Inventory Management

Steven Co Jr., CIE, AAE

Inventory

 One of the most expensive assets of many companies representing as much as

50% of total invested capital
 Operations managers must balance inventory investment and customer
service
Functions of Inventory

 To decouple or separate various parts of the production process

 To decouple the firm from fluctuations in demand and provide a stock of
goods that will provide a selection for customers
 To take advantage of quantity discounts
 To hedge against inflation
Types of Inventory

 Raw material
 Purchased but not processed
 Work in process
 Undergone some change but not completed
 A function of cycle time for a product
 Maintenance/repair/operating (MRO)
 Necessary to keep machinery and processes productive
 Finished goods
 Completed product awaiting shipment
Inventory Management

 How inventory items can be classified

 How accurate inventory records can be maintained
ABC Analysis

 Divides inventory into three classes based on annual dollar volume

 Class A high annual dollar volume
 Class B medium annual dollar volume
 Class C low annual dollar volume
 Used to establish policies that focus on the few critical parts and not the
many trivial ones
ABC Analysis

 Example:
Silicon Chips, Inc maker of superfast DRAM chips, wants to categorize its 10
major inventory items using ABC analysis.

Item % of no. Annual Unit cost Annual % of Class

stock no. of items volume dollar Annual
stocked (units) volume dollar
volume
#10286 20% 1000 $ 90.00 $ 90000 38.8% A
#11526 500 154.00 77000 33.2% A
#12760 1550 17.00 26350 11.3% B
#10867 30% 350 42.86 15001 6.4% B
#10500 1000 12.50 12500 5.4% B
ABC Analysis
Item % of no. Annual Unit cost Annual % of Class
stock no. of items volume dollar Annual
stocked (units) volume dollar
volume
#12572 600 $ 14.17 $ 8502 3.7% C
#14075 2000 0.60 1200 0.5% C
#01036 50% 100 8.50 850 0.4% C
#01307 1200 0.42 504 0.2% C
#10572 250 0.60 150 0.1% C
8550 $232057 100%
ABC Analysis
ABC Analysis

 Other criteria than annual dollar volume may be used

 Anticipated engineering changes
 Delivery problems
 Quality problems
 High unit cost
 Policies employed may include
 More emphasis on supplier development for A items
 Tighter physical inventory control for A items
 More care in forecasting A items
Record Accuracy

 Accurate records are a critical ingredient in production and inventory systems

 Allows organization to focus on what is needed
 Necessary to make precise decisions about ordering, scheduling, and shipping
 Incoming and outgoing record keeping must be accurate
 Stockrooms should be secure
Cycle Counting

 Items are counted and records updated on a periodic basis

 Often used with ABC analysis to determine cycle
 Has several advantages
 Eliminates shutdowns and interruptions
 Eliminates annual inventory adjustment
 Trained personnel audit inventory accuracy
 Allows causes of errors to be identified and corrected
 Maintains accurate inventory records
Cycle Counting

 Example:
Cole’s Trucks, Inc a builder of high quality refuse trucks, has about 5 000 items in
its inventory It wants to determine how many items to cycle count each day. The
firm determined that it has 500 A items, 1750 B items, and 2750 C items.
Company policy is to count all A items every month (every 20 working days), all B
items every quarter (every 60 working days), and all C items every 6 months
(every 120 working days) The firm then allocates some items to be counted each
day.
Cycle Counting

 Answer:
5000 items in inventory, 500 A items, 1750 B items, 2750 C items
Policy is to count A items every month 20 working days), B items every quarter 60
days), and C items every six months 120 days)

Item class Quantity Cycle counting # of items

policy counted per day
A 500 Each month 500/20 = 25/day
B 1750 Each quarter 1750/60 = 29/day
C 2750 Every 6 months 2750/120 = 23/day
Total: 77/day
Control of Service Inventories

 Can be a critical component of profitability

 Losses may come from shrinkage or pilferage
 Applicable techniques include
 Good personnel selection, training, and discipline
 Tight control on incoming shipments
 Effective control on all goods leaving facility
Independent vs. Dependent Demand

 Independent demand - the demand for item is independent of the demand

for any other item in inventory
 Dependent demand - the demand for item is dependent upon the demand for
some other item in the inventory
Holding, Ordering, and Setup Costs

