`Notes on

Inventory Models


The focus of this set of notes is on inventory models with uncertain
demand. In all the models the EOQ model is partially included.
The solutions provided are exact if one accepts the average
inventory cost approach. In some of these models we apply the
cost minimization approach, in others the service level approach,
or some combination of these two.



The Order Size Reorder Point (Q, R) inventory Model

This model deals with continuous review inventory system, uncertain demand with
annual mean value of D units, and known lead time L. Mean lead time demand is
L
and
the standard deviation of the lead time demand is o
L
. Placing an order costs C
o
, and
holding a unit for a year costs C
h
. Because demand is uncertain shortages might occur,
which incurs shortage costs. We assume unsatisfied demand is backordered (that is, sales
are not lost). Two types of shortage costs will be discussed later which differ in the way
shortage penalties are charged: (i) The unit shortage cost (ii) The cycle shortage cost. To
control the amount of shortages (to some degree) a reorder inventory level is set; when
the inventory reaches this level of R an order of size Q is placed.

The objective in the two models presented next is to minimize the expected costs,
composed of ordering cost, holding cost, and shortage cost. The two models differ in the
way shortage is looked at and being charged, but have the same annual ordering cost and
holding cost. Thus well discuss these two costs first and separate the discussion on
shortage cost based on the two shortage assumptions. The decision variables are Q and R
since both affect these costs (as can be seen below).

Annual Ordering cost: The average demand for the long run is D units per year, the
average number of orders per year is D/Q and the annual ordering cost is C
o
(D/Q).

Annual Holding cost: As in the EOQ model, the holding cost is calculated by
(Unit holding cost per year)
*
(Average inventory per year). In this model we need to make
two observations that call for adjustments of C
h
and of the average inventory:
(i) Scaling C
h
- Holding cost is paid for the time inventory is actually exists. So we
need to correct C
h
relative to the actual time inventory is held. To do this note that
the average shortage per cycle is S(R). Thus we estimate the maximum
accumulated shortage per cycle by 2S(R), and reasonably approximate the
proportion of time inventory is actually held the proportion (Q 2S(R))/Q. So the
unit holding cost for the time inventory is actually held is C
h
(Q 2S(R))/Q.
(ii) Scaling average inventory - we need to produce the average inventory for which
holding cost is paid: When inventory drops to R an order is placed and is received
L time units later when the average inventory is R -
L
. At this point in time a
new cycle starts with an order of Q. The average inventory is therefore [(R
L
)
+ (R
L
+ Q)] = R
L
+ Q/2, but this average contains also negative
inventories (i.e. shortages, when D
L
>R); for the sake of holding cost calculation
we are interested in the average inventory for which holding cost is actually paid.
Therefore we correct the average inventory to become R )
L
S(R)) +Q/2.
The figure below demonstrates the situation.













Calculating S(R): As mentioned S(R) is the mean shortage per cycle. Its definition is
therefore S(R)

(D
L
) is the density function of the
lead time demand (later well concentrate on the normal distribution).

Calculation of S(R) when demand is normally distributed
For the normal distribution

where

, and L(Z) is a function

whose values have been calculated over a large range of Z; see the table called Normal
Partial Expected Value. You can formulate an Excel function to calculate L(Z) yourself
for any Z
0
by: L(Z
0
) = |(Z
0
) Z
0
(1 u(Z
0
)) [|(Z) is the standard normal density
function, and u(Z) is the cumulative function, that is, u(Z
0
) = Pr(Z<Z
0
). The Excel
function to calculate L(Z
0
) is: = normdist(Z
0
,0,1,0) Z
0
[1 normsdist(Z
0
)].

The cycle shortage cost model
Assume penalty of C
b
is paid for each cycle where stock out occurs. This may happen
when the damage caused by any shortage is independent of the shortage magnitude.
Under this assumption the shortage cost applies on the average to (D/Q)Pr(D
L
> R)
cycles. So the expected annual shortage cost is C
b
(D/Q)Pr(D
L
>R). The objective is

The optimal inventory policy is obtained by taking the partial derivatives with respect to
Q and R.

