LOGISTICS

Lecture 05
Review of Inventory Models

Rosa G. González Ramírez

Universidad de Los Andes Chile
 Power of Two Policy
• Sometimes, if we have several items, we would like to have cycle times
that are similar among the products and consolidate the orders.
• We want to make sure that T* value is practical and be able to aggregate
multiple items into common schedules
• A Power of Two time interval is guaranteed to be within 6% of the Total
relevant costs (ordering & holding costs) with the optimal time interval,
and is a powerful heuristic to derive a policy that is very close to the
optimal value but also practical. This can be computed by the following
relationship:

• STEPS:
Steps to find a practical T:
1. Calculate T*
2. Pick a base time period (day, week, etc.)
3. Find the lowest value of k that satisfies the following relationship:
 Power of Two Policy
Steps to find a practical T:
1. Calculate T*
2. Pick a base time period (day, week, etc.)
3. Find the lowest value of k that satisfies:

Example:
Demand: 25.000 units per year Step 1
Ordering cost: 750 $/order Q*=3.131 units/order
Cost of product: 25,5 $/unit T*=0,125 years/order
Holding cost: 15% of unit cost per year TCosts= $11.976 $/year

Step 2.
Base time period: weeks. T*=52(0,125)=6,5 weeks/order
T*/√2=6,5/√2=4,59. √2T*=√2(6,5)=9,19

Step 3.
The value of 2k that is between those bounds is 8 =(23), hence, k=3
Then T*=8 weeks=8/52=0,153
Now we update Q=TD=0,153(25.000)=3846 units and Tcosts= 12.230$/year
Economic Production Quantity: Finite Replenishment
We previously assumed that replenishment quantity arrives at the same time. Now, it
becomes available at a rate of P per unit time rather than all at one time. So P is
the production rate. In this case we assume that it is internally replenished.
So we have now the EOQ with concurrent production and the average inventory level
is now Q  1 − D  2 . This lowers holding costs and leads to higher EPQ.
 P 

How long does it take to What is the inventory

produce Q units? accumulation rate?
?
Q/P Q/P
?
Q Q

P
P D
P-D
?
Economic Production Quantity: Finite Replenishment

What is the maximum level of inventory?

Q/P
? Q/P
?
Q Q

D =(P-D)*Q/P
P P D
=QP/P-DQ/P
P-D
? ?
P-D
? =Q-QD/P
=Q(1-D/P)

What is my average inventory? =Q(1-D/P)/2

=(1-D/P)Q/2
Economic Production Quantity: Finite Replenishment
What are the total costs?   D
 Q 1 −  
TC (Q) = A + h  
What is the value of Q* D P 
+ CD
Q/P
? Q  2 
 
Q  
D
hQ(1 − )
dTC − AD P +0=0
P D = 2 +
P-D =Q(1-D/P) dQ Q 2
Solving ,
Average inventory 2 AD 2 AD
Q =
2
 Q =
*
(1-D/P)Q/2 h(1 − D / P) D
h(1 − )
P
EOQ
 D
=
Q 1 −   D
 P
P-D 1 − 
-D  P
 EPQ: Economic Production Quantity
 D
Q 1 −  2 AD
 P Q* = = Lot Size
P-D -D D
h(1 − )
P

Insights:

▪ What happen if D/P is very small (reduces to zero)?

▪ Notice that If P →  then EPQ  EOQ
▪ What happen if D/P>1? (note that this means that D>P)
Example EPQ
Example: Cosmetics Plant
▪ Production Capacity 1000 tubes/hr.
▪ Daily Demand 1680 tubes
▪ Production cost $0,50/tube (C = 0,50)
▪ Set-up cost $150 per set-up (A = 150)
▪ Annual holding cost rate: 40% (h= 0,4(0,50) = 0,20)

Compute the EPQ that minimizes the costs.