 Holding costs - the costs of holding or “carrying” inventory over time

 Ordering costs - the costs of placing an order and receiving goods
 Setup costs - cost to prepare a machine or process for manufacturing an
order

 Holding costs vary considerably depending on the business, location, and

interest rates.
Inventory Models for Independent
Demand
 Basic economic order quantity
 Production order quantity
 Quantity discount model
Basic EOQ Model

 Important assumptions
 Demand is known, constant, and independent
 Lead time is known and constant
 Receipt of inventory is instantaneous and complete
 Quantity discounts are not possible
 Only variable costs are setup and holding
 Stockouts can be completely avoided
Inventory Usage Over Time
Minimizing Costs
EOQ Model

 Annual setup cost = (Number of orders placed per year)*(Setup/order cost per
order)
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑
𝐴𝑛𝑛𝑢𝑎𝑙 𝑆𝑒𝑡𝑢𝑝 𝐶𝑜𝑠𝑡 = ∗ (𝑆𝑒𝑡𝑢𝑝 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟)
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟

𝑫
𝑨𝒏𝒏𝒖𝒂𝒍 𝒔𝒆𝒕𝒖𝒑 𝒄𝒐𝒔𝒕 = (𝑺)
𝑸
 Where:
 Q = number of pieces per order
 D = annual demand in units
 S = setup or order cost for each order
EOQ Model

 Annual holding cost = (Average inventory level)*(Holding cost per unit per
year)
𝑂𝑟𝑑𝑒𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝐴𝑛𝑛𝑢𝑎𝑙 𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = ∗ (𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡)
2

𝑸
𝑨𝒏𝒏𝒖𝒂𝒍 𝒉𝒐𝒍𝒅𝒊𝒏𝒈 𝒄𝒐𝒔𝒕 = (𝑯)
𝟐
 Where:
 Q = number of pieces per order
 H = holding or carrying cost per unit per year
EOQ Model

 Optimal order quantity is found when annual setup cost equals annual holding
cost
𝐷 𝑄
𝑆= 𝐻
𝑄 2

𝟐𝑫𝑺 𝟐𝑫𝑺
𝑸∗ = 𝒐𝒓 𝑸∗ =
𝑯 𝑰𝑷
 Where:
 Q* = optimal number of pieces per order (EOQ)
 I = inventory cost in percent of cost
 P = product cost
EOQ Model

 Example:
Sharp Inc., a company that markets painless hypodermic needles to hospitals,
would like to reduce its inventory cost by determining the optimal number of
hypodermic needles to obtain per order. The annual demand is 1000 units the
setup or ordering cost is $10 per order and the holding cost per unit per year is
$0.50.
EOQ Model

 Answer:
D = 1,000 units
S = $10 per order
H = $0.50 per unit per year

𝟐𝑫𝑺 𝟐(𝟏𝟎𝟎𝟎)(𝟏𝟎)
𝑸∗ = = = 𝟐𝟎𝟎 𝒖𝒏𝒊𝒕𝒔
𝑯 𝟎. 𝟓𝟎
EOQ Model
 Additional equations:
𝑫
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒐𝒓𝒅𝒆𝒓𝒔 𝑵 =
𝑸∗

𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒘𝒐𝒓𝒌𝒊𝒏𝒈 𝒅𝒂𝒚𝒔 𝒑𝒆𝒓 𝒚𝒆𝒂𝒓

𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒕𝒊𝒎𝒆 𝒃𝒆𝒕𝒘𝒆𝒆𝒏 𝒐𝒓𝒅𝒆𝒓𝒔 (𝑻) =
𝑵

𝑫 𝑸
𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒔𝒕 𝑻𝑪 = 𝑺 + 𝑯
𝑸 𝟐

 For the previous example:

 N = 5 orders per year
 T = 50 days between orders
 TC = $100
Robust Model

 The EOQ model is robust

 Robust means giving satisfactory answers even with substantial variation in the
parameters
 It works even if all parameters and assumptions are not met
 The total cost curve is relatively flat in the area of the EOQ
Robust Model

