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Operations Management: Analysis and

Improvement Methods Module 2 Inventory
Management
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Contents
Lesson 2-1 Inventory Basics
Lesson 2-1.1 Inventory Basics

Lesson 2-2 Economic Order Quantity

Lesson 2-2.1 Economic Order Quantity (part 1)
Lesson 2-2.2 Economic Order Quantity (part 2)

Lesson 2-3 Re-Order Point

Lesson 2-3.1 Re-Order Point (part 1)
Lesson 2-3.2 Re-Order Point (part 2)
Lesson 2-3.3 Re-Order Point (part3)

Lesson 2-1 Inventory Basics

Lesson 2-1.1 Inventory Basics

US Business Inventories - Slide 1

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According to the US Census Bureau, seasonally adjusted business inventories stood at $1.929 trillion in
March 2018

Business Inventories - Slide 1

Sector Inventory
$677.285
Manufacturers
billion
$624.902
Retailers
billion
$627.396
Wholesalers
billion

(U.S. Census Bureau, 2018)

Transcript

In the early 1950's, the Vice-President of Toyota Motor Company, Taiichi Ohno, visited the United
States. While he was here, he visited grocery stores and he saw how people picked up stuff from grocery
stores depending on what they needed and how it was felt. What he realized is that the reason why
there's so many things in the grocery stores and yet the grocery stores run them relatively effectively, is
that people only buy things that they need and then they come back and ask for more. This was a
revelation for him which resulted in his whole concept of just-in-time manufacturing. The idea behind
that was to reduce inventories, the inventories within manufacturing plants. Now, a simple observation
like that revolutionized the whole manufacturing process. One of the key things that one should look at
in this particular case is this concept of inventories. So, allow me to talk to you a little bit about how
large a problem this is. So, according to the Census Bureau, at the end of March 2018, all US inventories
stood at $1.929 trillion almost $2 trillion. Out of that, manufacturers held $677 billion, retailers had
$674 billion and wholesalers who are intermediaries held $627 billion. So, roughly, a third of all
inventories was held by the manufacturers retailers or wholesalers. So, we can see that this is a massive
massive problem considering that 1.929 trillion is a fairly significant number.

What are Inventories? - Slide 2

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Inventories are good or material that are in any stage of readiness that are being held for future sale

Transcript

So, what are these inventories? Inventories are goods or materials that are in any stage of readiness and
are being held for future sale. All of operations management is concerned with the fulfillment of demand
for a product or demand for service and this fulfillment requires us to carry inventories.

Reasons for Inventories - Slide 3

Transactional efficiency

Speculation

Hedging

Strategic positioning

Transcript

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Now, there are multiple reasons why we might decide to carry inventories. For example, we might have
a setup cost when we decide to set up a machine or when we decide to order from a supplier. These costs
have to be paid for every time that we decide to either manufacture or we decide to order. If we choose
to order too often, we have to pay a lot of setup costs. So, accordingly, what we've tried to do is order in
batches. When we order in batches, we end up with a large chunk of the good that we're ordering and
then we slowly depleted, but in the meantime, we are holding inventory. This kind of inventory is being
held for transactional efficiency reasons so that we're not doing too many transactions of ordering or
setting up our machinery. A second reason why we might choose to carry inventory is speculation. So, if
we expect, for example, prices to go up next month, it makes sense for us to buy things right now and
hold on to those things. For example, countries where there is a lot of inflation, countries like Zimbabwe,
for example. The minute you get paid, the best thing you can do instead of saving the money is to take
the money and go out and buy things for your household because the next day the prices are going to be
higher, so the sooner you buy the better off you are. So, you carry inventory because you're speculating
that costs are going to go up. A third reason that you keep inventory is what we'll call hedging. This is to
take care of the fact that things can be uncertain. We do not know, for example, what the demand is
going to be for a particular item. We do not know if supplies are going to be available. To protect
ourselves from these uncertainties, we decided that we're going to keep inventors. Lastly, we might want
to carry inventory for strategic positioning. For example, the United States has a big buffer of petroleum
supplies. This is a strategic petroleum reserve that the US government carriers. Why? Because that
prevents it from being held hostage in the event of a war by foreign powers who supply us with
petroleum. So, this is strategic positioning, companies do this as well when they buy an extra amount so
that they have stuff available so that a supplier can not hold them hostage.So, there are four primary
reasons why inventories are kept; ransactional efficiency, speculation, hedging and strategic positioning.

Types of Inventories (1 of 2) - Slide 4

Based on stage of completion

Raw material
Work-In-Process
Finished goods

Transcript

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Now, we can think of inventories in a variety of different ways. We can think of the type of inventory
based on the stage of completion of this inventory. So, for example, we might think in terms of raw
material inventory. These are the inputs that go into our process. During the process, we have inventories
of partially finished product. This we call a work-in-process inventory. Finally, we may have an
inventory of finished product which we'll call our finished goods inventory.

Types of Inventories (2 of 2) - Slide 5

Based on reason for keeping

Cycle inventory due to batching

Anticipation inventory for seasonality
Safety stock to buffer against uncertainty
Pipeline inventory that is on-order or in-transit
Strategic inventory to position for better negotiation

Transcript

We might also look at inventory based on the reason why we are keeping the inventory. So, we might,
for example, in the case where we order a large batch and then consume it, that inventory is called cycle
inventory. Inventory that is kept to hedge against uncertainty. For example, if we have uncertain demand
or uncertain supply, we might keep a safety stock. If we have certainty that demand is going to increase,
for example, demand for items that are seasonal in nature, we might keep inventory that we will call
anticipation inventory. If we have ordered inventory, if we've ordered from a supplier and that order
hasn't been received yet, we might call it pipeline inventory. This is inventory that's in order or that's in
transit. We might have strategic inventory that we might keep to position ourselves for better
negotiation. Now, when we think in terms of inventories, given the various inventories that we keep, it's
important to think in terms of how do we measure inventories.

Inventory Metrics - Slide 6

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Macro level metrics

Inventory Turnover Ratio or Inventory Turns = Cost of Goods Sold ÷ Average Inventory in $
Periods(days/weeks/months) of Inventory = Average Inventory in $ ÷ Cost of Goods Sold in a
period
Inventory Turnover is the reciprocal of Periods of Inventory

Transcript

So, there are some macro level metrics that are used to measure inventories, and those are used
sometimes at a national level other times they are used at a corporate level or at a location of a particular
corporation, for example, a warehouse. One of the metrics that's often used is what's called the inventory
turnover ratio or the inventory turns. This is calculated by looking at the cost of goods sold and then
dividing it by the average amount of inventory that we have in our system. So, we look at the cost of
goods sold instead of looking at the sale price of the good mainly because it is how much money we
have invested in that particular good. Then, the average inventory, we can calculate based on our starting
inventory in the period and the ending inventory in the period and then looking at the average of that.
Now, we may also look at what's called periods of inventory. So, how many days worth of inventory do
we carry or how many weeks worth of inventory do we carry on average? So, the period is selected
depending on what's appropriate in our particular context, it could be days, it could be weeks, it could be
months. The way it's calculated is we look at the average inventory that we have and we divide it by the
cost of goods sold. So, in this sense, the inventory turnover ratio is the reciprocal of the periods of
inventory. So, calculating one and taking the reciprocal gives us the other metric.

