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POM-04 1

Inventory
Management
POM-04 2
Inventory Management
Introduction
Inventory System: an Input-output Description
Inventory-related Costs
Inventory Model Building
Economic-order-quantity (EOQ Model
Economic-production-quantity (EPQ) Model
Inventory Model Allowing Shortages
Inventory Model Allowing Price Discounts
POM-04 3
Inventory Management
Definition
In operations management, inventory
refers to any scarce resource that
remains idle in anticipation of satisfying
a future demand for it.

POM-04 4
Inventory Management
System Inventories
Factory: Raw materials, Spare-parts Semi-finished goods
Finished goods

Commercial bank: Cash reserves, Tellers


Hospital: Number of beds, Specialized personnel, drugs, etc.


Airline company: Aircraft seat miles per route, engine parts for
repairs

POM-04 5
Inventory Management
The inventory problem involves the formulation of
decision rules that answer two important questions :
1.When is it necessary to place an order (or set up for
production) to replenish inventory?
2.How much is to be ordered (or produced) for each
replenishment?

The decision rules must aim at satisfying anticipated
demand at minimum cost or maximum profit.

POM-04 6
Inventory Management
Types of I nventory
Pipeline (or transit) ) inventories
Economic order quantities
Safety (or buffer) stocks
Decoupling inventories
Seasonal inventories

POM-04 7
Inventory Management

Inventory system
Input

Output
Operating decision
rules
When?
How much?
Operating
constraints
Replenishment
(Physical
inflow)
Demand
(Physical
outflow)
Total Inventory cost
Figure-1: An input-output representation of an inventory system


POM-04 8
Inventory Management
Decision-making mechanism The decision-
making mechanism is designed to respond to
when inventory must be replenished, t
how much must be ordered (or produced
internally) for each replenishment, Q.

POM-04 9
Inventory Management
(1) Replenishment may take place at fixed time
intervals (t = constant), by orders of variable
size (Q = variable) to bring inventory to a
desired level
(2) Replenish by a fixed amount (Q = constant)
when inventory drops to a certain reorder
level, an event which may happen at
variable cycle times (t = variable).
POM-04 10
Inventory Management
Types of inventory cost
C
B
= purchase cost = cost of buying items placed on
inventory
C
H
= holding cost = cost incurred from having surplus
inventories
C
S
= shortage cost = cost incurred from shortages or
lack of inventories
C
R
= replenishment cost = cost of placing an order
with an outside supplier or setting up production



POM-04 11
Inventory Management
Total Inventory Cost
TC = C
H
+ C
S
+ C
R
+ C
B
=Holding cost + Shortage cost+Replenishment
cost + Purchase cost
Holding Cost
C
H
= c
h
* I
H

c
H
= f .b ( holding cost as fraction * unit cost)
I
H
= l
1*
(I
Max
+

I
min
)/2; where l
1
is % time surplus
exists


POM-04 12
Inventory Management
Inventory
level
Q(T)
I
max
= 600


I
H
= 400


I
min
= 200

Figure-2(a): Reorder cycle time (without shortage)
t = 3 months
0 Time T
Surplus
POM-04 13
Inventory Management
Inventory
level Q(T)
Max Surplus

= 600


0


Max.shortage
= 300


Shortage
t
2
= 1 month
t
1
= 2 months
0 Time T
Figure-2(b): Reorder cycle time (with shortage)


Surplus
POM-04 14
Inventory Management
Shortage cost: C
S
= c
S
I
S *.
l
2
= c
S*.
l
2*.
(I
max+
I
min
)

/2




c
S
is determined by estimating the cost incurred when
demand cannot be satisfied for lack of inventory :
The extra expenses (administrative, clerical, etc.) for
expediting an order
Possible loss in goodwill resulting from failure to satisfy
customer
The forgone profits from lost customers

time unit per
shortage of amount Average
time unit per unit
short being of Cost
t
Shortage