 Assume that in the previous example, the management in the Sharp Inc.
underestimates total annual demand by 50% while using the same Q. How will
the annual inventory cost be impacted?
D = 1,500 units Q* = 200 units
S = $10 per order N = 5 orders
H = $0.50 per unit per year T = 50 days

𝟏𝟓𝟎𝟎 𝟐𝟎𝟎
𝑻𝑪 = 𝟏𝟎 + 𝟎. 𝟓𝟎 = $𝟏𝟐𝟓
𝟐𝟎𝟎 𝟐

*Total annual cost increases by only 25%

Robust Model

 Actual EOQ for new demand will change to 244.9 units

D = 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders
H = $0.50 per unit per year T = 50 days

𝟏𝟓𝟎𝟎 𝟐𝟒𝟒, 𝟗
𝑻𝑪 = 𝟏𝟎 + 𝟎. 𝟓𝟎 = $𝟏𝟐𝟐. 𝟒𝟖
𝟐𝟒𝟒. 𝟗 𝟐

*Only 2% less than the total cost when the order quantity is 200
Reorder Points

 EOQ answers the “how much” question

 The reorder point (ROP) tells when to order

𝑅𝑂𝑃 = 𝐷𝑒𝑚𝑎𝑛𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦 ∗ 𝐿𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑓𝑜𝑟 𝑎 𝑛𝑒𝑤 𝑜𝑟𝑑𝑒𝑟 𝑖𝑛 𝑑𝑎𝑦𝑠

𝑹𝑶𝑷 = 𝒅 ∗ 𝑳

𝑫
𝒅=
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒘𝒐𝒓𝒌𝒊𝒏𝒈 𝒅𝒂𝒚𝒔 𝒊𝒏 𝒂 𝒚𝒆𝒂𝒓
Reorder Points

 Example:
An Apple distributor has a demand for 8000 iPods per year The firm operates a
250 day working year. On average, delivery of an order takes 3 working days. It
wants to calculate the reorder point.
Reorder Points

 Answer:
Demand = 8000 iPods per year
250 working day year
Lead time for orders is 3 working days

𝐷 8000
𝑑= = = 𝟑𝟐 𝒖𝒏𝒊𝒕𝒔
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟 250

𝑅𝑂𝑃 = 𝑑 ∗ 𝐿 = 32 ∗ 3 = 𝟗𝟔 𝒖𝒏𝒊𝒕𝒔
Production Order Quantity Model

 Used when inventory builds up over a period of time after an order is placed
 Used when units are produced and sold simultaneously
Production Order Quantity Model
Production Order Quantity Model
 Maximum inventory level = Total produced – Total used during the production
run
𝑀𝑎𝑥 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 = 𝑝𝑡 − 𝑑𝑡
 Where:
 p = daily production rate
 d = daily demand/usage rate
 However, Q = pt, thus t = Q/p

𝑄 𝑄 𝑑
𝑀𝑎𝑥 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 = 𝑝− 𝑑 =𝑄 1−
𝑝 𝑝 𝑝

 Thus, for Holding cost:

𝑀𝑎𝑥 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 𝑸 𝒅
𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = 𝐻= 𝟏− 𝑯
2 𝟐 𝒑
Production Order Quantity Model
 If:
𝑄 𝑑
𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = 1− 𝐻
2 𝑝

𝐷
𝑆𝑒𝑡𝑢𝑝 𝑐𝑜𝑠𝑡 = (𝑆)
𝑄
 Thus:
𝟐𝑫𝑺
𝑸∗ 𝑷 =
𝒅
𝑯 𝟏−𝒑

 If annual data are used:

𝟐𝑫𝑺
𝑸∗ 𝑷 =
𝒂𝒏𝒏𝒖𝒂𝒍 𝒅𝒆𝒎𝒂𝒏𝒅 𝒓𝒂𝒕𝒆
𝑯 𝟏−
𝒂𝒏𝒏𝒖𝒂𝒍 𝒑𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒐𝒏 𝒓𝒂𝒕𝒆
Production Order Quantity Model
 Example:
Nathan Manufacturing Inc makes and sells specialty hubcaps for the retail
automobile aftermarket Nathan’s forecast for its wire wheel hubcap is 1 000
units next year, with an average daily demand of 4 units However, the production
process is most efficient at 8 units per day So the company produces 8 per day
but uses only 4 per day The company wants to solve for the optimum number of
units per order This plant schedules production of this hubcap only as needed,
during the 250 days per year the shop operates
Consider:
S = $10 H = $0.50 per unit per year
Production Order Quantity Model
 Answer:
D = 1000 units p = 8 units per day
S = $10 d = 4 units per day
H = $0.50 per unit per year