From cTV/cQ = 0 we have the following result:

From here on well use the common notation F(R) = P(D
L
< R).

R-
L+ Q/2
R
R
L L
R-
L
R-
L
R-
L+ Q
Safety stock
The other partial derivation cTV/cR = 0 yields

[(

) (

Solution procedure
Generally, the procedure that solves the two equations manually is iterative. When no
significant difference between two consecutive iterations is observed (in terms of Q and
R) the process can stop. First calculate EOQ by EOQ =

and substitute it for

Q (call it Q
0
) in equation (3). Solve this equation for R
0
, and substitute it in equation (2)
after obtaining S(R
0
) [how to calculate S(R) was discussed above]. Now solve the
equation (2) for Q
1
, and return to equation (3) to obtain R
1
. Continue in this manner until
Q and R dont change by more than 1 unit each.

Practically, this procedure should be programmed being too hectic to perform by hand.
Alternatively, we can minimize TV(Q,R) directly over Q and R using Excel-Solver. In
case we are interested in graphical results we can use equation (2) to substitute Q
*

in
equation (1), and minimize TV(Q(R),R) over R by Excel-Solver. This will make it
possible to select a range of values for R and graph TV
*
(R).

Example 1:
Let C
o
= 40, C
h
= 3, p = 45, D = 1200. Assume D
L
is normally distributed where
L
= 100
and o
L
= 25. Let us first graph TV(Q(R),R) with respect to R to demonstrate the convex
nature of the cost function.



The optimal values were found by minimizing TV over R using Solver; as explained we
use equation (2) to express Q as a function of R (Q(R)), and apply Q(R) to equation (1).
Results: R
*
= 124.038; Q
*
= 194.97; TV
*
= 659.78. The safety stock held is
R
*

L
= 124 100 = 24. See Example1
650
655
660
665
670
675
116
118
120
122
124
126
128
130
132
134
136
138
TV*(R)

The unit shortage cost model
Assume shortages are charged for every unit of unsatisfied demand ($C
b
per unit short).
This cost may reflect higher unit cost for rushing a special order to cover shortages,
and/or additional administrative costs for putting a customer on backorder list. In this
case we need to calculate the expected shortage per cycle (S(R)) and add the expected
shortage cost of C
b
S(R)(D/Q) to the objective function. As mentioned, S(R) is the
expected number of stock-outs per cycle, so C
b
S(R) is the expected shortage cost per
cycle. When multiplied by D/Q we have the expected shortage cost per year.

Comment: There is another type of shortage cost that can be applied to the unit shortage
cost case. This is the time-dependent unit shortage cost (C
s
). This kind of cost is incurred
when additional charge proportional to the time the shortage lasts is imposed on the
inventory system. In this case C
s
represents the unit shortage cost if a customer is waiting
for a year for his/her order to be filled. Such a cost can represent for example loss of
goodwill (which is assumed to grow linearly with the time the customer is waiting), or
may represent the rental fees paid by management to rent a loaner and give it to the
waiting customer until his order is shipped, etc. The annual expected shortage cost in this
case is

[]

, and can be added to the shortage cost of the total expected cost function
shown in (4) below. This will not be further pursued and developed to keep the
mathematical complexity moderate. Therefore the equations presented next, obtained
after taking derivatives, dont include this time dependent shortage cost. However, in
your assignments youll be asked to optimize the ordering policy using Solver for the full
model.

Adding all the costs mentioned above we get the total variable cost function for the unit
shortage cost model (omitting the time dependent shortage cost):

Ann. Ordering Cost Ann. Holding Cost Ann. Shortage cost

To determine the optimal values of Q and R we take the partial derivatives of the
objective function with respect to Q and R and set them equal to zero. The resulting
equations are:

The results presented next were obtained by Solver when TV(Q, R) was minimized.

