MBPF Ch7 solutions.

Last updated: May 12, 2006 (jvm)

CHAPTER 7: MANAGING FLOW VARIABILITY: SAFETY

INVENTORY

7.3 Solutions to the Problem Set

Problem 7.1
[a] Given quantities: mean weekly demand = 400; standard deviation of weekly demand =
125; replenishment lead time = 1 week and reorder point (ROP) = 500 units. We compute
the average demand during leadtime to be 400 units. Thus the safety stock, Isafety = 100
units; to find the service level provided, we need to find the area under the normal curve
to the left of the reorder point (ROP) = 500. Let the demand during lead time be LTD.
The cycle service level

Prob( LTD  ROP) = Prob( LTD  R + Isafety) = 0.7881.

So the cycle service level is 78.81%.

[b] The standard deviation of lead time demand, LTD = 125 units. For each service level the
z-value can be read from the standard normal table. The safety inventory
Isafety = z x LTD Finally, ROP = 400 + Isafety.

Cycle Service Level 80% 90% 95% 99%

z= 0.842 1.282 1.645 2.326
Isafety = 105 160 205 290
ROP = 505 560 605 690

Problem 7.2
[a] Average weekly demand (R) = 1000
Standard deviation of weekly demand (R) = 150.
Lead time (L) = 4 weeks.
Standard deviation of demand during lead time (LTD ) = L R = 300.
Current reorder point (ROP) = 4,200.
Average demand during lead time (LTD) = L x R= 4,000.
Current level of safety stock (Isafety)= 200.
Current order quantity (Q) = 20,000
Average inventory (I) = Isafety + Q/2 = 200 + (20,000/2) = 10,200.

Average time in store (T) = I/R = 10,200/1,000 = 10.2 weeks.

Annual ordering cost = S x R/Q = $100 x 2.5 = $250.
Annual holding cost = H x I = $0.25 x 10,200 = $2,550.

[b] We use the EOQ formula to determine the optimal order quantity.
H = $1 * 25%/year = $.25/year
R = 1,000 /week = 50,000/year
S = $100.
Thus, the economic order quantity is
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 MBPF Ch7 solutions. Last updated: May 12, 2006 (jvm)

2 RS 2  50,000  100
Q=  = 6,325 units.
H 0.25
To determine the safety inventory, Is, for a 95% level of service, we first observe that the
z-value = 1.65. Then Isafety = z x LTD = 1.65 x 300 = 495.

Average inventory (I) = Isafety + Q/2 = 495 + (6,325/2) = 3,657.5.

Average time in store (T)= I/R = 3.6575 weeks.

[c] If lead time (L) reduces to 1 week, then standard deviation of demand during lead time
(LTD) = 150. Safety stock for 95% level of service = 1.65 x 150 = 247.5.
Average inventory = 247.5 + (6,325/2) = 3,410.
Average time in store = 3.41 weeks.

Problem 7.3
7.3 The Home and Garden (HG) chain of superstores imports decorative planters from Italy. Weekly
demand for planters averages 1,500 with a standard deviation of 800. Each planter costs $10. HG
incurs a holding cost of 25% per year to carry inventory. HG has an opportunity to set up a
superstore in the Phoenix region. Each order shipped from Italy incurs a fixed transportation and
delivery cost of $10,000. Consider 52 weeks in the year.

(a) The optimal order quantity of planters for HG is

(i) About 24,980

(ii) About 3,464
(iii) About 78,994
(iv) None of the above

* 2 RS 2  1500  52  10000
Q    24,980
H 2.5

(b) If the delivery lead time from Italy is 4 weeks and HG wants to provide its customers a cycle
service level of 90%, how much safety stock should it carry?

(i) About 1,025 planters

(ii) About 2,050 planters
(iii) About 4,100 planters
(iv) None of the above

Safety stock = NORMSINV(.9)*sqrt(4)*800 = 2050

(c) Fastship is a new shipping company that promises to reduce the delivery lead time for planters
from 4 to 1 week using a faster ship and expedited customs clearance. Using fast ship will add
$0.2 to the cost of each planter compared to the current approach. Should HG go with Fastship?
Why? Quantify the impact of the change.

Additional transportation cost per year = 1500*52*.2 = $15,600

Savings in holding cost = NORMSINV(.9)*800*(sqrt(4)-sqrt(1))*10*0.25 = $2562.5
 MBPF Ch7 solutions. Last updated: May 12, 2006 (jvm)

Thus Fastship should not be used.

(One could be more precise and compare the total costs under current shipping with that with Fastship. The latter
has slightly higher unit holding cost H, which also will slightly increase the cycle stock, in addition to the
transportation cost. Given that even at the old holding cost, transportation increased cost exceed holding cost
savings, the above answer is sufficient to draw the correct conclusion.)