2𝐷𝑆 2(1000)(10)
𝑄∗ 𝑃 = = = 𝟐𝟖𝟐. 𝟖 𝒉𝒖𝒃𝒄𝒂𝒑𝒔
𝑑 4
𝐻 1−𝑝 (0.50) 1 − 8
Quantity Discount Models

 Reduced prices are often available when larger quantities are purchased
 Trade-off is between reduced product cost and increased holding cost
 Total cost becomes combination of setup cost, holding cost, and product cost

𝑫 𝑸
𝑻𝑪 = 𝑺 + 𝑯 + 𝑷𝑫
𝑸 𝟐
Quantity Discount Models

 A typical quantity discount schedule:

Discount number Discount Discount % Discount price

quantity (P)
1 0 to 999 no discount $5.00
2 1000 to 1999 4 $4.80
3 2000 and over 5 $4.75
Quantity Discount Models

 Steps in analyzing a quantity discount:

 For each discount, calculate Q*
 If Q* for a discount doesn’t qualify, choose the smallest possible order size to get
the discount
 Compute the total cost for each Q* or adjusted value from Step 2
 Select the Q* that gives the lowest total cost
Quantity Discount Models
Quantity Discount Models

 Example:
Wohl’s Discount Store stocks toy race cars. Recently, the store has been given a
quantity discount schedule for these cars. This quantity schedule was shown in
the table. Thus, the normal cost for the toy race cars is $5.00. For orders
between 1,000 and 1,999 units, the unit cost drops to $4.80; for orders of 2,000
or more units, the unit cost is only $4.75. Furthermore, ordering cost is $49.00
per order, annual demand is 5,000 race cars, and inventory carrying charge, as a
percent of cost, I, is 20%.What order quantity will minimize the total inventory
cost?
Quantity Discount Models

 Answer:

Discount number Discount quantity Discount price (P)

1 0 to 999 $5.00
2 1000 to 1999 $4.80
3 2000 and over $4.75

 S = $49
 I = 20%
 D = 5000 units
Quantity Discount Models

 Step 1:
 Calculate Q* for every discount
2(5000)(49)
𝑄∗1 = = 𝟕𝟎𝟎 𝒄𝒂𝒓𝒔/𝒐𝒓𝒅𝒆𝒓
(0.2)(5.00)

2(5000)(49)
𝑄∗2 = = 𝟕𝟏𝟒 𝒄𝒂𝒓𝒔/𝒐𝒓𝒅𝒆𝒓
(0.2)(4.80)

2(5000)(49)
𝑄∗3 = = 𝟕𝟏𝟖 𝒄𝒂𝒓𝒔/𝒐𝒓𝒅𝒆𝒓
(0.2)(4.75)
Quantity Discount Models

 Step 2:
 If Q* for a discount doesn’t qualify, choose the smallest possible order size to
get the discount.
2(5000)(49)
𝑄∗ 1 = = 𝟕𝟎𝟎 𝒄𝒂𝒓𝒔/𝒐𝒓𝒅𝒆𝒓
(0.2)(5.00)

2(5000)(49)
𝑄∗ 2 = = 714 𝑐𝑎𝑟𝑠 = 𝟏𝟎𝟎𝟎 (𝒂𝒅𝒋𝒖𝒔𝒕𝒆𝒅)
(0.2)(4.80)

2(5000)(49)
𝑄∗ 3 = = 718 𝑐𝑎𝑟𝑠 = 𝟐𝟎𝟎𝟎 (𝒂𝒅𝒋𝒖𝒔𝒕𝒆𝒅)
(0.2)(4.75)
 Quantity Discount Models

