Managing Inventories in

Supply Chain II
 Inventory management
with demand uncertainty
A Global Manufacturer with a Factory in Singapore
- Let’s take a look at the data set sample on LumiNUS…
re-order point Jan 13 _Report_Sample.xls

• Can you save S$2.7-2.8 Million of inventory cost out of a S$4

million system in 9 months?
 Yes, you can! That’s one learning objective for this course!
• Is it a Single Period or Multi-Period Problem?
• In addition to the issues on the data quality, what can we do to
improve the company’s inventory replenishment policy?
 How to set Re-order Point? (i.e., when should we order?)
 How much to order when “re-order point” is reached?
The Effect of
Demand Uncertainty
• EOQ Model does not consider demand uncertainty
• What is the effect of demand uncertainty?
• Most companies treat the world as if it were predictable:
• Production and inventory planning are based on forecasts of demand made
far in advance of the selling season
• Companies are aware of demand uncertainty when they create a forecast, but
they design their planning process as if the forecast truly represents reality
The Effect of Demand Uncertainty
• But, does forecast truly represent reality ?
• See next slide about demand forecast
 Demand Forecast
• The three principles of all forecasting
techniques:

• Forecasting is always wrong

• The longer the forecast horizon, the
worse is the forecast
• Aggregate forecasts are more accurate
Why is it more and more important to
consider demand uncertainty?

• Recent technological advances have increased the

level of demand uncertainty:
• Short product life cycles
• Increasing product variety
Inventory Models with Demand Uncertainty
• Single period inventory model: also called newsvendor
(newsboy) model  for perishable products
• Multiple-period inventory model  for durable
products We will learn today
Inventory Models with Demand Uncertainty
• Single period inventory model: also called
newsvendor (newsboy) model
• Multiple-period inventory model
 Demand Variability: Example 1

Product Demand

250 225
200
150 150
Demand 150 125
100 104
(000's) 100 75 61
50 48 53 45
50
0

Month
Demand Variability: Example 1

Histogram for Value of Orders Placed in a Week

25
Frequency

20
15
10
5
0

Value of Orders Placed in a Week

Reminder:
The Normal Distribution

Standard Deviation = 5

Standard Deviation = 10

Average = 30

0 10 20 30 40 50 60
 What is important?
how to handle demand during lead time?
How do we model demand during lead time? Math
Behind…Recall…(where to fill in “n” below)
• E(X1+X2) = E(X1)+E(X2)
• E(X1+X2+….+X ) = E(X1)+E(X2)+….+E(X )

• Var(X1+X2) = Var(X1)+Var(X2) if X1 and X2 are independent

• Var(X1+X2+…+X ) = Var(X1)+Var(X2)+…+Var(X ) if X1, X2, …X are
independent
The DC holds inventory to:

• Satisfy demand during lead time

• Protect against demand uncertainty

• Balance fixed costs and holding costs

The Multi-Period Inventory Model
• We assume that the demand is random and follows a normal distribution
• Ordering cost has two components: (1) Fixed ordering cost K per order + (2) a
variable ordering cost C which is proportional to the amount ordered.
• Inventory holding cost is charged per item per unit time  use h to denote
• We assume that if an order arrives and there is no inventory, the order is lost
• The distributor has a required service level. This is expressed as the likelihood
that the distributor will not stock out during lead time.
• Intuitively, how will this affect our policy?
The DC holds inventory to:

• Satisfy demand during lead time

 in EOQ setting, we order when inventory level drops to DL.
• Protect against demand uncertainty
 in EOQ setting, no demand uncertainty. So this part is ignored.
• Balance fixed costs and holding costs
 in EOQ setting, we order (2KD)/h so that we can balance our
fixed costs and holding costs, which allows us to minimize the total
ordering and holding cost.
 What will change when we consider demand uncertainty on top
of an EOQ setting?
The DC holds inventory to:
• Satisfy demand during lead time
 in EOQ setting, we order when inventory level drops to DL.
 With demand uncertainty, it makes more sense to say “Satisfy EXPECTED demand during lead
time”.
• Protect against demand uncertainty
 in EOQ setting, no demand uncertainty. So this part is ignored.
 With demand uncertainty, we need to add some safety stock in addition to the “EXPECTED
demand” to Protect against demand uncertainty. How to model this if demand is normally distributed?
• Balance fixed costs and holding costs
 in EOQ setting, we order (2KD)/h so that we can balance our
fixed costs and holding costs, which allows us to minimize the total ordering and holding cost.
 With demand uncertainty, this is still valid. That is, everytime we place an order, we still want to
balance our fixed costs and holding costs, which allows us to minimize the total ordering/holding cost
The Multi-Period Inventory Model: Continuous
Review Policy v.s. Periodic Review Policy
• Continuous Review: also called (Q, R) Policy
• Q = order quantity
• R = reorder point
• How to determine Q and R?
• Periodic Review:
• Short review period (e.g. daily): (s, S) Policy
• Set s = R
• Set S = R + Q
 Continuous Review: also called (Q, R) Policy

