099S131 Aa06l01

Inventory Management:
Safety Inventory ( I )
CC
3.0
Inventory Management: Safety Inventory ( I )

1
Safety Inventory
Demand uncertainty
Supply uncertainty
Safety Inventory is inventory carried for the purpose of satisfying
demand that exceeds the amount forecasted for a given period.
Purposes of holding safety inventory
Average
Inventory
Inventory
Time
Safety Inventory

Cycle Inventory
2
Planning Safety Inventory
Appropriate level of safety inventory is determined by
Actions to improve product availability while reducing safety inventory
Uncertainty of both demand and supply
Uncertainty increases, then safety inventory increases.
Desired level of product availability Desired level of product availability
increases, then safety inventory increases.
3
Measuring Demand Uncertainty

k
i=1
D
i
P=
CV= o/
P=KD
D
k
o = O
Coefficient of variation
The total demand during k period is normally distributed with a mean of P
and a standard deviation of O :
If demand in each period is independent and normally distributed with a
mean of D and a standard deviation of o
D
, then
O=
o
i
2
+2 Cov(i,j)
i=1 i>j
k
=
o
i
2
+2 o
i
o
j
i=1 i>j
k
Uncertainty within lead time
Assume that demand for each period i, i=1,.,k is normally distributed
with a mean D
i
and standard deviation o
i
.
o
i
2

i=1
k
+2 o
i
o
j
i>j
D
k
o
4
Measuring Product Availability
Order fill rate
Product fill rate ( f
r
)
Cycle service level (CSL)
The fraction of replenishment cycles that end with all the customer demand being
met
The CSL is equal to the probability of not having a stockout in a replenishment
cycle
A CSL of 60 percent will typically result in a fill rate higher than 60%
The fraction of product demand that is satisfied from product in inventory
It is equivalent to the probability that product demand is supplied from available
inventory
The fraction of orders that are filled from available inventory
Order fill rates tend to be lower than product fill rates because all products must be
in stock for an order to be filled
CoolCLIPS
5
Product fill rate ( f
r
)

Order fill rate

Cycle service level (CSL)

Measuring Product Availability -- Page 5
On-hand
inventory
Order
received
Unfilled
demand
Filled
demand
0
Don't run out of inventory in 6 out of 10
replenishment cycles
An order for a total of 100 palms and has 90 in inventory
Customer may order a palm along with a calculator. The order is filled only if both
products are available.
CSL = 60%
fill rate > 60%
fill rate of 90%
In the 40% of the cycles where a stockout
does occur, most of the customer demand
is satisfied from inventory
Cycle
Microsoft
Microsoft
6
A replenishment policy consists of decisions regarding
When to reorder
How much to reorder.
Continuous review
Inventory is continuously tracked and an order for a lot size Q is placed
when the inventory declines to the reorder point (ROP).
Replenishment Policies
Periodic review
Inventory status is checked at regular periodic intervals and an order is
placed to raise the inventory level to a specified threshold, i.e. order up
to level (OUL) .
Q
P
7
A replenishment policy consists of decisions regarding
When to reorder
How much to reorder.
Continuous review
Inventory is continuously tracked and an order for a lot size Q is placed
when the inventory declines to the reorder point (ROP).
Replenishment Policies
Periodic review
Inventory status is checked at regular periodic intervals and an order is
placed to raise the inventory level to a specified threshold.
Q
P
8
Continuous Review System
Other names are: Reorder point system, fixed order quantity system
Decision rule
The remaining quantity of an item is reviewed each time a withdrawal is
made from inventory, to determine whether it is time to reorder.
Inventory position
IP = inventory position
OH = on-hand inventory
SR = scheduled receipts (open orders)
BO = units backordered or allocated
IP = OH+SR-BO
Whenever a withdrawal brings IP down to the reorder point (ROP), place
an order for Q (fixed) units.
9
Time
On-hand
inventory
Order
received
ROP
OH
IP
TBO
2
TBO
3

L
2
L
3

Order
received
OH
Q
IP
Order
placed
ROP = average demand during lead time + safety stock
ROP
Order
placed
L
1

