Managing Inventory under Risks

Leadtime and reorder point

Uncertainty and its impact
Safety stock and service level
The lot-size reorder point system
Managing system inventory

Leadtime and Reorder Point

Inventory level

Usage
rate R

Average inventory = Q/2

Reorder
point

Receive
order

Place
order

Receive
order

Place
order

Receive
order

Time

Leadtime
2

When to Order?
ROP (reorder point): inventory
level that triggers a new order
ROP = LR

(1)

Example:

L
(days)

R = 20 units/day

40

Q*= 200 units

140

L =

leadtime with certainty

14

280

LR = leadtime demand

22

440

ROP

Motorola Hong Kong Revisited

It takes the supplier 3 full working days to
deliver the material to Motorola
Consumption rate is 90 kg/day
At what inventory level should Mr. Chan place
an order?

Uncertainty and Its Impact

Sandy is in charge of inventory control and ordering at
Broadway Electronics. The average demand for their
best-selling battery is on average 1,000 units per week
with a standard deviation of 250 units
With a one-week delivery leadtime from the supplier,
Sandy needs to decide when to order, i.e., with how
many boxes of batteries left on-hand, she should place
an order for another batch of new stock
What is the difference between Mr. Chans task at
Motorola and this one?

Forecast and Leadtime Demand

Often we forecast demands and make stocking
decisions accordingly trying to satisfy arriving
customers from on-hand stock
Often, forecasting for a whole year is easier than
for a week
Leadtime demands usually can not be treated as
deterministic

Inventory Decision Under Risk

When you place an
order, you expect the
remaining stock to cover
all the leadtime demands
Any order now or later
can only satisfy demands
after the leadtime L
When to order? ROP1?

Inventory on hand

order

ROP1
ROP2
L

ROP under Uncertainty

When DL is uncertain, it often makes sense to
order a little earlier, i.e., at an inventory level
higher than the mean
ROP = + IS

(2)

IS = safety stock or extra inventory

IS = z

z = safety factor

Random Leadtime Demand

Random Variable

Mean

std

Demand

Leadtime

R
L

Leadtime demand (DL)

= LR

L 2R R 2 2L

Safety Stock
Inventory on hand

order

order

order

ROP

mean demand
during supply
lead time

safety stock

Time t
L

Leadtime
10

Some Relations
safety stock

ROP
safety stock

safety factor

safety factor

service level

Given demand distribution, there is a one-to-one

relationship, so we also have
ROP

Is

11

Safety Stock and Service Level

Service level is a measure of the degree of
stockout protection provided by a given amount
of safety inventory
Cycle service level:
the probability that all demands in the leadtime
are satisfied immediately
SL = Prob.( LT Demand ROP) =

12

Service Level under Normal Demands

Service Level: SL = ? (The area of the shaded part under the curve)

Is= ROP = 200

Mean: = 1,000

ROP = 1,200

SL = Pr (LD ROP) = probability of meeting all demand

(no stocking out in a cycle)
13

Compute Cycle Service Level

Given Is and

I S ROP
z

Use normal table, we find from z

Use excel:
SL= NORMDIST(ROP, ,,True)

(4)

(5)

14

Example 7.3 (MBPF)

ROP = 24,000, = 20,000, = 5,000
z =
=
NT

or

SL = NORMDIST(24,000,20,000, 5,000, True)

9-EX1
15

Compute Safety Stock

Given , we obtain z from the normal table
Use (3), we obtain the safety stock
Use (2), we obtain ROP
Given , we can also have
z = NORMSINV ()

(6)

ROP = NORMINV(, , )

(7)
16

Example 7.4 (MBPF)

= 20,000, = 5,000

85%

90%

95%

99%

z =
ROP =
NT

17

Price of High Service Level

NORMSINV ( 0.999)200

Safety Stock

NORMSINV ( 0.99)200

0.5 0.6

NORMSINV ( 0.97)200
NORMSINV ( 0.95)200
NORMSINV ( 0.90)200
NORMSINV ( 0.85)200

0.7

0.8

0.9

1.0

Service Level
9-EX2
18

Example, Broadway
Sandy orders a 2-week supply whenever the
inventory level drops to 1,250 units.
What is the service level provided with this ROP ?
If Sandy wants to provide an 95% service level to
the store, what should be the reorder point and
safety stock ?
Average weekly demand = 1,000
Demand SD = 250
Reorder point ROP = 1,250
19

The Service Level

Safety stock
Is =
Safety factor
z =
Service level
By normal table NT

=
By excel

9-EX1

SL= NORMDIST (1250, 1000, 250, True)

