Topics – Lecture 6

● Stochastic Inventory
● Period and Continuous Review Systems
● Stochastic Demand and Lead Time
● News Vendor Problem (single period)
● Conclude inventory and start supply chain
Next Lecture

● Read and bring:

● Troyer, Smith, Marshall, Yaniv, Tayur, Barkman,
Kaya, and Liu (2005). Improving Asset
Management and Order Fulfillment at Deere and
Company C&CE Division. Interfaces, January
2005.
 Inventory Review Slide
System EOQ News Vendor / Q,R s,S
P Policy
Demand Constant Random Random Random
Periodic Continuous Periodic Continuous Periodic
Capacity Unlimited Unlimited Unlimited Unlimited
Setup Cost Yes No Yes Yes
Holding Cost Yes Yes Yes Yes
Backorder / Lost No Yes Yes Yes
Sales
Policy Order Q items when Return the inventory Order Q items when Periodically return the inventory to
inventory a reorder to a set level each the inventory hits S if the level is less than s.
point. period. level r.

System MRP Lot Sizing Finite Capacity Conwip /

Scheduling Kanban

Demand Forecast Forecast Forecast Random

Periodic Periodic Periodic Periodic Continuous
Capacity Unlimited Unlimited Restricted Restricted
Setup Cost No Yes Yes No
Holding Cost No Yes Yes Yes
Backorder / Lost No No Yes Yes
Sales
Policy Calculus of explosion. Optimization Optimization One for one item reordering
Formulation Formulation
Stochastic Inventory

● Demand, usable quantity, and lead time can be

random variables.
● Allow many variables in a problem to be described
by probability distributions creates interesting
research problems.
● In practice, systems handle random variables
based on relatively simple rules. We will discuss
this more in the supply chain management section
of the course that is the next lecture.
Demand

Suppose that we represent demand as

D = Ddeterministic + Drandom

If the random component is small compared to the

deterministic component, the models of chapter 4
will be accurate. If not, randomness must be
explicitly accounted for in the model.
In this chapter, assume that demand is a random
variable with cumulative probability distribution
F(t) and probability density function f(t).
Fixed Period vs Fixed Quanity

● The inventory models up to now are considered

fixed-quantity systems
 Meaning the same fixed amount of inventory is added
every time an order is placed
 We saw that orders are event-triggered
● When inventory decreases to the reorder point (ROP), a new
order for Q is placed
Fixed Period

● Answers how much to order

● Orders placed at fixed intervals
 Inventory brought up to target amount
 Amount ordered varies
● Only the amount necessary to bring total inventory up to a
pre-specified target level is ordered
 Inventory ordered at the end of fixed intervals
● No continuous inventory count
 Possibility of stockout between intervals
● Useful when vendors visit routinely
 Daily or weekly delivery systems
News Vendor Models Are Fixed
Period
● For one period models, the objective is to
“balance” overage and underage.
● Single period models are useful for:
 Planning initial shipment size for any “high fashion”
item.
 Food products with limited shelf life.
 Items with short life spans (newspapers)
Basic News Vendor Assumptions

● One period model.

● A cost exists for positive inventory at the end of
the period and for unsatisfied demand.
● No setup cost
● No holding cost just costs for unsatisfied demand
and positive inventory.
● Can only order once at the start of the period.
Development of News Vendor Cost
Function
• Let D be demand.
• Let Q be order quantity G (Q, D)  Under  Over cost

• G(Q,D) be the cost G(Q, D)  co max( 0, Q  D)  cu max( 0, D  Q)

function as a function of
demand and order quantity.
• Let co be the cost per unit
of positive inventory at the
end of the period
• Let cu be the cost per unit
of unsatisfied demand.
Optimal Policy for News Vendor

● It can be shown that the optimal number of papers

to purchase is the fractile of the demand
distribution given by F(Q*) = cu / (cu + co) where
F() is the cummulative probability function of the
demand distribution. See table 4 for the z values
corsponding to this distribution.
● If demand is not described by a continuous
variable then it is best to round up (see page 245)
Lets work problem 8
• Bakery makes bagels.
• .08 USD to make and .35 USD to Number Sold Probability
sell. The unsold bagels are worth 0 0.05
5 0.1
.03 USD. 10 0.1
• Based on the given discrete 15 0.2
20 0.25
distribution, how many bagels 25 0.15
should you make? 30 0.1
35 0.05
• If you were to approximate with
the normal distribution, how
many bagels would you make?
Multi-period

● We periodically order items.

