Operations Management

Previous (Class #5): Queueing and the OM Triangle

» Review/introduction of basic probability theory.
» Attributes of a queueing system (e.g., a single-server queue)
» The Pollaczek-Khinchin (PK) Formula for average queue lengths and average
system times.
» The OM triangle trade-off: Inventory, Capacity, Information
» Key Concepts: Queues, buffer, inventory, input process, output process,
service policy (e.g., FCFS), coefficient of variation, random variables, mean,
standard deviation, variance, distributions (Poisson, exponential), balking,
reneging.
Today (Class #6) Cycle Stock and Economic Order Quantity (EOQ)
» How to model inventory in a fixed-order quantity setting with deterministic
lead times and constant demand rates.
» What is the economic order quantity and where does it comes from?
» How to include reorder points for positive lead times and all-quantity
discounts into the basic EOQ model.
» Key Concepts: Economic order quantity, reorder points, all units discount,
holding costs, ordering costs, unit costs, setup costs, cost equation, lead
time, purchasing cost, demand rate. 1
Housekeeping Issues

 Midterm exam will be held on

– Monday between 9 am to 11 am, Nov. 2nd 2020

 Questions from last class?

2
Inventory Management:
Learning Objectives
 Introduce concepts and terminology associated with
managing inventory (i.e., what is inventory
management?)

 Understand the analytical approaches used in modeling

and making inventory decisions

 Describe the basics of the Economic Order Quantity

model (EOQ) and Reorder Points (ROP)

 Describe the basics of the EOQ model with all-unit

quantity discount

 Describe the basics of the Economic Production

Quantity (EPQ) model 3
Fundamental Questions

Inventory Management (when and how much to order)

 What is inventory?

 Why is inventory important?

 What are the reasons for holding or not holding inventory?

 How much inventory to hold?

4
What is Inventory?
Stock of any item or resource used in an organization
– Raw materials & component parts
– Work in process
– Finished products
– Replacement parts, tools, & supplies
– Goods-in-transit to warehouses or customers

5
 Importance of Inventory

2005 Fiscal Year

General
Wal-Mart Boeing Dell
Motors
(Billion $) (Billion $) (Billion $)
(Billion $)
Cash & Short-term
6.4 5.9 50.4 9
investments
Account receivables 2.6 5.2 180.7 5.4
Inventories 32.2 73.5% 7.7 35% 30.1 9.6% 0.57 3.3%
Other current assets 2.5 2.8 51.7 2.6
Total current assets 43.8 100% 22 100% 312.9 100% 17.7 100%
Others assets 94.3 38.1 163.1 5.4
Total assets 138.2 60 476.1 23.1

6
Managing Inventory is Hard
 Too much
– “For the three months ended Aug. 28, Micron Technology posted a
net loss of $344 million, […] included a charge of $205 million
related to an inventory write-down.” USA Today, October 2008.
– “Saks Inc. reported a wider-than-expected loss for the third quarter,
[…] predicting deteriorating profit margins in the fourth quarter as it
sees the need to keep discounting to clear out piles of designer
merchandise.” USA Today, November 2008.
 Too Little
– “Boeing is experiencing an unexpected shortage of nuts and bolts
as it races to complete the first of its Dreamliners for a public
unveiling.” WSJ, June 2007.
– “Apple has been unable to meet demand for its iPad, which went on
sale in April, or its iPhone 4. […], analysts point to shortages of the
gadgets' specialized touch displays.” WSJ, July 2010. 7
Amount of inventory in the U.S.A.
 1.1 Trillion in inventory spread out along the
supply chains 
– 450 billion at the disposal of manufacturers
– 290 billion at the disposal of wholesalers
– 400 billion at the disposal of retailers

Average holding cost in U.S.A. is estimated to be 30%

of the total value of its inventory

8
Why Hold Inventory?

 Meet predictable variability in demand

– Seasonal inventories (e.g., candy for Halloween)
– Sales (e.g., BOGO for 50% off)

 Safeguard for unpredictable variability in demand

– Safety stock (i.e., extra stock maintained to mitigate risk)
– Significant price fluctuations (e.g., oil reserves)

