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Inventory Management Subject
to Uncertain Demand
ISYE 3104 - Fall 2012
Inventory Control Subject to Uncertain Demand
In the presence of uncertain demand, the objective
is to minimize the expected cost or to maximize the
expected profit
Two types of inventory control models
Fixed time period - Periodic review
One period (Newsvendor model)
Multiple periods
Fixed order quantity - Continuous review
(Q,R) models
2
Types of Inventory Control Policies
Fixed order quantity policies
The order quantity is always the same but the time
between the orders will vary depending on demand
and the current inventory levels
Inventory levels are continuously monitored and an
order is placed whenever the inventory level drops
below a prespecified reorder point.
Continuous reviewpolicy
Types of Inventory Control Policies
Fixed time period policies
The time between orders is constant, but the
quantity ordered each time varies with demand and
the current level of inventory
Inventory is reviewed and replenished in given time
intervals, such as a week or month (i.e., review
period)
Depending on the current inventory level an order
size is determined to (possibly) increase the
inventory level up-to a prespecified level (i.e., order-
up-to level)
Periodic review policy
3
Inventory Control - Demand
U
n
c
e
r
t
a
i
n
t
y
Variability
D
e
t
e
r
m
i
n
i
s
t
i
c
S
t
o
c
h
a
s
t
i
c
Constant/Stationary Variable/Non-Stationary
Economic Order
Quantity (EOQ)
Tradeoff between
fixed cost and holding
cost
Aggregate Planning
Planning for capacity
levels given a forecast
Materials Requirements
Planning (MRP)
Very difficult problem!
Lot size/Reorder point
(Q,R) or (s,S) models
Tradeoff between fixed
cost, holding cost, and
shortage cost
Newsvendor single
period
READ THE APPENDIX ON
PROBABILITY REVIEW
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Newsvendor Models
ISYE 3104 Fall 2012
Example - INFORMS
INFORMS (The Institute for Operations Research and
Management Science, www.informs.org) will hold its annual
meeting in Washington D.C. in 2008. Six months before the
meeting begins, INFORMS must decide how many rooms
should be reserved at the conference hotel. At this time,
rooms can be reserved at a cost of $50 per room. It is
estimated that the demand for rooms is normally distributed
with mean 5000 and standard deviation 2000. If the number
of rooms required exceeds the number of rooms reserved,
extra rooms will have to be found at neighboring hotels at a
cost of $80 per room. The inconvenience of staying at
another hotel is estimated at $10. How many rooms should
be reserved to minimize the expected cost?
5
Example Fashion Bags
The buyer for What-a-Markup Fashion Bags must
decide on the quantity of a high-priced womans
handbag to procure in Italy for the following
Christmas Season. The unit cost of the handbag to
the store is $28.50 and the handbag will sell for
$150. A discount firm purchases any handbags not
sold by the end of the season for $20. In addition,
the store accountants estimate that there is cost of
$0.40 for each dollar tied up in inventory at the end
of the season (after all sales have been made).
Newsvendor model - Properties
One-time decision
Current decisions only impact the next period but
not future periods
Retail: fashion/seasonal items
One-time events
6
Tradeoff in inventory decisions
Shortage
Supply < Demand Lost sales / Lost profit
Excess inventory
Supply > Demand Inventory cost
Supply
Demand
Supply
Demand
Newsvendor model - Properties
One-time decision
Current decisions only impact the next period but not future
periods
Retail: fashion/seasonal items
One-time events
Relevant costs
C
o
: Unit cost of excess inventory (cost of overage)
C
u
: Unit cost of shortage (cost of underage)
Demand Dis a random variable with
Probability density function (pdf), f(x)
cumulative distribution function (cdf), F(x)
Objective: Choose the ordering quantity Q(before you know
the demand) to minimize
Total expected overage and underage costs
7
Newsvendor model Finding the optimal order
quantity
First, write the cost function:
o u
u
Q
u
Q
o
o
u
c c
c
Q F dx x f Q D c dx x f D Q c
dx x f x Q G D Q G Q G
Q Q G
Q D D Q c
Q D Q D c
D Q G
D Q D Q G
+
= + =
= =
+ =

s
>
=
+
} }
}

) ( ) ( ) ( ) ( ) (
) ( ) , ( ] , ( [ E ) (
ordered is if cost underage overage expected ) (
if ) (
if ) (
: ) , (

) is demand and ordered is (if cost underage overage total : ) , (
0
0
Critical Ratio
Derivation of the Critical Ratio - 1
) ( ). ), ( ( ) ( ). ), ( (
) , (
) , (
Rule s Leibniz' use G(Q), of derivative the take To
) ( ) ( ) ( ) ( ) (
ordered is if cost underage overage expected ) (
'
1 1
) (
) (
'
2 2
) (
) (
2 1
0
2
1
2
1
y f y y f h y f y y f h dx
y
y x h
dx y x h
dy
d
G c G c dx x f Q D c dx x f D Q c Q G
Q Q G
y f
y f
y f
y f
u o
Q
u
Q
o
} }
} }
+
c
c
=
+ = + =
+ =

