Review of Inventory Models

Recitation, Feb. 4
Guillaume Roels
15.762J Supply Chain Planning

Why hold inventories?

Economies of Scale
Uncertainties
Demand
Lead-Time: time between order and delivery
Supply

Transportation
Smoothing (Seasonality)
Speculation

Inventory Costs
Holding Cost
Cost of Capital, Warehouse, Taxes and Insurance,
Obsolescence

Order Cost
Fixed and variable

Penalty Cost
Lost sale vs. Backorder

Consider only costs that are relevant to the

ordering decision

Outline
Newsboy
1-period
Random demand
(Stochastic)
Shortages allowed
Variable costs only
No Lead Time

EOQ
Multiple periods
Known demand
(Deterministic)
Constant Demand
No Shortages
Fixed and variable
order costs
No Lead Time

Newsboy Example
Every week, the owner of a newsstand purchases
a number of copies of The Computer Journal.
Weekly demand for the Journal is normally
distributed with mean 10 and standard deviation
5.
He pays 25 cents for each copy and sells each for
75 cents.
How many copies would you recommend him to
order?
Example from Nahmias, Production and
Operations Analysis

Other applications
Short product life cycles / Long lead times
Computers
Apparel

Fresh products
Fresh food, newspapers

Services
Airline industry

Newsboy Model: Notations

Random Demand: D
Ordering decision: Q
Unit Selling Price: p
Unit Purchase Cost: c

Objective: Find Q that maximizes

Expected Profit, E[]

Review of Optimization
Max f(x)
First-Order Conditions
f(x*)=0
Second-Order Conditions
f(x*) 0

Max E[] = p E[min{D,Q}] c Q

First-Order Conditions
(E[])
= p E[(min{D,Q})] c
= p P(D Q)-c = 0
since min{D,Q}=
D when D Q
(min(Q,D))=0
Q when Q D
(min(Q,D))=1
Second Order Conditions
One can check that (E[])= p (P(D Q)) 0

Order Q* such that P(DQ *) = c/p

Distribution Function
Suppose that demand has cdf F(x), i.e.,
F(x)=P(Dx)
Therefore,
P(DQ*)=c/p 1-P(DQ*)=c/p
1-F(Q*)=c/p
F(Q*)=(p-c)/p
Ratio (p-c)/p is a probability (btw 0 and 1)
and is called the critical fractile

Generalization
cU: Underage Cost (when D Q)

In the example, opportunity cost, p-c

Loss of goodwill

cO: Overage Cost (when D Q)

In the example, c
Salvage value

Min cU E[max{D-Q, 0}] + cO E[max{Q-D, 0}]

Solving for Q,
F(Q*)=cU/(cU+ cO)

F(Q)

How to find Q*:

Graphical Representation

cU/(cU+cO)

Q*

How to find Q*:

Analytical Derivation
Uniform Demand between [A,B]
F(x)=(x-A)/(B-A)
A

Solve (Q*-A)/(B-A)=cU/(cU+ cO), i.e.

Q*=A+ (B-A) cU/(cU+ cO)

How to find Q*:

Excel
Normal Demand
Q*=NORMINV(, , cU/(cU+ cO))
F(Q*)=cU/(cU+ cO) Q*=F-1(cU/(cU+ cO))
Alternatively, use standardized normal
Q*= + (z*)
where z*=NORMSINV(cU/(cU+ cO))

How to find Q*:

Tables
Example:
cU=p-c=.75-.25= $.50
cO=c= $.25
Critical Fractile = cU/(cU+ cO) = 0.67
Standardized Normal Table z*=0.43
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

0.8

0.7881

0.7910

0.7939

0.7967

0.7995

0.8023

0.8051

0.8078

0.8106

0.8133

Q*= + (z*) =10+(0.43) 5 = 12.15

Service Levels
Shortage Penalty
P(D Q*) = 1 - F(Q*) = cO/(cU+ cO)
Example: 0.333
Fill Rate
E[min{D,Q*}]/E[D]
Example: 89% (from tables or simulation)

Extensions
Initial Inventory I
Order Q* - I if I Q*, 0 otherwise
Q* is called the Base Stock and represents the
target inventory level

Discrete demand
Order quantity: Round Up Q*

Multiple periods
Fixed cost
Many applications in Supply Contracts

Outline
Newsboy
1-period
Random demand
(Stochastic)
Shortages allowed
Variable costs only
No Lead Time

EOQ
Multiple periods
Known demand
(Deterministic)
Constant Demand
No Shortages
Fixed and variable
order costs
No Lead Time

EOQ Example
Number 2 pencils at the campus bookstore are
sold at a fairly steady rate of 60 per week.
The pencils cost the bookstore 2 cents each and
sell for 15 cents each.
It costs $3 to initiate an order, and holding costs
are based on an annual interest rate of 25
percent.
Determine the optimal number of pencils for the
bookstore to purchase and the time between
placement of orders.
Example from Nahmias, Production and
Operations Analysis

