Module 4: Inventory

Management in Supply Chain

- Stochastic Models

IE 570 Huanan Zhang

 Topics
Newsvendor model
(Q,r) and (s,S) models
Multi-echelon model

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 Statistical Inventory Control Models

When your pills get down to four,

Order more.
Anonymous, from Hadley & Whitin

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 EOQ Assumptions
1. Instantaneous production. EPL model relaxes this one

2. Constant demand Wagner-Whitin algorithm relaxes this one

3. Deterministic demand. Newsvendor and (Q,r) relax this one

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 Modeling Philosophies for Handling
Uncertainty
1. Use stochastic model

2. Use deterministic model, then adjust solution

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 Perishable Inventories
Unsold or unused perishable products are not
typically carried over from one period to the
next; rather they are salvaged or disposed of.

Examples:
Fruits and vegetables
Seafood
Cut flowers
Blood (blood products in a blood bank)
Newspapers, magazines,
High Fashion clothing
Holiday-only items (Christmas trees, Hannukah, Easter, )

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 Costs
Shortage cost may be a charge for loss of
customer goodwill, or the opportunity cost of
lost sales (or customer!):
cs = Revenue per unit - Cost per unit.
Overage cost applies to the items left over at
end of the period, which need salvaging
co = Overage Cost = Original cost per unit - Salvage
value per unit.

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 The Newsvendor Approach
Assumptions:
1. single period
2. random demand with known distribution
3. linear overage/shortage costs
4. minimum expected cost criterion

Example:
Mr. Tan, a retiree, sells the local newspaper at a Bus
terminal. At 6:00 am, he meets the news truck and
buys # of the paper at $4.0 and then sells at $8.0. At
noon he throws the unsold and goes home for a nap.

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 Newsvendor Model Notation
X demand (in units), a random variable.
G ( x) P( X x)
cumulative distribution function of demand
(assumed continuous.)
d
g (x ) G (x )
dx
probability density function of demand.
co cost (in dollars) per unit le ft over after demand is realized.
cs cost (in dollars) per unit of shortage.
Q production or order quantity (in units), the decision variable.

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 Newsvendor Model
Cost Function:
Y (Q ) expected overage expected shortage cost

co E units over cs E units short

co max Q x , 0 g ( x ) dx cs max x Q , 0 g ( x ) dx
0 0

Q
co (Q x ) g ( x ) dx cs ( x Q ) g ( x ) dx
0 Q

Note: for any given day, we will be either

over or short, not both.
But in expectation, overage and shortage
can both be positive.

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 Newsvendor Model (cont.)
Note: The method used to derive the optimal solution on this page is only FYI.
Optimal Solution: taking the derivative of Y(Q) with respect to Q, setting it equal to zero,
and solving yields:

d Leibnitz's Rule:
0 Y (Q )
dQ d f Q

f Q , x dx
2

dQ
d c Q (Q x ) g ( x ) dx f Q

o 0

1

f 2 Q f Q , x dx
dQ

cs ( x Q ) g ( x ) dx

f1 Q Q
Q
f Q , f1 Q d f1 Q

co 1 g ( x ) dx 0
Q
dQ
0
f Q, f 2 Q d f 2 Q

cs 1 g ( x ) dx 0

dQ
Q
co G (Q ) cs 1 G (Q )
G (Q ) P X Q
* cs *

co c s G ( Q ) c s co cs
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 Newsvendor Model (cont.)
Optimal Service Level (Type 1):

G (Q ) P X Q
* *
cs
co c s

G(Q)

1
cs
co c s

Q* Q

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 Back to Mr. Tans Example
Mr. Tan, a retiree, sells the local newspaper at a Bus
terminal. At 6:00 am, he meets the news truck and buys #
of the paper at $4.0 and then sells at $8.0. At noon he
throws the unsold and goes home for a nap.

The critical ratio is ($8$4)/($4+($8$4))=1/2.

Mr. Tans ordering quantity should be the median of the

demand distribution.

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 Newsvendor Model with Normal
Demand
Suppose demand is normally distributed with mean
and standard deviation . Then the critical ratio
formula reduces to:
3.00

Q * cs
(z)
G (Q * )
co c s

Q * cs 0.00

z where ( z )
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103 109 115 121 127 133 139 145 151 157

0 z
co c s

Note: Q* increases in both

Q* z
and if z is positive (i.e.,
if ratio is greater than 0.5).
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 Example with Normally
Distributed Demand
Note: Computing the optimal stocking level differs slightly
depending on whether demand is continuous (e.g. normal)
or discrete. We began with continuous cases (e.g. normal,
exponential, etc.).
Suppose demand for apple cider at a downtown street stand
varies continuously according to a normal distribution with
a mean of 200 liters per week and a standard deviation of
100 liters per week:
Revenue per unit = $ 1 per liter
Cost per unit = $ 0.40 per liter
Salvage value = $ 0.20 per liter.
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 Example with Normally
Distributed Demand-Contd
Cs = 60 cents per liter
Co = 20 cents per liter.
SL = Cs/(Cs + Co) = 0.75

To maximize profit, we should stock enough product to

satisfy all the demand with 75 % probability.

