Class 3 Notes

Mean and Range Charts
When standard deviation is not known, must estimate using R.

Now, we check if variation between samples (i.e., the average) is
stable with a Mean (xbar) chart:
Calculate the average for each sample:

Then, determine the average range:

Finally, determine control limits (LCL, UCL):
th
th
data points in sample
# of data points in sample
i
i
x
i
=
1 2
# of samples
x x
x
+ +
=
R A x
R A x
2
2
LCL
UCL
=
+ =
( ) R A z
x 2
~ o
(x-bar-bar)
Example: Mean chart using o
Step 1: Calculate sample means
10 . 12
4
08 . 12 11 . 12 10 . 12 11 . 12
1
=
+ + +
= x
12 . 12
4
11 . 12 10 . 12 11 . 12 15 . 12
2
=
+ + +
= x
11 . 12
4
15 . 12 11 . 12 09 . 12 09 . 12
3
=
+ + +
= x
10 . 12
4
10 . 12 08 . 12 10 . 12 12 . 12
4
=
+ + +
= x
12 . 12
4
12 . 12 13 . 12 14 . 12 09 . 12
5
=
+ + +
= x
Example: Mean chart using R
Step 2: Calculate the overall mean:

Step 2: Choose the appropriate factor:

Step 3: Calculate the control limits:

12.10 12.12 12.11 12.10 12.12
12.11
5
x
+ + + +
= =
( ) 144 . 12 046 . 0 73 . 0 11 . 12 UCL
2
= + = + = R A x
( ) 076 . 12 046 . 0 73 . 0 11 . 12 LCL
2
= = = R A x
2
4 0.73 n A = =
12.144
12.11
12.076
x
LCL
x
UCL
x

Variation between samples is in control.
Establishing Mean and Range charts (initial method):
1) Obtain a large (typically 20-25) sample
2) Determine control limits for Mean and Range charts
3) Check if data is inside limits on both
Inside limits on Range chart, then variation within samples is stable
Inside limits on Mean chart, then variation between samples is stable
4) If not, investigate process, correct and return to (1),
otherwise assume process is stable and use control charts.

Using Mean and Range charts:
Periodically,
Collect
Sample Data
Plot Sample
Data on R-
Chart
Is Data
Inside Limits?
Investigate
Source of
Variation
No
Plot Sample
Data on Mean
Chart
Is Data
Inside Limits?
Investigate
Source of
Variation
No
Within
Samples
Between
Samples
Yes
Yes
Example: Mean and Range Chart
The quality inspector has taken samples over the last 5 weeks.
Using the control charts found previously, determine if the
process needs to be investigated.

Week
Obs. 6 7 8 9 10
1 12.10 12.11 12.13 12.15 12.18
2 12.14 12.08 12.07 12.11 12.16
3 12.13 12.09 12.12 12.09 12.15
4 12.07 12.12 12.10 12.04 12.12
Step 1: Calculate sample ranges
Min value in week 6: 12.07
Max value in week 6: 12.14
`
)
6
12.14 12.07 0.07 R = =
`
)
7
12.12 12.08 0.04 R = =
`
)
8
12.13 12.07 0.06 R = =
`
)
9
12.15 12.04 0.11 R = =
`
)
10
12.18 12.12 0.06 R = =
0.105
0 LCL
R
UCL
R

Step 2: Plot on Range chart
0.046
R
6 7 8 9 10
Variation within
sample is out of
control
STOP! Investigate source of variation.
A review of the data in week 9 revealed that the final entry was, in
fact, a typo. It should have be 12.14, not 12.04. Is the process
in control.

Week
Obs. 6 7 8 9 10
1 12.10 12.11 12.13 12.15 12.18
2 12.14 12.08 12.07 12.11 12.16
3 12.13 12.09 12.12 12.10 12.15
4 12.07 12.12 12.10 12.14 12.12
Step 1: Calculate sample ranges
`
)
6
12.14 12.07 0.07 R = =
`
)
7
12.12 12.08 0.04 R = =
`
)
8
12.13 12.07 0.06 R = =
`
)
9
12.15 12.10 0.05 R = =
`
)
10
12.18 12.12 0.06 R = =
0.105
0 LCL
R
UCL
R

Step 2: Plot on Range chart
0.046
R
6 7 8 9 10
Variation within samples is stable.
Step 3: Calculate sample means
6
12.10 12.14 12.13 12.07
12.110
4
x
+ + +
= =
7
12.11 12.08 12.09 12.12
12.100
4
x
+ + +
= =
8
12.13 12.07 12.12 12.10
12.105
4
x
+ + +
= =
9
12.15 12.11 12.10 12.14
12.125
4
x
+ + +
= =
10
12.18 12.16 12.15 12.12
12.153
4
x
+ + +
= =
12.144
12.11
12.076
x
LCL
x
UCL
x

6 7 8 9 10
Variation between
sample is out of
control
STOP! Investigate source of variation.
In-Class Exercises: Mean/Range Chart
The weight (in grams) of toner bottles is measured in the
following 5 samples (assume that it is a continuous random
variable). Each sample composed of 4 observations, one from
each of four machines. Using 3o control limits determine if the
process is in control.

Observation Samples
1 6330 6328 6325 6328 6337
2 6326 6327 6333 6331 6333
3 6334 6333 6330 6327 6338
4 6331 6332 6329 6333 6340
Table S6.1 (pg. 227):
# observations
per sample
Mean Factor
(for x chart)
Upper Range
(for R chart)
Lower Range
(for R chart)
n A
2
D
4
D
3

2 1.88 3.27 0
3 1.02 2.57 0
4 0.73 2.28 0
5 0.58 2.11 0
6 0.48 2.00 0
7 0.42 1.92 0.08
8 0.37 1.86 0.14
9 0.34 1.82 0.18
In-Class Exercises: Mean/Range Charts
LCL
R
=
UCL
R
=
R=
In-Class Exercises: Mean/Range Chart
LCL
xbar
=
UCL
xbar
=
x =
LCL
xbar
=
UCL
xbar
=
x =
Updating Control Charts
Updating Control Charts
Typically, an initial sample of 15-20 data points is
collected and used to establish charts.
If process remains in control for next 15-20, charts
can be updated.
Centerline of old (original) is tested against
centerline of new
If significantly (statistically) different, use new data to
make new chart(s).
If not significantly different, use both old and new data
to make chart(s).

