Inventory Control

Part 1 Subject to Known Demand

By Ming Dong
Department of Industrial Engineering & Management
Shanghai Jiao Tong University

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 Contents
Types of Inventories
Motivation for Holding Inventories;
Characteristics of Inventory Systems;
Relevant Costs;
The EOQ Model;
EOQ Model with Finite Production Rate

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 Introduction
Definition: Inventory is the stock of any item or resource
used in an organization.
An inventory system is the set of policies and controls that
monitors levels of inventory or determines what levels
should be maintained.
Generally, inventory is being acquired or produced to meet
the need of customers;
Dependant demand system - the demand of components and
subassemblies (lower levels depend on higher level) -MRP;
The fundamental problem of inventory management :
When to place order for replenishing the stock ?
How much to order?

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 Introduction
Inventory: plays a key role in the logistical behavior of
virtually all manufacturing systems.

The classical inventory results: are central to more

modern techniques of manufacturing management, such
as MRP, JIT, and TBC.

The complexity of the resulting model depends on the

assumptions about the various parameters of the system
-the major distinction is between models for known
demand and random demand.

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 Introduction
The current investment in inventories in USA is enormous;
It amounted up to $1.37 trillion in the last quarter of 1999;
It accounts for 20-25% of the total annual GNP (general net product);
There exists enormous potential for improving the efficiency of
economy by scientifically controlling inventories;

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Breakdown of total investment in inventories 5
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 Types of Inventories
A natural classification is based on the value added
from manufacturing operations
Raw materials: Resources required in the production
or processing activity of the firm.
Components: Includes parts and subassemblies.
Work-in-process (WIP): the inventory either waiting
in the system for processing or being processed.

The level of WIP is taken as a measure of the
efficiency of a production scheduling system.
JIT aims at reducing WIP to zero.
Finished good: also known as end items or the final
products.

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 Why Hold Inventories (1)
For economies of scale
It may be economical to produce a relatively large
number of items in each production run and store
them for future use.
Coping with uncertainties
Uncertainty in demand
Uncertainty in lead time
Uncertainty in supply
For speculation
Purchase large quantities at current low prices and
store them for future use.
Cope with labor strike
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 Why Hold Inventories (2)
Transportation
Pipeline inventories is the inventory moving from
point to point, e.g., materials moving from suppliers
to a plant, from one operation to the next in a plant.
Smoothing
Producing and storing inventory in anticipation of
peak demand helps to alleviate the disruptions caused
by changing production rates and workforce level.
Logistics
To cope with constraints in purchasing, production,
or distribution of items, this may cause a system
maintain inventory.

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 Characteristics of Inventory Systems
Demand (patterns and characteristics)
Constant versus variable
Known versus random
Lead Time
Ordered from the outside
Produced internally
Review
Continuous: e.g., supermarket
Periodic: e.g., warehouse
Excess demand
demand that cannot be filled immediately from stock
backordered or lost.
Changing inventory
Become obsolete: obsolescence
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 Relevant Costs - Holding Cost
Holding cost (carrying or inventory cost)
The sum of costs that are proportional to the amount
of inventory physically on-hand at any point in time
Some items of holding costs
Cost of providing the physical space to store the
items
Taxes and insurance
Breakage, spoilage, deterioration, and obsolescence
Opportunity cost of alternative investment
Inventory cost fluctuates with time
inventory as a function of time
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 Relevant Costs - Holding Cost

Inventory as a Function of Time

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 Relevant Costs - Order Cost
It depend on the amount of inventory that is ordered or
produced.
Two components
The fixed cost K: independent of size of order
The variable cost c: incurred on per-unit basis

0 if x 0;
C ( x)
K cx if x 0

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 Relevant Costs - Order Cost

Order Cost Function

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 Relevant Costs - Penalty Cost
Also know as shortage cost or stock-out cost
The cost of not having sufficient stock on-hand to satisfy a
demand when it occurs.
Two interprets
Backorder case: include delay costs may be involved
Lost-sale case: include loss-of-goodwill cost, a measure of
customer satisfaction
Two approaches
Penalty cost, p, is charged per-unit basis.

Each time a demand occurs that cannot be satisfied immediately,
a cost p is incurred independent of how long it takes to
eventually fill the demand.
Charge the penalty cost on a per-unit-time basis.

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 EOQ History
Introduced in 1913 by Ford W. Harris, How Many Parts to
Make at Once
Product types: A, B and C
A-B-C-A-B-C: 6 times of setup
A-A-B-B-C-C: 3 times of setup

A factory producing various products and switching

between products causes a costly setup (wages, material and
overhead). Therefore, a trade-off between setup cost and
production lot size should be determined.

Early application of mathematical modeling to Scientific

Management

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 EOQ Modeling Assumptions
1. Production is instantaneous there is no capacity constraint
and the entire lot is produced simultaneously.
2. Delivery is immediate there is no time lag between
production and availability to satisfy demand.
3. Demand is deterministic there is no uncertainty about the
quantity or timing of demand.
4. Demand is constant over time in fact, it can be represented as
a straight line, so that if annual demand is 365 units this
translates into a daily demand of one unit.
5. A production run incurs a fixed setup cost regardless of the
size of the lot or the status of the factory, the setup cost is
constant.
6. Products can be analyzed singly either there is only a single
product or conditions exist that ensure separability of products.
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 Notation
demand rate (units per year)

c proportional order cost at c per unit ordered (dollars per unit)

K fixed or setup cost to place an order (dollars)

h holding cost (dollars per year); if the holding cost consists

entirely of interest on money tied up in inventory, then h = ic
where i is an annual interest rate.

Q the unknown size of the order or lot size

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 Inventory vs Time in EOQ Model

slope = -
Inventory

Q/ 2Q/ 3Q/ 4Q/

Time

Order cycle: T=Q/

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 Costs
Q
Holding Cost: average inventory
2
hQ
annual holding cost
2
hQ
unit holding cost
2

K K
Setup Costs: K per lot, so unit setup cost , annual setup cost
Q Q

hQ K
The average annual cost: G (Q)
2 Q

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 MedEquip Example
Small manufacturer of medical diagnostic equipment.
Purchases standard steel racks into which components
are mounted.
Metal working shop can produce (and sell) racks more
cheaply if they are produced in batches due to wasted
time setting up shop.
MedEquip doesn't want to hold too much capital in
inventory.

Question: how many racks should MedEquip order at

once?

