Assumptions for the (Q, R) policy

Probabilistic demand
• Demand is NOT deterministic
but probability distribution is known
• Lead time MIGHT NOT BE deterministic
• Shortages MAY OCCUR
• All ordered units arrive at once
• Purchasing cost is independent of the order
quantity
 A Probabilistic Inventory Model.
Assumptions:
• Probabilistic lead-time demand (DL)
– mean DL
– standard deviation DL
– probability distribution fcn. P(DL) / density fcn. f(DL)

L L
– cumulative distribution fcn.
 DF(D )
= 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
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[DL] + SS = DL + SS

• Safety stock: SS = R - DL or: SS = ZDL

• Average inventory (approximations):
– Expected max. inventory on hand: SS + Q
– Expected min. inventory on hand: SS
– Average inventory on hand: SS + Q/2 = R - DL + Q/2
Determination of the order point R ?
3 alternative models:
1. Specified probability of no stockout during lead time
 service level: P DL  R   F  R   

2. Specified proportion of demand satisfied from inventory

E  # of units short 
on hand
P service level: 1  P
E  demand
3. Cost minimization
cs shortage cost
Discrete probability distribution
 service level
Lead time Cumulative
0.350
demand Probability probability
0.300
10 0.025 0.025

Probability
0.250
11 0.050 0.075
0.200
12 0.150 0.225
0.150
13 0.050 0.275
0.100
14 0.150 0.425
0.050
15 0.300 0.725
0.000
16 0.150 0.875
17 0.050 0.925 10 11 12 13 14 15 16 17 18 19
18 0.050 0.975 Lead time demand
19 0.025 1.000

  0.9
 P  DL  R   0.9
 R  17
 P service level
The expected number of shortages
during lead time for a given order point R?
0.350
0.300
Probability

0.250
0.200
0.150
0.100
0.050
0.000
10 11 12 13 14 15 16 17 18 19
Lead time demand

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):
Normally distributed
Discrete distribution :
lead  time demand :
 

E S    D L  R  P DL  DL  N  DL ,  DL
DL  R ( 1)

 E  S    DL N  Z  ,
Continuous distribution :
where N  Z  is the

E  S     DL  R  f  DL  dDL ' Unit normal loss function'
R 
and Z  R   DL  DL
 P service
level
A maximal expected number of shortages
E  # of units short per year
P  1
E  demand per year
D  D 

ES   
ES  
Q  Lost sales : P  1  Q  E S  
 P  1
D  D 
 
 
E S 
 P  1
Q

 E  S   Q 1  P 
  1 P 
 Lost sales : E  S   Q 
 P 
Discrete probability distribution P service
Lead time Cumulative
level
0.350
demand Probability probability
0.300
10 0.025 0.025

Probability
0.250
11 0.050 0.075
0.200
12 0.150 0.225
0.150
13 0.050 0.275
0.100
14 0.150 0.425
0.050
15 0.300 0.725
0.000
16 0.150 0.875
17 0.050 0.925 10 11 12 13 14 15 16 17 18 19
18 0.050 0.975 Lead time demand
19 0.025 1.000

Q = 100 E(S|R=19) = 0
E(S|R=18) = (1)0.025 = 0.025
P = 0.999 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
E(S) < 100(1-0.999) = 0.1
=> R = 17
 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 - DL increases by one (1) unit,
causing an increase of the annual inventory holding cost by ch

• The expected number of shortages E[S] during the lead time

 DL  R
P DL   1  P DL  R   1  F  R 
decreases by:
D
cs 1  F  R  
causing a decrease of the
annual shortage cost by: Q
 Why increasing R decreases E(S):

E  S R   E  S R  1  D L  R  P DL     D   R  1  P D 
L L
DL  R DL  R 1

 
  R  1  R  P R  1    DL  R  P DL  
 DL  R 1 
 
    DL  R  P DL    P DL  
 DL  R 1 DL  R 1 
 P R  1   P DL    P DL   1  P DL  R 
DL  R 1 DL  R
 The marginal cost approach
The order point R is increased as long as
the shortage cost decrease exceeds the holding cost increase:

D
cs 1  F  R    ch
Q

ch Q
1  F  R   
cs D

ch Q
F  R  1  if chQ  cs D 
cs D