 Example EPQ
Example: Cosmetics Plant
▪ Production Capacity 1000 tubes/hr.
▪ Daily Demand 1680 tubes
▪ Production cost $0,50/tube (C = 0,50)
▪ Set-up cost $150 per set-up (A = 150)
▪ Annual holding cost rate: 40% (h= 0,4(0,50) = 0,20)

Since demand is 1680 per day and the production rate is 1000 per
hour and assuming that the plant operates 24 hours per day:
▪ D = 1680(365) = 613.200
▪ P = 1000(24)(365) = 8.760.000

2 AD 2(150)(613.200)
Q* = =  31.449
h(1 − D / P) 0, 20(1 −
613.200
)
8.760.000
 Other EOQ models

▪ EOQ with discounts:

-All units discount: Discount applies to all units purchased if
total amount exceeds the break point quantity. (Note that we
cover this type of model in Operations Management
Course)
-Incremental discount: Discount applies only to the quantity
purchased that exceeds the break point quantity
-One time only discount: A one time only discount applies to all
units you order right now (no quantity minimum or limit)

▪ A multitude of other models….

 Homework 7b
HOMEWORK 7b: Due date Tuesday 9th.
Solve the excersices from Ballou, Chapter 9:
▪ 9.4: (very simple)
▪ 9.7: consider it as a single-order problem or base stock. Use
critical ratio (formula ballou) to compute the expected number of
withdrawals (S*) and translate it to money (average money taken
per withdrawal).
▪ 9.11: EPQ
▪ Excersise given from exam of previous year (Mermelada de
cereza)

▪ Read by yourselves the Min-Max System, pages 363 (end) to 367.

As a reference consider the first example of page 367 and answer
exercise 9.17.
 Probabilistic EOQ Models:
Relaxation of Stochastic Demand
Deterministic relaxation.- This can be modeled as a relaxation of the single
item EOQ model by creating a safety stock ss (or buffer) to accommodate
the demand (stochastic) during the order-lead time (deterministic).

Inventory

Q Reorder
Lever (R)
Average R=D*LT
Leadtime
Usage (d)

Safety stock (ss)

Order Order Order Time
Placed Placed Placed
Buffer size in stochastic demand

▪ Demand during lead time:

▪ When the demand is stochastic (variable) we do not know in advance the
inventory position after L days

Current Inventory
R Position
Demand
Variability
D = d1 + d 2 +  + d L
(forecast error)

▪ Usually we assume that the demand each day has the same
mean and standard deviation. Thus, we can determine:

ED  = L d Var D  = L d2 StdDevD =  D = L d

 Buffer Size under normal distribution
▪ Commonly we assume that the demand follows the (standard) normal
distribution

X −
Z=  Nor (0,1)
 Z 0.5 Z 0.95 = 1.65
▪ The size of the safety stock (ss) should be large enough to
accommodate the demand during the lead time with a probability of 1-
a, the service level
mean = Ld, Std. Dev. = √L*d

Mean demand
during lead time L D
ss Pr  D  Ld + ss   a
 Example

▪ Daily demand follows a normal distribution with mean of 100 and

standard deviation of 25 units/day. Determine the size of the buffer
if the ordering cost is 100 $/order, the holding cost is 0,02 $/unit-
day, the average lead time is 2 days and the desired service level is
95%

2dA 2(100)(100)
Q= = = 1000
h 0, 02

▪ Distribution of demand during lead time = Normal with a mean =

2*100=200, and standard deviation of 21/2*25=35,35.

▪ We want that Pr  D  Ld + ss   a where 𝛼 is equal to 0,05.

Example (cont)

Pr  D  Ld + ss   a

Z 0,95 = 1, 644
▪ Z0,95 = 1,644

Z1−a =
X −
=
( Ld + ss ) − Ld
=
ss
 L d L d
▪ Solving for ss:
ss = Z1−a L d
▪ In our example:

ss = Z1−a L d = 1, 644 2 ( 25 ) = 58,12  59

Safety Stock with service levels (Normal dist.)

▪ Restocking point (Stochastic Demand):

R = d L + Z L d

▪ In our example

R = (100)(2) + 1, 644  ( )
2  25 = 258,15
 Types of Service Levels
1. Cycle Service Level (CSL) or Probability of not having a stock out in a
replenishment cycle. This is usually represented by 1- a
2. Fill rate (fr) level.- probability or proportion of demand filled from stock.
It is usually represented by 1- b
CSL is related with whether there will be a stock out, while fill
rate is related with how many unit we will be short in case of a
stock out.
fr = 1 – Expected shortage per replenishment cycle (ESC)/Q
∞
𝐸𝑆𝐶 = න 𝑥 − 𝑅 𝑓 𝑥 𝑑𝑥 R = DL + ss
𝑥=𝑅
For a normal distribution:
−( x −  )
2

