Ch 12 pt 1: Managing Uncertainty – Safety Inventory

When to Reorder?: In a continuous review policy, a reorder is triggered whenever the inventory position reaches a specific limit.  When the demand rate D is constant:  Reorder point = Lead time x Demand rate  ROP = L x D 
ReOrder Point:: Continuous review Policy - also known as (𝑄, 𝑅) policy, a reorder is triggered whenever the inventory position reaches a specific limit. When the demand rate D is constant: Reorder point = Lead time x Demand rate [ROP = L x D] - When
Demand during LT is uncertain, ROP = LxD is not good enough -> use[ ROP = LxD + SS] (safety stock). ROP under Uncertainty: Demand or lead time uncertainty creates the possibility that demand will be greater than available supply  Safety stock -
Stock that is held in excess of expected demand due to variable demand and/or lead time. It can be positive or negative depending on the relationship between excess and stockout costs  The service level is the probability that the there will be no
stockout within a time interval. [ROP = Expected demand during LT + SS] *Desired service level in the distribution of demand during lead time determines SS (?). How Much Safety Stock?  The amount of safety stock that is appropriate for a given
situation depends upon: 1. Demand and lead time variability 2. The desired service level * Service Level: The probability that demand will not exceed supply during lead time = = 100% - Stock-out risk. [ ROP = Expected demand during LT + zL WHERE z =
# std devs associated w/ target cycle Service level & L= std dev of demand during LT ] \ Safety Inv & Service Level: The service level is measured by the probability that the actual leadtime demand will not exceed the reorder point. [SL = Prob(LT demand
<= ROP)… SS = ROP-DL = z x L & z = (ROP-DL )/ L ] Cumulative Standard Normal Distribution - Finding z value given a service level: If we want 85% service level: From z table -> z = 1.035 Then SS can be obtained SS =z *𝜎𝐿 Finding service level given z
value: For example, if z = 1.28, SL = 0.8997 ≈ 0.90 Finding SL given ROP: So to find the service level for a given reorder point, calculate: [𝑧 = 𝑅𝑂𝑃−𝐷𝐿 / 𝜎𝐿] and look up z in the table on the right.\ Excel Functions:  Given ROP, to find the associated service
Level =NORM.DIST(ROP, DL , 𝜎𝐿 , 1)  For instance, suppose ROP = 112.8, DL = 100 and 𝜎𝐿=10. What is SL? SL = NORM.DIST(112.8, 100, 10, 1) ≈0.9  Given SL, to find ROP =NORM.INV(SL, DL , 𝜎𝐿 )  For instance, target SL = 0.9, DL = 100 and 𝜎𝐿=10.
What is ROP? ROP = NORM.INV(0.9, 100, 10, 1) ≈112.8 Calculation of Lead-time Demand Variability:: Variability in replenishment leadtime demand can result from variability in the demand rate, variability in the replenishment leadtime, or both. 
Replenishment leadtime demand standard deviation is calculate as: Idnetifying the distribution of customer demand during LT when LT and Periodic Demand are uncertain, demand during LT is normally distrubted w/ a mean of DL and std dev of 𝜎𝐿 => [
𝜎𝐿 = √𝐿𝜎𝐷2 + 𝐷 2𝑆𝐿2 where D: average demand per period : 𝜎𝐷 is the standard deviation of the demand per period L: Average lead time for replenishment S L: standard deviation of the lead time. ]\\ Pooling Efficiency Through Aggregation: Physical
Centralization  Physical centralization (vs. decentralization) of inventory to serve customers eliminates the possibility of stock imbalance and reduces the coefficient of variation of replenishment leadtime demand.  SSC = z x √𝑁 x𝜎𝐿  (assuming each
warehouse has the same D and 𝜎𝐿𝑇𝐷 ) \\ SC Goals: (1) reduce supplier LT (L) -> if lt decreases by a factor of k the required safety inventory decreases by a factor of √k, (2)reduce underlying uncertainty of demand ( 𝜎𝐷 ) -> if uncertainty 𝜎𝐷 is
reduced by a factor of k the required safety inventory also decreases by a factor of k.