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 MedEquip Example Costs
= 1000 racks per year
c = $250
K = $500 (estimated from suppliers pricing)
h = i*c + floor space cost = (0.1)($250) + $10 =
$35 per unit per year

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 Costs in EOQ Model
20.00

18.00

16.00

14.00
Cost ($/unit)

12.00

10.00 Y(Q)
Q* =169
8.00

6.00 hQ/2D

4.00

2.00 c A/Q

0.00
0 100 200 300 400 500

Order Quantity (Q)

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 Economic Order Quantity
hQ K
G (Q)
2 Q
dG (Q) h K Solution (by taking derivative
G ' (Q) 2 0
dQ 2 Q and setting equal to zero):
2 K
G ' ' (Q) 3 0 if Q 0 Since Q>0 G(Q) is convex
Q function of Q

* 2 K
Q EOQ Square Root Formula
h

2(500)(1000)
Q *
169 MedEquip Solution
35
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 Another Example
Example 2
Pencils are sold at a fairly steady rate of 60 per week;
Pencils cost 2 cents each and sell for 15 cents each;
Cost $12 to initiate an order, and holding costs are based on
annual interest rate of 25%.
Determine the optimal number of pencils for the book store to
purchase each time and the time between placement of orders
Solutions
Annual demand rate =6052=3,120;
The holding cost is the product of the variable cost of the
pencil and the annual interest-h=0.02 0.25=0.05

2K 2 12 3,120 Q 3,870
Q *
3,870 T 1.24 yr
h 0.05 3,120
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 The EOQ Model-Considering Lead Time
Since there exists lead time (4 moths for Example 2), order
should be placed some time ahead of the end of a cycle;
Reorder point R-determines when to place order in term of
inventory on hand, rather than time.

IE&M Reorder Point Calculation for Example 2 25

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 The EOQ Model-Considering Lead Time
Determine the reorder point when the lead time
exceeds a cycle. Computing R for placing order
Example: 2.31 cycles ahead is the same as
Q=25; that 0.31 cycle ahead.
=500/yr;
=6 wks;
T=25/500=2.6
wks;
/T=2.31---2.31
cycles are included
in LT.
Action: place
every order 2.31
cycles in advance.
Reorder Point Calculation for Lead Times
Exceeding One Cycle
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 EOQ Modeling Assumptions
1. Production is instantaneous there is no capacity constraint
and the entire lot is produced simultaneously.

relax via EOQ Model for Finite Production Rate

2. Delivery is immediate there is no time lag between production and

availability to satisfy demand.
3. Demand is deterministic there is no uncertainty about the quantity
or timing of demand.
4. Demand is constant over time in fact, it can be represented as a
straight line, so that if annual demand is 365 units this translates into
a daily demand of one unit.
5. A production run incurs a fixed setup cost regardless of the size
of the lot or the status of the factory, the setup cost is constant.
6. Products can be analyzed singly either there is only a single
product or conditions exist that ensure separability of products.

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 The EOQ Model for Finite Production Rate
The EOQ model with finite production rate is a
variation of the basic EOQ model
Inventory is replenished gradually as the order is
produced (which requires the production rate to be
greater than the demand rate)
Notice that the peak inventory is lower than Q since
we are using items as we produce them

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 Notation EOQ Model for Finite Production Rate
demand rate (units per year)

P production rate (units per year), where P>

c unit production cost, not counting setup or inventory costs

(dollars per unit)

K fixed or setup cost (dollars)

h holding cost (dollars per year); if the holding cost is consists

entirely of interest on money tied up in inventory, then h = ic
where i is an annual interest rate.

Q the unknown size of the production lot size decision variable

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 Inventory vs Time
1. Production run of Q takes Q/P time units
slope = -
(P-)(Q/P)
Inventory

- P-
(P-)(Q/P)/2

slope = P-
Time

2. When the inventory reaches 0, production begins until

Q products are produced (it takes Q/P time units). During
the Q/P time units, the inventory level will increases to (P- )(Q/P)

Time
Inventory
increase rate
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 Solution to EOQ Model with Finite Production Rate
Annual Cost Function:
K h(1 / P)Q
G (Q)
Q 2
setup holding

Solution (by taking first dG Q d 2G Q

0 0
derivative and setting equal dQ dQ 2

to zero):
tends to EOQ as P
2 K
Q*
h(1 / P ) otherwise larger than EOQ
because replenishment takes
longer
2 K
Q* EOQ model
h
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 Example: Non-Slip Tile Co.
Non-Slip Tile Company (NST) has been using
production runs of 100,000 tiles, 10 times per year
to meet the demand of 1,000,000 tiles annually. The
set-up cost is $5000 per run and holding cost is
estimated at 10% of the manufacturing cost of $1
per tile. The production capacity of the machine is
500,000 tiles per month. The factory is open 365
days per year.

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 Example: Non-Slip Tile Co. (Cont.)
This is a EOQ Model with Finite Production Rate
problem with
= 1,000,000
P = 500,000*12 = 6,000,000
h = 0.1
K = 5,000

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 Example: Non-Slip Tile Co. (Cont.)
Find the Optimal Production Lot Size

How many runs should they expect per year?

How much will they save annually using EOQ

Model with Finite Production Rate?

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 Example: Non-Slip Tile Co. (Cont.)
Optimal Production Lot Size

2 K 2(5000)(1000000)
Q* 346410
h(1 / P ) 0.1(1 1000000 / 6000000)

Number of Production Runs Per Year

The number of runs per year = /Q* = 2.89 times per year

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 Example: Non-Slip Tile Co. (Cont.)
Annual Savings:

K
TC 1 Q *h *
P Q
Holding Setup
cost cost

TC = 0.04167Q + 5,000,000,000/
Current TC = 0.04167(1,000,000) + 5,000,000,000/(1,000,000)
= $54,167
Optimal TC = 0.04167(346,410) + 5,000,000,000/(346,410)
= $28,868
Difference = $54,167 - $28,868 = $25,299
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 Sensitivity of EOQ Model to Quantity
Optimal Unit Cost: *
hQ K
G * G (Q * ) *
2 Q
h 2 K h K

2 2 K h
2K

2 K h

Optimal Annual Cost: Multiply G* by and simplify,

Annual Cost 2 Kh

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 Sensitivity of EOQ Model to Quantity (cont.)
Annual Cost from Using Q':
hQ K
G (Q)
2 Q

Ratio: Cost (Q) Y (Q) hQ 2 K Q

*
*
......
Cost (Q ) Y (Q ) 2 K h
1 Q Q *
*
2 Q Q

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 Sensitivity of EOQ Model to Quantity (cont.)
Cost (Q) 1 Q Q *
*
*
Cost (Q ) 2 Q
Q

Example: If Q' = 2Q*, then the ratio of the

actual cost to optimal cost is
(1/2)[2 + (1/2)] = 1.25

If Q' = Q*/2, then the ratio of the actual cost to

optimal cost is
(1/2)[(1/2)+2] = 1.25

A 100% error in lot size results in a 25% error in

cost.
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 EOQ Takeaways
Batching causes inventory (i.e., larger lot sizes translate into
more stock).

