Outline

Single-Period Models
Discrete Demand
Continuous Demand, Uniform Distribution
Continuous Demand, Normal Distribution
Multi-Period Models
Given a Q, R Policy, Find Cost
Optimal Q, R Policy without Service Constraint
Optimal Q, R Policy with Type 1 Service Constraint
Optimal Q, R Policy with Type 2 Service Constraint
LESSON 1: INVENTORY MODELS
(STOCHASTIC)
Stochastic Inventory Control Models
Inventory Control with Uncertain Demand
In Lessons 16-20 we shall discuss the stochastic
inventory control models assuming that the exact
demand is not known. However, some demand
characteristics such as mean, standard deviation and
the distribution of demand are assumed to be known.
Penalty cost, : Shortages occur when the demand
exceeds the amount of inventory on hand. For each
unit of unfulfilled demand, a penalty cost of is
charged. One source of penalty cost is the loss of
profit. For example, if an item is purchased at $1.50
and sold at $3.00, the loss of profit is $3.00-1.50 =
$1.50 for each unit of demand not fulfilled.
p
p
More on penalty cost,
Penalty cost is estimated differently in different situation.
There are two cases:
1. Backorder - if the excess demand is backlogged and
fulfilled in a future period, a backorder cost is
charged. Backorder cost is estimated from
bookkeeping, delay costs, goodwill etc.
2. Lost sales - if the excess demand is lost because the
customer goes elsewhere, the lost sales is charged.
The lost sales include goodwill and loss of profit
margin. So, penalty cost = selling price - unit variable
cost + goodwill, if there exists any goodwill.
p
Stochastic Inventory Control Models
Inventory Control with Uncertain Demand
Single- and Multi- Period Models
Stochastic models are classified into single- and multi-
period models.
In a single-period model, items are received in the
beginning of a period and sold during the same period.
The unsold items are not carried over to the next
period.
The unsold items may be a total waste, or sold at a
reduced price, or returned to the producer at some
price less than the original purchase price.
The revenue generated by the unsold items is called
the salvage value.
Single- and Multi- Period Models
Following are some products for which a single-period
model may be appropriate:
Computer that will be obsolete before the next order
Perishable products
Seasonal products such as bathing suits, winter
coats, etc.
Newspaper and magazine
In the single-period model, there remains only one
question to answer: how much to order.
Single- and Multi- Period Models
In a multi-period model, all the items unsold at the
end of one period are available in the next period.
If in a multi-period model orders are placed at regular
intervals e.g., once a week, once a month, etc, then
there is only one question to answer: how much to
order.
However, we discuss Q, R models in which it is
assumed that an order may be placed anytime. So,
as usual, there are two questions: how much to order
and when to order.
Single-Period Models
In the single-period model, there remains only one
question to answer: how much to order.
An intuitive idea behind the solution procedure will
now be given: Consider two items A and B.
Item A
Selling price $900
Purchase price $500
Salvage value $400
Item B
Selling price $600
Purchase price $500
Salvage value $100
Single-Period Models
Item A
Loss resulting from unsold items = 500-400=$100/unit
Profit resulting from items sold = $900-500=$400/unit
Item B
Loss resulting from unsold items = 500-100=$400/unit
Profit resulting from items sold = $600-500=$100/unit
If the demand forecast is the same for both the items, one
would like to order more A and less B.
In the next few slides, a solution procedure is discussed
that is consistent with this intuitive reasoning.
Single-Period Models
First define two terms:
Loss resulting from the items unsold (overage cost)
c
o
= Purchase price - Salvage value
Profit resulting from the items sold (underage cost)
c
u
= Selling price - Purchase price
The Question
Given costs of overestimating/underestimating
demand and the probabilities of various demand
sizes how many units will be ordered?
Demand may be discrete or continuous. The demand
of computer, newspaper, etc. is usually an integer.
