Operations Management

Session 24: Inventory Systems

 Previous Lectures

 EOQ Model
 Known demand, multi-periods
 Newsvendor Model
 Uncertain demand, but only 1 period
 The tension between setup cost and inventory holding cost is
not relevant.
 How do we handle uncertain demand and multiple
periods?

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 Today’s Lecture

 Inventory systems
 Inventory turns/turnover
 Briefing on the simulation game

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 Inventory Level in Real Life
Inventory on Hand

Order quantity, Q

Q
Reorder point

Amount used d1
during
first lead time

Safety stock, First lead time, LT2

SS LT1
Time
Order 1 Order 2 Order 3
placed placed placed
Shipment 1 Shipment 2
received received

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 Inventory Systems

 Continuous (perpetual) system: System that

keeps track of removals from inventory continuously,
thus monitoring current levels of each item. Fixed
quantity is ordered when a certain level is reached.
 Good: (1) Keeps constant count of inventory and (2)
fixed order quantity.
 Bad: (1) Higher record keeping cost; (2) Periodic
inventory counting is still require; (3) Time of delivery is
random.

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 Continuous System with
Positive Lead-time
 (ROP,Q) policy
 Order when the inventory reaches the ROP
 The order size is always Q
 What is the optimal Q?
 How do we decide when to order? Should the re-
order point be greater than dL?

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 Safety Stock

 Safety Stock: Stock that is held in excess of expected

demand due to variable demand rate and/or lead time.
 An expense of doing business.
 Necessary to ensure good customer service.

 Safety stock is determined by demand variability and

target service level.

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 Example

 Daily demand for a certain product is normally distributed

with a mean of 60 and a standard deviation of 7. The
source of supply is reliable and maintains a constant lead
time of six days. The cost of placing the order is $10 and
annual holding costs are $0.50 per unit. There are no
stockout costs, and unfilled orders are filled as soon as the
order arrives. Assume sales occur over the entire 365 days
of the year. Find the order quantity and reorder point to
satisfy a 95% probability of not stocking out during the lead
time. (Example 17.4, page 562)

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 Example

 Let us first ignore the random/uncertainty part.

 If daily demand is 60 for sure, what is the order
quantity and the reorder point?

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 Example

2DS 2 * 60 * 365 *10

The optimal order quantity is :   936 units
H 0.50

Average daily demand Leadtime

Reorder point : R  dL  z
z value

st. dev. of demand over the leadtime

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 Example

Reorder point : R  dL  z
The z-value associated with 0.95 is 1.64.
 i1 d

L 2
 6 * 7 2
 17.15
The re-order point R is 60(6)+1.64*17.15 = 388 units.
To summarize, an order for 936 units is placed
whenever the number of units remaining in inventory
drops to 388.

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 Example

 What happens if demand is not normal?

Demand Probability
2 0.02
3 0.05
4 0.09
5 0.14
6 0.2
7 0.17
8 0.15
9 0.1
10 0.05
11 0.03

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 Example

 What is the average on hand inventory level?

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 Example

 What if the supplier is able to reduce the leadtime

from 6 days to 3 days?

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 Example

 What if the cost of placing an order is reduced

from $10 to $2.5?

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 Inventory Level in Real Life
Inventory on Review
Hand period RP
Target inventory level, RP
TIL

First order quantity, Q2

Q1

Amount used d1
during RP+
first lead time

Safety stock, First lead time, LT2 LT3

SS LT1
Time
Order 1 Order 2 Order 3
placed placed placed
Shipment 1 Shipment 2 Shipment 3
received received received

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 Inventory Systems

 Periodic system: Physical count of items made at

periodic intervals (weekly, monthly)
 Good: (1) Economics of scale and (2) Delivery is performed on
a known schedule
 Bad: (1) Lack of control between reviews; (2) Carry extra stock
to protect against shortages between reviews; (3) Order
quantity is random

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 Periodic System

 (Order-up-to,T) policy
 How do we compute how much to order at every
review period?
 If there was no variability in the system, we would
order exactly the amount needed to satisfy
demand over the period T+L.

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 Example

 Daily demand for a product is 10 units with a standard

deviation of 3 units. The review period is 30 days, and the
lead time is 14 days. Management has set a policy of
satisfying 98 percent of demand from items in stock. At the
beginning of this review period, there are 150 units in
inventory.
 How many units should be ordered? (Example 17.5, page
563)

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 Example

 Let us first ignore the random/uncertainty part.