Under specific modeling assumptions the lot size that

optimally balances holding and setup costs is given by the
square root formula: 2 AD
Q*
h

Total cost is relatively insensitive to lot size (so rounding for

other reasons, like coordinating shipping, may be attractive).

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 Inventory Control
Part 2 Inventory Control Subject to
Unknown Demand

By Ming Dong
Department of Industrial Engineering & Management
Shanghai Jiao Tong University

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 The Wagner-Whitin Model

Change is not made without inconvenience,

even from worse to better.
Robert Hooker

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 EOQ Assumptions
1. Instantaneous production.

2. Immediate delivery.

3. Deterministic demand.

4. Constant demand. WW model relaxes this one

5. Known fixed setup costs.

6. Single product or separable products.

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 Dynamic Lot Sizing Notation
t a period (e.g., day, week, month); we will consider t = 1, ,T,
where T represents the planning horizon.

Dt demand in period t (in units)

ct unit production cost (in dollars per unit), not counting setup or
inventory costs in period t

At fixed or setup cost (in dollars) to place an order in period t

ht holding cost (in dollars) to carry a unit of inventory from period t to

period t +1

Qt the unknown size of the order or lot size in period t

decision variables
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 Wagner-Whitin Example
Data
t 1 2 3 4 5 6 7 8 9 10
Dt 20 50 10 50 50 10 20 40 20 30
ct 10 10 10 10 10 10 10 10 10 10
At 100 100 100 100 100 100 100 100 100 100
ht 1 1 1 1 1 1 1 1 1 1

Lot-for-Lot Solution
t 1 2 3 4 5 6 7 8 9 10 Total
Dt 20 50 10 50 50 10 20 40 20 30 300
Qt 20 50 10 50 50 10 20 40 20 30 300
It 0 0 0 0 0 0 0 0 0 0 0
Setup cost 100 100 100 100 100 100 100 100 100 100 1000
Holding cost 0 0 0 0 0 0 0 0 0 0 0
Total cost 100 100 100 100 100 100 100 100 100 100 1000

Since production cost c is constant, it can be ignored.

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 Wagner-Whitin Example (cont.)
Data
t 1 2 3 4 5 6 7 8 9 10
Dt 20 50 10 50 50 10 20 40 20 30
ct 10 10 10 10 10 10 10 10 10 10
At 100 100 100 100 100 100 100 100 100 100
ht 1 1 1 1 1 1 1 1 1 1

Fixed Order Quantity Solution

t 1 2 3 4 5 6 7 8 9 10 Total
Dt 20 50 10 50 50 10 20 40 20 30 300
Qt 100 0 0 100 0 0 100 0 0 0 300
It 80 30 20 70 20 10 90 50 30 0 0
Setup cost 100 0 0 100 0 0 100 0 0 0 300
Holding cost 80 30 20 70 20 10 90 50 30 0 400
Total cost 180 30 20 170 20 10 190 50 30 0 700

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 Wagner-Whitin Property
A key observation
If we produce items in t (incur a setup cost) for use to satisfy
demand in t+1, then it cannot possibly be economical to
produce in t+1 (incur another setup cost) .
Either it is cheaper to produce all of period t+1s demand in
period t, or all of it in t+1; it is never cheaper to produce some
in each.
Under an optimal lot-sizing policy
(1) either the inventory carried to period t+1 from a previous
period will be zero (there is a production in t+1)
(2) or the production quantity in period t+1 will be zero
(there is no production in t+1)

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 Basic Idea of Wagner-Whitin Algorithm

By WW Property, either Qt=0 or Qt=D1++Dk for some k.

If jk* = last period of production in a k period problem,

then we will produce exactly Dk+DT in period jk*. Why?

We can then consider periods 1, , jk*-1 as if they are an

independent jk*-1 period problem.

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 Wagner-Whitin Example
t 1 2 3 4 5 6 7 8 9 10
Dt 20 50 10 50 50 10 20 40 20 30
ct 10 10 10 10 10 10 10 10 10 10
At 100 100 100 100 100 100 100 100 100 100
ht 1 1 1 1 1 1 1 1 1 1

Step 1: Obviously, just satisfy D1 (note we are neglecting production

cost, since it is fixed). Z * A 100
1 1

j1* 1

Step 2: Two choices, either j2* = 1 or j2* = 2.

* A1 h1 D2 , produce in 1
Z 2 min *
Z1 A2 , produce in 2
100 1(50) 150
min
100 100 200
150
j2* 1
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 Wagner-Whitin Example (cont.)
Step3: Three choices, j3* = 1, 2, 3.

A1 h1 D2 (h1 h2 ) D3 , produce in 1

Z 3* min Z1* A2 h2 D3 , produce in 2
Z*2 A3 , produce in 3
100 1(50) (1 1)10 170

min 100 100 (1)10 210
150 100 250
170

j3* 1

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 Wagner-Whitin Example (cont.)
Step 4: Four choices, j4* = 1, 2, 3, 4.
A1 h1 D2 (h1 h2 ) D3 (h1 h2 h3 ) D4 , produce in 1
Z* A h D (h h ) D , produce in 2
1 2 2 3 2 3 4
Z 4* min
2 A3 h3 D4 ,
*
Z produce in 3
Z*3 A4 , produce in 4
100 1(50) (1 1)10 (1 1 1)50 320
100 100 (1)10 (1 1)50 310

min
150 100 (1)50 300
170 100 270
270

j4* 4

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 Planning Horizon Property
In the Example:
Given fact: we produce in period 4 for period 4 of a 4 period
problem.
Question: will we produce in period 3 for period 5 in a 5

period problem?
Answer: We would never produce in period 3 for period 5 in

a 5 period problem.

If jt*=t, then the last period in which production occurs in

an optimal t+1 period policy must be in the set t, t+1,t+1.
(this means that it CANNOT be t-1, t-2)

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 Wagner-Whitin Example (cont.)
Step 5: Only two choices, j5* = 4, 5.
Z 3* A4 h4 D5 , produce in 4
Z min *
*
5
Z 4 A5 , produce in 5
170 100 1(50) 320
min
270 100 370
320

j5* 4choices, j6* = 4, 5, 6.