) ( ) ( ) , (
0 ) ( ) ( : G1 In
1 2
x f x Q Q x h
y f Q y f Q y
=

8
Derivation of the Critical Ratio - 2
} }
} }
}

= =
= = = =
= = = =
=
c
c
=
c
c
+
c
c
=
=
Q
Q
y f
y f
y f
y f
Q
dx x f Q G
dQ
d
dx x f Q G
dQ
d
y f x Qf x f Q Q h y y f h
y f x f Q Q Q Q h y y f h
x f
Q
x f D Q
y
y x h
y f y y f h y f y y f h dx
y
y x h
dx y x h
dy
d
dx x f D Q Q G
) ( ) ( Similarly, ) ( ) (
0 ) ( ) ( ) ( ) 0 ( ) , 0 ( ) ), ( (
1 ) ( 0 ) ( ) ( ) , ( ) ), ( (
) (
)] ( ) [( ) , (
) ( ). ), ( ( ) ( ). ), ( (
) , (
) , (
Rule s Leibniz' use G(Q), of derivative the take To
) ( ) ( ) (
2
0
1
'
1 1
'
2 2
'
1 1
) (
) (
'
2 2
) (
) (
0
1
2
1
2
1
) ( ) ( ) , (
0 ) ( ) ( : G1 In
1 2
x f x Q Q x h
y f Q y f Q y
=

Derivation of the Critical Ratio - 3
) ( ) ( 1 ) ( ) ( ) ( ) (
1 ) ( : Recall
) (
0 ) ( ) (
)) ( 1 ( ) ( ) ( ) ( ) (
0
0
0
Q D P Q F dx x f Q D P Q F dx x f
dx x f
c c
c
Q F
c Q F c c
Q F c Q F c dx x f c dx x f c Q G
dQ
d
Q
Q
o u
u
u u o
u o
Q
u
Q
o
> = = s = =
=
+
=
= + =
= =
} }
}
} }

Also need to check if G(Q) is convex. Second derivative is (co+cu)f(Q)0

9
Example - INFORMS
D = number of rooms actually required
Q = number of rooms reserved
What are C
o
and C
u
?
Example - INFORMS
D = number of rooms actually required
Q = number of rooms reserved
DsQ: cost = 50Q
D>Q: cost = 50Q+80(D-Q)+10(D-Q) =90D-40Q
Cost of
reserving
Cost of
reserving
extra rooms
in other hotels
Cost of
inconvenience
10
Example - INFORMS
D = number of rooms actually required
Q = number of rooms reserved
DsQ: cost = 50Q
D>Q: cost = 50Q+80(D-Q)+10(D-Q)=90D-40Q
What is Q?
Cost of
reserving
Cost of
reserving
extra rooms in
other hotels
Cost of
inconvenience
C
o
C
u
=
+
=
+
=
9
4
50 40
40
) (
o u
u
c c
c
Q F
Example - INFORMS
Recall: D ~ Normal(5000,2000)
We have lookup tables for Standard Normal distribution
( =0, o=1) Convert to Standard Normal!
Find z from the lookup table Q =o z +
o
) ( ) ( ) ( ) (
444 . 0
9
4
) ( ) (
z z Z P
Q D
P Q D P Q D P
Q D P Q F
u = s = |
.
|

\
|
s

= s = s
= = s =
o

o


Z z Standard normal
11
Example - INFORMS
Recall: D ~ Normal(5000,2000)
We have lookup tables for Standard Normal distribution
( =0, o=1) Convert to Standard Normal!
Find z from the lookup table Q =o z +
o
) ( ) ( ) ( ) (
444 . 0
9
4
) ( ) (
z z Z P
Q D
P Q D P Q D P
Q D P Q F
u = s = |
.
|

\
|
s

= s = s
= = s =
o

o


Z z Standard normal Expected
demand
Safety
stock
Standard Normal Distribution - 1
) P(Z
e
z
z
s = =
=

1 curve
entire under the Area
mean the around Symmetric
2
) ( function Density
2
2
t
|
12
Standard Normal Distribution - 2
) P(Z
e
z
z
s = =
=

1 curve
entire under the Area
mean the around Symmetric
2
) ( function Density
2
2
t
|
z
F(z)=P(Zz)
We will use (z) and F(z)
interchangeably
Standard Normal Distribution - 2
) P(Z
e
z
z
s = =
=