TBO
1

10
Time
On-hand
inventory
TBO
2
TBO
3

L
2
L
3

Order
received
OH
Q
IP
Order
placed
Order
placed
L
1

TBO
1

FIX
Order
received
ROP
OH
IP
11
Time
On-hand
inventory
TBO
2
TBO
3

L
2
L
3

L
1

TBO
1

Order
received
OH
Q
IP
Order
placed
Order
placed
Order
received
ROP
IP
OH
12
Example
Given the following data
Average demand per week, D = 2,500
Standard deviation of weekly demand, s
D
=500
Average lead time for replacement, L = 2 weeks
Reorder point, ROP = 6,000
Average lot size, Q = 10,000
=ROP-DL=6,000-5,000=1,000 Safety inventory,ss
Cycle inventory
Average inventory
Average flow time
=Q/2=10,000/2=5,000
=5,000+1,000=6,000
= Average inventory / Throughput=6,000/2,500
=2.4weeks
13
Evaluating Cycle Service Level and Safety Inventory
D L L
L DL D o o = = and
CSL=Function ( ROP,D
L
,o
L
)
CSL= Prob (Demand during lead time of L weeks s ROP)
z=F
s
-1
(CSL)
ss=z Lo
D

Demand during lead time is normally distributed with a mean of D
L
and a
standard deviation of o
L
ROP=DL+Z Lo
D
CSL
14
Finding Safety Stock with a Normal Probability
Distribution for an 85 Percent CSL
Safety stock = z

o
L

Average
demand
during
lead time
Probability of stockout
(1.0 - 0.85= 0.15)
ROP
CSL = 85%
?
z

o
L
1
2
3
4:->ROP
15
Evaluating Cycle Service Level and Safety Inventory
D L L
L DL D o o = = and
CSL=Function ( ROP,D
L
,o
L
)
CSL= Prob (Demand during lead time of L weeks s ROP)
z=F
s
-1
(CSL)
ss=z Lo
D

Demand during lead time is normally distributed with a mean of D
L
and a
standard deviation of o
L
ROP=DL+Z Lo
D
16
Example
Q = 10,000
ROP = 6,000
L = 2 weeks
D=2,500/week,
D
=500
2x2,500=5,000 D
L
=DL=
=F(ROP, DL, o
L
)=F(6000,5000,707)
=NORMDIST(6000,5000,707,1)=0.92
= 2 x500=707
CSL=Proability of not stocking out in a cycle
o
L
= L o
D
17
Normal Distribution in Excel
Commands (Page 12)

) ( NORMINV ) (
) 0 , 1 , 0 , ( NORMDIST ) (
) 1 , 1 , 0 , ( NORMDIST or ) ( NORMDIST ) (
Normal Standard
1
p p F
x x f
x x x F
s
s
s
=
=
=
) , , ( NORMINV ) , , (
) 0 , , , ( NORMDIST ) , , (
) 1 , , , ( NORMDIST ) , , (
1
o o
o o
o o
p p F
x x f
x x F
=
=
=
18
Normal Distribution in Excel
(Demo)

19
Example
Q = 10,000
ROP = 6,000
L = 2 weeks
D=2,500/week, oD=500
CSL=0.9
2x2,500=5,000 D
L
=DL=
=F(ROP, DL, sL )=F(6000,5000,707)
=NORMDIST(6000,5000,707,1)=0.92
= 2 x500=707
ss=F
s
-1
(CSL
)
o
L
= L o
D
20
Example
D=2,500/week
o
D
=500
L = 2 weeks
Q = 10,000,
CSL=0.9
2x2,500=5,000 D
L
=DL=
=1.282x707=906
= 2 x500=707
ss=F
s
-1
(CSL)xo
L
=NORMDIST(CSL)xo
L

o
L
= L o
D
ROP=
2x2,500+906=5,906
21
Example
D=2,500/week
o
D
=500
L = 2 weeks
Q = 10,000,
CSL=0.9
2x2,500=5,000 D
L
=DL=
=1.282x707=906
= 2 x500=707
ss=F
s
-1
(CSL)xo
L
=NORMDIST(CSL)xo
L

o
L
= L o
D
ROP=
2x2,500+906=5,906

22
Periodic Review System
Other names are:
fixed interval reorder system or periodic reorder system.
Decision Rule
Review the items inventory position IP every T time periods. Place an
order equal to (OUL-IP) where OUL is the target inventory, that is, the
desired IP just after placing a new order.
The periodic review system has two parameters: T and
OUL.
Here Q varies, and time between orders (TBO) is fixed.
23
On-hand
inventory
Periodic Review System
OUL
Time
Order
placed
IP
L
T
L L
Order
received
OH
Q
2

IP
Order
placed
Q
1

Q
3

Order
placed
T
Protection interval
OH
IP
1

IP
3

IP
2

OUL
24
The new order must be large enough to make the inventory position, IP,
last not only beyond the next review, which is T periods from now, but
also for one lead time (L) after the next review. IP must be enough to
cover demand over a protection interval of T + L.