Step 6: Three

And so on.

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 Wagner-Whitin Example Solution
Last Period Planning Horizon (t)
with Production 1 2 3 4 5 6 7 8 9 10
1 100 150 170 320
2 200 210 310
3 250 300
4 270 320 340 400 560
5 370 380 420 540
6 420 440 520
7 440 480 520 610
8 500 520 580
9 580 610
10 620
Zt 100 150 170 270 320 340 400 480 520 580
jt 1 1 1 4 4 4 4 7 7 or 8 8
Produce in period 1 Produce in period 4 Produce in period 8
for 1, 2, 3 (20 + 50 + for 4, 5, 6, 7 (50 + 50 + for 8, 9, 10 (40 + 20 +
10 = 80 units) 10 + 20 = 130 units) 30 = 90 units

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 Wagner-Whitin Example Solution (cont.)
Optimal Policy:
Produce in period 8 for 8, 9, 10 (40 + 20 + 30 = 90 units)
Produce in period 4 for 4, 5, 6, 7 (50 + 50 + 10 + 20 = 130 units)
Produce in period 1 for 1, 2, 3 (20 + 50 + 10 = 80 units)

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 Problems with Wagner-Whitin
1. Fixed setup costs.

2. Deterministic demand and production (no uncertainty)

3. Never produce when there is inventory (WW Property).

safety stock (don't let inventory fall to zero)
random yields (can't produce for exact no. periods)

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 Statistical Reorder Point Models

When your pills get down to four,

Order more.

Anonymous, from Hadley &Whitin

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 EOQ Assumptions
1. Instantaneous production. EPL model relaxes this one

2. Immediate delivery. lags can be added to EOQ or other models

3. Deterministic demand. newsvendor and (Q,r) relax this one

4. Constant demand. WW model relaxes this one

5. Known fixed setup costs. can use constraint approach

Chapter 17 extends (Q,r) to

6. Single product or separable products. multiple product cases

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 Modeling Philosophies for Handling Uncertainty

1. Use deterministic model adjust solution

- EOQ to compute order quantity, then add safety stock
- deterministic scheduling algorithm, then add safety lead time

2. Use stochastic model

- news vendor model
- base stock and (Q,r) models
- variance constrained investment models

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 The Newsvendor Approach
Assumptions:
1. single period
2. random demand with known distribution
3. linear overage/shortage costs
4. minimum expected cost criterion

Examples:
newspapers or other items with rapid obsolescence
Christmas trees or other seasonal items

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 Newsvendor Model Notation
X demand (in units), a random variable.

G ( x) P ( X x), cumulative distribution function of demand

(assumed continuous.)

d
g ( x) G ( x) density function of demand.
dx

co cost (in dollars) per unit left over after demand is realized.

c s cost (in dollars) per unit of shortage.

Q production/order quantity (in units); this is the decision variable.

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 Newsvendor Model
Units over = max {Q-X, 0}
Units short = max {X-Q, 0}
Cost Function:
Y (Q) expected overage expected shortage cost

co E units over cs E units short

co max Q x,0 g ( x)dx cs max x Q,0 g ( x)dx

0 0

Q
co
0
(Q x) g ( x)dx cs ( x Q) g ( x)dx
Q

Objective: find the value of Q that minimizes this expected cost.

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 Newsvendor Model Leibnitzs rule
For Y(Q): taking its derivative and setting it to 0.
To do this, we need to take the derivative of integrals with limits that
are functions of Q. A tool called Leibnitz's rule can do this.
d a2 ( Q ) a2 ( Q ) da (Q) da (Q)
dQ a1 ( Q )
f ( x, Q )dx a1 ( Q ) Q
[ f ( x, Q)]dx f (a2 (Q), Q) 2
dQ
f (a1 (Q), Q) 1
dQ

Applying this for Y(Q):

dY (Q) Q

dQ
c0 0
1g ( x)dx c s (1) g ( x)dx c G(Q) c [1 G(Q)] 0
Q
0 s

cs*
G (Q )
co c s

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 Newsvendor Model (cont.)

G (Q ) P X Q
* cs
*

co c s
Critical Ratio is that
probability stock
covers demand
G(Q*) represents the probability that demand is less than or equal to Q*.

Note:
c o Q * 1
cs G(x)
co c s

c s Q *
Q*

IE&M 64
Shanghai Jiao
Tong University
 Newsvendor Example T Shirts
Scenario:
Demand for T-shirts is exponential with mean 1000 (i.e., G(x) =
P(X x) = 1- e-x/1000). (Note - this is an odd demand distribution;
Poisson or Normal would probably be better modeling choices.)
Cost of shirts is $10.
Selling price is $15.
Unsold shirts can be sold off at $8.

Model Parameters:
cs = 15 10 = $5
co = 10 8 = $2

IE&M 65
Shanghai Jiao
Tong University
 Newsvendor Example T Shirts (cont.)
Solution:
Q
cs 5
G (Q ) 1 e
* 1000
0.714
co cs 2 5
Q * 1,253

Sensitivity: If co = $10 (i.e., shirts must be discarded) then

Q
cs 5
G (Q ) 1 e
* 1000
0.333
co cs 10 5
Q * 405

IE&M 66
Shanghai Jiao
Tong University
 Newsvendor Model with Normal Demand
Suppose demand is normally distributed with mean and
standard deviation . Then the critical ratio formula reduces to:

Q * cs
G (Q * ) is the cumulative distribution
co c s function (cdf) of the standard
normal distribution.
Q * cs
z where ( z ) z is the value in the standard
co c s normal table.
3.00

Q* z Note: Q* increases in both

(z)
and if z is positive (i.e.,
if ratio is greater than 0.5).

0.00
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103 109 115 121 127 133 139 145 151 157

0 z
IE&M 67
Shanghai Jiao
Tong University
 Multiple Period Problems
Difficulty: Technically, Newsvendor model is for a single
period.

Extensions: But Newsvendor model can be applied to

multiple period situations, provided:
demand during each period is iid distributed according to

G(x)
there is no setup cost associated with placing an order

stockouts are either lost or backordered

Key: make sure co and cs appropriately represent overage

and shortage cost.
IE&M 68
Shanghai Jiao
Tong University
 Example
Scenario:
GAP orders a particular clothing item every Friday
mean weekly demand is 100, std dev is 25
wholesale cost is $10, retail is $25
holding cost has been set at $0.5 per week (to reflect obsolescence,
damage, etc.)

