Basestock Model
Chapter 13
These slides are based in part on slides that come with Cachon & Terwiesch
book Matching Supply with Demand http://cachon-terwiesch.net/3e/. If you
want to use these in your course, you may have to adopt the book as a textbook
or obtain permission from the authors Cachon & Terwiesch.
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Learning Goals
Basestock policy:Inventory management when the
leftover inventory is not salvaged but kept for the next
season/period
Demand during lead time
Inventory position vs. inventory level
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Medtronic’s InSync pacemaker supply chain
Supply chain:
– 1 Distribution Center (DC) in Mounds View, MN.
– ~ 500 sales territories throughout the country.
» Consider Susan Magnotto’s territory Madison, WI.
Objective:
– Because the gross margins are high, develop a
system to minimize inventory investment while
maintaining a very high service target, e.g., a
99.9% in-stock probability or a 99.9% fill rate.
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InSync demand and inventory, the DC
Normal distribution
DC receives pacemakers with a delivery lead time of 3 weeks.
700
600 (Evaluations for weekly demand assume 4.33 weeks
per month and demand independence across weeks.)
500
400 Average monthly demand (MD)= 349 units
Units
300 Standard deviation of demand = 122.28
200 MD=W1D+W2D+W3D+W4D+0.33W5D
100
Average weekly demand = 349/4.33 = 80.6
0 Standard deviation of weekly demand =
Aug
Nov
Jul
Apr
Feb
May
Jun
Sep
Mar
Jan
Oct
Dec
122.38 / 4.33 58.81
Month
DC shipments (columns) and end of
month inventory (line)
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InSync demand and inventory, Susan’s territory
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14
12
10 Total annual demand = 75 units
Units
8 Average daily demand = 0.29 units
(75/260), assuming 5 days per week.
6
Poisson demand distribution better
4
for slow moving items
2
0
Jul
Jun
Aug
Apr
Dec
Jan
May
Nov
Oct
Mar
Feb
Sep
Month
Susan’s shipments (columns) and end of
month inventory (line)
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Order Up-To (=Basestock) Model
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Sequence of events:
Timing in the basestock (=order up-to) model
Time is divided into periods of equal length, e.g., one hour, one month.
During a period the following sequence of events occurs:
– A replenishment order can be submitted.
– Inventory is received.
– Random demand occurs.
Lead time l: Number of periods after which the order is received.
Recall the production planning example of LP notes.
An example with l = 1
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Newsvendor model vs. Order up-to model
Both models have uncertain future demand, but there are differences…
Newsvendor Order up-to
Inventory
After one period Never
obsolescence
Number of
One Unlimited
replenishments
Demand occurs during
No Yes
replenishment
Newsvendor applies to short life cycle products with uncertain demand and the
order up-to applies to long life cycle products with uncertain demand.
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The Order Up-To Model:
Model design and implementation
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Order up-to model definitions
On-hand inventory = the number of units physically in inventory
ready to serve demand.
Backorder = the total amount of demand that has not been satisfied:
– All backordered demand is eventually filled, i.e., there are no lost sales.
Inventory level = On-hand inventory - Backorder.
On-order inventory / pipeline inventory = the number of units that
have been ordered but have not been received.
Inventory position = On-order inventory + Inventory level.
Order up-to level S
– the maximum inventory position we allow.
– sometimes called the base stock level.
– this is the target inventory position we want to have in each period before
starting to deal with that period’s demand.
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Why inventory position
but not inventory level?
Suppose orders are daily (=period), like cleaning aisle at a Wal Mart
On Monday morning at 8 am, the inventory level is 2 plastic 1-gallon containers for
Clorox regular bleach.
The ideal number of containers to start the day with is 10 and daily demand is 1.
Lead time is slightly over 1 day. Monday’s order is received on Tuesday at 9 am.
Should we order 10-2=8 containers on Monday?
– Yes, if the pipeline inventory is 0.
– No, if the pipeline inventory is 1. This pipeline inventory arrives at 9 am on Monday.
Effectively this makes the inventory available to us 3 rather 2 containers for most of
Monday.
– No, if the pipeline is 2, 3, or, 10 or more containers.
We have already ordered the pipeline inventory which must be taken into
account when issuing new orders:
» inventory position = inventory level + pipeline inventory
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Order up-to model implementation
Each period’s order quantity = S – Inventory position
– Suppose S = 4.
» If a period begins with an inventory position = 1, then 3 units are ordered.
(4 – 1 = 3 )
» If a period begins with an inventory position = -3, then 7 units are ordered
(4 – (-3) = 7)
» If a period begins with an inventory position = 5, then 0 units are ordered
(4 – 5 = -1), how can the inventory position be 5 when S=4?