OUL =
Finding OUL
+
Safety stock for
protection interval

D
1
s
L T ) CSL ( F D ) L T ( o + + + =

Average demand
during protection
interval
25
Administratively convenient (such as each Friday)
weeks ) 52 (
D
EOQ
T =
weeks 4 or weeks 4.3 ) 52 (
1200
100
= = T
Selecting the Reorder Interval (T )
Example: Suppose D = 1200 /year and EOQ = 100
Approximation of EOQ
26
Example
D=2,500/week
o
D
=500
L = 2 weeks
T= 4weeks
CSL=0.9
(4+2)x2,500=15,000 D
T+L
=(T+L)D=
=1,570
ss=F
s
-1
(CSL)xo
T+L
=F
s
-1
(0.9)xo
T+L
OUL=D
T+L
+ss =
1,5000+1,570=16,570
D
T+L
= T+L oD= (4+2) x500=1,225
27
Periodic System versus Continuous System
Feature
Continuous review
system
Periodic review system
Order quantity Q-constant Q-variable
When to place
order
When quantity on hand
drops to the reorder level
When the review period
arrives
Recordkeeping Each time a withdrawal or
addition is made
Counted only at review period
Size of inventory Less than periodic system Larger than continuous system
Factors driving
safety inventory
Demand uncertainty
Replenishment lead time
Demand uncertainty
Replenishment lead time
Reorder interval
Type of items Higher-priced, critical, or
important items

28
Evaluating Fill Rate Given a Replenishment Policy
f (x) is density function of demand
distribution during the lead time
f
r
=1- =
In the case of normal distribution, we have
ESC
X=ROP
}
=

(X-ROP) f(x)dx
For a continuous review policy
Expected shortage per replenishment cycle (ESC) is the average units
of demand that are not satisfied from inventory in stock per cycle
Q
Q-ESC
Q
ESC
29
f (x) is the density function of demand
f
r
=1- =
ESC
X=ROP
}
=

(X-ROP) f(x)dx
ESC
Q
Q-ESC
Q
30
f
r
=1- =
ESC
X=ROP
}
=

(X-ROP) f(x)dx
ESC
Q
Q-ESC
Q
31
( ) | |
( ) 0 1 0
1 1 0 1
1
, , , /
, , , /
L L
L
L
s L
L
s
ss NORMDIST
ss NORMDIST ss
ss
f
ss
F ss ESC
o o
o
o
o
o
+
=
|
|
.
|
\
|
+
(
|
|
.
|
\
|
=
f
r
=1- =
ESC
X=ROP
}
=

(X-ROP) f(x)dx
ESC
Q
Q-ESC
Q
32
Proof
=
}
=

=ROP x
dx x f ROP x ESC ) ( ) (
}

+ =

ss D x
D x
L
L
L
dx
L L
e ss D x
2
1
) (
2 2
2 ) ( o
o t

WIKIPEDIA
WIKIPEDIA
33
o
L
dz
Proof
=
}
=

=ROP x
Substituting Z=(X-D
L
)/o
L
and dx=o
L
dz , we have
}
=
L
ss z
z
L
dz e ss z ESC
o
t
o
/
2 /
2
2
1
) (
}

+ =

ss D x
D x
L
L
L
dx
L L
e ss D x
2
1
) (
2 2
2 ) ( o
o t
34
Proof
}
=
L
ss z
z
L
dz e ss z ESC
o
t
o
/
2 /
2
2
1
) (
=
}
=