Example - Slide 7

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Starbucks Corporation

For the quarter ending March 2018, Starbucks Cost of Goods Sold (COGS) was $2,516 million
and the Average Inventory for the period was $1,345 million
Inventory Turns = Cost of Goods Sold ÷ Average Inventory in $ = (2,516 ÷ 1,345) = 1.87
Months of Inventory = (1,345 ÷ 2,516) × 3 = 1.604 months
Days of Inventory = (1,345 ÷ 2,516) × (365 ÷ 4) = 48.78 days

(Gurufocus, 2018)

Transcript

Let's take an example. Let's take the example of Starbucks corporation. So, for the quarter ending 2018,
Starbucks cost of goods sold as reported by Starbucks was $2,516 million or $2.516 billion. At the same
time, the average inventory over that quarter was 1.345 billion or 1345 million. So, now, we can
calculate the inventory turns for Starbucks as the cost of goods sold divided by the average inventory. If
you plug in the numbers, we get the inventory turns to be 1.87. How many months of inventory is that?
Well, we can calculate that by looking at the average inventory 1.345 billion divided by the cost of the
goods sold which is 2.516 billion. I'm multiplying by three because I want to convert it into months, and
all the numbers are for a quarter. So, multiplied by three then gives me 1.604 months. I can similarly
convert it into days of inventory, and because now this is days of inventory, I have to find out how many
days there are per quarter. So, I'm taking 365 divided by four as the multiplier and that gives me 48.78
days of inventory.

US Business Inventories - Slide 8

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Years of Supply for the United States

US Business inventories are shown in a graph. Time (years) is on x-axis and total business inventories to
sales ratio is on y-axis. Inventories level start decreasing in 2008 but started gradually increasing from
2012 until 2016. From 2016, inventory levels are going down because of the political climate.

(U.S. Census Bureau, 2018)

Transcript

I can look at a larger scale and I can look at US business inventories. So, if you look at US business
inventories and we track the years of supply of inventory, what we notice is, and data comes from the
US Census Bureau, what we notice is that the inventory levels were quite high in 2008 but then we had
the downturn which caused inventory levels to drop because businesses became very careful and the
lower the amount of inventory that they were carrying. Now, as we see economy pick up, you see that
the years of supply of inventory starting to increase and then we see a slight downturn again as people
became unsure about the political climate. So, inventories are a reflection of what happens in the larger
economy, what happens from a company's point of view, how they look at their own business outlook as
well as the economic outlook.

Summary - Slide 9

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In this lesson we studied

Reasons for keeping inventory

Types of inventory
Macro measures of inventory performance

Transcript

So, in summary then,what we've looked at right now in this particular module are the reasons for
keeping inventory. We've looked at the types of inventory and we have looked at some macro measures
of inventory performance.

Lesson 2-2
Lesson 2-2.1 Economic Order Quantity (Part 1)

Inventory Related Costs (1 of 2) - Slide 10

Transaction costs for each order

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Setup/ordering cost denoted by "S":

Ordering
Receiving
Fixed costs of transporting

Transcript

We've talked about inventories as being a vital part of meeting demand for both services and products.
However, inventory is bring costs with them and since they bring costs with them, it's important to figure
out what's the right amount of inventory to have so that they serve the purpose for which we are keeping
them and yet we can keep costs as low as possible. So, let's look at a few different ways that we can
decide on how much inventory to keep in our system and let's start out with transaction costs. What
happens when we are keeping inventory for transactional efficiency? When we keep inventory for
transactional efficiency, we are trying to balance the cost of ordering versus the cost of keeping that
inventory or carrying that inventory. So accordingly, let's think in terms of what are those costs? So, the
transaction costs for each order or each time we decided to set up might be and there's the cost of
ordering which might be the cost of the person doing the ordering or the cost that we charge for every
transaction in our computer system. Once that order is placed and it's shipped to us, there might be costs
of transporting it back to us and then there's the cost of receiving the goods in our warehouse. So,
ordering costs, receiving costs, fixed transportation costs, are all costs that become part of the setup cost
or ordering cost and we usually denote that by the capital letter S

Inventory Related Costs (2 of 2) - Slide 11

Holding costs (depend on how much average inventory)

Holding Cost/Item/Year H = Item Cost × Interest Rate + Storage Cost/Item/Year:

Storage costs + Cost of working capital

Transcript

Now, there are other costs involved. For example, once I order a batch of an item, that batch will get

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slowly depleted. During the time that it is being consumed to, I have investments in this particular
inventory. I have to store this particular inventory and there are costs associated with that storage as
well. So, there are two costs that I need to be worried about. I have to worry about the storage costs, the
cost of actually physically keeping this inventory in storage, and then there's the cost of the working
capital that's tied up in this inventory. Together, we call this the holding cost. The amount of holding cost
are depends on how much inventory I'm carrying and so, this is a particular cost that's dependent on the
decision that I make of how much I choose to carry. So, I have two costs now. I have the cost of the
transaction itself, the set-up cost, and then I have the holding cost of carrying inventory. Those two costs
will depend on the amount that I choose to order at any given time. So, how often should I order and
how much should I order at a time?

How Often to Order? - Slide 12

Graph of inventory against time is shown, inventory is on y-axis and time is on x-axis. The two cases are
as follows

Order more often is represented by a solid line. If you order more often, you pay more transaction
cost but with lower holding costs.
Order less often is represented by a dotted line. If you order less often, you pay lower transaction
cost but with higher holding costs.

In case of more frequent orders, solid line makes small right-angle triangles on x-axis while in case of
order less often, dotted line make big right-angle triangles on x-axis.

Transcript

Now, if I decide to order too often, Graph of inventory against time is shown, inventory is on y-axis and
time is on x-axis. The two cases are as followsthen I will pay a lot of ordering costs or setup costs.
However, because I'm ordering frequently, I don't have to order as much at a time and so my inventory
carrying costs will be lower. On the other hand, if I want to lower my inventory cost, I can choose to
order less frequently and so, I pay more inventory carrying costs and I pay less ordering costs. So, if you
look at the figure, the small triangles represent the case when I order frequently and as you can notice
that I order frequently so I have a lot of orders and my inventories are lower. When I order less
frequently, the dotted red lines then I have lot fewer orders but a lot more inventory. So the question is,

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how do I balance these two costs? So, let's look at what happens to my costs for each of those
individually.

Annual Cost - Slide 13

Annual cost of ordering = number of orders × ordering cost/order

= Annual Demand ÷ Order Quantity × S = D ÷ Q × S

Annual cost of inventory = Average inventory × holding cost

Graph of inventory against time is shown, inventory is on y-axis and time is on x-axis. The two cases are
as follows

Order more often is represented by a solid line. If you order more often, you pay more transaction
cost but with lower holding costs.
Order less often is represented by a dotted line. If you order less often, you pay lower transaction
cost but with higher holding costs.

In case of more frequent orders, solid line makes small right-angle triangles on x-axis while in case of
order less often, dotted line make big right-angle triangles on x-axis.