The folks in marketing could get worried! If this is a

business where stock outs lose long-term customers, then:
we must increase Cs to reflect the actual cost of lost customer due to
stockout
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 Example with Normally
Distributed Demand-Contd
Demand is Normal (200 liters per week, variance = 10,000
liters2/wk) so = 100 liters per week
Continuous example continued:
75% of the area under the normal curve must be
to the left of the stocking level.
z table shows a z of 0.67 corresponds to a left
area of 0.749
Optimal weekly purchase/ stocking level
= mean + z () = 200 + (0.67)(100) = 267

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 Example: Penn State T-Shirts
Scenario:
Demand for Penn State T-shirts is exponential with mean 1000,
so G(x) = P(X x) = 1 ex/1000.
(Note: this is an odd demand distribution;
Poisson or Normal would probably be better modeling choices.)
Cost of shirts is $10.
Selling price is $15.
Unsold shirts can be sold off at $8.

Model Parameters:
cs = 15 10 = $5
co = 10 8 = $2

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 Newsvendor Example T Shirts
(cont.)
Solution: Q
cs 5 5
G (Q ) 1 e 1000 0.714
co c s 2 5 7
5
Q 1000 ln 1 1, 253
*

7
Sensitivity: If co = $10 (i.e., shirts must be discarded) then

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 Discrete demand cases

When demand does not follow a continuous distribution, we

may not be able to hit the exact service level.

Round up or down?

= min{ }
+

Example of discrete distributions:

Poisson distribution
binomial distribution
geometric distribution
From empirical data

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 Example of Discrete p.m.f. on Demand

Probability that demand

Cumulative will be less than or equal to x
Demand follows a
discrete (relative Relative Relative
frequency) Frequency Frequency
distribution, which is Demand (pmf) (cdf)
described by a prob.
mass function (p.m.f.) 19 0.05 0.05 P(D < 19 )

or a cumulative 20 0.05 0.10 P(D < 20 )

distribution function 21 0.08 0.18 P(D < 21 )
(c.d.f). 22 0.08 0.26 P(D < 22 )

23 0.13 0.39 P(D < 23 )

24 0.14 0.53 P(D < 24 )

25 0.10 0.63 P(D < 25 )

What if = 0.55? 26 0.12 0.75 P(D < 26 )
+
27 0.10 you do P(D < 27 )

28 0.10 you do P(D < 28 )

29 0.05 1.00 P(D < 29 )

* pmf = prob. mass function

 Multi-Period Newsvendor Problems
Difficulty: Technically, the Newsvendor model is for a single period.

Extensions: However, the Newsvendor model can be applied to multiple

period situations, provided:
demand during each period is iid, distributed according to G(x)
there is no setup cost associated with placing an order
stockouts are either lost or backordered
Infinite periods

Key: make sure co and cs appropriately represent

overage and shortage cost.

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 Example: GAP
Scenario:
GAP orders a particular clothing item every Friday
mean weekly demand is 100, standard deviation is 25
(assumed to be normally distributed)
wholesale cost is $10, retail is $25, unsatisfied
demands are lost
holding cost has been set at $0.5 per week (to reflect
obsolescence, damage, etc.)

Problem: how should they set order amounts?

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 GAP Example (cont.)
Newsvendor Parameters:
co = $0.5
cs = $15
Solution:

Every Friday, they should order up to 146, that is, if there

are x on hand, then order 146x.

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 Newsvendor Takeaways
Inventory is a hedge against demand uncertainty.

Amount of protection depends on overage and

shortage costs, as well as distribution of demand.

If shortage cost exceeds overage cost, optimal order

quantity generally increases in both the mean and
standard deviation of demand.

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 Inventory Management - Recap
Deterministic models:
- Economic order quantity (EOQ) model Demand is fixed (static models)
- Economic production lot size (EPL) model
- Dynamic lot sizing models and solutions Demand varies over time

Stochastic models:
- Newsvendor problem: random demand, single time period
- Inventory replenishment systems: random demand, multiple time periods

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 Inventory Management
Deterministic demand:

Number
of Items

Q
D
Time
Stochastic demand:
Number
of Items

Time Stockout
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 Inventory Replenishment System
To avoid a stockout, inventory must be replenished from time to time, by
placing new orders for items.