=ROP x
Substituting Z=(X-D
L
)/o
L
and dx=o
L
dz , we have
}

+ =

ss D x
D x
L
L
L
dx
L L
e ss D x
2
1
) (
2 2
2 ) ( o
o t
}
=

=
L
ss z
z
dz ss e
o t /
2 /
2
2
1
}
+

=
L
ss z
z
L
dz z e
o t
o
/
2 /
2
2
1
35
Proof
}
=
L
ss z
z
L
dz e ss z ESC
o
t
o
/
2 /
2
2
1
) (
}
=

=
L
ss z
z
dz ss e
o t /
2 /
2
2
1
}
+

=
L
ss z
z
L
dz z e
o t
o
/
2 /
2
2
1
36
Proof
}
=
L
ss z
z
L
dz e ss z ESC
o
t
o
/
2 /
2
2
1
) (
}
+

=
L
ss z
z
L
dz z e
o t
o
/
2 /
2
2
1
+ = )] / ( 1 [
L s
ss F ss o
}
=

=
L
ss z
z
dz ss e
o t /
2 /
2
2
1
37
Proof
}
=
L
ss z
z
L
dz e ss z ESC
o
t
o
/
2 /
2
2
1
) (
}
+

=
L
ss z
z
L
dz z e
o t
o
/
2 /
2
2
1
+ = )] / ( 1 [
L s
ss F ss o
}
=

=
L
ss z
z
dz ss e
o t /
2 /
2
2
1
}
o =
t
o
2
L
2
2 / ss w
w
L
dw
2
1
e
]
2
1
[ )] / ( 1 [
2
2
1
|
|
.
|
\
|
+ =
L
ss
L L s
e ss F ss
o
t
o o
) 2 / : (note
2
z w =
dw=2zdz/2
dw=zdz
38
Proof
}
=
L
ss z
z
L
dz e ss z ESC
o
t
o
/
2 /
2
2
1
) (
}
+

=
L
ss z
z
L
dz z e
o t
o
/
2 /
2
2
1
+ = )] / ( 1 [
L s
ss F ss o
}
=

=
L
ss z
z
dz ss e
o t /
2 /
2
2
1
}
2
2 /
2

2
1
L
ss w
w
L
dw e
o
t
o
]
2
1
[ )] / ( 1 [
2
2
1
|
|
.
|
\
|
+ =
L
ss
L L s
e ss F ss
o
t
o o
) 2 / : (note
2
z w =
ESC derivation
e
t
e
o e
d e
L
ss
=
}
2
2 /
2
2
1
0
=
2
2 /
2
2
1
L
ss
e
o
e
t
2
) / (
2
1
2
1 L
ss
e
o
t

=
39
Proof
}
=
L
ss z
z
L
dz e ss z ESC
o
t
o
/
2 /
2
2
1
) (
}
+

=
L
ss z
z
L
dz z e
o t
o
/
2 /
2
2
1
+ = )] / ( 1 [
L s
ss F ss o
}
=

=
L
ss z
z
dz ss e
o t /
2 /
2
2
1
}
o =
t
o
2
L
2 / ss w
w
L
2
dw
2
1
e
) 2 / : (note
2
z w =
]
2
1
[ )] / ( 1 [
2
2
1
|
|
.
|
\
|
+ =
L
ss
L L s
e ss F ss
o
t
o o
) / ( )] / ( 1 [
L s L L s
ss f ss F ss o o o + =
40
( ) | |
( ) 0 1 0
1 1 0 1
1
, , , /
, , , /
L L
L
L
s L
L
s
ss NORMDIST
ss NORMDIST ss
ss
f
ss
F ss ESC
o o
o
o
o
o
+
=
|
|
.
|
\
|
+
(
|
|
.
|
\
|
=
f
r
=1- =
ESC
X=ROP
}
=

(X-ROP) f(x)dx
ESC
Q
Q-ESC
Q
41
Example
For a continuous review system with the following data
Lot size ,Q=10,000
D
L
=5,000
o
L
= 707
ss=ROP-DL=6,000-5,000=1,000
ESC= -1,000[1-NORMDIST(1000/707,0,1,1)]
f
r
= =0.9975
10,000
10,000-25
+707xNORMDIST(1000/707,0,1,1)
=25
42
Excel-Demo
For a continuous review system with the following data
Lot size ,Q=10,000
D
L
=5,000
o
L
= 707
ss=ROP-DL=6,000-5,000=1,000
ESC= -1,000[1-NORMDIST(1000/707,0,1,1)]
f
r
= =0.9975
10,000
10,000-25
+707xNORMDIST(1000/707,0,1,1)
=25

