Customer Demand

• Customer demand varies in both timing and quantity:

Individual Customer Order

Quantity

Time
 Customer Demand

• If demand for a product comes from many, independent

customers, then we don’t need to be concerned about
individual customer orders, but rather cumulative
demand over a period of time.
 Customer Demand

Cumulative Demand for Period

Individual Customer Demand

Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9

Demand
 Customer Demand

• In statistics, when there is reason to suspect the

presence of a large number of small effects acting
additively and independently, it is reasonable to assume
that the observations will be normally distributed.
• Therefore, if demand for a product comes from many,
independent customers, we can assume that the
variability in cumulative demand over a period of time
can be described by the normal distribution.
 EOQ and Reorder Point Systems

• Using the EOQ model, we developed a reorder point

(ROP) inventory management system:

Q
ROP

LT LT

• In the EOQ model, demand is assumed to be constant

 ROP with Variable Demand

• When demand is not constant, the reorder point

calculation should consider demand variability. If the
reorder point is only based on average demand,
stockouts will occur:

Q Q
ROP
Q
DDLT*

LT LT
*(average) Demand During Lead Time
 Safety Stock

• To avoid stockouts, the reorder point should include

additional inventory, safety stock, to reduce the
probability of a stockout.

Q
ROP
DDLT*

Safety Stock

LT LT

*(average) Demand During Lead Time

Safety Stock

Using the standard deviation of

the DDLT, we can set an
a safety stock level based on
the probability of a stockout

σDDLT
Probability of a
Stockout

SS ZSLσ DDLT

DDLT
 Safety Stock

Cumulative
Probability Z
0.50 0.0000
Cumulative
0.55 0.1257
Probability
0.60 0.2533
0.65 0.3853
0.70 0.5244
0.75 0.6745
Z 0.80 0.8416
0.85 1.0364
0.90 1.2816
For a given service level (cumulative probability), 0.95 1.6449
the safety stock is calculated as: 0.98 2.0537
0.99 2.3263
SS  ZSLσDDLT 0.995
0.998
2.5758
2.8782
 Safety Stock Example

• Suppose we have the following

weekly demand (consumption)
data for a product:
Week Demand
If the lead time is one week,
1 98 then we have:
2 92
3 111
4 88
DDLT = 97.5
5 124
6 94 If we want a 95% service level,
7 86 then the safety stock should be:
8 109
9 97
10 76 SS = (1.6449)(13.9) = 22.86
Average Demand 97.5 So the reorder point should be:
Standard Deviation
of Demand
13.9 ROP = 97.5 + 22.86 = 120.36
So a ROP of 120 should be used
 Safety Stock using MAD

• Many times, Safety Stock levels are calculated using the

Mean Absolute Deviation as a measure of variability
rather than the Standard Deviation. There are two
reasons for this:
– Historical: Before calculators, the calculation of a
standard deviation was not a trivial task, while the
calculation of the Mean Absolute Deviation is fairly
simple to perform by hand
– Robustness: The Mean Absolute Deviation measure
is not as easily affected by outlier points as it is using
the absolute value of the deviation rather than the
squared deviation
 MAD Calculation

Week Demand xi  x
975
1 98 0.5 X  97.5
10
2 92 5.5
3 111 13.5 104
4 88 9.5 MAD   10.4
10
5 124 26.5
6 94 3.5
7 86 11.5
8 109 11.5
9 97 0.5
10 76 21.5
975 104
 Standard Deviation Calculation

Week Demand x i  x 2 975

1 98 0.25 X  97.5
10
2 92 30.25
3
4
111
88
182.25
90.25 SD 

 i
X  X 2
5 124 702.25 n 1
6 94 12.25 1744.5
7 86 132.25   13.9
8 109 132.25 9
9 97 0.25
10 76 462.25
975 1744.5
 Safety Stock using MAD

• The standard deviation can be

estimated from the MAD using:
Cumulative
Probability R
SD = 1.25 MAD 0.50 0.0000
• As a result, we can define a 0.55 0.1571
safety factor R which can be 0.60 0.3167
0.65 0.4817
used to determine the safety
0.70 0.6555
stock based on the MAD and
0.75 0.8431
the desired service level: 0.80 1.0520
0.85 1.2955
SS = (R)(MAD) 0.90
0.95
1.6019
2.0561
0.98 2.5672
0.99 2.9079
0.995 3.2198
0.998 3.5977
 Safety Stock Example Revisited

• The following weekly demand

(consumption) data for the
product was: The Demand During Lead Time is:
Week Demand
1 98 DDLT = 97.5
2 92
3 111 For a 95% service level,
4 88
5 124 the safety stock should be:
6 94
7 86
8 109
SS = (2.0561)(10.4) = 21.38
9 97
10 76
So the reorder point should be:
ROP = 97.5 + 21.38 = 118.88
Average Demand 97.5
So a ROP of 119 should be used
MAD 10.4
(vs. 120 calculated using the SD)
 Demand Period vs. Lead Time Period