 To deal with production or service variability

– Buffer inventory (or the Queue)
– Decouple the arrival/service variability
9
Why Hold Inventory?
 Economies of scale (cycle stocks)
– Reduce the production cost by using big batches
– Reduce the transportation cost by shipping large loads

 Pipeline inventories
– There is a time lag between ordering and receiving

 Strategic inventories
– Optimal planning (e.g., Apple’s iPhone 6)

 Speculative inventories
– In 1979, the Hunt brothers attempted to corner the silver
market. The price jumped from $6 to $49 per ounce (a
712% increase in a few months). The brothers were 10
Why Not Hold Inventory?
 It’s not free
– Storage costs
– Opportunity cost of capital

 It’s risky
– Short product life cycles increase obsolescence risk

 It may not be needed

– Information substitution

 It hides problems
– (see JIT, Lean Manufacturing)
11
Why Not Hold Inventory?

12
Why Hold Inventory? How Much?
Type of Inventory Decision Tool

Buffer/Decoupling Build-up diagrams

Seasonal/Anticipation Build-up diagrams

Cycle stock EOQ model (today)

Safety stock Newsvendor model (next)

Pipeline Little’s Law

Basic Quantitative Inventory
Management Questions
 When should we order more inventory?
Reorder point

 How much inventory should we order?

Quantity

 Two basic inventory management systems:

– Fixed-order quantity model (Q-model)
– Fixed-time period model (P-model)

14
Inventory Management Systems
 Fixed-order quantity, Q model
   Feature: Continuous review system
– Each order is the exact same size
– The ordering is triggered by an event
– The timing of this event is random
– A typical example:

An order of a fixed quantity Q is placed every time

the inventory position falls below a reorder point R
 Inventory ordering for economies of scale:
Economic Order Quantity (EOQ)
15
Inventory Management Systems
 Fixed-time period, P model
    Feature: Periodic review system
– Each order is of a different size
– The ordering is triggered by a moment in time
– The timing is deterministic and predictable
– A typical example:

Every P days, current inventory levels are

obtained and an ordering decision is made.
 An order quantity q that usually depends on the current
inventory level is ordered every P time units.
16
Inventory Costs
 Ordering/Setup costs (fixed costs)
– Fixed transportation costs
– Order processing costs

 Holding (or carrying) costs

– Costs for storage, handling, insurance, working capital
tied up, technology, skilled workers, security, etc.

 Shortage (opportunity) costs

– Lost sales, lost goodwill, shortage penalty, backorder
cost, lawsuits, external/internal investments, etc.
17
How Much Inventory to Hold?

Consider two important trade-offs (there are others)

– Inventory holding costs and inventory ordering

costs (economies of scale)
» Will be covered today

– Cost of running out of inventory and cost of having

excess (too much!) inventory
» Will be covered next class

18
 Inventory Tradeoffs:
Holding Costs & Ordering Costs
Profile of Inventory Level Over Time
Q Average
Demand
Or Sales
Quantity Rate
On-hand

Time
Receive Receive Receive
Order Order Order
19
Inventory Tradeoffs:
Holding Costs & Ordering Costs
Inventory Imagine an annual demand =2400 units
Q Average
Large Sales
order Rate
size

Time
Inventory
Q
Small
order
size Time

Is there an “optimal” order size in between?

20
Economic Order Quantity (EOQ)
 The Economic Order Quantity balances the
inventory holding costs and inventory ordering
costs via economies of scale.
– Key to evaluate cycle inventory

 Assumptions:
– Known annual demand, constant demand rate
– Lead time (delay between placing the order and receiving
the order) is fixed (constant) and there is no variability
– Act of ordering and receiving an order is instantaneous
– Costs are fixed an do not fluctuate through the year
– In the basic model, only one product is involved
21
Notation
 D: annual demand rate
 Q: quantity to be ordered
 S: set up cost or average cost of
processing/placing an order
 C: cost per unit of the product ordered
 H: annual holding and storage cost per unit of
product stored in inventory
 i: the percent carrying cost

Usually, H=iC although they can be defined independently.

22
Model Objective

 How much product should we order so that our

costs (i.e., the cost function) is minimized?