1

cos
=
POM-04 15
Inventory Management
Shortage Cost




Replenishment Cost
C
R
=
c
R *.
I
R;
where

2
max min
2
l
I I
I
S

+
=
exist shortages time
cycle of percentage cycle during
shortage imum
cycle during
shortage imum
inventory
shortage Average


2

max

min



|
|
.
|

\
|
+
|
|
.
|

\
|
=
time unit per setups
or orders of number Average
setup per
or order per Cost
t
t plenishmen





cos
Re
=
Q
D
I
R
=
POM-04 16
Inventory Management
Cost of Purchase

C
B
= bD



time unit
per Demand
Q is size lot
when unit per ice
t
Purchase




Pr
cos

=
POM-04 17
Inventory Management
Total Inventory Cost




Total Incremental Inventory Cost
t
purchase
t
ent replenishm
t
shortage
t
holding
t
inventory Total
cos

cos

cos

cos

cos

+ + + =
t
ent replenishm
t
shortage
t
holding
Cost
Inventory
l Incrementa
Total
cos

cos

cos




+ + =
POM-04 18
Inventory Management
Inventory System Specification
Demand
D = demand rate is known and constant throughout the reorder
cycle time

Replenishment
p = replenishment (or production) rate is infinite (entire
quantity ordered Q is added to existing stock all at once)
L = lead time is known and constant
b = price per unit is constant [no discounts offered: thus, b(Q) =
for all order quantities Q].

POM-04 19
Inventory Management
Inventory System Specification (contd.)
Costs
c
H
, c
R
= unit costs of holding inventory and ordering
are known and constant
c
S
= unit cost of shortage is infinite (system
operates without shortages; that is, I
s
= 0)

2.Decision variables
Q = order quantity replenishment size
t = reorder cycle time, i.e., time between successive
decisions to replenish


POM-04 20
Inventory Management
Order
arrives
Maximum
Inventory
I
max
= Q


Reorder point,
R




Order
placed
L t
Time T
Reorder
cycle time

Supply lead
time
POM-04 21
Inventory Management
start with maximum amount of inventory
equal to the order quantity (I
max
= Q).
inventory level drops at a fixed rate equal to
the demand rate D.
a reorder point R, we have enough inventory
to cover expected demand during the lead
time (R = D L).
order is placed equal to Q, which arrives at
the end of the lead time
POM-04 22
Inventory Management
shortage cost C
S
will be zero since we do not
allow for any shortages
purchase cost C
B
will remain constant
regardless of Q, because no discounts.
total incremental inventory cost
TIC = C
H
+ C
R

Since we seek to find the value of Q that
makes TIC a minimum, we must express C
H

and C
R
in terms of Q.
POM-04 23
Inventory Management
Q
D
c I c C
Q
c
Q
c
I I
c I c C
R R R R
H H H H H
= =
=
+
=
+
= =
2 2
0
2
min max
H
Q
D
c
Q
c TIC
R H
+ =
2
POM-04 24
Inventory Management

Optimal Order Qty (EOQ)

TIC
0
Fig:4-Cost relationships in EOQ model
Holding cost
Ordering cost
TIC
POM-04 25
Inventory Management
? order much to How
2
H
R
o
c
D c
Q =
? order to When
D
Q
t
o
=
cost inventory l incrementa Minimum
2 D c c TIC
R H o
=
POM-04 26
Inventory Management
Let us consider an inventory system, where
there is production contributing to inventory
Production is @ p: finite, constant
Demand is @ D
During production, we are adding @ p, while
demand causes inventory to deplete @ D
During no production, depletion @ D
No shortages
POM-04 27
Inventory Management
Inventory
added @ p
Inventory taken
out @ D
p>D
During
production,
build @ p-D
No
addition
P=0
Inventory
taken out @ D
After production,
depletion
@ D
Figure 7: Inventory fluctuation during production & after production stops
POM-04 28
Inventory Management
t
p

