Inventory Management OPMG 406

Probabilistic Models and Safety Stock

Zakaria Yahia, PhD

Associate Professor – Industrial Engineering and Systems Management
School of Business Administration
Nile University
Course Outline and Plan
Week No. Date Lecture
1 23-Feb Opening the Course and Registration
2 02-Mar Course Overview
3 09-Mar Introduction to Inventory Management (Basic Concepts) & ABC Analysis
4 16-Mar One-Item Inventory Models: Economic Order Quantity
5 23-Mar One-Item Inventory Models: Production Order Quantity & Discount Models
6 30-Mar Stochastic Models
7 06-Apr Revision & Inventory Simulation
8 13-Apr Mid-term Exam
9 20-Apr Spring Break
10 27-Apr Presentations
11 04-May Labor Day and Eid El-Fitr Holiday
12 11-May Material Cost/Pricing Policies (Material from Inventory)
13 18-May Independent-and-dependent demands, MRP and ERP
14 25-May Material Handling & Kanban System/Just-In-Time (JIT)
15 01-Jun Field trip/Guest Speaker/ABC INVENTORY SOFTWARE
16 08-Jun Project Discussion
17 15-Jun Final Term Exams
Course contents and Weekly plan may be changed or rearranged, stay tuned to Moodle for updates.
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Managing Inventory: Three basic questions

1. How often the inventory status should be

determined ?
2. When a replenishment order should be
placed ?
3. How large the replenishment order should
be ?

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Basic EOQ Model: Inventory Level Over Time
Total order received
Average
Order Usage rate inventory
quantity = Q
Inventory level

on hand
(maximum
Q
inventory
level) 2

Minimum
inventory 0
Time

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Production Order Quantity Model
• Used when inventory builds up over a period of time after an order is
placed
• Used when units are produced and sold simultaneously

Part of inventory cycle during which

Inventory level

production (and usage) is taking place

Demand part of cycle with
no production (only usage)
Maximum
inventory

t Time

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Quantity Discount Models
• Reduced prices are often available when larger quantities are
purchased
• Trade-off is between reduced product cost and increased holding cost
A Quantity Discount Schedule
DISCOUNT
DISCOUNT (%) PRICE (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75

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Reorder Points for Deterministic Cases
• EOQ answers the “how much” question
• The reorder point (ROP) tells “when” to order
• Lead time (L) is the time between placing and receiving an order

Demand Lead time for a new

ROP = per day order in days

=dxL
D
d=
Number of working days in a year

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Probabilistic Models and Safety Stock
• Used when demand is not constant or certain
• Use Safety Stock to achieve a desired service level and avoid
stockouts

ROP = d x L + ss

Annual stockout costs = the sum of the units short x the

probability x the stockout cost/unit
x the number of orders per year

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Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

NUMBER OF UNITS PROBABILITY

(Expected Demand) (Probability of Demand Level Occurrence)
30 .2
40 .2
ROP  50 .3
60 .2
70 .1
1.0

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Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

SAFETY ADDITIONAL TOTAL

STOCK HOLDING COST STOCKOUT COST COST

20 (20)($5) = $100 $0 $100

10 (10)($5) = $ 50 (10)(.1)($40)(6) = $240 $290

0 $ 0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960 $960

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
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Probabilistic Demand

Minimum demand during lead time

Inventory level
Maximum demand during lead time

Mean demand during lead time

ROP = 350 + safety stock of 16.5 = 366.5

ROP 
Normal distribution probability of
demand during lead time
Expected demand during lead time (350 kits)

Safety stock 16.5 units

0 Place Lead Receive

order
time
order
Time

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Probabilistic Demand

Use prescribed service levels to set safety

stock when the cost of stockouts cannot be
determined

ROP = demand during lead time + ZσdLT

where Z = Number of standard deviations

σdLT = Standard deviation of demand during lead time

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Probabilistic Demand

Probability of Risk of a stockout

no stockout (5% of area of
95% of the time normal curve)

Mean ROP = ? kits Quantity

demand
350
Safety
stock
0 z
Number of
standard deviations
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Probabilistic Example
µ =Average demand = 350 kits
σdLT = Standard deviation of demand during lead time = 10 kits
Z @5% stockout policy (service level = 95%)

Using Appendix I, for an area under the curve of 95% >>> the Z = 1.65
95% >>> (0.5 + 0.45) >>> the Z = 1.65 90% >>> the Z = 1.28
Excel formula >>> NORMSINV(.95)
Safety stock = ZσdLT = 1.65(10) = 16.5 kits

Reorder point = Expected demand during lead time + Safety stock

= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits

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NORMAL CURVE AREAS!

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Other Probabilistic Models
• When data on demand during lead time is not available, there are
other models available
I. When demand is variable and lead time is constant

II. When lead time is variable and demand is constant

III. When both demand and lead time are variable

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Other Probabilistic Models
I. Demand is variable and lead time is constant

ROP = (Average daily demand x Lead time in days) + Z σdLT

where σdLT = σd Lead time

σd = standard deviation of demand per day

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Probabilistic Example
Average daily demand (normally distributed) = 15
Lead time in days (constant) = 2
Standard deviation of daily demand = 5
Service level = 90% Z for 90% = 1.28
From Appendix I

ROP = (15 units x 2 days) + ZσdLT

= 30 + 1.28(5)( 2)
= 30 + 9.02 = 39.02 ≈ 39

Safety stock is about 9 computers

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Other Probabilistic Models
II. Lead time is variable and demand is constant

ROP = (Daily demand x Average lead time in days) +Z x (Daily demand) x σLT

where σLT = Standard deviation of lead time in days

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Probabilistic Example
Daily demand (constant) = 10
Average lead time = 6 days
Standard deviation of lead time = σLT = 1
Service level = 98%, so Z (from Appendix I) = 2.055

ROP = (10 units x 6 days) + 2.055(10 units)(1)

= 60 + 20.55 = 80.55

Reorder point is about 81 cameras

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NORMAL CURVE AREAS!

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Other Probabilistic Models
III. Both demand and lead time are variable

ROP = (Average daily demand x Average lead time) + ZσdLT

where σd = Standard deviation of demand per day

σLT = Standard deviation of lead time in days
σdLT = (Average lead time x σd2)
+ (Average daily demand)2σ2LT

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Probabilistic Example
Average daily demand (normally distributed) = 150
Standard deviation = σd = 16
Average lead time 5 days (normally distributed)
Standard deviation = σLT = 1 day
Service level = 95%, so Z = 1.65 (from Appendix I)

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  Probabilistic Models:
 Demand is variable and lead time is constant

Summary:  Lead time is variable and demand is constant

Discussion  Both demand and lead time are variable

&Questions!

Inventory Management