead time. The marginal distribution of

demand during the lead time is

f(x) = g(x, y)h(y)dy

0

∞

∫

(53)

This pdf can then be used in conjunction with the standard normal

distribution table to determine approximate solutions.

The (R, S) Inventory Policy 43

25.7 The (R, S) Inventory Policy

A different way to manage a stochastic inventory system is illustrated in Fig. 12 This is

called a periodic review policy in that the inventory level is only observed at intervals of

R. If the inventory is at level y, a quantity S – y is ordered to bring the inventory position

to S. S is called the order level. After a lead time interval L, the replenishment order is

delivered. Figure 12 shows the inventory position with dotted lines and the inventory

level with solid lines.

Time

0

0

L

L L L

R R R

S

Figure 12. The (R, S) inventory policy

The analysis of this policy is much like that for the (s, Q) policy. For the

(s, Q) policy, the reorder point s is set to protect against the possibility of

shortage during the lead time L. For the (R, S) policy, the order level S is

set to protect against a shortage in the time interval R + L. In the event of

a particular order at time t, the lowest inventory that is affected by that

order occurs at time t + R + L. The quantity S must be large enough to

keep the probability of a shortage in that time interval small. The (R, S)

policy is much more affected by variability than the (s, Q) policy because

of the longer interval. The advantage of the policy is that it does not

require continuous review.

To analyze this system, we define the demand in the interval R + L

to be the random variable X. The pdf and CDF are f

P

(x) and F

P

(x),

respectively. The mean and variance during the interval are

P

and

P

(the subscript “P” stands for periodic). The cost (per unit time) of

operation of the inventory system expressed in terms of R and S is

EC(R, S) = h (

aR

2

+ S – ) Inventory cost

44 Inventory Theory

+

K

R

Replenishment cost

+

1

R

C

S

Shortage cost (54)

Evaluation of the shortage cost depends on the assumption of the costs

experienced in the event of a stockout.

Fixed cost per stockout: C

s

=

1

(1 – F(S)) =

1

f

P

(x)

S

∞

∫

dx

¸

¸

_

,

(55)

Charge per unit short: C

s

=

2

E

s

=

2

(x – s) f

P

(x

S

∞

∫

)dx

¸

¸

_

,

(56)

Charge per unit short per unit time:

C

s

=

3

T

s

=

1

2a

(x – s)

2

f

P

(x)

S

∞

∫

dx

¸

¸

_

,

(57)

Charge per lost sale: C

s

=

L

E

s

=

L

(x – s) f

P

(x

S

∞

∫

)dx

¸

¸

_

,

(58)

We cannot determine the optimal R easily in this case because C

s

depends on R. In particular the distribution of demand in the expressions

for C

s

have a mean and variance that depends on the interval L + R. If we

assume that the review interval R is set elsewhere, the determination of the

optimal order level follows exactly the derivation for s* for the (s, Q)

policy. The optimal conditions are found in Table 1. We create Table 3

from Table 1 by replacing

s with S, Q with aR, and L with R + L.

A similar table for discrete distributions can be constructed starting from

Table 2.

The (R, S) Inventory Policy 45

Table 3. The (R, S) Policy for Continuous Distributions

Situation C

s

Optimal reorder point Normal solution

Fixed cost per

stockout (

1

)

1

(1 – F(S))

f

P

(S

*

) =

hR

1

(k

*

) =

P

hR

1

Charge per unit

Short (

2

)

2

E

s

F

P

(S

*

) = 1 –

hR

2

(k

*

) = 1 –

hR

2

Charge per unit

short per snit time

(

3

)

3

T

s

E

s

(S

*

) =

haR

3

G(k

*

) =

haR

P 3

Charge per unit of

lost sales (

L

)

L

E

s

F(S

*

) = 1 –

hR

hR +

L

(k

*

) = 1 –

hR

hR +

L

Example 14

We consider again the situation of Example 9 except the inventory is

reviewed every month. The monthly demand for the product has a normal

distribution with a mean of 100 and a standard deviation of 20. The

holding cost is $10 per unit per month. When it is necessary to backorder

a customer request, the cost of paperwork and good will is estimated to be

$200 per unit. The lead time for orders is zero. Find the optimal

inventory policy.

The parameters of the model are as follows

R = 1 month

h = $10, the cost of holding one unit for one month

2

= 200, the cost of backordering one unit

= 100 and = 20 during the review period (the distribution is

normal)

With these values we can determine the optimal policy.

(k

*

) = 1 –

hR

2

= 1 – (10/200) = 0.95

Using the standard normal table, we find that the CDF has the value 0.957

for z = 1.65. The order level is

S = 100 + 20(1.65) = 133.

46 Inventory Theory

The optimal policy is to order a quantity (133 – x) each month. The

probability of a shortage during the month is

1 – (k

*

) = 0.05.

The safety stock is S – µ = 33 units.

Now we consider the same problem when the review period is

every 2 months. The situation is the same except

R = 2 months

= 200 and = 20 2 = 28.28 during the review period (here we

assume that the monthly demands are independent)

(k

*

) = 1 –

hR

2

= 1 – (10)(2)/200) = 0.90.

Using a standard normal table, we find that the CDF has the value 0.899

for k = 1.28. Thus the reorder level is

S = 200 + 28.28(1.28) = 236.

The optimal policy is to order a quantity (236 – x) every two months. The

safety stock is: S – µ = 36. Three extra units of inventory are necessary

for the longer review period. For the continuous review of Example 9 the

safety stock is 17 units.

Exercises 47

25.8 Exercises

Section 25.2

1. It is now January 1. A hardware distributor is reviewing his inventory policy for

hammers, which have a relatively constant demand of 2000 units per month. The

distributor buys the hammers from his supplier for $5 each and sells them for $10.

Every time he places an order for replenishment a shipping and paper preparation

cost of $500 is charged. The distributor's holding cost is 15% (annual) of his

average investment in inventory. (The holding cost is h = (0.15)(5) = $0.75 per

hammer per year.)

Answer each of the following independently ( one part does not depend on another).

a. The current inventory policy is to replenish the inventory every month. What is

the total annual cost of this policy?

b. What is the optimal lot size when no shortages are allowed?

c. The distributor wants to order only at the beginning of the month, so the cycle

time must be in whole months. What is the optimal lot size in this case?

d. An OR analyst suggests that money might be saved if the customers would

accept backorders. If the distributor offers a discount of 1% of the purchase

price for every day the customer has to wait for delivery, what is the optimal

policy?

e. The supplier, in an effort to get larger orders, offers a $0.10 discount on the price

of hammers for an order of at least 10,000 units. Should the distributor take

advantage of this deal? Assume no shortages are allowed.

f. It is now January 1, and the current inventory is 3500 units. There is a lead time

(time between when the order is placed and when it is delivered) of 1 month.

When should the next order be placed for the solutions of parts (b), (c), (d), and

(e) of this problem?

g. Compute the annual profit on hammers for parts (a), (b), (c), (d), and (e).

2. Rather than an instantaneous replenishment of inventory as assumed in Section 25.2,

the inventory is replaced by a production process that can add units to the inventory

at a constant rate r (r > a ). Of course, the process cannot be operated continually

but must be started and stopped. Each time the process is begun a setup cost K is ex-

pended. Otherwise the inventory problem is the same as previously stated. Derive a

formula for the optimal lot size when no shortages are allowed.

3. A meat market advertises that its hamburger is the freshest in town. To get rid of old

stock, the price of the hamburger is reduced by $0.10 per pound for every hour it

remains unsold after it is ground (for simplicity assume this reduction is linear in

time). The demand for hamburger is 250 pounds per hour. No shortages are al-

48 Inventory Theory

lowed. The cost to set up and run the hamburger grinder is $100, independent of the

amount processed. How much should be ground at each setup?

4. Consider a gift shop operator with a relatively constant demand for a certain type of

wall hanging. She can order a case that holds 12 units for a cost of $1200 or a gross

that holds 144 units for $13,000. These costs include delivery and product cost. The

demand for the product is 12 units per month, so the alternatives represent ordering a

1-month or 1-year supply. As an approximation assume that demand is at a constant

rate and no shortages are allowed. A principal concern for this business woman is

the cost of capital, which is 20% per year. Which plan should she adopt?

5. Light bulbs come in cases of 144 bulbs. A case of bulbs costs $200. An office

building uses bulbs at an average rate of 1000 bulbs per month. The company that

sells the bulbs charges $50 per delivery, regardless of the number of cases delivered.

The management of the building uses a 15% annual carrying cost rate for inventory.

No shortages are allowed.

a. Assuming the usage rate for bulbs is constant, how many cases of bulbs should

be ordered in each delivery? Only whole cases can be ordered.

b. With this order quantity, how often will bulbs be delivered?

c. A long-standing policy has been to receive 10 cases per delivery. What is the

annual cost penalty of this nonoptimal policy over the cost of the optimal policy?

6. Find the optimal policy for 5 if backorders are allowed. A failed bulb is simply not

replaced until the beginning of the next month if the supply is exhausted. The

management assumes a "loss of good will" charge of $10 per bulb per month for

backorders.

Section 25.4

7. A garden nursery has a short selling season of 20 days for a certain kind of tree. The

nursery currently has 20 such trees in stock and has one last opportunity to order

more. The expected demand for trees is 3 per day, but the actual demand has a

Poisson distribution. The nursery purchases the trees for $75 and sells them for

$175. Trees remaining at the end of the season must be cared for until the next year.

The cost of such care per tree is $20 and the holding cost on investment is $2. If

demand occurs after the inventory is exhausted, the sales are lost. Find the number

of trees that should be ordered and the probability that this inventory level will be

sufficient to meet all demand. (Note that since leftover trees will actually be kept

after the season and eventually sold, the purchase cost is not relevant. Only the

shortage cost and holding cost should be used.)

8. For the parameters given in Example 6 in the text, the probability of a shortage is

almost 70%. Management has determined that this is too high. A level of 10% is

considered an acceptable probability of shortage. If all other parameters remain the

same, what penalty is implicitly being charged for a shortage? For this value find

Exercises 49

the optimal policy assuming the distribution of demand is uniform between 50 and

250 items.

9. Use the penalty found in Exercise 8, and find the optimal policy if the demand is

exponential distributed with a mean of 150.

10. A dishonest developer wants to make quick money building a condominium. He

sets a 1-year time table for his activities, after which he will leave town for places

unknown. His problem is to determine how many units to build. He estimates the

following probabilities for the demand for his units. In the table below, x is the

number of units demanded and p (x) is the probability of that demand.

x 1 2 3 4 5 6 7 8

p (x) 0.02 0.03 0.09 0.14 0.19 0.14 0.10 0.05

x 9 10 11 12 13 14 15

p (x) 0.05 0.05 0.04 0.04 0.03 0.02 0.01

The selling price for a condo unit is $100,000, while it will cost only $40,000 to

build it. If the developer runs out of units while there is still demand, he charges a

lost opportunity cost of $10,000. If the year passes and he has not sold all his units,

he will have to dump them for $20,000 each. How many units should he build to

maximize his expected profit?

11. A military commander faces a dangerous mission which requires the use of

helicopters. The commander wants to determine how many to bring on the mission.

The helicopters cost $1 million each. At least five are required for mission success.

Any number less than five is judged a serious detriment to the mission. In order to

quantify the situation, the commander has attached a cost of $100 million for every

unit less than five that finishes the mission. Any units that remain at the end of the

mission are destroyed.

Failure-causing events are assumed to occur at random on the average of once every

hour. The number of events is independent of the number of helicopters active.

Each event will destroy one helicopter. The mission lasts 10 hours.

How many helicopters should the commander bring?

12. Consider a problem with the following parameters.

c = $10, h = $1, p = $100, and K = $200.

Find the optimal (s , S) policy when:

a. Demand has a uniform distribution with A = 20 and B = 60

b. Demand has an exponential distribution with a mean value of 40

50 Inventory Theory

Section 25.5 - 25.7

13. We repeat the conditions of Example 9. The demand per month has a normal

distribution with mean 100 and standard deviation 20. The lead time is one week.

Assume four weeks per month.

a = 1200 units/year.

h = $120/unit-year.

2

= $200.

K = $800.

Find the optimal (s, Q) policy when the following changes are made. The changes

are not cumulative.

a. The average demand doubles but the standard deviation remains the same.

b. The standard deviation of demand per week doubles.

c. The fixed setup cost doubles.

d. The holding cost doubles.

e. The backorder cost doubles.

f. The lead time doubles.

14. Find the optimal order level for an inventory system for which orders are placed

every 2 weeks. The weekly demand has a normal distribution with a mean of 25 and

a standard deviation 5. The cost of the item is $20. Interest per year is 20%.

Assume a 50-week year. The backorder cost is $5 per unit.

15. Use the data of Exercise 14 and add the information that the setup cost is $200 and

the lead time is 1 week. Find the optimal continuous review policy for the following

situations.

a. The order quantity is set to the average demand for 1 month.

b. The reorder point is set at the average demand over the lead time.

c. Neither the reorder point nor the order quantity is specified.