Problem: how should they set order amounts?

IE&M 69
Shanghai Jiao
Tong University
 Example (cont.)
Newsvendor Parameters:
c0 = $0.5
cs = $15

Solution: 15
G (Q * ) 0.9677
0.5 15
Q 100
0.9677
25
Q 100 Every Friday, they should
1.85 order-up-to 146, that is, if
25
there are x on hand, then
Q 100 1.85(25) 146
order 146-x.

IE&M 70
Shanghai Jiao
Tong University
 Newsvendor Takeaways
Inventory is a hedge against demand uncertainty.

Amount of protection depends on overage and

shortage costs, as well as distribution of demand.

If shortage cost exceeds overage cost, optimal order

quantity generally increases in both the mean and
standard deviation of demand.

IE&M 71
Shanghai Jiao
Tong University
 The (Q, r) Approach
Decision Variables:
Reorder Point: r affects likelihood of stockout
(safety stock).
Order Quantity: Q affects order frequency (cycle

inventory).

Assumptions:
1. Continuous review of inventory.
2. Demands occur one at a time.
3. Unfilled demand is backordered.
4. Replenishment lead times are fixed and known.
IE&M 72
Shanghai Jiao
Tong University
 Inventory vs Time in (Q,r) Model
Inventory

r
l

Time
Delivery lead time

IE&M 73
Shanghai Jiao
Tong University
 The Base-Stock Policy
Start with an initial amount of inventory R. Each
time a new demand arrives, place a replenishment
order with the supplier.
An order placed with the supplier is delivered l
units of time after it is placed.
Because demand is stochastic, we can have multiple
orders that have been placed but not delivered yet.

IE&M 74
Shanghai Jiao
Tong University
 Base Stock Model
What the policy looks like
Choose a base-stock level stock level R
Each period, order to bring inventory position up to
the base-stock level R
That order will arrive after a lead time l
Costs are incurred based on net inventory
Balance holding costs vs. backorder costs

IE&M 75
Shanghai Jiao
Tong University
 Base Stock Model Assumptions
That is, we can replenish
one at a time (Q=1).
1. There is no fixed cost associated with placing an
order.

2. There is no constraint on the number of orders

that can be placed per year.

IE&M 76
Shanghai Jiao
Tong University
 Base Stock Notation
Q = 1, order quantity (fixed at one)
r = reorder point
R = r +1, base stock level
l = delivery lead time
= mean demand during l
= std dev of demand during l
p(x) = Prob{demand during lead time l equals
x}
G(x) = Prob{demand during lead time l is less
than x}
h = unit holding cost
b = unit backorder cost
S(R) = average fill rate (service level)
B(R) = average backorder level
I(R) = average on-hand inventory level

IE&M 77
Shanghai Jiao
Tong University
 Inventory Balance Equations
On-order quantity
from suppliers Inventory
position R

On-hand Back-orders from

inventory customers

Balance Equation:
inventory position = on-hand inventory - backorders + orders

Under Base Stock Policy

inventory position = R

IE&M 78
Shanghai Jiao
Tong University
 Inventory Profile for Base Stock System (R=5)
7

R 5

r 4 l On Hand Inventory
Backorders
Orders
3
Inventory Position

0
0 5 10 15 20 25 30 35
Time

# of orders = # of demands
IE&M 79
Shanghai Jiao
Tong University
 Service Level (Fill Rate)
Let:
X = (random) demand during lead time l

so E[X] = . Consider a specific replenishment

order. Since inventory position is always R, the only
way this item can stock out is if X R.

Expected Service Level:

G ( R), if G is continuous
S ( R) P( X R)
G ( R 1) G (r ), if G is discrete

IE&M 80
Shanghai Jiao
Tong University
 Backorder Level
Note: At any point in time, number of orders equals number demands
that have occurred during the last l time units, (X), so from our
previous balance equation:

R = on-hand inventory - backorders + orders

on-hand inventory - backorders = R - X

Note: on-hand inventory and backorders are never positive at the

same time, so if X=x, then

0, if x R
backorders
Expected Backorder Level: x R, if x R
simpler version for
spreadsheet computing

B( R) ( x R) p( x) p( R) ( R)[1 G( R)]
xR

IE&M 81
Shanghai Jiao
Tong University
 Inventory Level
Observe:
on-hand inventory - backorders = R-X
E[X] =
E[backorders] = B(R) from previous slide

Result:
I(R) = R - + B(R)

IE&M 82
Shanghai Jiao
Tong University
 Base Stock Example
l = one month

= 10 units (per month)

Assume Poisson demand, so

x
10 k e 10
x
G ( x) p (k ) Note: Poisson
demand is a good
k 0 k 0 k!
choice when no
variability data
is available.

IE&M 83
Shanghai Jiao
Tong University
 Base Stock Example Calculations

Summarize the results in Table

R p(R) G(R) B(R) R p(R) G(R) B(R)
0 0.000 0.000 10.000 12 0.095 0.792 0.531
1 0.000 0.000 9.000 13 0.073 0.864 0.322
2 0.002 0.003 8.001 14 0.052 0.917 0.187
3 0.008 0.010 7.003 15 0.035 0.951 0.103
4 0.019 0.029 6.014 16 0.022 0.973 0.055
5 0.038 0.067 5.043 17 0.013 0.986 0.028
6 0.063 0.130 4.110 18 0.007 0.993 0.013
7 0.090 0.220 3.240 19 0.004 0.997 0.006
8 0.113 0.333 2.460 20 0.002 0.998 0.003
9 0.125 0.458 1.793 21 0.001 0.999 0.001
10 0.125 0.583 1.251 22 0.000 0.999 0.000
11 0.114 0.697 0.834 23 0.000 1.000 0.000

IE&M 84
Shanghai Jiao
Tong University
 Base Stock Example Results
Service Level: For fill rate of 90%, we must set R-1= r
=14, so R=15 and safety stock s = r- = 4. Resulting
service is 91.7%.

Backorder Level:

B(R) = B(15) = 0.103

Inventory Level:

I(R) = R - + B(R) = 15 - 10 + 0.103 = 5.103

IE&M 85
Shanghai Jiao
Tong University
 Optimal Base Stock Levels
Objective Function:
Y(R) = hI(R) + bB(R) holding plus backorder cost
= h(R-+B(R)) + bB(R)
= h(R- ) + (h+b)B(R)

Solution: if we assume G is continuous, we can

get
Implication: set base stock
b level so fill rate is b/(h+b).
G( R )
*

hb Note: R* increases in b and

decreases in h.