 Decision
Q: quantity to be ordered

 Objective
Minimize the sum of all the costs

23
The Total Cost Function
The Objective Function:
– Identify the fundamental time unit.
– How many orders are made per time unit?
» Calculate the overall ordering cost.
– What is the average inventory on hand?
» Calculate the annual holding cost.
– How many items are ordered?
» Calculate the purchase costs.
– Put it all together (i.e., sum the costs) !

 Make sure there are no other hidden costs.

24
 The Total Cost Function
D: Annual Demand
C: Cost per unit Inventory Inventory Profile:
Q: Number of units per # of units in
replenishment order inventory over time.
S: Setup cost for order
D = Demand rate
H: Annual Holding cost per unit Q

 Number of Orders / Year = D / Q

 Annual Ordering Cost = (D / Q) x S Time t

 Average Inventory = Q / 2 D Q
T  CD  S  H
 Annual Holding Cost = (Q / 2) x H Q 2
 Annual Purchase Cost = C x D 25
EOQ Example:
The South Face
The South Face retail shop sells outdoor clothing
D: 1200 jackets/year
S: $2,000
C: $200 per jacket
i: 25%
H: $ 50 per jacket for one year
What order size (Q) would you recommend?

Warehouse

26
 D Q
EOQ Example: T  CD  S  H
Q 2
The South Face
D = 1200 jackets/year, S = $ 2000, C = $ 200 per
jacket, i = 25%  H = $ 50 per jacket for one year
Number of Number of
units per order orders per Annual Annual Annual Annual
Q year: D/Q Ordering Cost Purchase Cost Holding Cost Total Cost
50 24.0 48000 240000 1250 289250
100 12.0 24000 240000 2500 266500
150 8.0 16000 240000 3750 259750
200 6.0 12000 240000 5000 257000
250 4.8 9600 240000 6250 255850
300 4.0 8000 240000 7500 255500
310 3.9 7742 240000 7750 255492
350 3.4 6857 240000 8750 255607
400 3.0 6000 240000 10000 256000
500 2.4 4800 240000 12500 257300
600 2.0 4000 240000 15000 259000
700 1.7 3429 240000 17500 260929
27
Cost Minimization Goal

28
Finding Economic Order Quantity (EOQ)
Purchasing Ordering Holding
Total Annual Cost = Cost + Cost + Cost

D Q
T  CD  S  H
Q 2
Minimum is attained at
dT - DS 1
first derivative w.r.t. Q
0  2
 H
dQ Q 2

2DS 2(Annual Demand)(Order or Setup Cost )

Q OPT = =
H Annual Holding Cost
29
EOQ Example:
The South Face
D: 1200 jackets/year, S: $2,000, C: $200 per jacket, i: 25%

EOQ for The South Face?

2* D* S 2 *1200 * 2000
QOpt    310 jackets
H 0.25 * 200

Number of orders/year?  D  1200  3.87

Q 310
Time between orders?  Q * 365  310 * 365  3 months
D 1200
Average inventory? Q 310
   155 jackets
2 2 30
What happens if there is a “Lead Time”?

• We denote the reorder point by ROP

Inventory
on hand I

Lead Lead Lead

Time Time Time

ROP
=dL

Receive Place Receive Place Receive Time 31

order order order order order
Reorder Point

• Inventory level at which a new order is placed

𝑹𝑶𝑷=𝒅𝑳  

 
demand rate
Lead time

32
Reorder Point
Consider an ePaint store that
  is open 311 days/year

Annual demand (D) = 10,000 gallons

Daily demand rate (d)=

Lead time = L =10 days

ROP = dL = 32.154*10 = 321.54 gallons

33
Self-Test Question
 Suppose the lead time (time between ordering
jackets and receiving jackets) is 2 weeks, what is
the re-order point with respect to the inventory
on hand?
D = 1200 jackets / year
d = 3.3 jackets / day
QOPT/D ≈ 3 months
L= 2 weeks= 14 days
ROPI = d  L= 3.3 jackets / day  14 days
= 46 jackets
34
Toronto General Hospital Example
Model Parameters
 Toronto General Hospital (TGH) consumes 500
boxes of bandages per week. The price of
bandages is $70 per box. The cost of
processing an order is $60, and the cost of
holding one box for a year is 15% of the value of
the material. The lead-time is one-half week.