• In the previous example, the demand period (the period

of time used to accumulate customer demand) was one
week, which was the same as the lead time.
• Suppose the lead time was two weeks. Then the
variability of the demand for a two week period would be
greater than the MAD calculated from demand data
aggregated weekly.
• We have assumed that customer demand is
independent, i.e. that the demand for the product comes
from a number of unrelated customers. In that case,
then we can use a theorem from statistics to determine
the appropriate variability of demand during lead time
when the demand period is different from the lead time
period
 Demand Period vs. Lead Time Period

• Suppose we have two

independent, normally
distributed random variables:
– X: mean X, standard
deviation X
– Y: mean Y, standard σZ
deviation Y σY

• Then the sum of these

variables, Z = X + Y has mean:
– Z = X + Y
and standard deviation σX
– σ Z  σ 2X  σ 2Y
 Demand Period vs. Lead Time Period

• Suppose that the demand period is 1 week (customer

demand is measured on a weekly basis) and the lead
time is two weeks. Then the standard deviation for the
lead time can be calculated as:

σ DP σ DP
DP = 1 week
σ LT LT = 2 weeks

σLT  σDP  σDP  2 σDP

 Demand Period vs. Lead Time Period

• Suppose that the demand period is 2 weeks (customer

demand is accumulated in 2 week intervals) and the lead
time is one week. Then the standard deviation for the
lead time can be calculated as:

σ DP DP = 2 weeks
σ LT σ LT LT = 1 weeks

σ DP  2  σ2
σ LT  2 σ LT
LT
1
σ LT  σ DP
2
 Safety Stock

In general terms, the standard deviation of the demand

for the lead time is:

lead time
σ LT  σ DP
demand period

where the lead time and demand period are measured in

the same time units (typically days). The demand period is
level of aggregation used for determining demand.
 Safety Stock

So the safety stock level can be calculated as:

SS  ZSL W σDemand
using the standard deviation of demand and:

SS  R W MAD
using the MAD, where:

W Lead Time
Demand Period
 DDLT

Note that if the Demand Period does not equal the Lead
Time, then the DDLT is calculated as:

DDLT  W Demand












   
 Safety Stock: Example 1

Demand data for a material has been collected on a weekly

basis for 6 months. Demand appears level, with:

Mean: 270 units/week

Standard deviation: 40 units/week

The lead time is 10 days. Calculate the safety stock

required for a 99% customer service level.
 Safety Stock: Example 1

• The formula for safety stock using the standard deviation

is:
SS  ZSL W σDemand
so for this example we have:

SS  2.3263 10 40
7
111.2 111
 Safety Stock: Example 2

Demand data for product has been collected on a weekly

basis with the following results:

Mean: 109 units/week

MAD: 20 units/week

The lead time is 4 days. Calculate the safety stock

required for a 95% customer service level.
 Safety Stock: Example 2

• The formula for safety stock using the standard deviation

is:
SS  R W MAD
so for this example we have:

SS  2.0561 4 20
7
 31.08  31
Demand Period and Lead Time in SAP

Demand period is set by the Period Indicator on the Forecasting View

of the Material Master

The applicable periods are:

M – Monthly
W – Weekly
T – Daily
Demand Period and Lead Time in SAP

In-house production is used for

Lead Time for products made in-house

Plnd delivery time + GR processing time +

Purchasing proc. time is used for
Lead Time for externally procured materials
 Exposure to Stockout

• Stockouts usually occur when stock gets low—for

example, during the lead time period before a new order
arrives:
Periods of maximum exposure to stockout

LT LT LT
 Exposure to Stockout

• The more frequently we order, the more chances there

are of stocking out.

Twice as many
LT LT LT
opportunities for
stockout

LT LT LT LT LT LT LT
 Exposure to Stockout

• To fully evaluate the customer service level, we should

calculate the customer service level on an annual basis:

 
D
 
SL Annual  SL Order




 

 Q 
 

where D is annual demand and Q is the order quantity.

 Exposure to Stockout

• For example, if we used a service level of 95% in

calculating the safety stock, the annual demand D is
12,000 units and the order quantity Q is 800 units, then
we have:  
D
 

SL Annual  SL Order   


 Q
 
 

 
 12,000 
 
15
 0.95




 800



  0.95





  0.463
   

• So there is only a 46.3% chance of going a year without

a stockout
 Demand Patterns

Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9

Week 1 Week 2
Regular Demand

Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9

Week 1 Week 2
Sparse Demand
 Demand Patterns

• In developing the safety stock calculations, it was

assumed that demand was generated from a “large”
number of independent sources, and
• The individual demands are aggregated over a time
period sufficiently long so that there are a number of
individual demands contributing to each period demand.
• If these conditions are not met, then the safety stock
values may not perform as expected.
 Demand Patterns

• If demand is sparse, then a more detailed approach to

inventory planning that considers the expected time
between orders as well as the expected order quantity

Quantity

Expected
order
quantity

Expected time
Time
between orders