IE&M 86
Shanghai Jiao
Tong University
 Base Stock Normal Approximation
If G is normal(,), then
b R *
G ( R*) z
hb
z is the value from the standard normal table.

where (z)=b/(h+b). So

Note: R* increases in
R* = + z and also increases in
provided z>0.

IE&M 87
Shanghai Jiao
Tong University
 Optimal Base Stock Example
Data: Approximate Poisson with mean 10 by normal with mean 10
units/month and standard deviation 10 = 3.16 units/month. Set
h=$15, b=$25.

Calculations: b 25
0.625
h b 15 25
since (0.32) = 0.625, z=0.32 and hence

R* = + z = 10 + 0.32(3.16) = 11.01 11

Observation: from previous table fill rate is G(10) = 0.583, so

maybe backorder cost is too low.

IE&M 88
Shanghai Jiao
Tong University
 Inventory Pooling
Situation:
n different parts with lead time demand normal(, )

z=2 for all parts (i.e., fill rate is around 97.5%)

cycle stock safety stock

Specialized Inventory:
base stock level for each item = + 2

total safety stock = 2n

Pooled Inventory: suppose parts are substitutes for one another

lead time demand is normal (n ,n )

base stock level (for same service) = n +2 n

ratio of safety stock to specialized safety stock = 1/ n

IE&M 89
Shanghai Jiao
Tong University
 Effect of Pooling on Safety Stock

Conclusion: cycle stock is

not affected by pooling, but
safety stock falls dramatically.
So, for systems with high safety
stock, pooling (through product
design, late customization, etc.)
can be an attractive strategy.

IE&M 90
Shanghai Jiao
Tong University
 Pooling Example
PCs consist of 6 components (CPU, HD, CD ROM, RAM,
removable storage device, keyboard)
3 choices of each component: 36 = 729 different PCs
Each component costs $150 ($900 material cost per PC)
Demand for all models is Poisson distributed with mean
100 per year
Replenishment lead time is 3 months (0.25 years)
Use base stock policy with fill rate of 99%

IE&M 91
Shanghai Jiao
Tong University
 Pooling Example - Stock PCs
Base Stock Level for Each PC: = 100 0.25 = 25, so using Poisson
formulas,

G(R-1) 0.99 R = 38 units

On-Hand Inventory for Each PC:

I(R) = R - + B(R) = 38 - 25 + 0.0138 = 13.0138 units

Total On-Hand Inventory:

13.0138 729 $900 = $8,538,358

IE&M 92
Shanghai Jiao
Tong University
 Pooling Example - Stock Components
Necessary Service for Each Component: 729 models of PC
S = (0.99)1/6 = 0.9983 3 types of each comp.
Base Stock Level for Components: = (100 729/3)0.25 = 6075, so
G(R-1) 0.9983 R = 6306

On-Hand Inventory Level for Each Component:

I(R) = R - + B(R) = 6306-6075+0.0363 = 231.0363 units

Total On-Hand Inventory:

231.0363 18 $150 = $623,798

93% reduction!

IE&M 93
Shanghai Jiao
Tong University
 Base Stock Insights
1. Reorder points control prob of stockouts by establishing safety stock.
2. To achieve a given fill rate, the required base stock level (and hence
safety stock) is an increasing function of mean and (provided
backorder cost exceeds shortage cost) std dev of demand during
replenishment lead time.
3. The optimal fill rate is an increasing in the backorder cost and a
decreasing in the holding cost. We can use either a service constraint
or a backorder cost to determine the appropriate base stock level.
4. Base stock levels in multi-stage production systems are very similar
to kanban systems and therefore the above insights apply.
5. Base stock model allows us to quantify benefits of inventory pooling.

IE&M 94
Shanghai Jiao
Tong University
 The Single Product (Q,r) Model
Motivation: Either
1. Fixed cost associated with replenishment orders and
cost per backorder.
2. Constraint on number of replenishment orders per year
and service constraint.

Objective: Under (1)

min fixed setup cost holding cost backorder cost
Q,r

As in EOQ, this makes

batch production attractive.

IE&M 95
Shanghai Jiao
Tong University
 Summary of (Q,r) Model Assumptions
1. One-at-a-time demands.
2. Demand is uncertain, but stationary over time and
distribution is known.
3. Continuous review of inventory level.
4. Fixed replenishment lead time.
5. Constant replenishment batch sizes.
6. Stockouts are backordered.

IE&M 96
Shanghai Jiao
Tong University
 (Q,r) Notation
D expected demand per year
replenishment lead time (assumed constant)
X (random) demand during replenishment lead time
E[ X ] expected demand during replenishment lead time
standard deviation of demand during replenishment lead time
p(x) P( X x) pmf of demand during lead time
G ( x) P ( X x) cdf of demand during lead time
A fixed cost per order
c unit cost of an item
h annual unit holding cost
k cost per stockout
b annual unit backorder cost

IE&M 97
Shanghai Jiao
Tong University
 (Q,r) Notation (cont.)
Decision Variables:
Q order quantity
r reorder point
s r safety stock implied by r

Performance Measures:
F (Q) average order frequency
S (Q, r ) average service level (fill rate)
B(Q, r ) average backorder level
I (Q, r ) average inventory level

IE&M 98
Shanghai Jiao
Tong University
 Inventory and Inventory Position for Q=4, r=4
9

5
Quantity

0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32
-1

-2

Time Inventory Position

uniformly distributed
Inventory Position Net Inventory between r+1=5 and
r+Q=8
IE&M 99
Shanghai Jiao
Tong University
 Costs in (Q,r) Model
Fixed Setup Cost: AF(Q)

Stockout Cost: kD(1-S(Q,r)), where k is cost per

stockout

Backorder Cost: bB(Q,r)

Inventory Carrying Costs: cI(Q,r)

IE&M 100
Shanghai Jiao
Tong University
 Fixed Setup Cost in (Q,r) Model
Observation: since the number of orders per year is
D/Q,
D
F(Q)
Q

IE&M 101
Shanghai Jiao
Tong University
 Stockout Cost in (Q,r) Model
Key Observation: inventory position is uniformly
distributed between r+1 and r+Q. So, service in (Q,r)
model is weighted sum of service in base stock model.

Result:
1 r Q 1
S (Q, r )
Q x r 1
G ( x 1)
Q
[G (r ) G (r Q 1)]

1 Note: this form is easier to use

S (Q, r ) 1 [ B (r ) B(r Q)]
Q in spreadsheets because it does
not involve a sum.