t
Replenishment cycle t
L
L
Reorder
point
I
max
Maxm.
Inventory
Prodn.
Lot
Size Q
Prodn. End
Prodn. start
POM-04 29
Inventory Management
If production is @ p over time t
p
Q=p. t
p
During production,inventory is added @ p and depleted @ D
Net inventory build-up = p-D
At the end of production, I
max
=(p-D) t
p
Max.Inventory level=(build-up rate) X (production period)
Total Incremental Inventory Cost=
(Holding cost) + (Set up cost)
TIC= C
H
+ C
R
Holding cost C
H
= C
H
.(1-D/p).Q/2
Set-up cost C
R
= C
R
. I
R
= C
R.
.(D/Q)



POM-04 30
Inventory Management
( )
?
/ 1
2
time each produce to much How
p D c
D c
Q
H
R
o

=
? produce to when
D
Q
t
o
o
=
t inventory l incrementa Minimium
D c
p
D
c TIC
R H o
cos
1 2
|
|
.
|

\
|
=
POM-04 31
Inventory Management
Inventory Model Allowing Shortages
1.Demand = known and constant
2.Replenishment
P = (instantaneous addition of order quantity to
inventory)
L = known and constant
b(Q) = b (no price discounts allowed)
3.Costs
C
H
, C
S
, C
R
= known and constant unit costs
c
S
= unit cost of shortage is infinite
(system operates without shortages; that is, I
s
= 0)

POM-04 32
Inventory Management
Inventory Model Allowing Shortages


Maximum
shortage R
t
1
t
1
t
2
t
2
Maximum
Surplus M
Reorder cycle t
M
0
POM-04 33
Inventory Management
4.Decision variables
Q = size of each order or replenishment
M = desired maximum, i.e., starting inventory at
beginning of cycle time
5.Relationships
Order quantity Q = D t

Reorder level R = M Q

Reorder cycle time t = t
1
+ t
2


POM-04 34
Inventory Management
t
ordering
t
shortage
t
holding
t inventory
l incrementa Total
cos cos cos cos

+ + =
TIC = C
H
+ C
S
+ C
R

or


t
t
l I M I and
exists surplus
cycle of
surplus
Average
l
I I
I where
I c C
H
H h H
1
1 min max
1
min max
, 0 ,

%

2

cost Holding
= = =
|
|
.
|

\
|
|
|
.
|

\
|
+
=
=
POM-04 35
Inventory Management
Shortage Cost
t
t
l I Q M R I and
exists shortage
cycle of
shortage
Average
l
I I
I where
I c C
S
S S S
2
2 min max
2
min max
, 0 ,

%

2


= = = =
|
|
.
|

\
|
|
|
.
|

\
|
+
=
=


POM-04 36
Inventory Management
Shortage Cost =



Ordering Cost =


Holding Cost=


S S s
c
Q
Q M
c
Q
Q M Q M
C

=
2
) (
2
2
Q
D
c I c C
r R r R
. . = =
Q
M
c C
h H
2
2
=
POM-04 37
Inventory Management
Total Incremental Cost
= Ordering + Shortage + Holding Cost



(

+
(

+
(

=
Q
M
c
Q
D
c c
Q
Q M
TIC
h r S
2
. .
2
) (
2 2
POM-04 38
Inventory Management





Minimum Incremental Inventory Cost
?
2
0
time each order to much How
c
c c
c
D c
Q
S
S H
H
R
+
=
inventory starting Desired
c c
c
c
D c
M
H S
S
H
R

2
0
+
=
t inventory l incrementa Minimum
c c
c
D c c TIC
S H
S
R H
cos 2
0
+
=
H
c
POM-04 39
Inventory Management
The reorder cycle time and reorder level are
determined easily as follows :