Nelsons Rules
Control Charts
Nelson Rules* set of 8 control chart rules for
determining when a process is out of control
Developed from Western Electric (later AT&T) rules
Look for statistically significant patterns in charts
Several use an A-B-C classification:
UCL
LCL
Center
Line
A
B
C
C
B
A
+ o
+ 2o
+ 3o
3o
2o
o
* Nelson, Lloyd S. "The Shewhart Control ChartTests for Special Causes,"
Journal of Quality Technology, vol. 16(4), pp. 237 239, October 1984
Note: Assumes Normal Distribution (e.g., works
for Xbar, but not for R, c or p.
Nelson Rules
Rule 1: single point falls on/outside the 3 sigma limit
UCL
LCL
Center
Line
A
B
C
C
B
A
Conclusion: one observation significantly out of control
Nelson Rules
Rule 2: two out of three consecutive points, all on the
same side of the center line, fall in zone A (or beyond)
UCL
LCL
Center
Line
A
B
C
C
B
A
Conclusion: medium tendency to be mediumly out of control
Nelson Rules
Rule 3: four out of five consecutive points, all on the
same side of the center line, fall in zone B (or beyond)
UCL
LCL
Center
Line
A
B
C
C
B
A
Conclusion: strong tendency to be slightly out of control
Nelson Rules
Rule 4: eight consecutive points, all on the same side of
the center line
UCL
LCL
Center
Line
A
B
C
C
B
A
Conclusion: bias exists
Nelson Rules
Rule 5: long series of points (about 14) are high, low,
high, low, without any interruption in the sequence
UCL
LCL
Center
Line
A
B
C
C
B
A
Conclusion: oscillation; not likely random noise
Nelson Rules
Rule 6: six (or more) consecutive points all increasing
or all decreasing
UCL
LCL
Center
Line
A
B
C
C
B
A
Conclusion: trend exists
First point to have increased
Nelson Rules
Rule 7: fifteen (or more) consecutive points fall in zone
C either above or below the centerline
UCL
LCL
Center
Line
A
B
C
C
B
A
Conclusion: stratification, more variability expected
Nelson Rules
Rule 8: eight (or more) consecutive points fall on both
sides of the centerline, with none falling in zone C
UCL
LCL
Center
Line
A
B
C
C
B
A
Conclusion: mixture (i.e., two different processes; one high, one low)
Control Charts
As noted, these rules apply to (approx.) normal data
Exist similar rules for charts based on non-normal data
Tend to be less reactive
E.g., for c-charts and p-charts:
1) 1 point outside limits
2) 9 points on one side of centerline
3) 6 points in a row increasing or decreasing
4) 14 points alternating high-low

Run Tests
Run Tests
Run uninterrupted sequence of observations with a
certain observable characteristic
Typically, there are two characteristics studied:
Above or below the median (A/B)
Increase or decrease from previous observation (Up/Down)
Run test test of existence and patterns in runs to
detect abnormalities and non-randomness in a process
Compares actual count normal range of counts.
Analysts often supplement control tests with a run test.
Dr. Deming highly recommended their use
Run Tests
Counting runs:
Counting Above/Below Median Runs (7 runs)
U U D U D U D U U D
B A A B A B B B A A B
Counting Up/Down Runs (8 runs)
Run Tests
Too many runs:

Too few runs:
Above/Below Median (10 runs)
B A B A B B A B A B A
Above/Below Median (2 runs)
B B B B B B A A A A A
Six Sigma
Six Sigma
Why 99% isnt good enough

20,000 lost articles of mail per hour
Unsafe drinking water almost 15
minutes out of each day
5,000 incorrect surgical operations
per week.
2 short or long landings at most major
airports each day
No electricity for almost 7 hours each
month
2
308,733
3 66,803
4
6,200
5
233
6
3.4
o
Defects
% Good
69.1%
93.3%
99.38%
99.976%
99.9996%
99% Good
Source: The Nature of Six Sigma Quality. M. Harry, Ph.d
Per million
(Note: #s allow for a shift in the mean.)
Six Sigma
Precise definition: 3.4 defects per million opportunities
Nearest customer specification limit is 6 standard deviations
from the mean output of the process
General definition: a measurement/data-driven method
for removing defects in any process
Part of most TQM efforts, but has taken on a life of its
own (e.g., Lean Six Sigma)
Two main processes: DMAIC and DMADV
Employees classified (trained/tested) as Six Sigma
Green Belts, Black Belts and Master Black Belts
Process Capability
Process Capability
Control vs. Capability:
Process
Control
Measure of
sample statistics
variation relative
to process
variation
Internal
Process
Capability
Measure of
process variation
relative to
customer
specifications
External
Process Capability
Process variability natural variability in a process,
measured by o
Known or estimated by
Specifications (or tolerances) range of acceptable
values established by customer requirements (or
engineering design)
Process capability measure of process variability
relative to specification
Measures how well the process satisfies the specifications
Process must be in control before capability can be measured
( )
2
3
x
n A n R o o = ~
Process Capability
Lets say we know what normal variation is:
UCL
3o
LCL
Can we simply build units until a
point falls outside the limits?
o
We establish
control charts.
Process Capability
What if the specs look like this:
UCL
3o
LCL
USL LSL
Process variation
exceeds specifications
USL = Upper Specification Limit UCL =Upper Control Limit
LSL = Lower Specification Limit LCL = Lower Control Limit
o
We would produce
parts outside of
specs and not know
there is a problem.
Process Capability
UCL
3o
LCL
USL/ LSL/
Process variation equals
specifications
o
Better, but do not
know there is a
problem until it is
too late (also, still
3/1000 out of spec,
if normal.)
Process Capability
UCL
3o
LCL
USL LSL
Process variation less
than specifications
o
Now, we have a
warning before
parts are out of spec
(also, very few out
of spec, if normal.)
Process Capability
Numerically:
Process capability ratio:

Traditionally, process was capable if C
p
1.33 (spec limits are +4o )
Six Sigma requires C
p
2.00 (spec limits are +6o , hence the name):
o 6
LSL USL
=
p
C
UCL
3o
LCL
USL LSL
6o
USL-LSL
Process variation less
than specifications
Process variation
matches specifications
Process Capability
Visually:
UCL
3o
LCL
USL LSL
Process variation
exceeds specifications
3o
USL/UCL LSL/LCL
UCL
3o
LCL
USL LSL
C
p
1 C
p
= 1 C
p
1
Traditional vs. Six-Sigma:
Traditional
Requirements
Process Capability
USL
C
p
1.33
UCL
3o
LCL
LSL
4o
Six-Sigma
Requirements
C
p
2.00
USL
UCL
3o
LCL
LSL
6o
Notice that the spec limits do not change (they are what they are),
but what is a capable process does (require less normal variation.)
Example: Process Capability
Three machines can perform a specific job. The tolerance range for
the job is 0.8 mm (with of specs; i.e., +/- 0.4 mm.) If the
machines have the correct mean and the following standard
deviations, which are capable of performing the job?
Both machine A and B have C
p
1.33, so they are
capable by traditional requirements.
Machine Capability 6 C
p
A 0.10
B 0.06
C 0.16
0.10(6) = 0.60
0.06(6) = 0.36
0.16(6) = 0.96
0.80/0.60=1.33
0.80/0.36=2.22
0.80/0.96=0.83
However, only machine B is capable under Six Sigma.
In-Class Exercise: Process Capability
As part of an insurance companys training program, participants
learn how to conduct an analysis of clients insurability. The
goal is to have participants achieve a time in the range of 30 to
45 minutes. For now, assume that all participants averaged
37.5 minutes. Test results for three participants were: Armand,
a had a standard deviation of 3 minutes; Jerry, a standard
deviation of 2.5 minutes; and Melissa, a standard deviation of
1.8 minutes.

