Inventory Management Policies
Inventory Management Policies:
Introduction
• Two decision dimensions:
◦ When shall we order?
 Periodic ordering policy „T“
e.g.: every first day of the month
 Continuous ordering policy „R“
e.g.: order as soon as the reorder-point R
has been reached
◦ How much shall we order?
 Constant order quantity„Q“
e.g.: Ermittlung mittels EOQ-Formel
 Variable order quantity „S“
Fill up to the desired/maximum load S.
The actual order quantity then equals:
𝑆 − 𝐼𝑡 with 𝐼𝑡 the current inventory
(period 𝑡).
2
 Inventory Management Policies:
Introduction

CONTINUOUS INVENTORY MONITORING PERIODIC INVENTORY MONITORING

Order Quantity
= ordering point R = periodic ordering T

(R,Q)-policy (T,Q)-policy
Fix order quantity
Q e.g.: Fuel: fill up 30 litres as soon as the e.g.: only in case of constant demand (drugs)
inventory has reached a critical value. e.g.: Fuel: 30 litres every 4 days.

(R,S)-policy
Variable order (T,S)-policy
quantity e.g.: Fuel: fill up to the maximum load as
e.g.: Fuel: fill up to the maximum load every 4
S soon as the inventory has reached a critical
days.
value.

+ low expenditures
Advantages + low risk of shortages + combination of ordering with other items
possible (lowers fix costs per item)

Disadvantages - Complex and costly - Higher risk of shortages

3
Periodic Multi-Period Inventory Management
The (T,S)-Policy or the „Order-up-to Model“
CT-14
Single Period vs. Multi Period Model
Single Period Model (Newsvendor)
Decisions (= order quantity 𝑄) influence
the inventory level and cost of the
current period only.
Surplus inventory at the end of the period
cannot be used in further periods.
Stock-outs cannot be fulfilled later/in
future periods.
Lead time = 1:
Multi-Period Model (T,S)-Policy
Decisions (= Order-up-to level 𝑆 and thereby
order quantity 𝑆 – 𝐼𝑡 ) influences the inventory
level and costs for the current and for future
periods.
Surplus at the end of the period can be used in
future periods.
Stock-outs can be fulfilled in future periods in
case backorders are allowed (not always).
5
Multi-Period Inventory Management
Model Assumptions
1. The firm is active during multiple periods.
2. Orders are placed at the beginning of each period, where T is called the review
interval, as the time (e.g. in weeks or days) between two successive orders.
3. The Distribution 𝐹(𝐷) of demand 𝐷 is known. Its mean value equals 𝜇 and its
standard deviation is 𝜎. (We mainly assume Poisson or Normal distributions, but any
distribution can be used.)
4. Variable costs per ordered item = 𝑐
5. Fix ordering costs are negligible 𝐾 = 0
6. Surplus inventory can be used to satisfy demand of future periods.
7. Inventory holding costs equal ℎ per item per period. Inventory holding costs have
to be considered for every item which is in stock at the end of the period.
8. Backorders are allowed. Stock-out costs (penalties) 𝑝 have to be paid per missing
item per period.
9. Orders are delivered using a lead time 𝐿𝑇 (e.g. weeks or days).
10. There are no restrictions concerning the order quantity.
11. Decision: Find the target inventory 𝑆, minimize the expected costs.

6
Target inventory policy 𝑺
• Under our model assumptions, the target inventory policy is optimal. This policy
assumes, that we order the difference of the current inventory level 𝐼𝑡 (plus
outstanding orders) and the target inventory 𝑆 at the beginning of each period 𝑡.

