MGT 4401

Supply Chain Modeling

Spring 2020
Tim Martin, P.E.

Inventory Management
What is Inventory Management?

The set of policies and controls that monitor

levels of inventory. These policies
determine what levels should be maintained,
when stock should be replenished, and what
quantities should be purchased.
Why is Inventory Management Important?

• Inventory is a necessary evil.

• Too little causes stock outs, expedite costs, overtime, customer
dissatisfaction
• Too much causes cash shortage, excessive holding costs, lost opportunity
costs
• Gives a firm a buffer against demand, production and supply chain
variability
• Allows for economies of scale when purchasing
• Goal: Have the right products, at the right place, at the time, in the
right quantity
General Motors (GM)

• GM’s Production & Distribution Network

• 20,000 material supplier plants
• 133 parts plants
• 31 assembly plants
• 11,000 dealers
• Freight Transportation Costs: $4.1b
• Inventory Value: $7.4b ($2.2b is FGI)
How Much Inventory is the Right Amount?
Inventory Management Requirement

• Inventory Management starts with a ???

• Forecast!
• Accurate Demand Forecast is critical for making inventory related
decisions
• What to order?
• When to order?
• How much is the optimal order quantity?
• These together will make up the firm’s inventory management
policy
Inventory Management Supply Chain Factors

• Forecast of customer demand

• Replenishment lead time
• Number of different products
• Length of the planning horizon
• Costs
• Order Cost (transportation cost)
• Material Cost
• Holding Cost (taxes, insurance, utilities, rent, obsolescence)
• Opportunity Cost
• Service level
• Lead time patience
Single Facility Inventory Control

• Variety of Techniques
• Economic Lot Size Model
• Demand Uncertainty
• Single Period Model
• Initial Inventory
• Multiple Order Opportunities
• Continuous Review Model (fixed-order quantity)
• Variable Lead Times
• Periodic Review Model (fixed-time period)
• Service Level Optimization
Single Period Models

• Short Lifecycle Products

• One ordering opportunity
• Order quantity to be decided before demand occurs
• Risks
• If Order Quantity > Demand = Excess inventory
• If Order Quantity < Demand = Lost sales
Single Period Models

• Forecasting Demand
• Use historical data to identify a variety of demand scenarios
• Determine the probability each of these scenarios will occur
• Inventory Ordering Policy
• Determine the potential profit associated with a particular scenario
• Order the quantity that maximizes the expected profit
Single Period Model Example - Swimsuits
Fixed Production Cost: $100,000
Variable Production Cost/Unit: $80
Sales Price/Unit: $125
Salvage Value: $20

Scenario 1
Firm produces 10,000 units
Demand is 12,000 units
Probability of Demand is 27%
Probabilistic Forecast
Average Demand = 13,120
Scenario 2
Firm produces 10,000 units
Demand is 8,000 units
Probability of Demand is 11%
 Single Period Model Example - Swimsuits Fixed Production Cost: $100,000
Variable Production Cost/Unit: $80
Sales Price/Unit: $125
Salvage Value: $20

Scenario 1 Scenario 2
Firm produces 10,000 units Firm produces 10,000 units
Demand is 12,000 units Demand is 8,000 units
Underproduced by 2,000 units Overproduced by 2,000 units

Profit = Revenue – Variable Production Cost – Fixed Production Cost

Profit Profit
=$125(10,000) – $80(10,000) – $100,000 = $125(8,000) + $20(2,000) – $80(10,000) – $100,000
= $350,000 = $140,000

Probability Probability
Probability of Demand = 12,000: 27% Probability of Demand = 8,000: 11%
Probability of $350,000 Profit = 27% Probability of $140,000 Profit = 11%
Single Period Model Example - Swimsuits

Order Quantity that Maximizes Expected Profit

Average Profit as a Function of Production Quantity

Optimal Quantity and Average Demand Relationship

• Should optimal quantity always be less than average demand?

• Compare marginal profit of selling an additional unit and marginal
cost of not selling an additional unit
• Marginal Profit/Unit = Selling Price – Variable Cost
• Marginal Cost/Unit = Variable Cost – Salvage Value

• If Marginal Profit > Marginal Cost:

• Optimal Quantity > Average Demand
• If Marginal Profit < Marginal Cost:
• Optimal Quantity < Average Demand
Single Period Model Example - Swimsuits

• Average Demand = 13,120 units

• Optimal Production Quantity = 12,000 units

• Marginal Profit: $125 - $80 = $45

• Marginal Cost: $80 - $20 = $60

• Marginal Profit < Marginal Cost:

• Optimal Order Quantity < Average Demand
Risk/Reward Tradeoffs- Swimsuits

• Optimal production quantity maximizes average profit at 12,000

• Producing 9,000 units or producing 16,000 units will lead to the
same average profit (~$295,000)
• If we had to choose between producing 9,000 or 16,000 units,
which should we choose?
Risk/Reward Tradeoffs- Swimsuits

• Production Quantity = 9,000 units

• Profit is:
• Either $200,000 with probability of about 11%
• Or $305,000 with probability of about 89%
• Production Quantity = 16,000 units
• Distribution of profit is not symmetrical
• Losses of $220,000 about 11% of the time
• Profits of at least $410,000 about 50% of the time
• With the same average profit, increasing the production quantity:
• Increases the possible RISK
• Increases the possible REWARD
Economic Lot Size Model (Economic Order Quantity)

• Seeks to minimize the total cost of inventory to the firm

• Occurs when holding cost = ordering cost
• Assumptions:
• Constant demand rate
• Constant lead time
• Order quantities are fixed
• Order cost is fixed
• Holding cost is fixed

Q = Order Quantity
R = Reorder Point
L = Lead Time
 Deriving Economic Order Quantity
Finding Optimal Quantity (Q) to Order (Economic Order Quantity):
• Total Cost is a concave curve with respect to Quantity
• How can we determine the minimum point of this function?

Total Cost is at a minimum

when slope is zero

D = Annual Demand
S = Ordering Cost
H = Holding Cost
Multiple Order Opportunities

• Reasons:
• To balance annual inventory holding costs and annual fixed order costs
• To satisfy demand occurring during a lead time
• To protect against uncertainty in demand
• Two Policies:
• Continuous Review Model (Fixed Order Quantity)
• Inventory is reviewed continuously
• An order is placed when the inventory reaches a particular level or reorder point
• Periodic Review Model (Fixed Time Period)
• Inventory is reviewed at periodic intervals
• Appropriate quantity is ordered after each review
Continuous Review Model

• Daily demand is random

• Inventory is held, so the firm will incur holding costs
• Inventory level is continuously reviewed (usually by ERP system)
• Once inventory level reaches a certain threshold (reorder point),
the system triggers an action that a new order should be placed
• The new order will arrive after a certain lead time
• If a customer arrives when there is no inventory, the order is lost
• The firm must determine what service level they want to achieve in
fulfilling customer orders
 Variables Needed:
Continuous Review Model TC = Total Annual Cost
Formula Summary: C = Cost per Unit
D Q Q = Order Quantity
Total Cost = TC = (D x C) + xS+ xH R = Reorder Point
Q 2 L = Lead Time
D Q D = Annual Demand
Ordering Cost = xS Holding Cost = xH S = Ordering Cost
Q 2 H = Annual Holding Cost
d = Daily Demand
Reorder Point = Lead Time Std Dev σ𝑑 𝐿 SS = Safety Stock
Z = Probability
Safety Stock = z x σL σ𝐿 = Lead Time Std Dev
σ𝑑 = Demand Std Dev
Reorder Point with SS = (d x L) + (z x σ𝑑 𝐿 )

Optimal Order Quantity =

Continuous Review Model

• Service Level
• What % does your firm want to ensure they always have product in stock?
• 100% service level = 100% of the time a customer places an order you
have the product in stock, or can delivery the product on time
• Z Score
• Once service level is chosen by firm, the Z score can be found in a table

Service 90% 91% 92% 93% 94% 95% 96% 97% 98% 99% 99.9%
Level

z 1.29 1.34 1.41 1.48 1.56 1.65 1.75 1.88 2.05 2.33 3.08
 Continuous Review Model
Inventory level as a function of time
What happens if demand goes down after order is placed?
Excess Inventory

Excess Inventory =

Q Holding Costs

L L
Inventory at Time
Place Order of Receipt
Receive Order
 Continuous Review Model
Inventory level as a function of time
What happens if demand goes up after order is placed?

No Inventory =
Stock Out
Point
Q Sales/Profit

Unfilled
L L Demand

Place Order
Receive Order
Receive Order
Continuous Review Model Example

• A distributor of TV’s that orders from a manufacturer and sells to

retailers
• Order Cost = $4,500
• Cost per TV Unit = $250
• Annual Inventory Holding Cost = 18% of Product Cost
• Lead Time from Manufacturer = 2 weeks (14 days)
• Expected Service Level = 97%
Continuous Review Model Example

• First Step:
• Look at historical demand
Month Sept Oct Nov. Dec. Jan. Feb. Mar. Apr. May June July Aug

Sales 200 152 100 221 287 176 151 198 246 309 98 156

• Annual Demand = 2,294

• Average Monthly Demand = 191.17
• Standard Deviation of Monthly Demand = 66.53

• Average Weekly Demand = 44.58 (191.17 / 4.3)

• Standard Deviation of Weekly Demand = 15.5

• Average Daily Demand = 6.37 (44.58 / 7)

• Standard Deviation of Daily Demand = 2.2
Continuous Review Model Example

• Second Step:
• Find the variables
Order Cost = S = $4,500
Holding Cost = H = 0.18 x $250 = $45 per TV per year
Lead Time = L = 14 days
Annual Demand = D = 2,294
Daily Demand = d = 6.3
Z Score = 1.88 for 97%
Std Dev of Daily Demand = 2.22
Continuous Review Model Example

• What should the order quantity be?