A period’s order quantity = the previous period’s demand:
– Suppose S = 4.
» If demand were 10 in period 1, then the inventory position at the start of period 2
is 4 – 10 = -6, which means 10 units are to be ordered in period 2.
– The order up-to model is a pull system as inventory is ordered in response to demand.
– But S is determined by the forecasted demand.
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The Basestock Model:
Performance measures
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What determines the inventory level?
Short answer:
– Inventory level at the end of a period = S minus demand over l +1 periods.
Example with S = 6, l = 3, and 2 units on-hand at the start of period 1
– Pipeline: 1 to arrive in Period 2; 2 to arrive in Period 3; 1 to arrive in Period 4
– Inventory level + Pipeline=6= S
Keep in mind:
Period 1 Period 2 Period 3 Period 4
Before meeting demand in a period,
Inventory level + Pipeline = S.
All inventory on-order at the start of
period 1 arrives before meeting the
demand of period 4
Time
D1 D2 D3 D4 Orders in periods 2-4 arrive after period
4; They are irrelevant.
?
All demand is satisfied so there are no
lost sales.
Inventory level at the end of period 4 = 6 - D1 – D2 – D3 – D4 =S - D1 – D2 – D3 – D4
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Expected on-hand inventory and backorder
Period 4
Inventory Period 1
S Period 2
Period 3 S – D > 0, so there is
on-hand inventory
In general,
D1 +D2 +D3 +D4=D
…
Inventory level
D = Demand over
in period 4 l +1 periods
Time in
periods
S – D < 0, so there
are backorders
This is a Newsvendor model where the order quantity is S and
the demand over season is demand over l +1 periods.
Bingo,
– Expected on-hand inventory at the end of a period can be evaluated like
Expected left over inventory in the Newsvendor model with Q = S.
– Expected backorder at the end of a period can be evaluated like Expected lost
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Stockout and in-stock probabilities,
on-order inventory and fill rate
The stockout probability is the probability that at least one unit is backordered in a
period:
Stockout probabilit y ProbDemand over l 1 periods S
1 ProbDemand over l 1 periods S
The in-stock probability is the probability all demand is filled in a period:
In - stock probabilit y 1 - Stockout probabilit y
ProbDemand over l 1 periods S
Expected on-order inventory = Expected demand over one period x lead time
– This comes from Little’s Law. Note that it equals the expected demand over l periods,
not l +1 periods.
The fill rate is the fraction of demand within a period that is NOT backordered:
Expected backorder
Fill rate 1-
Expected demand in one period
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Demand over l+1 periods
DC:
– The period length is one week, the replenishment lead time is three weeks, l = 3
– Assume demand is normally distributed:
» Mean weekly demand is 80.6 (from demand data)
» Standard deviation of weekly demand is 58.81 (from demand data)
» Expected demand over l +1 weeks is (3 + 1) x 80.6 = 322.4
» Standard deviation of demand over l +1 weeks is 3 1 58.81 117.6
Susan’s territory:
– The period length is one day, the replenishment lead time is one day, l =1
Assume demand is Poisson distributed:
Mean daily demand is 0.29 (from demand data)
Expected demand over l+1 days is 2 x 0.29 = 0.58
Recall, the Poisson is completely defined by its mean (and the standard deviation is always the
square root of the mean)
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DC’s Expected backorder with S = 625
Expected backorder is analogous to the Expected lost sales in the
Newsvendor model:
– Suppose order up-to level S = 625 at the DC
– Normalize the order up-to level: S 625 322.4
z 2.57
117.6
– Lookup L(z) in the Standard Normal Loss Function Table: L(2.57)=0.0016
– Convert expected lost sales L(z) for the standard normal to the expected
backorder with the actual normal distribution that represents demand over l+1
periods:
Expected backorder L(z) 117.6 0.0016 0.19
– Therefore, if S = 625, then on average there are 0.19 backorders at the end of
any period at the DC.
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Other DC performance measures with S = 625
Expected backorder 0.19
Fill rate 1- 1 99.76%.
Expected demand in one period 80.6
So 99.76% of demand is filled immediately (i.e., without being backordered).
Expected on - hand inventory S D max{ D S ,0}
Demand that can be serviced
Expected on-hand inventory S-Expected demand over l 1 periods
Expected backorder
=625 - 322.4 0.19 302.8.
So on average there are 302.8 units on-hand at the end of a period.