1 x − DL
f ( x) = e 2 2
dx =  L dz Z=
 2 L
𝑠𝑠 𝑠𝑠
𝐸𝑆𝐶 = −𝑠𝑠 1 − 𝐹𝑠 + 𝐿 𝑓𝑠
𝐿 𝐿
 Example fill rate (fr)

▪ In the previous example SS = 59, std. dev. = 35,35; Q =

1000
𝑠𝑠 𝑠𝑠
𝐸𝑆𝐶 = −𝑠𝑠 1 − 𝐹𝑠 + 𝐿 𝑓𝑠 =
𝐿 𝐿

59 59
−59 1 − 𝐹𝑠 + 35,35𝑓𝑠 =0,6968
35,35 35,35
; 0,1,1 )+35,35 ∗ (𝑛𝑜𝑟𝑚𝑑𝑖𝑠𝑡
59 59
-59*(1-normdist ; 0,1,0 =0,6968
35,35 35,35

𝐸𝑆𝐶 0,6968
𝑓𝑟 = 1 − =1- =0,9993
𝑄 1000
En Excel:
Fs()=normdist(x;0;1;1)
fs()=normdist(x;0;1;0)
Demand when lead time is stochastic

Current Inventory
Position
Demand
Variability
(forecast error)

Leadtime
Variability
Safety Stock with service levels (Normal dist.)

▪ Restocking point (Stochastic lead time):

R = dL + Zd L

▪ Restocking point (Stochastic demand and lead

time)

R = d L + Z L  d2 + d 2 L2
Example

▪ Demand has a mean of 100 units/day (assume it as a constant

value). Determine the reorder point if the ordering cost is 100
$/order, the holding cost is 0,02 $/unit-day, the average lead
time is normally distributed with a mean of two days and
standard deviation of ½ days and the service level desired is
95%
2 DA 2(100)(100)
Q= = = 1000
h 0,02

R = dL + Zd L = (100 ) 2 + 1, 65 (100 )( 0,5 ) = 282,5

 Example

For the previous example assume that the demand is also

stochastic with a mean of 100 and a standard deviation of
25 units/day. Find the reorder point.

R = dL + Z L + d  = 2(100) + 1, 65 2(25) + 100 (1/ 2 )

2 2 2 2 2 2
d L

R = 363,15
Exercise

▪ Exercise 12,4 (Chopra and Meindel)

▪ Weekly demand for HP printers at Sam’s Club is normally
distributed, with a mean of 250 and std. dev. of 150. The
storage manager closely monitors the inventory levels and
orders 1,000 printers each time the inventory level falls below
600 printers. HP takes 2 weeks to fill an order.
▪ How much safety inventory does the store carry?
▪ What CSL (Cycle Service Level) does Sam’s Club achieve as a
result of this policy?
▪ What fill rate does the store achieve?
 Exercise Solution
▪ Demand during lead time = (250)(2) = 500
▪ Safety inventory = SS= R-D = 600 - 500 = 100

Z1−a =
X −
=
( Ld + ss ) − Ld
=
ss
=
100
= 0, 4714
 L d L d 2 *150

Using Excel’s function NORM.S.DIST(0.4714,1), we get 1- a =

0.6813, thus a =0.318
Standard normal
  ss   ss 
ESC = − ss 1 − Fs   +  L s
f = cummulative
 L  L  distribution

  100   100 
ESC = −100 1 − Fs    + 212,132 f s   = 43,86
  2 *150 = 212,132    212,132 
ESC 43,86
fr = 1 − = 1− = 0,956
Q 1000
EOQ with planned backorders
▪ What happen if now we want to evaluate if it is convenient to order Q
under a certain level of backorders?
▪ So lets consider now:

Inventory

Ce=cost of excess
inventory (h)

Q Q-b
Cs=shortage cost

T2
T1 Time
b b
T
 EOQ with planned backorders
▪ What is my total cost function?
D 1 T  1 T 
TC (Qb) = A   + ce     1   ( Q − b ) + cs     2   ( b )
Q 2 T  2  T 

Now, we have 3 triangles

that can be related as:

Q Q −b b Ce=cost of excess
= = inventory (h)