Example 2
For the following information find the optimal Q and R.
C = $10; H = .20; C
b
= $25; C
o
= $50;
L
= 100; o
L
= 25; Demand is described by a
normal distribution, and annual mean demand is 200.

Solution
The optimal values are: Q
*
= 100; R
*
= 143.83; TV
*
= $307.76
Let us provide a few more results regarding the above solution.
a. Safety stock = R -
L
= 143.83 100 = 43.83
b. Average time between orders (cycle time) = Q/D = 143.86/200



See Example2

The Q, R model and Service Level
The following service level approach allows management to consider shortages and to
respond to its possible damage without the need to directly evaluate the shortage cost.
This might be necessary when it is difficult to put a value on the shortage cost p or C
b
.
In such cases acceptable Q and R can be found based on a pre-determined service level.
Two types of service level can be used, which conform to the previously taken two
approaches to shortage.

- The cycle service level (called SL1)
We predetermine the required probability no stock-out occurs during lead time (SL1).
That is

290
300
310
320
330
1
3
0
1
3
2
1
3
4
1
3
6
1
3
8
1
4
0
1
4
2
1
4
4
1
4
6
1
4
8
1
5
0
1
5
2
1
5
4
1
5
6
1
5
8
1
6
0
1
6
2
TV*(R)
This means the longrun proportion of cycles where inventory is sufficiently large to
meet all the demand, is SL1.

- The unit service level (called SL2)
We predetermine the required probability demand is met from inventory. Note that
the mean fraction of demands that stock out each cycle is

. Then

Using SL1 to determine Q, R policies

Determining R: Equation (8) provides the required reorder point R. In example 1 above
assume SL1 = .90. Then .90 = P(D
L
R) or .90 = P[Z(R 100)/25]. Since (from the
normal table) Z
.10
= 1.28 we have 1.28 = (R 100)/25 or R
*
= 100 + 1.28 (25) = 132.
[from Excel R = norminv(.9,100,25) = 132.04]; if R can take only whole values well
take R = 133. The safety stock is R
L
= Z
.10
o
L
= 32.04 (or 33).

Determining Q
*
: There are two options open for us:
(i) The order size commonly used is EOQ, and is determined independent of R.
(ii) The order size is optimized. For R
*
found by applying SL1 above (by (7)), we can
now express pD/C
h
from equation (3) [dont forget p is assumed to be unknown],
and substitute this expression into equation (2) to get a quadratic equation in Q. Its
positive root is the optimal value of Q.

With the values provided in this example we have:

; (EOQ =
178.88) ; also

[
( )

] . With the aid from Excel we

have:
f(132.04) = normdist(132.04,100,25,0) = .007
F(132.04) = normdist(132.04,100,25,1) = .9
S(132.04) = o
L
L(Z
R
) = 25L[(132.04-100)/25] = 1.185
After substitutions we get the following equation for pD/C
h
:
pD/C
h
= [1/( ][(1-.9)32.04+1.185(1-2.9)+(1+.9)(Q/2)] = 457.3983+135.7164Q
This expression is now substituted in (2) in order to calculate Q
*
. Equation (2)
becomes:

[ ]

This is a quadratic equation in Q whose solution is Q
*
= 193.15. The implied penalty
p that justifies 10% of the cycles are out of stock can now be found by
p = (3/1200)(457.3983+135.7164(193.15)) = 66.67.

Determining R and Q when SL1 is a function of Q:
Sometimes management finds it more convenient to define the cycle service level in
terms of the ratio of cycles where stock-out does not occur.

where n is the number of cycles per year in which inventory is insufficient to meet all
the demand, and D/Q is the well-known expected number of cycles per year (D is the
average annual demand). If n is pre-specified and if Q = EOQ, SL1 can be computed,
and we can proceed to determine the re-order point as before by equation (7). As you can
see, in this case Q
*
and R
*
are not determined completely by cost minimization. Of
course, as before, we can improve the solution suggested above once R
*
is determined by
(7), by optimizing TV with respect to Q for the given R
*
.