Problem 7.4

First, is this an EOQ problem? Well, notice that the question dictates that we do a run
every two years. That would mean, in a deterministic EOQ setting, that Q must equal two
years of mean demand, i.e., 32000. Hence, this question does not give us the freedom to
change when we do a run (which is what EOQ is all about).

Thus, the question is whether 32000 is the best quantity we can print every tow years?
This thus asks about what the appropriate safety stock (or service level) should be. We
know that this is answered via newsvendor logic. Answer these two questions:
1. What is my underage cost (cost of not having enough)? I.e., if I were to stock one
more unit, how much could I make? Every catalog fetches sales of $35.00 and
costs $5.00 to produce. Thus, the net marginal benefit of each additional unit
(MB), or the underage cost, is p – c = $35 - $5= $30.
2. What is my overage cost? I.e., if I had stocked one less unit, how much could I have
saved? The net marginal cost of stocking an additional unit (MC) = c – v = $5 – 0 = $5.
Now, we can figure out the optimal service level (or critical fractile): SL = 30/(30+5) =
0.857.

The last step is to convert the SL into a printing quantity. Recall that total average
demand for 2 years (R) = 32,000 with a standard deviation of 5656.86. The optimal
printing quantity, Q* is determined such that
MB 30
Prob(R    Q*) =    0.857 .
 MB  MC  30  5

The optimal order quantity Q* = R + z  where z is read off from the standard Normal
tables such that area to the left of z is 0.857. That is, z = 1.07. This gives Q* = 38,053
catalogs. It can be verified that the optimal expected profit (when using Q* = 38053) is
larger than $25,000, the fixed cost of producing the catalog.

Problem 7.5

The revenue per crate, p = $120.00, variable cost, c = $18.00, and salvage value, v = – $2.00. The
marginal benefit of stocking an additional crate (MB) = p – c = $120 - $18 = $102. The marginal
cost of stocking an additional unit (MC) = c – v = $18 + $2 = $20. Then
MB/(MB+MC) = 102/(102+20) = 0.836.
The probability density of demand and its cumulative probability is listed below.
 MBPF Ch7 solutions. Last updated: May 12, 2006 (jvm)

Demand 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Frequency 0 0 0 1 3 2 5 1 6 7 6 8 5 4 1 3
Prob. 0 0 0 0.02 0.06 0.04 0.1 0.02 0.12 0.13 0.12 0.15 0.1 0.08 0.02 0.06
Cumulative
Prob. 0 0 0 0.02 0.08 0.12 0.21 0.23 0.35 0.48 0.6 0.75 0.85 0.92 0.94 1

The optimal order quantity is the smallest number of crates such that cumulative probability is at
least 0.836. From the table this gives the number of crates to be 12.

Problem 7.6
The residents of Bucktown, Illinois, place their trash at the curb each Wednesday morning to be picked up
by municipal crews. Experience shows that the total amount of trash put out has a normal distribution
with a mean of 35 tons and a standard deviation of 9 tons. Crews of full-time city employees assigned to
trash collection collect trash. Each crew can collect 5 tons of trash per working day. The city has plenty
of trucks of the kind used for trash collection. The marginal cost of operating one trash collection crew
for one working day, including both personnel-related costs and truck-related costs is reckoned at $625.
Whatever trash remains at the end of the work day must be collected that evening by an outside contractor
who charges $650 per ton.

How many crews should the city assign to trash collection? For simplicity, you may treat the
number of crews as a continuous variable. For example, 4.1 crews would be a perfectly acceptable
answer.

One solution approach (starting from the basics):

Note that the marginal cost of scheduling one more ton = $125/ton.
This only has value if demand exceeds current planned schedule, in which case it saves $650. In other
words, the expected marginal revenue is $650 Prob(R>Q).
At optimality, marginal cost equals marginal revenue:
 Prob(R>Q) = 125/650 or SL = 525/650 = 80.77%  z = .87  Q = 35tons + .87*9tons = 42.8 tons
= 8.56 crews.

Another approach to get the critical fractile probability SL uses the newsvendor solution directly:
Here we are stocking up on local trash collection capacity.
Cost of overstocking by 1 ton = MC = 625/5 = $125
Cost of understocking by 1 ton = additional cost of using outside trash pick up = MB = $650-$125 =
$525
Thus: SL = Prob(RQ) = MB /( MB + MC) = 525/(125 + 525) = 0.8077

appropriate # of crews = 8.56 crews

 MBPF Ch7 solutions. Last updated: May 12, 2006 (jvm)

Problem 7.7 (This is an advanced problem)

We are concerned about the overbooking problem; that is, how many seats to overbook. The
randomness in demand arises from uncertain cancellations, which are uniformly distributed
between 0 and 20. One can think of this question as asking “what is the optimal service level of
cancellations?”