T T1 T2 Q-b
Q
T1 Q − b T2 b Cs=shortage cost
= = T2
T Q T Q T1 Time
b b
T
Then we can substitute in TC(Qb):

D  ( Q − b )2   b2 
TC (Qb) = A   + ce    + cs  
 
Q  2Q   2Q 
 
EOQ with planned backorders
▪ If we take the derivatives and some math, we will get the following:

2 AD cs + ce cs + ce
Qb* =  = Q*
ce cs cs So what is the
inventory policy?
ceQb *  cs 
b* = = 1 −  Qb *

( cs + ce )  ( cs + ce ) 

Here one important aspect is what we will refer

as the “CRITICAL RATIO” (Observe that you will cs + ce
see this term in the Book of Ballou, and we will Critical Ratio=
use it in the Newsboy Vendor Problem) cs
 Single period model: the Newsvendor Problem
A newsboy is trying to decide, at the beginning of the day, how many
newspapers to buy to satisfy the demand for that day. If he buys too
many newspapers, at the end of the day he will be left with unsold
newspapers, if he buys too few, he will lose potential sales:

Amount
Ordered (Q)
Sales
observed
Demand
Distribution (D)

Newspapers Shortage
leftover (overage)
Single Period Model

Recall that we have defined ce and cs before. The former represents

the excess of products, while the latter the shortage, when you
have too little products.

Assuming a continuous distribution of demand the expected excess

and shortage cost of the Qth unit ordered are defined as ce P  X  Q 
(
and cs 1 − P  X  Q )
If E  ExcessCost   E ShortageCost  then, increase Q. The
optimal value Q* is obtained when E  Excess Cos t  = E  Shortage Cos t 
 Single Period Model

Solving the equation we obtained:

E  Excess Cos t  = E  Shortage Cos t 

= ce  P  x  Q  = cs (1 − P  x  Q )
= ce  P  x  Q  = cs − cs P  x  Q 
= ce  P  x  Q  + cs P  x  Q  = cs
P  x  Q  ( ce + cs ) = cs
cs
P  x  Q =
( ce + cs )
Notice that it is the same critical ratio that we could find in the EOQ with
backorders, and corresponds to the well known “critical ratio”. Note that in the
book of Ballou, the notation is “Cpn=ganancia/(ganancia+perdida)”
 Example
Consider that we are selling t-shirts for the world champion football game.
We have the following information: c = $12.000, the selling price p
=$20.000. Demand is normally distributed with mean of 35.000 and standard
deviation of 15.000. Determine the number of units to order.
Solution:
In this case, we must assume that the cost of excess inventory is the cost of
the t-shirt, that is: c=ce=$12.000. Now, the cost of shortage is the utility
that we are losing, that is: p-c=20.000-12.000=cs=$8.000.
Now, lets compute the Critical Ratio: 8000/(12000+8000)=0,40.

How can we determine Q? Select Q such that P(X≤Q)=0,40.

Q=INV.NORM(0,4; 35000;15000)=31.200 units

Now what happen if the leftlovers can be sold by a salvage value

and there exists in addition a penalization for lost sales?
Salvage and penalization parameters
▪ New Parameters:
s = salvage value
B= penalization for not fulfilling demand (in addition to lost
profit)

Then we have to adjust the critical ratio parameters:

ce = c − s
cs = p − c + B
cs p−c+ B p−c+ B
CriticalRatio = = =
cs + ce p − c + B + c − s p + B − s
 Example
Considering previous example, but now we have s=5.000 and B=3.000.
How much should I order?

Solution:
Lets compute the Critical Ratio:
CR=(20.000-12.000+3.000)/(20.000+3.000-5.000)=0,6111

How can we determine Q? Select Q such that P(X≤Q)=0,611.