16. A supplier of rebuilt engines expects an average of three engine customers every 2

months. Customer arrivals follow a Poisson process. The engines are obtained from

a manufacturer who delivers 2 months after an order is placed.

a. What should be the supplier's reorder point if she wants a 60% chance of not

having a shortage during the lead time?

b. What should be the reorder point if the lead time were 1 month?

Exercises 51

17. Consider the light bulb situation of Exercise 5, except that demand is stochastic

rather than deterministic. The weekly demand for light bulbs is a random variable

with a normal distribution that has a mean of 250 bulbs and a standard deviation of

50 bulbs. An order for bulbs is placed once a month (on the first of the month) and

the order is delivered right away. If the supply of bulbs runs out and a bulb fails, the

tenant simply must wait until the beginning of the next month. For purposes of

analysis, this event is assumed to have a cost of $10. Assume for simplicity that

months are 4 weeks long and that there are 48 weeks in a year. What specific

numerical rule should the management use to determine how much to order each

month?

18. The average demand for a product at a warehouse is 1200 units per year. Customers

arrive at random (a Poisson process) so the exact demand for any given period of

time cannot be computed. The warehouse manager replenishes the inventory by a

monthly order to the factory. The size of the order equals the previous month's

sales.

a. What kind of inventory system is this?

b. What order level will provide a 95% chance that the inventory will not run out

during an order cycle?

19. The manager in Exercise 18 installs computerized inventory control so that

continuous review is possible. He adopts a (s, Q) policy. A lead time of 1 week

passes between when an order is placed and when the inventory is replenished. A

lot size of 100 is selected. Assume a month is 4 weeks.

a. What reorder point will provide a 95% chance that the inventory will not run out

during an order cycle?

b. What is the average cycle time for this plan?

20. A gasoline distributor has a weekly demand that is approximately normally

distributed. The average demand is 10,000 gallons per week; however, the standard

deviation is 3000 gallons. His supply is replenished every 6 weeks. He must pay

$0.75 per gallon. His cost of capital is 0.5% per week. He recovers this cost in the

price he charges for gasoline, but if any remains in inventory when the next order

arrives he charges a holding cost based on this interest rate and the value of the

inventory. If the distributor runs out of supply during the period, he "borrows" gas

from other distributors, paying an extra $0.10 per gallon for the privilege. The

borrowed gas must be returned when his supply is replenished. What is the optimal

inventory policy for the distributor?

21. One of the disadvantages of using large order quantities in a production process is,

of course, large holding costs. Another disadvantage is the inflexibility associated

with having a large inventory. If a design change is to be incorporated into the

52 Inventory Theory

product or some custom feature is to be added for particular customers, the

modification must await the next production cycle while the entire inventory is

depleted. The average length of the cycle is Q /a, so as Q grows so does the length

of the cycle. This might be called the lead time of the production process. The

reason for a large order quantity is a large setup cost, so reducing setup cost results

in reduced holding cost, decreased production lead time, and increased flexibility.

This is one of the tenants of the "just-in-time" production systems, which go to great

measures to reduce setup costs. Analyze the following production systems that are

characterized by different setup costs K, and different annual costs to implement the

production process B.

a. K = $10,000 , B = $10,000

b. K = $5,000 , B = $30,000

c. K = $1,000 , B = $110,000

In each case weekly demand follows a normal distribution with mean 50, and

standard deviation 10. Use a 50-week year and an (s, Q) inventory policy. The

holding cost is h = $200/unit-year. The lead time when a reorder is placed is 1

week. The shortage cost is $100 per unit. Compute the optimal values of s and Q

for each case and compare the total costs (including B) and production lead times.

Choose the least cost system.

Exercises 53

Table 4. Function Values for the Standard Normal Distribution, y ∈ −3,0 [ ]

†

y ( y) ( y) G( y) y ( y) ( y) G( y)

-3.00 0.0044 0.0013 3.0004 -1.50 0.1295 0.0668 1.5293

-2.95 0.0051 0.0016 2.9505 -1.45 0.1394 0.0735 1.4828

-2.90 0.0060 0.0019 2.9005 -1.40 0.1497 0.0808 1.4367

-2.85 0.0069 0.0022 2.8506 -1.35 0.1604 0.0885 1.3909

-2.80 0.0079 0.0026 2.8008 -1.30 0.1714 0.0968 1.3455

-2.75 0.0091 0.0030 2.7509 -1.25 0.1826 0.1056 1.3006

-2.70 0.0104 0.0035 2.7011 -1.20 0.1942 0.1151 1.2561

-2.65 0.0119 0.0040 2.6512 -1.15 0.2059 0.1251 1.2121

-2.60 0.0136 0.0047 2.6015 -1.10 0.2179 0.1357 1.1686

-2.55 0.0154 0.0054 2.5517 -1.05 0.2299 0.1469 1.1257

-2.50 0.0175 0.0062 2.5020 -1.00 0.2420 0.1587 1.0833

-2.45 0.0198 0.0071 2.4523 -0.95 0.2541 0.1711 1.0416

-2.40 0.0224 0.0082 2.4027 -0.90 0.2661 0.1841 1.0004

-2.35 0.0252 0.0094 2.3532 -0.85 0.2780 0.1977 0.9600

-2.30 0.0283 0.0107 2.3037 -0.80 0.2897 0.2119 0.9202

-2.25 0.0317 0.0122 2.2542 -0.75 0.3011 0.2266 0.8812

-2.20 0.0355 0.0139 2.2049 -0.70 0.3123 0.2420 0.8429

-2.15 0.0396 0.0158 2.1556 -0.65 0.3230 0.2578 0.8054

-2.10 0.0440 0.0179 2.1065 -0.60 0.3332 0.2743 0.7687

-2.05 0.0488 0.0202 2.0574 -0.55 0.3429 0.2912 0.7328

-2.00 0.0540 0.0228 2.0085 -0.50 0.3521 0.3085 0.6978

-1.95 0.0596 0.0256 1.9597 -0.45 0.3605 0.3264 0.6637

-1.90 0.0656 0.0287 1.9111 -0.40 0.3683 0.3446 0.6304

-1.85 0.0721 0.0322 1.8626 -0.35 0.3752 0.3632 0.5981

-1.80 0.0790 0.0359 1.8143 -0.30 0.3814 0.3821 0.5668

-1.75 0.0863 0.0401 1.7662 -0.25 0.3867 0.4013 0.5363

-1.70 0.0940 0.0446 1.7183 -0.20 0.3910 0.4207 0.5069

-1.65 0.1023 0.0495 1.6706 -0.15 0.3945 0.4404 0.4784

-1.60 0.1109 0.0548 1.6232 -0.10 0.3970 0.4602 0.4509

-1.55 0.1200 0.0606 1.5761 -0.05 0.3984 0.4801 0.4244

-1.50 0.1295 0.0668 1.5293 0.00 0.3989 0.5000 0.3989

†

y is a standard normal variate

(y) is the probability density function, pdf

(y) is the cumulative distribution function, CDF

G(y) = (y) – y[1 – (y)]

54 Inventory Theory

Table 4. (Cont.) Function Values for the Standard Normal Distribution y ∈ 0,3 [ ]

†

y ( y) ( y) G( y) y ( y) ( y) G( y)

0.00 0.3989 0.5000 0.3989 1.50 0.1295 0.9332 0.0293

0.05 0.3984 0.5199 0.3744 1.55 0.1200 0.9394 0.0261

0.10 0.3970 0.5398 0.3509 1.60 0.1109 0.9452 0.0232

0.15 0.3945 0.5596 0.3284 1.65 0.1023 0.9505 0.0206

0.20 0.3910 0.5793 0.3069 1.70 0.0940 0.9554 0.0183

0.25 0.3867 0.5987 0.2863 1.75 0.0863 0.9599 0.0162

0.30 0.3814 0.6179 0.2668 1.80 0.0790 0.9641 0.0143

0.35 0.3752 0.6368 0.2481 1.85 0.0721 0.9678 0.0126

0.40 0.3683 0.6554 0.2304 1.90 0.0656 0.9713 0.0111

0.45 0.3605 0.6736 0.2137 1.95 0.0596 0.9744 0.0097

0.50 0.3521 0.6915 0.1978 2.00 0.0540 0.9772 0.0085

0.55 0.3429 0.7088 0.1828 2.05 0.0488 0.9798 0.0074

0.60 0.3332 0.7257 0.1687 2.10 0.0440 0.9821 0.0065

0.65 0.3230 0.7422 0.1554 2.15 0.0396 0.9842 0.0056

0.70 0.3123 0.7580 0.1429 2.20 0.0355 0.9861 0.0049

0.75 0.3011 0.7734 0.1312 2.25 0.0317 0.9878 0.0042

0.80 0.2897 0.7881 0.1202 2.30 0.0283 0.9893 0.0037

0.85 0.2780 0.8023 0.1100 2.35 0.0252 0.9906 0.0032

0.90 0.2661 0.8159 0.1004 2.40 0.0224 0.9918 0.0027

0.95 0.2541 0.8289 0.0916 2.45 0.0198 0.9929 0.0023

1.00 0.2420 0.8413 0.0833 2.50 0.0175 0.9938 0.0020

1.05 0.2299 0.8531 0.0757 2.55 0.0154 0.9946 0.0017

1.10 0.2179 0.8643 0.0686 2.60 0.0136 0.9953 0.0015

1.15 0.2059 0.8749 0.0621 2.65 0.0119 0.9960 0.0012

1.20 0.1942 0.8849 0.0561 2.70 0.0104 0.9965 0.0011

1.25 0.1826 0.8944 0.0506 2.75 0.0091 0.9970 0.0009

1.30 0.1714 0.9032 0.0455 2.80 0.0079 0.9974 0.0008

1.35 0.1604 0.9115 0.0409 2.85 0.0069 0.9978 0.0006

1.40 0.1497 0.9192 0.0367 2.90 0.0060 0.9981 0.0005

1.45 0.1394 0.9265 0.0328 2.95 0.0051 0.9984 0.0005

1.50 0.1295 0.9332 0.0293 3.00 0.0044 0.9987 0.0004

Bibliography 55

Bibliography

Askin, R.G. and C.R. Standridge, Modeling and Analysis of Manufacturing Systems, John

Wiley & Sons, New York, 1993.

Elsayed, E.A. and T.O. Boucher, Analysis and Control of Production Systems, Second

Edition, Prentice Hall, Englewood Cliffs, NJ, 1994.

Hopp, W. and M. Spearman, Factory Physics, Second Edition, McGraw Hill, New York,

2000.

Johnson, L.A. and D.C. Montgomery, Operations Research in Production Planning,

Scheduling, and Inventory Control, John Wiley & Sons, New York, 1974.

Moskowitz, H. and G.P. Wright, Operations Research Techniques for Management,

Prentice Hall, Englewood Cliffs, NJ, 1979.

Nahmis, S., Production and Operations Analysis, Third Edition, Irwin, Chicago, 1997.

Peterson, R. and E.A. Silver, Decision Systems for Inventory Management and

Production Planning, John Wiley & Sons, New York, 1979.

Ritzman, L.P. and L.J. Krajewski, Foundations of Operations Management, Prentice

Hall, Upper Saddle River, NJ, 2003.

Russell, R.S. and B.W. Taylor III, Operations Management, Fourth Edition, Prentice

Hall, Upper Saddle River, NJ, 2003.

Silver, E.A., D.F. Pyke and R. Peterson, Inventory Management and Production

Planning and Scheduling, Third Edition, John Wiley & Sons, New York, 1998.

Sipper, D., Production: Planning, Control and Integration, McGraw Hill, New York,

1997.

Tersine, R.J., Principles of Inventory and Materials Management, Fourth Edition,

Prentice Hall, Prentice Hall, Englewood Cliffs, NJ, 1994.

Zipkin, P.H., Foundations of Inventory Management, McGraw Hill, New York, 2000.

2

Inventory Theory

regarding the costs of operation. Sections 25.5 and 25.6 derive optimal solutions for the (s, S) policy under a variety of conditions. This policy places an order up to level S when the inventory level falls to the reorder point s. Section 25.7 extends these results to the (R, S) policy. In this case, the inventory is observed periodically (with a time interval R), and is replenished to level S. Flow, Inventory and Time An inventory is represented in the simple diagram of Fig. 1. Items flow into the system, remain for a time and then flow out. Inventories occur whenever the time an individual enters is different than when it leaves. During the intervening interval the item is part of the inventory.