Ch 12, pt II: Managing Uncertainty – Extensions

Measures of Product Availability: (1) Service Level (SL) Replenishment cycle = interval between two replenishment deliveries Fraction of replenishment cycles that end with all customer demand being met Equivalently, this is the probability of not having
a stockout in a replenishment cycle E.g. A store orders 10 times throughout a year, and in 8 cycles it does not run out of inventory ⇒ Service level of 80% \\ (2) Fill rate:  Product fill rate: Fraction of product demand satisfied from inventory. E.g. A store
provides smartphones to 90% of customers from inventory, but 10% is lost to a competitor due to lack of available inventory ⇒ Fill rate of 90%  Order fill rate: Fraction of orders filled from available inventory All products of an order must be in stock
for it to be filled, so this tends to be lower than product fill rate /|||\ SL and fill rate are two different metrics that can be used according to the situation: are you more interested in the chance of stockout (CSL), or the volume of stockout (fill rate)? E.g. If
a single stockout is very costly, such as when your customer highly values reliability, then you may be more interested in CSL. Ex: 0% service level, but nearly 100% fill rate. Fill rate is usually more relevant b/c it allows a retailer to est. the fraction of
demand turned into sales.. Fill Rate of a Given Policy:- FR = fraction of customer demand satisfied from available inventory [ aka Fill Rate = 1 – (fraction of demand not satisfied by inv = 1 – (expected shortage per cycle / lot size of cycle) = 1 – ESC / Q ]
Expected Shortage per Cycle (ESC): avg units of demand not satisfied from inventory per replenishment cycle.. Formula for ESC: [ ESC = -SS (1 – Fs ( SS / 𝜎L )) + 𝜎Lfs(SS/ 𝜎L) ] .. Excel Formula for ESC: ESC = -SS (1 – NORMDIST(SS/ 𝜎L, 0,1,1)) + 𝜎L *
NORMDIST(SS/ 𝜎L , 0,1,0) ]  Fill Rate of a Given Policy: Example Weekly demand for phones at B&M is normally distributed, with a mean of 2,500 and a standard deviation of 500. The replenishment lead time is two weeks. Evaluate the fill rate resulting
from a policy of ordering 10,000 phones when there are 6,000 phones in the inventory. 8 Fill Rate of a Given Policy: Example 𝜎𝐿 = √𝐿𝜎 2 𝐷 + 𝐷2𝑠 2 𝐿 = √2(500) 2+25002 (0)2 = 707.1 Applying the formula in Excel: −1,000 ∗ (1 − 𝑁𝑂𝑅𝑀𝐷𝐼𝑆𝑇 (1,000/707.1 ,
0,1,1) + 707.1 ∗ 𝑁𝑂𝑅𝑀𝐷𝐼𝑆𝑇 (1,000 707.1 , 0,1,0) we obtain 𝐸𝑆𝐶 = 25 That is, on average 25 phones are demanded by customers but not available in inventory The fill rate is 𝑓𝑟 = 1 − 𝐸𝑆𝐶 𝑄 = 1 − 25 10,000 = 0.9975 That is, 99.75% of the demand is filled
from stock  Inventory Policy from Desired Fill Rate: Finding the reorder point 𝑅 given a fill rate 𝑓𝑟 is a bit more complicated\ First, calculate the desired expected shortage per cycle (ESC) -> 𝐸𝑆𝐶 = (1 – 𝑓𝑟)* Q .\ Next find a safety inventory SS that
matches desired ESC w/ that long ass ESC formula. Then we have to use the Goal Seek tool in Excel to run trial/error to find an answer (** create a cell in Excel that represents the safety inventory (with any value), and a cell with the ESC formula.. then in
Data | What-If Analysis | Goal Seek, have Excel try to set the cell with the formula to the desired ESC value (that you calculated from the fill rate) by changing the safety inventory)  Continuous Review Policy – Inventory is continuously tracked, and an
order for lot size Q is placed when the inventory declines to the reorder point (ROP) [EVERYTHING UP UNTIL NOW HAS BEEN CRP]  Periodic Review Policy – Inventory status is checked at regular periodic intervals T, and an order is placed to raise the
inventory level to a specific threshold \ does not require tech to continuously monitor inv levels\ orders placed regularly are easier to organize \\\  Periodic Review Policy: Instead of a reorder level R, it is more appropriate to consider and order-up-to
level (OUL) – takes place of the Q+R level. W/ This policy, we order at every review time T, and want to identify an OUL that meets cycle service requirements. Periodic Review calc for SL: ***SEE WRITTEN NOTES & EXAMPLE FOR PERIODIC REVIEW***

