CTL.

SC1x -Supply Chain & Logistics Fundamentals

Single Period Inventory Models:

Allowing for Stockouts

MIT Center for

Transportation & Logistics
 Assumptions: EOQ with Planned Backorders
• Demand • Discounts
n Constant vs Variable n None
n Known vs Random n All Units vs Incremental vs One Time
n Continuous vs Discrete • Excess Demand
• Lead Time n None
n Instantaneous n All orders are backordered
n Constant vs Variable n Lost orders
n Deterministic vs Stochastic n Substitution
n Internally Replenished • Perishability
• Dependence of Items n None
n Independent n Uniform with time
n Correlated n Non-linear with time
n Indentured • Planning Horizon
• Review Time n Single Period
n Continuous vs Periodic n Finite Period
• Number of Locations n Infinite
n One vs Multi vs Multi-Echelon • Number of Items
• Capacity / Resources n One vs Many
n Unlimited • Form of Product
n Limited / Constrained n Single Stage
n Multi-Stage
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 2
 EOQ with Planned Backorders
T*
Inventory On Hand

Q*

Time

What will happen to Q* and T* if we allow

for planned backorders at some cost (cs)?
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 EOQ with Planned Back Orders

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 Notation
D = Average Demand (units/time)
c = Variable (Purchase) Cost ($/unit)
ct = Fixed Ordering Cost ($/order)
h = Carrying or Holding Charge ($/inventory $/time)
ce = c*h = Excess Holding Cost ($/unit/time)
cs = Shortage Cost ($/unit/time)
Q = Replenishment Order Quantity (units/order)
T = Order Cycle Time (time/order)
N = 1/T = Orders per Time (order/time)

TRC(Q) = Total Relevant Cost ($/time)

TC(Q) = Total Cost ($/time)
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 5
 EOQ with Planned Backorders
T From similar triangles:
Inventory On Hand

Q Q−b
= =
(b )
Q-b
T T1 T2
Q T1 T2 (
T1 Q − b ) T2 b
= =
T Q T Q
b
Time
! D$ ! 1 $! T1 $ ! 1 $! T2 $
TRC(Q,b) = ct # & + ce # &# & Q − b + cs # &# & b
"Q% " 2 %" T %
(
" 2 %" T %
) ()
! D$ ! 1 $! (Q − b) $ ! 1 $! b $
TRC(Q,b) = ct # & + ce # &#
"Q% " 2 %" Q %
( )
& Q − b + cs # & # & b
" 2 %" Q %
()
! 2 $
TRC(Q,b) = ct # & + ce #
! D$(# Q−b ) & ! b2 $
"Q% # 2Q && + cs # 2Q &
" %
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models " %
 Planned Backorders - Solution

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 7
 EOQ with Planned Backorders
! 2 $
! D$ # Q−b
TRC(Q,b) = ct # & + ce #
( ) & ! b2 $
"Q% # 2Q && + cs # 2Q &
" %
" %

Q *
=
2ct D (c s
+ ce ) = Q (c
* s
+ ce )
PBO
ce cs cs

*
ceQPBO " cs %
b* = $
= 1− ' Q*
(c + ce ) $ (
cs + ce ) ' PBO
s # &

Inventory Policy Critical Ratio

Order Q*PBO when IOH = - b* cs
CR =
Order Q*PBO every T*PBO time periods (c s
+ ce )
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 EOQ with Planned Backorders
1000%
Critical Ratio
Q*(PBO) as percent of Q* (w/o backorders)

900%
If cs is very small, cs
800%
CR =
then Q*PBO>>Q* (c s
+ ce )
700%

600%

500%

400%
If cs is very big,
300% then Q*PBO=Q*
200%

100%

0%
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
Critical Ratio Cs/(Cs+Ce)

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 Probabilistic Demand:
Single Period Models