Flow In

Inventory Level (Residence Time)

Flow Out

Figure 1. A system component with inventory For example, say the box in Fig. 1 represents a manufacturing process that takes a fixed amount of time. A product entering the box at one moment leaves the box one hour later. Products arrive at a rate of 100 per hour. Clearly, if we look in the box, we will find some number of items. That number is the inventory level. The relation between flow, time and inventory level that is basic to all systems is Inventory level = (Flow rate )(Residence time) where the flow rate is expressed in the same time units as the residence time. For the example, we have Inventory Level = (100 products/hour )(1 hour) = 100 products. When the factors in Eq. (1) are not constant in time, we typically use their mean values. Whenever two of the factors in the above expression are given, the third is easily computed. Consider a queueing system for which customers are observed to arrive at an average rate of 10 per hour. When the customer finds the servers busy, he or she must wait. Customers in the system, either waiting or be served, are the inventory for this system. Using a sampling procedure we determine that the average number of customers in the inventory is 5. We ask, how long on the average is each customer in the system? Using the relation between the flow, time and (1)

Inventory Models inventory, we determine the answer as 0.5 hours. As we saw in the Chapter 16, Queueing Models, Eq (1) is called Little's Law.

3

The relation between time and inventory is significant, because very often reducing the throughput time for a system is just as important as reducing the inventory level. Since they are proportional, changing one factor inevitably changes the other. The Inventory Level The inventory level depends on the relative rates of flow in and out of the system. Define y(t) as the rate of input flow at time t and Y(t) the cumulative flow into the system. Define z(t) as the rate of output flow at time t and Z(t) as the cumulative flow out of the system. The inventory level, I(t) is the cumulative input less the cumulative output. ⌡ ⌡ I(t) = Y(t) – Z(t) = ⌠y(x)dx - ⌠z(x)dx

0 0 t t

(2)

**Figure 2 represents the inventory for a system when the rates vary with time.
**

Inventory Level

0 0

Time

Figure 2. Inventory fluctuations as a function of time The figure might represent a raw material inventory. The flow out of inventory is a relatively continuous activity where individual items are placed into the production system for processing. To replenish the inventory, an order is placed to a supplier. After some delay time, called the lead time, the raw material is delivered in a lot of a specified amount. At the moment of delivery, the rate of input is infinite and at other times it is zero. Whenever the instantaneous rates of input and output to a component are not the same, the inventory level changes. When the input rate is higher, inventory grows; when output rate is higher, inventory declines. Usually the inventory level remains positive. This corresponds to the presence of on hand inventory. In cases where the cumulative output

4

Inventory Theory exceeds the cumulative input, the inventory level is negative. We call this a backorder or shortage condition. A backorder is a stored output requirement that is delivered when the inventory finally becomes positive. Backorders may only be possible for some systems. For example, if the item is not immediately available the customer may go elsewhere; alternatively, some items may have an expiration date like an airline seat and can only be backordered up to the day of departure. In cases where backorders are impossible, the inventory level is not allowed to become negative. The demands on the inventory that occur while the inventory level is zero are called lost sales.

Variability, Uncertainty and Complexity The are many reasons for variability and uncertainty in inventory systems. The rates of withdrawal from the system may depend on customer demand which is variable in time and uncertain in amount. There may be returns from customers. Lots may be delivered with defects causing uncertainty in quantities delivered. The lead time associated with an order for replenishment depends on the capabilities of the supplier which is usually variable and not known with certainty. The response of a customer to a shortage condition may be uncertain. Inventory systems are often complex with one component of the system feeding another. Figure 3 shows a simple serial manufacturing system producing a single product.

1 2 3 Oper. 4 Delay 5 Inspect 6 Delay 7 Oper. 8 Delay 9 10

Raw Delay Material

Inspect Finished Goods

Figure 3. A manufacturing system with several locations for inventories We identify planned inventories in Fig. 3 as inverted triangles, particularly the raw material and finished goods inventories. Material passing through the production process is often called work in process (WIP). These are materials waiting for processing as in the delay blocks of the figure, materials undergoing processing in the operation blocks, or materials undergoing inspection in the inspection blocks. All the components of inventory contribute to the cost of production in terms of handling and investment costs, and all require management attention. For our analysis, we will often consider one component of the system separate from the remainder, particularly the raw material or finished goods inventories. In reality, rarely can these be managed independently. The material leaving a raw material inventory does not leave the system, rather it flows into the remainder of the production

Inventory Models

5

system. Similarly, material entering a finished goods inventory comes from the system. Any analysis that optimizes one inventory independent of the others must provide less than an optimal solution for the system as a whole.

so we provide the dimensions of each factor. The dimension of ordering cost is ($). The fixed cost is called the setup cost and given in ($). Dimensional analysis is sometimes useful for modeling inventory systems. and a variable cost that depends on the amount ordered. lots are of a fixed size Q. Additional model dependent notation is introduced later. • Setup cost (K): A common assumption is that the ordering cost consists of a fixed cost. We use this deterministic model of the system to explain some of the notation associated with inventory. the total cost is cz. the product cost may be a decreasing function of the amount ordered. The resulting behavior of the inventory is shown in Fig.2 The Deterministic Model An abstraction to the chaotic behavior of Fig. Inventory Level s+Q s 0 0 Q/a 2Q/a 3Q/a 4Q/a 5Q/a 6Q/a Time Figure 4. 2 is to assume that items are withdrawn from the inventory at an even rate a. Alternatively. The amount ordered is z and the function c(z) is often nonlinear. 4. • Product cost (c): This is the unit cost of purchasing the product as part of an order. If the cost is independent of the amount ordered.6 Inventory Theory 25. we are able to find an optimal solutions to the deterministic model for several operating assumptions. Because of its simplicity. The inventory pattern without uncertainty Notation This section lists the factors that are important in making decisions related to inventories and establishes some of the notation that is used in this section. ($/unit) . that is independent of the amount ordered. and lead time is zero or a constant. • Ordering cost (c(z)): This is the cost of placing an order to an outside supplier or releasing a production order to a manufacturing shop. where c is the unit cost and z is the amount ordered.

which shows a plot of inventory level as a function of time. ($/time) • Optimal Quantities (Q*.The Deterministic Model 7 • Holding cost (h): This is the cost of holding an item in inventory for some given unit of time. ($/unittime) • Shortage cost (p): When a customer seeks the product and finds the inventory empty. S*. The fact that it never goes below 0 indicates . Although lost sales are often important in inventory analysis. (units) • Cycle time ( ): The time between consecutive inventory replenishments is the cycle time. this component of the cost is c . The holding cost may also include the cost of storage. T*): The quantities defined above that maximize profit or minimize cost for a given model are the optimal solution. insurance. If c is the unit cost of the product. and other factors that are proportional to the amount stored in inventory. The constant of proportionality is p. The total backorder cost is assumed to be proportional to the number of units backordered and the time the customer must wait. it is less than Q. The former case is called a lost sale. (time) • Cost per time (T): This is the total of all costs related to the inventory system that are affected by the decision under consideration. the demand can either go unfulfilled or be satisfied later when the product becomes available. they are not considered in this section. and the latter is called a backorder. (units) • Order level (S): The maximum level reached by the inventory is the order level. When backorders are allowed. but it is an important component of the cost of inventory. where is the discount or interest rate. Lot Size Model with no Shortages The assumptions of the model are described in part by Fig. (units / time) • Lot Size (Q): This is the fixed quantity received at each inventory replenishment. It usually includes the lost investment income caused by having the asset tied up in inventory. the per unit backorder cost per unit of time. The inventory level ranges between 0 and the amount Q. For the models of this section = Q/a. ($/unit-time) • Demand rate (a): This is the constant rate at which the product is withdrawn from inventory. When backorders are not allowed. this quantity is the same as Q. so no notation is assigned to it. 5. *. This is not a real cash flow.

The order quantity is Q. Solving for the optimal policy. Q* = 2aK h (4) (5) Q* and * = a Substituting the optimal lot size into the total cost expression. causing the inventory level to shoot from 0 to the amount Q. Figure 5. . (3). The factor 2 is the average inventory level. Q is the number of orders per unit time. (3) a Q In Eq. Lot size model with no shortages The total cost expressed per unit time is Cost/unit time = Setup cost + Product cost + Holding cost aK hQ T = Q + ac + 2 . Eq.8 Inventory Theory that no shortages are allowed. (3). Setting to zero the derivative of T with respect to Q we obtain dT aK h dQ = – Q2 + 2 = 0. The arrival of the order is assumed to occur instantaneously. The time between orders is called the cycle time. Periodically an order is placed for replenishment of the inventory. and is the time required to use up the amount of the order quantity. and preserving the breakdown between the cost components we see that T* = ahK 2 + ac + ahK 2 = ac + 2ahK (6) . or Q/a. Between orders the inventory decreases at a constant rate a.

The results do not depend on the time dimension that is used. not included in T*. while holding cost may be measured in dollars per year. indicating that there is an economy of scale associated with the flow through inventory. The maximum backorder level is Q – S. it is necessary that demand be translated to an annual basis or holding cost translated to a weekly basis. A backorder is represented in the figure by a negative inventory level. Find the optimal lot size and the corresponding cost of maintaining the inventory. (6) is T* = $282.84 per week. The optimal lot size from Eq.07 weeks. t* = 7. therefore. 6. Although these results are easy to apply. (4) is Q* = 2(100)(1000) = 707. The maximum inventory level is S and occurs when the order arrives. The product cost is. the holding cost is equal to the setup cost. Shortages Backordered A deterministic model considered in this section allows shortages to be backordered. For this model.4 The total cost of operating the inventory from Eq. The unit cost of the product was not given in this problem because it is irrelevant to the determination of the optimal lot size. however. we compute the cycle time.40 per week. No shortages are allowed. The cost to place an order for inventory replenishment is $1000. The holding cost for a unit in inventory is $0. This situation is illustrated in Fig. (5). Demand may be measured in units per week. 0. the optimal policy does not depend on the unit product cost.The Deterministic Model 9 At the optimum. In this model the inventory level decreases below the 0 level. This implies that a portion of the demand is backlogged. . Example 1 A product has a constant demand of 100 units per week. The optimal lot size increases with increasing setup cost and flow rate and decreases with increasing holding cost. From Q* and Eq. a frequent mistake is to use inconsistent time dimensions for the various factors. We see that optimal inventory cost is a concave function of product flow through the inventory (a).

S)2 T = Q + ac + 2Q + 2Q (7) The factor multiplying h in this expression is the average on-hand inventory level. 7.10 Inventory Theory Figure 6 Lot-size model with shortages allowed The total cost per unit time is Cost/time = Setup cost + Product cost + Holding cost + Backorder cost aK hS2 p(Q . This is the positive part of the inventory curve shown in Fig. We see the first cycle in Fig. S On-Hand Area Backorder Area 0 S-Q Figure 7. The first cycle of the lot size with backorders model Defining O(t) as the on-hand inventory level and O as the average on-hand inventory . Because all cycles are the same. 6. the average on-hand inventory computed for the first cycle is the same as for all time.

The optimal policy for this situation is found with Eqs. Example 2 We continue Example 1. (8). 2Q Setting to zero the partial derivatives of T with respect to Q and S yields S* = Q* = 2aK h 2aK h p p+h p+h p (8) (9) (10) Q* and * = a Comparing these results to the no shortage case.4 = 836.The Deterministic Model 11 ⌡ O = (1/ )⌠O(t)dt = (1/ )[On -hand Area] 0 a S2 S2 = = 2Q Q 2a Similarly the factor multiplying p is the average backorder level. ph S*/Q*= p + h (11) This factor is 1/2 when the two costs are equal. The backorder cost is $1 per unit-week. indicating that the inventory is in a shortage position one half of the time. but now we allow backorders. we see that the optimal lot size and the cycle times are increased by the factor [(p + h)/h]1/2.4 1 1 + 0. where B = (1/ )(Backorder Area) = (Q − S)2 .4 2(100)(1000) 0. B . The ratio between the order level and the lot size depends only on the relative values of holding and backorder cost.61 1 + 0. (9) and (10).4 = 597.66 1 . S* = Q* = 2(100)(1000) 0.

so the inventory pattern appears as in Fig. with q1 equal zero. There backorder level is 239 during each cycle.04 per week. Quantity Discounts The third deterministic model considered incorporates quantity discount prices that depend on the amount ordered.36 weeks. (12) We then find the optimal order quantity for each price range. The cost of operation has decreased since we have removed the prohibition against backorders.12 Inventory Theory 836. For this model no shortages are allowed. if qk ≤ Q* < qk+1 then Qk* = Q* . 5. (7) T* = $239. if Q* < qk then Qk* = qk.66 t* = 100 = 8. …. For this model we assume there are N different prices: c1. indicating that the price cN holds for any amount greater than qN. with the prices decreasing with the index. The quantity level at which the kth price becomes effective is qk. The value of Qk* would be the same for all price levels if not for the ranges of order size over which the prices are effective. Find for each k the value of Qk* such that if Q* > qk+1 then Qk* = qk+1. The discounts will affect the optimal order quantity. c. c2. we find from Eq. For purposes of analysis define q(N+1) equal to infinity. Therefore we compute the optimal lot size Q* using the parameters of the problem. To determine the optimal policy for this model we observe that the optimal order quantity for the no backorder case is not affected by the product price. Again neglecting the product cost. Since the price decreases as quantity increases the values of qk increase with the index k. cN. Q* = 2aK h .

but now assume quantity discounts. the unit price is $90. from Eq. We observe that this quantity falls in the second price range. (13). q2 = 500 and c2 = 90. This price applies to all units purchased. (13) b. * T2 = $9282 (for Q2 = 707 and c2 = 90) (14) c. Also q1 = 0 and c1 = 100. Example 3 We return to the situation of Example 1. Let this be level n*. Let k* be the level that has the smallest value of Tk. Find the price level for which Q* lies within the quantity range (the last of the conditions above is true). Neglecting the quantity ranges. The company from which the inventory is purchased hopes to increase sales by offering a break on the price of the product for larger orders. hQk* aK Tk = Q * + ack + 2 k size Q** is the lot size giving the least total cost as calculated in Steps b and c. All lower ranges are then excluded. For an amount purchased from 0 to 500 units. (14). For the cost c2 we use Eq. . We must then compare the cost at Q = 707 and c2 = 90. Compute the total cost for this lot size aK hQ* Tn* = Q* + acn* + 2 . For each level k > n*. compute the total cost Tk for the lot size Qk* .The Deterministic Model Optimal Order Quantity (Q** ) 13 a. From this data we establish that N = 3. The optimal lot For the cost c3 we use Eq. For orders at or greater than 1000 units. the unit price is $85. (12) we find the optimal lot size is 707 regardless of price. For orders at or above 500 but less than 1000. with the cost at Q = 1000 and c3 = 85. the unit price is $100. q3 = 1000 and c3 = 85. q4 = ∞.