Expected on-order inventory Expected demand in one period Lead time
= 80.6 3 241.8.
utdallas.edu/~metin So there are 241.8 units on-order at any given time. 19
The Order Up-To Model:
Choosing an order up-to level S to meet
a service target
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Choose S to hit a target in-stock
with normally distributed demand
Suppose the target in-stock probability at the DC is 99.9%:
– From the Standard Normal Distribution Function Table,
F(3.08)=0.9990; F is the cumulative density for Standard Normal
– So we choose z = 3.08
– To convert z into an order up-to level:
S z 322.4 3.08 117.6
685
– Note that and are the parameters of the normal distribution
that describes demand over l + 1 periods.
– Or, use S=norminv(0.999,322.4,117.6)
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Choose S to hit a target fill rate
with normally distributed demand
Find the S that yields a 99.9% fill rate for the DC.
Step 1: Evaluate the target lost sales
Standard deviation of demand over l 1 periods * L( z )
1 - Fill rate
Expected demand in one period
1 Fill rate
Expected demand in one period
L( z )
Standard deviation of demand over l 1 periods
80.6
(1 0.999) 0.0007
117.6
Step 2: Find the z that generates that target lost sales in the Standard
Normal Loss Function Table:
– L(2.81) = L(2.82) = L(2.83) = L(2.84) = 0.0007
– Choose z = 2.84 to be conservative (higher z means higher fill rate)
Step 3: Convert z into the order up-to level: S=322.4+2.84*117.62=656
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Summary
Basestock policy: Inventory management when the
leftover inventory is not salvaged but kept for the next
season/period
Expected inventory and service are controlled via the
order up-to (basestock) level:
– The higher the order up-to level the greater the expected
inventory and the better the service (either in-stock probability
or fill rate).
Demand during lead time
Inventory position vs. inventory level
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The Order Up-To Model:
Computations with Poisson Demand
The rest is not included in OPRE 6302 exams
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Performance measures in Susan’s territory
Look up in the Poisson Loss Function Table expected backorders for
a Poisson distribution with a mean equal to expected demand over
Mean demand = 0.29 Mean demand = 0.58
l+1 periods:
S F(S) L (S ) S F(S) L (S )
0 0.74826 0.29000 0 0.55990 0.58000
1 0.96526 0.03826 1 0.88464 0.13990
2 0.99672 0.00352 2 0.97881 0.02454
3 0.99977 0.00025 3 0.99702 0.00335
4 0.99999 0.00001 4 0.99966 0.00037
5 1.00000 0.00000 5 0.99997 0.00004
F (S ) = Prob {Demand is less than or equal to S}
L (S ) = loss function = expected backorder = expected
Suppose S = 3: amount demand exceeds S
– Expected backorder = 0.00335
– In-stock = 99.702%
– Fill rate = 1 – 0.00335 / 0.29 = 98.84%
– Expected on-hand = S–demand over l+1 periods+backorder = 3–0.58+0.00335 = 2.42
– Expected on-order inventory = Demand over the lead time = 0.29 25
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What is the Poisson Loss Function
As before we want to compute the lost sales=E(max{D-Q,0}), but when D has
a Poisson distribution with mean μ
The probability for Poisson demand is given as
d e
P( D d ) for d { 0,1,2,3,.....}
d!
Or, use Excel function Poisson(d,μ,0)
Then the lost sales is
d e
d e
E (max{ D Q,0}) max{ d Q,0} ( d Q)
d 0 d! d Q d!
You can use Excel to approximate this sum for large Q and small μ.
Or, just look up the Table on p. 383 of the textbook.
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Choose S to hit a target in-stock
with Poisson demand
Recall:
– Period length is one day, the replenishment lead time is one day, l = 1
– Demand over l + 1 days is Poisson with mean 2 x 0.29 = 0.58
Target in-stock is 99.9%
S Probability { Demand over l+1 periods <= S )
0 0.5599
1 0.8846 These probabilities can be
2 0.9788 found in the Poisson
distribution function table or
3 0.9970 evaluated in Excel with the
4 0.9997 function Poisson(S, 0.58, 1)
5 1.0000
In Susan’s territory, S = 4 minimizes inventory while still
generating a 99.9% in-stock:
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Choose S to hit a target fill rate
with Poisson demand
Suppose the target fill rate is 99.9%
Recall, Fill rate 1- Expected backorder
Expected demand in one period
So rearrange terms in the above equation to obtain the target
expected backorder:
Target expected backorder = Expected demand in one period 1 Fill rate
In Susan’s territory:
Target expected backorder = 0.29 1 0.999 0.00029
From the Poisson Distribution Loss Function Table with a mean of
0.58 we see that L(4) = 0.00037 and L(5) = 0.00004,
So choose S = 5
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The Order Up-To Model:
Appropriate service levels
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Justifying a service level via cost
minimization
Let h equal the holding cost per unit per period
– e.g. if p is the retail price, the gross margin is 75%, the annual holding cost is
35% and there are 260 days per year, then h = p x (1 -0.75) x 0.35 / 260 =
0.000337 x p
Let b equal the penalty per unit backordered
– e.g., let the penalty equal the 75% gross margin, then b = 0.75 x p
“Too much-too little” challenge:
– If S is too high, then there are holding costs, Co = h
– If S is too low, then there are backorders, Cu = b
Cost minimizing order up-to level satisfies
(0.75 p)
Prob Demand over l 1 periods S
Cu b
Co Cu hb (0.000337 p) (0.75 p)
0.9996
Optimal in-stock probability is 99.96% because
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The optimal in-stock probability is
usually quite high
Suppose the annual holding cost is 35%, the backorder penalty cost equals the
gross margin and inventory is reviewed daily.