?
0
0
order to When
D
Q
t =
Re
0 0
level order Q M R =
POM-04 40
Inventory Management
Inventory Model With Price Discounts
Suppliers offer price discounts to encourage large
orders,price becomes a step-function, instead of fixed


Do savings in the purchase cost due to discounts and
reduction in ordering costs (less number of orders)
absorb the additional holding costs ?
Shortage cost C
s
is not considered
Purchase cost C
B
is now affected by the order quantity
Q. For this case, it is necessary to minimize the total
inventory cost TC.
units k Q when unit dollars b
units k Q when unit dollars b Q b
/
/ ) (
2
1
>
< =
POM-04 41
Inventory Management
Inventory Model With Price Discounts

t
purchase
t
ordering
t
holding
t
inventory Total
cos cos cos cos

+ + =
D Q b
Q
D
c
Q
Q b f C C C TC
R B R H
) (
2
)] ( [ + + = + + =
POM-04 42
Inventory Management
Example:
D=3600; f=0.25; c
r
= $16/0rder
Price

> =
< =
=
gal Q if gallon per b
gal Q if gallon per b
Q b
300 6 $
300 8 $
) (
2
1
POM-04 43
Inventory Management
Example
The EOQ at the lower price $6 will be

order gal
f b
D c
b Q
R
o
/ 13 . 277
800 , 76
) 6 )( 25 (
) 600 , 3 )( 16 )( 2 (

2
) (
2
2
=
=

= =
POM-04 44
Inventory Management
Example
This amount is less than the order size of 300
needed to take advantage of the discount
offered. Therefore, we must calculate the
total costs incurred for the EOQ at the regular
price and for orders equal to k = 300 at the
discounted price.
POM-04 45
Inventory Management
yr
b TC
theref ore
D b
Q
D
c
Q
b f b TIC
D b Q where
D b b TIC b TC
o
o
R
o
o
o
/ 280 , 29 $
800 , 28 480 ) (
800 , 28 $ 3600 * 8
480 $ 240 240
2
) (
) , 3600 , 8 $ , 240 ( ,
) ( ) (
1
1
1 1
1
1 1 1
=
+ =
= =
= + = + =
= = =
+ =
POM-04 46
Inventory Management
When Q = k = 300 gal, we have



. / 017 , 22 $
600 , 21 192 225
) 600 , 3 )( 6 (
300
600 , 3
) 16 (
2
300
) 6 )( 25 (
2
) (
2 2
yr
D b
k
D
c
k
b f b at k Q TC
R e
=
+ + =
+ + =
+ + = =
POM-04 47
Inventory Management
Thus, to minimize total inventory costs the
maintenance department must order in
amounts equal to Q* = 300 gal

POM-04 48
Inventory Management


Single-stage Inventory Model Under Conditions Of Risk
For certain items replenishment of inventory occurs only
once during each planning period
Demand is uncertain and can be described with a
statistical distribution, from record of past experience
The cost of each unit stocked C and its selling price B.
If demand is insufficient during the current period, the
leftover units are sold at a reduced price S overstocking
If demand exceeds the number of units stocked, there is a
stock out, cost per unit equal is forgone profit B-C (under
stocking).
Specifying a decision rule that would minimize the
expected cost during the period






POM-04 49
Inventory Management



The Edelweiss Bakery Shop prepares a deluxe cake each
weekend for its best customers. The demand for this
cake from week to week is uncertain, but the owner of
the bakery has kept a record of sales in past weeks, and
the statistical distribution for demand is shown in
Computation Table

The owner sells the cakes for $8 each and has
estimated that they cost $5 to prepare. If any fresh cakes
are left over after the weekend, they are put on special
sale on Monday and sold at $ 3 and all are sold.
POM-04 50
Decision Rule A
For the single-stage inventory problem
under conditions of risk, the optimal
action on the number of units to stock
Q
o
is the one yielding the minimum
total expected cost, i.e.,
TEC(Q
o
)
= minimum TED (Q) over all Q values
POM-04 51
Inventory Management