Such a demand is discrete. On the other hand, the
demand of gasoline is not restricted to integers. Such
a demand is continuous. Often, the demand of
perishable food items such as fish or meat may also
be continuous.
Consider an order quantity Q
Let p = probability (demand<Q)
= probability of not selling the Q
th
item.
So, (1-p) = probability of selling the Q
th
item.
Single-Period Models (Discrete Demand)
Decision Rule
Expected loss from the Q
th
item =
Expected profit from the Q
th
item =
So, the Qth item should be ordered if
Decision Rule (Discrete Demand):
Order maximum quantity Q such that
where p = probability (demand<Q)
u o
u
u o
c c
c
p or
c p pc
+
s
s
,
) 1 (
o
pc
( )
u
c p 1
u o
u
c c
c
p
+
s
Single-Period Models (Discrete Demand)
Decision Rule
Example 1: Demand for cookies:
Demand Probability of Demand
1,800 dozen 0.05
2,000 0.10
2,200 0.20
2,400 0.30
2,600 0.20
2,800 0.10
3,000 0,05
Selling price=$0.69, cost=$0.49, salvage value=$0.29
a. Construct a table showing the profits or losses for each
possible quantity (Self study)
b. What is the optimal number of cookies to make?
c. Solve the problem by marginal analysis.
Single-Period Models (Discrete Demand)
Note: The demand is
discrete. So, the demand
cannot be other numbers
e.g., 1900 dozens, etc.
Demand Prob Prob Expected Revenue Revenue Total Cost Profit
(dozen) (Demand) (Selling Number From From Revenue
all the units) Sold Sold Unsold
Items Items
1800 0.05
2000 0.1
2200 0.2
2400 0.3
2600 0.2
2800 0.1
3000 0.05
a. Sample computation for order quantity = 2200:
Expected number sold = 1800Prob(demand=1800)
+2000Prob(demand=2000) + 2200Prob(demand>2200)
= 1800(0.05)+2000(0.1)+2200(0.2+0.3+0.2+0.1+0.05)
= 1800(0.05)+2000(0.1)+2200(0.85) = 2160
Revenue from sold items=2160(0.69)=$1490.4
Revenue from unsold items=(2200-2160)(0.29)=$11.6
Single-Period Models (Discrete Demand)
Self Study
Demand Prob Prob Expected Revenue Revenue Total Cost Profit
(dozen) (Demand) (Selling Number From From Revenue
all the units) Sold Sold Unsold
Items Items
1800 0.05 1 1800 1242.0 0.0 1242 882 360
2000 0.1 0.95 1990 1373.1 2.9 1376 980 396
2200 0.2 0.85 2160 1490.4 11.6 1502 1078 424
2400 0.3 0.65 2290 1580.1 31.9 1612 1176 436
2600 0.2 0.35 2360 1628.4 69.6 1698 1274 424
2800 0.1 0.15 2390 1649.1 118.9 1768 1372 396
3000 0.05 0.05 2400 1656.0 174.0 1830 1470 360
Single-Period Models (Discrete Demand)
a. Sample computation for order quantity = 2200:
Total revenue=1490.4+11.6=$1502
Cost=2200(0.49)=$1078
Profit=1502-1078=$424
b. From the above table the expected profit is maximized for
an order size of 2,400 units. So, order 2,400 units.
Self Study
c. Solution by marginal analysis:
Order maximum quantity, Q such that
Demand, Q Probability(demand) Probability(demand<Q), p
1,800 dozen 0.05
2,000 0.10
2,200 0.20
2,400 0.30
2,600 0.20
2,800 0.10
3,000 0,05
( ) =
+
s < =
0
c c
c
Q p
u
u
demand y Probabilit
=
=
o
u
c
c
Single-Period Models (Discrete Demand)
In the previous slide, one may draw a horizontal line that
separates the demand values in two groups. Above the line,
the values in the last column are not more than
The optimal solution is the last demand value above the line.