 If daily demand is 10 for sure, what is the order-
up-to level?

 d(T+L)

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 The Safety Stock Level and Order
Quantity
Safety stock =
z*(st. dev. of demand over review and lead time)
q = d(T+L) + zσ - I
Part in light blue is the target inventory level.
q = Quantity to be ordered
T = number of days between reviews
L = lead time
d = forecast avg. daily demand
z = z-value for a specified service level
σ = st. dev. of demand over review and lead time
I = current inventory level
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 Example

Formula: q = d(T+L) + z*σ - I

d = 10; T = 30; L = 14; I = 150

We must calculate z and σ.
The z value for 0.98 is 2.05.


T L
 i 1
 d2  (T  L) d2  (30  14)(32 )  19.90
The quantity to order is:
q = 10(30+14)+2.05*19.90-150 = 331 units
to ensure 98% probability of not stocking out
over the review period.
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 Example

 What is the average on hand inventory level?

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 Inventory Level
T

L T-L
Safety stock,
SS
Time

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 Inventory Level
6+20

20

6 6

3 7
Safety stock,
SS

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 Inventory Level

20

6 6

3 7 3
Safety stock,
SS

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 Inventory Level

20

3 7 3
Safety stock,
SS

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 Inventory Level

dT

dL

L T-L L
Safety stock,
SS

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 Example

 What if the supplier is able to reduce the leadtime

from 14 days to 7 days?

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 Example

 What if the review period is reduced from 30 days

to 15 days?

 What is the main trade-off that determines T, the

review cycle?

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 Inventory Turn

 Inventory Turn
= (Annual) Cost of goods sold/Average inventory value
= [(Annual) Sales quantity * Unit Cost] /
(Average inventory quantity * Unit Cost)
= (Annual) Sales quantity / Average inventory
quantity
= Throughput Rate / Average WIP
= 1 / Throughput Time

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 Inventory Turn

 Continuous System
Inventory turn = D / (Q/2 + SS)

 Periodic System
Inventory turn = D / (DT/2 + SS)

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 Comparison: Continuous
Review vs Periodic
 Continuous review inventory system: The order
quantity Q is constant (i.e., the same amount is
ordered every time), and an order is placed every time
the inventory drops to the reorder level R. The time
between orders is variable.
 Periodic review inventory system: There is a target
inventory level, and an order is placed every T time
units. The size of the order is variable, and equals the
target inventory level minus the inventory currently on
hand. The time between orders is constant.
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 The Simulation Game:
First Run
 Monitoring utilization rate
 Buy machines when the utilization rate is high

 Forecasting and planning

 Occasional information updating and monitoring

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 The Simulation Game:
First Run
 Monitoring utilization rate
 It is very hard to play catch-up game
 What the cause of peak rate? Noise? Underlying demand?
 What is the right utilization rate for the desired leadtime?

 Forecasting and planning

 Capacity requirement
 Capacity requirement with 85% target utilization rate
 Spreadsheet waiting time calculation for leadtime

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 The Simulation Game:
First Run
 Do we want to delay the purchase?

 Do we want to sell the machines in the end?

 Do we want to change the queue priority?

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 The Simulation Game:
Second Run

Preparing Testing

Decisions: Centrifuging
1. Three pricing contract type (7 day, 1 day, and half day)
2. The number of machines at each station. (Start with 1.)
3. The inventory policy (reorder point, reorder quantity)
4. The priority at the testing queue (FIFO, initial, or final).
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 The Simulation Game:
Second Run
 Observation period for the second simulation
game starts at 7:00 pm, 4/15/09 (Wed.).
 Second Simulation Game Starts at 4/16/09
7:00pm (Thurs.)
 The simulator stops running at 7 pm on 4/23/09
7:00pm (Thurs.)
 50% is your standing against the other teams in
this class.
 50% is a 2 page write-up.
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 Next Class

 Supply Chain Coordination

 Article reading: "Back to the Future: Benetton Transforms it’s
Global network" MIT Sloan management Review, Fall 2001.

 Beer Game
 Please download the game before class at
http://scm.bus.umich.edu/BeerNet/Beerwin32.exe
 Bring laptops to the class next time

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