Session 05 and 06

Inventory Control Systems

Probabilistic inventory models,
service levels and safety stocks.
D 0 8 5 4
Supply Chain : Manufacturing and Warehousing
Probabilistic inventory models,
service levels and safety stocks
Bina Nusantara University
2
A Probabilistic Inventory Model.
Assumptions:
Probabilistic lead-time demand (D
L
)

mean
D
L

standard deviation o
D
L

probability distribution fcn. P(D
L
) / density fcn. f(D
L
)
cumulative distribution fcn. F(D
L
)
= P(lead-time demand
Continuous review (Q, R) system (<=> (s, Q) system)
fixed order size Q
order point R (or s), i.e., variable order period
Demand during stock-out periods is backlogged
)
L
D s
Determination of the
order quantity Q ?
Heuristic approach:
Simply use the EOQ
(with or without quantity discounts)
or the Economic Batch Size model

=> Robust and simple model
Inventory levels:
Order point: R = E[D
L
] + SS =
D
L
+ SS

Safety stock: SS = R -
D
L
or: SS = Zo
D
L

Average inventory (approximations):
Expected max. inventory on hand: SS + Q
Expected min. inventory on hand: SS
Average inventory on hand: SS + Q/2 = R -
D
L
+ Q/2
Determination of the order point R ?
3 alternative models:
1. Specified probability of no stockout during lead time
| service level:
2. Specified proportion of demand satisfied from inventory
on hand
P service level:
3. Cost minimization
c
s
shortage cost
( ) ( ) | > = s R F R D P
L
| |
| |
P
E
E
>
demand
short units of #
1
Reorder
Point , R
X
Safety Stock (SS)
Time
Inventory Level
Optimal
Order
Quantity
SS
s
Expected
Demand
P(Stockout)
Freq
Lead Time
Place
order
Receive
order
Probabilistic Models
When to Order
Uncertain Demand
Time
O
n
-
h
a
n
d

i
n
v
e
n
t
o
r
y

Order
received
Q
On
Hand
Order
placed
Order
placed
Order
received
IP
IP
R
TBO
1
TBO
2
TBO
3
L
1
L
2
L
3
Q
Order
placed
Q
Order
received
Order
received
Expected Inventory (Assumptions)
Time
I(t)
Slope
-
Q

SS

Q
T =
Expected cost function
Include expected: holding, setup, penalty and ordering (per unit)
costs
Average Holding Cost:


Average Set-up Cost:


K
T
=
K
Q


2
Q
h SS
| |
+
|
\ .
Expected cost function
Expected Shortage per Cycle:



Interpret n(R) as the expected number of stockouts per cycle given by the
loss integral formula.
The unit normal loss integral values appear in Table A-4.

Expected Penalty Cost :
) ( ) ( ) ( )) 0 , ( (max R n dx x f R x R D E
R
= =
}

( ) ( )
( )
n R n R
P P
T Q

=
Cost Minimization
c
Q
R n p
Q
K
R
Q
h R Q G

t + + + + =
) (
)
2
( ) , (
Expected Cost Function:


Partial Derivatives:
(1)



(2)

| |
h
p n(R) K
Q
Q
R n p
Q
K h
Q
G +
= => = =
c
c 2
0
) (
2
2 2
cG
cR
= h +
p
Q
' n (R)
This is the first equation
we will use to determine
optimal values Q and R
Cost Minimization

p
Qh
R F
R F R n
dx x f R x R n
R n
Q
p
h
R
G
R
=
=
'
=
'
+ =
c
c
}

) ( 1
)) ( 1 ( ) (
) ( ) ( ) ( : Note
) (
Partial Derivatives:
(2)





This is the second equation
we will use to determine
optimal values Q and R
Service Level

0.000
0.050
0.100
0.150
0.200
0.250
0.300
0.350
10 11 12 13 14 15 16 17 18 19
Lead time demand
P
r
o
b
a
b
i
l
i
t
y
Discrete probability distribution
Lead time
demand Probability
Cumulative
probability
10 0.025 0.025
11 0.050 0.075
12 0.150 0.225
13 0.050 0.275
14 0.150 0.425
15 0.300 0.725
16 0.150 0.875
17 0.050 0.925
18 0.050 0.975
19 0.025 1.000
( )
17
9 . 0
9 . 0
=
> s
=
R
R D P
L
|
| service level
0.000
0.050
0.100
0.150
0.200
0.250
0.300
0.350
10 11 12 13 14 15 16 17 18 19
Lead time demand
P
r
o
b
a
b
i
l
i
t
y
The expected number of shortages
during lead time for a given order point R?
R = 16: E(# shortages | R =16) =
= (17-16)P(17) + (18-16)P(18) + (19-16)P(19)
= (1)0.05 + (2)0.05 + (3)0.025 = 0.225
P service level
Expected number of shortages during lead time E(S):
| | ( ) ( )
| | ( ) ( )
}

