TOPIC 4

PROBABILISTIC INVENTORY
CONTROL MODEL
PROBABILISTIC MODELS
FOR INVENTORY CONTROL

 Removes the condition of certainty and

allows probabilities to be assigned to
variables
 Develop models when variables are not
known exactly
 In practice, almost every inventory system
contains uncertainty
 Uncertainty in Inventory Systems includes:
 Demand
 Costs & price
 Lead Time
 Supplied Quantity

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Inventory terms

 Safety stock
 buffer added to on hand inventory during
lead time
 Stockout
 an inventory shortage
 Service level
 probability that the inventory available
during lead time will meet demand

12-3
 Inventory Costs

 Carrying cost
 cost of holding an item in inventory
 Ordering cost
 cost of replenishing inventory
 Shortage cost
 temporary or permanent loss of sales
when demand cannot be met
 Example: Uncertain Demand using EOQ
Analysis

 Demand for an item over the past 6 months has

been 20, 80, 240, 120, 100 and 40 units
respectively. The reorder cost is $50 an order and
holding cost is $1 a unit a month. No shortages are
allowed and lead time is constant at 1 month.
Describe an ordering policy for this item based on
average values. How satisfactorily is this policy?
 SOLUTION:
Listing the values given:
D = 100 units a month (taking the
average value)
S = $50 an order
i = $1 a unit a month
LT = 1 month
 Then, substitution gives:
Q = 2DS/H = (2)(50)(100)/1 = 100
units

T = Q/D = 100/100 = 1 month

ROL = LT x D = 1 x 100 = 100 units

The optimal policy is to order 100 units

whenever gross stock declines to 100 units. On
average, this happens once a month.
 CONCLUSION?? SATISFY?? WHY??
Month 1 2 3 4 5 6 7

Opening Stock 0 80 100 0 0 0 60

Replenishment 100 100 100 100 100 100
Demand 20 80 240 120 100 40
Closing Stock 80 100 -40 -20 0 60

These figures assume:

1. An opening stock of zero, but an order of 100 units arrives at the
start of month 1
2. Replenishments arrive at the beginning of the month and are
available during the
month they arrive
3. All unmet demand – negative closing stock – is lost
4. No order is placed in month 2 as the ROL is only reached at the
end of the month
 MODELS FOR UNCERTAIN/DISCRETE
DEMAND
• Marginal Analysis
 Design for short-term analysis
 Useful for items which have a strong seasonal demand
 Marginal Analysis is based on the expected profit & cost
of each unit (expected profit & expected loss on a unit)
 General Rule of the model:
Prob(DQ)  UC – SV
SP – SV
Whereas: UC = unit cost
SP = Selling Price
SV = Scrap value of an unsold unit

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Example: Marginal Analysis model

A shop is about to order some industrial heaters for a

forecast spell of cold weather. The shop pays $1000 for
each heater, and during the cold spell they sell for $2000
each. Demand for the heaters declines markedly after a
cold spell, and any unsold units are sold at $500. Previous
experience suggest the likely demand for heaters is as
follows:

Demand: 1 2 3 4 5
Probability 0.2 0.3 0.3 0.1 0.1

Q: How many heaters should the shop buy??

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• SOLUTION:
Listing the variables given:
UC = $1000 a unit
SP = $2000 a unit
SV = $500 a unit

Then, General Rule:

(UC – SV)/(SP – SV) = (1000 – 500)/(2000 – 500)
= 0.33 (probability DQ)

Prob(DQ) is the cumulative probability, and we are looking for

the largest value of Q which makes this less than 0.33.

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 If Q = 1, Prob(D1) = 1.0. This is greater than 0.33, so the
inequality is valid and we increase Q
 If Q = 2, Prob(D2) = 0.8. This is greater than 0.33, so the
inequality is valid and we increase Q
 If Q = 3, Prob(D3) = 0.5. This is greater than 0.33, so the
inequality is valid and we increase Q
 If Q = 4, Prob(D4) = 0.2. This is less than 0.33, so the inequality
is no longer valid

This identifies Q = 3 as the highest value where the

inequality is valid and this is the optimal solution

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• Newsboy Problem
• The Newsboy model is useful for seasonal goods and
“no second-hand value” stock such as newspapers
• Originally, the newsboys has to decide how many
papers to buy from his supplier when customer
demand is uncertain
• If he buys too many papers he is left with unsold stock
which has no value at the end of the day; if he buys too
few papers he has unsatisfied demand which could
have given higher a profit
• Also referred as The Single Period Model