a) Which of the participants would you judge to be capable,
using the traditional rules? Six Sigma rules?
Process Capability
C
p
can be misleading:
UCL
3o
LCL
USL LSL
Process is capable (C
p
1.33), but mean
(sometimes called X) is not centered.
Mean
Process Capability
For uncentered processes:
Process capability index:
Looks at process variation relative to the closest spec limit:

Used in addition to C
p
Traditionally, process is capable if C
pk
1.0 (closest SL +3o )
Six Sigma requires C
pk
1.5 (closest SL +4.5o), though newer
versions require C
pk
2.0.
USL Mean Mean LSL
min ,
3 3
pk
C
o o

=
`
)
UCL
3o
LCL
USL LSL
3o
Mean-LSL
UCL
3o
LCL
USL LSL
3o
USL-Mean
Process Capability
Example: Process Capability
The output for the three machines in the previous example were
found to not be centered a 1.45. Analysis of the process reveals
the means and standard deviations below. Spec limits are 1.0
and 1.8. Are the processes capable to six sigma levels?
Machine B meets traditional and (original) Six Sigma requirements.
Machine X C
pk
A 0.10 1.29

B 0.06 1.35

C 0.16 1.33

Min{(1.8-1.29)/(3*0.10),
(1.29-1.0)/(3*0.10)=0.97
Min{(1.8-1.35)/(3*0.06),
(1.35-1.0)/(3*0.06)=1.94
Min{(1.8-1.33)/(3*0.16),
(1.33-1.0)/(3*0.16)=0.69
As part of an insurance companys training program, participants
learn how to conduct an analysis of clients insurability. The
goal is to have participants achieve a time in the range of 30 to
45 minutes. Now, the means are also different. Test results for
three participants were: Armand, a mean of 38 minutes and a
standard deviation of 3 minutes; Jerry, a mean of 37 minutes
and a standard deviation of 2.5 minutes; and Melissa, a mean of
37.5 minutes and a standard deviation of 1.8 minutes.

a) Which of the participants would you judge to be capable,
using the traditional rules? Original Six-Sigma rules?
Putting It Together
Putting It Together
Stability and Capability:
Collect Initial
Sample Data
(20+)
Create/Plot
Control Charts
Investigate
Source of
Variation
No
Calculate C
p

and C
pk
Is Process
Capable?
Take Steps to
Reduce
Variability
No
Verify
Stability
Verify
Capability
Yes
Yes
Monitor
Is Process
Stable?
Putting It Together
Spec limits are what they are, so we focus on changing
the process mean or reducing the process variability:
UCL
3o
LCL
USL LSL
UCL
3o
LCL
USL LSL
UCL
3o
New
LCL
USL LSL
Putting It Together
Improving process capability: requires changing the
process target value (move X) and/or reducing the
process variability (lower o)
Simplify: eliminate steps, reduce the number of parts, use
modular design
Standardize: use standard parts, procedures
Mistake-proof: design parts that can only be assembled the
correct way
Upgrade equipment: replace worn out equipment, take
advantage of technological improvements
Automate: substitute automated for manual processing
Supply Chain Management
SCM Job Outlook
U.S. News & World Report describes supply chain
management as one of the 20 hottest job tracks for this
century.
Logistics--the second largest employment sector in the
United States (Council of Logistics Management).
Bureau of Labor Statistics projects, for 2001-2012:
Employment growth will be concentrated in the service-
providing sector of the economy transportation and
warehousing are other service -providing industries that are
projected to grow faster than average.
SCM Job Outlook
Source: www.odinjobs.com
SCM Job Outlook
Source: www.careersinsupplychain.org
Supply Chain
Supply Chain
Supply chain sequence of organizations (facilities,
functions, and activities) that are involved in producing
and delivering a product or service
Begins with raw materials
Ends with delivery to the end consumer
A.k.a. Value Chains
Manufacturing Supply Chain
Example: LNG Supply Chain
Service vs. Manufacturing
Supplier
Supplier
Supplier
Supplier
Supplier
Storage
Mfg
Storage
Dist.
Storage
Ret.
Storage
Serv.
C
u
s
t
C
u
s
t
Hybrid Supply Chain
Supplier
Supplier
Storage
Serv.
Supplier
Supplier
Supplier
Storage
Mfg
Storage
Dist.
Storage
Ret.
C
u
s
t
o
m
e
r
Supply Chain
Purchasing Production Distribution
Value-Adding
Supply Demand
In addition to traditional focus on internal production,
firms now focus on two additional external areas:
Supply and Demand
Supply starts with most basic raw materials, ends with
the beginning of internal operations
Demand starts with product delivery to organizations
immediate customer, ends with final customer in chain

Supply Chain
Supplier
Supplier
Supplier
Storage
Mfg
Storage
Dist.
Storage
Ret.
C
u
s
t
Closer organization is to final customer, shorter its
demand component and longer its supply component
Demand
Supply
Demand
Supply
Three types of flows in SCs:
Supply Chain
Supplier
Supplier
Supplier
Storage
Mfg
Storage
Dist.
Storage
Ret.
E
n
d

C
u
s
t
o
m
e
r

Physical materials value added along the way
Money member take their piece of the pie
Information (dis)aggregated, updated
UPSTREAM DOWNSTREAM
Supply Chain Management efficient integration of
suppliers, factories, warehouses and stores so that
merchandise is produced and distributed:
In the right quantities
To the right locations
At the right time
Goal: maximize total profits
Share a bigger pie
SCM involves all three flows:
Physical Material
Order timing
Quantities
Holding of surplus
Event (interruption)
management
Returns/repairs
Replacement parts

Money
Extending credit
Contract terms
Buybacks
Payment timing
Repair/service costs
Information
POS data
Inventory levels
Forecasts
Shipment status
Capabilities
Limitations

Organizations within supply chains have different,
conflicting objectives:
Manufacturers: long run production, high quality, high
productivity, low production cost

Distributors: low inventory, reduced transportation costs,
quick replenishment capability

