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Probabilistic Demand
¨ Characteristics
5
Example
¨ Consider the situation facing an appliance store sells a
particular model of TV. Because space is limited and
because the manufacturer makes frequent deliveries of
other appliances, the store finds it practical to order
replacement TVs each time one is sold. In fact, they
have a system that places purchase orders (POs)
automatically whenever a sale is made. But, because
the manufacturer is slow to fill replenishment orders,
the store must carry some stock in order to meet
customer demands promptly. Under these conditions,
the key question is how much stock to carry?
The Base-Stock Policy
¨In the base stock model, inventory is refilled one unit at a time and demand
is random.
¨Start with an initial amount of inventory R. Each time a new demand arrives, place a
replenishment order with the supplier.
¨An order placed with the supplier is delivered L units of time after it is placed.
¨Because demand is stochastic, we can have multiple orders (inventory on-order) that have
been placed but not delivered yet.
¨The amount of demand that arrives during the replenishment leadtime L is called the
leadtime demand (inventory on order).
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Assumptions
1. Demands occur one at a time.
2. Any demand not filled from stock is backordered.
3. Replenishment lead times are fixed and known;
4. Times between consecutive orders are stochastic but
independent and identically distributed (i.i.d.)( random
distribution)
5. Inventory is reviewed continuously
6. There is no fixed cost associated with placing an order; and
7. There is no constraint on the number of orders that can be
placed per year.
¨ On-hand and backorders are never positive at the same time, so if X=x,
then:
¨ Backorder Level:
B(r) = 0.187
¨ Inventory Level:
¨ Calculations:
since , z =0.32 and hence
R* = + z = 10 + 0.32(3.16) = 11.01 ~ 11
¨ Observation: from previous table fill rate is G(10) = 0.583, so
maybe backorder cost is too low.
Base Stock Insights
1. Reorder points control the probability of stockouts by
establishing safety stock.
2. The “optimal” fill rate is an increasing function of the backorder
cost and a decreasing function of the holding cost. We can
use either a service constraint or a backorder cost to
determine the appropriate base stock level.
3. Base stock levels in multi-stage production systems are very
similar to kanban systems and therefore the above insights
apply to those systems as well.
4. Base stock model allows us to quantify benefits of inventory
pooling.
3. The (Q,r) or (Q,s) Model
Assumptions
¨Demand occurs continuously over time
¨Times between consecutive orders are stochastic but independent and identically
distributed (i.i.d.)
¨Inventory is reviewed continuously
¨Supply leadtime is a fixed constant L
¨ Orders that cannot be fulfilled immediately from on-hand inventory are
backordered
¨Fixed cost associated with replenishment orders and cost per backorder.
¨Constraint on number of replenishment orders per year and service constraint
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The (Q, r) Policy
¨Start with an initial amount of inventory R. When inventory level reaches
level r, place an order in the amount Q = R-r to bring inventory position
back up to level R. Thereafter whenever inventory position drops to r,
place an order of size Q.
¨The base-stock policy is the special case of the (Q, r) policy where Q =
1.
¨Objective:
¨ Performance Measures:
Inventory versus Time
2
Demand during Leadtime
2
Demand during Leadtime
r r)
2
Costs in (Q,r) Model
¨ Result:
¨ Type II:
Note: neglects B(r,Q)
term, underestimates S(Q,r)
Backorder Costs in (Q,r) Model
¨ Result:
Notes:
1. B(Q,r)» B(r) is a base stock approximation for backorder level.
¨ Objective Function:
¨ Results:
¨ Conclusion: this has higher service and lower inventory than the
original policy (Q=4, r=2). But the cost of achieving this is an
extra 3.5 replenishment orders per year.
3.2. (Q,r) Model with Stockout Cost
¨ Objective Function:
¨ Assumptions:
¨ Q,r can be treated as continuous variables
¨ G(x) is a continuous cdf
¨ Results:
¨ Stockout Model
¨ when concern is about fill rate
¨ better approximation of lost sales situations (e.g., retail)
¨ Note:
¨ We can use either model to generate frontier of solutions
¨ Keep track of all performance measures regardless of model
¨ B-model will work best for backorders, S-model for stockouts
3.3. Lead Time Variability
¨ Problem: replenishment lead times may be variable, which increases
variability of lead time demand.
¨ Notation:
L = replenishment lead time (days), a random variable
l = E[L] = expected replenishment lead time (days)
L = Var(L) = std dev of replenishment lead time (days)
D = demand per period t, a random variable, assumed i.i.d.
d = E(D) = expected demand per period
D = Var(D) = variance demand
¨ We have:
E(X)=E(L)E(D)
Var(X)=E(L)Var(D) + E(D)2Var(L)
Including Lead Time Variability in Formulas
44
Expected Leadtime Demand
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Variance of Leadtime Demand
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Variance of Leadtime Demand
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Single Product (Q,r) Insights
¨ Basic Insights:
¨ Safety stock provides a buffer against stockouts.