1 curve
entire under the Area
mean the around Symmetric
2
) ( function Density
2
2
t
|
z
F(z)=P(Zz)
We will use (z) and F(z)
interchangeably
-z
F(-z)=P(Z-z)=1-F(z)
13
z = - 0.14
Example - INFORMS
4720 *
5000 ) 14 . 0 ( 2000
*
-0.14 z 0.444
curve under the Area ) ( ) (
=
+ =
+ =
= =
= u = s
Q
z Q
z z Z P
o
Example - INFORMS
Why is Q*<5000,
i.e., less than the
expected demand?
Expected
total cost
Expected
cost of
underage
Expected
cost of
overage
Q*=4720
14
Example - INFORMS
What if c
o
=150?
Expected
total cost
Expected
cost of
underage
Expected
cost of
overage
Q*=3390
3390
5000 ) 805 . 0 )( 2000 (
*
805 . 0 21 . 0
150 40
40
) (
=
+ =
+ =
= =
+
=
+
=
oz Q
z
c c
c
Q F
o u
u
Example - INFORMS
What if c
o
=150?
Expected
total cost
Expected
cost of
underage
Expected
cost of
overage
Q*=3390
3390
5000 ) 805 . 0 )( 2000 (
*
805 . 0 21 . 0
150 40
40
) (
=
+ =
+ =
= =
+
=
+
=
oz Q
z
c c
c
Q F
o u
u
C
o
| Q* +
C
u
| Q* |
15
When do we have Q*=Expected demand?
! ! ! i.e., , 5 . 0 ) (
need we * For
0 z 0.5
curve under the Area
) ( ) (
! ! ! 0 then * If
*
o u
o u
u
c c
c c
c
Q F
Q
z z Z P
z Q
z Q
= =
+
=
=
= =
=
= u = s
= =
+ =

o
z = 0
Optimal quantity versus expected demand
demand expected order same, cost the inventory excess and shortages If
* 0 5 . 0 ) (
demand expected than less order costly more is inventory excess If
* 0 5 . 0 ) (
demand expected than more order costly, more are shortages If
* 0 5 . 0 ) (

= = =
+
= =
< < <
+
= <
> > >
+
= >
Q z
c c
c
Q F c c
Q z
c c
c
Q F c c
Q z
c c
c
Q F c c
o u
u
o u
o u
u
o u
o u
u
o u
Note: Assuming the demand distribution is symmetric around its mean
16
The impact of standard deviation
What happens to the optimal quantity as the
standard deviation increases?
The impact of standard deviation
What happens to the optimal quantity as the standard
deviation increases? (Assuming the demand distribution is symmetric around its mean)
deviation standard of regardless demand expected order
same, cost the inventory excess and shortages If
in change not does * 0
dev. std. in decreases * , costly more is inventory excess If
in decreases * 0
dev. std. in increases * costly, more are shortages If
in increases * 0
o
o o
o o
= = =
+ = < <
+ = > >
Q z c c
Q
z Q z c c
Q
z Q z c c
o u
o u
o u
17
Example - INFORMS
c
u
=40 < c
o
=50 z=-0.14 c
u
=70 > c
o
=50 z=0.21
Q*
Q*
Standard deviation
Standard deviation
Example Fashion Bags
Input
Unit cost c = $28.50
Selling price p = $150
Salvage value s = $20
Cost of inventory = $0.40 for each dollar tied up in
inventory at the end of the season
18
Example Fashion Bags
Input
Unit cost c = $28.50
Selling price p = $150
Salvage value s = $20
Cost of inventory = $0.40 for each dollar tied up in
inventory at the end of the season
Computed input:
Holding cost per bag h =
c
u
=
c
o
=
=
+
=
o u
u
c c
c
Q F ) (
Example Fashion Bags
Input
Unit cost c = $28.50
Selling price p = $150
Salvage value s = $20
Cost of inventory = $0.40 for each dollar tied up in
inventory at the end of the season
Computed input:
Holding cost per bag h = (0.40)(28.50) = $11.4
c
u
= p c = $121.5
c
o
= c s + h = $19.9
86 . 0
9 . 19 5 . 121
5 . 121
) ( =
+
=
+
=
o u
u
c c
c
Q F
19
z = 1.08
Example Fashion Bags Normally distributed
demand
172 *
150 ) 08 . 1 )( 20 (
*
08 . 1 86 . 0 ) (
) 20 , 150 ( Normal ~ Demand
~
+ =
+ =
= =
= =
Q
z Q
z Q F
o
o
Area under the curve=
Critical ratio = 0.86
Example Fashion Bags Uniformly distributed
demand
Demand Uniform between 50 and 250 =150
Same expected demand as in Normal distribution
50 250
Uniform density
Q
Q*= 222
Area under the curve =
Critical ratio = 0.86
222 *
200
1
) 50 * ( 86 . 0
=
=
Q
Q
1/200
20
Example Fashion Bags
Even though both the Normal and the Uniform distributions
have the same mean (=150), why did we get different
quantities?
Normal distribution Q*=172
Uniform distribution Q*=222
Example Fashion Bags
Even though both the Normal and the Uniform distributions
have the same mean (=150), why did we get different
quantities?
Normal distribution Q*=172
Uniform distribution Q*=222
Because of the variance (equivalently, standard deviation) and
the shape of the distribution !!!
Normal o=20
Uniform o=57.7
Normal
Uniform