Q=INV.NORM(0,4; 35000;15000)=39.233 units
Newsvendor: expected profit
▪ What is the expected profit? I first need to estimate the
demand that I will face. Consider that x represents the demand
that will occur:

 px − cQ if x  Q
Profit ( Q ) = 
 pQ − cQ if x  Q
E  Profit ( Q )  = pE  x  − cQ − pE  Units Short 

In the first term I am multiplying my price per unit times the expected
demand, but we do not necessarily sell all the units, so we have to
substract the exptected units short. The second term is simply the cost of
the units ordered Q.
Newsvendor: expected profit
▪ If we have the penalty B and salvage s parameters then:

 −cQ + px + s (Q − x) if x  Q
Profit ( Q ) = 
−cQ + pQ − B ( x − Q) if x  Q

( )
E  Profit ( Q )  = p ( E  x  − E US ) − cQ + s Q − ( E  x  − E US ) − B ( E US )

= ( p − s ) ( E  x ) − ( c − s ) Q − ( p − x + B ) E US 
In the first term is the expected number of units that i will sell, is the
expected total demand minus the units that i will be short. The first term is
the revenue i get. The second term is just the cost of each ítem i order. The
third term is the salvage value of the Q as the amount that i order minus
the units that i sell. The last term has to do with the penalization that i pay
for the expected units with short.
Newsvendor: expected units short
▪ So the expected demand, units sold and units short is (assuming
the continues case, and the analougous for the discrete one):

▪ Notice that the Expected Units demanded is equal to the expected

units sold plus the expected units short
Expected units short: Unit Normal Loss Function
We consider F(Z) is the probability that a variable from a standard normal
distribution will be les tan or equal to Z, or alternatively, the service level for a
quantity ordered with a z-value of Z. On the other hand, the Unit Normal Loss
Function L(Z) (or standard los function) refers to the expected amount that the
random variable x (demand) exceeds the threshold value Z (that in our case, Z=Q,
which is the amount of units ordered). This is the expected shortage per
replenishment cycle. Remember that for a standard normal distribution, we have:

x− Q−
Z= =Z = = Norminv ( CriticalRatio )
 

The expected units short (lost sales) will be: E US  = L( Z )

Note: L(Z) is also known as G(k), where k=Z.

Expected units short: Unit Normal Loss Function
For example, suppose that we have a mean of 160, standard deviation of 45 units.
We also have defined Q=190. What will be the expected units lost?
Q− 190 − 160
z= = = 0, 67
 45
L ( 0, 67 ) = 0,15028
E US  = 45  0,15028 = 6, 76
 T-Shirts Example
Data:
Case 1: No salvage value, Q=31.200 units ce=12000 Mean: 35000
Case 2: Salvage and penalty, Q=39.233 units cs=8000 Std: 15000
s=5000 B=3000

What is the expected profit and the expected units short?

= ( p − s ) ( E  x ) − ( c − s ) Q − ( p − x + B ) E US 

Hint: Estimate first, the Expected units short for each case and then we
estimate the total profit.

Answer:
Case 1: $238.600.000
Case 2: $176.389.000
 Base-Stock Policy S*
Continuous review policy that assumes that demand is variable, random
and continuous. Lead time is constant and deterministic. Planning horizon
is infinite.

This policy is very simple, and what it simply do is that you place an order
everytime that you face demand. If you have a demand of four units, then
you place an order of four units. However, your order will arrive after a
certain leadtime. So, the question here, is what is your inventory position
(IP), that is what we refer as the Base-Stock or S*?
S*

Inventory on Hand
 Base-Stock Policy S*
How can I define S* ? I want to set it so that I cover the demand during
the leadtime. Hence, I can use the critical ratio to determine what is the
service level (LoS) I want to offer:
cs
LoS = P   DLT  S * = CR =
ce + cs
The Base Stock S* policy is computed as: S * =  DLT + Z LOS  DLT in which
ZLOS is determined as NORMSINV(CR) or in the tables of a standard
normal distribution

S*

Inventory on Hand
 Base-Stock Policy S*
Example
Consider the case in which we have a daily demand that follows a Normal
Distribution with mean 100 and standard deviation 15. Lead time is two
days. Excess cost of inventory is $5 per unit per day and the shortage cost
is $25 per unit per day.

Solution:

 DLT = 100(2) = 200

 DLT = 15 2 = 21, 2
LOS = CR = 25 ( 5 + 25 ) = 0,833
Z LOS = NORMSINV (0,833) = 0,967
S * = 200 + (0,967)(21, 2) = 220,5 = 221 units
Continuous or Periodic Review?

▪ Advantages of Periodic Review

▪ Coordination of replenishments
▪ Able to predict workload
▪ Forces a periodic review
▪ Continuous Review
▪ Replenishments made dynamically
▪ Cost of equipment (scanners etc.)
▪ Able to provide same level of service with less
safety stock