¨ Cycle stock is an alternative to setups/orders.
¨ Other Insights:
1. Increasing D tends to increase optimal order quantity Q.
2. Increasing tends to increase the optimal reorder point. (Note: either
increasing D or l increases .)
3. Increasing the variability of the demand process tends to increase the optimal
reorder point (provided z > 0).
4. Increasing the holding cost tends to decrease the optimal order quantity and
reorder point.
3.4. Uncertain Demand with Safety Stock
IP
IP
Order
Order
Order received
Order received
received
On-hand inventory
received
Q
Q Q
On
Hand
r
Order Order Order
placed placed placed
L1 L2 L3 Time
TBO1 TBO2 TBO3
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Expected Inventory (Assumptions)
I(t)
Q Slope
-D
Q
SS T=
D
Time
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Expected cost function
¨ Include expected: holding (h), setup (A), penalty (p – e.g.
backorder) and ordering (per unit) costs (c)
¨ Average Holding Cost:
Q
h SS
¨ Average Set-up Cost: 2
A AD
=
T Q
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Expected cost function
Expected Shortage per Cycle:
¥
E(max(X - r, 0)) = ò(x - r) g(x) dx =n(r)
r
¶Y h D pDn(r) 2D [ A + p n(r)]
= - A 2- 2
=0 => Q =
¶Q 2 Q Q h
(2) This is the first equation
¶Y pD we will use to determine
=h + n¢(r) optimal values Q and r
¶r Q
Cost Minimization
Partial Derivatives:
(2)
¶Y pD
=h + n¢(r)
¶r Q
¥
Note: n(r) = ò(x - r)g(x)dx
r
2 éë + ( )ùû 2(800)(10 +5 ( ))
= =
2
= 8000 + 4000 ( )
2
1- ( )= = =
5(800) 2000
58
Solution
From Uniform U(0,200) distribution:
1 1
U(0,200): g(x) = =
b-a 200
200
¥
1
n(r) = ò(x - r)g(x)dx = ò(x - r) dx
r r 200
æ 2 x=200 ö
æ200 2 2 ö
1 çx 1 r 2
=
ç
- rx ÷=
÷ ç - 200r - + r ÷
200 è 2 x=r ø
200 è 2 2 ø
r2
=100 + -r
400
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r2
Solution n(r) =
400
- r +100
Qi = 8000 + 4000n(r)
Q
Iteration 1: 1- G(r) =
2000
2AD 2(10)(800)
EOQ = = = 8000 =89.44 =Qo
h 2
G(r)
Qo h 89
1- G(ro ) = = =.04
pD 2000
G(ro ) =.96
ro =(.96)(200 - 0) =192 0 200
R
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r2
Solution n(r) =
400
- r +100
Qi = 8000 + 4000n(r)
Q
Iteration 2: 1- G(r) =
2000
2
(192)
n(r0 ) = - 192 +100 =.198
400
Q1 = 8000 + 4000(.198) =93.76
94
1- G(r1 ) = =.05
2000
Þ r1 =(.95)(200) =190
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r2
Solution n(r) =
400
- r +100
Qi = 8000 + 4000n(r)
Q
Iteration 3: 1- G(r) =
2000
190 2
n(r1 ) = - 190 +100 =.2197
400
Q2 = 8000 + 4000(.2197) =94.228
94
(1- G(r2 )) = =.05
2000
r2 =190
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Solution
r didn’t change => CONVERGENCE
(Q*,r*) = (94,190)
I(t)
253
Slope
190
-800
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Example: Normal Distribution
Demand is Normally distributed with mean of 40 per week and
a weekly variance of 8
Find (Q,r)
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Solution
Demand is N (40,2 2 ) per week.
Lead time is two weeks long. Thus, during the lead
time:
Mean demand is 2(40) = 80
Variance is (2*8) = 16
Demand observed in one week is independent from
demand observed in any other week:
E(demand over 2 weeks) = E (2*demand over week 1)
= 2 E(demand in a single week) = 2 μ = 80
¥
( 0 ) = ò( - ) ( )
2
1æ - m ö
¥
1 - ç ÷
( 0 ) = ò( - ) 2è s ø
2p s
æ - mö æ86.68 - 80 ö
=s ç ÷=4 ç ÷=4 (1.67)
è s ø è 4 ø
=4(.0197) =.0788
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Solution
Iteration 2:
n(r0 ) =.0788
2D ( A + pn(r)) 2(40) ( 50 + 5(.0788))
Q1 = = =423.3
h .0225
Q1h 423.3(.0225)
1- G(r1 ) = = =.0476
pD 5(40)
G(r1 ) =.9523
r1 =86.68
Convergence!