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 Assumptions: Single Period Models
• Demand • Discounts
n Constant vs Variable n None
n Known vs Random n All Units vs Incremental vs One Time
n Continuous vs Discrete • Excess Demand
• Lead Time n None
n Instantaneous n All orders are backordered
n Constant vs Variable n Lost orders
n Deterministic vs Stochastic n Substitution
n Internally Replenished • Perishability
• Dependence of Items n None
n Independent n Uniform with time
n Correlated n Non-linear with time
n Indentured • Planning Horizon
• Review Time n Single Period
n Continuous vs Periodic n Finite Period
• Number of Locations n Infinite
n One vs Multi vs Multi-Echelon • Number of Items
• Capacity / Resources n One vs Many
n Unlimited • Form of Product
n Limited / Constrained n Single Stage
n Multi-Stage
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 11
 Example: NFL Replica Jerseys
• Situation:
n In 2002 Reebok had sole rights to sell
replica NFL football jerseys
n Jerseys have unique names & numbers
n Peak sales last about 8 weeks
n Lead time from contract manufacturer is 12-16 weeks

• Main Issue:
n Reebok had to commit to an order in advance while the actual
demand was uncertain

• Question:
n How many Jerseys of each player should they order?
Case adapted from Parsons, J. (2004) “Using A Newsvendor Model for Demand Planning of NFL Replica Jerseys,” MIT
Supply Chain Management Program Thesis.
Image Source: http://commons.wikimedia.org/wiki/File:Tom_Brady_%28cropped%29.jpg
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 12
 Example: NFL Replica Jerseys
• Data:
n Unit cost = c = 10.90 $/jersey
n Unit selling price = p = 24 $/jersey
n Forecast demand = 32,000 jerseys (σ = 11,000)
w History showed demand to be Normally distributed

• Select Q* that maximizes profit where X = actual demand:

(
Profit = p MIN !" x,Q#$ − cQ )
• How do I determine the “best” policy?
1. Data table
2. Marginal analysis

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 13
 Solving Single Period Model:
Data Table

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 Sample spreadsheets in MS Excel and LibreOffice are available in this unit.

Data Table Profit = pMIN (x,Q) − cQ

Potential order sizes (Q)

=$D$4*MIN($B8,E$5)-$F$4*E$5

Probability of demand P[x]

Potential demand (x)

=NORMDIST(B10,$B$2,$B$3,1)
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 15
 =SUMPRODUCT($C$7:$C$48,E7:E48)

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 Expected Profits
Expected Profit
$350.00

$325.00

$300.00

$275.00

$250.00
Expected Total Profit ($k)

$225.00

$200.00

$175.00

$150.00

$125.00

$100.00

$75.00

$50.00

$25.00

$-
0 5 10 15 20 25 30 35 40 45 50
Order Quantity

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 Solving Single Period Model:
Marginal Analysis

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 18
 Marginal Analysis

For single-period problems we have two costs:

ce = Excess cost when D<Q ($/unit) i.e. having too much product
cs = Shortage cost when D>Q ($/unit) i.e. having too little product

Assuming a continuous distribution of demand , we get

ce P[X≤Q] = expected excess cost of the Qth unit ordered
cs (1-P[X≤Q]) = expected shortage cost of the Qth unit ordered

If E[Excess Cost] < E[Shortage Cost] then increase Q

We are at Q* when E[Shortage Cost] = E[Excess Cost]
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 Marginal Analysis
Marginal Shortage and Excess Costs
$14.00

$13.00 (
cs 1− P #$ x ≤ Q%& )
$12.00

$11.00

$10.00
Marginal Cost per Jersey

$9.00

$8.00

$7.00

$6.00

$5.00

$4.00

$3.00
ce P "# x ≤ Q$%
$2.00

$1.00

$-
0 5 10 15 20 25 30 35 40 45 50 55 60
Order Quantity

Excess Cost Shortage Cost

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 20
 Marginal Analysis

(
ce P "# x ≤ Q$% = cs 1− P "# x ≤ Q$% )
ce P "# x ≤ Q$% = cs − cs P "# x ≤ Q$%

ce P "# x ≤ Q$% + cs P "# x ≤ Q$% = cs

(
P "# x ≤ Q$% ce + cs = cs )
cs
P "# x ≤ Q$% =
(c e
+ cs )
The Critical Ratio

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 NFL Jersey Example - solved