Transcript

Now, if I choose to look at the ordering cost and I look at this on an annual basis, then the number of
orders that I have to place for ordering depends on the order quantity that I have. So, if I take the annual
demand, divided by the order quantity that tells me the number of orders that I will have in that
particular year. That multiplied by the setup cost will then tell me the total cost of actually ordering. The
inventory on the other hand, depends on the average inventory that I'm carrying. If I have an order
quantity of Q, then the average inventory, if you look at our graph previously, starts of at a maximum of
Q and ends up at a minimum of zero, so, the average is cube divided by two.

Annual Cost - Slide 14

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Annual cost of ordering = number of orders × ordering cost/order

= Annual Demand ÷ Order Quantity × S= D ÷ Q × S

Annual cost of inventory = Average inventory × holding cost

= Order quantity ÷ 2 × H = Q ÷ 2 × H

Total cost = Cost of ordering + cost of inventory

= (D ÷ Q × S) + (Q ÷ 2 × H)

Transcript

That multiplied by the holding cost becomes Q divided by two times H and that becomes the annual cost
of inventory. The total cost of having this inventory system then, is the cost of ordering plus the cost of
inventory and so I add those two formula together to get the total cost of inventory. Now, as you can
notice both those costs depend on the quantity that I'm ordering Q. So what happens as Q increases?

How Often to Order? - Slide 15

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Ordering cost, inventory carrying cost and total cost curves are shown in the graph. Order quantity is on
x-axis and cost is on y-axis. Ordering cost decreases rapidly as order quantity increases making a
hyperbolic curve. Inventory carrying cost increases linearly starting from origin point as order quantity
increases. By adding both, ordering cost and inventory carrying cost curve, we get total cost curve. Total
cost curve starts decreasing rapidly as the order quantity increases but it flattens and then starts
increasing afterwards. Minimum total cost can be obtained where ordering cost curve and inventory
carrying cost curve intersect.

Transcript

So, if I look at the cost of ordering, if Q increases, then the cost of ordering which is shown by the red
graph keeps dropping rapidly as the order quantity increases. It's a hyperbolic graph and it
asymptotically goes to zero as the order quantity goes to infinity. The inventory carrying cost on the
other hand, increases linearly so as Q increases, it increases as a straight line. When you add the two
together, you get a total cost curve which drops rapidly initially then seems to flatten off and then
gradually increases. The minimum total cost can be obtained where the inventory carrying cost curve
and the ordering cost curve intersect. That gives me the location where I get the minimum total cost and
if I'm trying to minimize total cost, that should be my order quantity.

Economic Order Quantity (1 of 2) - Slide 16

To minimize the Total Annual Cost we use the Economic Order Quantity (EOQ)

Q∗ = √ 2×D×S
H

Transcript

So, mathematically, I can solve this by finding out what's called the Economic Order Quantity or EOQ.
So, the EOQ is the quantity that minimizes the total annual cost and it's given by Q star, we use Q
superscript star to denote the economic order quantity. It's given by the square root of two times the
demand, multiplied by the setup cost, divided by the holding cost.

Economic Order Quantity (2 of 2) - Slide 17

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With annual total costs=√2 × D × S × H

Annual ordering costs= √ D×S×H

2

Annual inventory costs= √ D×S×H

2

Transcript

Now, if I choose to use a economic order quantity, then my total on annual costs which are the lowest
possible total annual cost are given by square root of two times the demand multiplied by the setup cost,
multiplied by the holding cost. Since the minimum is obtained where the two costs are equal, the annual
ordering cost and the annual inventory costs, each of those is then half of the total annual cost and
they're given by the formulae as shown there, which is square root of D times S, times H, divided by
two.

Lesson 2-2.2 Economic Order Quantity (Part 2)

Example - Slide 18

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Coyote Inc. orders detonators from the Acme Company. Every time Coyote orders from Acme, it must
incur the cost of shipping which is charged at a flat rate of $75 per shipment.

Coyote consumes the detonators at a steady rate of 2000 per year. Each detonator costs Coyote $10 and
Coyote has a capital cost of 20% per annum. Storage cost for a detonator per year is $2.

How much should Coyote order to minimize its annual cost?

(U.S. Census Bureau, 2018)

Transcript

So let's take an example. Coyote Inc orders detonators from the Acme Company. For fans of the Road
Runner you know what I'm talking about. So, every time Coyote orders from Acme, it must incur a cost
of shipping which is charged at a flat rate of 75 per shipment. Coyote consumes these detonators at a
steady rate of 2,000 per year. Each detonator costs Coyote $10 and Coyote has a capital cost of 20% per
annum. Storage costs for the detonators are $2 per year. So, how much should Coyote order to minimize
its annual cost?

Example Solution - Slide 19

D = 2000/year

S = $75

H = carrying cost + storage cost

= $10 × 0.2 + $2 = $4

Q∗ = √ 2×D×S
H
=√
2×75×2000
4
=273.86~274

Transcript

Let's look at the data that we've been given. Our demand is 2,000 per year. Our setup cost or ordering

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cost is $75 per order. Our carrying cost depends on the cost of storage plus the capital cost and so, that
turns out to be the storage costs was $2, the carrying cost is per item $10 times 20 percent. So, 0.2 per
year and so that gives us a total of $4. If you plug it into the EOQ formula, Q* turns out to be 273.86 or
approximately 274. So, Coyote should order 274 detonators at a time. Now, when we think in terms of
this order 274, notice that we took the 273.86 and rounded it up to 274. How much of our differences
that make in terms of the cost?

Robustness of EOQ - Slide 20

Notice the total cost does not change much if order quantity is a little different from Q* the EOQ

Quadrupling the Ordering cost or demand only doubles EOQ

Quadrupling the holding cost only halves the EOQ

Ordering cost, inventory carrying cost and total cost curves are shown in the graph. Order quantity is on
x-axis and cost is on y-axis. Ordering cost decreases rapidly as order quantity increases making a
hyperbolic curve. Inventory carry cost increases linearly starting from origin point as order quantity
increases. By adding both, ordering cost and inventory carrying cost curve, we get total cost curve. Total
cost curve starts decreasing rapidly as the order quantity increases but it flattens and then starts
increasing afterwards. Minimum total cost can be obtained where ordering cost curve and inventory
carrying cost curve intersect.

Transcript

Well, the difference it makes is not that significant and the reason why it's not that significant is notice
that the minimum point for the total cost curve occurs in the relatively flat part of the total cost curve.
So, small changes in the order quantity do not affect the cost very much. In fact, if we were to quadruple
the ordering cost or quadruple the demand, then the EOQ quantity only doubles. Okay? Similarly,
quadrupling the holding cost only halves the EOQ. What this tells us is that the EOQ is relatively robust
to small changes in both the input data and to small rounding that we can do to the final answer. Now,
why does this matter?

Practical Considerations - Slide 21

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Difficult to accurately assess costs

Suppliers insist on minimum order quantities

Suppliers only supply in package quantity

(Saved by the robustness!)

