INVENTORY MODELS in

supply chain
 Inventory Models

Single Period Model Multi Period Model

News Vendor Problem

Continuous Periodic
Review system Review system

Constant Variable
Demand model Demand model
 Continuous Review System (Q)
A continuous review (Q) system or reorder point
(ROP) system or fixed order-quantity system tracks the
remaining inventory of an item each time a withdrawal is
made to determine whether it is time to reorder.
In practice, these reviews are done frequently (e.g. daily)
and often continuously (after each withdrawal).
At each review a decision is made about an items
inventory position.
If it is considered to be too low, the system triggers a new
order.
 Multi Period Inventory Model

a) Constant Demand model: Usage rate or average

demand is constant and known with certainty.
Also known as EOQ model with multi-period
inventory planning
Total cost: material cost + total holding cost +total
ordering cost
TC = DC + QH/2 + DS/Q
 Multi Period Inventory Model

b) Variable demand model: demand during lead time is

uncertain and assumed to follow normal distribution
with mean, Is and std dev. L
Reorder Point = (Avg demand) x (Lead time) + Safety stock

R = d L + zL = d L + zd L
Total Cost:
TC = DC + QH/2 + DS/Q + (zL)H
 Finding Safety Stock and R
Example-1
Records show that the demand for dishwasher detergent during
the lead time is normally distributed, with an average of 250
boxes and L = 22. What safety stock should be carried for a 95
percent cycle-service level? What is the value of Reorder point?

Safety stock = zL
= 1.64(22) = 36 1.64 is the number of standard
deviations, z, to the right of
= 36 boxes
average demand during the lead
time that places 95% of the area
Reorder point = dL + IS
under the curve to the left of that
= 250 + 36 point.
= 286 boxes
 Finding Safety Stock
With a normal Probability Distribution
for an 95% Cycle-Service Level

Cycle-service level = 95%

Probability of
stockout
Average (0.05)
demand
during
lead time R

zL

IS
 Example-2
Suppose,
Annual demand, D = 1000 units
Economic order quantity, Q* = 200 units
Desired service level, P = 95%
Std. dev of demand during lead time, L = 25 units
Lead time, L = 15 days
Determine reorder point? Assume demand is for 250
working days in a year.
 Periodic Review System (P)
An alternative inventory control system is the Periodic review
system (P) or fixed interval reorder system or periodic reorder
system.
In the periodic review system (P) an items inventory position
is reviewed periodically rather than continuously.
A new order is always placed at the end of each review and the
time between orders (TBO) is fixed at P.
Demand is a random variable. So, demand between reviews
varies.
In a P system, the lot size Q may change from one order to the
next, but the time between orders is fixed.
 Periodic Review System (P)
There are no constraints on the size of the lot
There is no uncertainty in lead times or supply
Lot size Q varies for different orders
Orders placed at every time period, P
Quantity ordered is upto target inventory level, T
 Periodic Review System (P)
The downward-sloping line represents on-hand inventory.
When the predetermined time P has elapsed since the last
review, an order is placed to bring the inventory position,
represented by the dashed line, up to the target level T.
The lot size for the first review is:
Q1=T -IP1.
When the new order arrives, at the end of the lead time, IP and
OH are identical.
Lot sizes vary from one cycle to the next.
 Periodic Review System (P)
The time interval for which inventory must be
planned when each new order is placed (protection
interval) is (P+L) periods.

The target inventory level T derives as:

T = d(P+L) + (Safety Stock for protection interval)
T = d(P+L) + zP+L= d(P+L) + z P L

Total Cost:
TC = (d P/2)H + (D/d P)S + z P L .H + Dc
 Example-1

Daily demand for a product is 10 units with a std. dev

of 3 units. The review period is 30 days and lead time
is 14 days. Management has set a policy of satisfying
98% of demand from its items in stock. At the
beginning of review period there are 150 units in
inventory. How many units should be ordered?
 Single Period Model/
News Vendor Problem

