Agenda

Fixed Order Quantity/Reorder Point Model (EOQ Model)

ROP
Variable demand and constant lead time
Both demand and lead time are variable

Service Level
Lead Time service level

Annual service level

Fixed Order Interval/Order up to Level Model

Single Period Model (Newsvendor Problem)
 Introduction
Reorder Point When inventory level drops to this amount, the
item is reordered.
ROP = demand at lead time= d LT
Inventory
Level
Q

ROP

0 LT Time

d = Demand rate (units per day or week)

LT = Lead time (in days or weeks)
Note: Demand and lead time must have the same time units.
 Example: ROP
Lead time = 7 days
Demand = 1,000 units/year
Days per year = 365

1,000 units/year
d= = 2.74 units/day
365 days/year

ROP = d .LT = 2.74 units/day (7days) = 19.18 or 20 units

Fixed Order Quantity/Reorder Point Model
ROP Expected demand
Safety stock
during lead time
Safety Stock

1. Variability of
2. Service Level
demand and lead time

2a. Lead time

service level

2b. Annual
service level

Safety Stock - Stock that is held in excess of expected demand due to

variability of demand and/or lead time.

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 Service Level
Service Level Probability demand will not exceed supply.
Lead time service level (fill rate): probability that demand will not
exceed supply during lead time.
Lead time service level=1-number short / lead time demand
Annual service level (fill rate): percentage of annual demand filled
Annual service level=1- number short / order cycle demand
Inventory Level
Q

ROP

LT
CT
 Concept Check
For the same number of safety stock, lead time service level
will be . than annual service level, because lead time
demand is . than order cycle demand.
a) smaller- smaller
b) smaller- larger
c) larger- smaller
d) larger -larger

Annual service level=1- (number short/ order cycle demand)

Lead time service level=1- (number short/ lead time demand)

 Safety Stock
Inventory

demand-ROP
Pr (ROP d <0) = 50%

50%
0
Time

LT
Risk of stock out
 Safety Stock
Inventory

Pr (ROP d <0) < 50%

demand-ROP
Safety Stock

0
Time
LT

Risk of stock out

Reorder Point based on a Normal distribution of
lead-time-demand

F(z)= service level or z= F-1(service level)

z = Safety factor; number of standard deviations above expected demand

dLT = The standard deviation of demand during lead time
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What is the z value for
service level of 98.8%?

Z=(2.25 +2.26)/2=2.255
 ROP with Lead Time Service Level:
variable demand and constant lead time (1)

ROP =
(average demand x lead time) + Z x st. dev. of demand during lead time
(demand and lead time measures in same time units)

Average demand Standard deviation of

in lead time demand in lead time
Demand During Lead Time

13
 ROP with Lead Time Service Level:
both demand and lead time are variable (2)
ROP =
(avg. demand x avg. lead time) + z x st. dev. of demand in lead time
(demand and lead time measures in same time units)

Average demand
in lead time Standard deviation of
demand in lead time
 Example 1: ROP with Lead Time Service Level
required service level= 95% , average demand= 350 units per week, lead
time= 1 week, standard deviation of demand in lead time= 10 unites.
What is optimal ROP?
What is daily standard deviation of demand?
What is daily average demand?

From z Table, z for 95% = 1.65

ROP = 350 + ZdLT
= 350 + 1.65 (10)
= 350 + 16.5 = 366.5 367
A new order should be placed when inventory level reaches 367 units.
 Example 2: ROP with Lead Time Service Level
Calculate the ROP and amount of safety stock required to
achieve a 90% service level for a product with variable demand
that averages 15 units per day with a standard deviation of 5.
Lead time is consistently 2 days.

From z table=> z for 90% = 1.28

ROP = (15 units x 2 days) + ZdLT

= 30 + 1.28 ( 2) (5)
= 30 + 8.96 = 38.96 39
Safety stock is about 9 units and a new order should be
placed when inventory level reaches 39 units.
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Example 3: ROP with Lead Time Service Level
Calculate the ROP for a product that has an average demand of 150
units per day and a standard deviation of 16. Lead time averages 5
days, with a standard deviation of 1. The company wants no more than
5% stockouts.

service level = 1 5% = 95%

From z table => z for 95% = 1.65

Place a new order when inventory level reaches 1004 units

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 ROP Using Annual Service Level
1.Calculate
Q(1 SLannual )
E( z)
dLT
2.Use a table to find the z value associated with E(z)
3.Use the z value in the appropriate ROP formula,
ROP expected demand during lead time z dLT
SLannual = annual service level
E(z) = standardized expected number of units short
during an order cycle.