Customers: shorter order lead time, high in-stock
inventory, large variety of products, low prices
Source: Supply Chain Council (www.supply-chain.org)
Supply Chain Operational Reference (SCOR) Metrics
Bullwhip Effect
Bullwhip effect distortion of demand information of
a product while it passes back through the SC
Common pattern: variability of orders to an upstream site are
always greater than those of the downstream site
Creates problems:
Excess inventory
Capacity shortages
Forecasting inaccuracies
Lost revenues
Obsolescence
Bullwhip Effect
Retailer Distributor Manufacturer Supplier
Stock
Increased Variability
Orders
Bullwhip Effect
Some (but not all) causes:
Demand forecast updating
Orders are used as signals of product demand
Forecasting techniques rely heavily on recent demand observations
Order batching
Fixed ordering costs and manufacturing setups lead to batching
Periodic planning/ordering as part inventory management systems
Economies of scale in transportation (full truckload rates)
Rationing and shortage gaming
Rationing of orders when demand exceeds manufacturing capacity
Customers exaggerate their real needs (gaming)
Sales promotions/discounts
Artificially inflates orders without demand
Bullwhip Effect
Sales promotions:
Bullwhip Effect
Ways to counter:
Generally, sales information must be shared up SC
Suppliers give point-of-sale (POS) data
Electronic Data Interchange (EDI)
Continuous Replenishment Program (CRP)
Advanced Continuous Replenishment (ACR)
Vendor Maintained Inventory (VMI)
Every Day Low Prices (EDLP)
Instead of promotions/sales
Strategic buffering
E.g., bulk of retail inventory held at distribution center
Collaborative Forecasting and Replenishment (CFAR)
Purchasing
Purchasing obtaining materials, parts, and supplies
needed to produce a product or provide a service
For manufacturing companies approximately 60% of total
product cost comes from purchased parts and materials
Interfaces with other functional areas and outside suppliers
Responsible for:
Vendor selection and monitoring
Quality of incoming parts, materials or subassemblies
Communication and timing of deliveries of goods or services
Purchasing
Legal
Accting
Op.s
Data
Process.
Design/
Eng.
Receiving
Suppliers
Purchasing
Q/A
Interfaces:
Purchasing
Vendor Selection
1) Vendor evaluation developing criteria (w/ weights),
finding potential suppliers and measuring their potential
Criteria: price, quality, reputation, services, location, transportation
costs/lead times, inventory policy, flexibility, financial stability
2) Vendor development readying supplier to potentially
become an integral part of operations
Provide information, training/technical knowledge, establishing
communications framework
3) Negotiations establishing terms (cost, quantity, etc.)
Cost-based pricing, market-based pricing, competitive bids

Purchasing
Global sourcing
Why is there increased usage?
Global trade agreements:
General Agreement on Tariffs and Trade (GATT)
North American Free Trade Agreement (NAFTA)
Improved technology
Increased speed and reduced cost of distribution
Improved worker skill levels/infrastructure in 2
nd
/3
rd
world countries
Growing/emerging markets over seas
What are some added concerns?
Cultural/legal/language differences
Currency exchange
Reduced oversight/control (QC, safety)
Increased lead time/transportation costs
Purchasing
Outsourcing buying goods or services from outside
sources rather than providing them in-house
What must we consider in making decision?
Make-vs.-buy analysis (cost to produce, investment)
Stability of demand and possible seasonality
Quality available versus quality in-house
Desire to maintain close control over operations
Idle capacity, lead times, expertise, stability of technology,
compatibility with other in-house operations (skill levels,
equipment)
Control of proprietary information/designs
Strategic Partnering
Strategic partnering (SP) - two or more firms with
complementary products/services (horizontal) or along
supply chain (vertical) join for strategic benefit
Advantages of SP include:
Fully utilize system knowledge
Decrease required inventory levels
Improve service levels
Decrease work duplication
Improve forecasts
Types of strategic partnering in SCM include:
Simple POS
Reverse purchase orders (RPO)
Quick response
Vendor managed inventory (VMI)
Continuous replenishment program (CRP)
Advanced continuous replenishment (ACR)
Simple POS: retailer determines order sizes/timing but
also passes point of sales (POS) data to the supplier
Improves suppliers forecasts
Reverse purchase order (RPO): supplier order size/
timing recommendations used by retailer to determine
actual order sizes/timing
Example: Panasonic (supplier) and BestBuy (retailer)
Upside: supplier seems to be providing high service
Downside: supplier does not see the real demand
Continuous Replenishment Program (CRP): vendors
receive POS data, use to prepare shipments at agreed
upon intervals to maintain agreed levels of inventory
Example: Walmart
Advanced Continuous Replenishment (ACR): suppliers
may gradually decrease inventory levels at retailer or
distribution center as long as service levels are met.
Inventory levels continuously improved in a structured way
Example: K-Mart
Quick response vendors receive POS data from
retailers; use to synchronize production and inventory
activities at supplier (JIT)
Retailer still prepares individual orders
POS data used by supplier to improve forecasting/scheduling
Example: Milliken & Company
Vendor managed inventory (VMI) inventory levels
monitored and controlled by vendor not retailer
Vendors inventory decisions based on actual POS data
Empirical results: sales increases of 20 to 25 percent, and 30
percent inventory turnover improvements (e.g., Walmart)
E-business
E-business use of electronic technology to facilitate
business transactions
Advantages:
Access to customers/suppliers outside of local area
Have a global presence
Collect detailed information on customer interests
Explore new opportunities such as new vendors and new customers
(an open system)
Have common standards
Lower set up costs, especially in many-to-many environment
Level the playing field for small companies
Supply Chain of B2C (e-Retailing)
With or without inventory?
Third-party fulfillers (drop shipping)
e.g. Amazon
Internet-based B2B Applications
Web sites for ordering and order tracking (MRO catalogs)
One-to-one connections: collaborative requirements
planning, vendor managed inventory (VMI), electronic data
interchange (EDI)
Many-to-many connections: industry specific hubs, e-
procurement
E-Business
Electronic Data Interchange (EDI) - direct computer-
to-computer transmission of inter-organizational
transactions.
Includes: purch. orders, shipping notices, debit/credit memos
Reduces paperwork, lead time, inventory and variability
Increases accuracy, timeliness
Facilitates Just-In-Time (JIT) systems
Logistics
Logistics management of the movement and storage of
materials within the supply chain.
Within a facility
Between facilities (incoming and/or out-going shipments)
Techniques in logistics:
Distribution requirement planning (DRP)
Third party logistics (3-PL)
Reverse logistics
Logistics
Costs in logistics:
Inventory: cycle stock, pipeline stock, buffer stock.
Transportation: trucking, railroads, airfreight, shipping
Warehousing: packaging, sorting, storage, conveyor belts,
robotics, forklifts, etc.
Facilities: distribution centers, warehouses, centralized sorting
centers.
Information: order fulfillment, coordination, scheduling

Logistics
Unlike inventory, transportation has remained stable
Logistics
Within a supply network:
Demand Location B
Demand Location C
Demand Location A
Demand Location D
Supply Location 1
Supply Location 2
Supply Location 3
Logistics
Within a facility:
R
e
c
e
i
v
i
n
g