20

Safety Stock for Target SL

For 95% service rate
By the normal table

z0.95

NT

ROP =
Is
=
By excel

9-EX1

ROP =NORMINV (0.95, 1000, 250)

21

Lot Size-Reorder Point System

Having determined the reorder point, we
also need to determine the order quantity
Note that we can forecast the annual
demand more accurately and hence treat
it as deterministic
Then, the order quantity can be obtained
using the standard EOQ

22

The Average Inventory

Let the order quantity be Q
The average inventory level
= (Q+Is+ Is)/2

Inventory on hand

Q +Is

= Q/2 +Is
The holding cost
= HQ/2+HIs
The ordering cost
= S(R/Q)
The optimal inventory cost
= HQ* + HIs

order
ROP

mean demand
during supply
lead time

safety stock

Time t

Leadtime
23

Example, Broadway
R=52000/year (52 weeks)
H=$1/unit/year
S=$200/order
Lot-size Reorder point
Order quantity 9-EX1
Q* =
For 95% service rate
Is = 250z =
Inventory cost

Sandys current policy

= 1000, Q = 2000
ROP = 1,250, SL =84%
Holding cost
=
Ordering cost
=
Inventory cost
=

=
24

Managing System Inventory

There are different stocking points with
inventories and at each stocking point,
there are inventories for different functions
Total average inventory includes three parts:
Cycle + Safety + Pipeline inventories
Total Average Inventory = Q/2 + Is + RL

(8)
25

Pipeline Inventory
If you own the goods in transit from the
supplier to you (FOB or pay when order),
you have a pipeline inventory
Average pipeline inventory equals the
demand rate times the transit time or
leadtime by Littles Law
Pipeline inventory = RL
26

Sandys Current System Inventory

Q=2,000, L =1 week, R = 1,000/week
ROP = 1250, Safety stock = Is = 250
Total system average inventory:
not own pipeline
I = 2000/2+250 = 1250
owns pipeline
I = 2000/2+250+1000 = 2250

27

Managing Safety Stock

Levers to reduce safety stock
- Reduce demand variability
- Reduce delivery leadtime
- Reduce variability in delivery leadtime
- Risk pooling

28

Demand Aggregation
By probability theory
Var(D1 + + Dn) = Var(D1) + + Var(Dn)
= n2
As a result, the standard deviation of the
aggregated demand is

a n

(9)

29

The Square Root Rule Again

We call (9) the square root rule:
For BMW Guangdong
Monthly demand at each outlet is normal with mean 25 and
standard deviation 5
Replenishment leadtime is 2 months. The service level used
at each outlet is 0.90

The SD of the leadtime demand at each outlet of our

dealer problem
5 2 7.07
The leadtime demand uncertainty level of the
aggregated inventory system

a 4 2 7.07 14.14
30

Cost of Safety Stock at Each Outlet

The safety stock level at each outlet
Is = z0.9
= 1.2857.07
= 9.08
The monthly holding cost of the safety stock
TC(Is) = HIs
= 4,000x9.08
= 36,340RMB/month

31

Saving in Safety Stock from Pooling

System-wide safety stock holding cost without
pooling
4C(Is) = 4 36,340=145,360 RMB/month
System-wide safety stock holding cost with
pooling
C(Isa ) = 2 36,340=72,680 RMB/month
Annual saving of 12x(145,360-72,680)
= 872,160 RMB!!

32

BMWs System Inventory

With SL = 0.9: L = 2, Q = 36 (using EOQ),
R=100/month
z0.9 =1.285, Is =(1.285)(14.4)= 18.5
ROP = 2x100+ 18.5 =218.5
Total system average inventory:
not own pipeline
I = 36/2+18.5 = 36.5
owns pipeline
I = 36/2+18.5+200 = 236.5
33

Takeaways (1)
Leadtime demand usually must be treated as
random, and hence creates risks for inventory
decision
We use safety stock to hedge the risk and
satisfy a desired service level
Together with the EOQ ordering quantity, the
lot-size reorder point system provide an
effective way to manage inventory under risk
Reorder point under normal leadtime demand

ROP = + IS = RL + z
34

Takeaways (2)
For given target SL
ROP

= + z

= NORMINV(SL, ,)

For given ROP

SL

= Pr(DL ROP)

= NORMDIST(ROP, , , True)

Safety stock pooling (of n identical locations)

I sa z n
Total system average inventory
= Q/2 + Is

not own pipeline

= Q/2 + Is+RL owns pipeline

35