43
Factors Affecting Fill Rate
Safety inventory
Fill rate increases if safety inventory is increased. This also increases the
cycle service level.
Lot size
Fill rate increases with the increase of the lot size even though cycle
service level does not change.
44
Factors Affecting Fill Rate -- Page 42
L s
CSL F ss o =

) (
1
) / ( )] / ( 1 [
L s L L s
ss f ss F ss ESC o o o + =
f
r
= 1- ESC/Q
f
r
= 1- ESC/Q
CSL = F(ROP, D
L
, s
L
) is independent of Q
Safety inventory
Fill rate increases if safety inventory is increased. This also increases the
cycle service level.
| | + | , f , , CSL ESC ss
r
Lot size
Fill rate increases on increasing the lot size even though cycle service
level does not change.
45
Evaluating Safety Inventory
Given Desired Fill Rate
|
|
.
|
\
|
+
(
|
|
.
|
\
|
= =
L
s
L
L
s
ss ss
F ss ESC
f
o
o
o
1 250
|
|
|
.
|
\
|
(
(
(
|
|
|
.
|
\
|
+ = 0 , 1 , 1 , 1 250
L
ss
NORMDIST
L
L
ss
NORMSDIST ss
o
o
o
If desired fill rate is fr = 0.975, how much safety inventory should be held?
ESC = (1 - fr)Q = 250
Solve
46
Excel-Demo

47
Evaluating Safety Inventory
Given Desired Fill Rate
|
|
.
|
\
|
+
(
|
|
.
|
\
|
= =
L
s
L
L
s
ss ss
F ss ESC
f
o
o
o
1 250
|
|
|
.
|
\
|
(
(
(
|
|
|
.
|
\
|
+ = 0 , 1 , 1 , 1 250
L
ss
NORMDIST
L
L
ss
NORMSDIST ss
o
o
o
If desired fill rate is fr = 0.975, how much safety inventory should be held?
ESC = (1 - fr)Q = 250
Solve
48
Evaluating Safety Inventory Given Fill
Rate
Fill Rate Safety Inventory
97.5% 67
98.0% 183
98.5% 321
99.0% 499
99.5% 767
The required safety inventory grows rapidly with an
increase in the desired product availability (fill rate).
49
Two Managerial Levers to Reduce Safety Inventory
Safety inventory increases with an increase in the lead time and
the standard deviation of periodic demand.
Reduce the underlying uncertainty of demand ( o
D
)
Reduce the supplier lead time (L)
k
If lead time decreases by a factor of k, safety inventory in the retailer
decreases by a factor of .
If o
D
is reduced by a factor of k, safety inventory decreases by a
factor of k.
The reduction in o
D
can be achieved by reducing forecast uncertainty,
such as by sharing demand information through the supply chain.
It is important for the retailer to share some of the resulting benefits to
the supplier.
50
Impact of Supply (Lead time) Uncertainty on
Safety Inventory
2 2 2
L D L
S D L + = o o
Assume demand per period and replenishment lead time are normally distributed
D:Average demand per period
o
D
:Standard deviation of demand per period (demand uncertainty)
L: Average lead time for replenishment
S
L
:Standard deviation of lead time (supply uncertainty)
Consider continuous review policy, we have:
Demand during the lead time is N(D
L
,o
L
2
)
DL D
L
=
51
Example
550 , 17 7 2500 500 7
500 , 17 7 500 , 2
9 . 0 ) days ( 7 ) days ( 7 500 500 , 2
2 2 2 2 2 2
= + = + =
= = =
= = = = =
L D L
L
L D
S D L
DL D
CSL S L D
o o
o
( ) 491 , 22
1
= =

L s
CSL F ss o
S
L
L
ss(units) ss(days)
6 15,058 7.72
5 12,570 6.44
4 10,087 5.17
3 7,616 3.90
2 5,172 2.65
1 2,828 1.45
0 1,323 0.68
Suppose we have
Required safety inventory,
A reduction in lead time uncertainty can help reduce safety inventory
19,298
16,109
12,927
9,760
6,628
3,625
1,695
52
/
5
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