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 Example :ROP Using Annual Service Level
Q=250,
Expected demand during lead time=50,
Standard deviation of demand during lead time=16
Desired service level=0.997
ROP=?
E(z)=250(1-0.997)/16=0.047
From table 12-3 , E(z)= 0.047 falls between E(z)= 0.48 E(z)=
and 0.44
using interpolation=> z=1.29 => ROP=50+1.29(16)=70.64
Inventory Models
EOQ/ROP model
Order size constant, time between orders changes

Fixed Order Interval/Order up to Level Model

orders placed at fixed time intervals
determine how much to order to bring inventory level up
to a predetermined point (order up to level)
used widely for retail
consider expected demand during lead time, safety stock,
and amount on hand
demand or lead time can be variable

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 Comparing Inventory Models

EOQ/ROP

Fixed
Interval/
Order up to
Fixed Order Interval: Benefits and Disadvantages
Benefits
grouping items from same supplier
can reduce ordering/shipping costs
practical when inventories
cannot be closely monitored

Disadvantages
requires a larger safety stock
increases carrying cost
costs of periodic reviews
Fixed Order Interval/Order up to Level Model
Determining the order interval
Total Annual Inventory Cost: D j .OI 1
TC = 2 j
R .i ( S ns )
OI

Optimal Order Interval:
2 ( S ns )
OI *

i DjRj
OI = order interval (in fraction of a year)
S = fixed ordering cost per purchase order
s = variable ordering cost per SKU included in the order (line item)
(assume s is the same for every SKU)
n = n number of SKUs purchased from the supplier
Rj = unit cost of SKUj , j = 1, , n
i = annual holding cost rate
Dj = annual demand of SKUj , j = 1, ., n
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Fixed Order Interval/Order up to Level Model

Determining the Order up to Level

Q I max Amount on hand

Expected demand
Safety
I max during protection
interval Stock

d OI LT z d OI LT

= Average daily or weekly or monthly demand

OI = Order interval (length of time between orders
LT = Lead time in days or weeks or months
z = Safety factor; # of standard deviations above expected demand
d = Standard deviation of daily or weekly or monthly demand
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 Example: Fixed Order Interval Model
Average daily demand for a product is 20 units, with a
standard deviation of 4 units. The order interval is 30 days,
and lead time is 10 days. Desired service level is 99%. If
there are currently 200 units on hand, how many should be
ordered?
I max d OI LT z d OI LT

I max= 20 (30 + 10) + (2.32) (4) 30 + 10

= 800 + 2.32 (25.298)
= 858.7 or 859 units stock up to level
Amount to order = 859 200 = 659 units
 Single Period Model
Single period model
model for ordering of perishables and other items with limited
useful lives
Shortage cost Cs
generally the unrealized profits per unit
Revenue per unit Cost per unit
Excess cost Ce
cost per unit - salvage per unit
for items left over at the end of a period

GOAL = find order quantity (stock level) that

minimizes total excess and shortage costs.
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 Single Period Model
Continuous stocking levels
Identifies optimal stocking levels
Optimal stocking level balances unit shortage and excess cost

Discrete stocking levels

Desired service level is equaled or exceeded
Compare service level to cumulative probability of demand

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 Optimal Stocking Level
Cs Cs = Shortage cost per unit
Service level (SL) =
Cs + Ce Ce = Excess cost per unit
P(Ce) P(Cs)

Service Level

Quantity

So
Balance point

So = Optimum stocking level (i.e., order quantity)

 Example 1: Single Period Model
Ce = $0.20 per unit
Cs = $0.60 per unit
Service level = Cs/(Cs+Ce) = .6/(.6+.2)
Service level = .75 what is the risk of stock out?
P(Ce) P(Cs)

Service Level = 75% %25

Quantity

Stockout risk = 1.00 0.75 = 0.25

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 Example 2: Single Period Model
A company usually carries spare parts that costs $500 and has no salvage value.
Shortage cost of spare parts is $2000. Part failures cumulative probability
distribution is given as below. Determine the optimal number of spare parts.
What is the resulting service level?

Cs =$2000 Ce = $500 Cs/(Cs+Ce)=2000/(2000+500)=0.8

Number of Failures
Cumulative Probability
0 .135
1 .406
2 .677
3 .857
4 .947
5 .983
 Example 3: Single Period Model
A company usually carries spare parts that costs $500 and has no salvage value.
Shortage cost of spare parts is $2000. Part failure has Normal probability
distribution with mean of 3 and standard deviation of 1.183. Determine the
optimal number of spare parts. What is the resulting service level?

Cs =$2000 Ce = $500 Cs/(Cs+Ce)=2000/(2000+500)=0.8

F(z)=0.8 (From table B, p. 717)=> z=0.845

optimal number of spare parts= average demand +z . standard deviation

= 3+0.845*1.183=4
 Example 4: Single Period Model
A company usually carries 2 units of a spare part that costs $500 and has no
salvage value. Part failures cumulative probability distribution is given as below.
Estimate the range of shortage cost for which stocking 2 units of this spare part is
optimal.

Cs is unknown Ce = $500
Number of Failures
Cs
Cumulative Probability .406, so Cs .406($500 Cs )
Cs $500
0 .135
1 Optimum stock .406 Cs = $343.17
level = 2, then
2 SL between .677 Cs
3 .857 .677, so Cs .677($500 Cs )
Cs $500
4 .947
Cs = $1,047.99.
5 .983
The range of shortage cost
is $343.17 to $1,047.99.
 Example 5: Newsvendor Problem
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 $0.2
and then sells at $0.50. At noon he recycles the unsold (i.e.
salvage value of zero) and goes home for a nap. The daily
demand is Normal with mean 100 and standard deviation 50.
How many copies to order? What is the service level?
Cu=0.5-0.2=0.3
Co=0.2-0=0.2
0.3/(0.3+0.2)=0.6
F(z)=0.6 =>z=0.255 (from Appendix B, p. AP-4)
Q=100+0.255*50=112.75
 Suggested Problems
Review all of the solved problems at the end of the
chapter (pages 502-506)

Other practice questions - 3, 4, 10, 11, 14, 21, 24, 31 &

36 pages 508-512