This model is applied to order an inventory

item for one time only based on past demand
experience.
Ex: stocking of perishable goods- dairy product,
winter cloths etc.
What is the Newsvendor Problem?
The newsvendor sells newspapers
he buys newspapers from the publisher for ($) p each
he sells them for ($) s each
he returns unsold papers for ($) r each

How many papers should he order?

he places an order for Q papers the night before
the next days demand, D, is uncertain

Quantity to Order, Q Random demand, D Profit = f(Q, D)

night before day of sales time

His demand estimate is based on past buying experience

Profit calculation:
P = f(Q, D) = Ds + (Q-D)r Qp ; D Q

P = f(Q, D) = Qs Qp ; D Q

Marginal Cost Calculation:

Newsvendor would increase the quantity of paper
if and only if;
Expected Marginal Revenue Expected Marginal Cost
Let,
Cu and Co be the cost of understocking and overstocking
Q* be the optimal stocking quantity

P (Demand > Q*)Cu P (Demand Q*)Co

1 P (Demand Q*)Cu P (Demand Q*)Co
(1- P)Cu PCo

P Cu / (Cu + Co) Service Level

 Example-1
Q: Suppose the newsvendor has estimated that the average
demand on Sunday is 90 papers with std. deviation of 10 papers.
Purchase cost of a paper = ($) 0.3
Selling price of a paper = ($) 0.6
Salvage cost of a paper = ($) 0.1
How much paper should be stocked by newsvendor? Assume the
demand is normally distributed.
 Continue with previous example
Demand distribution of paper is given below with their
respective frequencies and average demand of 91.5 papers.
Calculate the optimal quantity of paper to be stocked by
newsvendor for Sunday sales.
Demand of Paper Frequency
89 10
90 15
91 25
92 25
93 15
94 10
 Example-2
Chris Ellis newsstand, usually sells 120 copies of the
Washington post each day. Chris believes the sale of
the post is normally distributed, with a standard
deviation of 15 papers. He pays 70 cents for each
paper, which sells for $1.25. The post gives him a 30
cent credit for each unsold paper. He wants to
determine how many papers he should order each day
and the stockout risk for the quantity.
 Inventory Control Techniques
In operations, it is defined as the technological system
and the programmed software necessary for managing
inventory.

Various Techniques are:

i. EOQ model
ii. ABC Analysis
iii. VED Analysis
iv. JIT System
 ABC Analysis
(Always Better Control)

ABC Analysis: A method of dividing inventory into 3

classes as per their dollar value.
Objective: To pay attention on A class of inventory
and enable the management to control them
effectively.
Inventory Class % by Volume % by dollar ($)
A 20 80
B 30 15
C 50 5
 ABC Analysis
100 Class C
Class B
90
Percentage of dollar value Class A
80

70

60

50

40

30

20

10

0
10 20 30 40 50 60 70 80 90 100
Volume Percentage
 Benefits of ABC Analysis
Helps in maintaining better control of costly
inventory (A-class item).
Class- A items could be better controlled through
centralized buying, switching suppliers and contract
negotiation.
Sufficient stock of C-class items maintained with
least attention.
Better use of working capital based on weightage of
items.
 VED Analysis
(Vital, Essential and Desirable)

VED Analysis: It examines the effect of items on production

process.
Analysis is done mainly for the maintenance of spare parts
according to their criticality in production.

Stands for Effect on non-availability

V Vital items Completely stops the production
E Essential items Temporary loss of production
D Desirable items Small disruption in production
 JIT System
(Just-in-time or lean production)

JIT concept was devised by Toyota motor company in

1970s
JIT philosophy means getting the right quantity of
goods at the right place and the right time
Strategy to increase the systems efficiency and reduce
the waste
Applicable in low volume and highly customized
product
 Questions for Case Analysis
Ford Motor Company
1. What historical legacies affect Fords ability to move
to a BTO (build-to-order) model?
2. What advantage does Dell derive from virtual
integration? How important are these advantages in the
auto business?
3. What practical challenges must Ford address as it tries to
establish internet linkages with its supply chain?
4. What steps might Ford reasonably take toward virtual
integration? What is your recommendation to Teri
Takai?