Lead time: The time from when an order is placed until it arrives

During the lead time, the items in the order are on their way (but have
not arrived). These items are pipeline inventories.

All items that have already arrived from previous orders are called
on-hand inventories.

Inventory position = pipeline inventories+ on-hand inventories

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Review Systems for Inventory Replenishment
Inventory replenishment policies use either a:

continuous review system

order is placed whenever the inventory drops below a
given level

periodic review system

order is placed at regular intervals of time.

We consider here a continuous review system.

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 (Q, r) Inventory Model
Consider a continuous review system with the following
replenishment policy:

Whenever the inventory position drops below a given level, r, an

order is placed for a fixed quantity Q.
The inventory level, r, is called
the reorder point. It is the
number of items that triggers an
order for more items.

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Inventory over time in a (Q, r) Model
Inventory Position
Inventory On Hand

Number
of Items
Q
Q

Reorder point r
Overshoot

Lead Lead Time

Time Time
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 (Q, r) Inventory Model: Parameters
Assume:
Demand for items is a random variable, X, with given mean and variance.
Demands in separate increments of time are independent.
Lead time is fixed.

Let
r = reorder point (number of items)
Q = order quantity (number of items)
D = E[X] = mean demand (number of items per unit time)
D2 = Var[X] = variance of demand (items2 per unit time)
L = lead time (units of time)

Objective: To determine the reorder point, r, in terms of D, D2 , and L.

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 (Q, r) Inventory Model
The order quantity Q can be set using the standard EOQ model:
2 AD
Q
h
where A is the ordering or set-up cost, and h is the holding cost.

The reorder point r must be set so that there is sufficient

inventory to cover demand during the lead time.

The inventory must:

cover this lead time demand on average,
avoid stockouts due to the random variability in demand

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 (Q, r) Inventory Model
Example:
Mean demand D = 30 items per day
Variance of demand = 20 items2 per day
Lead time L = 5 days
If demand is X1 in day 1, X2 in day 2, etc.,
total demand during the 5-day lead time, S =
Since demand each day, X, is a random variable, S is also a random variable.
Let = E[S] = mean of S, and 2 = Var[S] = variance of S.

Mean demand during lead time, = E[S] = E[X1 + X2 + X3 + X4 + X5]

=D+D+D+D+D
= 5D
= 150 items

Variance of demand during lead time, 2 = Var[S] = Var[X1 + X2 + X3 + X4 + X5]

= D2 *5 since demands each day
are independent
= 100
 (Q, r) Inventory Model
Need to set reorder point, r, so that the probability that S > r is small (e.g., 2.5%),
i.e., only a 2.5% probability of a stockout. Set r so that P{S > r} = 0.025
or P{S r} = 1 0.025 = 0.975 (i.e., service level of 97.5%)
In our example, S is a random variable with mean = E[S] = 150 items
and variance 2 = Var[S] = 100 items2 (i.e., standard deviation = 10 items)
S S 150
Let Z
10
If demand S during the 5-day lead time is normally distributed, then Z has a
1
standard normal distribution, with probability density function ( z ) ez
2
2

2
(z)

Mean of Z, E[Z] = 0
Variance of Z, Var[Z] = 1

-3 -2 -1 0 1 2 3
z
 (Q, r) Inventory Model
For a 97.5% service level, set r so that P{S r} = 0.975

S 150 r 150
P{S r} = P
10 10

r 150
P Z
10
r 150
= P{Z k} where k
10
Therefore,
setting r so that P{S r}= 0.975
is the same as:
setting k so that P{Z k} = 0.975

where Z is a random variable with a standard normal distribution.

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 (Q, r) Inventory Model
1
Z has a standard normal distribution ( z ) e z2 2
( < z < )
2
From statistical tables for the standard normal distribution,
the value of k that gives P{Z k} = 0.975 is k = 1.96

(z)

P{Z k} = 0.975

P{Z > k} = 0.025

-3 -2 -1 0 1 2 3
z
k =1.96
1.96
1
P{Z k} = e
z2 2
dz 0.975
2 37
 (Q, r) Inventory Model
For 97.5% service level, k = 1.96, i.e.,
r 150
1.96 service level factor
10

Reorder point r = 150 + 1.9610

= 150 + 19.6 = 170 items (approximately)

Average demand Safety stock due to random

during lead time variability in demand

i.e, for this example,

set reorder point r at 170 items to ensure 97.5% probability of no stockout.