So, optimal solution is 2,400 units.
Single-Period Models (Discrete Demand)
=
+
0
c c
c
u
u
Continuous Distribution
Often the demand is continuous. Even when the
demand is not continuous, continuous distribution may
be used because the discrete distribution may be
inconvenient.
For example, suppose that the demand of calendar can
vary between 150 to 850 units. If demand varies so
widely, a continuous approximation is more convenient
because discrete distribution will involve a large number
of computation without any significant increase in
accuracy.
We shall discuss two distributions:
Uniform distribution
Continuous distribution
Continuous Distribution
First, an example on continuous approximation.
Suppose that the historical sales data shows:
Quantity No. Days sold Quantity No. Days sold
14 1 21 11
15 2 22 9
16 3 23 6
17 6 24 3
18 9 25 2
19 11 26 1
20 12
Continuous Distribution
A histogram is constructed with the above data and shown
in the next slide. The data shows a good fit with the normal
distribution with mean = 20 and standard deviation = 2.49.
There are some statistical tests, e.g., Chi-Square test, that
can determine whether a given frequency distribution has
a good fit with a theoretical distribution such as normal
distribution, uniform distribution, etc. There are some
software, e.g., Bestfit, that can search through a large
number of theoretical distributions and choose a good one,
if there exists any. This topic is not included in this course.
Continuous Distribution
Mean = 20
Standard deviation = 2.49
Continuous Distribution
The figure below shows
an example of uniform
distribution.
The decision rule for continuous demand is similar to
the decision rule for the discrete demand
Decision Rule (Continuous Demand):
Order quantity Q such that
where p = probability (demandsQ)
Note the following difference
The word maximum
The = in the formula for p
The s in the definition of p
Single-Period Models (Continuous Demand)
Decision Rule
u o
u
c c
c
p
+
=
There is a nice pictorial interpretation of the decision
rule. Although we shall discuss the interpretation in
terms of normal and uniform distributions, the
interpretation is similar for all the other continuous
distributions.
The area under the curve is 1.00. Identify the vertical
line that splits the area into two parts with areas
The order quantity corresponding to the vertical line
is optimal.
Single-Period Models (Continuous Demand)
Decision Rule
( ) right the on
and left the on
u o
o
u o
u
c c
c
p
c c
c
p
+
=
+
=
1
Pictorial interpretation of the decision rule for uniform
distribution (see Examples 2, 3 and 4 for application
of the rule):
Single-Period Models (Continuous Demand)
Decision Rule
850 150
Demand
P
r
o
b
a
b
i
l
i
t
y

Area
u o
u
c c
c
p
+
=
=
( )
u o
o
c c
c
p
+
=
= 1
Area
*
Q
Pictorial interpretation of the decision rule for normal
distribution (see Examples 3 and 4 for application of
the rule):
Single-Period Models (Continuous Demand)
Decision Rule
P
r
o
b
a
b
i
l
i
t
y
Demand

Area
u o
u
c c
c
p
+
=
=
*
Q
( )
u o
o
c c
c
p
+
=
= 1
Area
Example 2: The J&B Card Shop sells calendars. The once-
a-year order for each years calendar arrives in
September. The calendars cost $1.50 and J&B sells them
for $3 each. At the end of July, J&B reduces the calendar
price to $1 and can sell all the surplus calendars at this
price. How many calendars should J&B order if the
September-to-July demand can be approximated by
a. uniform distribution between 150 and 850
Single-Period Models (Continuous Demand)
Solution to Example 2:
Overage cost
c
o
= Purchase price - Salvage value =
Underage cost
c
u
= Selling price - Purchase price =
Single-Period Models (Continuous Demand)
p s =
Now, find the Q so that p = probability(demand<Q) =
Q
*
= a+p(b-a) =
u o
u
c c
c
+
Area =
850 150
Demand
P
r
o
b
a
b
i
l
i
t
y
Area
=
Q
*
Single-Period Models (Continuous Demand)
Example 3: The J&B Card Shop sells calendars. The once-
a-year order for each years calendar arrives in
September. The calendars cost $1.50 and J&B sells them
for $3 each. At the end of July, J&B reduces the calendar
price to $1 and can sell all the surplus calendars at this
price. How many calendars should J&B order if the
September-to-July demand can be approximated by
b. normal distribution with = 500 and o=120.