2𝐷𝑆 2 2,294 4,500

𝑄𝑜𝑝𝑡 𝑄𝑜𝑝𝑡 = 677 TV’s
𝐻 45

• How many times per year should orders be placed?

D 2,294
= # of Orders = 3.4 orders/yr
Q 677
Continuous Review Model Example

• When should the order be placed? (Reorder Point)

d = 6.3 TV’s per day
z = 1.88
R = (d x L) + (z x σ𝑑 𝐿 ) R = (6.3 x 14) + (1.88 x 2.2 14) = 103.6 TV’s
When the inventory level decreases and reaches 104, order 677 more TV’s

• What is the Safety Stock level?

SS = z x σL z x σ𝑑 𝐿 1.88 x 2.2 14 = 15.5 TV’s
Periodic Review Model

• Inventory level is reviewed at regular time intervals

• An appropriate quantity is ordered after each review
• Two Cases:
• Short Intervals (Daily)
• Define two inventory levels s and S
• During each inventory review, if the inventory position falls below s, order enough to
raise the inventory position to S
• Longer Intervals (Weekly or Monthly)
• Most likely will always need to order after a review
• Determine a target inventory level (base-stock level)
• During each review period, the inventory position is reviewed
• Order enough to raise the inventory position to the base-stock level
Periodic Review Model – Short Interval Policy

• Calculate the Quantity and Reorder point as if this were a

continuous review model
• Set s = R
• Set S equal to R + Q
Periodic Review Model – Long Interval Policy

• Determine a target inventory level (the base-stock level)

• Each review period, review the inventory position and order
enough to raise the inventory position to the base-stock level
Periodic Review Model – Long Interval Policy
• Forecasted Demand: 10 tv’s with a standard deviation of 3 tv’s
• Review Period is every 30 days (T)
• Lead Time: 14 days
• Service Level: 98%
• At Review Period, 150 tv’s are counted in inventory (I)
Q1. How many should you order?
Std Deviation of Time: Quantity:

Q = d(T + L) + zσT+L - I
σ𝑇 𝐿 𝑇 𝐿 σ
Q = 10(30 + 14) + 2.05(19.9) - 150
σ𝑇 𝐿 30 14 32 Q = 331 tv’s

σ𝑇 19.90 Order 331 tv’s to ensure 98% probability of

𝐿
not having a stock out during the next 30 days
Service Level Optimization

• Optimal inventory policy assumes a specific service level target

• High Service Level = Higher Safety Factors in Ordering Policies
• Low Service Level = Lower Safety Factors in Ordering Policies
• What is the appropriate level of service?
• Determined by a combination of the customer and your competitor
• You must satisfy customer requirements to earn their business
• You must stay ahead of your competition as to not lose business
Service Level Optimization

• In general, the higher the service level, the higher the inventory
level
• The longer the lead time from your suppliers, the lower the level of
service you will be able to provide
• Why?
• Service level can vary across different products within the same
firm
• Why?
• High volume, high profit products = high service level
Economy of Scale Discounts

• What happens when cost per unit varies with the order size?
• When quantity discounts are offered, the total cost curve for each cost
variation is different
• But we must weigh the decrease in cost per unit with the increase in holding
costs
Economy of Scale Discounts
Annual Demand: 5,000 units Compare to Discount Options:
Order Cost: $48
Holding Cost: $2 per unit 1. Find range where Qopt falls, and calculate TC for Qopt
Cost per Unit: 2. Calculate TC for all less expensive options using discount Q
0 – 399 units = $10.00
400 – 599 units = $9.00 1: Q = 490, C = $9.00
600+ units = $8.00
5,000 490
TC = (5,000 x 9) + x 48 + x 2 = $45,980
490 2
Find Optimal Order Qty:
2: Q = 600, C = $8.00
2𝐷𝑆
𝑄𝑜𝑝𝑡 5,000 600
x 2 = $41,000
𝐻 TC = (5,000 x 8) + x 48 +
600 2

2 5000 48
𝑄𝑜𝑝𝑡 = 490 “Typically”, cost breaks will outweigh holding costs
2
Does not factor in potential for obsolescence
Next Class:
Inventory Simulation