Slides by

John
Loucks
St. Edward’s
University

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 Chapter 10, Part B
Inventory Models with Probabilistic Demand

 Single-Period Inventory Model

with Probabilistic Demand
 Order-Quantity, Reorder-Point Model
with Probabilistic Demand
 Periodic-Review Model
with Probabilistic Demand

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 Probabilistic Models

 In many cases demand (or some other factor) is not

known with a high degree of certainty and a
probabilistic inventory model should actually be used.
 These models tend to be more complex than
deterministic models.
 The probabilistic models covered in this chapter are:
• single-period order quantity
• reorder-point quantity
• periodic-review order quantity

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 Single-Period Order Quantity

 A single-period order quantity model (sometimes

called the newsboy problem) deals with a situation in
which only one order is placed for the item and the
demand is probabilistic.
 If the period's demand exceeds the order quantity, the
demand is not backordered and revenue (profit) will
be lost.
 If demand is less than the order quantity, the surplus
stock is sold at the end of the period (usually for less
than the original purchase price).

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 Single-Period Order Quantity

 Assumptions
• Period demand follows a known probability
distribution:
• normal: mean is µ, standard deviation is 
• uniform: minimum is a, maximum is b
• Cost of overestimating demand: $co
• Cost of underestimating demand: $cu
• Shortages are not backordered.
• Period-end stock is sold for salvage (not held in
inventory).

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 Single-Period Order Quantity

 Formulas
Optimal probability of no shortage:
P(demand < Q *) = cu/(cu+co)
Optimal probability of shortage:
P(demand > Q *) = 1 - cu/(cu+co)
Optimal order quantity, based on demand distribution:
normal: Q * = µ + z

uniform: Q * = a + P(demand < Q *)(b - a)

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 Example: McHardee Press

 Single-Period Order Quantity

McHardee Press publishes the Fast Food Menu
Book and wishes to determine how many copies to
print. There is a fixed cost of $5,000 to produce the
book and the incremental profit per copy is $0.45.
Any unsold copies of the book can be sold at salvage
at a $.55 loss.

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 Example: McHardee Press

 Single-Period Order Quantity

Sales for this edition are estimated to be normally
distributed. The most likely sales volume is 12,000
copies and they believe there is a 5% chance that sales
will exceed 20,000.
How many copies should be printed?

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 Example: McHardee Press

 Single-Period Order Quantity

m = 12,000. To find  note that z = 1.65
corresponds to a 5% tail probability. Therefore,
(20,000 - 12,000) = 1.65 or  = 4848
Using incremental analysis with Co = .55 and Cu = .45,
(Cu/(Cu+Co)) = .45/(.45+.55) = .45
Find Q* such that P(D < Q*) = .45. The probability
of 0.45 corresponds to z = -.12. Thus,

Q* = 12,000 - .12(4848) = 11,418 books

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 Example: McHardee Press

 Single-Period Order Quantity (revised)

If any unsold copies can be sold at salvage at a
$.65 loss, how many copies should be printed?
Co = .65, (Cu/(Cu + Co)) = .45/(.45 + .65) = .4091
Find Q* such that P(D < Q*) = .4091. z = -.23
gives this probability. Thus,
Q* = 12,000 - .23(4848) = 10,885 books
However, since this is less than the breakeven
volume of 11,111 books (= 5000/.45), no copies
should be printed because if the company produced
only 10,885 copies it will not recoup its $5,000 fixed
cost.

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 Reorder Point Quantity

 A firm's inventory position consists of the on-hand

inventory plus on-order inventory (all amounts
previously ordered but not yet received).
 An inventory item is reordered when the item's
inventory position reaches a predetermined value,
referred to as the reorder point.
 The reorder point represents the quantity available to
meet demand during lead time.
 Lead time is the time span starting when the
replenishment order is placed and ending when the
order arrives.

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 Reorder Point Quantity

 Under deterministic conditions, when both demand

and lead time are constant, the reorder point
associated with EOQ-based models is set equal to
lead time demand.
 Under probabilistic conditions, when demand and/or
lead time varies, the reorder point often includes
safety stock.
 Safety stock is the amount by which the reorder point
exceeds the expected (average) lead time demand.

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 Safety Stock and Service Level

 The amount of safety stock in a reorder point

determines the chance of a stock-out during lead time.

 The complement of this chance is called the service

level.
 Service level, in this context, is defined as the
probability of not incurring a stock-out during any one
lead time.
 Service level, in this context, also is the long-run
proportion of lead times in which no stock-outs occur.

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 Reorder Point

 Assumptions
• Lead-time demand is normally distributed
with mean µ and standard deviation .
• Approximate optimal order quantity: EOQ
• Service level is defined in terms of the probability of
no stock-outs during lead time and is reflected in z.
• Shortages are not backordered.
• Inventory position is reviewed continuously.