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 (Q, r) Inventory Model: General Case
In general case: Mean demand is D items per day
Variance of demand is D2 items2 per day
Lead time is L days
Demand is X1 in day 1, X2 in day 2, etc.
Total demand during the lead time, S = X1 + X2 + ...... + XL
E[S] = L E[X] = DL
Var[S] = L Var[X] = LD
2

Std. Dev[S] = L D2 D L

i.e., = DL and = D L

If demand S during the L days of lead time is normally distributed, then

S
P{S r} = P{Z k} where Z has a standard normal distribution

r r DL
and k
D L
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 (Q, r) Inventory Model: General Case
r DL
Since k , r is given by
D L

Reorder point r DL k D L where k is the service level factor

Average demand Safety stock due to random

during lead time variability in demand
DL k D L

Probability
density
function
of S
f (s)
P{S > r} = P{stockout}

r k DL k D L
Lead time demand, S
If required service level is 97.5% , then service level factor k = 1.96
If required service level is 99.0% , then service level factor k = 2.33
 The Order Cycle Service Level, (SL)

SL = % of demand during the lead time (% of DDLT)

the firm wishes to satisfy. SL = probability that
random customer during lead time is served

SL must be set according to Shortage Cost

SL should not be 100% for most firms. (90%? 95%?

98%?) SL increases as Safety Stock increases, but
with diminishing returns (due to shape of demand
distribution)
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Reorder Point (ROP)

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale

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Normal Dist. on Demand During Lead
Time
Q: Which requires a higher ROP?

Standard Deviation = 5

Standard Deviation = 10

Average = 30

0 10 20 30 40 50 60

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 Including Lead Time Variability
Standard Deviation of Lead Time Demand:

s = Ls D2 + d 2s L2
Inflation term due to
lead time variability
Modified Base Stock Formula

r DL k

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 (s, S) Inventory Replenishment Model
The (Q, r) inventory model is a continuous review system.

Another continuous review system that is often used in practice is

the (s, S) inventory model. In this model, an order placed whenever the
inventory position drops below the reorder point, just as in the (Q, r) model.
However, when an order is placed, the quantity ordered is for a sufficient
amount to bring the inventory position up to a fixed level, S, known as the
order-up-to level.

The reorder point in this model is generally denoted by s (but it is the same as
r in the (Q, r) model).

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 Inventory over time in the (s, S) Model
Inventory Position
Inventory On Hand

Order-up-to level S

Number
of Items

Reorder point s
Overshoot

Lead Lead Time

Time Time
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 Comparison of Continuous Review Systems

(Q, r) model (s, S) model

# of # of
Items Items Order-up-to level
S

Q
Q

r s
Overshoot Overshoot

0 0
Lead Lead Time Lead Lead Time
Time Time Time Time

Inventory position
Inventory on hand IE 570 Huanan Zhang 47
 (s, S) Inventory Replenishment Model
D = E[X] = mean demand (number of items per unit time)
D2 = Var[X] = variance of demand (items2 per unit time)
L = lead time (units of time)
k = service level factor (typically about 2)

Just as in the (Q, r) model, the reorder point in the (s, S) model is set to be

Reorder point s DL k D L

The order-up-to level S is set to be

Order-up-to level S = s + Q

2 AD
where Q is taken as the EOQ result, Q
h

In the (Q, r) model, the order quantity is fixed, and the inventory position
just after an order is placed is variable.
In the (s, S) model, the inventory position just after an order is placed is
fixed, and the order quantity is variable.
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 Comparison of Continuous Review Systems
(Q, r) and (s, S) models

If demand occurs one item at a time,

then the (s, S) policy is the same as the (Q, r) policy.

If, however, demand can occur in batches,

so that the inventory position can drop from a level above the
reorder point to a level below the reorder point instantaneously
(i.e., an overshoot can occur),
then the (Q, r) and (s, S) policies are different
(since the order quantity is fixed in the (Q,r) model, but varies in
the (s, S) model).

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 Multi-echelon Models

1 2 3 4
e4
e2 e3
e1

Echelon inventory at stage j includes inventory at j

and all inventory downstream from j
Thus, with inventory in-transit to stage j given by Tj,
echelon inventory at stage j is
N
I j I j T I i i
i j 1

Ravindran and Warsing CRC Press (2013) 50

 Multi-echelon Models
Serial system uncertain demand (Shang and Song, 2003)

N-stage system with stage N backorder penalty of b

and stage j echelon inventory cost of Hj

Stage N base-stock level SN* FDLT

1
,N N
*

b i 1 H i
N 1

where *

b i 1 H i
N N

Ravindran and Warsing CRC Press (2013) 51

 Multi-echelon Models
Serial system uncertain demand (Shang and Song, 2003)

S l
S j
u
Stage j base-stock level Sj
j

2

where S lj FDLT
1
,j l
j and S u
j F 1
DLT , j j
u

b i 1 H i b i 1 H i
j 1 j 1

with
l
and u

b i 1 H i b i 1 H i
j N j j

Ravindran and Warsing CRC Press (2013) 52