Production Process
Shipping
Storage
Work
center
Work center
Storage
Work center
Work
center
Storage
Logistics
Within a facility:
Logistics
Distribution Requirements Planning (DRP) - an
extension of the concepts of MRP
*
to finished goods
inventory management and distribution planning
1) Starts with demand at the end of the channel
2) Works backward through the warehouse system
3) Obtains a time phased replenishment schedule for moving
inventories through the warehouse network
Extremely useful when multiple warehouses are present
(e.g. Wal-Mart)
Many MRP vendors also have a DRP module
* Material Requirements Planning we will discuss later.
Logistics
Third Party Logistics (3PL) - use of an outside
company to perform part or all of a firms materials
management and product distribution function
Have knowledge/expertise that is expensive or impractical to
gain internally
Give up control; requires sufficient oversight
Examples 3PL providers: Ryder Dedicated Logistics and
J.B. Hunt
Examples 3PL users: 3M, Dow Chemical, Kodak and Sears
New trend: online freight matching
3PL Freight Matching
Logistics
Reverse Logistics backward flow of goods returned
to the supply chain from their final destination
Reasons for return: defective, unsold, change of mind
Involves sorting, testing, repairing/reconditioning,
restocking, recycling or disposing
Goal: create/recapture value in returned product
Methods for managing returns:
Gatekeeping screening returns to prevent incorrect acceptance
Avoidance managing internal processes (design, quality control,
forecasting) to minimize number of items returned

Inventory Management
Inventory stock or store of goods
Examples:
Manufacturing: firms carry supplies of raw materials,
purchased parts, finished items, spare parts, tools,....
Department stores: carry clothing, furniture, stationery,
tools, appliances,...
Supermarkets: stock fresh and canned foods, packaged and
frozen foods, household supplies, ...
Hospitals: stock drugs, surgical supplies, life-monitoring
equipment, sheets, pillow cases, ... patients!
Inventory
Types:
Raw materials & purchased parts
Pipeline stock goods-in-transit to warehouses or customers
Cycle stock inventory held due to ordering in batches
Safety stock inventory held to buffer against variability
Work-in-progress (WIP) partially completed goods
Finished-goods completed products (manufacturing firms)
Merchandise (retail stores)
Replacement parts, tools, & supplies
Inventory
In processes:
Transformation
Input Output
Raw materials
Materials received
Customers waiting
in a bank
Paperwork in in-box
Work-in-Process (WIP)
Semi-finished
products
Customers at the
counter
Paperwork on desk
Finished goods
Products waiting to
be shipped
Customers leaving
the bank
Paperwork in out-box
Functions of Inventory:
To meet anticipated demand: anticipation stock (avg.)
To smooth production requirements: seasonal inventories
To deal with uncertainty (variability):
To decouple operations: buffer inventories
To protect against stock-outs: safety stock
To take advantage of order cycles: cycle stock (batches)
To permit operations: WIP, pipeline stock
To take advantage of quantity discounts
To help hedge against price increases
Requirements to for effective IM:
1) Reliable forecasting system (demand)
2) Accurate supply information:
Lead times, including variability
Costs (holding, ordering, shortage)
Garbage In Garbage Out
3) System for counting/tracking inventory on hand and on order
4) Classification/priority system of inventory
Counting systems
Periodic system: physical count of items made at
periodic intervals (weekly, monthly)
Order placed up to predetermined amount
Good: economies of scale in processing many items
Bad: lack control between reviews carry extra stock
Continuous (perpetual) system: tracks changes to
inventory continuously, monitoring current levels
Fixed quantity is ordered when a certain level is reached
Good: keep constant count of inventory, fixed order quantity
Bad: higher tracking costs, periodic counting still required,
suppliers may work on periodic system
Counting systems
Of periodic and continuous systems, which do think
are used more and is that changing? Why?
Example: Classification System
ABC Classification System: classifying inventory
according to some measure of importance and
allocating control efforts accordingly
A - very important
B - mod. important
C - least important
Annual
$ value
of items
A
B
C
High
Low
Few
Many
Number of Items
ABC Approach
Class A typically contains about 10-20% of the items
and 60-70% of the annual dollar value
Receives close attention: frequent reviews make sure
customer service levels
Class C contains about 50-60% of the items, but only
10-15% of the dollar value
Receives only loose control, usually order in large quantities
Class B is between the two extremes
How much to order:
EOQ (Basic)
Economic Order Quantity
Economic Order Quantity (EOQ): optimal batch size
for ordering, minimizing holding and ordering costs
Uses:
In periodic system: determine (approximate) review interval
Interval = avg. demand rate / EOQ
Used if an order is placed every review
In continuous system: determine (approximate) amount to
order when inventory falls to predetermined level (ROP)
Assumptions:
1. Ordering in batch from supplier
2. Only one product is involved
3. Relatively constant demand rate
Noise, but no trend/cycles
4. Constant lead time
5. Single delivery for each order
6. A single flat unit price from the supplier
No quantity discounts
7. Unit cost is independent of quantity
Most of these assumptions
can be relaxed with minor
adjustments. We will see
one such case later.
Inputs to EOQ:
(Fixed) ordering/set-up cost (S): cost of ordering and getting
an order into inventory regardless of quantity ordered
Per-order supplier fee
Labor to place order determining how much is needed, typing up
invoices, calling in order
Shipping costs (fixed)
Moving to storage (whole order)
Typically, S is expressed in $/order
Inputs to EOQ (contd):
Unit (variable) price (P): cost of obtaining and getting it into
inventory one unit
Unit price of the item
Sales tax paid on unit price
Shipping costs (variable)
Inspecting goods for quality and quantity (per unit)
Moving to storage (single item)
Typically, P is expressed in $/unit
Holding (carrying) cost (H): cost of holding a single item in
storage for a period of time (e.g., one year)
Opportunity cost of capital (H = rP)
Insurance
Taxes
Depreciation
Obsolescence
Warehouse costs per unit (physical holding cost)
Typically, H is expressed in $/unit/year
Average demand rate (D): expected demand during a period
of time (e.g., one year)
Typically, D is expressed in units/year
Example: EOQ Inputs
Buildexs most popular item is a standard sheet of fiberboard. Demand has been constant
at 170,000 per year and is expected to remain so for the next few years.
Fiberboard is purchased from a supplier down river for $30 per sheet. Buildex hires
barges to transport the boards to its central warehouse Each barge costs $1800 per
trip plus $4 per sheet. Placing an order requires about five hours of employee time.
Once at the warehouse, sheets are unloaded at a rate of 10/hour/employee. The
unloading equipment used by each employee is rented at a rate of $25 per hour.
The employees working in the warehouse have several tasks:
1. Security guards and general maintenance require about 7,000 hours per year, and this
does not depend upon how much inventory is stored in the building.
2. Placing the sheets into storage, after they are unloaded, can be done at the rate of
about 25 per employee per hour. No additional equipment is necessary for this.
3. Removing a sheet from inventory and preparing it for shipment requires about hr
4. Materials used to ship one board to a customer costs $1 and delivery costs are about
$2 per sheet
The average cost per hour of labor is approximately $12. Buildex usually hires temporary
workers to process large deliveries from the supplier and large orders from customers.
Example: EOQ Inputs
Item S P H
Purchasing cost ($30/sheet) X (X)
Barge cost ($1800/order) X
Barge cost ($4/sheet) X (X)
Ordering labor ($12/hour, 5 hr/order) X
Warehouse guards/maintenance
($12/hour, 7000 hours/year)
Unloading labor
($12/hour, 10 sheets/employee/hr)
X (X)
Unloading equipment
X (X)
Placing in storage
X (X)
Removing from storage
Material/delivery to cust. ($3/sheet)
Inputs summary
S: ordering cost
P: unit cost
H: holding costs
D: average demand rate

If Q is the order quantity (batch size), then we want to
find the optimal value, Q
0
, which we call the EOQ.