Transcript

Economic Manufacturing Quantity (EMQ) - Slide 22

Instantaneous replenishment may be difficult in a manufacturing environment

Suppose we have a known rate of production (R) then the optimal manufacturing quantity is

EMQ= √ 2×S×D×R
H(R−D)

Transcript

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Well, practically some of these costs are somewhat difficult to assess. What should be included in the
setup cost? Oftentimes, many of the costs that are involved in set-ups and ordering, are costs across
multiple parts and then they are apportioned to individual parts based on accounting principles. But
accounting principles don't necessarily tell you exactly what the cost is and for that specific part. So,
those costs are somehow approximate. Not only that, despite what we may choose to calculate, suppliers
often insist that you order minimum quantity. So that even if you decide that you wanted to order 274 of
these detonators, the supplier might say the minimum order for detonators is 1,000 and that forces you
then to order 1,000. It may also be possible that suppliers supply in package quantities and the package
quantity might be 100. So, if I want to order 274, I have to order three packages of 100, which means I
have to order 300. In all these cases, we have to make adjustments to the EOQ quantity that we've
calculated, but the robustness of the EOQ model saves us in this case because the cost to not increase
dramatically if we have to shift from the calculator or the optimum EOQ quantity q* that we calculate.

Example (1 of 2) - Slide 23

Coyote decides to manufacture detonators at the rate of 5000/yr?

EMQ= √ 2×S×D×R =√
2×75×2000×5000
H(R−D) 4(5000−2000)
= 353.55~354

Assuming 365 days a year,

Time to produce EMQ = 354 × 365 ÷ 5000 = 25.81 days

Time to consume EMQ = 354 × 365÷2000 = 64.52 days

Transcript

Let's take this example further. Coyote decides that instead of ordering from Acme, Coyote is going to
manufacture their detonators in-house and they can do it at the rate of 5,000 per year. Now, to keep the
data similar to our previous example, let's assume that the setup cost for this manufacturing remains $75
orders, and the consumption rate remains 2,000 and the holding cost also remains the same. We can now
calculate the economic manufacturing quantity and it turns out if you plug in all those values into the
formula, our economic manufacturing quantity turns out to be 354. Remember our economic order

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quantity when we're ordering from Acme, was 274. The economic manufacturing quantity is now larger
is 354. But what does this mean? Well, let's assume that Coyote has manufacturing going on for 365
days a year and they have demand continuously during those 365 days of the year. So, the amount of
time it takes to produce the economic quantity of 354 at the rate of 5,000 per year can be calculated as
354 divided by 5,000 to get it in years multiplied by 365 to convert it into days, and that turns out to be
25.81 days. To consume that same 354, Coyote requires 354 divided by 2,000 that many years
multiplied by 365 to get the days or 64.52 days. So, Coyote produces 425.81 days and consumes the
amount that is produced in 25.81 days over 64.52 days.

Example (2 of 2) - Slide 24

For 25.81 days, inventory builds up at the rate of (5000 − 2000) ÷ 365 = 8.22 detonators per day

Reaching a maximum of 212.13

The rest of the cycle Coyote consumes the detonators at the rate of 2000 ÷ 365 = 5.48/day

Inventory graph for this example is shown. Inventory is on y-axis and time is on x-axis. Inventory starts
increasing (straight line) to 212 units in 25.81 days then starts decreasing (straight line) and becomes
zero by 64.52 days making a triangle with x-axis. The same cycle repeat itself making another triangle
with x-axis.

Transcript

Let's look at the inventory graph for this particular system. So, for 25.81 days, Coyote is producing
detonators at the rate of 5,000 per year but during the same time, it's also consuming them at the rate of
2,000 per year. So therefore, the rate at which inventory is building up becomes 5,000-2,000 or 3,000
divided by 365 to find the rate of buildup per day. So, we get detonator inventory building up at the rate
of 8.22 detonators per day and that's reflected by the increasing inventory in the first part of the triangle
that represents the inventory for each cycle. So, inventory keeps building up, it reaches a maximum of
212.13 and then at that time productions stops. Coyote continues to consume inventory at the rate of
2,000 per year or 5.48 per day and so, inventory gets depleted until it drops down to 0, at which point
Coyote resumes manufacturing again and starts rebuilding inventory. So, we still have a triangular shape
for our inventory profile, but unlike the EOQ where inventory used to increase instantaneously to its

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maximum, it now builds up over a period of time.

Summary - Slide 25

In this lesson we learned about

The costs associated with ordering decisions

The Economic Order Quantity
The Economic Manufacturing Quantity

Transcript

So, we've looked at two possible scenarios. One in which manufacturing or replenishment is occurring
instantaneously and one in which replenishment or manufacturing occurs over a period of time. For each
of these two scenarios, we looked at the costs associated with our ordering decisions. The ordering cost
plus the inventory costs and came up with the optimum quantity that should be ordered to minimize the
total cost of this particular decision.

Lesson 2-3
Lesson 2-3.1 Re-Order Point (Part 1)

Assumptions - Slide 26

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The EOQ/EMQ quantity minimizes the total cost of inventory when

Replenishment begins instantaneously

Demand is constant and known with certainty
Inventory over time is shown in the graph. Time is x-axis and inventory is on y-axis. Inventory is
making right angle triangles on x-axis

Transcript

So far, we've looked at the EOQ and EMQ, and we've made some assumptions. In this section, we'll
focus more on making changes to the EOQ and similar changes could be made for the EMQ. For the
EOQ, we've made the assumption that replenishment begins instantaneously and demand is both
constant and known with certainty. The problem is that that's not very practical. As we saw when we had
to make a change when he had the economic manufacturing quantity. But let's look at it in the context of
having a supplier from whom we are ordering and so the EOQ is the appropriate model.

Supplier Leadtime - Slide 27

Supplier delivers the product a fixed time after the order is placed

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This is called the leadtime (L)

If leadtime (L) is fixed we can anticipate the delay and order earlier

"Order when the amount of inventory on-hand is D × L"

This is called the Re-Order Point (ROP)

Transcript

If we think in terms of the instantaneous replenishment, suppose supplier says, "I can't replenish
instantaneously, but I need a certain amount of time," and the supplier might offer me a time of maybe
seven days before a shipment can be received. So from the time that I order till the time that I get my
order, might be seven days. This is what's called the leadtime and we will denote it by the letter L. If this
leadtime is fixed and if we assume that we know the demand exactly with certainty, then we can
anticipate the delay that's going to occur because of the leadtime and order earlier. So, what we could do
for example is we could order when the amount of inventory on hand is D multiplied by L, which is the
amount that we would consume during the leadtime. This point at which we decide to order is going to
be called the Re-Order Point, and the Re-Order Point is the amount of inventory that we have when we
choose to order.

Inventory Position (1 0f 2) - Slide 28

On-hand inventory is shown in inventory over time graph. Time is on x-axis and inventory is on y-axis.
Inventory is making right angle triangles on x-axis. D*L is shown as a parallel line to x-axis. Leadtime
(L) point is labelled on x-axis and depicts the time from the point at which D*L intersects the inventory
curve to the point where inventory curve touches the x-axis.

On-hand Inventory (solid lines)

Transcript

So, let's think about this Re-Order Point. If I look at the Re-Order Point in this particular case, I start out
with some inventory on hand, I continuously deplete my inventory, and as I deplete the inventory, I

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reach a point when the inventory becomes D multiplied by L, and at that point, I choose to order. When I
order, I find that the order is going to take a certain amount of time before it arrives, the leadtime L, and
during the time that I'm waiting for the order to arrive, I have some residual inventory, some leftover
inventory which I continue to consume, and right when I hit an inventory of zero, I get my new order
which then bumps up my inventory level up to its highest again, and I continue this process repeatedly.
On the graph, I've shown this on-hand inventory profile using solid lines. However, let's see what
happens. If I have a computer system, typically the way I would set my computer system would be to
say, "If you notice that the inventory on hand is less than the reorder point, then place an order." This has
the unfortunate side effect that once the inventory becomes less than the reorder point, every time the
computer sees it, it is likely to reorder and I'm going to have multiple orders even though I have an order
that has been placed already.