R
B( R) ( x R) p( x) B( R) [1 G( x)]
xR x 0

IE&M 102
Shanghai Jiao
Tong University
 Service Level Approximations
Type I (base stock):

Note: computes number

S (Q, r ) G (r ) of stockouts per cycle,
underestimates S(Q,r)

Type II:

B(r ) Note: neglects B(r,Q)

S (Q, r ) 1
Q term, underestimates S(Q,r)

IE&M 103
Shanghai Jiao
Tong University
 Backorder Costs in (Q,r) Model
Key Observation: B(Q,r) can also be computed by
averaging base stock backorder level function over the
range [r+1,r+Q]. (Similar to the fill rate)

Result:
1 r Q 1
B(Q, r )
Q x r 1
B( x) [ B(r 1) B (r Q)]
Q

Notes:
1. B(Q,r) B(r) is a base stock approximation for backorder level.

2. If we can compute B(x) (base stock backorder level function),

then we can compute stockout and backorder costs in (Q,r) model.
IE&M 104
Shanghai Jiao
Tong University
 Inventory Costs in (Q,r) Model
Approximate Analysis: on average inventory
declines from Q+s to s+1 so
(Q s ) ( s 1) Q 1 Q 1
I (Q, r ) s r
2 2 2

Exact Analysis: this neglects backorders, which add to

average inventory since on-hand inventory can never go
below zero. The corrected version turns out to be

Q 1
I (Q, r ) r B(Q, r )
2

IE&M 105
Shanghai Jiao
Tong University
 Inventory vs Time in (Q,r) Model

Expected Inventory Actual Inventory

Exact I(Q,r)
s+Q =
Approx I(Q,r)
Inventory

+ B(Q,r)

r Approx I(Q,r)
s+1=r-+1

Time

IE&M 106
Shanghai Jiao
Tong University
 Expected Inventory Level for Q=4, r=4, =2
7

s+Q 6

5
Inventory Level

s 2

0
0 5 10 15 20 25 30 35

Time

IE&M 107
Shanghai Jiao
Tong University
 (Q,r) Model with Backorder Cost
Objective Function:
D
Y (Q, r ) A bB (Q, r ) hI (Q, r )
Q

Approximation: B(Q,r) makes optimization

complicated because it depends on both Q and r. To
simplify, approximate with base stock backorder
formula, B(r):
~ D Q 1
Y (Q, r ) Y (Q, r ) A bB(r ) h( r B(r ))
Q 2

IE&M 108
Shanghai Jiao
Tong University
 Results of Approximate Optimization
Assumptions:
Q,r can be treated as continuous variables
G(x) is a continuous cdf

Results:

2 AD
Q* Note: this is just the EOQ formula
h
b Note: this is just the
G (r*) r * z
hb base stock formula
if G is normal( , ),
where (z)=b/(h+b)

IE&M 109
Shanghai Jiao
Tong University
 (Q,r) Example
Stocking Repair Parts:
D = 14 units per year
c = $150 per unit
h = $25 per unit
l = 45 days
= (14/365) 45 = 1.726 units during replenishment
lead time
A = $10
b = $40
Demand during lead time is Poisson
IE&M 110
Shanghai Jiao
Tong University
 Values for Poisson( ) Distribution

r p(r) G(r) B(r)

0 0.178 0.178 1.726
1 0.307 0.485 0.904
2 0.265 0.750 0.389
3 0.153 0.903 0.140
4 0.066 0.969 0.042
5 0.023 0.991 0.011
6 0.007 0.998 0.003
7 0.002 1.000 0.001
8 0.000 1.000 0.000
9 0.000 1.000 0.000
10 0.000 1.000 0.000

IE&M 111111
Shanghai Jiao
Tong University
 Calculations for Example

2 AD 2(10)(14)
Q* 4 .3 4
h 15

b 40
0.615
h b 25 40

(0.29) 0.615, so z 0.29

r* z 1.726 0.29(1.314) 2.107 2

IE&M 112
Shanghai Jiao
Tong University
 Performance Measures for Example
D 14
F (Q*) 3.5
Q* 4

1 1
S(Q * ,r * ) 1 [ B (r*) B (r * Q*)] 1 [ B ( 2) B ( 2 4)]
Q* Q
1
1 [0.389 0.003] 0.904
4

1 r * Q * 1
B (Q*, r*)
Q * x r *1
B ( x )
Q
[ B (3) B (4) B (5) B (6)]

1
[0.140 0.042 0.011 0.003] 0.049
4

Q * 1 4 1
I (Q*, r*) r * B (Q*, r*) 2 1.726 0.049 2.823
2 2
IE&M 113
Shanghai Jiao
Tong University
 Observations on Example
Orders placed at rate of 3.5 per year
Fill rate fairly high (90.4%)
Very few outstanding backorders (0.049 on
average)
Average on-hand inventory just below 3 (2.823)

IE&M 114
Shanghai Jiao
Tong University
 Varying the Example
Change: suppose we order twice as often so F=7 per year, then
Q=2 and:
1 1
S (Q, r ) 1 [ B (r ) B(r Q)] 1 [0.389 0.042] 0.826
Q 2
which may be too low, so increase r from 2 to 3:
1 1
S (Q, r ) 1 [ B (r ) B( r Q)] 1 [0.140 0.011] 0.936
Q 2
This is better. For this policy (Q=2, r=3) we can compute
B(2,3)=0.026, I(Q,r)=2.80.

Conclusion: this has higher service and lower inventory than the
original policy (Q=4, r=2). But the cost of achieving this is an
extra 3.5 replenishment orders per year.

IE&M 115
Shanghai Jiao
Tong University
 (Q,r) Model with Stockout Cost
Objective Function:
D
Y (Q, r ) A kD(1 S (Q, r )) hI (Q, r )
Q

Approximation: Assume we can still use EOQ to

compute Q* but replace S(Q,r) by Type II approximation
and B(Q,r) by base stock approximation:
~ D B(r ) Q 1
Y (Q, r ) Y (Q, r ) A kD h( r B (r ))
Q Q 2

IE&M 116
Shanghai Jiao
Tong University
 Results of Approximate Optimization
Assumptions:
Q,r can be treated as continuous variables
G(x) is a continuous cdf

Results:

2 AD
Q* Note: this is just the EOQ formula
h
kD Note: another version
G (r*) r* z
kD hQ of base stock formula
if G is normal( , ), (only z is different)
where (z)=kD/(kD+hQ)

IE&M 117
Shanghai Jiao
Tong University
 Backorder vs. Stockout Model
Backorder Model
when real concern is about stockout time
because B(Q,r) is proportional to time customers wait for backorders

useful in multi-level systems

Stockout Model
when concern is about fill rate
better approximation of lost sales situations (e.g., retail)

Note:
We can use either model to generate solutions
Keep track of all performance measures regardless of model

B-model will work best for backorders, S-model for stockouts

IE&M 118
Shanghai Jiao
Tong University
 Lead Time Variability
Problem: replenishment lead times may be variable, which
increases variability of lead time demand.