(a) When should TGH place an order?

(b) TGH orders 900 boxes of bandages every time.

How much could TGH save?

35
EOQ With All-units Discounts
 Definition:
Refers to discounts that lower the purchase price (C)
on every unit purchased when the size of the order is
equal to or greater than some quantity threshold.

 Decision:
Q: quantity to be ordered

 Objective:
Minimize the total costs
36
EOQ With All-units Discounts
 Definition:
Refers to discounts that lower the purchase price on
every unit purchased when the size of the order is
equal to or greater than some quantity threshold.

 Quantity Thresholds
– c1Q for q0  Q  q1
– c2Q for q1 < Q  q2
– c3Q for q2 < Q  q3
– c4Q for q3 < Q  q4
…
–  cjQ for qj-1 < Q  qj
37
 EOQ with All-units Discount:
Quantity Thresholds
c1Q for q0  Q  q1
c2Q for q1 < Q  q2
c3Q for q2 < Q  q3
Slope c3
Order
Cost Slope c2

Slope c1

Order Quantity Q
q0 = 0 q1 q2
38
 EOQ with All-units Discount:
Total Cost Curve
c1Q for q0  Q  q1
c2Q for q1 < Q  q2
c3Q for q2 < Q  q3
T(Q)

Order Quantity Q
q0 = 0 q1 q2
39
 EOQ with All-unit Discount:
Efficient Solution Procedure
 The independent optimal EOQ’s quantities are Qj*= 2DS/Hj
 Optimal order quantity is guaranteed to be one of the following
– The largest “feasible”(realizable) Qk* (k=2, in the figure below)
– Breakpoints that exceed it (q2 in the figure)
 Choose the lowest cost (at Q2* in the figure)
T(Q)

Q1 *
Q 2*
q2
Q 3* Order Quantity Q
q0 = 0 q1 q2 40
 EOQ with All-units Discount:
Full Search Solution Procedure
Step 1: For each unit cost  , find the independent
optimal order quantity
Step 2: For each unit cost , find the best order
quantity within its range 3 possible cases
– If (i.e. infeasible), then
– If (i.e. feasible), then
– If (i.e. infeasible), then discard range

Step 3: Compute the total cost of all not discarded.

Select the one with the lowest cost.
41
 EOQ with All-units Discount:
Surge Electric Example
 Surge Electric uses 4,000 toggle switches a year.
Switches are priced as shown in the following table.
It costs approximately $18 to prepare an order and receive it,
and carrying costs are 18 percent of purchase price per unit
on an annual basis. Determine the optimal order quantity. 

 The cost regions are:

c1 = $0.90Q for 1  Q  499

c2 = $0.85Q for 500  Q  999
c3 = $0.82Q for 1000  Q  Infinity

42
 EOQ with All-units Discount:
Surge Electric Example
 Surge
  Electric uses 4,000 toggle switches a year.
Switches are priced as shown in the following table.
It costs approximately $18 to prepare an order and receive it,
and carrying costs are 18 percent of purchase price per unit
on an annual basis. Determine the optimal order quantity.
Step 1: For each , calculate

Range Unit Cost Hj Qj* = (2DS/Hj )1/2

1 to 499 $0.90 0.18(0.90) = 0.162 [2(4000)(18)/0.162]1/2 = 943
500 to 999$0.85 0.18(0.85) = 0.153 [2(4000)(18)/0.153]1/2 = 970
 1,000 $0.82 0.18(0.82) = 0.1476 [2(4000)(18)/0.1476]1/2 = 988

43
 EOQ with All-units Discount:
Surge Electric Example

 Surge
  Electric uses 4,000 toggle switches a year.
Switches are priced as shown in the following table.
It costs approximately $18 to prepare an order and receive it,
and carrying costs are 18 percent of purchase price per unit
on an annual basis. Determine the optimal order quantity.
Step 2: Select the best order quantity Qj* for each price .