• Notation: 𝑐 Ordering costs [€/unit]

𝑟 Selling price [€/unit]
ℎ Inventory holding costs [€/unit/period]
𝑝 Penalty costs [€/item/period]
𝑡 Time period, e.g. a week or a day.
𝐼𝑡 Inventory level at the beginning of period 𝑡
𝑆 Target inventory level
𝑋𝑡 Order quantity at the beginning of period 𝑡
𝑍(𝑆) Expected costs per period in relation to 𝑆
Π(𝑆) Expected profit per period in relation to 𝑆
𝐿𝑇 Lead time in periods between ordering and receiving units.
𝐷𝑡 Demand in period 𝑡.
T Review period length.
7
Target inventory policy 𝑺
Simple Example, 𝑆 = 40, 𝐿𝑇 = 0

Inventory level at the beginning of period 𝑡:

𝑡 1 2 3 4 𝐼𝑡 = 𝑆 − 𝐷𝑡−1
𝐼𝑡 0 10 -10 20
𝑋𝑡 40 30 50 20
Order quantity in period 𝑡 = Demand in 𝑡 − 1:
𝐷𝑡 30 50 20
𝑋𝑡 = 𝐷𝑡−1 ⇒ 𝑋𝑡 = 𝑆 − 𝐼𝑡

𝐼𝑡
Given ℎ = 1 and 𝑝 = 3, the total 50

costs are: 40

• Inventory holding costs: 30

0 + 10 + 0 + 20 ∙ 1 = 30 20

• Stockout costs: 10
10 ∙ 3 = 30
• Total costs: 30 + 30 = 60 0
1 2 3 4
-10

8
Target inventory policy 𝑺
Simple Example, 𝑆 = 50, 𝐿𝑇 = 0

Inventory level at the beginning of period 𝑡:

𝑡 1 2 3 4 𝐼𝑡 = 𝑆 − 𝐷𝑡−1
𝐼𝑡 0 20 0 30
𝑋𝑡 50 30 50 20
Order quantity in period 𝑡 = Demand in 𝑡 − 1:
𝐷𝑡 30 50 20
𝑋𝑡 = 𝐷𝑡−1 ⇒ 𝑋𝑡 = 𝑆 − 𝐼𝑡

𝐼𝑡
Given ℎ = 1 and 𝑝 = 3, the total 50

costs are: 40

• Inventory holding costs: 30

0 + 20 + 0 + 30 ∙ 1 = 50 20

• No Stockout costs 10
• Total costs: 50 + 0 = 50
0
1 2 3 4
-10

9
Order up-to model implementation

• Each period’s order quantity = S – Inventory position

Inventory position = on-order inv. + on-hand inv. - backorders
◦ Suppose S = 4.
 If a period begins with an inventory position = -3, how many units will
be ordered?
 If demand was 10 in period 1, then how many units are ordered at
the start of period 2?

• A period’s order quantity = the previous period’s demand:

◦ The order up-to model is a pull system because inventory is
ordered in response to demand.
◦ The order up-to model is sometimes referred to as a 1-for-1
ordering policy.
Target inventory policy 𝑺
Determining the cost and profit functions

• The costs function consists of the following elements:

◦ Expected inventory holding costs at the end of the period 𝑡
◦ Expected stock-out costs in period 𝑡
◦ Expected variable ordering costs in period 𝑡

• What are the costs of having ordered one unit too much in the
given period?  holding costs ℎ
• What are the costs of having ordered one unit too little in the
given period?  penalty costs 𝑝

• Again, we are facing a „too little – too much“ situation!

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Target inventory policy 𝑺
Determining the cost and profit functions, 𝑳𝑻 = 𝟎

Given 𝐷~𝑁(𝜇, 𝜎) Periodic Model Newsvendor Model

𝑝 𝐶𝑢
Critical Ratio 𝐶𝑅 = 𝐶𝑅 =
𝑝+ℎ 𝐶𝑢 + 𝐶𝑜
Optimal Order-
up-to level and 𝑆∗ = 𝜇 + 𝑧 ∙ 𝜎 𝑄∗ = 𝜇 + 𝑧 ∙ 𝜎
Optimal Order with 𝑧 = 𝐹𝑁−10,1 (𝐶𝑅) with 𝑧 = 𝐹𝑁−10,1 (𝐶𝑅)
Quantity

