INVENTORY MANAGEMENT

(STOCHASTIC MODEL)

Dr. Debadyuti Das (Professor)

Faculty of Management Studies
University of Delhi
das_debadyuti@rediffmail.com
Stochastic Inventory Models: Agenda
• Background
• Broad classification (Multi-period & Single period)
• Multi-period models
• Continuous Review Model
• Periodic Review Model
• Role of Safety Inventory
• A snapshot on single period Model
Stochastic Inventory Models: Rationale

• To balance annual inventory holding costs and annual

fixed order costs.
• To satisfy demand occurring during lead time.
• To protect the organization against uncertainty (or
fluctuation) in demand during lead time.
• To protect the organization against fluctuation in lead
time during lead time of procurement.
• To protect the organization against fluctuation in both
lead time and demand during procurement lead time.
Broad Types of Stochastic Inventory
Models
• Multi-period
- Inventory carried over from one stage to another
• Single Period
- Inventory is perishable & cannot be carried over to
the next period
Multi-period Stochastic Inventory Models
• Continuous review model (or policy)
• inventory is reviewed continuously
• an order is placed when the inventory reaches a
particular level or reorder point.
• inventory can be continuously reviewed
(computerized inventory systems are used)

• Periodic review model (or policy)

• inventory is reviewed at regular intervals
• appropriate quantity is ordered after each review.
• it is impossible or inconvenient to frequently review
inventory and place orders if necessary.
Continuous Review Policy
• Daily demand is random and follows a normal
distribution.
• Every time the distributor places an order from the
manufacturer, the distributor pays a fixed cost, A, plus
an amount proportional to the quantity ordered.
• Inventory holding cost is charged per item per unit time.
• Inventory level is continuously reviewed, and if an order
is placed, the order arrives after the appropriate lead
time.
• If a customer order arrives when there is no inventory on
hand to fill the order (i.e., when the distributor is stocked
out), the order is lost.
• The distributor specifies a required service level.
Continuous Review Model

• Normally utilized when the items purchased or

handled are expensive in nature and
• Management needs to closely monitor the level of
its inventory on a continuous basis.
• Popularly known as Q model or FOQ model or
ROP model.
Continuous Review Model

• Relevant policy is known as (s, S) or (s, Q) policy. ‘s’ and

‘S’ stand for reorder point (ROP) and order upto level
(OUL) respectively while Q indicates order quantity. The
relationship is as follows:
S=Q+s
ROP: Sum of the expected demand during lead time PLUS
safety stock which is determined in case of ROP or FOQ
model.
OUL: Expected demand during lead time and review period
PLUS safety stock during lead time and review period.
Continuous Review Model
There are five determinants of reorder point quantity.
• The rate of demand
• The lead time
• The extent of demand variability
• The extent of lead time variability
• The degree of stockout risk acceptable to the
management (safety stock)
Continuous Review Model
• ROP = Reorder point
• The reorder point (s) has two components:
• To account for average demand during lead time

• To account for deviations from average (we call this safety

stock)
ROP (s) = Average demand during lead time Plus Safety stock
• If demand and lead time are both constant, the reorder point is
simply
ROP (s) = Average demand during lead time
Since there is a fixed cost, we order more than up to the reorder
point:
Q = (2 A D)/h
• The total order-up-to level is:
S=Q+s
Reorder Point
The ROP based on a normal
Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale
Safety stock
Continuous review policy
Notations:
• = average daily/weekly demand
• d = standard deviation of daily/weekly demand
• dLT = standard deviation of demand during lead time
• LT = replenishment lead time in days/weeks
• = average replenishment lead time in days/weeks
• LT = standard deviation of lead time
• h = holding cost of one unit per period
• A = fixed cost
• SL = Service level (for example, 95%). This implies that the
probability of stocking out is 5%
• SS = Safety inventory
• s = Reorder point (ROP)
• S = Order upto level
• z = standard normal variable corresponding to a particular service
level provided to customers
Continuous review policy

Case 1: Only demand is variable

• Average demand during lead time =
• Safety stock (SS) =
• ROP (s) = +
• Order upto level (S) = Q + s
Continuous review policy

Case 2: Only lead time is variable

• Average demand during lead time =
• Safety stock (SS) =
• ROP (s) = +
• Order upto level (S) = Q + s
Continuous review policy

Case 3: Both demand and lead time is variable

• Average demand during lead time =
• Safety stock (SS) =
• ROP (s) = +
• Order upto level (S) = Q + s
Continuous review policy
Case1: Only lead time is variable

• The distributor has historically observed weekly

demand of:
= 44.6 d = 32.1

• Replenishment lead time is 2 weeks, and desired

service level SL = 97%, z = 1.88
• Average demand during lead time is:
44.6  2 = 89.2
• Safety Stock is:
1.88  32.1  2 = 85.3
• Reorder point is thus 175, or about 3.9 weeks of
supply at warehouse and in the pipeline
 Case1: Example (Contd.)
• Q=679

• Order-up-to level (S) thus equals:

Reorder Point (s) + Q = 175+679 = 854

• Cycle inventory = Q/2 = 340

• Average Inventory = cycle inventory + SS = 340 + 85 = 425

Case 2: Only lead time is variable

d = 600,
• Average lead time ( ) = 6
• S.D. of LT (LT) = 2
• Desired service level = 90 %, z = 1.28
• Demand during average LT = (d X )= (600 X 6) =
3600
• Safety stock = z d (LT) = 1.28 X 600 X 2 = 1536
• ROP = 5136
Case 3: Both demand and lead time are variable