Ch 11: Managing Economies of Scale – Cycle Inventory

Inventory: the total number of flow units present within the process boundaries/the stock of any item or resource used in an organization. Forms: raw materials, component parts, WIP, Finished goods, replacement stuff, goods in transit. Avg US Inv
2007: retail 499B, Wholesale 399B, Manuf 517B. **Inv Holding cost is 30-35% of value!!** Why do we hold inventory?: (1) To form process flow (Pipeline Inventory):  Theoretical inventory = Throughput x Theoretical flow time I
th=RxTth (Little’s Law)  (2) To reduce the inter-dependence of various operations in production or service; prevent “starving” (decoupling/buffer inventory)  (3) Economies of scale  When buying or creating inventory,
the firm incurs fixed ordering and setup costs, respectively. Batch purchasing or production reduces the average unit cost. The average inventory arising due to a batch activity is cycle inventory. cycle inv: avg inventory in a
supply chain due to production or purchases in lot sizes that are larger than those demanded by the customer. [Cycle Inv = lot size/2 = Q/2 ].  Quantity discounts are another type of economies of scale.  (4) Production
and capacity smoothing due to seasonality  Inventories serve as buffers to absorb seasonal fluctuations of supply and demand are seasonal inventories. (5) Stock-out protection  Due to potential disruptions in supply or
uncertain demand  Inventory maintained to insulate the process from unexpected supply disruptions or surges in demand is safety inventory or safety stock. (6) Price speculation (financial hedging) (speculative
inventory)  Often used when the price of inputs is expected to increase. Consequences of Not Enough Inventory  Why Not to Hold Too Much Inventory?  It’s costly  Physical storage costs  Cost of spoilage  Opportunity
cost of capital  Insurance cost  It’s risky  Risk of product obsolescence  Risk of over supply  It can be substituted  By Information or capacity  It hides problems  Sea of inventory Inventory Management asks 2
questions – When to Order, and How much to Order?? {both these decisions together are known as inventory policy} -> need to consider costs (holidng/carrying, ordering, shortage, obsolescence, unit) and the tradeoffs
between these costs & customer service.  ECONOMIC ORDER QUANTITY (EOQ) MODEL: Key Assumptions  Only one product is involved  All aspects are known with certainty (Constant demand stream (spread evenly
throughout the year), Constant setup (ordering) cost per order, Constant annual holding cost per unit, Constant lead time (= zero in the basic setting))  No backorders are allowed  Each order of multiple units (a batch) is
received in a single delivery  There are no quantity discounts  Only two relevant costs (holding and ordering costs) \\\ **Large Q = low setup cost, high holding/ Small Q = high setup, low holding** Inventory holding cost: a
financial cost associated with holding inventory. It has two components-the physical holding cost and the opportunity cost of capital tied up in inventory:  a)Physical holding cost (cost of storing inventory) b) Opportunity
cost (foregone return on the funds tied up in inventory)  Fixed set up (ordering) cost, which is independent of order quantity  When determining the optimal order quantity, these two costs must be balanced .
ECONOMIC ORDER QUANTITY (EOQ) MODEL: Data: D = Annual demand (throughput) rate (units / yr) C = Cost of purchasing or producing a unit ($ / unit) S = Setup cost or per order ($) H = Annual holding cost per unit of
inventory ($ / (unit•yr))  H = hC, where h is the holding cost rate per year.  Decision: Q = Quantity of an order (units)  Objective: To minimize the total cost