12
Target inventory policy 𝑺
Determining the cost and profit functions, 𝑳𝑻 = 𝟎

General Periodic Model Newsvendor Model

Expected backorder (lost
= 𝜎 ∙ 𝐿(𝑧) = 𝜎 ∙ 𝐿(𝑧)
sales)
Expected sales = 𝜇 − 𝜎 ∙ 𝐿(𝑧) = 𝜇 − 𝜎 ∙ 𝐿(𝑧)
Exp. on-hand (leftover) inv. = 𝑆 − Expected Sales = 𝑄 − Expected Sales
Expected on-order
= 𝜇 ∙ 𝐿𝑇 none
inventory

In-Stock Probability = 𝐹(𝑧) = 𝐹(𝑧)

Stock-out Probability = 1 − 𝐹(𝑧) = 1 − 𝐹(𝑧)

Expected Backorders Expected Lost Sales

Expected Fill Rate = 1− =1−
𝜇 𝜇

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Target inventory policy 𝑺
How to deal with 𝑳𝑻 > 𝟎

• In case leadtime 𝐿𝑇 is greater than 0, we order at the beginning of

each period the difference between the disposable (dt.
disponible) inventory level and the target inventory level 𝑆.

• Notation
𝑡 Time period
𝐿𝑇 Lead time in periods between ordering and receiving units.
𝐼𝑡 Physical inventory level at the beginning of period 𝑡
𝑂𝑡 Outstanding (on-order) inventory level at beginning of period 𝑡
Disposable inventory level at the beginning of period 𝑡 (before
𝐼𝑃𝑡
ordering in period 𝑡) = 𝐼𝑡 + 𝑂𝑡
𝑆 Target inventory level
𝑋𝑡 Order quantity at the beginning of period 𝑡 ⇒ 𝑋𝑡 = 𝑆 − 𝐼𝑃𝑡
𝐷𝑡 Demand in period 𝑡.

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 Target inventory policy 𝑺
How to deal with 𝑳𝑻 > 𝟎, simple example, 𝑺 = 𝟏𝟓, 𝑳𝑻 = 𝟐

𝑡 1 2 3 4 5 6 7 Inventory level at the beginning of period 𝑡:

𝐼𝑡 15 10 7 5 5 0 -1 𝐼𝑡 = 𝐼𝑡−1 − 𝐷𝑡−1 + 𝑋𝑡−𝐿𝑇−1
𝑂𝑡 0 5 8 5 7 13
𝐼𝑃𝑡 15 10 12 13 10 7 12 Order quantity in period 𝑡 = Demand in 𝑡 − 1:
𝑋𝑡 0 5 3 2 5 8 3 𝑋𝑡 = 𝑆 − 𝐼𝑃𝑡
Delivered 0 0 0 5 3 2 5
𝐷𝑡 5 3 2 5 8 3 3 Outstanding Inventory in period 𝑡:
𝑡−1
𝑂𝑡 = ෍ 𝑋𝜏
𝜏=𝑡−𝐿𝑇

Given ℎ = 1 and 𝑝 = 3, the total 15

14
13
costs are: 12
11
10
9
8
• Inventory holding costs: 7
6
5
15 + 10 + 7 + 5 + 5 + 0 + 0 ∙ 1 4
3
2
= 42 1
0
• Stockout costs = 1 ∙ 3 = 3 -1
-2
-3
1 2 3 4 5 6 7

• Total costs: 45 -4
-5

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Target inventory policy 𝑺 with 𝑳𝑻 > 𝟎
Determining the cost and profit functions

• The demand distribution changes:

◦ We need to consider the demand distribution of the whole lead time
LT plus the review period length T: 𝐷𝐿𝑇+𝑇 ~𝑁(𝜇𝐿𝑇+𝑇 , 𝜎𝐿𝑇+𝑇 )
◦ Recall the sum of (independent!) normally distributed random
variables 𝑋~𝑁(𝜇𝑋 , 𝜎𝑋 ) and 𝑌~𝑁 𝜇𝑌 , 𝜎𝑌 , then
𝑋 + 𝑌 = 𝑍~𝑁 𝜇𝑋 + 𝜇𝑌 , 𝜎𝑋2 + 𝜎𝑌2