Q
Time
Small Q (frequent orders)
Big Q (infrequent orders)
Q
Incur high
ordering costs
(many Ss)
Incur low
holding costs
(low avg. inv.)
Incur low
ordering costs
(few Ss)
Incur high
holding costs
(high avg. inv.)
Note: total inventory ordered is same in both case and is equal to total demand (in long-run)
Total cost (per period) for order size Q:

Holding
cost per
period
Total cost =
Ordering
cost per
period
+
Purchasing
cost per
period
+
PD + =
|
|
.
|
\
|
+

S
# orders
per period
|
|
.
|
\
|

H
average
inventory
What are these?
Average inventory:
Q
Right after an
order, we have
Q units, Q/2
above Q/2.
Right before an
order, we have
0 units, Q/2
below Q/2.
For each time we
have an amount
above Q/2, there is
a time we have that
amount below Q/2.
Q/2
Average inventory
= Q/2
Q
Time
Orders per period:
Total demand per
period is D, so the
average amount
ordered per period
must also be D.
(# orders/period)(quantity per order) = D
(# orders/period) = D/Q
Q
Total cost (per period) for order size Q:

Holding
cost per
period
Total cost =
Ordering
cost per
period
+
Purchasing
cost per
period
+
PD + =
|
|
.
|
\
|
+

S
# orders
per period
|
|
.
|
\
|

H
average
inventory
PD
Q
D
S
2
Q
H = TC +
|
|
.
|
\
|
+
|
.
|
\
|
Does not
depend
on Q
We just need to minimize these
Holding & ordering costs:
Order Quantity (Q)
C
o
s
t

p
e
r

p
e
r
i
o
d

Q
0
Holding
costs
Ordering
costs
Finding the optimal value:

At min (Q
0
), slope = 0:
PD
Q
D
S
2
Q
H = TC +
|
|
.
|
\
|
+
|
.
|
\
|
0
Q
D
S
2
H
=
dQ
dTC
2
=
|
|
.
|
\
|

H
DS 2
= Q
0
Example: Economic Order Quantity

Piddling Manufacturing assembles security monitors. It
purchases 3,600 LCD monitors per year at $65 each.
Ordering costs are $31, and the annual carrying costs
are 20 percent of the purchasing price. Compute the
optimal quantity.
D =
P =
S =
H =
3,600 units/yr
$65/unit
$31/order
(.20)($65) = $13/unit/yr
Q
0
= 2DS/H = 2(3,600)($31)/$13 = 131 units
r = 0.20
What is Piddlings annual cost of holding and ordering?
D =
P =
S =
H =
3,600 units/yr
$65/unit
$31/order
$13/unit/yr
H&O Costs = H(Q
0
/2) + S(D/Q
0
)
= $1,704/yr
= (13)(131/2) + (31)(3600/131)
Q
0
= 131 units
What is Piddlings total annual cost?
D =
P =
S =
H =
3,600 units/yr
$65/unit
$31/order
$13/unit/yr
TC = H(Q
0
/2) + S(D/Q
0
) + DP
= $235,704/yr
= $1,704 + (3600)($65)
Q
0
= 131 units
In-Class: Economic Order Quantity
A pet shop sells bird cages at a rate of 18 per week.
Their supplier charges $60 per cage and the cost of
placing an order is $45. Due to their limited space,
they store cages at a nearby warehouse at a cost of $3
per cage per year. Annual cost of capital is 20%.
What is the optimal ordering size?
In-Class: Economic Order Quantity
What is the total cost to the pet shop for cages?
Ordering Close to EOQ
Ordering Close to EOQ
EOQ is just an approximate number
Not always practical to order exactly
What is impact of order close, but convenient amount?
Example 2: Economic Order Quantity
Dell uses 1,350 Intel Atom processors per week. The
price of each unit is $100. Placing an order costs $2,000
and the opp. cost of capital is 20% per year. There is also
a physical holding of $10 per unit per year.
D =
P =
S =
H =
(1,350 units/wk)(52 wks/yr)
$100/unit
$2,000/order
(.20)($100) + $10 = $30/unit/yr
Q
0
= 2DS/H = 2(70,200)($2,000)/$30 = 3,059 units
= 70,200 units/yr
H&O Costs = H(Q
0
/2) + S(D/Q
0
)
= $30(3059/2) + $2000(70200/3059)
= $91,782/yr
Example 2: Economic Order Quantity
Remember that the # of orders per year is:

Dell would rather place 24 orders per year (twice/month). What
would it cost to switch to this order frequency?
D/Q
0
= (70,200 units/yr)/(3,059 units/order)
= 22.94 orders/yr
H&O Costs =
= $30(2925/2) + $2000(70200/2925)
= $91,875/yr
Q = D/(# orders/yr) = 70200/24 = 2925
Cost = $91,875 $91,782 = $93! (0.1%)
H(Q/2) + S(D/Q)
Total costs are flat around EOQ:
Q
TC
Range
of TC
Range of Q
Q
0
Estimation Error with EOQ
Estimation Error with EOQ
EOQ is often based on estimated costs
What happens when those costs are off?
Example: Estimation Error
K-Mart stocks a model of cordless phones. Demand is estimated to
be 150 units/month. They are purchased from a supplier for $50.
They have recently switched to an EDI system with the supplier
and the manager estimated that placing an order will now cost $20.
Cost of capital is 20% per year. What is the optimal order quantity
given these costs?
D =
P =
S =
H =
150 phones/months
$50/phone
$20/order
(.20)($50) = $10/phone/yr
Q
0
= 2DS/H = 2(1,800)($20)/$10 = 85 phones
= 1800 phones/year
The system was set up to place orders of size 85. The manager,
however, was wrong and it will actually cost $25 to place an order.
What is the cost of the mistake?