 Step 3:
 Compute the total cost for each Q* or adjusted value from Step 2

Discount Unit Q* Product Cost Annual Ordering Cost Annual Holding Cost Total
number price (PD) [(D/Q)*S] [(Q/2)*H]
1 $5.00 700 $25000 $350 $350 $25700
2 $4.80 1000 $24000 $245 $480 $24725
3 $4.75 2000 $23750 $122.50 $950 $24822.50
 Quantity Discount Models

 Step 4:
 Select the Q* that gives the lowest total cost

Discount Unit Q* Product Cost Annual Ordering Cost Annual Holding Cost Total
number price (PD) [(D/Q)*S] [(Q/2)*H]
1 $5.00 700 $25000 $350 $350 $25700
2 $4.80 1000 $24000 $245 $480 $24725
3 $4.75 2000 $23750 $122.50 $950 $24822.50

 Buy 1000 units at $4.80 per unit

Probabilistic Models and Safety Stock

 Used when demand is not constant or certain

 Use safety stock to achieve a desired service level and avoid stockouts
 Annual stockout costs = the sum of the units short x the probability x the
stockout cost/unit x the number of orders per year

𝑅𝑂𝑃 = 𝑑 ∗ 𝐿 + 𝑆𝑆
Probabilistic Models and Safety Stock

 Example:
David Rivera Optical has determined that its reorder point for eyeglass frames is
50 units. Its carrying cost per frame per year is 5 and stockout (or lost sale) cost
is 40 per frame. The store has experienced the following probability distribution
for inventory demand during the lead time (reorder period). The optimum
number of orders per year is six. How much safety stock should David Rivera keep
on hand?
Number of units Probability
30 0.2
40 0.2
50 (ROP) 0.3
60 0.2
70 0.1
1.00
Probabilistic Models and Safety Stock

 Answer:
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

Safety Add ‘l Holding Stockout Cost Total Cost

Stock Cost
20 20*5 = $100 $0 $100
10 10*5 = $50 (10)(0.1)(40)(6) = $240 $290
0 $0 (10)(0.2)(40)(6) + $960
(20)(0.1)(40)(6) =
$960

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
Probabilistic Models and Safety Stock
Probabilistic Demand

 Use prescribed service levels to set safety stock when the cost of stockouts
cannot be determined

𝑅𝑂𝑃 = 𝑑𝑒𝑚𝑎𝑛𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 + 𝑍𝜎𝑑𝐿𝑇

 Where:
 Z = number of standard deviations
 𝜎𝑑𝐿𝑇 = standard deviation of demand during lead time
Probabilistic Demand

 Example:
Memphis Regional Hospital stocks a “code blue” resuscitation kit that has a
normal distributed demand during the reorder point. The mean demand during
the reorder period is 350 kits, and the standard deviation is 10 kits. The hospital
administrator wants to follow a policy that results in stockouts only 5% of the
time.
a. What is the appropriate value of Z?
b. How much safety stock should the hospital maintain?
c. What reorder point should be used?
Probabilistic Demand

 Answer:
Average demand = m = 350 kits
Standard deviation of demand during lead time = 𝜎𝑑𝐿𝑇 = 10 kits
5% stockout policy (service level = 95%)
Using Normal Distribution Table, for an area under the curve of 95%, the Z =
1.6449
Safety stock = Z𝜎𝑑𝐿𝑇 = 1.6449(10) = 16.449 kits
Reorder point = expected demand during lead time + safety stock
= 350 kits + 16.449 kits of safety stock
= 366.449 kits
Other Probabilistic Models

 When data on demand during lead time is not available, there are other
models available
 When demand is variable and lead time is constant
 When lead time is variable and demand is constant
 When both demand and lead time are variable

2
𝑅𝑂𝑃 = (𝑑ҧ ∗ 𝐿𝑇) + 𝑍 𝐿𝑇 𝜎𝑑 2 + 𝑑ҧ 𝜎𝐿𝑇 2

 If demand or lead time is constant, it does not have a standard deviation

(thus, σ = 0)
Other Probabilistic Models

 Example 1:
The average daily demand for Apple iPods at a Circuit Tower store is 15 with a
standard deviation of 5 units. The lead time is constant at 2 days.
a. Find the reorder point if management wants a 90% service level (i e risk
stockouts only 10 of the time)
b. How much of this is safety stock?
Other Probabilistic Models