Determining R
*
and Q
*
for a given number of bad cycles (n)
Suppose

a process is disrupted (the production line stops) when the stream of goods
delivered by the inventory system is interrupted. In such a case it is as detrimental to have
a shortage of one unit as it is to have a shortage of more units; yet the exact dollar value
of the damage caused per interruption is unknown although it is assumed to be large.
Management would like to limit the possible occurrences of such interruption (the
number of cycles where stock out occurs) to some n. One might think of this as just
another cycle service level case but a second look makes it clear that (9) cant be used
unless Q
*
was known. If it were not we need to optimize both Q and R using the expected
cost function (1). The problem to solve is then

) (

)
Subject to

( )

Notice that the third term in the objective function becomes pn, a constant for any given
p. This is fortunate, because we can now drop it when minimizing TV over Q and R.
Furthermore, since Q = (D/n)(1 F(R)), this problem can be solved taking a regular
derivative [i.e. dTV/dR = 0]. Once Q
*
and R
*
are determined we can find the implied p
which justifies n cycles of stock-out per year by using equation (3).

Using SL2 to determine Q, R policies

Determining Q: Usually taking Q = EOQ yields good results.

Determining R: S(R) = (1 SL2)EOQ (see (8)). This equation is solved for R. In
example 2 above suppose management has decided SL2 = .90. Then S(R) = (1 .90)100
= 10. Since demand is normal S(R) = o
L
L(Z) , so

= 10/25 = .4, resulting in z

= .01, and R =
L
+ zo
L
= 100 .01(25) = 99.75. Note: This reorder point results in
negative safety stock (R
L =
.25) meaning, no safety stock is actually held, and on the
average the inventory levels are replenished when .25 units are backordered. This assures
the demand is met from stock 90% of the time.

Using SL2 to determine optimal Q, R policies
The solution above is non-optimal in the sense the expected total cost is not necessarily
minimized. In what follows well show how to minimize TV(Q,R) as presented in
equation (4) under SL2. Well consider the existence of the unit shortage cost C
b

although it is unknown, which is why the service level approach was applied in the first
place.

Substituting pD/C
h
from(6) into (5) we get a quadratic equation in Q, whose solution is:

SL2 provides the second equation needed to solve for Q and R as follows:



Recall that we assume demand is normally distributed so, S(R)=o
L
L(Z
R
), where
Z
R
=(R-
L
)/o
L
.

Example 3:
Let us solve example 2 when n = 0.5 (one stock-out cycle in two years is allowed on the
average (p is unknown). The results follow:

Q
*
R
*
TV(Q,R) SL1 C
b
192.24 135.11 681.37 ~92% 184.96

It is optimal to order 192.24 units, each time the inventory drops to 135.11 units. The
cycle service level achieved is 1-n(Q
*
/D) = 1 - .5(192.24/1200) = 92%. For this policy to
be optimal the penalty on cycle stock-out is (See equation (11)) p = $184.96, (which was
unknown before, but was reflected in managements decision to limit the expected
number of stock-out cycles to 0.5 per year).

Estimating the lead time mean demand and standard deviation of the demand
So far the lead time mean demand and its standard deviation were known. In real
problems one need to estimate them from the data collected. Note that these estimates are
made for future values of the time series; therefore the forecast values need to be part of
these estimates.
- The estimated mean demand per period is the next period forecast of the demand
(F
t+1
). So the estimated mean per lead time as of time t is
L
= L*F
t+1
.
- The estimated standard deviation of the demand per period as of time t is taken
as the estimated standard deviation of the error term in the forecasting model
used. This is done by tracking the mean absolute deviation MAD
t
as follows:
MAD
t
= MAD
t-1
+ (1 )|F
t
D
t
| . Now the estimate of the standard deviation of
the error term per period is about1.25MAD
t
, and therefore the standard deviation
of the lead time demand as of time t is o
L
= 1.25MAD
t
. Good values to use
for are around 0.9 [We can follow a simple procedure to help find a good
Gamma: For the sampled time series calculate the standard deviation SD
t
by