Range Unit Cost Hj QjOPT

1 to 499 $0.90 0.18(0.90) = 0.162 943 > 499  DISCARD
500 to 999$0.85 0.18(0.85) = 0.153 500 < 970 < 999  Q2OPT= 970
 1,000 $0.82 0.18(0.82) = 0.1476 988 < 1000  Q3OPT = 1000

44
 EOQ with All-units Discount:
Surge Electric Solution
  
Range Unit Cost Hj QjOPT
1 to 499 $0.90 0.18(0.90) = 0.162 943 > 499  DISCARD
500 to 999 $0.85 0.18(0.85) = 0.153 500 < 970 < 999  Q2OPT = 970
 1,000 $0.82 0.18(0.82) = 0.1476 988 < 1000  Q3OPT = 1000

 Step 3: Compute the total cost among all options and select the
with the lowest cost where T(Q) = CD + (D/Q)*S + (Q/2)*H.

T(Q2OPT=970) = 0.85(4000) + (4000/970)18 + (970/2)0.153 = $3,548

T(Q3OPT=1000) = 0.82(4000) + (4000/1000)18 + (1000/2)0.1476 = $3,426

Min{T(Q2OPT=970), T(Q3OPT=1000)} = Min{$3,548, $3426} = $3,426.

QOPT is 1000 switches, which corresponds to a total cost of $3426.

Economic Production Quantity Model

 Order is received (produced) gradually, as

inventory is simultaneously being consumed.
– AKA non-instantaneous receipt model
– assumption that Q is received all at once is relaxed

 p - daily rate at which an order is received over

time, a.k.a. production rate
 d - daily rate at which inventory is demanded

46
 Economic Production Quantity Model
Q is the quantity to be optimized.

Inventory
level 𝒑−
  𝒅 𝒅
 
  𝒅𝒑 )
𝑸(𝟏−
Maximum
inventory level

𝑸 𝒅
(𝟏 − ) Average
inventory level
𝟐 𝒑

Begin End Time

Receipt Receipt
period period
Order
Receipt period
47
 Economic Production Quantity Model
𝒑=𝐝𝐚𝐢𝐥𝐲 𝐩𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧
  𝐫𝐚𝐭𝐞 𝒅 =𝐝𝐚𝐢𝐥𝐲 𝐝𝐞𝐦𝐚𝐧𝐝
  𝐫𝐚𝐭𝐞

  𝒅
𝐌𝐚𝐱𝐢𝐦𝐮𝐦 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐥𝐞𝐯𝐞𝐥 𝑸=𝑸 (𝟏 − )
𝒑
  𝑸 𝒅
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐥𝐞𝐯𝐞𝐥= (𝟏 − )
𝟐 𝒑
  𝟐 𝑫𝑺
𝐄𝐜𝐨𝐧𝐨𝐦𝐢𝐜 𝐏𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 : 𝑸 𝑶𝑷𝑻 =

𝐓𝐨𝐭𝐚𝐥 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐂𝐨𝐬𝐭 =

𝑫  × 𝑺+
√ 𝒅
𝑯 (𝟏 − )

𝑯 × 𝑸 𝑶𝑷𝑻
𝒑
𝒅
(𝟏 − ) 48
𝑸 𝑶𝑷𝑻 𝟐 𝒑
Economic Production Quantity Model
• The ePaint store has its own manufacturing facility in which
it produces Ironcoat paint.
• Ordering cost (S): 150 dollars
• Holding cost per litre of paint (H): 0.75 dollars
• Demand (D): 10,000 litres per year
• Working days: 311 days per year
• Production rate (p): 150 litres per year

• Calculate the following

• Optimal order size
• Total inventory cost
• Length of time to receive an order
• Number of orders per year
• Maximum inventory level 49
Economic Production Quantity Model
𝑫   𝟏𝟎 , 𝟎𝟎𝟎
𝒑=𝟏𝟓𝟎
  𝒅= = =𝟑𝟐. 𝟐
Working days 𝟑𝟏𝟏
𝑯=𝟎 .𝟕𝟓  𝐩𝐞𝐫 𝐠𝐚𝐥𝐥𝐨𝐧 𝑺=$  𝟏𝟓𝟎

