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Inventory management in supply

chain

Single period models

Impact of demand uncertainty
Only one ordering opportunity

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Source: MIT Sloan School of Management

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Arshinder,DoMS, IIT MAdras

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Arshinder,DoMS, IIT MAdras

Arshinder,DoMS, IIT MAdras

30-03-2015

Arshinder,DoMS, IIT MAdras

Arshinder,DoMS, IIT MAdras

30-03-2015

Decision

How much to Produce or Buy

One Time Shot
Perishable Goods
Excess Demand is Lost

Arshinder,DoMS, IIT MAdras

The Principal Trade-Off

Ordering Too Much
Inventory left over at Period End
Inventory sold at Loss

Ordering Too Little

Not all Demand is served
Loosing out on Revenue

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What should be the optimal order

quantity?
Using historical data
identify a variety of demand scenarios
determine probability each of these scenarios will occur

Given a specific inventory policy

determine the profit associated with a particular scenario
given a specific order quantity
weight each scenarios profit by the likelihood that it will occur
determine the average, or expected, profit for a particular ordering
quantity.

Order the quantity that maximizes the average profit.

Example: Summer fashion items

swimsuits
A company designs, produces, and sells summer
fashion items such as swimsuits.
About six months before summer, the company
must commit itself to specific production
quantities for all its products.
Since there is no clear indication of how the
market will respond to the new designs, the
company needs to use various tools to predict
demand for each design, and plan production and
supply accordingly.

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Construct probabilistic forecast of

demand

Average demand
=13000
Probabilistic forecast based on five years historical data,
current economic conditions and other relevant factors

Additional Information
Fixed production cost: Rs.100,000
Variable production cost per unit: Rs. 80.
During the summer season, selling price: Rs.
125 per unit.
Salvage value: Any swimsuit not sold during
the summer season is sold to a discount store
for Rs. 20.

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Important decisions
Though average demand is 13000 but there is
a probability that demand will be either larger
than average or smaller than average.
What should be the production quantity?
Relationship between production quantity,
customer demand and profits

Two Scenarios
Manufacturer produces 10,000 units while demand
ends at 12,000 swimsuits
Profit
= 125(10,000) - 80(10,000) - 100,000
= Rs. 350,000
Manufacturer produces 10,000 units while demand
ends at 8,000 swimsuits
Profit
= 125(8,000) + 20(2,000) - 80(10,000) - 100,000
= Rs. 140,000

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Probability of Profitability Scenarios

with Production = 10,000 Units
Probability of demand being 8000 units is 11%
Probability of profit of Rs. 140,000 = 11%

Probability of demand being 12000 units =

27%
Probability of profit of Rs. 140,000 = 27%

Total profit = Weighted average of profit

scenarios

Order Quantity that Maximizes

Expected Profit

FIGURE 2-6: Average profit as a function of production quantity

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Relationship Between Optimal

Quantity and Average Demand
Compare marginal profit of selling an additional unit and marginal
cost of not selling an additional unit
Marginal profit/unit =
Selling Price - Variable Ordering (or, Production) Cost
Marginal cost/unit =
Variable Ordering (or, Production) Cost - Salvage Value
If Marginal Profit > Marginal Cost
=> Optimal Quantity > Average Demand
If Marginal Profit < Marginal Cost
=> Optimal Quantity < Average Demand

For the Swimsuit Example

Average demand = 13,000 units.
Optimal production quantity = 12,000 units.
Marginal profit = Rs. 45
Marginal cost = Rs. 60.
Thus, Marginal Cost > Marginal Profit
=> optimal production quantity < average demand.

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Can you make out risk reward tradeoff in the previous example?

Marginal cost analysis approach to

single period uncertain demand
inventory model
News vendor case

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Newsvendor strategy
Consider the qth unit purchased by a
newsvendor. The newsvendor will be able to
sell qth unit if and only if
The total demand, d >=q
By buying and then making the qth unit available
to the customer, newsvendor have avoided
underage cost
Otherwise, an overage cost will be incurred for
the qth unit

Newsvendor strategy
The last unit q (or optimal quantity Q* ) we
would want to acquire is one where the
expected overage cost incurred exactly
equaled the expected underage cost saved.
< =
,
,

< =
+

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Notations

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Newsvendor model

< =

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Optimal order quantity

P (d < q)
Probability of meeting customer demand or cycle
service level (CSL) at corresponding q is optimal
order size q
Change the notation to Q* for optimal order size
P (d < Q* )=Optimal Cycle Service level (CSL*)
= ku / (ku + ko)
Optimal order size, Q* = F-1(CSL*, , )
Where, is the mean of demand distribution and
is the standard deviation of demand
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