+ =
=
=
R
L L L
R D
L L
dD D f R D S E
D P R D S E
L
: on distributi Continuous
: on distributi Discrete
) 1 (
( )
| | ( )
( )
( )
L L
L
L L
D D
D
D D L
R Z
Z N
Z N S E
N D
o
o
o
=
=
~

and
function' loss normal Unit '
the is where
,
,
: demand time lead
d distribute Normally
P service level
A maximal expected number of shortages
| |
| |
| | | |
| |
| |
| | ( ) | |
( )
|
.
|

\
|

s s
s
|
|
|
|
.
|

\
|
+
s s
s
P
P
Q S E P Q S E
Q
S E
P
D
S E Q
D
S E
P
D
Q
D
S E
P
E
E
P
1
: sales Lost 1
1
1 : sales Lost 1
year per demand
year per short units of #
1
P service level
0.000
0.050
0.100
0.150
0.200
0.250
0.300
0.350
10 11 12 13 14 15 16 17 18 19
Lead time demand
P
r
o
b
a
b
i
l
i
t
y
Discrete probability distribution
Lead time
demand Probability
Cumulative
probability
10 0.025 0.025
11 0.050 0.075
12 0.150 0.225
13 0.050 0.275
14 0.150 0.425
15 0.300 0.725
16 0.150 0.875
17 0.050 0.925
18 0.050 0.975
19 0.025 1.000
Q = 100
P = 0.999
=>
E(S) < 100(1-0.999) = 0.1
E(S|R=19) = 0
E(S|R=18) = (1)0.025 = 0.025
E(S|R=17) = (1)0.05 + (2)0.025 = 0.1
E(S|R=16) = (1)0.05 + (2)0.05 + (3)0.025 = 0.225

=> R = 17
P service level
Order point R?
3. Cost minimization: A marginal cost approach
Given a fixed order quantity Q,
suppose R is increased to R + 1.
Then:
The safety stock SS+1 = R+1 -
D
L
increases by one (1) unit,
causing an increase of the annual inventory holding cost by c
h

The expected number of shortages E[S] during the lead time
decreases by:
causing a decrease of the
annual shortage cost by:

( ) ( ) ( ) R F R D P D P
L
R D
L
L
= s =

>
1 1
( ) | | R F
Q
D
c
s
1
Why increasing R decreases E(S):
| | | | ( ) ( ) ( ) | | ( )
( ) ( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( ) ( ) R D P D P D P R P
D P D P R D
D P R D R P R R
D P R D D P R D R S E R S E
L
R D
L
R D
L
R D
L
R D
L L
R D
L L
R D
L L
R D
L L
L L
L L
L
L L
s = = + + =
(

+ + + =
+ = +

> + >
+ > + >
+ >
+ > >
1 1
1 1
1 1
1
1 1
1
1
The marginal cost approach
The order point R is increased as long as
the shortage cost decrease exceeds the holding cost increase:
( ) | |
( ) | |
( ) ( ) D c Q c
D c
Q c
R F
D c
Q c
R F
c R F
Q
D
c
s h
s
h
s
h
h s
s s
>
>
if 1
1
1

Service Levels in (Q,R) Systems

In many circumstances, the penalty cost, p, is difficult to estimate.
For this reason, it is common business practice to set inventory
levels to meet a specified service objective instead.
1) Type 1 service: Choose R so that the probability of not stocking out
in the lead time is equal to a specified value.
Appropriate when a shortage occurrence has the same consequence
independent of its time and amount.
2) Type 2 service: Choose both Q and R so that the proportion of
demands satisfied from stock equals a specified value.
In general, | is interpreted as the fill rate.
Solution to (Q,R) Systems
with Type 1 Service Constraint
F(R) = o probability demand is satisfied
Set Q = EOQ =
2K
h
For type 1 service, if the desired service level
is then one finds R from F(R)= and
Q=EOQ
Specify o, which is the proportion of cycles in
which no stockouts occur.
This is equal to the probability that demand
is satisfied.