◦ E.g. 𝐷~𝑁(𝜇 = 200, 𝜎 = 50) for 1 week and 𝐿𝑇 = 1, 𝑇 = 1 leads to:

 𝜇𝐿𝑇+𝑇 = 200 + 200 = 400
 𝜎𝐿𝑇+𝑇 = 502 + 502 = 2 ∙ 50 = 70.71

◦ So, generally: 𝐷𝐿𝑇+𝑇 ~𝑁(400, 70.71)

 𝜇𝐿𝑇+𝑇 = (𝐿𝑇 + 𝑇) ∙ 𝜇
 𝜎𝐿𝑇+𝑇 = 𝐿𝑇 + 𝑇 ∙ 𝜎

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Target inventory policy 𝑺
Determining the cost and profit functions

Given 𝐷~𝑁(𝜇, 𝜎) Periodic Model Newsvendor Model

𝑝 𝐶𝑢
Critical Ratio 𝐶𝑅 = 𝐶𝑅 =
𝑝+ℎ 𝐶𝑢 + 𝐶𝑜
Optimal Order-
up-to level and 𝑆 ∗ = 𝜇𝐿𝑇+𝑇 + 𝑧 ∙ 𝜎𝐿𝑇+𝑇 𝑄∗ = 𝜇 + 𝑧 ∙ 𝜎
Optimal Order with 𝑧 = 𝐹𝑁−10,1 (𝐶𝑅) with 𝑧 = 𝐹𝑁−10,1 (𝐶𝑅)
Quantity

19
Target inventory policy S,
Performance Measures
For any target inventory policy („order-up-to level“) S, we can evaluate the
following performance measures:
• Expected backorders (EB): Expected number of back orders at the end of
each period.
• Safety inventory (SI): Inventory which is carried to absorb higher than
expected demand.
• Expected „leftover“ inventory (ELI): Expected inventory level at the end of
the review period.
• Expected ordering quantity (EQ)
• Expected average inventory (EAvI): Expected average inventory during the
review period.
• Expected costs (EC): Costs during one review period.
• Expected fill rate (EFR, 𝜷): The fraction of demand that is satisfied directly
from stock.
• In-stock probability or cycle service level (CSL, 𝜶): Probability all demand
during the review period is directly delivered (from stock).

20
Target inventory policy S,
Performance Measures
For any target inventory policy („order-up-to level“) 𝑆, we can
evaluate the following performance measures:
• Expected backorders (EB): 𝐸𝐵 = 𝐿 𝑧 ∙ 𝜎𝐿𝑇+𝑇
• Safety inventory (SI): 𝑆𝐼 = 𝑧 ∙ 𝜎𝐿𝑇+𝑇
• Expected „leftover“ inventory (ELI): 𝐸𝐿𝐼 = 𝑆 − 𝜇𝐿𝑇+𝑇 + 𝐸𝐵 =
𝑆𝐼 + 𝐸𝐵
• Expected ordering quantity (EQ): 𝐸𝑄 = 𝜇 𝑇
• Expected average inventory (EAvI): 𝐸𝐴𝑣𝐼 = 𝐸𝑄/2 + 𝑆𝐼
• Expected costs (EC1): 𝐸𝐶1 = ℎ ∙ 𝐸𝐴𝑣𝐼 + 𝑝 ∙ 𝐸𝐵
• Expected costs (EC2, CT): 𝐸𝐶2 = ℎ ∙ 𝐸𝐿𝐼 + 𝑝 ∙ 𝐸𝐵
𝐸𝐵
• Expected fill rate (𝛽): 𝛽 = 1 −
𝜇𝑇
• In-stock probability or cycle service level (𝛼): 𝛼 = 𝐹(𝑧)