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Four Steps To Solve Newsboy Problems
1. List the different levels of demand that are possible, along with the
estimated probability of each
2. Develop a Payoff table that shows the profit for each purchase
quantity, Q, at each assumed demand level, D.

a. If Q  D, all units are sold at the full profits margin, p,during the
regular season.
so, Payoff = (profit per unit)(purchase quantity)
= pQ
b. If Q > D, only D units are sold at the full profit margin and the
remaining unsold units must be disposed of at a loss, l, after the
season.
so,

Payoff = (profit per unit sold during season)(demand) – (loss per unit)
(amount disposed of after season)
= pD - l(Q - D)
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3. Calculate the expected payoff for each Q (or row in the
payoff table) by using the expected value decision rule.

4. Choose the order quantity Q with the highest expected

payoff

*Remember, the main objective remained to be the

maximization of potential profit!!!

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 Exercise Newsboy Problems
One of many items sold at a museum of natural history is a
Christmas ornament carved from wood. The gift shop
makes a $10 profit per unit sold during the season, but it
takes a $5 loss per unit after the season is over. The
following discrete probability distribution for the season’s
demand has been identified:

Demand : 10 20 30 40 50
Demand Prob : 0.2 0.3 0.3 0.1 0.1

How many ornaments should the museum’s buyer order??

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 Solution
Each demand level is a candidate for best order quantity, so
the payoff table should have five rows.

Whenever demand is at least as great as the purchase

quantity (Q = D) or where all units are sold during the
season (Q  D), thus:
Payoff = pQ

If there are some units must be disposed (unsold after the

season) or Q > D, Then:
Payoff = pD – l(Q – D)

Then, we have to develop the Payoff Table!!

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 The Payoff Table
D
Q 10 20 30 40 50
10 $100 $100 $100 $100 $100
20 50 200 200 200 200
30 0 150 300 300 300
40 -50 100 250 400 400
50 -100 50 200 350 500

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HOW TO CALCULATE??
Example:

1. For Q = 10, D = 10. Then, pQ = (10)(10) = $100

2. For Q = 40, D = 50. Then, pQ = (10)(40) = $400
3. For Q = 40, D = 30 :
pD – l(Q – D) = (10)(30) – (5)(40 – 30) = $250

THEN??
Now we calculate the expected payoff for each Q by
multiplying the payoff for each demand quantity by
the probability of that demand and then adding the
results. For example; for Q = 30

Payoff: 0.2(0) + 0.3(150) + 0.3(300) + 0.1(300)+ 0.1(300) + 0.1(300)

= $195
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 The Expected Payoff Table

Order Quantity, Q Expected Payoff

10 $100
20 170
30 195
40 175
50 140
• Because Q = 30 has the highest payoff at $195, it is the best
order quantity#
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• The Service Level: Uncertainty in Demand
• Aggregate demand for an item is usually formed from a large
number of smaller demands from individual customers
• Therefore, it is reasonable to assume the resulting demand is
continuous and normally distributed
• To determine the safety stock:
safety stock = Z x standard deviation of lead time demand
Z x  x LT
• Where Z is the number of standard deviations from the mean
corresponding to the probability specified by the service level.
This value of Z can be found in Normal distribution tables
• A 95% service level, for example, has a probability of 0.05 that
lead time demand is higher than safety stock

Hendrik Lamsali: Inventory Management 20

 Variable Demand with
a Reorder Point
Q
Inventory level

Reorder
point, R

0
LT LT
Time
 Reorder Point with
a Safety Stock
Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Time
Reorder Point for
a Service Level
Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
zd L

dL R
Demand
Reorder Point With
Variable Demand

R = dL + zd L
where
d = average daily demand
L = lead time
d = the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
probability
zd L = safety stock
 Reorder Point for
Variable Demand
The carpet store wants a reorder point with a 95%
service level and a 5% stockout probability
d = 30 yards per day
L = 10 days
d = 5 yards per day

For a 95% service level, z = 1.65

R = dL + z d L Safety stock = z d L
= 30(10) + (1.65)(5)( 10) = (1.65)(5)( 10)
= 326.1 yards = 26.1 yards
 The Service Level: Uncertainty in Lead Time
– In this section, discussion will be based on the assumptions
that demand is constant and lead time is uncertain
– In most circumstances the delay between placing an order
and having goods arrive in stock ready for use is to some
extent uncertain.
– Some suppliers are totally reliable, but there are many
causes of uncertainty which are outside of their control
– If we base inventory control on the mean lead time and do
not allow any safety stocks, there are three possible
outcomes:
• Lead time is the expected length, in which case we get the
ideal amount of stock
• Lead time is shorter than expected, in which case there is
some unused stock
• Lead time is longer than expected, in which case stock runs
out and there are shortages

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 In particular, the probability of a shortage is the probability that
lead time demand is greater than the reorder level.
 Thus, the formula of the required service level is:
Service level = Prob(LT x D < ROL)
Prob(LT < ROL/D)
Example:
Lead time for a product is Normally distributed with mean 8
weeks and a standard deviation 2 weeks. If demand is constant
at 100 units a week, what ordering policy gives a 95% cycle
service level?