If I overbook by 1 additional unit, then

 If there are more cancellations than “stocked”, we are fine: there are sufficient seats for every
passenger who shows up. The net benefit is that we sold one more ticket at $600. (This is the
“underage cost”; i.e., cost of having more cancellations than “stocked.”)
 If there are fewer cancellations than “stocked,” there are insufficient seats for those passengers
that have a ticket and show up. The net cost of this is that we must compensate the “bumped”
customer (who had a reservation but did not get a seat) by $250 (the $600 earned from the
additional ticket is spent on getting another ticket on another flight).

Thus optimal service level is MB/(MB+MC) = 600/(600+250) = 70%. The optimal overbooking
quantity is determined by Prob(RQ) = MB/(MB+MC) = 0.7. For uniform distribution between
0 and 20, Prob(RQ)=Q/20. Thus Q = 20 * 0.7 = 14 seats so that the optimal overbooking level
is 14 seats.

Problem 7.8

[a] To compute the optimal order quantity at each store we use the EOQ formula.
Assume 50 sales weeks/year.
H = $10 * 25%/year = $2.5/year
R = 10,000 /week = 500,000/year
S = $1000. Thus,
2 RS 2  500,000  1000
Q = EOQ =  = 20,000 units.
H 2. 5
The replenishment lead time (L) = 1week.
Standard deviation of demand during lead time at each store () = 2,000.
Safety stock at each store for 95% level of service (Is) = 1.65 x 2,000 = 3,300.
Reorder point (ROP)=  + Is = 10,000 + 3,300 = 13,300.
Average inventory across four stores (Id)
= 4 x (Is + Q/2) = (3,300+(20,000/2)) = 53,200.
Annual order cost for all four stores = 4 x S x R/Q = 4 x 1,000 x25= $100,000.
Annual holding cost for all four stores = H x Id = $133,000.
Average time unit spends in store (T) = Id / 4 x R = 53,200/40,000 = 1.33 weeks.

[b] To compute the optimal order quantity at centralized store observe that this store
faces a cumulative average weekly demand = 4 x 10,000 = 40,000. This gives an annual
demand of 2,000,000 units.
2 RS 2  2,000,000  1000
Q = EOQ =  = 40,000 units.
H 2 .5
 MBPF Ch7 solutions. Last updated: May 12, 2006 (jvm)

Standard deviation of demand during lead time at central store ()

= 4  2000 = 4,000.
Safety stock at central store for 95% level of service = 1.65 x 4,000 = 6,600.
Reorder point (ROP) = 40,000 + 6,600 = 46,600.
Average inventory in central store (Ic) = (6,600+(40,000/2)) = 26,600.
Annual order cost for central store = S x R/Q = $1,000 x 50 = $50,000.
Annual holding cost for central store = H x Ic = $66,500.
Average time unit spends in store (T) = Ic / 4 x R = 26,600/40,000 = 0.67 weeks.

Problem 7.9

Hi-Tek is a retailer of computer equipment in the Chicagoland region with four retail outlets.
Currently each outlet manages its ordering independently. Demand at each retail outlet averages 4,000
units per week. Each unit costs $200 and Hi-Tek has a holding cost of 20%. The fixed cost of each order
(administrative + transportation) is $900. Assume 50 weeks in a year.

(a) Given that each outlet orders independently and gets its own delivery, the optimal order size
at each outlet is

(i) 424
(ii) 3,000 = sqrt(2RS/H) = sqrt(2*4000*50*900/(.20*200))
(iii) 6,000
(iv) 42,426
(v) None of the above

(b) On average, how long (in weeks) does each unit spend in the Hi-Tek system before being
sold?

T = I / R = (Q/2) / R = 1,500 / 4000 weeks = 3/8 weeks = .375 weeks

(c) Hi-Tek is thinking of centralizing purchasing (for all four outlets). In this setting, Hi-Tek will
place a single order (for all outlets) with the supplier. The supplier will deliver the order on a
common truck to a transit point. Since individual requirements are identical across outlets, the
total order is split equally and shipped to the retailers from this transit point. This entire
operation has increased the fixed cost of placing an order to $1,800. If Hi-Tek manages
ordering optimally in the new setting, average inventory in the Hi-Tek system (across all four
outlets) can be expected to

(i) Increase
(ii) Decrease
(iii) Remain unchanged