for all t = 3, 4, , n, (e
t
is the error in period t and

is
the mean error by time t). Then build an objective function that calculates the
absolute value of the sum of differences between SD
t
and 1.25MAD
t.
This
function depends on the Gamma selected. Find Gamma that minimizes this
function. In other words minimize

by finding the
optimal value of ]. This procedure, as well as other concepts covered above, is
demonstrated in the following example.

Example 4:
A paint store is using a (Q, R) inventory system to control its stock levels. For a
particular paint historical data show demand is approximately normally distributed, but
the owner is reluctant to use old estimates of the mean and standard deviation.
Replenishment lead time is 14 weeks; each can of paint costs the store $6; excess demand
is backordered at a cost of $10 per unit; ordering cost is $15 per order, and annual
holding rate is 30%.
(a) What are the optimal lot size and reorder point for this paint?
(b) What is the optimal safety stock?
(c) If management feels unease about the backorder cost of $10, and would rather use
a cycle service level of 90%, what is the resulting (Q, R) policy?
(d) Repeat part (c) for a 90% unit service level.
(e) Can the store save on holding cost by using a unit service level rather than a cycle
service level? How much?
Solution
Before turning to answer the questions above we need to estimate and o from the data.
The data were collected weekly over the last 20 weeks. We use the FORECAST template
to calculate the optimal alpha for the exponential smoothing model (we assume the time
series is indeed stationary, and arbitrarily decide to use the exponential smoothing
approach to perform forecasts). After running Solver we find that alpha = 0.42 performs
best for the exponential smoothing model when using MAD to optimize it. Note that the
values of e
t
= |F
t
d
t
| are already calculated under Absolute error, so they will be used
in our next step. In addition we can now estimate the weekly mean demand by

. Here is how we proceed to calculate the estimate of the weekly variance.

(i) In the template add a column for MAD
t
as follows: MAD
2
= |E
2
| (that is, the
absolute value of the forecast error at t = 2).
(ii) For all t = 3, 4, , 20 calculate MAD
t
= MAD
t-1
+ (1 )|F
t
D
t
|. Since is
yet unknown use an empty cell where its value will be found by Solver under
Changing Cells.
(iii) For all t = 3, 4, , 20 calculate (i) 1.25MAD
t
, (ii) the errors standard
deviation (SD
t
) for periods 2 through t.
(iv) For all t = 3, 4, , 20 determine the difference |SD
t
1.25MAD
t
|; then sum
them up.
(v) Use Solver to minimize the sum calculated in part (iv) above. The decision
variable is , selected under the Changing Cells, and there is one constraint:
1. [Also use non-negativity under Options].

After running the template with the data and using Solver to optimize , we get = 0.78.
The estimate of the standard deviation at t=20 is .68 per week. For details see the
template results at the Appendix. We are ready to answer the rest of the questions.

Answers:
(a) We should use iteratively the two equations provided above for Q and R the same
way the first example was solved above. Rather well create a spreadsheet that
finds a near optimal solution. See the spreadsheet in the Appendix.
(b) The safety stock = R -
L
= 987 948 = 39
(c) For a cycle service level Q = EOQ = 242. R =
L
+Z
0.1
o = 948+1.28(17.5) = 971.
(d) F
(e) Holding costs under Q, R with cycle service level: C
h
[EOQ/2+SS] = 258.32
Holding costs under Q, R with unit service level: C
h
[Q/2+SS] = 274.52. No
saving.



Appendix 3
By definition the mean absolute deviation is the expected absolute difference between the
variable X and its mean .