Table 3: Total Expected cost of inventory decisions

P(y)

.05

.15

.20

.25

.20

.15

TEC
values

Demand

Action

0

1

2

3

4

5

0

0

3

6

9

12

15

8.55

1

2

0

3

6

9

12

5.8

2

4

2

0

3

6

9

3.8

3

6

4

2

0

3

6

2.8

4

8

6

4

2

0

3

3.05

5

10

8

6

4

2

0

4.3

POM-04 52
Inventory Management


Decision Rule B
For the single-stage inventory problem under
conditions of risk, the optimal action on the number of
units to stock Q
o
corresponds to the largest value of Q
for which:

ratio value Critical
C C
C
Q y P
o u
u
) (
+
s <
POM-04 53
Inventory Management


600
2 3
3
) (
) (
=
+
s <
+
s <
Q y P or
C C
C
Q y P
o u
u
For the bakery-shop example we have:
POM-04 54
Inventory Management


For a production quantity Q = 3

40
20 15 05
) 2 ( ) 1 ( ) 0 ( ) 3 (
=
+ + =
= + = + = = < y P y p y P y P
while for a production quantity Q = 4

65
25 20 15 05
) 3 ( ) 2 ( ) 1 ( ) 0 ( ) 4 (
=
+ + + =
= + = + = + = = < y P y P y p y P y P
POM-04 55
Inventory Management


Therefore, the value of Q, for which
cumulative probability is less than or
equal to 0.60 is Q = 3

The obvious advantage of this method is
that it completely obviates the
calculation of entries in tabular form, for
stock-out and surplus costs and expected
costs for each action.

/POM/2004 56
Inventory Management 2
.
/POM/2004 57
In this module, we will look in to:
Introduction
ABC Analysis for Proper Control
Estimation of Inventory Costs
Safety Stocks for Absorbing Random Variability
Determination of Safety-stock Size for Specified Service Level
The Fixed-order-quantity (Continuous-review) System
The Fixed-order-interval (Periodic-review) System
The Base-stock (Optional-replenishment) System
/POM/2004 58
The inventory models:
to idealized situations dealing with one item
appropriate for no uncertainty.
real life inventory systems are complex
present major difficulties in their design,
analysis, and operation.
/POM/2004 59
Among the most serious complicating features, we
have:
1. The need for handling a large number of items
deserving different degrees of control, ordered from
several suppliers, and having unique requirements for
packaging, storage, and handling
2. The difficulty of estimating with accuracy the
relevant costs of holding inventory, ordering or
setting up, and stock outs
3. The inherent variability, which is often random, in
the demand rate D, the supply lead-time L, the
production rate P.
/POM/2004 60
ABC Analysis :
An inventory-management system handles thousands
of different items.
wasteful practice to exercise the same degree of control
over all
necessary to classify on the basis of value or criticality
resulting categories are then ranked according to the
desired degree of control, reflecting the size of
investment and the criticality of an item
more capital invested in a given category the tighter the
required control.
more critical an item, the closer the surveillance
required, even though the per unit value of may not be
high.

/POM/2004 61
10 20 30 40 50 60 70 80 90 100
30
40
50
60
70
80
90
20
10
100
A B C
ABC Analysis
/POM/2004 62
ABC Analysis: Degree of Control
Class Degree of
Control
Review
Frequency
A

Tight Daily or Weekly
B Medium Bi-weekly or
Monthly
C Limited or None Every 2-3 months
/POM/2004 63
Control refers to the degree of attention given to:
1. The time interval between successive reviews
of requirements t
2. Order frequencies
3. Expected demand rates D
4. Order quantities Q
5. Review of information system operation
concerning timing, accuracy, and frequency of
reporting relevant data
/POM/2004 64
Estimation of Inventory Costs
Holding costs
the sum of cost of capital tied up, storage or warehouse
costs, depreciation, obsolescence, insurance, handling,
taxes, etc. Cost of capital depends on the companys
rate of return. frequently assumed. Insurance rates drop
as the value of inventory increases; warehouse costs
may be determined on area or volume, and handling
charges may decrease with volume as more efficient
equipment is purchased to handle greater traffic.
Depreciation and obsolescence are also difficult to
assess, and the same may be true for other costs.
/POM/2004 65
Estimation of Inventory Costs