21
Target inventory policy S,
Example for 𝑳𝑻 = 𝟑, 𝑻 = 𝟏
• 𝜇 = 200, 𝜎 = 50, 𝑐 = 4.50, 𝑟 = 7.00, 𝑝 = 1.00, ℎ = 0.05, 𝑇 = 1
• 𝜇𝐿𝑇+𝑇 = 800, 𝜎𝐿𝑇+𝑇 = 3 + 1 ∙ 50 = 100
𝑝 1.00
• 𝐶𝑅 = 𝑝+ℎ = 1.00+0.05 = 0.9524 ⇒ 𝑧 = 1.67 !
• 𝑆 ∗ = 𝜇𝐿𝑇+𝑇 + 𝑧 ∙ 𝜎𝐿𝑇+𝑇 = 800 + 1.67 ∙ 100 = 967
• Expected backorders (EB): 𝐸𝐵 = 𝐿 𝑧 ∙ 𝜎𝐿𝑇+𝑇 = 0.0197 ∙ 100 = 1.97 ≅ 2
• Safety inventory (SI): 𝑆𝐼 = 𝑧 ∙ 𝜎𝐿𝑇+𝑇 = 1.67 ∙ 100 = 167
• Expected „leftover“ inventory (ELI): Should be plus+

𝐸𝐿𝐼 = 𝑆 − 𝜇𝐿𝑇+𝑇 − 𝐸𝐵 = 𝑆𝐼 − EB = 167 − 2 = 165 167+2= 169

• Expected ordering quantity (EQ): 𝐸𝑄 = 𝜇 𝑇 = 200
𝐸𝑄 200
• Expected average inventory (EAvI): 𝐸𝐴𝑣𝐼 = 2
+ 𝑆𝐼 = 2
+ 167 = 267
• Expected costs (EC1): 𝐸𝐶1 = ℎ ∙ 𝐸𝐴𝑣𝐼 + 𝑝 ∙ 𝐸𝐵 = 0.05 ∙ 267 + 1.00 ∙ 2 = 15.35
• Expected costs (EC2, CT): 𝐸𝐶2 = ℎ ∙ 𝐸𝐿𝐼 + 𝑝 ∙ 𝐸𝐵 = 0.05 ∙ 165 + 1.00 ∙ 2 = 10.25
EB 2
• Expected fill rate (EFR): EFR = 1 − 𝜇 = 1 − 200 = 0.99
𝑇
• In-stock probability or cycle service level (CSL): 𝐶𝑆𝐿 = 𝐹 𝑧 = 0.9524

22
Target in-stock probability 𝜶
𝜶-Servicelevel
• As with the newsvendor model, we could aim to reach a minimum in-
stock probability instead of maximizing cost.
• Remember, that 𝐼𝑡 = 𝑆 − 𝐷𝐿𝑇+𝑇
• Then, we choose lowest 𝑆 ∗ , so that
𝑃 𝐼𝑡 ≥ 0 = 𝑃 𝑆 − 𝐷𝐿𝑇+𝑇 ≥ 0 = 𝑃 𝐷𝐿𝑇+𝑇 ≤ 𝑆 = 𝐹𝐿𝑇+𝑇 𝑆 = 𝛼
• Choose lowest 𝑺∗ and lowest 𝒛 so that the desired level in-stock
probability is reached.

• E.g. assume 𝐷𝐿𝑇+𝑇 ~𝑁 400, 70.71 and 𝛼 = 0.999

◦ 𝑧 = 𝐹𝑁−10,1 0.999 ⇒ 𝑧 = 3.08
◦ 𝑆 ∗ = 𝜇 + 𝑧 ∙ 𝜎 = 400 + 3.08 ∙ 70.71 = 617.79 ≅ 618