Some assumptions. In addition it is often difficult to accurately estimate the parameters used in the formulas.800 (for Q3 = 1000 and c3 = 85). We should point out that whether or not the formulas are used. However abstract the models are. with the model specified as the total cost function. however. For example. Comparing the two costs. and constraints on maximum inventory are easily incorporated. Modeling The inventory analyst has three principal tasks: constructing the mathematical model. The model can be varied in a number of important aspects. one might question whether the lot size formulas should be used at all. we find the optimal policy is to order 1000 for each replenishment. The cycle time associated with this policy is 10 weeks. noninstantaneous replenishment rate. This section has presented only the simplest cases.14 Inventory Theory * T3 = $8. specifying the values of the model parameters. lead to complex optimization problems requiring nonlinear programming or other numerical methods. multiple products. When a deterministic model contains a nonlinear total cost function with only a few variables. The classic lot size formulas derived in this section are based on a number of assumptions that are usually not satisfied in practice. With the admitted difficulties of inaccurate assumptions and parameter estimation. lot size decisions are frequently required. and finding the optimal solution. the tools of calculus can often be used find the optimal solution. they do recognize important relationships between the various cost factors and the lot size. . and they do provide answers to lot sizing questions.

In this section we deal with inventory models in which the stochastic nature of demand is explicitly recognized.Stochastic Inventory Models 15 25.3 Stochastic Inventory Models There is no question that uncertainty plays a role in most inventory management situations. These situations are common. • Random Variable for Demand (x): This is a random variable that is the demand for a given period of time. An order too small increases the risk of lost sales and unsatisfied customers. but whose answers can provide guidance and insight to the inventory manager. The decision maker faced with uncertainty does not act in the same way as the one who operates with perfect knowledge of the future. • Discrete Demand Probability Distribution Function (P(x)): When demand is assumed to be a discrete random variable. Care must be taken to recognize the period for which the random variable is defined because it differs among the models considered. • Discrete Cumulative Distribution Function (F(b)): The probability that demand is less than or equal to b is F(b) when demand is discrete. f(x) is its density function. The retail merchant wants enough supply to satisfy customer demands. The operations manager sets a master production schedule considering the imprecise nature of forecasts of future demands and the uncertain lead time of the manufacturing process. F(b) = ∑ P(x) x =0 b • Continuous Demand Probability Density Function (f(x)): When demand is assumed to be continuous. The water resources manager must set the amount of water stored in a reservoir at a level that balances the risk of flooding and the risk of shortages. and the answers one gets from a deterministic analysis very often are not satisfactory when uncertainty is present. but ordering too much increases holding costs and the risk of losses through obsolescence or spoilage. P(x) gives the probability that the demand equals x. The probability that the demand is between a and b is P(a ≤ X ≤ b) = ∫ f (x)dx . Probability Distribution for Demand The one feature of uncertainty considered in this section is the demand for products from the inventory. Mathematical derivations will determine optimal policies in terms of the distribution. a b . but that the probability distribution of demand is known. Several models are presented that again are only abstractions of the real world. We assume that demand is unknown.

Then for an interval of time t the expected demand is at. If the . Selecting a Distribution An important modeling decision concerns which distribution to use for demand. Values of F(b) are evaluated using tables for the standard normal distribution. Of course other distributions can be assumed for demand. there is inventory remaining at the end of the interval. If the demand is less than the initial inventory level. Common assumptions are the normal distribution with other values of the mean and standard deviation. This assumption leads to the Poisson distribution when the expected demand in a time interval is small and the normal distribution when the expected demand is large. • Abbreviations: In the following we abbreviate probability distribution function or probability density function as pdf. We abbreviate the cumulative distribution function as CDF. Finding the Expected Shortage and the Expected Excess We are often concerned about the relation of demand during some time period relative to the inventory level at the beginning of the time period. x! When at is large the Poisson distribution can be approximated with a normal distribution with mean and standard deviation = at . • Continuous Cumulative Distribution Function (F(b)): The probability that demand is less than or equal to b when demand is continuous. A common assumption is that individual demand events occur independently.16 Inventory Theory We assume that demand is nonnegative. The latter two are useful for their analytical simplicity. the uniform distribution. This is the condition of excess. so f(x) is zero for negative values. We include these tables at the end of this chapter. and = at . The Poisson distribution is then P(x) = (at) x e −(at) . F(b) = ∫ f (x)dx 0 b • Standard Normal Distribution Function ( (x) and (x)): These are the density function and cumulative distribution function for the standard normal distribution. and the exponential distribution. Let a be the average demand rate.

sums replace the integrals in Eqs. the demand is a random variable x with pdf. assume the inventory level is a positive value z. and CDF. Ps = P{x ≥ z} = ∑ P(x)dx = 1 – F(z). Ps. x =0 z . Es. and the probability of excess. The mean and standard deviation of this distribution are and . (15) through (18). Pe. F(x). This depends on whether the demand is greater or less than z. (18) For discrete distributions.Stochastic Inventory Models 17 demand is greater than the initial inventory level. we compute the probability of a shortage. During some interval of time. f(x). x=z ∞ (19) (20) Pe = P{x ≤ z} = ∑ P(x)dx = F(z). we have the condition of shortage. With the given distribution. the expected excess is Ee Ee = ∫ (z – x) f (x)dx 0 z The expected excess is expressed in terms of Es Ee = ∫ (z – x) f (x)dx – 0 ∞ ∫ (z – x) f (x)dx z ∞ = z – µ + Es. z ∞ (17) Similarly for excess. At some point. 0. For a continuous distribution Ps = P{x > z} = ∫ f (x)dx = 1 – F(z) z ∞ (15) Pe = P{x ≤ z} = ∫ f (x)dx = F(z) 0 z (16) In some cases we may also be interested in the expected shortage. if x ≤ z Items short = x – z. if x > z Then Es is the expected shortage and is Es = ∫ (x – z) f (x)dx . respectively.

(y) and G(y). z= +k or k = z– We have included at the end of this chapter. the following relationships hold. (23) (24) (25) (26) . We have formerly identified the first two of these functions as the pdf and CDF. The third is defined as G(k) = ∞ ∫ (y − k) k (y)dy = (k) − k [1− (k)] . (y). x =0 (22) When the Distribution of Demand is Normal When the demand during the lead time has a normal distribution. tables are used to find these quantities. We specify the inventory level in terms of the number of standard deviations away from the mean. Assume the demand during the lead time has a normal distribution with mean and standard deviation .18 Inventory Theory Es = z ∑ (x – z)P(x)dx . f(z) = (1/ ) (k) F(z) = (k) Es(z) = G(k) Ee = z – µ + G(k) We have occasion to use these results in subsequent examples. x=z ∞ (21) Ee = ∑ (z – x)P(x)dx = z – µ + Es. Using the relations between the normal distribution and the standard normal. a table for the standard normal distribution.

First we assume there is no setup cost for placing a replenishment order. The profit in this case is Profit = bS – cS – d(x – S) for x ≥ S.Single Period Stochastic Inventories 19 25.4 Single Period Stochastic Inventories This section considers an inventory situation in which the current order for the replenishment of inventory can be evaluated independently of future decisions. Single Period Model with No Setup Cost Consider an inventory situation where the merchant must purchase a quantity of items that is offered for sale during a single interval of time. x – S. x. . but the current inventory decision must be independent of future periods. The profit in this case is Profit = bx – cS + a(S – x) for x ≤ S. If the demand is greater than S. If the demand is not satisfied during the interval. or when inventory spoils or becomes obsolete (fresh fruit. stocks for the Christmas season). The items are purchased for a cost c per unit and sold for a price b per unit. The demand during the period is a random variable x with given pdf and CDF. The expression for the profit during the interval depends on whether the demand falls above or below S. the expected profit is E[Profit] = b ∫ xf (x)dx + b ∫ Sf (x)dx 0 S S ∞ – cS + a ∫ (S – x) f (x)dx – d ∫ (x – S) f (x)dx . revenue is obtained only for the number sold. Assuming a continuous distribution and taking the expectation over all values of the random variable. Salvage is obtained for the unsold amount S – x. Such cases occur when inventory cannot be added later (spares for a space trip. S. For this section. If an item remains unsold at the end of the period. We call this the order level. because the purchase brings the inventory to level S. there is no cost for placing the order for the items. while the quantity purchased is S. current newspapers). 0 S S ∞ Rearranging and simplifying. it has a salvage value of a. S. there is a cost of d per unit of shortage. The problem may have multiple periods. A shortage cost of d is expended for each item short. If the demand is less than S. revenue is obtained only for the number sold. and then we assume that there is a setup cost. The problem is to determine the number of items to purchase.

is determined by b–c+d F(S*) = b – a + d . expended for every unit held at the end of the period. a holding cost h. c. The two solutions are equivalent if we identify h = –a = negative of the salvage value p = b + d = lost revenue per unit + shortage cost. dS 0 S or –c + aF(S) + (d + b)[1 – F(S)] = 0. or S= The optimality condition becomes +k . expended for every unit of shortage at the end of the period. the expected profit is easily evaluated for any given order level. (28) This result is sometimes expressed in terms of the purchasing cost. The profit is written in these terms as E[Profit] = b – cS + aEe – (d + b)Es (27) To find the optimal order level. The order level is expressed in terms of the number of standard deviations from the mean. and the expected shortage. S*. 0 S S ∞ E[Profit] = b We recognize in this expression the expected excess. (29) . and a cost p. If the demand during the period has a normal distribution with mean and standard deviation and . The optimal solution has p–c F(S*) = p + h . Ee. S ∞ The CDF of the optimal order level.20 Inventory Theory – cS + a ∫ (S – x) f (x)dx – (d + b) ∫ (x – S) f (x)dx . dE[Profit] = –c + a ∫ f (x)dx + (d + b) ∫ f (x)dx = 0. we set the derivative of profit with respect to S equal to zero. Es. In these terms the optimal expected cost is E[Cost] = cS + hEe+ pEs.

the salvage value of a newspaper. (32) . That is b–c+d p–c F(S*) ≥ b – a + d or p + h .02. The boy has kept a record of sales and shortages.15 for each customer who is not be satisfied if the supply of papers runs out.15. No reasonable values of the parameters will result in a threshold less than 0 or larger than 1. the penalty cost for a shortage.Single Period Stochastic Inventories b–c+d p–c (k*) = b – a + d = p + h .10. b = 0. (28) or (29) the threshold. Papers unsold at the end of the day are returned to the publisher for $0.02. By manipulation of the summation terms that define the expected profit.25.10 and they are sold to customers for a price of $0.25. For discrete distributions the optimal value of the order level is the smallest value of S such that E[Profit |S + 1] ≤ E[Profit | S + 1]. The factors required by the analysis are a = 0. The expected value of profit is evaluated with the expression E[Profit] = b – cS + a[S – + G(k)] – (d + b) G(k). Example 4: Newsboy Problem The classic illustration of this problem involves a newsboy who must purchase a quantity of newspapers for the day's sale. we can show that the optimal order level is the smallest value of S whose CDF equals or exceeds the threshold. The boy does not like to disappoint his customers (who might turn elsewhere for supply). the selling price of each paper. and estimates that the mean demand during the day is 250 and the standard deviation is 50. Optimality conditions for the order level give values for the CDF. so he estimates a "good will" cost of $0. How many papers should he purchase? This is a single-period problem because today's newspapers will be obsolete tomorrow. d = 0. the purchase cost of each paper. The purchase cost of the papers is $0. c = 0. For continuous random variables there is a solution if the threshold is in the range from 0 to 1. 21 (30) (31) Call the quantity on the right of the Eq. A Normal distribution is assumed.

is convenient in this case.7895.000 is added for every component remaining unused at the end of the trip.85) = 0. components in the spares stock do not fail. every additional failure requires an expensive resupply operation with a cost of $75. Failures occur at random.15 = 0.1192. Thus the expected number of failures during the cruise is 2.15 (k*) = b – a + d = 0. and the supply officer must determine how many spares of the component to stock. Example 5: Spares Provisioning A submarine has a very critical component that has a reliability problem. and E[Profit] = $32.000 if stocked at the beginning of the cruise. Interpolating in the G(k) column in Table 4. The second form of the solution. (30). Eq. The submarine is beginning a 1-year cruise. With linear interpolation. we find that (0. Then S* = (0.10 + 0. A failed component cannot be repaired but must be replaced from the spares stock. If the stock is exhausted. . Only the component actually in operation may fail. Ee = 46.211. Component spares also use up space and other scarce resources. To reflect these factors a cost of $25. Rounding up.2. we find that G(k*) = G(0.805)(50) + 250 = 290. (26) and (31). we have from Eq. The number of failures has a Poisson distribution.22 Inventory Theory Because the demand distribution is normal. Then from Eqs. Analysis shows that the time between failures of the component is 6 months. we determine k* = 0. we suggest that the newsboy should purchase 291 papers for the day.7881 and (0. b–c+d 0. The component has a unit cost of $10.8022.2.25 – 0.80) = 0. with an average rate of 2 per year. Es = 5.02 + 0.805. From the normal distribution table. (29). There is essentially no value to spares remaining at the end of the trip because of technical obsolescence. (25). This is a single-period problem because the decision is made only for the current trip.000 per component. The risk of a shortage during the day is 1 – F(S*) = 0.96.25 – 0.805) = 0.02 per day.