Solution to (Q,R) Systems
with Type 2 Service Constraint

Type 2 service requires a complex iterative solution procedure to
find the best Q and R

However, setting Q=EOQ and finding R to satisfy n(R) = (1-)Q
(which requires Table A-4) will generally give good results
Average Stockouts per Cycle
Average Demand per Cycle
=
n(R)
T
=
n(R)
Q
n(R)
Q
= 1 |,
n(R) = 1 | ( )Q
Service Constraints: Type 2
May specify fill rate |, and use EOQ for Q to compute R
Or, solve for p :

and substitute into the equation:
( )
0
)) ( 1 (
) (
2
)) ( 1 (
) (
2
)) ( 1 (
) (
2
) ( 2
2
2
=

+ =
|
|
.
|

\
|

+
=
+
=
K Q
R F
R hn hQ
Q
R F
R hn
K
hQ
h
R F
R Qhn
K
h
R pn K
Q

1 ( )
Qh
F R
p
=
Service Constraints: Type 2
Result:






Q R n
R F
R n
h
K
R F
R n
Q
) 1 ( ) (
) ( 1
) ( 2
) ( 1
) (
2
|

=
|
|
.
|

\
|

+ +

=
Other Continuous Review System:
Order-Up-To-Level (s, S) vs (Q, R) System
R+Q
R
s
S
(Q,,R) system
(s, S) system
(Q,R) system
(s,S) system
R
R + Q
s
S
Periodic Review System:
Order-Up-To-Level (R, S) System
SAFETY STOCKS
Why Safety Stock?
Safety Stock: Average level of the net stock just before a
replenishment arrives

Pressure for higher safety stocks
Increased product variety and customization
Increased demand uncertainty
Increased pressure for product availability

Pressure for lower safety stocks
Short product life cycles
The ABC Inventory Classification System
The ABC classification, devised at General Electric during the 1950s, helps a
company identify a small percentage of its items that account for a large
percentage of the dollar value of annual sales. These items are called Type A
items.
Adaptation of Paretos Law
20% of the people have 80% of the wealth (in 1897 Italy)

Since most of our inventory investment is in Type A items, high
service levels will result in huge investments in safety stocks.


Tight management control of ordering procedures is essential for
Type A items.

For Type B items inventories can be
reviewed periodically
Items can be ordered in small
groups, rather than individually.

Type C items require the minimum
degree of control
Parameters are reviewed twice a
year. Demand for Type C items
may be forecasted by simple
methods. The most inexpensive
items of type C can be ordered
in large lot, to minimize number
of orders. An expensive type C
items ordered only as they are
demanded
The ABC Inventory Classification System
10 20 30 40 50 60 70 80 90 100
Percentage of items
P
e
r
c
e
n
t
a
g
e

o
f

d
o
l
l
a
r

v
a
l
u
e

100
90
80
70
60
50
40
30
20
10
0
Class C
Class A
Class B
Replenishment Policies
When and how much to order

Continuous review with (Q,R) policy:
Inv. is continuously monitored and when it
drops to R, an order of size Q is placed

Periodic review with (R,S) policy:
Inv. is reviewed at regular periodic intervals (R),
and an order is placed to raise the inv. to a
specified level (order-up-to level, S)
Measures of Customer Service:
(Average) Product availability measures
Fill rate (P
2
):
Percentage of demand that is
satisfied from inventory
Compute Expected Shortage per
Replenishment Cycle (ESPRC)
P
2
= 1-ESPRC/Q

Cycle Service Level (P
1
): Prob. of
no stockout per replenishment
cycle, or percentage of cycles
without stockouts
Safety Stock Level
0
100
200
300
400
500
600
700
800
900
97 97.5 98 98.5 99 99.5 100
P_2
S
S
SS
Comparison of Type 1 and Type 2 Services
Order Cycle Demand Stock-Outs
1 180 0
2 75 0
3 235 45
4 140 0
5 180 0
6 200 10
7 150 0
8 90 0
9 160 0
10 40 0

For a type 1 service objective there are two cycles out of ten in which a stock-out
occurs, so the type 1 service level is 80%. For type 2 service, there are a total of
1,450 units demand and 55 stockouts (which means that 1,395 demand are
satisfied). This translates to a 96% fill rate.