100%
Optimal in-stock probability
98%
96%
94%
92%
90%
88%
0% 20% 40% 60% 80% 100%
Gross margin % 31
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The Order Up-To Model:
Controlling ordering costs
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Impact of the period length
Increasing the period length leads to larger and less
frequent orders:
– The average order quantity = expected demand in a single period.
– The frequency of orders approximately equals 1/length of period.
Suppose there is a cost to hold inventory and a cost to
submit each order (independent of the quantity ordered)…
… then there is a tradeoff between carrying little inventory
(short period lengths) and reducing ordering costs (long
period lengths)
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Example with mean demand per week = 100 and
standard deviation of weekly demand = 75.
Inventory over time follows a “saw-tooth” pattern.
Period lengths of 1, 2, 4 and 8 weeks result in average inventory of 597, 677,
832 and 1130 respectively:
1600 1600
1400 1400
1200 1200
1000 1000
800 800
600 600
400 400
200 200
0 0
0 2 4 6 8 10 12 14 16 0 2 4 6 8 10 12 14 16
1600 1600
1400 1400
1200 1200
1000 1000
800 800
600 600
400 400
200 200
0 0
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0 2 4 6 8 10 12 14 16 0 2 4 6 8 10 12 14 16 34
Tradeoff between inventory holding costs and
ordering costs
22000
Costs: 20000
18000
– Ordering costs = $275 per order Total costs
16000
– Holding costs = 25% per year 14000
– Unit cost = $50 12000 Inventory
Cost
– Holding cost per unit per year = 10000 holding costs
8000
25% x $50 = 12.5
6000
4000 Ordering costs
Period length of 4 weeks minimizes 2000
0
costs: 0 1 2 3 4 5 6 7 8 9
– This implies the average order Period length (in weeks)
quantity is 4 x 100 = 400 units
2 K R 2 275 5200
EOQ model: Q 478
h 12.5
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The Order Up-To Model:
Managerial insights
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Better service requires more inventory at
an increasing rate
140
More inventory is
120
needed as demand
100 uncertainty increases
for any fixed fill rate.
Expected inventory
80
60 The required
inventory is more
40
Inc re a s ing sensitive to the fil rate
s ta nda rd de via tion
20
level as demand
uncertainty increases
0
90% 91% 92% 93% 94% 95% 96% 97% 98% 99% 100%
Fill rate
The tradeoff between inventory and fill rate with Normally distributed demand
and a mean of 100 over (l+1) periods. The curves differ in the standard
deviation of demand over (l+1) periods: 60,50,40,30,20,10 from top to bottom.
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Shorten lead times and to reduce inventory
600
500 Reducing the lead
time reduces
Expected inventory
400
expected
300 inventory,
especially as the
200
target fill rate
100 increases
0
0 5 10 15 20
Lead time
The impact of lead time on expected inventory for four fill rate targets,
99.9%, 99.5%, 99.0% and 98%, top curve to bottom curve respectively.
Demand in one period is Normally distributed with mean 100 and
standard deviation 60.
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Do not forget about pipeline inventory
3000
Reducing the lead
2500 time reduces expected
2000 inventory and pipeline
Inventory
inventory
1500
The impact on
1000
pipeline inventory can
500 be even more
0 dramatic that the
0 5 10 15 20 impact on expected
Lead time inventory
Expected inventory (diamonds) and total inventory (squares), which is
expected inventory plus pipeline inventory, with a 99.9% fill rate requirement
and demand in one period is Normally distributed with mean 100 and
standard deviation 60
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