Inventory Position (2 of 2) - Slide 29

Inventory position is shown in inventory over time graph. Time is on x-axis and inventory is on y-axis.
Inventory is making right angle triangles on x-axis. D*L is shown as a parallel line to x-axis. Leadtime
(L) point is labelled on x-axis and depicts the time from the point at which D*L intersects the inventory
curve to the point where inventory curve touches the x-axis. Inventory positions is shown as dotted line
making right angle triangles on D*L line and it touches the D*L line where D*L intersects the on-hand
inventory.

On-hand Inventory (solid lines)

Inventory Position = on-hand inventory + inventory on-order (dashed line)

Transcript

To get around this, we define something called the inventory position. And the inventory position is
simply the on-hand inventory plus any inventory that is on order. So, anything that's been ordered and
has still not arrive. Put that together and that's called the inventory position. The inventory position is
shown in the picture by dotted lines. So basically the inventory position and on-hand inventory are the
same until I reach my reorder point. When I reach my reorder point, I end up with on-hand inventory
continuing to decrease, but I now have an increase in the inventory position because there's an order that
has been placed, and now that higher inventory position starts getting depleted because the on-hand

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component of inventory position gets depleted. Until the point when the order is received, at which point
the on-hand inventory is exactly zero and a new order arrives and so the inventory position and on-hand
inventory become exactly the same. So, the dotted lines in that figure are the inventory position, the dark
lines are the on-hand inventory. So, the way I would now do this is I would set my computer system to
check inventory position instead of having it check on-hand inventory so that if inventory position is less
than Re-Order Point, we will choose to order, and every time the computer goes and checks, it will find
that the inventory position after an order is placed is going to be higher than the Re-Order Point so it
won't make frivolous extra orders. So, that takes care of the situation where I know demand exactly,
there is no uncertainty in demand, and I have a leadtime. However, demand being certain and constant is
also an unrealistic assumption. It's very likely that demand is going to be uncertain. So, when demand
becomes uncertain, we now have to worry about what happens during that leadtime.

Demand Uncertainty - Slide 30

Demand uncertainty is shown in the graph. Time is on x-axis and inventory is on y-axis. Instead of
having straight lines to make right angle triangles, we have jagged lines creating right-angle triangle like
structure because of demand uncertainty. ROP line is parallel to x-axis and lead time starts from the
point where ROP (re-order point) intersects on demand inventory and becomes tangent to inventory
position. Safety stock line is parallel and close to x-axis and inventory might go below safety stock.

Stock-outs may occur

To avoid stock-out add extra inventory—Safety stock

Transcript

So, if you look at the figure, instead of having a nice smooth inventory profile, you see that we have a
Jaggard inventory profile which indicates that demand is uncertain and sometimes we have a little more
and sometimes we have a little less. The significance of this is actually during the leadtime. Because
until then, as long as I have inventory, I'm okay. The minute my computer system notices that my
inventory position is at the Re-Order Point, it decides to place a new order. From that time onwards,
however I run into a problem. My Re-Order Point right now has been set as the average inventory or the
average demand D multiplied by the leadtime. So what could happen for example is during the leadtime,
I might see some unusually high demand and I might run out of inventory before the new order arrives.

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This is what we call a stock-out. So, while I might be able to satisfy part of my demand during the
leadtime, around the end of that leadtime, I might find that I run out of stocks. So, how do I deal with
this? The standard way to deal with this is to say let's provide a little bit of extra inventory instead of
having a Re-Order Point of D multiplied by L, what if you order a little bit before that. And that's the
same as providing what's called a safety stock. So, that raises the amount of inventory I have and that
helps me avoid the stock-out. Now, of course if I have unusually high demand, I could still run out, and
so I have to make some kind of judgment about how often I want to allow stock-outs to occur, and we'll
talk about that in a little bit.

Re-Order Point (ROP) - Slide 31

ROP = Average demand during leadtime + Safety stock

When to order : Order if: Inventory position ≤ Re-Order Point

Transcript

But before that, let's redefine what we call a Re-Order Point. So until now, a Re-Order Point was the
average demand during the leadtime, to that, we're going to add the safety stock. And so, our Re-Order
Point now is slightly higher. And our ordering condition is going to be that inventory position, if it
happens to be less than the Re-Order Point, we will place a new order. Remember we are checking
inventory position and not on-hand inventory when we do this. So now, let's think about this problem a
little bit more.

Periodic Review - Slide 32

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Why consider periodic review with modern computer systems?

Deliveries only occur once a week (r = 7 days)

Orders are transmitted at the end of the day (r = 1 day)

Inventory position might drop below ROP right after a review occurs

Next review is r days later and then a leadtime of L so POU = (r + L)

Transcript

Let's look at the conditions or scenarios that can occur in practice. So, we will think in terms of this
period of time that we are calling the leadtime, which we're going call the period of uncertainty. The
period of uncertainty is dependent on how often we observe inventory. Now, if you are observing
inventory continuously, so if there's a computer system that is constantly watching inventory all the time,
then we will know immediately when the Re-Order Point is reached, and then, the period of uncertainty
simply is the leadtime, the point from which we order till the point at which it's delivered. This system is
called the continuous review system, and in the continuous review system, the period of uncertainty is
the leadtime. There is an alternative system though called the periodic review system. In this system, we
don't watch inventory continuously. We might for example come and check inventory once a week, or
we might decide that we're going to check inventory at the end of the day. So, if it's the end of the day,
then my review interval is one day, if it's end of the week, my review interval is seven days. Now, in this
case, we say that our period of uncertainty is now the re-order interval plus the leadtime. So if I'm
checking every week, my review interval will be seven days plus the leadtime however many days that
is. Now, notice that in either case during that period of uncertainty, demand tends to be probabilistic.

Period of Uncertainty - Slide 33

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Period of Uncertainty (POU)

How often is inventory observed?

Continuous review: POU = Leadtime
Periodic review: POU = Review interval ( r ) + Leadtime

Demand is probabilistic during this period

Transcript

A question that people often ask is If we have computer systems that continuously monitor Inventory,
why is it that we need to consider periodic review systems? Well, the reason might be that we might
have, even though we are monitoring inventory continuously, we might get shipments from our supplier
only once a week. And so, it doesn't matter that we're monitoring continuously, we can only order once a
week. It might be that we decide to batch all the orders during the day and send them to our supplier at
the end of the day. So, if you get shipments once a week, then we have a re-order interval of seven days,
if we batch our orders and transmit them at the end of the day, we have a review period of one day.
There are also other situations. For example, if you look at grocery stores, grocery stores get two
shipments a week. And so, the shipment might be one on Sunday and then one on Wednesday. So, since
they get shipments twice a week, their average re-order interval is about three and a half days. So, in this
particular situation, we end up with the following problem: the inventory position may drop below the
Re-Order Point right after we've reviewed our inventory. So, from that point till we actually detect that
we've dropped below the Re-Order Point is going to be R days, the review period, and then at that point
once we order, it will take another L days before that shipment is received. So, we now have an
uncertainty period of R plus L, and so that's why we end up with a period of uncertainty of R plus L, and
that's why we still need to consider periodic review systems. So, even with the advent of modern
computers, it is normal to think in terms of when shipments are received or when orders are actually
transmitted to the supplier when you calculate the period of uncertainty.