First, we calculate what the EOQ should have been:
D =
P =
S =
H =
150 phones/months
$50/phone
$25/order
(.20)($50) = $10/phone/yr
Q
0
= 2DS/H = 2(1,800)($25)/$10 = 95 phones
= 1800 phones/year
Next, we compare what the cost should have been

With the actual cost
H&O Cost (Q = 95) =
= $10(95/2) + $25(1800/95)
= $948.68/yr
H(Q/2) + S(D/Q)
H&O Cost (Q = 85) =
= $10(85/2) + $25(1800/85)
= $954.51/yr
H(Q/2) + S(D/Q)
Cost of Error = $954.51 $948.68 = $5.73 (0.6%)
Estimation Error
Total costs are flat around EOQ:
Q
TC
Change
in TC
Change in Q
85

95

TC w/ S = $20

TC w/ S = $25

Changes in Inputs
Changes in Inputs
Looking at EOQ:

Q
0
grows with square root of items in numerator (D, S)
E.g., doubling S, increases Q
0
by just 41.4% (1.414x)
Q
0
grows with 1/square root of H
E.g., doubling H, decreases Q
0
by just 29.5% (0.705x)
0
2DS
Q =
H
EOQ has economies of scale as demand rises:
Demand, D
Holding &
Ordering
Costs
Price Breaks:
EOQ (advanced)
(Not on Exam)
Starting Simple
Often times max order size is limited by transportation
capacity (e.g., barge size for Buildex).
Order Quantity (Q)
C
o
s
t

p
e
r

p
e
r
i
o
d

Q
0
Q
max
How much should we
order if limit > Q
0
?

Q
max
What if limit < Q
0
?

Starting Simple
Sometimes, supplier place a restriction on the
minimum size order that a manufacturer can place.
Order Quantity (Q)
C
o
s
t

p
e
r

p
e
r
i
o
d

Q
0
Q
min
How much should we
order if limit < Q
0
?

Q
min
What if limit > Q
0
?

Putting Them Together
A common practice is to offer price breaks for larger
order sizes. For example:

Now, each price level has a min and a max quantity.
How many should we order?

Order Quantity Prices per Unit
1 to 4,999 $100
5,000 to 9,999 $90
10,000 or more $80
Different Cs
mean different
Hs, giving
different EOQs.
First Step
For each price, where is its EOQ? What Q is best?
Q
TC TC
Q
Q
TC
Q
0
Q
0
Q
0
Above the range In the range
Below the range
Second Step
Find the price whose best Q has the lowest TC:
Q
TC
Skip Problems
Example: Price Breaks
Dell needs 130,000 E7200s per year. Placing an order
costs $9,000 and the opportunity cost of capital is 20%
per year. There is a physical holding of $6 per unit per
year. Intel offers the following unit price options:
Order Quantity Price per Unit
1 to 4,999 $100
5,000 to 9,999 $90
10,000 or more $80
H (< 5k) =
H (5-10k) =
H ( 10k) =

Q
0
(< 5k) =
Q
0
(5-10k) =
Q
0
( 10k) =
(.20)($100) + $6 = $26/unit/yr
(.20)($90) + $6 = $24/unit/yr
(.20)($80) + $6 = $22/unit/yr
2(130,000)($9000)/($26) = 9,487 units
2(130,000)($9000)/($24) = 9,874 units
2(130,000)($9000)/($22) = 10,313 units
For each range, where is its Q
0
?
Q
TC TC
Q
Q
TC
Q
0
Q
0
Q
0
< 5,000 5,000-10,000
10,000
Q* = 5,000 Q* = 9,874
Q* = 10,313
TC (< 5k) =

TC (5-10k) =

TC ( 10k) =

(26)(5,000/2) + (9,000)(130,000/5,000) + (130,000)($100)
= $13,299,000/yr
(24)(9,874/2) + (9,000)(130,000/9,874) + (130,000)($90)
= $11,936,981/yr
(22)(10,313/2) + (9,000)(130,000/10,313) + (130,000)($80)
= $10,626,892/yr
The optimal order is 10,313
Exercise 2: EOQ Quantity Discount
A service garage uses 200 boxes of industrial strength cleaning cloths a year.
The boxes cost $8 each and the company has an annual cost of capital of
25%. Your vendor charges $10 per order, regardless of the quantity ordered.

a) What order quantity minimizes total cost?

b) How many orders per year will they place if they use this
quantity?
Exercise 2: EOQ Quantity Discount
c) You vendor offers a lower unit price of $7 per box, but only for
orders of 55 boxes or more. What quantity should they order?
Additional considerations:
Multiple products
Transportation pooling
Economic production quantity (we will omit)
When to order (ROP)
Next
Normal Distribution
(Refresher)
Normal classic bell shaped curve
Uniquely defined by:
mean () average value, measure of location
standard deviation (o) measure of spread in distribution
Probability Theory

x
Normal (cont)
Easier to use Standard (0, 1) Normal:
Probability Theory
0
1
o
o
z x
x
z + =
=
z-value = # std. dev.s from the mean
x

o
x
o
0
x
1
0
(x)/o
Demand for your product is normally distributed with
mean of 100 units and standard deviation of 20 units.

What is the z value for 127 units?
Z-Value Example
100 127
=
=
=
x
o
100
20
127
20
x
z
=
20
100 127
=
35 . 1 =
(127 is 1.35 std. dev.s above 100)
Demand for your product is normally distributed with
mean of 100 units and standard deviation of 20 units.
What inventory level gives a 90% chance (probability)
of not stocking out?
Z-Value Example
o z x + =
( ) 20 28 . 1 100 + =
126 6 . 125 =
100
20
o
=
=
From table, z for 90% is 1.28.
We want 1.28 std. dev.s above 100.
When to order?
(ROP)
Reorder Point
Reorder Point (ROP) level of inventory position, at
which a replenishment order (~ Q
0
) is placed
Inventory on-hand inventory held that is available for use
Inventory position inventory on-hand, plus orders already
placed, but not yet received (pipeline stock)
We will assume that at most one order is in the
pipeline, so we will just track inventory on-hand
Time between orders > time order spends in pipeline
In reality, inventory position can trigger an order
during the lead time of another.
Reorder Point
Lead time (LT) time interval between placing an
order and receiving it
May be constant or variable
LT
If demand is 100 units/day and lead time is 3 days, how
much should we have left to hit 0 as the order arrives?
Reorder Point
Q
0
100

3
???

Reorder Point
Q
0
d

In general, given constant lead time (LT) and demand
(d), when should we place an order?
Want to just run out when order arrives.
LT
???

ROP = d*LT
First problem: what if demand rate is not constant?
Reorder Point
When we order, we do not know how
much we will have left after LT
LT
ROP

Sometimes lower than avg.
Sometimes higher than avg.
What if ROP = avg. demand?

Safety
Stock (ss)

Safety stock reduces chance of
stockout during lead time
Average
Demand

So, we add a little extra.

Reorder Point
Second problem: what if lead time is not constant?
When we order, we do not know
how long lead time will be
A
v
g
.

l
e
a
d

t
i
m
e

ROP

L
o
n
g
e
r

t
h
a
n

a
v
g
.

What if ROP = avg. demand
Safety
Stock (ss)

Safety stock reduces chance of
stockout during lead time
S
h
o
r
t
e
r

t
h
a
n

a
v
g
.

Average
Demand

So, we add a little extra.

