DAO2703 OTM / DSC2006 OM

Week 8
MANAGING INVENTORIES
– WITH DEMAND UNCERTAINTY
 Recall that in Week 7, we introduced EOQ for
inventory management with NO demand
uncertainty.

We derived EOQ formula assuming lead time L=0

 EOQ: Optimal Order Quantity = Q*
To minimize total inventory holding cost & ordering cost per unit time, we order EOQ → Best Q (Q*)

Q* = Optimal Order Quantity

= (2 x Setup Cost x Demand Rate) / holding cost rate

= (2KD)/h

Note: when using EOQ formula, make sure D and h use the same time unit, e.g., if D is “daily”
demand, then h should be “daily” holding cost per unit of product.
 Under EOQ: What if lead time L > 0?
How to decide Q and T to minimize the total holding costs and ordering costs?
Order EOQ whenever inventory position drops to DL, which is the
demand during lead time L. In fact, this is true no matter L = 0 or L > 0.
Note:
Inventory • No Stockouts
• Order when no inventory
• Order Size determines policy
Order Size Q

Q/2
Average Inventory Level
0
Cycle Time = T T 2T …… Timeline
The Effect of Demand Uncertainty
EOQ Model does not consider demand uncertainty
What is the effect of demand uncertainty?
Most companies treat the world as if it were predictable:
◦ Production and inventory planning are based on forecasts of demand made far in advance
of the selling season

◦ Companies are aware of demand uncertainty when they create a forecast, but they design
their planning process as if the forecast truly represents reality

But, does forecast truly represent reality ?

Demand Forecast
The three principles of all forecasting techniques:
◦ Forecasting is always wrong
◦ The longer the forecast horizon, the worse is the forecast
◦ Aggregate forecasts are more accurate
Why is it increasingly important to
consider demand uncertainty?
Recent technological advances have increased the level of
demand uncertainty:
◦ Short product life cycles
◦ Increasing product variety
 Demand Variability: Example 1
Product Demand

250 225
200
150 150
Demand 150 125
100 104
(000's) 100 75 61
50 48 53 45
50
0

ct

ov

ec
l

ar
pr

ay

ep

n
n

ug

b
Ju

Ja

Fe
Ju

M
A

D
N
M

S
A

Month
Demand Variability: Example 1
Histogram for Value of Orders Placed in a Week

25
20
Frequency

15
10
5
0

,000 ,000 ,000 ,0 00 ,0 00 ,0 00 ,0 00 ,0 00

5 0 5 00 25 50 75 00
$2 $5 $7 $1 $1 $1 $1 $2
Value of Orders Placed in a Week
 Notations:
Average = mean = μ
Standard Deviation = std dev = σ
The Normal Distribution
Standard Deviation = 5

Standard Deviation = 10

Average = 30

0 10 20 30 40 50 60
 Returns on Safety
Stock Investment
Demand
Uncertainty
and Bell Curve
(Example)
Mean = 1
Standard Deviation = 0.2

15% 33% 33% 15%

2% 2%
μ - 2σ μ - 1σ μ μ + 1σ μ + 2σ
Risk Pooling: Demand variability is reduced if one aggregates demand across locations / time periods)

Demand during
Demand during 1 day
1 day

33% 33%

15% 15%
2% 2%
2,700 3,100 3,500 3,900 4,300 2,700 3,100 3,500 3,900 4,300

Demand during
33%
lead time (2 day)

15%
2%
5,868 6,434 7,000 7,566 8,132
 Demand during
1 day with
mean=m
and
Standard Deviation = s

Demand during
lead time (L days)
33%

15%
2%
Lm Lm + s L Lm + 2s L
What is important when we develop a multi-
period inventory model with demand uncertainty?

→how to handle demand during lead time?

→Anything else? Let's understand inventory further and recall

some important inventory characteristics
Understanding Inventory
The inventory policy is affected by:
◦ Demand Characteristics
◦ Lead Time
◦ Number of Products
◦ Objectives
◦ Service level
◦ Minimize costs
◦ Cost Structure
Inventory Cost Structure
Ordering Costs
◦ Fixed ordering cost (setup cost)
◦ Variable ordering cost (purchase cost)

Holding Costs
◦ Insurance
◦ Maintenance and Handling
◦ Taxes
◦ Opportunity Costs
◦ Obsolescence
EOQ: Calculating Total Cost in a Cycle Time T (i.e., total
holding costs and ordering costs in during the cycle time T)
Purchase Cost during the cycle time T:
Note: Holding Cost Rate h is the cost
$C per unit of product * Demand during a period of T units of time for holding one unit of product for one
unit of time, e.g., if h= $7 per unit of
CQ = CDT product weekly, we can also say h= $1
per unit of product daily
Holding Cost during the cycle time T:

(Average Inventory level) * (Holding Cost Rate h) *(Period of T units of time)

(Q/2) x h x T

Fixed ordering cost (Setup Cost) during the cycle time T :

Fixed Order Cost K Goal: Find the Order Quantity Q that Minimizes These Costs
Understanding Inventory
The inventory policy is affected by:
◦ Demand Characteristics
◦ Lead Time
◦ Number of Products
◦ Objectives
◦ Service level
◦ Minimize costs
◦ Cost Structure
The Multi-Period Inventory Model
We consider a single product inventory model (In Week 9 we will introduce models
which can handle multiple products)
We assume that the demand is random and follows a normal distribution
Ordering cost has two components: (1) Fixed ordering cost K per order + (2) a variable
ordering cost C which is proportional to the amount ordered.
Inventory holding cost is charged per item per unit time → use h to denote
We assume that if an order arrives and there is no inventory, the order is lost
The distributor has a required service level. This is expressed as the likelihood that
the distributor will not stock out during lead time.
Intuitively, how will this affect our policy?
 A distributor or a Distribution Center (DC) holds
inventory to:
Satisfy demand during lead time
→ in EOQ setting, we order when inventory level drops to DL.
→ With demand uncertainty, it is more logical to say, “Satisfy EXPECTED demand during lead time”.

Protect against demand uncertainty

→ in EOQ setting, no demand uncertainty. So, this part is ignored.
→ With demand uncertainty, we need to add some safety stock in addition to the “EXPECTED
demand” to Protect against demand uncertainty. How to model this if demand is normally distributed?
 A distributor or a Distribution Center (DC) holds
inventory to:
Balance fixed costs and holding costs
→ in EOQ setting, we order (2KD) / h so that we can balance the fixed ordering
costs and holding costs, which allows us to minimize the total ordering & holding cost.
→ With demand uncertainty, this is still valid. That is, every time we place an order,
we still want to balance our fixed ordering costs and holding costs, which allows us to
minimize the total ordering/holding cost
The Multi-Period Inventory Model: Continuous
Review Policy v.s. Periodic Review Policy
Continuous Review: also called (Q, R) Policy
◦ Q = order quantity
◦ R = reorder point
◦ How to determine Q and R?
The Multi-Period Inventory Model: Continuous
Review Policy v.s. Periodic Review Policy
Periodic Review:
◦ Short review period (e.g. daily): (s, S) Policy
◦ Set s = R
◦ Set S = R + Q
◦ Long review period (e.g. weekly, monthly, etc.):
◦ Always order after an inventory position review (We must pay fixed cost after each review!)
◦ In this case, what is the role of fixed costs here? Do we still care about reorder point? (No!)
◦ We use a Base-Stock Policy: in each review period, review inventory position and order enough
to raise the inventory position to the base-stock level
◦ How to determine an effective base-stock level?
Continuous Review: also called (Q, R) Policy
 Continuous Review policy – Notation
(assuming demand is normally distributed)
AVG = average daily demand
STD = standard deviation of daily demand
L = replenishment lead time in days
h = holding cost of one unit for one day
SL = service level (for example, 95%). This implies that the probability of stocking out
is 100%-SL (for example, 5%)

Also, the Inventory Position at any time is the actual inventory on hand plus items
already ordered, but not yet delivered minus items that are backordered.
Actual inventory on hand is called "inventory level".
Continuous Review Policy - Analysis
The reorder point R has two components:
◦ To account for average demand during lead time:

L  AVG
◦ To account for deviations from average (we call this safety stock)

z  STD  L
where z is chosen from statistical tables to ensure that the probability of stockouts during lead time is
100%-SL.

◦ The reorder point R = L  AVG + z  STD   L

Continuous Review policy - Example
The distributor has historically observed weekly demand of:
AVG = 44.6 STD = 32.1

Replenishment lead time is 2 weeks, and desired service level SL = 97%

Average demand during lead time is:
44.6  2 = 89.2
Safety Stock is:
1.88  32.1  2 = 85.3
Reorder point is thus 175, or about 3.9 weeks of supply at warehouse and in the
pipeline
Continuous Review Policy – Now that we know the Re-order
Point, how much should we order each time? That is, Q = ?

What are the factors we should consider?

