IE 421 - Decision Systems Under Probabilistic

Demand

Z. Pelin Bayındır

Middle East Technical University, Department of Industrial Engineering

Fall 2010

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 1 / 20

Outline

1 Review of Terminology

2 Key Decisions
Periodic or Continuous Review
Form of the Inventory Policy
Cost and Service Objectives

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 2 / 20

Assumption
Average demand remains (approximately) constant over time.

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Review of Terminology
On-hand stock: physically on the shelf.
Net stock=on-hand stock - backorders
Inventory Position=Net stock+on-orders-committed stock
Safety (buffer) stock: average level of the net stock just before a
replenishment arrives
Backorders vs Lost Sales: what happens to a customer’s order
when an item is temporarily out of stock?
backordering: demand is met a later time
lost sales: demand is lost
combination of the two

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 4 / 20

Key Decisions

1 How often the inventory status should be determined?

In the deterministic case, it is trivial.
Frequent review: consumes resources.
The less frequent the review, the longer the period over which the
system must protect against uncertainties.
2 When a replenishment order should be placed?
In the deterministic case, at a specified value of inventory position.
Tradeoff: cost of ordering early (inventory carrying cost) vs. cost of
providing inadequate service.
3 How large the replenishment order should be?
Tradeoff: Inventory holding cost ve setup cost (like EOQ)
Under service criteria (2) may be affected by (3)

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 5 / 20

To answer these, several things must be determined:

1 Importance of the item (ABC analysis)

2 Continuous or periodic review
3 Form of the inventory policy
4 Costs or service objectives to be set

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 6 / 20

Periodic or Continuous Review

Periodic Review:
the stock status is determined only every R time units.

Continuous Review:
the stock status is always known.
Each transaction triggers an immediate update of the status.
May be computerized or manual.

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 7 / 20

Periodic Review

is appealing when items in a coordinated group can be given the

same R.
allows a prediction on the level of the workload on the staff
involved.
For slow moving items, may be more effective than continuous
review in detecting the spoilage.

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 8 / 20

Continuous Review

Major advantage: requires less safety stock than periodic review

does (to provide the same level of service).
More expensive than periodic review.

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 9 / 20

Form of the Inventory Policy: 4 types of Structured Policies

(s, Q) : order-point, order quantity

(s, S) : order-point, order-up-to level (min-max)
(R, S) : periodic review, order-up-to
(R, s, S) : periodic implementation of (s, S)
Under all, inventory position is the system state.

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 10 / 20

(s, Q) Policy

2-bin system: one physical form of implementation

As long as units remain in the first bin, demand is satisfied from the
first bin.
When the second bin is opened, an order of size Q is placed.
When the replenishment arrives, the second bin is refilled, and the
remaining is put into the first
Kanban system is identical to (s, Q).
Quite simple; errors are not likely; requirements for the supplier
are predictable.
Not effective in coping with the situation in which transactions are
large; then Q won’t raise the inventory position above s.

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 11 / 20

(s, S) Policy

Replenishment quantity is variable, you order enough to raise

inventory position to S.
If all demand transactions are unit sized, will be identical to (s, Q);
S = s + Q, Q = S − s.
best(s, S) is better than best(s, Q) in terms of costs. But to find
best(s, S) requires more computational effort.
More common in practice, however the values of control
parameters are set in an arbitrary fashion.
For B items, it is not worth finding mathematically optimal solution.
Reasonable values of s, S are OK.
Disadvantage: variable order quantity; suppliers could make
errors.

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 12 / 20

(R, S) Policy

Used if there is no computer control; items share the same

resources or ordered from the same supplier.
Much preferred to order point systems in terms of coordinating the
replenishment of related items.
Disadvantage: carrying costs are higher than in continuous review.

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 13 / 20

(R, s, S) Policy

It has been shown that the best (R, s, S) system produces a lower
total cost than any other system. But obtaining the best values of
R, s, S is very hard.
In practice, usually, R = 1 .
If R = 0, (R, s, S) ≡ (s, S).
If s = S − 1, (R, s, S) ≡ (R, S)

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 14 / 20

A simple rule of thumb in choosing the form of the policy

Continuous Review Periodic Review

A items (s, S) (R, s, S)
B items (s, Q) (R, S)

For C items, employ a more simple approach.

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Cost and Service Objectives

Tradeoff: stockout risk vs high inventory risk

How to balance these two types of risk?
Four possible methods of modelling the management perspective.
Safety stocks (SS) are established through the use of
simple-minded approach: use of common factors
SS based on minimizing costs
SS based on customer service
SS based on aggregate considerations

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 16 / 20

SS based on common factors

Does not take individual variances into account.

Equal time supply:

SS=k months supply for all items
Reorder ⇔ Inventory position - Forecasted lead time demand =
k -month supply

Equal safety factor:

SS=k σL where k is a constant for all items, and σL standard
deviation of the demand during the lead time (of the errors of total
demand forecast over L).

IE 421 (METU) Decision Systems Under Probabilistic Demand Spring 2010 17 / 20

SS based on minimizing costs

B1 : fixed cost per stockout occasion (independent of duration and

magnitude). Arises when a firm expedites orders to prevent
stockouts.
B2 : fractional charge per unit short ($ B2 v / unit) Used when
shortages are satisfied with overtime production.
B3 : fractional charge per unit short per unit time ($ B3 v / unit / unit
time) (e.g., a spare part inventory system where shortages result
in machine idleness)
B4 : charge per customer line item short

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SS based on Customer Service

P1 : specified probability of no stockout per replenishment cycle -

cycle service level: Equivalently, P1 is the fraction of cycles in
which a stockout does not occur. Using a common P1 is
equivalent to using a common safety factor k .
P2 : specified fraction of demand to be satisfied routinely from the
shelf - fill rate: Using B3 is equivalent. P2 = BB3 +r
3
.
P3 : specified fraction of time during which net stock is positive -
ready rate: Considered for emergency equipment. Under Poisson
demand P3 ≡ P2 .
1
TBS : specified average time between stockout occasions. TBS :
average number of stockout occasions in unit time. Used when
each stockout occasions is dealt with an expediting action.

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SS based on aggregate considerations

ETSOPY: allocation of given SS among items to minimize

Expected Total Stockout Occasions Per Year
ETVSPY: allocation of given SS among items to minimize
Expected Total Value of Shortages Per Year

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