65. that only two spares should be brought. we find F(0) = 0. This occurs for S* = 2 which means. the purchase cost of each component. If more items are purchased to increase the stock to a level S. it may be less expensive to purchase no additional items than to order up to some order level. c = 10.323.000.135. the threshold is F(S*) = p –c 75–10 = = 0. a fixed ordering charge K is expended. Single Period Model with a Fixed Ordering Cost When the merchant has an initial source of product and there is a fixed cost for ordering new items. PO(z. we select the smallest value of S such that the CDF exceeds 0. then the assumption of the linear cost of lost sales would be violated.65. called the reorder point.857. p = 75.677. we assume that initially there are z items in stock.406. Such a policy is called the reorder point. Expressed in thousands. p + h 75 + 25 23 From the cumulative Poisson distribution using a mean of 2. We want to determine a level s. order level system. F(2) = 0. The expression for the expected profit is the same as developed previously. Because this is a discrete distribution. In this section. F(1) = 0. such that if z is greater than s we do not purchase additional items.000. If the system simply stopped after the spares were exhausted and a single cost of failure were expended. S) system. the extra cost of storage. except we must subtract the ordering charge and it is only necessary to purchase (S – z) items. or the (s. We consider first the case where additional product is ordered to bring the inventory to S at the start of the period.Single Period Stochastic Inventories h = 25.000 the cost of resupply. somewhat surprisingly. F(3) = 0. S) = b – c(S – z) + aEe[S] – (d + b)Es[S] – K (33) . The relevance of this model is due in part to the resupply aspect of the problem. This is in addition to the component initially installed. so that only on the third failure will a resupply be required. The probability of one or more resupply operations is 1 – F(2) = 0.

When z equals S. the profit when we replenish the inventory up to the level S is PO(z. we have plotted these the costs with and without an order. he should not restock. The two expressions are equal when z equals s. The higher of the two curves in Fig. When the demand has a normal distribution. If he has more than 210 papers. The two curves cross at about 210. PO(s*. As z decreases. The expected profit in this case is PN(z) =b + aEe[z] – (d + b)Es[z]. however. In Fig. This is the reorder point for the newsboy. Neither z nor K affect the optimal solution. but rather operate with the items on hand the profit is PN(z) = E[Profit] = b Here z = + kz . the optimal reorder point. The profit for a given day depends on how many papers the boy starts with. + a[z – + G(kz)] – (d + b)[ G(kz)]. he should order enough papers to bring his stock to 291.24 Inventory Theory We include the argument S with Ee[S] and Es[S] to indicate that these expected values are computed with the starting inventory level at S. S) = PN(s*) Generally it is difficult to evaluate the integrals that allow this equation to be solved. PN is greater than PO by the amount K. 8. z. (31) We modify the newsboy problem by assuming that the boy gets a free stock of papers each morning. . The profit is low when the initial stock is low and we do not reorder. Assuming a normal distribution and given the initial supply. (34) where the expected excess and shortage depend on z. As expected the profit grows with the number of free papers. If he has 210 papers or less. 8 shows the daily profit if one follows the optimal policy. If we choose not to replenish the inventory. and certainly no additional items should be purchased. and as before b–c+d F(S*) = b – a + d If no addition items are purchased. the system must suffice with the initial inventory z. PN and PO become closer. Then the optimal reorder point is s* where. the expected profit in the two cases can be written as a function of the distribution parameters. S) = b – c(S – z) + a[S – + G(k)] – (d + b)[ G(k)] – K (35) Here S = + k . The question is whether he should order more? The cost of placing an order is $10.

the lost income associated with a lost sale h = –$20. All remaining are disposed of at this price. If the inventory is not sufficient. a delivery fee will consist of a fixed charge of $500 plus $10 per item ordered.0 Reorder Not reorder 20. Determining the reorder point for the newsboy problem Example 6: Demand with a Uniform Distribution The demand for the next period is a random variable with a uniform distribution ranging from 50 to 250 units.0 Profit 30. such that . The current level of inventory is 100 units. sales are lost. the negative of the salvage value of the product. with a penalty equal to the selling price of the item. Items unsold at the end of the period go "on sale" for $20. however.Single Period Stochastic Inventories 25 70.0 50. c = $110. Additional items may be ordered at this time. (29). the order level is S.0 10. From Eq. and if so. the purchase cost plus the variable portion of the delivery fee K = $500. The selling price is $150.0 100 120 140 160 180 200 220 240 260 280 300 Initial Stock Figure 8.0 40.0 0. The purchase cost of an item is $100. Should an order be placed.0 60. the fixed portion of the delivery fee p = $150. how many items should be ordered? To analyze this problem first determine the parameters of the model.

1 ⌠ (S – A)2 Ee[S] = (B – A)⌡(S – x)dx = 2(B – A) A S 1 (B – S)2 ⌡ Es[S] = (B – A)⌠(x – S)dx = 2(B – A) S B CO = c(S – z) + K + h(S – A)2 + p(B – S)2 2(B – A) When no order is placed. CN = h(z – A)2 + p(B – z)2 .3 = 0 .3077.26 Inventory Theory F(S*) = p – c 150 – 1 1 0 = = 0. Expressing CN entirely in terms of z. 2(B – A) Evaluating CO with the order level equal to 112.05(s – 50)2 + 0.3077 or S = 111.729 – 110z. we solve for the optimal reorder point.375(250 – s)2 0. 19729 – 110s = –0. we find that CO = 19. we select S* = 112.05(z – 50)2 + 0.5s + 3543. S – 50 F(S) = 250 – 50 = 0. `Modifying the expected cost function to include the initial stock and the cost of placing and order. CO = c(S – z) + hEe[S] + pEs[S] + K For the uniform distribution ranging from A to B.325s2 – 72. Rounding up. p + h 1 5 0 –20 Setting the CDF for the uniform distribution equal to this value and solving for S. CN = –0.5.375(250 – z)2 Setting CO equal to CN. substituting s for z. the purchase cost and the reorder cost terms drop out and z replaces S.

Single Period Stochastic Inventories Solving the quadratic1 we find the solutions s = 150.3077.814. If there were no fixed charge for delivery. for s = 72. so we select the reorder point of 72. we get S = – [ln(1 – 0.3077)] = 55.17. The difference between s and S for the exponential distribution is approximately ∆=S–s= 2 K = c+h 2(150)(500) = 41 100 − 20 s = 56 – 41 = 15 For this distribution of demand.8 and s = 72. no additional inventory should be purchased. 1 The solution to the quadratic ax2 + b x + c = 0 is x = –b ± b2 –4a c] . the order would be for 12 units.3. 2a .3. At the optimal order level F(S*) = 1 – exp(–S/ ) = 0. the current inventory of 100 is considerably above both the reorder point and the order level. Certainly an order should not be placed. 27 Because the current inventory level of 100 falls above the reorder point. Example 7: Demand with an Exponential Distribution Consider the situation of Example 6 except that demand has an exponential distribution with a mean value = 150. we have CN = CO = 11. The solution lying above the order level is meaningless. Solving for S. At this point.

we consider the (s. Inventory Level Q r L L L L L 0 0 Time Figure 9. it is likely that only one order is outstanding at any one time. This is also called the stockout event. If we assume that L is relatively small compared to the expected time required to exhaust the quantity Q. The cycle begins with the receipt of the lot. alternatively called the reorder point. an order is placed for a lot size. L. This is called continuous review. The only uncertainty is associated with demand. We assume shortages are backordered and are satisfied when the next . The model assumes that the inventory level is observed at all times. but in reality the inventory decreases in a stepwise and uneven fashion due to the discrete and random nature of the demand process. s. Q) inventory policy.5 The (s. but allow the demand to be stochastic. that is the event of the inventory level falling below zero. Figure 9 shows the inventory pattern determined by the (s. we show the decrease in inventory level between replenishments as a straight line. we are most concerned with the possibility of shortage during an order cycle. order quantity system. Q. As we see in the figure. and then it continues for the time L when the next lot is received. There are a number of ways one might operate an inventory system with random demand. In Fig. In the following analysis. 9. it progresses as demand depletes the inventory to the level s. This is the case illustrated in the figure. The order arrives to replenish the inventory after a lead time. The lead time is assumed known and constant. When the level declines to some specified reorder point. Q) inventory policy. Q) Inventory Policy We now consider inventory systems similar to the deterministic models presented in Section 25.2. the inventory level increases instantaneously by the amount Q with the receipt of an order. We call the period between sequential order arrivals an order cycle. At this time. Inventory Operated with the reorder point-lot size Policy Model The values of s and Q are the two decisions required to implement the policy.28 Inventory Theory 25.

In practical instances the reorder point is significantly greater than the mean demand during the lead time so that Ps is quite small. With the average rate of demand equal to a. defined as Ps. one need only be concerned about the random variable that is the demand during the lead time interval. To determine probabilities of shortages. is Ps = P{x > s} = ∫ f (x)dx = 1 – F(s). It is the expected inventory level at the end of an order cycle (just before a replenishment arrives). Inventory Level Q s SS 0 0 L L L L Time Figure 10. The safety stock. s ∞ The service level is the probability that the inventory will not be depleted during one order cycle. This is the inventory maintained to protect the system against the variability of demand. The random demand during the lead time gives rise to the possibility that the inventory level will be depleted before the replenishment arrives. This is seen in Fig. and CDF F(x). This figure will also be useful for the cost analysis of the system. This probability.The (s. The (s. where we show the (s. Q) Inventory Policy 29 replenishment arrives. 10. is defined as SS = s – . f(x). The mean and standard deviation of the distribution are and respectively. Q) policy for deterministic demand . Q) policy for deterministic demand. SS. This is the random variable X with pdf. or Service level = 1 – Ps = F(s). the mean demand during the lead time is = aL A shortage will occur if the demand during the period L is greater that s.

and we observe that it is a function of the reorder point s. Q) = h( Q +s– ) 2 Ka + Q Inventory cost Replenishment cost . When we assume that the event of a stockout is rare and inventory declines in a continuous manner between replenishments. a practical assumption in many instances. The principal assumption is that stockouts are rare. The model is approximate in that we do not explicitly model all the effects of randomness. so the expected replenishment cost per unit time is Expected replenishment cost per unit time = Ka . the holding cost per unit time is Expected holding cost per unit time = h( With the backorder assumption. Q With the (s. The model and its optimal solution depends on the assumption we make regarding the cost effects of shortage. Q) policy and the assumption that L is relatively smaller than the time between orders. Q) policy. The cost for replenishment is K. EC(s. Q/a. the average inventory is approximately Average inventory level = Q +s– . Q) Policy We develop here a general cost model for the (s. We call this Cs. we use a as the time averaged demand rate per unit time. 2 Because the per unit holding cost is h. 2 Q + s – ). Combining these terms we have the general model for the expected cost of the (s.30 Inventory Theory General Solution for the (s. Dividing this cost by the length of a cycle we obtain a Expected Shortage cost per unit time = Q Cs. the shortage cost per cycle depends only on the reorder point. Since demand is a random variable.2. the time between orders is random with a mean value of Q/a. We investigate several alternatives for the definition of this shortage cost. In the model we use the same notation as for the deterministic models of Section 25. Q) policy.

there is a cost 1 expended whenever there is the event of a stockout. . (39) with Eq. Taking the partial derivative with respect to the variable s. s Now the partial derivative of Eq. We consider four different cases in the remainder of this section2. ∂s Combining Eq. Q) Inventory Policy a Cs Q 31 + Shortage cost (37) There are two variables in this cost function. with respect to each variable and set them equal to zero. we have for the optimal value of s ∂Cs hQ = – 1f(s*) = − . Eq. just on the fact that a stockout has occurred. ∂s or ∂Cs hQ =– ∂s a (39) The solution for the optimal reorder point depends on the functional form of the cost of shortage. (37). Chapter 7. a ∂Cs ∂EC = h + Q ∂s = 0. Q and s. First. To find the optimal policy that minimizes cost.The (s. This cost is independent of the number of items short. we take the partial derivatives of the expected cost. The expected cost per cycle is ∞ Cs = 1P{x > s} = 1 ∫ f (x)dx . the partial derivative with respect to Q is ∂EC h a(K + Cs ) = – =0 ∂Q 2 Q2 or Q* = 2a(K + Cs ) h (38) We have a general expression for the optimal lot size that depends on the cost due to shortages. ∂s a 2In (40) this article we follow the development in Peterson and Silver [1979]. Case of a Fixed Cost per Stockout In this case. (40). (40) with respect to s is ∂Cs = – 1f(s).