R+Q
Inventory Position
Inventory Level

Q Lead
Time

0
Time
Notation (assuming demand is normally
distributed)
• AVG = average daily demand
• STD = standard deviation of daily demand
• L = replenishment lead time in days
• h = holding cost of one unit for one day
• SL = service level (for example, 95%). This implies that the probability of stocking
out is 100%-SL (for example, 5%)
• Also, the Inventory Position at any time is the actual inventory plus items already
ordered, but not yet delivered minus items that are backordered.
 Analysis

• The reorder point R has two components:

• To account for average demand during lead time:
LAVG
• To account for deviations from average (we call this safety stock)
z  STD L
where z is chosen from statistical tables to ensure that the probability of stockouts during
leadtime is 100%-SL.
• The reorder point R = LAVG + z  STD L
 Example
• The distributor has historically observed weekly demand of:
AVG = 44.6 STD = 32.1
Replenishment lead time is 2 weeks, and desired service level SL = 97%
• Average demand during lead time is:
44.6  2 = 89.2
• Safety Stock is:
1.88  32.1  2 = 85.3
• Reorder point is thus 175, or about 3.9 weeks of supply at warehouse and in the
pipeline
 (Q, R) Policy – Now that we know the Re-order Point, how much should we
order each time?
Q=?

• What are the factors we should consider?

• Fixed costs = 0 (Model One)
• Fixed costs > 0 (Model Two)
(Q, R) Policy - Model One: Fixed Costs = 0
• It costs you NOTHING to place an order, how much should
you order every time?
• Big Q vs. small Q  High inventory holding cost vs. low inventory holding
cost
• Q should be as small as possible  Just maintain the inventory level
at around reorder point R
(Q, R) Policy - Model Two: Fixed Costs > 0
• Intuitively, how will this affect our policy?

• In addition to previous costs, a fixed cost K is paid every time an order is placed.
• The reorder point will be the same as the previous model, in order to meet the
service requirement:

R = LAVG + z  STD  L

• What about order quantity Q?

• Extend the EOQ model  Q=(2 K AVG)/h
(Q, R) Policy - Model Two:
The Order-Up-To Level
• We have used the extended EOQ to balance the fixed costs and the holding costs:
Q=(2 K AVG)/h
• If there was no variability in demand, we would order Q when inventory level was
at L AVG. Why?
• However, there is demand variability, so we need safety stock
z  STD * L
• The total order-up-to level is:
S = Q+R = Q+ L AVG + z  STD * L
(Q, R) Policy - Model Two: Example
• Consider the previous example, but with the following additional info:
• fixed cost of $4500 when an order is placed
• $250 product cost
• holding cost 18% of product
• Weekly holding cost:
h = (.18  250) / 52 = 0.87
• Order quantity
Q=(2 4500  44.6 / 0.87 = 679
• Order-up-to level:
S = R + Q = 175 + 679 = 854
Evaluating Inventory holding cost  Evaluating Inventory Level
(Continuous Review Policy)
Inventory level as a function of time in a (Q,R) policy

z  STD  L
(1) Inventory level before receiving an order (lowest point) =
(2) Inventory level after receiving an order (highest point) = Q  z  STD  L

[(1)+(2)]/2 = Average Inventory =

Q
2  z  STD  L
29
 (Q, R) Policy (continuous review policy) vs.
(s,S) Policy (periodic review policy)
• (Q, R) Policy is also called continuous review policy because we
assume that we can review our inventory level continuously (i.e., all
the time) and can place an order anytime we want.
• In a periodic review environment, we do not know the inventory level
all the time, thus when the inventory reaches “R” – the reorder point
under the continuous review policy, we may not know and can NOT
order “Q” in every order as suggested by the continuous review
policy. Therefore, we need a more general policy called (s, S) Policy.
• (s, S) Policy: Whenever the inventory position drops below a certain
level, s, we order to raise the inventory position to level S.
• s: reorder point
• S: order-up-to level
Periodic Review Policy: Short Review Period
• When the review period is short, the situation is very
close to continuous review environment, thus we can
use the continuous review policy to approximate the
reorder point “s” and order-up-to level “S”.
• Periodic Review: Short review period (e.g. daily): (s, S)
Policy
• Set s = R
• Set S = R + Q
Continuous Review Policy v.s. Periodic
Review Policy
• Continuous Review: also called (Q, R) Policy
• Q = order quantity
• R = reorder point
• Periodic Review:
• Short review period (e.g. daily): (s, S) Policy
• Set s = R
• Set S = R + Q
• When you get to review your inventory level, if it is no more than R, you
should order enough to raise your inventory position to R+Q. So for example,
if your inventory level is X when you review and there is no incoming orders
that you are still waiting for and there is no backorders, that is, your inventory
position is X when you review, then you should order R + Q – X to bring your
inventory position to R + Q.