Lesson 2-3.2 Re-Order Point (Part 2)

Probabilistic Demand - Slide 34

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Common to assume Gaussian (i.e. Normal Demand Distribution)

N (mean, variance)

Picture shows a N (3.3, 1) demand distribution

Gaussian (normal demand distribution) is shown here. It is a bell-shaped graph with mean of 3.3 and
variance of 1.

Transcript

So what happens during this period of uncertainty? So during this period of uncertainty, we are
experiencing some demand, and that demand is going to have some probability distribution. It is
common to assume that this probability distribution is the Gaussian distribution, or what's more
commonly called Normal Demand Distribution. You may have seen the figure that's shown here as the
bell curve in popular literature. Now, a normal demand distribution is used commonly because of what's
called the central limit theorem, which allows us to say that as long as there are a number of different
influences, independent influences on something that we are studying, then it's very likely that the thing
that we are studying will tend to have a normal distribution. If you look at the sidebar about normal
distribution, you will see a little bit more detail about the normal distribution and how to work with the
normal distribution. The normal distribution is usually denoted by N for normal, and then it has two
parameters, the mean and the variance. So N with the mean and variance specifies what normal
distribution we are concerned with. The picture that we have shows in normal 3.3,1 demand distribution,
where the 3.3 is the mean and 1 is the variance. Now, remember that the variance is the square of the
standard deviation. So if I want the standard deviation of this normal distribution, I take the variance and
take the square root of that. So in this particular case. The square root of 1 is equal to 1, so the standard
deviation is also going to be equal to 1.

Reorder Point Explanation - Slide 35

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Gaussian (normal demand distribution) is shown here. It is a bell-shaped graph with mean of 3.3 and
variance of 1. Safety stock is shown here as the distance between average demand and ROP. ROP (re-
order point) depends on the probability of stockout and z-value. Z-value is added to average demand to
calculate ROP.

Reorder Point - Slide 35

Probability of
Z-value ROP
Stockout
1.645 3.3+1.645=4.945 0.05
1.96 3.3+1.96=5.26 0.025

Transcript

So how do we figure out what the reorder point is once we know what the demand distribution is? The
way we do this is that to find the average demand, we look at the mean of this demand distribution. So
during that period of uncertainty, we experience an average demand and now we have to add to it a
safety stock. How much safety stock we add depends on what tolerance I have for stockouts. So for
example, if I want to have stockouts no more than 5 percent of the time, so if I say that the probability of
a stockout is no more than 0.05. In that case, I calculate what is known as the z-value and for a stockout
probability of 0.05, which means the probability of not having a stockout is 95 percent or 0.95, I have to
use a z-value of 1.645. So using the z-value, I can calculate what is the reorder point as follows. I take
3.3 the mean, plus the z-value multiplied by the standard deviation, so 3.3 plus 1.645 times 1 gives me
4.945. If on the other hand I want to be even more service conscious, and I decide that I want the
probability of stockout to be no more than two and a half percent, in that case I have to use a z-value of
1.96, and that gives me correspondingly a reorder point of 5.26, which is larger than 4.945, which means
that I'm carrying extra safety stock to make sure that I have stockouts less frequently.Let's figure out how
we are going to calculate what our safety stock is, and let's do this in the form of an algorithm

Safety Stock Calculation - Slide 36

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Given the demand distribution during Period of Uncertainty (POU)

1. Decide your tolerance to stockouts

Probability of Stockout = α
2. Service Level = (1- Probability of Stockout) = (1 — α )
3. Find the z-value
a. using Standard Normal Tables or
b. using Microsoft Excel NORM.INV(1 — α , 0, 1)
4. ROP = mean + z× standard deviation

Transcript

So let's start out by assuming that we have been given the demand distribution during the period of
uncertainty. For our lecture, we are going to assume that this demand is normally distributed. So the first
step we have to do is we have to decide what is our tolerance to stockout, so we are going to decide the
probability of a stockout, and we're going to call this probability Alpha. This is the Greek letter Alpha.
Now, based on that, we get the probability of not having a stockout, which we call our service level, as 1
minus the probability of stockout, or 1 minus Alpha. So if I have an Alpha equals 0.05, then my service
level will be 0.95, or I have a service level of 95 percent. Given this service level, I have to find the
corresponding z-value, which I can do using either a standard normal table or I can use using Microsoft
Excel and using the function NORM.INV, where INV stands for inverse. The side bar shows you how to
actually use this both this normal table as well as the Excel function. So once we've figured out what the
z-value is, the reorder point is simply the mean plus the z-value that we just found, multiplied by the
standard deviation for our demand distribution for the period of uncertainty, and from there, we can
calculate the safety stock as simply being the reorder point minus the mean or during that period of
uncertainty.

Example (1 of 2) - Slide 37

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Daily demand

Mean = 5
Standard deviation of daily demand = 3

During Period of Uncertainty (POU) of 7 days

Demand distribution N(7 × 5, 7 × 9)

Mean during POU = 7 × 5 = 35
Standard deviation during POU = √(7 × 9)~7. 94

Transcript

Let's take an example. Suppose I have a daily demand which is normally distributed, and we have a
mean of 5 for the daily demand, and a standard deviation of daily demand equal to 3. Let's say that we
have a period of uncertainty of seven days. So during the seven days, the mean demand that I'm going to
experience is going to be 7 times 5, and the variance of demand that I'm going to experience is going to
be 7 times the variance for the daily demand, which is 3 squared or 9, so 7 times 9. So I'm going to have
a mean during the period of uncertainty of 35, and a standard deviation of 7.94, and my demand
distribution is going to be normally distributed.

Example (2 of 2) - Slide 38

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1. Select Stockout Probabilityα= 0.05

2. Service level 1 —α= 0.95
3. From tables z˜1.645 for service level 0.95
4. ROP = mean + z × standard deviation = 35 + 1.645 ×7.94 ˜ 48
5. Safety Stock = ROP- mean = 48 — 35 = 13

Transcript

So let's now say I decide that I want a stockout probability of 0.05, which then gives me a service level
of 0.95 or 95 percent. I go to my z-tables, and my z-tables give me a z-value of 1.645 for a service level
of 0.95. So now I calculate my reorder point. My mean is 35, my z-value is 1.645, and my standard
deviation is 7.94. I do the calculation, and it gives me a reorder point of 48. In turn, this now gives me a
safety stock of 48 minus 35 equal to 30.

Uncertainty in Leadtime - Slide 39

Demand is already uncertain: mean = D; std. dev= SDD

What if leadtime is uncertain?