Notation:
L = replenishment lead time (days), a random variable
l = E[L] = expected replenishment lead time (days)
L = std dev of replenishment lead time (days)
Dt = demand on day t, a random variable, assumed independent
and identically distributed
d = E[Dt] = expected daily demand
D = std dev of daily demand (units)

IE&M 119
Shanghai Jiao
Tong University
 Including Lead Time Variability in Formulas
Standard Deviation of Lead Time Demand:
if demand is Poisson

D2 d 2 L2 d 2 L2
Inflation term due to
lead time variability

Modified Base Stock Formula (Poisson demand case):

R z z d 2 L2 Note: can be used in any

base stock or (Q,r) formula
as before. In general, it will
inflate safety stock.

IE&M 120
Shanghai Jiao
Tong University
 Single Product (Q,r) Insights
Basic Insights:
Safety stock provides a buffer against stockouts.
Cycle stock increases as replenishment frequency decreases.

Other Insights:
1. Increasing D tends to increase optimal order quantity Q.
2. Increasing tends to increase the optimal reorder point. (Note:
either increasing D or l increases .)
3. Increasing the variability of the demand process tends to increase
the optimal reorder point (provided z > 0).
4. Increasing the holding cost tends to decrease the optimal order
quantity and reorder point.

IE&M 121
Shanghai Jiao
Tong University
 Safety Stock
Stock carried to provide a level of protection
against costly stockouts due to uncertainty of
demand during lead time

Stock outs occur when
Demand over the lead time is larger than
expected
service level (1 - )100%.

ServiceLevel
Service Level

IE&M 122
Shanghai Jiao
Tong University
 Computing Inventory Position
Assumption:Demand
Assumption: Demandover
over lead-time
lead-timeisisnormally
normallydistributed
distributed

Probability {Demand over lead-time < s} = 1-

Probabilitydistribution
Probability distribution ServiceLevel
Service Level
ofofdemand
demandover
overLL

1-

IE&M 123
Shanghai Jiao
Tong University
 Computing Inventory Position: Normal Distribution
Probabilitydistribution
Probability distribution
ofofdemand
demandover
overL:L:
Mean==;;Std
Mean Dev==
StdDev

1-

s

1- .90 .95 .98 .99 .999

s
s
z 1.28 1.65 2.05 2.33 3.09 zz ss zz

1-


From normal table
0 z
or, in Excel, use:
=normsinv (0.90)

IE&M 124
Shanghai Jiao
Tong University
 Computation of Variance for Demand over Lead Time:
Variability Comes From Two Sources

1: Suppose only demand di in day i is variable; lead time is constant at AVGL

DL d1 d 2 ... d AVGL
AVGL times

Var {DL } Var {d1 d 2 ... d AVGL } Var {d1} Var {d 2 } ... Var {d AVGL } AVGL STD 2

dis are independent dis are identically distributed

2: Now, suppose only lead time is variable; daily demand is constant at AVG
DL L AVG
Var {DL } Var {L AVG } AVG 2 Var {L } AVG 2 STDL2
3: Adding the two terms, we get to our result
Var {DL } AVGL STD 2 AVG 2 STDL2

IE&M 125
Shanghai Jiao
Tong University
 More specifically.
Safety
factor (std Standard deviati
Mean demand on of demand ove
normal
over LT r LT
table) Safety stock SS

s AVG AVGL z STDL2 AVG 2 STD 2 AVGL

Note:
If lead time is constant, STDL 0
If demand is constant, STD 0

IE&M 126
Shanghai Jiao
Tong University
 Example:
Consider inventory management for a certain SKU at
Home Depot. Supply lead time is variable (since it
depends on order consolidation with other stores) and has a
mean of 5 days and std deviation of 2 days. Daily demand
for the item is variable with a mean of 30 units and std
deviation of 6 units. Find the reorder point for 95% service
level.
AVG = 30, STD = AVGL 5; STDL 2
6
95% service level z = 1.64

s AVG AVGL z STDL2 AVG 2 STD 2 AVGL

30 5 1.64 22 302 62 5 150 100.8 251

IE&M 127
Shanghai Jiao
Tong University
 The (s,S) Policy: Fixed Ordering Costs

Inventory

S
sR
Average demand
during lead time

L Safety Stock

Order Order
placed arrives Time

s should be set to cover the lead time demand and together with a
safety stock that insures the stock out probability is within the
specific limit (When to reorder).
S depends on the fixed order cost EOQ (How much)
IE&M 128
Shanghai Jiao
Tong University
 The (s,S) Policy: Fixed Ordering Costs
Order when: inventory position (IP) drops below s
Order how much: bring IP to S

Compute s exactly as in the base-stock model:

s AVG AVGL z 22 AVG22 STD22 AVGL

STDL
s AVG AVGL z STDL AVG STD AVGL

Compute Q using the EOQ formula, using mean

demand D = AVG (be careful about units):

2 AD
Q*
h
Set S = s + Q
IE&M 129
Shanghai Jiao
Tong University
 Example: (s,S) Model
Consider previous Home Depot example, however, there
are fixed ordering costs, which are estimated at $50.
Assume that holding costs are 15% of the product cost
($80) per year. Also, assume that the store is open 360
days a year.

s 251 (from previous calculations)

h = (0.15)*80/360=0.0333; A = K = 50, D = AVG = 30

2 AVG K 2(30)50 S s Q 251 300 551

Q 300
h 0.0333

IE&M 130
Shanghai Jiao
Tong University
 Summary of Inventory Models

Use EOQ
How much: EOQ formula
When: d*L

yes
Use (s, S) policy
Is demand rate and How much: Q = S s (Q is from
EOQ formula)
lead time constant? Are there fixed When: IP drops below s (base-
ordering costs? yes
stock policy formula)
no

no Use base stock (s) policy

When: IP drops below s
How much: necessary to
bring IP back to s
IE&M 131
Shanghai Jiao
Tong University