Single-Period Models (Continuous Demand)
Solution to Example 3: c
o
=$0.50, c
u
=$1.50 (see Example 2)
ps = = 0.75
0.50 1.50
1.50
+
u o
u
c c
c
+
Single-Period Models (Continuous Demand)
Single-Period Models (Continuous Demand)
Now, find the Q so that p = 0.75
Example 4: A retail outlet sells a seasonal product for $10
per unit. The cost of the product is $8 per unit. All units not
sold during the regular season are sold for half the retail
price in an end-of-season clearance sale. Assume that the
demand for the product is normally distributed with =
500 and o = 100.
a. What is the recommended order quantity?
b. What is the probability of a stockout?
c. To keep customers happy and returning to the store
later, the owner feels that stockouts should be avoided if
at all possible. What is your recommended quantity if the
owner is willing to tolerate a 0.15 probability of stockout?
d. Using your answer to part (c), what is the goodwill cost
you are assigning to a stockout?
Single-Period Models (Continuous Demand)
Self Study
Solution to Example 4:
a. Selling price=$10,
Purchase price=$8
Salvage value=10/2=$5
c
u
=10 - 8 = $2, c
o
= 8-10/2 = $3
ps = = 0.4
Now, find the Q so that
p = 0.4
or, area (1) = 0.4
Look up Table A-1 for
Area (2) = 0.5-0.4=0.10
3 2
2
+
u o
u
c c
c
+
P
r
o
b
a
b
i
l
i
t
y
Demand
=500
Area=0.40
z = 0.255
o = 100
Area=0.10
(1)
(2)
(3)
Single-Period Models (Continuous Demand)
Self Study
z = 0.25 for area = 0.0987
z = 0.26 for area = 0.1025
So, z = 0.255 (take -ve, as p = 0.4 <0.5) for area = 0.10
So, Q
*
=+ z o=500+(-0.255)(100)=474.5 units.
b. P(stockout)=P(demand>Q)=1-P(demand<Q)=1-p=1-0.4=0.6
Single-Period Models (Continuous Demand)
Self Study
c. P(stockout)=Area(3)=0.15
Look up Table A-1 for
Area (2) = 0.5-0.15=0.35
z = 1.03 for area = 0.3485
z = 1.04 for area = 0.3508
So, z = 1.035 for area = 0.35
So, Q
*
=+ z o=500+(1.035)(100)=603.5 units.
P
r
o
b
a
b
i
l
i
t
y
Demand
=500
Area=0.35
z = 1.035
o = 100
Area=0.15
(1)
(2)
(3)
Single-Period Models (Continuous Demand)
Self Study
d. p=P(demand<Q)=1-P(demand>Q)
=1-P(stockout)=1-0.15=0.85
For a goodwill cost of g
c
u
=10 - 8+g = 2+g, c
o
= 8-10/2 = $3
Now, solve g in p = = =0.85
Hence, g=$15.
u o
u
c c
c
+
3 2
2
+ +
+
) ( g
g
Single-Period Models (Continuous Demand)
Self Study
READING AND EXERCISES
Lesson 1
Reading:
Section 5.1 - 5.3 , pp. 245-254 (4
th
Ed.), pp. 232-245
(5
th
Ed.), pp. 248-261 (6
th
Ed.)
Exercise:
8a, 12a, and 12b, pp. 256-258 (4
th
Ed.), pp. 248-250
(5
th
Ed.), pp. 264-266 (6
th
Ed.)