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 Reorder Point

 Formulas
Reorder point: r = µ + z

Safety stock: z

Average inventory: Q*/2 + z

Total annual cost: [Ch(Q */2)] + [Ch z ] + [Co(D/Q *)]

(hold.(normal) + hold.(safety)
+ ordering)

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 Example: Robert’s Drug

 Reorder Point Model

Robert's Drugs is a drug wholesaler supplying
55 independent drug stores. Roberts wishes to
determine an optimal inventory policy for Comfort
brand headache remedy. Sales of Comfort are
relatively constant as the past 10 weeks of data (on
next slide) indicate.

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 Example: Robert’s Drug

 Reorder Point Model

Week Sales (cases) Week Sales (cases)

1 110 6 120
2 115 7 130
3 125 8 115
4 120 9 110
5 125 10 130

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 Example: Robert’s Drug

Each case of Comfort costs Roberts $10 and

Roberts uses a 14% annual holding cost rate for its
inventory. The cost to prepare a purchase order for
Comfort is $12. What is Roberts’ optimal order
quantity?

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 Example: Robert’s Drug

 Optimal Order Quantity

The average weekly sales over the 10 week period
is 120 cases. Hence D = 120 X 52 = 6,240 cases per
year;
Ch = (.14)(10) = 1.40; Co = 12.
∗
𝑄 √ 2 𝐷𝐶 𝑂 /𝐶 h =√ ( 2 ( 6420 ) (12 ) /1.40 ) =327

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 Example: Robert’s Drug

The lead time for a delivery of Comfort has

averaged four working days. Lead time has
therefore
been estimated as having a normal distribution with a
mean of 80 cases and a standard deviation of 10
cases.
Roberts wants at most a 2% probability of selling
out of Comfort during this lead time. What reorder
point should Roberts use?

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 Example: Robert’s Drug

 Optimal Reorder Point

Lead time demand is normally distributed with m
= 80,  = 10.
Since Roberts wants at most a 2% probability of
selling out of Comfort, the corresponding z value is
2.06. That is, P (z > 2.06) = .0197 (about .02).
Hence Roberts should reorder Comfort when
supply reaches r = m + z = 80 + 2.06(10) = 101
cases.
The safety stock is z = 21 cases.

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 Example: Robert’s Drug

 Total Annual Inventory Cost

Ordering: Co(D/Q*) = 12(6240/327) = $229

Holding-Normal: Ch(Q*/2) = 1.40(327/2) = 229
Holding-Safety Stock: Ch(21) = (1.40)(21) = 29
TOTAL = $487

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 Periodic Review System

 A periodic review system is one in which the inventory

level is checked and reordering is done only at
specified points in time (at fixed intervals usually).
 Assuming the demand rate varies, the order quantity
will vary from one review period to another.
 At the time the order quantity is being decided, the
concern is that the on-hand inventory and the quantity
being ordered is enough to satisfy demand from the
time the order is placed until the next order is received
(not placed).

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 Periodic Review Order Quantity

 Assumptions
• Inventory position is reviewed at constant intervals.
• Demand during review period plus lead time period
is normally distributed with mean µ and standard
deviation .
• Service level is defined in terms of the probability of
no stockouts during a review period plus lead time
period and is reflected in z.
• On-hand inventory at ordering time: H
• Shortages are not backordered.
• Lead time is less than the review period length.

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 Periodic Review Order Quantity

 Formulas
Replenishment level: M = µ + z

Order quantity: Q=M-H

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 Example: Ace Brush

 Periodic Review Order Quantity Model

Joe Walsh is a salesman for the Ace Brush
Company. Every three weeks he contacts Dollar
Department Store so that they may place an order to
replenish their stock. Weekly demand for Ace
brushes at Dollar approximately follows a normal
distribution with a mean of 60 brushes and a
standard deviation of 9 brushes.

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 Example: Ace Brush

 Periodic Review Order Quantity Model

Once Joe submits an order, the lead time until
Dollar receives the brushes is one week. Dollar
would like at most a 2% chance of running out of
stock during any replenishment period. If Dollar
has 75 brushes in stock when Joe contacts them,
how many should they order?

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 Example: Ace Brush

 Demand During Uncertainty Period

The review period plus the following lead time totals 4
weeks. This is the amount of time that will elapse before
the next shipment of brushes will arrive.
Weekly demand is normally distributed with:
Mean weekly demand, µ = 60
Weekly standard deviation,  = 9
Weekly variance,  2 = 81
Demand for 4 weeks is normally distributed with:
Mean demand over 4 weeks, µ = 4 x 60 = 240
Variance of demand over 4 weeks,  2 = 4 x 81 = 324
Standard deviation over 4 weeks,  = (324)1/2 = 18

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 Example: Ace Brush

 Replenishment Level
M = µ + z where z is determined by the desired
stock-out probability. For a 2% stock-out probability
(2% tail area), z = 2.05. Thus,
M = 240 + 2.05(18) = 277 brushes
As the store currently has 75 brushes in stock,
Dollar should order:
277 - 75 = 202 brushes
The safety stock is:
z = (2.05)(18) = 37 brushes

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 End of Chapter 10, Part B

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