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Mean leadtime = L
Std. dev of leadtime = SDL  

Mean during POU = L × D

Std. dev during POU = √L × (SDD ) +  D2   × (SDL )

2 2

Transcript

So far, we've considered what happens when we have uncertainty in the demand during the leadtime. So
demand is uncertain, but what happens if the leadtime itself is also uncertain. Most of us have waited for
packages to be shipped from Amazon, and we wait for our package, we've been told it's going to come
in three days, but occasionally, it comes in two days and occasionally it comes in four days. So even
though we have an average time of three days, it could be sometimes less and sometimes more, and so
leadtime itself can be a variable. So since leadtime is variable, let's say that the mean leadtime happens
to be L as before, but now we also have a standard deviation of leadtime which we're calling standard
deviation of L. So we have a mean demand during this time of D and a standard deviation during this
time SD of D, and then we also have a leadtime which has a mean L and a standard deviation of SD with
subscript L. So if I have a period of uncertainty which is not only uncertain because of the leadtime, but
is even more uncertain because of the uncertainty in the leadtime itself, I now can calculate the mean
demand during the period of uncertainty as being L multiplied by D. The standard deviation during this
period of uncertainty do becomes a little more complicated. It has two components, one component
looks at the variability caused by the demand uncertainty. The second component looks at the variability
caused by the leadtime uncertainty. Put together, we get this complicated looking formula which is
square root of mean leadtime multiplied by the variance of the demand, plus square of the mean demand
multiplied by the variance of the leadtime uncertainty.

Example - Slide 40

Demand: D=5; SDD   =1

Leadtime: L=7; SDL   =2

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Mean during POU = L × D = 7 × 5 = 35

Std. dev during POU = √L × (SDD ) + D2 × (SDL   ) =√7 × (1) + 52 × (2) =10.334
2 2 2 2

For a service level of 95%, z=1.645 and

ROP = 35 + 1.645 × 10.334 ~52

Transcript

Let's look at an example to see how we work with this. Suppose I have a daily demand of 5, which has a
standard deviation of 1. Let's say my average leadtime happens to be 7, and let's say the standard
deviation of leadtime happens to be 2. Then the mean demand during the period of uncertainty is going
to be L multiplied by D, which is 35, and the standard deviation during the period of uncertainty, using
the formula that we gave before, turns out to be 7 multiplied by 1 squared plus 5 squared, multiplied by
2 squared, which turns out to be 10.334. If I assume a service level of 95 percent, I get a z-value of
1.645, which then in turn gives me a reorder point of 35, which was my mean during the period of
uncertainty plus the z-value of 1.64 multiplied by the standard deviation during the period of uncertainty
of 10.334, which is approximately 52. Notice my reorder point now is 52, which is higher than what I
had of 48 previously when there was no leadtime uncertainty. So I've had to increase the amount of
safety stock to take into account the fact that I have leadtime uncertainty.

Lesson 2-3.3 Economic Order Quantity (Part 3)

Order Quantity Revisited - Slide 41

Modification to deal with

Lumpy demand
Periodic review

Demand uncertainty is shown in inventory over time graph. Time is on x-axis and inventory is on y-axis.
Instead of having straight lines to make right angle triangles, we have jagged lines creating right-angle
triangle alike structure because of demand uncertainty. ROP (re-order point) line is parallel to x-axis and

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it intersects inventory and is tangent to inventory position. Safety stock line is parallel and close to
x-axis and inventory might go below safety stock. Because of lumpy demand, inventory can drop down
ROP line right before ROP. It means after the re-order there is still less inventory than what was
required.

Transcript

So, now that we are considering uncertain demand, we need to go and revisit how we figure out what
other quantity we need to order. Until now, we've made the assumption that we need to calculate the
EOQ and that's the quantity that we are. However, it's not unusual for demand to be lumpy, and what
does that mean? It simply means that instead of demand coming in for single units of whatever we are
looking at, demand might come in for multiples of the units at the same time. For example, if I'm selling
shirts, it's possible that, let's assume that we are looking at white shirts, in fact, the particular brand that
I'm wearing. It's possible that most people come in and order one shirt at a time, but there might be
someone who might come in and order five shirts at the same time, and so my demand becomes lumpy
because of this. Now, let's look at the case where we are observing the demand and right before we cross
the reorder point, we are about the reorder point and then somebody comes in and orders a multiple, say
five shirts. So, all of a sudden, we drop down below the reorder point. Now, immediately, the computer
system is going to trigger an order and under our normal ordering policy, would have ordered an EOQ,
but notice that we are lower than the reorder point by four now because there was an order for five
instead of an order for one. So, when we get our order shipped to us, we will end up with an inventory
level that is not as high as we would have wanted it to be. It's four less than where we wanted it to be. To
overcome this, we do what's called an order up to policy.

Order Up To Policy - Slide 42

Instead of ordering the EOQ quantity

Calculate

Order up to level = ROP + EOQ

Order Quantity = Order up to level — inventory position

Transcript

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To overcome this, we do what's called an order up to policy. So, what's an order of policy? Instead of
ordering the EOQ quantity, what we do is we calculate an order up to level which is the reorder point
plus the EOQ quantity. Now, this establishes the high level of inventory that we are going to ever
experience. So, this is the high watermark for inventory for us. Now, the order quantity becomes the
order up to level that we just calculated minus the inventory position at the time that we order, and let's
look at an example to see how this works.

Example - Slide 43

ROP = 48

EOQ = 274

Order up to level = ROP + EOQ = 322

If inventory position = 43 then

Order Quantity= 322 − 43 = 279

Transcript

Let's assume that our reorder point is 48 and let's have an economic order quantity of 274. So, our order
up to level is going to be 274 plus 48 which is 322. Now, suppose right around the time that we were
supposed to order, we got a bulk order, which dropped our inventory position down to 43. In that case,
our order quantity is going to be 322 minus 43 which is equal to 279. Notice, this is higher than the EOQ
which was to 274 because we are now ordering five extra units so that we can top up with the order up to
level. Now, we've set up our inventory system whereby we know how much to order, we know when to
order. We have tried to minimize the costs associated with ordering and carrying inventory. We have
tried to minimize the probabilities of stock-outs by providing a pre-determined service level.

Measuring Performance - Slide 44

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Service level is not a convenient KPI

Takes many cycles to calculate

Only concerned about leadtime
All or nothing

Inventory over time graph is shown. Time is on x-axis and inventory is on y-axis. Jagged lines creating
right-angle triangle alike structure because of demand uncertainty. ROP line is parallel to x-axis and lead
time starts from the point where ROP (re-order point) intersects on demand inventory. A straight vertical
line intersecting through the point where ROP intersects inventory demand is called order cycle.