● All items are backordered (no lost sales).
● We can reinterpret cu and c0 as a holding cost and
a loss of good will for backorder.
● As such, the optimal policy for an infinite period
looks like the single period problem. See
Appendix 5-B page 285.
 F(Q) = p / (p+h) where p is the backorder cost and h is
the holding cost.
● We develop a policy to order up to Q* based on our
current inventory status.
Restated

● Assume D1,D2, D3 are iid.

● The policy is to order up to Q.
● All excess demand is backorder.
● The number of unit sold equal demand.
Multi-period

● With no backorders,
● Cu = p+S-C = lost good will + lost profit
● Co = h = Holding cost
● The problem with these models is that they do not
consider order setup cost.
Part B – Work Problems

● Forecasting
● EOQ
Identify the problem

● You are a high volume assembly line that must

order parts from a supplier. Parts have a setup cost
for ordering and a holding cost. What inventory
model would you employ?
● You are buy swim suits with a 4 month lead time
for Target?
● You are trying to determine the production run for
a machine with a long setup time.
● Your supplier is offering a quantity discount.
Should you accept it.
(Q,R) Policy

● The (Q, R) policy is a generalization of the EOQ that allows

random demeand. We tread the R (level of on hand inventory
when we reorder) and Q the quantity to order as independent
decision variables.
● We have the following system assumptions:
 Continously reviewed.
 Demand is random and stationary
 There exist a fixed positive lead time τ.
 The following cost are assumed:
● Setup cost K.
● Holding cost h.
● Proprtional order cost of c per item
● Stock out cost of p per unit of unsatisfied demand.
 How does the policy work?
● When the inventory level on hand reach R, an order
for Q units is placed that arrive in τ units of time.
● When lead times are long, R should be interpreted as
the inventory position (on hand plus on order), rather
then inventory level.
● The (Q,R) policy discussed in the book assumes
backorders where the number of units ordered is
equal to the demand. Similar models can be created
with lost sales (page 255).
Optimal (Q, R) policy
● The average annual cost is:
G (Q, R )  h(Q / 2  R   )  K  / Q  p n( R ) / Q.

● Interpret n(R) as the expected number of stockouts

per. The optimal values of (Q,R) that minimizes
G(Q,R) can be shown to be:

2 ( K  pn( R ))
Q
h

1  F ( R )  Qh / p
Type 1 and Type 2 Service Levels

The penalty cost, p, is difficult to estimate. As

such, we might set the inventory levels to meet a
specified service objective. The two most common
service objectives are:
1) Type 1 service: Choose R such that the probability
of not stocking out in the lead time is equal to a
specified value.
2) Type 2 service. Choose both Q and R such that the
proportion of demands satisfied from stock equals
a specified value.
Find Q and R With Service Level
Restrictions (from book slides)
● For type 1 service, if the desired service level is α
then one finds R from F(R)= α and Q=EOQ.
● Type 2 service requires a complex interative
solution procedure to find the best Q and R.
However, setting Q=EOQ and finding R to satisfy
n(R) = (1-β)Q (which requires Table A-4) will
generally give good results (Bonus Material).
Restated and Practical
Considerations
Type 1 service is lead time service. Restated, do
we cover the lead time without stockouts?
Type 2 service is generally referred to as the fill
rate. Restated, what fraction of the demand do we
cover
In reality, inventory levels are set by the ERP /
Supply chain management system and you work
within their limitations and business logic. Use
these models as policy guides.
Example From Book

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
stockout 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.
(s, S) Policies
The (Q,R) policy is a continuous review police. In
the case of periodic review, a slight alteration of
this policy is required. Define two levels, s < S,
and let u be the starting inventory at the beginning
of a period. Then

If u  s, order S  u.
If u  s, don't order.
Computing the optimal values of s and S is typically
difficult. Simulation sometimes used.
P Policy

● A common inventory policy often implimented in

practice.
● Review inventory periodically.
● Order up to level P.
● P policy is S,s without setup costs.
● Math same as news vendor.
 Overage cost = Inventory cost
 Under cost = Backorder or lost sales (include both lost
profit and goodwill)