Insights on EOQ  Robustness of EOQ: Notice that the annual cost is very flat in the neighborhood of the optimal order quantity. So, even if H, S, D, etc. are just estimated, as long as they are reasonably close, the true
optimal order quantity should be close to the calculated Q*.  Purchase Cost (CxD) does not change with the order size that we choose, so it is constant here. (it does not affect EOQ which is a result of trade off between
ordering and holding costs)  If ordering cost is larger than holding cost, we know that the order size is probably too small and we order too frequently.  If order cost is less than holding cost, we know that the order size
is probably too large and we old too many inventories on average.  At EOQ, Holding cost = Ordering cost  If demand increases by a factor of 𝑘, Q* increases by a factor of 𝑘 . That is, when your demand increases by a
factor k, you don’t need k times more inventory.  Price Discounts: In the case of quantity discounts (price incentives to purchase large quantities), the unit cost, C, varies by order quantity and is a crucial element in
determining the EOQ.  Quantity discount policies:  With an all unit quantity discount policy, the buyer receives a discount on all units purchased whenever the quantity purchased exceeds a certain threshold.  EXAMPLE:
 With price discounts using an all quantity discount policy, the following two-step process determines the EOQ:  Beginning with lowest price, calculate the EOQ for each price level until a feasible EOQ is found. It is
feasible if it lies in the order quantity range corresponding to its price.  If the first feasible EOQ found is for the lowest price level, this quantity is best. Otherwise, calculate the total cost for the first feasible EOQ and for the
larger price break quantity at each lower price level. The quantity with the lowest total cost is optimal. *if an order placed is at least as large as qi but smaller than qi+1, each unit is obtained at a cost of Ci.. unit cost
decreases as qty ordered increases* \\\ With an incremental (marginal) quantity discount policy, a buyer receives a discount only on additional units purchased above a certain threshold value. Define 𝑉𝑖 as the cost of 𝑞𝑖
units i.e. ordering up to the entire (𝑖 − 1)-th discount block 𝑉𝑖 = 𝐶0 (𝑞1 − 𝑞0) + 𝐶1 (𝑞2 − 𝑞1) + ⋯ + 𝐶𝑖−1(𝑞𝑖 − 𝑞𝑖−1) The cost of 𝑄 units in the range between 𝑞𝑖 and 𝑞𝑖+1 is 𝑉𝑖 + (𝑄 – 𝑞𝑖)𝐶𝑖 that is, the cost of all the units of
previous discount blocks and a portion of the 𝑖-th block.. The costs are Annual order cost =(𝐷/𝑄)*𝑆 Annual holding cost = (𝑉𝑖 + (𝑄 – 𝑞𝑖) 𝐶𝑖)( ℎ/2).. Annual material cost = (𝐷/𝑄)* (𝑉𝑖 + (𝑄 – 𝑞𝑖) 𝐶𝑖) Note that the only
difference from the original costs is that the per unit cost 𝐶 is now (𝑉𝑖+ 𝑄 −𝑞𝑖 𝐶𝑖)/Q. As Usual, the total annual cost is the sum of these three components: 𝑇𝐶𝑖 = (𝐷/𝑄)*𝑆 + (𝑉𝑖 +( 𝑄 – 𝑞𝑖)*𝐶𝑖)*ℎ)/2 + (𝐷/𝑄)* (𝑉𝑖 + (𝑄 –
𝑞𝑖)*𝐶𝑖). THEN you have to recalculate the optimal lot size for price Ci  Qi = SQRROOT([2D( S+Vi – qi*Ci)] / h*Ci) **basically use this calculation for each option, then pick the best option {or just pray this shit isn’t on the
test}* Ordering with Multiple Products: Three approaches (Aggregation in general works better when joint setup cost 𝑆 is large relative to 𝑠i)
1. No aggregation Products are ordered independently *use normal EOQ on each product individually*
2. Complete aggregation Products are always ordered jointly  Pro: Easy to administer and may reduce costs
Con: May not be effective to order low-demand and high-demand items at the same frequency
Deriving the formula: It is easier to rederive the formula in terms of the order frequency 𝑛 since we now have a lot size 𝑄𝑖 for each item.. Let 𝑆𝑐 be the total fixed order cost: 𝑆𝑐 = 𝑆 + ∑𝑖∈𝑃 𝑠𝑖 (p = set of products). Annual
𝑄 ∑𝑖∈𝑃 𝐷𝑖 𝐻𝑖 ∑𝑖∈𝑃 𝐷𝑖 𝐻𝑖 ∑𝑖∈𝑃 𝐷𝑖 𝐻𝑖
ordering cost : 𝑆𝑐 𝑛 Annual holding cost : (recall 𝑛 = 𝐷𝑖 /𝑄𝑖 ) ∑𝑖∈𝑃 ( 𝑖) 𝐻𝑖 = Total annual cost: 𝑆𝑐 𝑛 + Taking derivative of 𝑆𝑐 𝑛 + w.r.t. to 𝑛 and setting it to zero yields the optimal frequency
2 2𝑛 2𝑛 2𝑛
∑𝑖∈𝑃 𝐷𝑖 𝐻𝑖
𝑛∗ = √ Lot sizes for each item may be obtained from 𝑄𝑖 = 𝐷𝑖 /𝑛
2𝑆𝑐

3. Tailored aggregation Select products to order jointly  Step 1: 𝐻𝑖 𝐷𝑖 ∑𝑖∈𝑃 𝐻𝑖 𝑚𝑖 𝐷𝑖

𝑛̅𝑖 = √ which is the desired optimal frequency of product 𝑖. the products 𝑛 = √ The ordering frequency of each product
Identify the most frequently ordered product. That is, let 𝑖 ∗ be the 2(𝑆+𝑠𝑖 )
2(𝑆+∑𝑖∈𝑃 𝑠𝑖 /𝑚𝑖 )

product with the largest ordering frequency considering 𝑆: 𝑛

̅𝑖 = ̅̅̅̅̅
𝑛
𝑛𝑖 must be then recalculated as well through the ratio 𝑛/𝑚𝑖 . Then the
𝑖∗
Then 𝑚𝑖 is the ratio ⌈ ⌉ , that is, rounded up to the closest integer. The total cost is 𝑛𝑆 + ∑𝑖∈𝑃 𝑛𝑖 𝑠𝑖 + ∑𝑖∈𝑃 ( 𝐷𝑖 ) 𝐻𝑖 The lot size of each product 𝑖
𝐻𝑖 𝐷𝑖 ̿̿̿𝑖
𝑛 2𝑛
√2(𝑆+𝑠 ) Step 2: Every other product 𝑖 ≠ 𝑖 ∗ will be included every 𝑚𝑖 - ratio of the baseline is 𝑚𝑖 ∗ = 1. Step 3: Recalculate the ordering is 𝐷𝑖 /𝑛𝑖
𝑖

𝑖
∗
th order of product 𝑖 ∗ . To calculate this frequency 𝑚𝑖 , first calculate frequency of the most ordered product 𝑖 now considering the rest of