Ordering costs
are supposed to be incremental in nature and vary
linearly with the number of orders & are primarily
related to the salaries of personnel in the
purchasing department,
/POM/2004 66
Estimation of Inventory Costs

Shortage costs
related to stock outs involving loss of customers
& goodwill. These costs are real & cannot be
assumed to be infinite, forcing the system to
maintain enough inventory to cover all possible
demand loads.
/POM/2004 67
Safety Stocks for Absorbing Random Variability
The random variability in the demand rate, the
supply time, and the production rate are difficult to
estimate
Variation due to seasonal fluctuations, and business
cycles, can be identified and removed, random
variability is unpredictable
When supply lead time and demand are both
variable, the problem is very complex; the only
feasible approach is to use simulation

/POM/2004 68
Safety Stocks for Absorbing Random Variability
To absorb random variability, especially in demand
and lead time, inventory systems rely on safety (or
buffer) stocks
Increase in safety stock raises the holding cost
The objective is to reach a balance between the extra
holding cost resulting from safety stocks and the
expected cost of shortage
Optimum safety stock minimizes the sum of these
costs

/POM/2004 69
Safety-stock for Empirical Demand Distribution
Safety stocks in a fixed-order-quantity inventory system
with constant lead-time, similar to that assumed in EOQ
model
When the inventory level drops to the reorder point, an
order of fixed quantity is placed
With average demand during the lead-time the inventory
reaches zero, at which time the new order arrives.

/POM/2004 70
Safety-stock for Empirical Demand Distribution.
If actual demand during the lead time exceeds expected
demand, there will be a stock out. Without safety stocks
shortages are likely to occur 50% of the time,
The objective in using safety stocks is to reduce the risk
of shortages from 50 % t to a more reasonable level, say
5 or 10 %
In a fixed-order-quantity system, stock outs only happen
due to lead time variation

/POM/2004 71
Definition: Safety stock is the amount of extra
inventory needed to satisfy maximum reasonable
demand for a given service level during the lead
time.
= average demand rate per unit time (usually a year)
D
max
= maximum reasonable demand rate per unit
time
L = supply lead time, days
= average demand during lead time = DL
X
max
= maximum reasonable demand during lead time
for given service level = D
max
L
B
FOQ
= safety stock in fixed-order-quantity system
D
X
/POM/2004 72
Then, B
FOQ
= X
max
-
B
FOQ
= D
max
L - DL = (D
max
-D)(L)
if X
i
occurs with a frequency p(X
1
) (i =1, 2,,n), then

X
( ) | | ( ) | | ( ) | |
n n
X p X X p X X p X X + + + = ...
2 2 1 1
/POM/2004 73
Safety-stock for an Empirical Demand Distribution
Example :A camera shop has experienced an uncertain
demand for one of its high-priced items and wishes to
determine the amount of buffer stock needed for various
service levels. The lead-time for replenishment is 2 weeks, or
10 working days.