Intuition
Trade-Off:
Spread the fixed ordering cost over many
items
Avoid high inventory costs

Replenishment from
An outside vendor
Internal production

Application
Steady Demand / Large Fixed Cost
Industries
Manufacturing: Automobile, Electrical
Appliances, Chemical Products (Lot Sizes)
Retail: Slow-moving items (pencils, bathroom
tissue)

EOQ Notations

EOQ = Economic Order Quantity

Constant Demand Rate:
Fixed order cost: K
Variable order cost: c
Inventory holding cost: h
Interest rate: i
Order quantity: Q
Time between orders: T

Evolution of Inventory
Inventory position
Q

Order when inventory position reaches zero

Order the same amount each time

time

Cost components (1)

Inventory holding cost
h = i * c (cost of capital)

Over a replenishment cycle:

Start from Q
Ends at 0
Decreases steadily
Average inventory = Q/2
Average inventory cost = h Q/2

Cost components (2)

Per replenishment cycle:
Fixed cost: K
Variable cost: c Q

Length of a cycle:
Order size: Q units
Demand rate: units/year
Time between orders T = Q/

Average order cost = 1/T (K + cQ)

= K /Q + c

Min h Q/2 + K /Q + c

First Order Conditions:

h/2 - K /Q2 = 0
Second Order Conditions:
2 K /Q3 0

Hence, order Q*=

2 K
h

Optimization
Optimal Cost:
Inventory Cost: h Q*/2 =
Fixed Order Cost: K/Q*=
Total Cost=c + 2 2 Kh

2 K h
2 K h

Graphical View
14
12
inventory

fixed cost

total cost

4
2

24
00

22
00

20
00

18
00

16
00

14
00

12
00

0
10
00

cost

10

Example
= 60 units/week = 3,120 units/year
K= $3, c =$0.02,
h=i c=(.25) (.02) = $0.005/(unit)/(year)
Q*=

2 K
(2)(3)(3,120)
=
= 1935 units
0.005
h

T=Q/=1,935/3,120=0.62 years =32 weeks

Work in the same units!

Observations
Very robust
Can round up or down with loosing much

Independent of selling price

Dependent of purchase cost only through
holding cost.

Extensions
Lead-time L
same ordering quantity
Order L periods in advance, when stock
reaches L/.

Finite production rates

Quantity discounts
Supply Chain Application:
Determine the lot sizes of all stages in the
supply chain (global view).

Summary
Newsboy
1-period
Random demand
(Stochastic)

EOQ

No Lead Time

Multiple periods
Known demand
(Deterministic)
Constant Demand
No Shortages
Fixed and variable
order costs
No Lead Time

cU
F (Q*) =
cU + cO

2 K
Q* =
h

Shortages allowed
Variable costs only

Newsboy Example (1)

The buyer for Needless Markup, a famous high end
department store, must decide on the quantity of a highpriced womens handbag to procure in Italy for the
following Christmas season.
The unit cost of the handbag to the store is $28.50 and the
handbag will sell for $150.00. Any handbags not sold by
the end of the season are purchased by a discount firm
for $20.00. In addition, the store accountants estimate
that there is a cost of $.40 for each dollar tied up in
inventory, as this dollar invested elsewhere could have
yielded a gross profit. Assume that this cost is attached
to unsold bags only.
Example from Nahmias, Production and
Operations Analysis

Newsboy Example (2)

Suppose that the sales of the bags are equally likely to be
anywhere from 50 to 250 handbags during this season.
Based on this, how many bags should the buyer
purchase?

cU = (150.00-28.50) = $121.50 (lost margin)

cO= (28.50 (1.4) -20.00) = $19.90 (purchase cost +
inventory holding cost salvage value)

Critical Fractile = cU/(cU+ cO) =.859

Demand is Uniform between 50 and 250
Q*= 50 +(250-50) *(.859) =222 units

EOQ Example (1)

The Rahway, New Jersey, plant of Metalcase, a
manufacturer of office furniture, produce metal desks at
a rate of 200 per month. Each desk requires 40 Phillips
head metal screws purchased from a supplier in North
Carolina.
The screws cost 3 cents each. Fixed delivery charges and
costs of receiving and storing shipments of the screws
amount to about $100 per shipment, independent of the
size of the shipment. The firm uses a 25 percent interest
rate to determine holding costs.
Metalcase would like to establish a standing order with the
supplier and is considering several alternatives. What
standing order size should they use?
Example from Nahmias, Production and
Operations Analysis

EOQ Example (2)

= (200)(40)(12)=96,000 units/year
K=$100, h=(.25)(0.03)=.0075

2 K
(2)(100)(96,000)
=
= 50,597
Q* =
.0075
h
Cycle time T = Q/ = .53 year