We adopt a continuous review policy in which the order quantity is the average demand for one month.32 Inventory Theory hQ . It can be shown that the cost function is minimized when f(x) is decreasing. We must first adopt a time dimension for those data items related to time. Find the optimal inventory policy.01) = $10/unit-month. The pdf may satisfy this condition at two different values. Holding cost is estimated using the interest cost of the money invested in a unit of inventory. a = 100 units/month h = 1000(0. 1a or f(s*) = (41) (42) and Cs = 1(1 – F(s*)). Equation (41) is a condition on the value of the pdf at the optimal reorder point. the order cost. Here we use 1 month. the cost of paperwork is estimated to be $200. If both parameters are flexible. is used to find values of Q and s that solve the problem. The fixed order cost is $800. for Q* define Example 8: Optimal reorder point given the order quantity ( 1 Given) The monthly demand for a product has a normal distribution with a mean of 100 and a standard deviation of 20. If no values of the pdf satisfy this equality. so for a unimodal pdf. We must also describe the distribution of demand during the lead time. select some minimum safety level as prescribed by management. (38) the optimal control parameters. For convenience we assume that 1 month has 4 weeks and that the demands in the weeks are independent and identically distributed normal variates. The lead time for this situation is 1 week. The purchase cost of the product is $1000. Equation (41) specifying the optimal s* together with the Eq. the unit cost multiplied by the interest rate (interest rate is 12%/12 = 1% per month) 1 = $1000. For this selection. The interest rate used for time value of money calculations is 12% per year. which is independent in time and number K = $800. as illustrated in Example 13. select the greater of the two solutions. When it is necessary to backorder. If one of the parameters are given at a perhaps not optimal value. the backorder cost. a successive approximation method. With these assumptions the weekly demand has . independent of the number backordered. these equations yield the optimum for the other parameter.

the expected shortage is Es = ∫ (x – s) f (x)dx .The (s. Taking the larger of the two possibilities we find s* = + (1. thus Q = 100. 1a The pdf of the standard normal distribution is related to a general normal distribution as f(s) = (1/ ) (k) or (k) = f(s) Then in terms of the standard normal we have (k*) = hQ = (10)(0.6 or 42 (conservatively rounded up). we may also be interested in the expected number of items backordered during an order cycle. Q) Inventory Policy = 100/4 = 25. 0. if x ≤ s Items backordered = x – s.01. ∂s s .1. 1a We look this up in the standard normal table provided at the end of this chapter to discover k* = ±1. This depends on the demand during the lead time.66) = 25 + 1. Es. (41). we find the associated optimal reorder point. if x > s Therefore. and 2 33 = 10.66. or f(s*) = (10)(100) hQ = (1000)(100) = 0. Using this value in Eq.01) = 0. This is the optimal reorder point for the given value of Q. we assume a cost 2 is expended for every unit short in a stockout event. s ∞ For this situation. The expected cost per cycle is Cs = 2Es. = 202/4 = 100 or The problem specifies the value of Q as 1 month's demand.66 (10) = 41. Case of a Charge per Unit Short In some cases. Now the partial derivative with respect to s is ∞ ∂Cs = – 2 ∫ f (x)dx0 = – 2(1 – F(s)).

95. The service level is actually the value of F(s).34 Inventory Theory From Eq. but change the cost structure for backorders. (25). . From the normal distribution table we find that this is associated with a standard normal variate of z = 1. The optimal policy is governed by Eq. ∞ Cs = 2Es = 2 ∫ (x – s*) f (x)dx . a 2 or (43) In this case. Now we assume that we must treat each backordered customer separately.64. (38) by substituting the value of Cs. One might require that the inventory meet demands from stock in 99% of the inventory cycles. The cost of paperwork and good will is estimated to be $200 per unit backordered. the optimal order quantity is determined from Eq. Managers may find it difficult to specify the shortage cost 2. (41). s (44) This integral is difficult to compute except for simple distributions. The reorder point is then . Example 9: Optimal reorder point given the order quantity ( 2 Given) We consider again Example 8. If the expression on the right is less than zero. use some minimum reorder point specified by management. It is easier to specify that the inventory meet some service level. Given values of h. F(s*) = 1 – (10)(100) hQ = 1 – (200)(100) = 0. (43) the implied shortage cost for the given service level. Q and a.95. 2a We know that the probabilities for a normal distribution is related to the standard normal distribution by s– F(s) = (k*) = 0. This is 2. (43). one can compute with Eq. It is evaluated with tables for the normal random variable using Eq. For a given value of s. the optimal value of s must satisfy ∂Cs hQ = – 2(1 – F(s*)) = − ∂s a hQ F(s*) = 1 – . we have a condition on the CDF at the optimal reorder point.

The expected cost per cycle is Cs = 3Ts.64 (10) = 41. the average time a customer must wait for delivery is x–s .The (s. This is the optimal for the given value of Q.4 35 or 42 (conservatively rounded up). Case of a Charge per Unit Short per Unit Time When the backorder cost depends not only on the number of backorders but the time a backorder must wait for delivery. 2a ∞ (45) We consider here the case when a cost 3 is expended for every unit short per unit of time. 2a The resulting unit-time measure for backorders is (x – s)2 . [1998] Qh report the result Es(s*) = which is derived using a more accurate h+ 3 . (41). ∂s a s a From Eq. we would like to compute the expected unit-time of backorders for an inventory cycle. Q) Inventory Policy s* = + (1. 2a Integrating we find the expected value Ts. (47) We have added the parameter s* to the expected shortage to indicate its value is a function of the reorder point. the optimal value of s must satisfy ∂Cs E hQ = − 3 s =– ∂s a a or Es(s*) = hQ 3 (46) . When the number of backorders is x – s and the average demand rate is a. Note that Silver et al. where 1 2 Ts = ∫s (x – s) f (x)dx . Now the partial derivative of Cs with respect to s is ∞ ∂Cs E = – 3 ∫ (x – s) f (x)dx = – 3 s .64) = 25 + 1.

When stock is exhausted during the lead time. This is 3.9) = 25 + 9 = 34 This is the optimum for the given value of Q. The two results are approximately the same when 3 >> h. Example 10: Optimal reorder point given the order quantity ( 3 Given) We consider again Example 8. the expected shortage at the optimum is Es(s*) = G(k*) = 1 where k* = s* − or G(k*) = 0. Es. We use L to indicate the cost for each lost sale. (47). The reorder point is then s* = + (0. Es(s*) = hQ 3 = (10)(100) = 1. Lost Sales Case In this case sales are not backordered.9. The effect of this situation is to raise the average inventory level by the expected number of shortages in a cycle. 1000 When the demand is governed by the normal distribution. For the case of lost sales the approximate expected cost is Q EC(Q. as assumed here.1 From the table at the end of the chapter k* = 0. but now we assume that $1000 is expended per unit backorder per month. The optimal policy is governed by Eq. s) = h + s − 2 + aK Q + Es Inventory cost Replenishment cost . A customer that arrives when there is no inventory on hand leaves without satisfaction. and the sale is lost. the inventory level rises to the level Q when it is finally replenished.36 Inventory Theory representation of the average inventory. We also experience a shortage cost based on the number of shortages in a stockout event.

This is L. These are summarized below for easy use. Q) Inventory Policy a 37 + L Q Es Shortage cost (48) Here we are neglecting the fact that with lost sales. We charge $2000 for every lost sale. but now we assume that the sale is lost given a stockout.995 hQ + L a L a From the table at the end of the chapter k* = 2. The number of orders per unit time is slightly less than a/Q. not all the demand is met. The optimal policy is governed by Eq.The (s. Taking partial derivatives with respect to Q and s we find the optimal lot size is Q* = 2a(K + h L Es ) ∂E s = 0. The reorder point is then s* = + (2.6 = 47.58) = 25 + 22.6 This is the optimum for the given value of Q. Summary We have found in this section solutions for several assumptions regarding the costs due to shortages. F(s*) = (2000)(100) = (10)(100) + (2000)(100) = 0.58. (50). The optimal reorder point requires one to find the value s* that corresponds to . ∂s (49) ∂EC ∂E a L = h 1 + s )+ ∂s ∂s Q or ∂Es hQ =− ∂s hQ + L a (1 – F(s*)) = hQ hQ + L a (50) or F(s*) = 1 – hQ La = hQ + L a hQ + L a Given) Example 11: Optimal reorder point given the order quantity ( L We consider Example 8 again.

and is given by Q* = 2a(K + Cs ) h This equation is used directly when a value of s is specified. F(s*) or Es(s*) equaling some simple function of the problem parameters. what is the optimal order quantity? For a normal distribution the expected shortage cost is Cs = 2 G(ks ) . Cs. Q) Policy for Continuous Distributions Situation Fixed cost per stockout ( 1) Charge per unit Short ( 2) Charge per unit short per unit time ( 3) Charge per unit of lost sales ( L) 1(1 Cs – F(s)) 2Es 3Ts Optimal reorder point f(s*) = hQ 1a hQ 2a Normal solution (k*) = (k*) = 1 – G(k*) = hQ 1a hQ 2a F(s*) = 1 – Es(s*) = hQ 3 hQ 3 LEs F(s*) = L a L hQ + a (k*) = L a L hQ + a Determination of the Order Quantity Up until this point. The demand during the lead time is normal with µ = 25 and = 10. The following examples illustrate the determination of the order quantity when the reorder point is given. If the reorder point is fixed at 50. Example 12: Optimal order quantity given the reorder point We continue from Example 9 in which the shortage cost is 2 = $200 per unit short. Table 1. The (s. The optimal order quantity for each case depends on the shortage cost. and the determination of optimal values for both variables simultaneously.38 Inventory Theory f(s*). It is used iteratively when the optimum for both s and Q is required. all our examples have determined the reorder point given the order quantity.

5.53) = (200)(10)(0. We need an iterative procedure to find both. Q= 2a(K + Cs ) . Q) Inventory Policy where ks = (s – )/ .5.8 10 39 or 127 (conservatively rounded up). G(2.53 or s = 40. we have Q2 = 130.5) = 0. Using this value of Q2. h (ks) = 1 – hQ . Cs = 4. Example 13: Both optimal order quantity and reorder point In the previous examples we fixed one of the decisions and found the optimal value of the other. . For s = 50 and ks = 2.1 Computing the associated Cs we find Q3 = 130.7.72 For this value of Cs.The (s.02736) = 54. so we adopt the policy Q* = 131 and s* = 40. Es = 0. Q1 = 126. Q* and s*. It appears that the values are converging. we find the optimal reorder point ks = 1.51 or s = 40. Cs = 2 G(ks ) a 2 The first step is to assume Cs = 0 and to find the corresponding optimal order quantity. we find the optimal reorder point ks = 1. Then the optimal order quantity is Q* = 2a(K + Cs ) = h 2(100)(800 + 4) = 126. We use the expression below sequentially. Using this value of Q1.9.020.0020.3 The expected shortage per period with this reorder point is Cs = 2 G(1.

11. A move practical idea is to use the inventory position rather than the inventory level as an indicator. The inventory position is the inventory level plus the quantity on order. Using inventory position as a measure for placing orders Using the inventory position in this manner. and the same order pattern is obtained using either measure. This probability depends on the reorder point and not the lot size. however. In this case the inventory level falls below the reorder point and never reaches it again. The difference is illustrated in Fig. Basing the order on the inventory level fails. however. as in the last cycle of the figure. Using the inventory position. also allows us to drop the requirement that the lot size be very much greater than the average demand during the lead time. The primary assumption for the derivations is that the probability of a stockout be small. the inventory level crosses the reorder point at the same time as the inventory position. thus keeping the inventory in control. . allows two orders to be placed in quick succession.40 Inventory Theory 25. when there is a lead time demand larger than the order quantity. We note that inventory level is the same as inventory position when there are no outstanding orders.6 Variations on the (s. Q) Model Reorder Point Based on Inventory Position In the foregoing. The results in the table can be used even in cases where the lot size is small in relation to the lead time demand. we have assumed that a replenishment order is to be placed whenever the inventory level reaches the reorder point. In the early cycles of the figure. Q s L L L L L 0 0 Time Inventory Position Inventory Level Figure 11.