Assuming = 0 for simplicity, as both absolute value and the normal distribution are
symmetrical around the mean, we can write

This integral is easily solved by the following u-substitution:

which results
with

So,

Assignments

1. Design a spreadsheet that solves the n-bad-cycles cycle service level problem.

2. Solve problem 23. Use your spreadsheet. Answer also the following questions:
a. What cycle shortage cost C
b
is implied by the goal of running out of stock in not more
than one cycle a year?
b. What is the cycle service level Click Pix is attaining? Use (i) Q = EOQ (ii) Q = Q
*

c. Revisiting its service level approach, Click Pix questions the validity of the cycle service
level currently utilized. It realizes that penalties on shortages should increase with the
amount of shortage. If the service level found in part b becomes the desired unit service
level, what is the optimal Q, R policy? What is the unit shortage cost implied by this
policy?

3. Based on problem 9:
Appliance Alley (AA) is a retailer of brand-name major appliances. One of its best sellers is
the Poseidon brand washing machine. Demand for this machine is normally distributed,
averages 8 units per week (7 working days), with a standard deviation of 3.25 per week. The
machine costs AA $625 each and sells for $999 each. AA estimates its annual holding cost
rate is 18%. The cost of placing an order is $150, and the lead time is 3 weeks. If AA is out of
stock it offers customers 10% discount on each backordered machine. In addition there is
administrative cost of $10 to place a customer on backorder.
a. What is AAs optimal policy for the Poseidon brand washing machine?
b. For the optimal policy, what percentage of the customers will have to wait for their
washing machines?
c. The Q, R unit shortage cost model developed in this set of notes does not include time
dependent shortage cost. Include this cost in the model. (Hint: Let C
s
represent the time
dependent unit shortage cost per year. What is the fraction of time this kind of shortage
cost is actually paid for? What is the average shortage this cost is paid for?)
d. Suppose AA offers $5 discount for each day a customer must wait for a washing machine
instead of the $10 discount per machine offered before. Find the optimal policy in this
case (use Solver).

4. Based on problem 32:
Add the following information: Standard deviation for weekly demand = 30.
a. Answer questions a d (answer question 'c' in relation to the expected percentage of
customers)
b. Suppose BSC can buy cash registers in bulks of 50 machines. What is the optimal
ordering policy now?
c. What is the cost of uncertainty for BSC? In other words, if demand was known with
certainty (i.e. s
L
= 0), how much less expensive the inventory ordering policy could be?

6. Based on problem 4
a. Answer the problem as is but let the mean demand per month be 5 rather than 2.
Solve this problem assuming playhouses dont have to be integers first. After the
optimal solution is found, determine the best integer solution.
b. Redo the problem assuming the demand is Poisson with a mean of = 5 per month.
Youll need the expression for the mean shortage per cycle for the Poisson
distribution: S(R) = (1-F(R-1)) R(1-F(R)). Optimize the TV(Q,R) function with
Excel-Solver. Remember that Q and R are integers.
c. Determine the cost of uncertainty by comparing the total costs (when Q and R are
integers) in part a and b. (Note: This is the additional cost incurred by the
presence of uncertainty, when you act optimally in both cases).
d. What would be the total cost in part b, if you applied the solution of part a? (This
is the additional cost for not implementing the optimal policy).

Solutionms

1. This is a cycle service level problem with cost optimization, based on a given
number of bad cycles of n = 1.
Input: C = 520; H = .18; C
o
= 90; D = (70/7)(6)(52) = 3120;
L
= 70; o
L
= 15
a. C
h
= .18(520) = 93.6
EOQ = sqrt{2(3120)(90)/[93.6]} = 77.46
L((R-m
L
)/s
L
) = f((R-m
L
)/s
L
) - ((R-m
L
)/s
L
)(1 F((R-m
L
)/s
L
))
Objective(Q,R) = 90(3120)/Q + 93.6[R 70 + 15(L(Z
R
))] where Q/D(1-F(R))
= n=1.
Using Solver to minimize the Objective over Q and R under the constraint
yields: Q = 84.13; R =98.9. We can round.