 Answer:
Average daily demand (normally distributed) = 15
Standard deviation = 5
Lead time is constant at 2 days
90% service level desired
Z for 90% = 1.282

2
𝑅𝑂𝑃 = (𝑑ҧ ∗ 𝐿𝑇) + 𝑍 𝐿𝑇 𝜎𝑑 2 + 𝑑ҧ 𝜎𝐿𝑇 2

𝑅𝑂𝑃 = 15 ∗ 2 + 1.282 2 5 2

𝑅𝑂𝑃 = 30 + 9.0651 = 𝟑𝟗. 𝟎𝟔𝟓𝟏 𝒊𝑷𝒐𝒅𝒔

Other Probabilistic Models

 Example 2:
The Circuit Town store sells about 10 digital cameras a day (almost a constant
quantity). Lead time for camera delivery is normally distributed with a mean
time of 6 days and a standard deviation of 3 days. A 98% service level is set. Find
the ROP.
Other Probabilistic Models

 Answer:
Daily demand (constant) = 10
Average lead time = 6 days
Standard deviation of lead time = 3
98% service level desired
Z for 98% = 2.054

2
𝑅𝑂𝑃 = (𝑑ҧ ∗ 𝐿𝑇) + 𝑍 𝐿𝑇 𝜎𝑑 2 + 𝑑ҧ 𝜎𝐿𝑇 2

𝑅𝑂𝑃 = 10 ∗ 6 + 2.054 10 2 3 2

𝑅𝑂𝑃 = 60 + 61.62 = 𝟏𝟐𝟏. 𝟔𝟐 𝒄𝒂𝒎𝒆𝒓𝒂𝒔

Single Period Model

 A system of ordering items that have little or no value at the end of a sales
period
 Often called “newsstand problem”

𝐶𝑠
𝑆𝑒𝑟𝑣𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙 =
𝐶𝑠 + 𝐶0
 Where:
 𝐶𝑠 = Cost of shortage (sales price – cost)
 𝐶0 = Cost of overage (cost – salvage value, if any)
Single Period Model

 Example:
Chris Ellie’s newsstand usually sells 120 copies of the Washington Post each day.
Chris believes the sale of the Post is normally distributed with a standard
deviation of 15 papers. He pays 70 cents for each paper, which sells for $1.25.
The Post gives him a 30 cent credit for each unsold paper. He wants to determine
how many papers he should order each day and the stockout risk for the quantity.
Single Period Model

 Answer:
Cs = $1.25 - $0.70 = $0.55
Co = $0.70 - $0.30 (salvage value) = $0.40
µ = 120 newspapers
σ = 15 newspapers

𝐶𝑠 0.55
𝑆𝑒𝑟𝑣𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙 = = = 0.5789
𝐶𝑠 + 𝐶0 0.55 + 0.40
Single Period Model

 Answer:
Cs = $1.25 - $0.70 = $0.55
Co = $0.70 - $0.30 (salvage value) = $0.40
µ = 120 newspapers
σ = 15 newspapers
Z value for 0.5789 = 0.1991

Optimal stocking level = 120 copies + 0.1991(15)

= 122.9865 copies
Stockout risk = 1 – 0.5789 = 0.4211 or 42.11%
Fixed-Period (P) Systems

 Orders placed at the end of a fixed period

 Inventory counted only at end of period
 Order brings inventory up to target level
 Only relevant costs are ordering and holding
 Lead times are known and constant
 Items are independent from one another

Order amount (Q) = Target (T) -On-hand inventory - Earlier orders not yet
received + Back orders
Fixed-Period (P) Systems

 Inventory is only counted at each review period

 May be scheduled at convenient times
 Appropriate in routine situations
 May result in stockouts between periods
 May require increased safety stock
Fixed-Period (P) Systems

 Example:
Mrs. Jones’s Department Store sells jackets during winter. She maintains 50
jackets in the store. It is already time to place an order and no jackets are in
stock. Three jackets are back ordered and are ready for the next delivery. How
many jackets are expected to be received?
Fixed-Period (P) Systems

 Answer:
3 jackets are back ordered
No jackets are in stock
Target value = 50

Q = 50 - 0 - 0 + 3 = 53 jackets
Z-Values
Thank you!