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 Example: NFL Replica Jerseys
• Data:
n Total cost = c = 10.90 $/jersey
n Selling price = p = 24 $/jersey
n Forecast demand ~N(32000, 11000)
• Solution:
n cs = p – c = 24 -10.90 = $13.10
n ce= c = $10.90
n CR = (13.10)/( 10.9 + 13.10) =0.546
n Select Q where P[x≤Q] = 0.546
w Normal Table or use spreadsheet:

Case adapted from Parsons, J. (2004) “Using A Newsvendor Model for Demand Planning of NFL Replica Jerseys,” MIT
Supply Chain Management Program Thesis.
Image Source: http://commons.wikimedia.org/wiki/File:Tom_Brady_%28cropped%29.jpg
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 23
 Standard Normal Table

P[x≤Q] = 0.546

Find k= 0.115

Recall k=(Q-μ)/σ

So, Q = μ+kσ
= 32000+(0.115)(11000)

Q = 33,267 units

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 24
 Example: NFL Replica Jerseys
• Data:
n Total cost = c = 10.90 $/jersey
n Selling price = p = 24 $/jersey
n Forecast demand ~N(32000, 11000)
• Solution:
n cs = p – c = 24 -10.90 = $13.10
n ce= c = $10.90
n CR = (13.10)/( 10.9 + 13.10) =0.546
n Select Q where P[x≤Q] = 0.546
w Normal Table or use spreadsheet:
w =NORMINV(CR, Mean, StdDev)
w =NORMINV(0.546, 32000, 11000)
n Q* = 33,267 - the profit maximizing quantity
But what if I can sell the left overs at a discount?
Case adapted from Parsons, J. (2004) “Using A Newsvendor Model for Demand Planning of NFL Replica Jerseys,” MIT
Supply Chain Management Program Thesis.
Image Source: http://commons.wikimedia.org/wiki/File:Tom_Brady_%28cropped%29.jpg
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 25
 Considering Other Costs
• Other costs:
• g = salvage value, $/unit
• B = Penalty for not satisfying demand
(beyond lost profit), $/unit

• The excess and shortage costs change:

• cs = p – c + B
• ce = c - g
• Critical Ratio = cs/(cs+ce)
= (p-c+B)/(p-c+B+c-g)
=(p-c+B)/(p+B-g)

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 Example: NFL Replica Jerseys
• Data:
n Total cost = c = 10.90 $/jersey
n Selling price = p = 24 $/jersey
n Forecast demand ~N(32000, 11000)
n Salvage value = g = 7 $/jersey
• Solution:
n cs = p – c = 24 - 10.90 = $13.10
n ce= c - g = 10.90 – 7.00 = $3.90
n CR = (13.10)/( 3.9 + 13.10) =0.771
n Select Q where P[x≤Q] = 0.771
w Normal Table or use spreadsheet:
w =NORMINV(CR, Mean, StdDev)=NORMINV(.771, 32000, 11000)
n Q* = 40,149- the profit maximizing quantity

But, how do I determine the profitability?

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 27
 Key Points from Lesson

CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models 28
 Key Points
• Newsvendor problems are everywhere
• Fashion items, perishable goods, fleet sizing,
contracting, space missions, etc.
• Whenever you have to make a firm bet in the face of
uncertain demand in a single period
• Classic trade off between:
• Having too much (excess cost ce)
• Having too little (shortage cost cs)
• Critical Ratio captures this trade-off
• CR = Cs / (Cs + Ce)
• CR = Pct of demand distribution to cover
= P[x≤Q]
CTL.SC1x - Supply Chain and Logistics Fundamentals Lesson: Single Period Inventory Models
 CTL.SC1x -Supply Chain & Logistics Fundamentals

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