𝟐×𝟏𝟎 ,𝟎𝟎𝟎  ×𝟏𝟓𝟎

𝐄𝐏𝐐 : 𝑸 𝑶𝑷𝑻 =

√
𝟎 . 𝟕𝟓(𝟏 −
𝟑𝟐 . 𝟐

𝑯
𝟏𝟓𝟎
)
=𝟐 , 𝟐𝟓𝟔 .𝟖 gallons

𝑫   ×𝑸 𝑶𝑷𝑻 𝒅
𝐓𝐨𝐭𝐚𝐥 𝐂𝐨𝐬𝐭 =
𝑸 𝑶𝑷𝑻
×𝑺+
𝟐 ( )
𝟏 − =𝟏 , 𝟑𝟐𝟗
𝒑
50
Economic Production Quantity Model
𝑫   𝟏𝟎 , 𝟎𝟎𝟎
𝒑=𝟏𝟓𝟎
  𝒅= = =𝟑𝟐. 𝟐
Working days 𝟑𝟏𝟏
𝑯=𝟎 .𝟕𝟓  𝐩𝐞𝐫 𝐠𝐚𝐥𝐥𝐨𝐧 𝑺=$  𝟏𝟓𝟎

  𝑸 𝒐𝒑𝒕 𝟐 , 𝟐𝟓𝟔 . 𝟖
𝐏𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧 𝐫𝐮𝐧 (𝐥𝐞𝐧𝐠𝐭𝐡)= = =𝟏𝟓 . 𝟎𝟓
𝒑 𝟏𝟓𝟎
𝑫  𝟏𝟎 , 𝟎𝟎𝟎
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐩𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧 𝐫𝐮𝐧= = =𝟒 . 𝟒𝟑 𝐫𝐮𝐧𝐬 / 𝐲𝐞𝐚𝐫
𝑸 𝑶𝑷𝑻 𝟐 , 𝟐𝟓𝟔 . 𝟖

  𝒅 𝟑𝟐. 𝟐
𝐌𝐚𝐱𝐢𝐦𝐮𝐦 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐥𝐞𝐯𝐞𝐥=𝑸 𝑶𝑷𝑻 𝟏−(𝒑 )
=𝟐 , 𝟐𝟓𝟔 . 𝟖 𝟏 − (
𝟏𝟓𝟎 )
¿ 𝟏 ,𝟕𝟕𝟐 𝐠𝐚𝐥𝐥𝐨𝐧𝐬
51
Managerial Implications of EOQ
 Cost curve is almost “flat” near the optimal point
– Use the EOQ formula, but do not worry about making
adjustments to get a number that is more realistic

 The flatness of the cost curve implies that the

EOQ figure is “robust”
– Estimating holding cost is usually difficult – the EOQ
formula guarantees that the “optimal” order quantity is
not very sensitive to errors in estimation.
– 40-20-2 Rule
» 40% error in one of the parameters
» 20% error in Qopt (the optimal order quantity)
» < 2% of total cost penalty 52
Summary: EOQ Models
 Can catch the trade-offs between variable
holding cost and fixed ordering costs in
simple deterministic settings but is robust.
 Can incorporate finite production, fixed lead
time, and different methods of quantity discounts
 Several extensions include incremental quantity
discounts (not covered), backordering costs,
multiple items, imperfect quality items, non-
instantaneous production (covered), etc.
53
So far we assumed demand is
constant…

Q
Quantity
on hand
Lead Lead Lead
Time Time Time
Reorder
point

Time
Receive Place Receive Place Receive
order order order order order

54
… But what if it is uncertain?

Q
Quantity
on hand
Lead Lead
Time Time
Reorder
point

Time
Receive Place Receive Place Receive
order order order order order

55
… But what if it is uncertain?

Q
Quantity
on hand

Lead time
Reorder
point

Stockout Time
Receive Place
order order

To minimize Stockouts we must have a Safety

Stock 56
… But what if it is uncertain?