Variations on the (s. The expected shortage and expected unit-time shortage are Es = x =s +1 ∑ (x – s) p(x) ∞ (51) Ts = 1 ∞ ∑+1(x – s)2 p(x) 2a x =s (52) Table 2. Q) Model 41 When the lot size is small. Indeed this is a very desirable characteristic of an inventory system. This is particularly true when the reorder point is relatively small. For the discrete distribution p(x) is the probability that the random demand during the lead time takes the value x. Discrete Demand During the Lead Time The results of the table were derived for continuous distributions. there may be many outstanding orders at any given time. This implies that a replenishment order is placed whenever an item is withdrawn from inventory. emphasizing the need to track the inventory position. Q) Policy for Discrete Distributions Situation Fixed cost per stockout ( 1) Charge per unit short ( 2) Charge per unit short per unit time ( 3) Charge per unit of lost sales ( L) 1(1 Cs – F(s)) 2Es 3Ts Optimal reorder point p(s* – 1) > F(s*) ≤ 1 – Es(s*–1) > hQ ≥ p(s*) 1a hQ < F(s*+1) 2a hQ 3 ≥ Es(s*) LEs F(s*) ≤ 1 – hQ < F(s*+1) hQ + L a Lead Time a Random Variable Previously we assumed that lead time is a constant. A particularly interesting case is when the lot size is 1. F(x) is the probability that the demand is less than or equal to x. The lead time may actually be uncertain in duration due to variability in shipping times. The (s. In fact the items in an inventory are usually discrete. material availability and supplier processing times. and a discrete demand distribution may be more appropriate. .

The marginal distribution of demand during the lead time is f(x) = ∫ g(x.42 Inventory Theory Let lead time be a random variable Y with pdf h(y).that is. . y)h(y)dy 0 ∞ (53) This pdf can then be used in conjunction with the standard normal distribution table to determine approximate solutions. and let demand be the random variable X with joint pdf g(x. the demand distribution depends on the lead time. y) -.

After a lead time interval L. the lowest inventory that is affected by that order occurs at time t + R + L. S) = h ( aR +S– ) 2 Inventory cost . For the (R. If the inventory is at level y. S) Inventory Policy A different way to manage a stochastic inventory system is illustrated in Fig. S) policy is much more affected by variability than the (s. For the (s. we define the demand in the interval R + L to be the random variable X. Q) policy. The mean and variance during the interval are P and P (the subscript “P” stands for periodic). the reorder point s is set to protect against the possibility of shortage during the lead time L. In the event of a particular order at time t. S) policy. S) Inventory Policy 43 25. The (R. the replenishment order is delivered. Q) policy. 12 This is called a periodic review policy in that the inventory level is only observed at intervals of R.7 The (R. S) inventory policy The analysis of this policy is much like that for the (s. S is called the order level. The (R. Q) policy because of the longer interval. respectively. The quantity S must be large enough to keep the probability of a shortage in that time interval small. a quantity S – y is ordered to bring the inventory position to S.The (R. The cost (per unit time) of operation of the inventory system expressed in terms of R and S is EC(R. To analyze this system. Figure 12 shows the inventory position with dotted lines and the inventory level with solid lines. the order level S is set to protect against a shortage in the time interval R + L. S 0 0 L R L R L R L Time Figure 12. The advantage of the policy is that it does not require continuous review. The pdf and CDF are fP(x) and FP(x).

the determination of the optimal order level follows exactly the derivation for s* for the (s. The optimal conditions are found in Table 1. . We create Table 3 from Table 1 by replacing s with S. and L with R + L. Q with aR. Q) policy. In particular the distribution of demand in the expressions for Cs have a mean and variance that depends on the interval L + R. If we assume that the review interval R is set elsewhere. A similar table for discrete distributions can be constructed starting from Table 2.44 Inventory Theory K R 1 + CS R + Replenishment cost Shortage cost (54) Evaluation of the shortage cost depends on the assumption of the costs experienced in the event of a stockout. ∞ Fixed cost per stockout: Cs = 1(1 – F(S)) = 1 ∫ fP (x)dx S Charge per unit short: ∞ Cs = 2Es = 2 ∫ (x – s) fP (x)dx S 1 ∞ Cs = 3Ts = ∫ (x – s)2 fP (x)dx 2a S Charge per lost sale: Cs = LEs (55) (56) Charge per unit short per unit time: (57) = L ∞ (x – s) fP (x)dx ∫ S (58) We cannot determine the optimal R easily in this case because Cs depends on R.

the cost of paperwork and good will is estimated to be $200 per unit. The monthly demand for the product has a normal distribution with a mean of 100 and a standard deviation of 20. When it is necessary to backorder a customer request. S) Inventory Policy Table 3. the cost of holding one unit for one month 2 = 200. the cost of backordering one unit = 20 during the review period (the distribution is = 100 and normal) With these values we can determine the optimal policy. Find the optimal inventory policy.957 for z = 1. we find that the CDF has the value 0. (k*) = 1 – hR 2 = 1 – (10/200) = 0.The (R.65. The (R. The order level is S = 100 + 20(1. S) Policy for Continuous Distributions Situation Fixed cost per stockout ( 1) Charge per unit Short ( 2) Charge per unit short per snit time ( 3) Charge per unit of lost sales ( L) Example 14 1(1 45 Cs – F(S)) 2Es 3Ts Optimal reorder point fP(S*) = hR 1 Normal solution (k*) = P hR 1 FP(S*) = 1 – Es(S*) = hR 2 (k*) = 1 – G(k*) = hR 2 haR 3 haR P 3 LEs F(S*) = 1 – hR hR + (k*) = 1 – L hR hR + L We consider again the situation of Example 9 except the inventory is reviewed every month. The parameters of the model are as follows R = 1 month h = $10. The holding cost is $10 per unit per month.65) = 133. The lead time for orders is zero. .95 Using the standard normal table.

we find that the CDF has the value 0. . The probability of a shortage during the month is 1 – (k*) = 0. Three extra units of inventory are necessary for the longer review period.28.05.90.28) = 236. The safety stock is S – µ = 33 units.46 Inventory Theory The optimal policy is to order a quantity (133 – x) each month.28 during the review period (here we assume that the monthly demands are independent) (k*) = 1 – hR 2 = 1 – (10)(2)/200) = 0. Now we consider the same problem when the review period is every 2 months. The situation is the same except R = 2 months = 200 and = 20 2 = 28. The safety stock is: S – µ = 36. The optimal policy is to order a quantity (236 – x) every two months. Thus the reorder level is S = 200 + 28.899 for k = 1.28(1. For the continuous review of Example 9 the safety stock is 17 units. Using a standard normal table.

(b). what is the optimal policy? e.15)(5) = $0. It is now January 1. the inventory is replaced by a production process that can add units to the inventory at a constant rate r (r > a ). When should the next order be placed for the solutions of parts (b). A hardware distributor is reviewing his inventory policy for hammers. which have a relatively constant demand of 2000 units per month. f. An OR analyst suggests that money might be saved if the customers would accept backorders. Derive a formula for the optimal lot size when no shortages are allowed. so the cycle time must be in whole months. Each time the process is begun a setup cost K is expended. Every time he places an order for replenishment a shipping and paper preparation cost of $500 is charged. and (e) of this problem? g.2. What is the optimal lot size when no shortages are allowed? c. There is a lead time (time between when the order is placed and when it is delivered) of 1 month. The distributor's holding cost is 15% (annual) of his average investment in inventory.10 discount on the price of hammers for an order of at least 10. (c). offers a $0. (d). What is the optimal lot size in this case? d. Rather than an instantaneous replenishment of inventory as assumed in Section 25. The current inventory policy is to replenish the inventory every month. A meat market advertises that its hamburger is the freshest in town.75 per hammer per year. a. Should the distributor take advantage of this deal? Assume no shortages are allowed. The distributor buys the hammers from his supplier for $5 each and sells them for $10. (The holding cost is h = (0.Exercises 47 25. and (e). It is now January 1. What is the total annual cost of this policy? b. and the current inventory is 3500 units. The supplier. (d). Otherwise the inventory problem is the same as previously stated. The distributor wants to order only at the beginning of the month. If the distributor offers a discount of 1% of the purchase price for every day the customer has to wait for delivery. (c). To get rid of old stock.000 units.2 1. the price of the hamburger is reduced by $0. Of course. the process cannot be operated continually but must be started and stopped.) Answer each of the following independently ( one part does not depend on another). in an effort to get larger orders. . No shortages are al- 3.10 per pound for every hour it remains unsold after it is ground (for simplicity assume this reduction is linear in time).8 Exercises Section 25. Compute the annual profit on hammers for parts (a). The demand for hamburger is 250 pounds per hour. 2.

She can order a case that holds 12 units for a cost of $1200 or a gross that holds 144 units for $13.000. the sales are lost. A principal concern for this business woman is the cost of capital. how often will bulbs be delivered? c. so the alternatives represent ordering a 1-month or 1-year supply. but the actual demand has a Poisson distribution. regardless of the number of cases delivered. The expected demand for trees is 3 per day. The demand for the product is 12 units per month. what penalty is implicitly being charged for a shortage? For this value find 8. a. Management has determined that this is too high. the purchase cost is not relevant. The management of the building uses a 15% annual carrying cost rate for inventory. Trees remaining at the end of the season must be cared for until the next year. A case of bulbs costs $200. A long-standing policy has been to receive 10 cases per delivery. A garden nursery has a short selling season of 20 days for a certain kind of tree. Only the shortage cost and holding cost should be used. An office building uses bulbs at an average rate of 1000 bulbs per month. Section 25. If all other parameters remain the same. These costs include delivery and product cost. (Note that since leftover trees will actually be kept after the season and eventually sold.48 Inventory Theory lowed. Which plan should she adopt? Light bulbs come in cases of 144 bulbs. The company that sells the bulbs charges $50 per delivery.) For the parameters given in Example 6 in the text. The management assumes a "loss of good will" charge of $10 per bulb per month for backorders. the probability of a shortage is almost 70%. What is the annual cost penalty of this nonoptimal policy over the cost of the optimal policy? 5. As an approximation assume that demand is at a constant rate and no shortages are allowed. which is 20% per year. Find the number of trees that should be ordered and the probability that this inventory level will be sufficient to meet all demand. Consider a gift shop operator with a relatively constant demand for a certain type of wall hanging. independent of the amount processed. A level of 10% is considered an acceptable probability of shortage.4 7. The cost of such care per tree is $20 and the holding cost on investment is $2. No shortages are allowed. Find the optimal policy for 5 if backorders are allowed. 6. Assuming the usage rate for bulbs is constant. With this order quantity. b. The nursery currently has 20 such trees in stock and has one last opportunity to order more. how many cases of bulbs should be ordered in each delivery? Only whole cases can be ordered. If demand occurs after the inventory is exhausted. A failed bulb is simply not replaced until the beginning of the next month if the supply is exhausted. How much should be ground at each setup? 4. The cost to set up and run the hamburger grinder is $100. . The nursery purchases the trees for $75 and sells them for $175.

he charges a lost opportunity cost of $10.02 9 0. How many units should he build to maximize his expected profit? 11. In the table below. p = $100.000 each. while it will cost only $40. Use the penalty found in Exercise 8. How many helicopters should the commander bring? 12.02 7 0. x is the number of units demanded and p (x) is the probability of that demand. A military commander faces a dangerous mission which requires the use of helicopters. The mission lasts 10 hours.14 12 0.000 to build it. Consider a problem with the following parameters.09 11 0. h = $1. Find the optimal (s . Failure-causing events are assumed to occur at random on the average of once every hour.000.03 6 0.05 3 0.10 15 0.14 14 0. he will have to dump them for $20.000. The helicopters cost $1 million each. Demand has a uniform distribution with A = 20 and B = 60 b. The number of events is independent of the number of helicopters active. His problem is to determine how many units to build.03 10 0. and K = $200.05 The selling price for a condo unit is $100. Demand has an exponential distribution with a mean value of 40 . after which he will leave town for places unknown.04 4 0.19 13 0. and find the optimal policy if the demand is exponential distributed with a mean of 150. x p (x) x p (x) 1 0. the commander has attached a cost of $100 million for every unit less than five that finishes the mission. In order to quantify the situation. Each event will destroy one helicopter.01 8 0. If the developer runs out of units while there is still demand. The commander wants to determine how many to bring on the mission.04 5 0. S) policy when: a. Any units that remain at the end of the mission are destroyed. 49 10. He estimates the following probabilities for the demand for his units. 9.Exercises the optimal policy assuming the distribution of demand is uniform between 50 and 250 items. A dishonest developer wants to make quick money building a condominium. At least five are required for mission success. He sets a 1-year time table for his activities.05 2 0. If the year passes and he has not sold all his units. Any number less than five is judged a serious detriment to the mission. c = $10.