23
Target fill-rate 𝜷
𝜷-Servicelevel
𝜎𝐿𝑇+𝑇 ∙𝐿(𝑧)
• Recall the fill-rate equals = 1 − .
𝜇𝑇
𝜎𝐿𝑇+𝑇 ∙𝐿(𝑧)
• Then, we choose lowest 𝑆 ∗ , so that 1 − ≥ 𝛽.
𝜇𝑇
• If demand is normally distributed, 𝐿(𝑧) can be found within the
corresponding Loss Function Table:
𝜎𝐿𝑇+𝑇 ∙ 𝐿(𝑧) 𝜇𝑇
≤ 1 − 𝛽 ⇒ 𝐿(𝑧) ≤ (1 − 𝛽) ∙
𝜇𝑇 𝜎𝐿𝑇+𝑇
• Choose the lowest 𝒛 and correspondingly lowest 𝑺∗ , so that the above
inequality still holds.
• E.g. assume (𝐿𝑇 = 1, 𝑇 = 1) 𝐷𝑡 ~𝑁 200, 50 and
𝐷𝐿𝑇+𝑇 ~𝑁 400, 70.71 and 𝛽 = 0.98:
200
𝐿 𝑧 ≤ 1 − 0.98 ∙ ⇒ 𝐿 𝑧 ≤ 0.05657 ⇒ 𝑧 = 1.20
70.71
𝑆 ∗ = 𝜇𝐿𝑇+𝑇 + 𝑧 ∙ 𝜎𝐿𝑇+𝑇 = 400 + 1.20 ∙ 70.71 = 484.852 ≅ 485

24
Period length 𝑻 and lead time 𝑳𝑻

• Assume 𝐿𝑇 = 8 weeks. Then the period length 𝑇 could be either

{1, 2, 4, 8} weeks. Assume fixed ordering costs 𝐾 = 0. Does this make a
difference in our setting?
• 𝑇 = 1 , 𝐿𝑇 = 8 weeks
LT
P1 P2 P3 P4 P5 P6 P7 P8

• 𝑇 = 2, 𝐿𝑇 = 8 weeks
LT
P1 P2 P3 P4

• 𝑇 = 4, 𝐿𝑇 = 8 weeks
LT
P1 P2

• 𝑇 = 8, 𝐿𝑇 = 8 weeks LT
P1
25
Period length 𝑻 and lead time 𝑳𝑻
• Assume 𝐿𝑇 = 8 weeks. Then the period length 𝑇 could be either {1, 2, 4, 8} weeks. Assume fixed
ordering costs 𝐾 = 0. Does this make a difference in our setting? Yes!
◦ Again, demand for one week ~𝑁(200,50), ℎ = 0.05, 𝑝 = 1.00
T [weeks] 1.00 2.00 4.00 8.00
LT [weeks] 8.00 8.00 8.00 8.00
mu_week 200.00 200.00 200.00 200.00
sigma_week 50.00 50.00 50.00 50.00
mu_(T+LT) 1 800.00 2 000.00 2 400.00 3 200.00
sigma_(T+LT) 150.00 158.11 173.21 200.00
CSL 0.9990 0.9990 0.9990 0.9990
z 3.0902 3.0902 3.0902 3.0902
L(z) 0.0003 0.0003 0.0003 0.0003
S 2 263.53 2 488.61 2 935.24 3 818.05
EQ 200.00 400.00 800.00 1 600.00
SI 463.53 488.61 535.24 618.05
EAvI 563.53 688.61 935.24 1 418.05
EB 0.04 0.04 0.05 0.06
ELI 463.58 488.65 535.29 618.10
EC1 28.22 68.90 187.10 567.27
EC2 23.22 48.91 107.11 247.30
EC1 - 52 weeks 1 467.35 1 791.52 2 432.26 3 687.28
EC2 - 52 weeks 1 207.46 1 271.63 1 392.38 1 607.42

26
Period length 𝑻 and lead time 𝑳𝑻
• Assume 𝐿𝑇 = 8 weeks. Then the period length 𝑇 could be either {1, 2, 4, 8} weeks. Assume fixed
ordering costs 𝐾 = 0. Does this make a difference in our setting? Yes!

What if fixed ordering costs of 𝐾 = 20 apply? 

EC1 - 52 weeks 1 467.35 1 791.52 2 432.26 3 687.28

EC2 - 52 weeks 1 207.46 1 271.63 1 392.38 1 607.42
Orders per year 52.00 26.00 13.00 6.50
Total ordering costs 1 040.00 520.00 260.00 130.00
Total expected costs 1 2 507.35 2 311.52 2 692.26 3 817.28
Total expected costs 2 2 247.46 1 791.63 1 652.38 1 737.42

27