IE6404 - Chapter 6

Stochastic Inventory Models

Single Period Stochastic Model

(News-boy Model)
 The problem relates to seasonal goods
 A typical example is a newsboy who buys news
papers from a news paper distributing truck at
the beginning of the day
 He tries to sell the news paper during the day,
but he doesn’t know the exact quantity
 At the end of the day, the news papers do not
have any value
Objective: determine the optimum order quantity
(number of news papers bought at the beginning
of the day)
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 Single Period Stochastic Model
(News-boy Model)
 Amount purchased > amount demanded
 he pays a penalty to dispose of them
(overage cost)
 Amount purchased < amount demanded
 he looses profit
(shortage cost)
 The solution is economic marginal
analysis; overage and shortage costs are
balanced.
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Notation
 D = demand during the period – a random
variable with probability density function of f(D)
 F(D) = cumulative probability function of D, i.e.,
the probability that demand  D
 cs = shortage cost per unit short at the end of the
period (the lost profit).
 co = overage cost per unit of overage, at the
end of the period
(the unit cost + additional cost to dispose of the
overage – any revenue “salvage”)

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 Optimal Order Quantity, Q*
“The optimum value of Q occurs where overage
and shortage costs are equal”

F(Q*)co = [1 – F(Q*)]cs
Probability of Probability of
being overage being shortage

Where,
Q = the decision variable
F(Q)co = expected overage cost
[1 – F(Q)]cs = expected shortage cost
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Optimal Order Quantity, Q*

the cost ratio in this equation is also called the “critical ratio”

Critical ratio = probability of satisfying demand during the period

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Example – A
 Company has made a table of the demand for a certain
seasonal product and its probability; it is obvious that
demand never below 22 units or above 36 units.

Demand, D 22 24 26 28 30 32 34 36
Probability, f(D) 0.05 0.10 0.15 0.20 0.20 0.15 0.10 0.05

•Unit production cost = $30 /unit

•Holding cost of products not sold
at the end of the season = $10 /unit
•Unit selling price = $70 /unit

Example Solution
co (overage cost) = $30 + $10 = $40
cs (shortage cost) = $70 – $30 = $40 (lost profit)

Critical ratio:

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 Example Solution
Demand, D 22 24 26 28 30 32 34 36
Probability, f(D) 0.05 0.10 0.15 0.20 0.20 0.15 0.10 0.05
F(D) 0.05 0.15 0.30 0.50 0.70 0.85 0.95 1.00

F(Q*) = 0.5  Q* = 28 units

Example – B
Senior class students plan to sell T-shirts to raise
money for regional conference. Demand for the
T-shirts is assumed to be equally likely for any
number between 48 and 72. Each T-shirt costs
$3.50 and will be sold for $5.00. If not enough
shirts are purchased, the only cost will be the
lost profit. Because these shirts will have the
conference logo, it is felt that shirts not sold
before the conference can only be sold for
$2.50. Due to high set-up cost, only one order
can be made.
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Example Solution
f(D) is uniformly distributed;

a = 48, b = 72

co = $3.50 – $2.50 = $1.00 (unit cost – salvage)

cs = $5.00 – $3.50 = $1.50 (lost profit)

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Example Solution
Critical ratio:

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Example Solution

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Inventory Policies
 Continuous Review Systems
 (R,r) policy
 (Q,r) policy

 Periodic Review Systems

 (R,r,T)policy
 (R,T) policy

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Continuous Review Systems
 If inventory level can be monitored
continuously, and if an order can be
placed at any desirable instant, this
system may be used

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(R,r) policy
WHEN I(t)  r
ORDER Qt = R – I(t)
On-hand
Inventory
inventory
R
Available
Q1 Q2 Q3 inventory

r
Lead time
demand
Time
t t t
lead time lead time lead time
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 (Q,r) policy
WHEN I(t)  r
ORDER Qt = Q*
On-hand
Inventory
inventory

Available
Q* inventory
Q* Q*
r

Time
t t t
lead time lead time lead time
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Inventory Management Under

Demand Uncertainty

: expected value of lead-time demand

•Demand during lead time may exceed this

expected value
•Hold more inventory than this expected value

•This extra inventory is called as Safety Stock

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Lead-time Demand
 Both demand and lead-time are non-
deterministic
 To simplify derivations, we assume that
lead-time is deterministic
 Demand is a continuous random variable
with probability density function f(D) and
cumulative distribution function F(D)

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Lead-time Demand Distribution

Parameters
: expected value of demand distribution
: standard deviation of the demand distribution
: lead time

= : expected value of lead-time demand

= : variance of lead-time demand

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 Lead-time Demand Example – A
Annual demand is normally distributed with;

= 800 units, and = 25 units

Lead time (t) = 5 days; 250 working days /year.

= t = 800 (5 / 250) = 16 units

= t = (25)2 (5 / 250) = 12.5

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Safety Stock and Service Levels

SS = safety stock
Service level () can be selected as a management policy
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Service level policises
Policy 1: Service level is set to the preferred
probability of not running out of stock during a
lead time (in any one inventory cycle), denoted
by =F(z).  can also be viewed as the
proportion of cycles in which no shortage occurs.
Policy 2: Service level is set to the preferred
proportion of annual demand (in units) that is
filled from stock, often called “fill rate” and
denoted by b.

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Reorder point with Policy 1

Step 1. From table A-1, find the value of z
that corresponds to
F(z) = 

Step 2. Determine r (reorder point) using the value of z.

SS = : safety stock
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 25

Example
 Annual demand is normally distributed with;

= 800 units, and = 25 units

 Lead time (t) = 5 days; 250 working days /year.

 If the company wants to make service level equal to 95%,

what must the safety stock be carried in each order cycle?

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Example Solution
= 800 (5 / 250) = 16 units

SS = ?

SS = r= + SS = 16 + ?

 = F(z) = 0.95 From table  z = 1.65

SS = 1.65 (3.54) = 6 units

r = 16 + 6 = 22 units
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Expected amount short druing lead time

L(z) is for s=1, so the expected amount
short during a lead time is as follows:

The expected annual number of units short:

or

Therefore;

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Reorder point with Policy 2
Step 1, From table A-2, find the value z
that corresponds to L(z) for a given fill rate, b and Q

Step 2. Determine r (reorder point)

using the value of z.

SS = : safety stock
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Example for comparing Policy 1 and Policy 2
For given:

Evaulate the saftey stock,SS according to both policies

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Solution
For policy 1:

For policy 2:

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Implied shortage cost
We pay a shortage penalty implied by the service
level selected
It is economical to hold an additional unit in safety
stock as long as its holding cost is no greater than the
expected shortage cost for one additional unit.

Rearranging terms:

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Implied shortage cost-example

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