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- Stochastic Models

Topics

Newsvendor model

(Q,r) and (s,S) models

Multi-echelon model

Statistical Inventory Control Models

Order more.

Anonymous, from Hadley & Whitin

EOQ Assumptions

1. Instantaneous production. EPL model relaxes this one

Modeling Philosophies for Handling

Uncertainty

1. Use stochastic model

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, )

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.

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.

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.

Newsvendor Model

Cost Function:

Y (Q ) expected overage expected shortage cost

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

over or short, not both.

But in expectation, overage and shortage

can both be positive.

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

IE 570 Huanan Zhang 11

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

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.

demand distribution.

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

Q* z

and if z is positive (i.e.,

if ratio is greater than 0.5).

IE 570 Huanan Zhang 14

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.

IE 570 Huanan Zhang 15

Example with Normally

Distributed Demand-Contd

Cs = 60 cents per liter

Co = 20 cents per liter.

SL = Cs/(Cs + Co) = 0.75

satisfy all the demand with 75 % probability.

business where stock outs lose long-term customers, then:

we must increase Cs to reflect the actual cost of lost customer due to

stockout

IE 570 Huanan Zhang 16

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

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

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

Discrete demand cases

may not be able to hit the exact service level.

Round up or down?

= min{ }

+

Poisson distribution

binomial distribution

geometric distribution

From empirical data

Example of Discrete p.m.f. on 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 )

distribution function 21 0.08 0.18 P(D < 21 )

(c.d.f). 22 0.08 0.26 P(D < 22 )

What if = 0.55? 26 0.12 0.75 P(D < 26 )

+

27 0.10 you do P(D < 27 )

Multi-Period Newsvendor Problems

Difficulty: Technically, the Newsvendor model is for a single period.

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

overage and shortage cost.

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.)

GAP Example (cont.)

Newsvendor Parameters:

co = $0.5

cs = $15

Solution:

are x on hand, then order 146x.

Newsvendor Takeaways

Inventory is a hedge against demand uncertainty.

shortage costs, as well as distribution of demand.

quantity generally increases in both the mean and

standard deviation of demand.

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

Inventory Management

Deterministic demand:

Number

of Items

Q

D

Time

Stochastic demand:

Number

of Items

Time Stockout

IE 570 Huanan Zhang 27

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.

Review Systems for Inventory Replenishment

Inventory replenishment policies use either a:

order is placed whenever the inventory drops below a

given level

order is placed at regular intervals of time.

(Q, r) Inventory Model

Consider a continuous review system with the following

replenishment policy:

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.

Inventory over time in a (Q, r) Model

Inventory Position

Inventory On Hand

Number

of Items

Q

Q

Reorder point r

Overshoot

Time Time

IE 570 Huanan Zhang 31

(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)

IE 570 Huanan Zhang 32

(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.

inventory to cover demand during the lead time.

cover this lead time demand on average,

avoid stockouts due to the random variability in demand

(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.

=D+D+D+D+D

= 5D

= 150 items

= 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

(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

-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

= 150 + 19.6 = 170 items (approximately)

during lead time variability in demand

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

(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

S

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

r r DL

and k

D L

IE 570 Huanan Zhang 39

(Q, r) Inventory Model: General Case

r DL

Since k , r is given by

D L

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)

the firm wishes to satisfy. SL = probability that

random customer during lead time is served

98%?) SL increases as Safety Stock increases, but

with diminishing returns (due to shape of demand

distribution)

IE 570 Huanan Zhang 41

Reorder Point (ROP)

Service level

Risk of

a stockout

Probability of

no stockout

ROP Quantity

Expected

demand Safety

stock

0 z z-scale

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

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

(s, S) Inventory Replenishment Model

The (Q, r) inventory model is a continuous review system.

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).

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

Time Time

IE 570 Huanan Zhang 46

Comparison of Continuous Review Systems

# 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

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.

IE 570 Huanan Zhang 48

Comparison of Continuous Review Systems

(Q, r) and (s, S) models

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

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).

Multi-echelon Models

1 2 3 4

e4

e2 e3

e1

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

Multi-echelon Models

Serial system uncertain demand (Shang and Song, 2003)

and stage j echelon inventory cost of Hj

1

,N N

*

b i 1 H i

N 1

where *

b i 1 H i

N N

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

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