?
Reorder Point
Overall, the ordering process will look like:
Q
0
SS

ROP

Q
0
Q
0
Q
0
Q
0
Inventory Position
Inventory On-Hand
Reorder Point
Demand rate (d): demand over period (day, week, etc.)
We will assume it follows a Normal distribution:

d = average demand per period (note: this is D in EOQ)
o
d
= standard deviation of demand per period

d

d
Reorder Point
Lead time (LT): time from placing to receiving an order
We will assume it follow a Normal distribution

LT = average lead time
o
LT
= standard deviation of lead time

LT

LT
Reorder Point
Demand during lead time (D
L
): amount of demand seen
between placing an order and receiving it
Product of random variables: D
L
= d*LT

ROP

Safety
Stock (ss)

Random # of
random demands
Creates
distribution of
demand over
lead time (D
L
)
Reorder Point
Demand during lead time (D
L
): - contd
Under assumptions, this will be a normal:

d*LT = average demand over lead time
o
dLT
= standard deviation of lead time
dLT

dLT
2 2 2
d LT
LT d o o = +
Reorder Point
Distribution of demand during lead time (D
L
):
d*LT
ss
Service Level (SL)
Risk (stockout)
ROP
The choice of ROP determines the probability of
stocking out over the lead time: Pr[D
L
ROP] = SL
Reorder Point
Choosing the service level (SL):
Tradeoff:
Cost of stocking out: goodwill lost, tracking fees, rush shipments
Cost of carrying more ss: additional holding cost
Used to determine appropriate z-value
Method:
1) Determine average and std. dev. for demand and lead time
2) Determine service level (given) and corresponding z
3) Calculate average demand over lead time:

4) Determine std. dev. of demand over lead time:

5) Calculate the Reorder Point (ROP)

Reorder Point
2
LT
2 2
d dLT
d LT o o o + =
d*LT
Math:
ROP =

= d*LT + z*o
dLT

Reorder Point
Average
Demand
Over LT
Safety
Stock
+
2
LT
2 2
d dLT
d LT o o o + =
Often, one of
these is zero
Example: Reorder Point
The housekeeping department of a motel stocks washcloths. Usage
can be approximated by a normal distribution that has a mean
of 400 and standard deviation of 9 per day. The lead time from
a linen supplier is a constant 3 days. The motel maintains a
98% service level. What ROP should they use?
0.98
2.053 (from z table)
d*LT + z o
dLT
= 400(3) + 2.053(15.58)

= 1,233 washcloths

SL =
z =
o
dLT
=
ROP =
d = 400 washcloths/day o
d
= 9 washcloths/day Demand:
LT = 3 days o
LT
= 0 days Lead time:
LTo
d
2
+ d
2
o
LT
2
= 3(9)
2
+ 400
2
(0)
2
= 15.58
(note: always round up)

Example 2: Reorder Point
The housekeeping department also stocks soap. Usage has been
relatively constant at 600 bars per day. The lead time follows a
normal distribution with a mean of 6 days and standard
deviation of 2 days. A service level of 90% is desired. What
ROP should they use?
0.90
d*LT + z o
dLT
= 600(6) + 1.282(1200)

= 5,138 bars

SL =
z =
o
dLT
=
ROP =
d = 600 bars/day o
d
= 0 bars/day Demand:
LT = 6 days o
LT
= 2 days Lead time:
LTo
d
2
+ d
2
o
LT
2
= 6(0)
2
+ 600
2
(2)
2
= 1200

The motel replaces broken glasses at a rate of 25 per day. Usage
has been tended to be normally distribution with a standard
deviation of 3 glasses. The lead time follows a normal
distribution with a mean of 10 days and standard deviation of 2
days. What ROP should they use for a service level of 95%?
0.95
d*LT + z o
dLT
= 25(10) + 1.645(50.89)

= 334 glasses

SL =
z =
o
dLT
=
ROP =
d = 25 glasses/day o
d
= 3 glasses/day Demand:
LT = 10 days o
LT
= 2 days Lead time:
LTo
d
2
+ d
2
o
LT
2
= 10(3)
2
+ 25
2
(2)
2
= 50.89

How much safety stock in glasses are the carrying?
d*LT + z o
dLT
= 25(10) + 1.65(51)

= 334 glasses

ROP =
Recall:
Avg. demand
over lead time
Safety
stock
1.65(51)

= 84 glasses

SS =
In-Class Exercise: ROP
A supermarket has added a new brand of Ketchup (or Catsup, if
you prefer) and needs to determine when to place orders. Daily
demand fluctuates highly with a mean of 50 bottles and a standard
deviation of 15 bottles. The supplier has not proven very reliable.
Lead times are 6 days with a standard deviation of 1.5 days. The
supermarket uses a service level of 90% (z = 1.282).
a) Find the level of safety stock and re-order point for the
supermarket.

In-Class Exercise: ROP
In-Class Exercise: ROP & EOQ
A small supermarket has one cash register. On average, they use
up 10 rolls of tape per day, but it is not consistent. The standard
deviation of usage is 2 rolls per day. They cannot afford to run out
frequently, as it requires manual tracking and later entry of sales,
so they use a service level of 99% (z = 2.326).
Their supplier charges $2 per roll, plus $10 per order. They
guarantee a 3 day delivery time.
The supermarkets annual cost of capital is 10%.
a) How much and at what inventory level should the place an
order?

Exercise 6: ROP & EOQ
b) The supplier begins to package orders more securely due to
damage in transit. To cover their additional cost, they now
charge $22 an order instead of $10. How do the quantities
calculated in (a) change with this different cost?

c) Loosely sketch the two situations.

See Solution
Safety Stock
Methods for reducing safety stock:
Reduce demand variability
Reduce lead time
Reduce variability of length of lead time
Economies of scale (pooling)
Pooling Safety Stock Example
Two towing companies have individual diesel tanks. Each
company uses 100 gal per day. Usage has been tended to be
normally distribution with a standard deviation of 20 gal. The
lead time from the supplier (same for both) is 7 days. How much
safety stock does each carry for a service level of 95%?
0.95
z o
dLT
= 1.645(52.92)

= 87 gal

SL =
z =
o
dLT
=
SS =
d = 100 gal/day o
d
= 20 gal/day Demand:
LT = 7 days o
LT
= 0 days Lead time:
LTo
d
2
+ d
2
o
LT
2
= 7(20)
2
+ 100
2
(0)
2
= 52.92
Pooling Safety Stock Example
If they agree to keep one central tank, how much safety stock would
they have to carry for a service level of 95%?
z o
dLT
= 1.645(74.83)

= 124 gal

o
dLT
=
SS =
d = (2)100 = 200 gal/day
o
d
= 20
2
+ 20
2

LTo
d
2
+ d
2
o
LT
2
= 7(28.28)
2
+ 200
2
(0)
2
= 74.83
= 28.28 gal/day
Reduction in SS =

2(87) 124

= 50 gals!

(if independent)

c) Loosely sketch the two situations.

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When standard deviation is not known, must estimate using R.

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