2 = $200. h = $120/unit-year. The average demand doubles but the standard deviation remains the same. 16. The order quantity is set to the average demand for 1 month. The backorder cost is $5 per unit. a = 1200 units/year. Find the optimal continuous review policy for the following situations. Q) policy when the following changes are made. The fixed setup cost doubles. What should be the reorder point if the lead time were 1 month? . Use the data of Exercise 14 and add the information that the setup cost is $200 and the lead time is 1 week. The holding cost doubles. Find the optimal order level for an inventory system for which orders are placed every 2 weeks. What should be the supplier's reorder point if she wants a 60% chance of not having a shortage during the lead time? b.7 Inventory Theory 13. b. The standard deviation of demand per week doubles. The changes are not cumulative. d. The cost of the item is $20.5 . Customer arrivals follow a Poisson process.25. a. The engines are obtained from a manufacturer who delivers 2 months after an order is placed. The backorder cost doubles. The demand per month has a normal distribution with mean 100 and standard deviation 20. K = $800. b. Assume four weeks per month. a. A supplier of rebuilt engines expects an average of three engine customers every 2 months. c. 15. a. e. The lead time doubles. Interest per year is 20%. 14. f. c. Find the optimal (s. The reorder point is set at the average demand over the lead time. Neither the reorder point nor the order quantity is specified. The lead time is one week.50 Section 25. We repeat the conditions of Example 9. The weekly demand has a normal distribution with a mean of 25 and a standard deviation 5. Assume a 50-week year.

Customers arrive at random (a Poisson process) so the exact demand for any given period of time cannot be computed. a.5% per week. the standard deviation is 3000 gallons.75 per gallon. He must pay $0. The average demand is 10. What reorder point will provide a 95% chance that the inventory will not run out during an order cycle? b. except that demand is stochastic rather than deterministic. The weekly demand for light bulbs is a random variable with a normal distribution that has a mean of 250 bulbs and a standard deviation of 50 bulbs.000 gallons per week. but if any remains in inventory when the next order arrives he charges a holding cost based on this interest rate and the value of the inventory. The size of the order equals the previous month's sales. What kind of inventory system is this? b. Assume for simplicity that months are 4 weeks long and that there are 48 weeks in a year. paying an extra $0. He adopts a (s. A lot size of 100 is selected. If the supply of bulbs runs out and a bulb fails. the tenant simply must wait until the beginning of the next month. For purposes of analysis. His cost of capital is 0. What specific numerical rule should the management use to determine how much to order each month? 18. The manager in Exercise 18 installs computerized inventory control so that continuous review is possible. He recovers this cost in the price he charges for gasoline. An order for bulbs is placed once a month (on the first of the month) and the order is delivered right away. What is the optimal inventory policy for the distributor? 21.10 per gallon for the privilege. If a design change is to be incorporated into the . One of the disadvantages of using large order quantities in a production process is. If the distributor runs out of supply during the period. Q) policy. Another disadvantage is the inflexibility associated with having a large inventory. The borrowed gas must be returned when his supply is replenished. of course. large holding costs. however. His supply is replenished every 6 weeks. this event is assumed to have a cost of $10. Consider the light bulb situation of Exercise 5. What is the average cycle time for this plan? 20. he "borrows" gas from other distributors. The average demand for a product at a warehouse is 1200 units per year.Exercises 51 17. A gasoline distributor has a weekly demand that is approximately normally distributed. The warehouse manager replenishes the inventory by a monthly order to the factory. a. What order level will provide a 95% chance that the inventory will not run out during an order cycle? 19. Assume a month is 4 weeks. A lead time of 1 week passes between when an order is placed and when the inventory is replenished.

B = $10. Compute the optimal values of s and Q for each case and compare the total costs (including B) and production lead times. c. This is one of the tenants of the "just-in-time" production systems.000 K = $1. B = $110. Use a 50-week year and an (s. and standard deviation 10. This might be called the lead time of the production process. so reducing setup cost results in reduced holding cost. and different annual costs to implement the production process B. Q) inventory policy. The reason for a large order quantity is a large setup cost.000 K = $5. which go to great measures to reduce setup costs.000 . and increased flexibility. so as Q grows so does the length of the cycle. b.000 In each case weekly demand follows a normal distribution with mean 50.52 Inventory Theory product or some custom feature is to be added for particular customers.000 . K = $10. Choose the least cost system. The average length of the cycle is Q /a. a. the modification must await the next production cycle while the entire inventory is depleted.000 . B = $30. The lead time when a reorder is placed is 1 week. . The holding cost is h = $200/unit-year. decreased production lead time. Analyze the following production systems that are characterized by different setup costs K. The shortage cost is $100 per unit.

0596 0.0044 0.1394 0.70 -0.9202 0.05 -1.6978 0.0022 0.0283 0.60 -0.45 -2.7687 0.0122 0.3264 0.7011 2.1686 1.0668 3.5293 -1.0175 0.4828 1.3867 0.55 -2.90 -2.4027 2.0030 0.3085 0.1469 0.30 -2.65 -0.00 0.9597 1.55 -1.1556 2.0040 0.7183 1. CDF G(y) = (y) – y[1 – (y)] .3446 0.0154 0.3989 0.55 -0.8054 0.0416 1.4207 0.2542 2.95 -2.5000 1.3984 0.6512 2.0355 0.3970 0.0104 0.0940 0.6232 1.3521 0.0224 0.1109 0.0574 2. Function Values for the Standard Normal Distribution.90 -0.80 -2.0179 0.2661 0.15 -2.0026 0.65 -1.1604 0.0540 0.3006 1.5761 1.0062 0.0079 0.0119 0.5668 0.0446 0.3910 0.8008 2.35 -0.3821 0.80 -0.1497 0.9005 2.1942 0.0863 0.0202 0.8626 1.6637 0.25 -1.0606 0.3683 0.15 -0.0885 0.3011 0.0071 0.0016 0.20 -2.0035 0.1714 0.0317 0.10 -0.0790 0.0107 0.75 -0.3989 † y is a standard normal variate (y) is the probability density function.1257 1.3605 0.0656 0.45 -1.60 -2.1587 0.65 -2.6304 0.4367 1.3532 2.1295 0.2119 0.1151 0.85 -0.00 -1.0401 0.9600 0.10 -1.4013 0.0054 0.4509 0.0069 0.4244 0.0287 0.0256 0.2059 0.50 -0.0091 0.2179 0.45 -0.8429 0.2541 0.8506 2.9505 2.2299 0.1200 0.5020 2.0548 0.10 -2.50 -1.6015 2.4523 2.20 -0.0440 0.3332 0.2561 1.2121 1.75 -1.3945 0.7662 1.90 -1.7509 2.4801 0.05 -2.0094 0.0198 0.3230 0.0013 0.1056 0.5981 0. y ∈ [−3.0252 0.0968 0.0721 0.2912 0.8812 0.0004 2.2780 0.4602 0.50 -2.3814 0.0488 0.0495 0.95 -1.3037 2.4784 0.1251 0.5293 1.0735 0.1841 0.8143 1.30 -1.0158 0.6706 1.0139 0.75 -2.1826 0.9111 1.0060 0.2420 0.0808 0.25 -2.35 -2.3752 0.5363 0.5517 2.2420 0.0359 0.15 -1.70 -1.1977 0.3455 1.1065 2.85 -2.0004 0.1711 0.1357 0.3632 0.0833 1.60 -1.40 -2.95 -0. pdf (y) is the cumulative distribution function.Exercises Table 4.0047 0.0228 0.2743 0.35 -1.0051 0.3909 1.4404 0.2897 0.0136 0.20 -1.7328 0.2578 0.50 0.40 -1.3123 0.40 -0.5069 0.3429 0.80 -1.2266 0.2049 2.0] † y (y) (y) G(y) y (y) (y) G(y) 53 -3.0668 0.30 -0.70 -2.0085 1.1295 0.85 -1.0019 0.0322 0.00 -2.1023 0.05 0.0396 0.0082 0.00 -0.25 -0.

0005 0.90 0.8289 0.0440 0.50 1.9987 0.8023 0.8749 0.45 0.9713 0.1100 0.6736 0.5000 0.0111 0.0757 0.0162 0.1978 0.05 0.30 0.0023 0.0206 0.8159 0.0283 0.1200 0.9842 0.1394 0.00 1.0621 0.30 2.0183 0.3867 0.50 2.3989 0.0074 0.95 3.0175 0.10 1.9332 0.5987 0.0252 0.0037 0.0506 0.0328 0.70 1.0060 0.15 0.0833 0.2863 0.0317 0.8849 0.45 1.30 1.9505 0.85 2.70 2.7422 0.3910 0.0056 0.65 1.9641 0.0455 0.0091 0.9893 0.7257 0.8944 0.0017 0.3509 0.1004 0.6915 0.9878 0.75 2.5199 0.9452 0.35 2.05 2.1942 0.6554 0.0042 0.1828 0.10 0.0367 0.0009 0.2541 0.6179 0.0916 0.3123 0.3605 0.1429 0.0104 0.0008 0.60 0.40 2.7734 0.8643 0.3011 0.54 Inventory Theory Table 4.0656 0.40 1.0012 0.00 2.9265 0.0049 0.0561 0.0079 0.50 0.3332 0.9744 0.55 0.0409 0.3683 0.0085 0.9032 0.65 2.50 0.0224 0. (Cont.0143 0.3284 0.40 0.0863 0.0293 0.25 1.9938 0.3] † y (y) (y) G(y) y (y) (y) G(y) 0.3521 0.80 1.1554 0.0136 0.55 2.20 1.0721 0.70 0.10 2.0065 0.90 2.3989 0.0198 0.1023 0.9970 0.2299 0.3069 0.9974 0.15 2.0293 1.9332 0.9965 0.1295 0.1497 0.0488 0.1295 0.80 2.0396 0.7580 0.9984 0.00 0.9918 0.1312 0.0069 0.9861 0.0355 0.0097 0.0540 0.2661 0.2420 0.85 1.85 0.05 1.3945 0.0051 0.35 1.0686 0.20 0.75 0.5596 0.0044 0.60 2.2059 0.2897 0.0027 0.9192 0.9929 0.1687 0.75 1.0020 0.3752 0.9960 0.2780 0.9821 0.25 2.0232 0.1109 0.9981 0.9978 0.7088 0.3970 0.0006 0.2668 0.3814 0.00 0.9798 0.3429 0.55 1.25 0.3984 0.2304 0.0119 0.0790 0.0011 0.0004 .9772 0.2179 0.9953 0.5793 0.) Function Values for the Standard Normal Distribution y ∈ [0.15 1.95 2.80 0.1714 0.2481 0.90 1.1826 0.9906 0.0261 0.7881 0.3230 0.20 2.1604 0.6368 0.35 0.45 2.95 1.9554 0.0032 0.8531 0.3744 0.0126 0.65 0.1202 0.9678 0.8413 0.9115 0.0154 0.0015 0.60 1.0005 0.9946 0.9394 0.0940 0.0596 0.5398 0.2137 0.9599 0.

Foundations of Operations Management. Operations Management. . Englewood Cliffs.R. McGraw Hill. New York. Russell. 2000. Peterson.J. 2003. Peterson. L. Upper Saddle River. NJ. Englewood Cliffs. Boucher. Modeling and Analysis of Manufacturing Systems..J. NJ. Control and Integration.C. and M.G. R. R. 1994. D. John Wiley & Sons. Principles of Inventory and Materials Management. McGraw Hill.O. Chicago. Factory Physics. New York.A. 1979. Hopp. Upper Saddle River. and B. and D. Sipper. S. Prentice Hall. New York. Silver. New York. H. R. New York. John Wiley & Sons. John Wiley & Sons. Johnson. 1979.H. Analysis and Control of Production Systems. Ritzman. 1998. and L. Moskowitz.. 2000. Second Edition. Second Edition. 2003.. Pyke and R.W.F.Bibliography 55 Bibliography Askin. Montgomery. NJ. Scheduling. 1994.S. Inventory Management and Production Planning and Scheduling. McGraw Hill. Spearman. Prentice Hall. and Inventory Control. 1974. Elsayed. John Wiley & Sons. Silver. Decision Systems for Inventory Management and Production Planning. Foundations of Inventory Management. Zipkin. 1997.P. Third Edition. Wright. Prentice Hall. 1997. E. and T. Production: Planning. Production and Operations Analysis. L. Fourth Edition. and C. Operations Research Techniques for Management. Prentice Hall. P. W. Tersine. Prentice Hall.A. Irwin.A. NJ. R.A. Nahmis.. Englewood Cliffs. Krajewski. D. Prentice Hall.. Taylor III. E. Third Edition. Standridge. 1993. NJ. and E. and G. Fourth Edition.P. Operations Research in Production Planning. New York. New York.

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