Q
Quantity
on hand

Lead time
Reorder
point
Safety
Stock

Excess Inventory

Time
Receive Place
order order But not too much Safety Stock
either! 57
Reorder Point without demand uncertainty

´
 
𝑹 =𝒅 × 𝑳
 
Inventory level at which a new order is placed
average daily demand
lead time

 10-58
Safety Stock
 Safety stock
– buffer added to on hand inventory during lead time

 Stock-out
– an inventory shortage (demand exceeds inventory)

 Service level
– probability that the inventory available during lead
time will meet demand
– P(Demand during lead time <= Reorder Point)
 10-59
Reorder Point For a Service Level
Probability of meeting demand
during
lead time (in-stock) = service
level

Probability of
a stock-out

Safety stock
𝒛 𝝈 𝒅  √ 𝑳
  𝑹 
Demand

 10-60
Reorder Point without demand uncertainty

= 10,000 gallons/year  
Store is open 311 days/year.
= 10,000 / 311 = 32.154 gallons/day
Lead time () = 10 days

gallons

 10-61
Reorder Point With Demand Uncertainty
´ × 𝑳+
𝑹 =𝒅  
𝒛 𝝈𝒅 √ 𝑳

average daily demand  

lead time
the standard deviation of daily demand
number of standard deviations corresponding to the
service level probability
: safety stock

 10-62
 Reorder Point For Demand Uncertainty
  point with a 95% service
The paint store wants a reorder
level and a 5% stockout probability
gallons per day
days
gallons per day
Write in excel NORM.S.INV(0.95)=1.65

𝑅=𝑑´ × 𝐿+ 𝑧 × 𝜎 𝑑 × √ 𝐿=32.154  ∗10 + 1.65 ×5 × √ 10=𝟑𝟒𝟕 . 𝟔𝟑

𝐒𝐚𝐟𝐞𝐭𝐲 𝐒𝐭𝐨𝐜𝐤 ( 𝐒𝐒 )=347.63−( 𝑑´ ×  𝐿)= 𝟑𝟒𝟕 . 𝟔𝟑  − 321 .54=26.09

 10-63
 Normal standard table - example
Find the probability that is greater than or equal to 95%.
Z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
R IG H T S ID E V A L U E Sm, z >

0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3.0 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990

z-value equal to 1.65 guarantees service level of 95%. 64

 Periodic Inventory System
Inventory T = mean review  interval demand
Order Up to Level (OUL)
L = Mean lead  time demand
 
T  
= mean weekly demand
= Lead time
= review interval
average
order
quantity
 
L

L L Time

𝑡𝑏
review & order 2
  6

receive order 4 8  10-65

Order Quantity for a Periodic
Inventory System

∗
𝑸 =𝒅´ ( 𝒕 𝒃+ 𝑳 )+ 𝒛  × 𝝈 𝒅 × √ 𝑳+𝒕 𝒃 − 𝑰

 
the fixed time between orders
at the time of ordering
Safety stock (SS):

 10-66
Example for Periodic Inventory
The KVS Pharmacy stocks a popular brand of over-the-
counter flu and cold medicine. The average demand for
the medicine is six packages per day, with a standard
deviation of 1.2 packages. A vendor for the
pharmaceutical company checks KVS's stock every 60
days. During one visit, the store had eight packages in
stock. The lead time to receive an order is five days.
Determine the order size for this order period that will
enable KVS to maintain a 95% service level.

67
Fixed-Period Model With Variable Demand

´ ∗  
𝑸 =𝒅 ( 𝒕 𝒃+ 𝑳 )+ 𝒛 𝝈 𝒅 √ 𝑳+𝒕 𝒃 − 𝑰
∗
𝑸 =𝟔 ( 𝟔𝟎+𝟓 ) +𝟏 . 𝟔𝟓× 𝟏 .𝟔𝟓
  × √ 𝟔𝟎+𝟓 − 𝟖=𝟑𝟗𝟕 .𝟗𝟔

 10-68
Summary
 Reorder point for continuous review policy
– The reorder point under demand uncertainty is always
higher than demand is known with certainty.
– To account for demand uncertainty during lead time, the
reorder point must include some level of safety stock.

 Reorder point for periodic review policy

– Periodic review policy exposes a firm to a longer period of
demand uncertainty.
– The longer exposure to demand uncertainty is
compensated by higher safety stock.

69
Readings
 If you want to have a better grasp of the key
concepts, the following readings are
recommended:
– Chapter 13.1-13.6 of Textbook

 For next class, please:

– Check Quercus for announcements

Mid-term grades will be announced this week.

 Next Class: Newsvendor Model

70