◦ Fixed costs = 0 (Model One)
◦ Fixed costs > 0 (Model Two)
 Continuous Review policy- Model One:
Fixed Costs = 0
If it costs you NOTHING to place an order, how much should you order every time?
◦ Big Q vs. small Q → High inventory holding cost vs. low inventory holding cost
◦ Q should be as small as possible → Just maintain the inventory level at around reorder point R
Continuous Review policy - Model Two:
Fixed Costs > 0
Intuitively, how will this affect our policy?

In addition to previous costs, a fixed cost K is paid every time an order is placed.
The reorder point will be the same as the previous model, in order to meet the service
requirement:

R = L  AVG + z  STD   L

What about order quantity Q?

◦ Extend the EOQ model → Q= (2  K  AVG) / h
Continuous Review policy - Model Two:
The Order-Up-To Level
We have used the extended EOQ to balance the fixed costs and the holding costs:

Q= (2  K  AVG) / h
If there was no variability in demand, we would order Q when inventory level at L  AVG.

However, there is demand variability, we will need safety stock:

z  STD *  L

The total order-up-to level is:

S = Q + R = Q+ L  AVG + z  STD *  L
 Continuous Review Policy - Model Two: Example
Consider the previous example, but with the following additional info:
◦ Fixed cost of $4500 when an order is placed
◦ $250 product cost
◦ Holding cost 18% of product

Weekly holding cost:

.

h = (0.18  250) / 52 = 0.87

Order quantity
.

Q= (2  4500  44.6 / 0.87 = 679

Order-up-to level:
S = R + Q = 175 + 679 = 854
Evaluating Inventory holding cost → Evaluating Inventory Level
(Continuous Review Policy)

Inventory level as a
function of time in a
(Q,R) policy

(1) Inventory level before receiving an order (lowest point) = z  STD  L

(2) Inventory level after receiving an order (highest point) = Q + z  STD  L

[(1) + (2)] / 2 = Average Inventory =

Q
2
+ z  STD  L
33
The Multi-Period Inventory Model:
Continuous Review Policy VS Periodic Review Policy
Continuous Review: also called (Q, R) Policy
◦ Q = order quantity
◦ R = reorder point
◦ How to determine Q and R?

Periodic Review:
◦ Short review period (e.g. daily): (s, S) Policy
◦ Set s = R
◦ Set S = R + Q
◦ Long review period (e.g. weekly, monthly, etc.):
◦ Always order after an inventory position review (This implies we have to pay fixed cost after each review!)
◦ In this case, what is the role of fixed costs here? Do we still care about reorder point? (No!)
◦ We use a Base-Stock Policy: in each review period, review inventory position and order enough to raise the inventory position
to the base-stock level
◦ How to determine an effective base-stock level?
(Q, R) Policy (continuous review policy) vs. (s,S)
Policy (short periodic review policy)

(Q, R) Policy is also called continuous review policy because we assume that we can review our
inventory level continuously (i.e., all the time) and can place an order anytime we want.
In a periodic review environment, we do not know the inventory level all the time, thus when the
inventory reaches “R” – the reorder point under the continuous review policy, we may not know
and can NOT order “Q” in every order as suggested by the continuous review policy. Therefore,
we need a more general policy.
For Short Review Period, we can use (s, S) Policy: Whenever the inventory position drops below a
certain level, s, we order to raise the inventory position to level S.
◦ s: reorder point
◦ S: order-up-to level
Periodic Review Policy: Short Review Period –
use (s, S) Policy – How to set s and S?
When the review period is short, the situation is very close to
continuous review environment, thus we can use the continuous review
policy to approximate the reorder point “s” and order-up-to level “S”.

Periodic Review: Short review period (e.g. daily): (s, S) Policy

◦ Set s = R
◦ Set S = R + Q
The Multi-Period Inventory Model:
Continuous Review Policy VS Periodic Review Policy
Continuous Review: also called (Q, R) Policy
◦ Q = order quantity
◦ R = reorder point
◦ How to determine Q and R?

Periodic Review:
◦ Short review period (e.g. daily): (s, S) Policy
◦ Set s = R
◦ Set S = R + Q
◦ Long review period (e.g. weekly, monthly, etc.):
◦ Always order after an inventory position review (This implies we have to pay fixed cost after each review!)
◦ In this case, what is the role of fixed costs here? Do we still care about reorder point? (No!)
◦ We use a Base-Stock Policy: in each review period, review inventory position and order enough to raise the inventory position
to the base-stock level
◦ How to determine an effective base-stock level?
Periodic Review Policy – Long Review Period
How to determine a good base-stock level?
Base-Stock level = (r + L)  AVG + z  STD   r+L

In the above formula, r is the review period.

For example, if we review every month, then r = 1 month.