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3.5. 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.
3.5.1. (Q,r) Systems with Type 1 Service Constraint
For type 1 service, if the desired service level is α
then one finds r from G(r)= α and Q=EOQ
Specify a, which is the proportion of cycles in
which no stockouts occur.
This is equal to the probability that demand is
satisfied.
G(r) =a ® probability demand is satisfied
2AD
Set Q =EOQ =
h
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3.5.2. (Q,r) Systems with Type 2 Service Constraint
n( r )
1 ,
Q
n ( r ) 1 Q
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Type 2 Service Constraint
¨ May specify fill rate b, and use EOQ for Q to compute r
¨ Or, solve for p (penalty caused by shortage) : 1- ( ) =
and substitute into the equation: æ Qhn(r) ö
2D çA + ÷
2D ( A + pn(r)) è (1- G(r))D ø
Q= =
h h
hQ 2 hn(r)
=A + Q
2D (1- G(r))D
hQ 2 hn(r)
- Q - A =0
2D (1- G(r))D
¨ Result: 2
n(r) 2AD æ n(r) ö
Q= + +ç ÷
1- G(r) h è1- G(r) ø
n(r) =(1- b )Q
4. The (R, r) Model
¨This is usually called the (s, S) model
¨Each demand order can be for multiple units
¨Demand orders are stochastic
¨A replenishment order is placed to bring inventory position back to
R
¨Decision variables are R (instead of Q) and r
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4.1. Order-Up-To-Level (s, S) vs (Q, r) System
SS • If all demand
transactions are
unit-sized, two
systems are the
ss same S= r+Q
• (s,S)~ “min-max”
(s,S) (s,
system
S) system rR+Q
+Q
rR
(Q,,R)
(Q,r) system
system
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Alternative (s, S) Policy
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4.2. Periodic Review (S, T) System
T T
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Periodic Review Systems
Continuous Review Systems
Always knew level of on-hand inventory
Could place an order at any time
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Periodic Review Systems
If demand were known and constant, we would just resort
to our EOQ solution, possibly modifying it to meet
shipping date
Now: demand is random variable
Setting:
Place an order every T periods
Policy: Order up to S
The value of Q (order quantity) will now change periodically
Previous concern: demand exceeding supply during the
lead time
Now: demand exceeding supply during the period and lead
time, or T + l
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Periodic Review Systems
Order up to S
every T periods of
time.
I(t) Order arrives.
S Cycle continues.
Demand
Q
l l
Time
T
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Expected Cost Function
Include expected holding, setup, penalty
and ordering (per unit) costs
Average Inventory Level:
S
At level r*,on average,
order Q = S-r* units.
r* l periods later, units arrive.
Inventory level?
l
T
80
Expected Cost Function
Include expected: holding, setup, penalty
and ordering (per unit) costs
Average Inventory Level:
S
S-Dl units present when
Q arrive (expected) as
Dl units consumed over
leading time.
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Expected Cost Function
Include expected: holding, setup, penalty
and ordering (per unit) costs
Average Inventory Level:
S S - Dl
D*T units
removed
(expected) from
inventory over
time T.
T
82
Expected Cost Function
Include expected: holding, setup, penalty
and ordering (per unit) costs
Average Inventory Level:
S S-Dl
D*T/2 D*T
S-Dl-D*T
T
DT DT
Average Inventory Level = ( S - Dℓ- DT ) + =S - Dℓ-
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2 2
Expected Cost Function
Include expected:
holding, setup, penalty and ordering (per unit) costs
(max( ( + ℓ) - ,0))
¥
= ò( - ) ( ) = ( )
n(S)
p
T
85
Cost Minimization
Expected Cost Function:
DT A pn(S)
Y (S, T ) =h(S - Dℓ- )+ + + Dc
2 T T
Derivative:
Recall that T and l are given:
dY p
=h + n¢(S)
dS T
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Cost Minimization
Derivative:
dY p
=h + n¢(S) =0
dS T
¥
Note: n(S) = ò(x - S)g(x)dx
S
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Solution
Holding cost is:
h = Ic = .30 (122.50) = 36.75 / 52 = $.7067 per week
Compute:
p - hT 100 - (.7067)1
G(S) = = =0.993
p 100
Demand Distribution is Normal
mean = 125 variance = 104.17
Z = 2.455 from Normal table
S = 125+(2.455)(104.17)1/2 = 150.06
S z
89
Solution
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