• Average demand ( ) = 25,

• Average lead time ( ) = 10
• d = 3, LT = 2
• Desired service level = 95 %
• ROP = X + Z ( d2 + 2 LT2)
= 25 X 10 + 1.65 10(3)2 + (25)2 (2)2
=334
Periodic Review Model
• Applicable for most of the retail stores handling FMCG or
groceries.
• Also known as fixed order interval (FOI) model or P model and
the relevant policy is known as periodic review policy or base
stock policy.
• Orders for the items are placed at fixed intervals.
• Inventory level is also checked only in those intervals.
• Order upto level remains fixed.
• Order quantity computed on the basis of order upto level and
inventory level on hand at fixed intervals.
• The amount of safety inventory to be kept in this model is much
higher than that in case of FOQ model. Because the safety
inventory has to cover the period of lead time plus the fixed
order interval.
 Periodic Review Policy

• Two Cases:
• Short Intervals (e.g. Daily)
• Define two inventory levels s and S
• During each inventory review, if the inventory position falls
below s, order enough to raise the inventory position to S.
• (s, S) policy

• Longer Intervals (e.g. Weekly or Monthly)

• May make sense to always order after an inventory level
review.
• Determine a target inventory level, the base-stock level
• During each review period, the inventory position is reviewed
• Order enough to raise the inventory position to the base-stock
level.
• Base-stock level policy
Base-Stock Policy

r r

L L L
Base-stock
Level Inventory
Inventory Level

Position

0
Time
Inventory level as a function of time in a periodic review policy
Periodic review policy

The base-stock level includes two components:

• Average demand during (r+LT) period (the time until the
next order arrives): (r+LT)*d
• Safety stock during that time: z* d * (r+LT)
• Items from the same supplier may be clubbed together,
which yield savings in ordering costs, packaging costs,
shipping costs, handling costs and other related
administrative costs.
Base-Stock Level Policy Example
• Assume:
• distributor places an order for TVs every 3 weeks
• Lead time is 2 weeks
• Base-stock level needs to cover 5 weeks
• Average demand per week is 44.58
• S.D. of demand per week is 32.8
• Average demand = 44.58 x 5 = 222.9
• Safety stock =1.9  32.8 5
• Base-stock level = 223 + 136 = 359
• Average inventory level = 3442 .58  1.9  32.08  5  203.17

• Distributor keeps 5 (= 203.17/44.58) weeks of supply.

 Issues involved in FOI Model

• Items from the same supplier may yield savings in:

• Ordering
• Packing
• Shipping costs
• May be practical when inventories cannot be
closely monitored
However,
• Requires a larger safety stock
• Increases carrying cost
• Costs of periodic reviews
Role of Safety Inventory
There is a fundamental tradeoff:
• Raising the level of safety inventory provides higher
levels of product availability and customer service
• Raising the level of safety inventory also raises the level
of average inventory and therefore increases holding
costs
• Very important in high-tech or other industries where
obsolescence is a significant risk (where the value of
inventory, such as PCs, can drop in value)
• Compaq and Dell in PCs
Impact of service level on safety stock
• Service level is the probability that all orders will be filled
from stock during the replenishment lead time or during
the reorder cycle.
• A retailer has specified a service level of 95 percent. This
implies that during 100 such reorder cycles, we can
expect stock out situation in about five cycles.
• A firm keeping a higher level of safety factor is in a
position to provide higher level of customer service.
• Service level increases as the level of safety inventory
increases.
• The marginal increase in service level in the initial period
is higher than that in the later period.
Impact of service level on safety stock
Impact of demand and supply uncertainty
on safety stock
• Variability in demand and lead time has an important
bearing on the amount of safety stock to be kept by a firm.
• The absolute value of lead time also has an impact on the
amount of safety stock to be maintained.
• Reduction in variability of supplier lead time provides
highest benefits to the firm in terms of minimizing safety
stock requirement.
• Reduction in variability of demand is not a significant driver
in minimizing safety stock requirement.
• Reduction in average lead time does not have much
impact in minimizing safety stock requirement.
Impact of demand and supply uncertainty on
safety stock ((Consider SL = 97.8%, i.e. Z = 2)
Average S.D. of Average S.D. of Safety Safety Remarks
daily daily lead time lead stock stock in
demand demand (days) time days

500 100 20 6 4990 9.98 Base case

500 100 20 0 736 1.472 No supply

uncertainty

500 0 20 6 4935 9.87 No demand

uncertainty

500 50 20 6 4949 9.898 Reduce demand

uncertainty

500 100 20 3 2575 5.15 Reduce supply

uncertainty

500 100 10 6 4962 9.924 Reduction in lead

time
Single Period Inventory Model
• Special category of items for which demand occurs for a
very short period.
• The problem of managing inventory in a single period with
uncertain demand widely known as newsvendor problem.
• Goods are to be kept ready before the selling season
starts in order to take care of the demand.
• Opportunity does not exist to place a second order during
the selling season.
• The issue is: how many items should the manager order
before the selling season starts?
• Examples: fashion products, high technology products,
perishable goods etc.
Single Period Inventory Model
• Co = overage cost = (Cost – Salvage value)
increase in profit you would have enjoyed had you
ordered one fewer unit.
• Cu = underage cost = (Selling Price – Cost)
increase in profit you would have enjoyed had you ordered one
more unit.
• Critical ratio is Cu / (Co + Cu)
• This ratio implies the optimum level of service from
which the value of standard normal variable (z) is
found out.
• Optimum order size = Mean demand + z*standard
deviation of demand
Questions??