Solution: for a 95% service level we want:

Prob(LT < ROL/D) = 0.95
From Normal tables, a probability of 0.95 corresponds to 1.64
standard deviations. On 95% of occasions lead time is less
than 8 + 1.65 x 2 = 11.3 weeks. This corresponds to a demand
of 1130 which is the required reorder level.
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• PERIODIC REVIEW SYSTEMS
• Where orders of varying size are placed at regular
intervals to raise stock to a specified level (the target
stock level)
• Periodic review systems allow for uncertainty by placing
orders of different sizes at fixed time intervals
• With a periodic review system, we are looking for
answers to two questions:
• How long should the interval between orders be?
• What should the target stock level be?
• The order interval, T, can really be any convenient
period such as every week, every morning or at the end
of a month
• Whatever interval is chosen, we need to find a suitable target
stock level (TSL)
• The system works by examining the amount of stock
on hand when an order is placed and ordering the
amount which brings this up to TSL
Order quantity = TSL – stock on hand

• Example: In the supermarket, every evening they

examine the shelves and replace items which were
sold during the day. The order period is a day and the
target stock level (TSL) is the amount of shelf space
allocated to the item
• In the following analysis, we will assume that the lead
time for an item is constant at LT and the demand is
Normally distributed
 Order Quantity for a
Periodic Inventory System

Q = d(tb + L) + zd tb + L - I

where
d = average demand rate
tb = the fixed time between orders
L = lead time
d = standard deviation of demand

zd tb + L = safety stock

I = inventory level
Fixed-Period Model with
Variable Demand
d = 6 bottles per day
d = 1.2 bottles
tb = 60 days
L = 5 days
I = 8 bottles
z = 1.65 (for a 95% service level)

Q = d(tb + L) + zd tb + L - I
= (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8
= 397.96 bottles
 Formula:
Safety stock = Z x  x (T + LT)

Target stock level (TSL) = demand over T + LT +

safety stock

this argument assumes that the lead time is less than

the cycle length. If this is not true, the order placed must
also take into account the stock already on order, so
that:

order quantity = TSL – stock on hand – stock on

order
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 Example:
Demand for an item is Normally distributed with a mean of
1000 units a month and standard deviation of 100 units.
Stock is checked every three months and lead time is
constant at one month. Describe the ordering policy which
gives a 95% service level? If the carrying cost is $20 a unit a
month, what is the cost of the safety stock with this policy?
What would be the effect of using a 98% service level?

Solution:
Listing all the variables in consistent units:
D = 1000 units a month
 = 100 units
i = $20 a unit a month
T = 3 months
LT = 1 month

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For a 95% safety stock , Z can be found from Normal
distribution tables to be 1.65. Then:
safety stock = Z x  x (T + LT)
= 1.65 x 100 x (3 + 1)
= 330

TSL = D x (T + LT) + Z x  x (T + LT)

= 1000 x (3 + 1) + 330
= 4330
So, every three months, when it is time to place an order,
the stock on hand should be found and an order placed
for:
order size = 4330 – stock on hand
For example, if there were 1200 units in stock, the order
would be for 4330 – 1200 = 3130 units
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The cost of holding safety stock = SS x i
= 330 x $20
= $6600 a month

If the service level is increased to 98%, Z = 2.05, and:

safety stock = 2.05 x 100 x (3 + 1) = 410

The new target stock level (TSL) is then 4410 units and
the cost of the safety stock is:
safety stock = 410 x $20 = $8200 a month

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 ADVANTAGES OF EACH SYSTEM
1. Periodic Review System
- simple and convenient to administer (there is a
routine)
- useful for cheap items with high demand
- the stock level is only checked at specific intervals
- the ease of combining orders for several items into
single order. This might encourage suppliers to give
price discount

2. Fixed Order Quantity System (aka continuous review

system)
- The orders of constant size are easier to regulate than
variable
- The system can cater for specific characteristics of
each item (flexibility to suit order frequency to demand)
- The system give lower stocks (smaller safety stock)
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