Transcript

Now, suppose we start executing this inventory system that we've constructed, and we would like to
measure the performance of this inventory system. Now, remember how well this inventory system
performs, one of the measures of that is what kind of service level we are able to provide. We selected
that service level initially and we used it to calculate safety stock etc. However, there's a problem with
figuring out whether our inventory system is actually meeting that service level. If you recall, service
level is the probability of stock out occurring during the lead time. Now, if I want stock outs to occur
infrequently, as I normally do, my service levels are going to be high, 95 percent even 99 percent. Which
means the chance of actually seeing a stock out is relatively small. So, to be able to get a good feel for
whether I have and whether I'm meeting my service level as we defined it before, I may have to observe
perhaps 100 cycles to see one stock out if my service level was 99 percent. Now, an inventory cycle
might be several weeks. Let's say an inventory cycle is four weeks. In that case, to observe 100 cycles, I
have to wait for 400 weeks. That's roughly 50 years for me to know whether I'm meeting my service
level. Now, that doesn't seem like a very practical thing to do. So it takes way too many cycles to
calculate it. Secondly, service level is only concerned about what happens during the lead time. Does a
stock out occur during the lead time? Because remember, we cannot have a stock out during the rest of
the cycle because that's how we've constructed our policy that we watch and when we reach the reorder
point, that's when reorder. So, until then, obviously there cannot be a stock out because the reorder point
always is a positive inventory. Then lastly, service level has a third problem, which is we get credit for
having provider service, if you do not have a stock or during the lead time and get no credit, if we have a
stock out during that period. So, we either have a stock out or we don't have a stock out and so we either
get credit or we don't get credit. Now, during that lead time, we might have taken care of most of the

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demand during lead time, but the fact that we had a stock out right at the end means that we get deemed
for the whole period. So, for all these various reasons, service level is not a very practical thing for us to
actually look at when we are measuring performance.

Fill Rate Definitions - Slide 45

Fill rate: The fraction of demand that is satisfied or "filled" from inventory

Unit fill rate−Unit Qty Filled ÷ Unit Qty Requested

Line fill rate−Lines Filled ÷ Lines Requested

Order fill rate−Orders Filled ÷ Orders Requested

Transcript

So, accordingly, there is a different measure that's used and this is what's commonly called the fill rate.
So, the fill rate is the fraction of demand that is satisfied or filled from inventory. This is a much easier
thing to both understand and to measure, because I can take any period of time. I can take a week, a day,
I can take a year and I can look at how much demand was requested by the customer. Then, I can look at
how much of that demand was I able to satisfy from inventory and that allows me then to calculate the
fill rate. There tends to be some confusion sometimes in practice because people often talk loosely about
service being provided. So, when they talk about the service level that they are achieving, they're
actually talking about the fill rate that's being achieved. In a broad sense, fill rate does measure the
service that is being offered, but it's different from the service level. Now, to complicate matters further,
there are different ways to measure the fill rate. The first measure is what's called the unit fill rate. So, for
example, if during a period of time, let's say during a week, if customers came requesting 100 units of a
particular item and we were able to provide them 90 of that item, then the unit fill rate is 90 divided by
100. Now, in large companies, we don't deal with a single item we deal with hundreds of thousands of
items and when customers order, they don't just order one thing from us, they order several things. So,
suppose a customer orders three items from us and we were able to satisfy completely two of those items
from inventory and the third we only have enough to send a partial amount, then from that order, there
were three lines and we are only able to fill two of those lines. So, we say that the line fill rate is two out
of three. Then, we also have something called the order fill rate which goes across customers. So, I

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might look at all the orders that came in and I might look at how many of those orders was I able to
satisfy completely. So, I look at the total orders that I successfully filled divided by the total orders that
were requested and that's called the order fill rate.

Example (1 of 2) - Slide 46

Order No: 1980-23

Unit fill rate - 230 ÷ 280 = 82.1%

Line fill rate - 1 ÷ 3 = 33.3%

Order No: 9350-38

Unit fill rate - 464 ÷ 485 = 95.67%

Line fill rate - 0 ÷ 4 = 0%

Order No 1980-23
Line No SKU Qty Ordered Qty Shipped Line Filled
1 A010345 150 100 NO
2 A30227 80 80 Yes
3 C13056 50 40 No
Order No 9350-38
Line No SKU Qty Ordered Qty Shipped Line Filled
1 A27645 250 240 NO
2 B56227 100 95 No
3 Z32556 75 70 No
4 Y45777 60 59 No

Transcript

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Let's take an example. Here is an example where we have two customer orders, and the first order is for
three items and the second order is for four items. Let's look at the different quantities. So, if I look at
the first order, order number 1980-23, I notice that I had three items that were ordered. The total of all
items that were ordered happens to be 280, which is the 150 plus the 80 plus the 50. So, that's 280 items
were ordered. I was able to ship 110 for the first item, 80 for the second item and 40 for the third item.
So, I was able to ship 230 items out of the 280 requested and that gives me a unit fill rate for that
particular order equal to 82.1 percent. Now, as you can see in the last column, of the three items that
were ordered, I was not able to satisfy two of them and satisfy one of them. That gives me a line fill rate
of one out of three, which means 33.3 percent. I can similarly do that for order number 9350-38, and in
this particular case, the total number of items ordered, if I sum up the quantities ordered, turns out to be
485. The quantity shipped turns out to be 464 and that gives me a unit fill rate of 95.67. So, if I look at
the unit fill rate that's quite a high unit for rate. However, when I look at the line fill rate, none of those
four items was I able to ship the complete amount requested by the customer. So, I was not able to fill a
single line completely, and so my line fill rate happen to be zero percent. So, the line fill rate is a much
stricter measure than the unit fill rate and therefore, you expect line fill rates to be much lower than unit
fill rates.

Example (2 of 2) - Slide 47

Overall

Unit fill rate - 230 + 464 ÷ 280 + 485 = 90.85%

Line fill rate - 1 ÷ 7 = 14.29%
Line fill rate - 0 ÷ 2 = 0%

Order No 1980-23
Line No SKU Qty Ordered Qty Shipped Line Filled
1 A010345 150 100 NO
2 A30227 80 80 Yes
3 C13056 50 40 No
Order No 9350-38
Line No SKU Qty Ordered Qty Shipped Line Filled

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1 A27645 250 240 NO

2 B56227 100 95 No
3 Z32556 75 70 No
4 Y45777 60 59 No

Transcript

Let's look at the overall performance across the two orders. So, now I look at the sum across all of them,
and so, if I look at the unit fill rate, I get a unit fill rate of 90.85 percent, I get a line fill rate since I was
only able to satisfy one line of the two orders together out of the seven lines that were requested, I get a
line fill rate of 14.29 percent, and since neither order was completely filled, I get an order fill rate of zero
or two or zero percent. So, the line fill rate tends to be much more severe than the unit fill rate, and the
order fill rate tends to be an even stricter measure than the line fill rate.

Fill Rate vs Service Level - Slide 48

Service Level and Fill Rate -

Slide 48
Service Level Fill rate
All or nothing Partial Credit
Only Leadtime Entire Cycle
Hard to
Intuitive
Measure
Multiple Order Any time
Cycles period

Transcript

Now, how does the fill rate compare with the service level? So, if you'll recall, the service level was an
all or nothing measure. The fill rate gives me partial credit for at least shipping some of the order. The
service level was only concerned about the lead time. The fill rate does not distinguish between inverting

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the cycle I am. So, I'm looking at the entire cycle any order that comes any time during the entire cycle
is part of the fill rate. The service level was hard to measure, we talked about how it might take us four
years to figure out whether we are meeting our service level if we are aiming for a fairly high service
level and we have longs order cycles. The fill rate is much more intuitive, it's what part of the demand
have we been able to satisfy. The service level required us to look at multiple order cycles to be able to
do this. The fill rate, I can do for any time period, I can do it even for a single order. So, the fill rate is a
much more easier thing to calculate and so accordingly is the way people measure the service provided
by an inventory system. However, to figure out what the safety stock is, they still usually use a service
level. So, both are important for us. One, to design the system, the other one to measure the performance
of the system.

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