/POM/2004 74
Demand during Lead Time
Demand
during
L X
Relative
frequency
p(X)
Probability
demand
exceeds
X
Demand
during
L X

Relative
frequency
p(X)

Probability
demand
exceeds
X
0 .00 1.00 9 .08 .15
1 .02 .98 10 .05 .10
2 .03 .95 11 .03 .07
3 .05 .90 12 .02 .05
4 .08 .82 13 .02 .03
5 .12 .70 14 .01 .02
6 .20 .50 15 .01 .01
7 .15 .35 16 .01 0
8 .12 .23
/POM/2004 75
If the camera shop is to satisfy the average, or
normal, demand during a lead time of 10 days
(L = 10), it must only carry 6 units
However, if demand follows the same pattern
observed in the past, with 6 units in stock
during L the shop will experience shortages
50 percent of the time.
On the other hand, with 16 units in inventory,
demand will be met 100 percent of the time.
/POM/2004 76
The manager of the camera shop wants to to
have 90% service level
Maximum reasonable demand for this service
level is 10 units, i.e. actual demand is likely to
exceed this amount 10 percent of the time.
For this risk level the buffer stock will be


the buffer-stock cost for 90 percent service level
is =
= (0.3) (4) $ (200) = $240


units X D B
FOQ
4 6 10
max
= = =
r FOQ c B f . .
/POM/2004 77
Cost effects for different inventory service levels
Service
level
%
Maximum
reasonable
demand
X
max

Safety
(Buffer)
stock
B
Extra
investment for
buffer stock
c
r
Extra
holding
cost
(f=0.3)
C
H
50 %

6 0 $0 $0

90 %
10
4 $800 $240

95 %

12 6 $1200 $360

99 % 15 9 $1800 $540

/POM/2004 78
Safety-Stock for a Theoretical Demand Distribution
empirical demand distribution can be approximated
satisfactorily by a theoretical statistical distribution, safety-
stock calculations can be carried out more easily using the
properties of the distribution.
demand experienced by an inventory system can sometimes
be viewed as the sum of demands from many sources each
having only a negligible effect.
often the case with a wholesale distributor receiving orders
from many local retailers, each requiring only a limited
quantity
total demand can be approximated with the normal
distribution
/POM/2004 79
Example: For a distributor, total demand during
L has a mean value equal to 3,600 units and a
standard deviation S
X
of 20 units
demand during the lead time

where Z
X
is the number of standard deviations
away from the mean that corresponds to a risk
level X, that is, a service level equal to I = X.
for a 90 percent service level (X = 10
percent) inspection of a table for the normal
distribution yields Z
X
= 1.282.
) 20 ( 600 , 3
max X X X FOQ
Z S Z D B + = + =
/POM/2004 80
Approximation using the Poisson distribution
certain inventory systems the total quantity demanded is
the sum of orders each having a very small probability of
materializing
average demand rate is constant and the amounts ordered
in successive time intervals are independent.
situation seems to describe sales at the retail level, where
the probability of receiving an order from any one of
numerous potential customers is very small
X X
S Z X X
'
+ =
max
X S
X
=
/POM/2004 81
Approximation using the Poisson distribution
adequately approximated by the Poisson
distribution as long as the mean demand is not
greater than 20.
where

95 % service level (o = 0.05) for the Poisson
distribution gives Z
o
= 1.57.
X X
S Z X X
'
+ =
max
X S
X
=
/POM/2004 82
The Fixed-Order-Quantity (Continuous review) System
Decision Rule A: In a fixed-order-quantity system with
lead time shorter than the reorder cycle time (L < t) an
order to fixed amount Q is placed when the inventory level
drops to a predetermined reorder point R.




Inventory
level Q(T)
Order arrives
Maximum
Inventory
I
max
= Q



Reorder point, R




Order placed
L t
Safety Stock
Reorder
cycle
time

/POM/2004 83
FOQ (Continuous review) System with varying demand
during Lead Time




Inventory
level
Q(T)
Order
arrives
Desired
Maximum
Inventory
I
max
= Q

Reorder point,
R




Order
placed
L t
Safety Stock
Reorder
cycle
time

/POM/2004 84
Q
1

Q
2
Q
3

Q
4

B
FOQ

R
Maxm. Desired Inventory M = Inv. On Hand + Inv. On order
Q
1
Q
2
Q
3
Fig 6: Inventory Fluctuations in FOQ ( L>t)
L
/POM/2004 85
ThankYou !!!