Q. A small manufacturing firm uses roughly 3,400 pounds of chemical dye a year.

Currently the firm purchases 300 pounds per order and pays $3 per pound. The
supplier has just announced that orders of 1,000 pounds or more will be filled at a
price of $2 per pound. The manufacturing firm incurs a cost of $100 each time it
submits an order and assigns an annual holding cost of 17 percent of the purchase
price per pound.
a. Determine the order size that will minimize the total cost.
b. If the supplier offered the discount at 1,500 pounds instead of 1,000 pounds,
what order size would minimize total cost?

Solution:
D = 3,400 pounds per year S = $100 per order H = .17P

a. Compute the EOQ for $2 per pound: The quantity ranges are as follows.
Range Unit Price
1 to 999 $3
1,000 + $2

Because this quantity is feasible at $2 per pound, it is the optimum.

b. When the discount is offered at 1,500 pounds, the EOQ for the $2 per pound range
is no longer feasible.
Consequently, it becomes necessary to compute the EOQ for $3 per pound and
compare the total cost for that order size with the total cost using the price break
quantity (i.e., 1,500).

Hence, because it would result in a lower total cost, 1,500 is the optimal order size.
13. A mail-order house uses 18,000 boxes a year. Carrying costs are 60 cents per box a
year, and ordering costs are $96. The following price schedule applies. Determine the
following:
a. The optimal order quantity
b. The number of orders per year
Number of Boxes Price per Box
1,000 to 1,999 $1.25
2,000 to 4,999 1.20
5,000 to 9,999 1.15
10,000 or more 1.10

14. A jewelry firm buys semiprecious stones to make bracelets and rings. The supplier
quotes a price of $8 per stone for quantities of 600 stones or more, $9 per stone for
orders of 400 to 599 stones, and $10 per stone for lesser quantities. The jewelry firm
operates 200 days per year. Usage rate is 25 stones per day, and ordering costs are $48.
a. If carrying costs are $2 per year for each stone, find the order quantity that will
minimize total annual cost.
b. If annual carrying costs are 30 percent of unit cost, what is the optimal order size?
c. If lead time is six working days, at what point should the company reorder?
15. A manufacturer of exercise equipment purchases the pulley section of the
equipment from a supplier who lists these prices: less than 1,000, $5 each; 1,000
to 3,999, $4.95 each; 4,000 to 5,999, $4.90 each; and 6,000 or more, $4.85 each.
Ordering costs are $50, annual carrying costs per unit are 40 percent of purchase
cost, and annual usage is 4,900 pulleys. Determine an order quantity that will
minimize total cost.

16. A company will begin stocking remote control devices. Expected monthly demand
is 800 units. The controllers can be purchased from either supplier A or supplier B.
Their price lists are as follows:

SUPPLIER A SUPPLIER B
Quantity Unit Price Quantity Unit Price
1–199 $14.00 1–149 $14.10
200–499 13.80 150–349 13.90
500 + 13.60 350 + 13.70

Ordering cost is $40 and annual holding cost is 25 percent of unit price per unit.
Which supplier should be used and what order quantity is optimal if the intent is
to minimize total annual costs?
17. A manager just received a new price list from a supplier. It will now cost $1.00 a
box for order quantities of 801 or more boxes, $1.10 a box for 200 to 800 boxes, and
$1.20 a box for smaller quantities. Ordering cost is $80 per order and carrying costs
are $10 per box a year. The firm uses 3,600 boxes a year. The manager has suggested a
“round number” order size of 800 boxes. The manager’s rationale is that with a U-
shaped cost curve that is fairly flat at its minimum, the difference in total annual cost
between 800 and 801 units would be small anyway. How would you reply to the
manager’s suggestion? What order size would you recommend?

18. A newspaper publisher uses roughly 800 feet of baling wire each day to secure
bundles of newspapers while they are being distributed to carriers. The paper is
published Monday through Saturday.
Lead time is six workdays. What is the appropriate reorder point quantity, given that
the company desires a service level of 95 percent, if that stockout risk for various
levels of safety stock is as follows:
1,500 feet, .10; 1,800 feet, .05; 2,100 feet, .02; and 2,400 feet, .01?
PROBABILISTIC MODELS AND SAFETY STOCK

• All the inventory models we have discussed so far make the assumption that
demand for a product is constant and certain.
• When product demand is not known but can be specified by means of a
probability distribution probabilistic inventory models are used.
• An important concern of management is maintaining an adequate service level in
the face of uncertain demand.
• The service level is the complement of the probability of a stockout. For instance,
if the probability of a stockout is 0.05, then the service level is .95.
• Uncertain demand raises the possibility of a stockout.
• One method of reducing stockouts is to hold extra units in inventory referred to
as safety stock. It involves adding a number of units as a buffer to the reorder
point.
When to Reorder with EOQ Ordering
• The EOQ models answer the question of how much to order, but not the
question of when to order. The reorder point occurs when the quantity on
hand drops to predetermined amount.

• That amount generally includes expected demand during lead time.

• In order to know when the reorder point has been reached, a perpetual
inventory is required.

• The goal of ordering is to place an order when the amount of inventory on

hand is sufficient to satisfy demand during the time it takes to receive that
order (i.e., lead time)
When to Order: Reorder Points (Make sure demand
and lead time are expressed in the same time units)

 If the demand and lead time are both

constant, the reorder point (ROP) is
simply:

Demand Lead time for a

ROP = per day new order in days
=dxL
D
d = Number of working days in a year
Reorder Point Curve
Q*
Inventory level (units)

Resupply takes place as order arrives

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
When to reorder(with variability)
• When variability is present in demand or lead time, it creates the possibility
that actual demand will exceed expected demand.

• Consequently, it becomes necessary to carry additional inventory, called

“safety stock”, to reduce the risk of running out of stock during lead time.
The reorder point then increases by the amount of the safety stock:

ROP = expected demand during lead time + safety stock (SS)

 Safety Stock
Quantity

Maximum probable demand

during lead time

Expected demand
during lead time

ROP

Safety stock
LT Time
Safety stock reduces risk of
stockout during lead time
 Safety stock
• Because it costs money to hold safety stock, a manager must carefully
weigh the cost of carrying safety stock against the reduction in stockout
risk it provides.
• The customer service level increases as the risk of stockout decreases.
• The order cycle “service level” can be defined as the probability that
demand will not exceed supply during lead time.
• A service level of 95% implies a probability of 95% that demand will not
exceed supply during lead time.
Safety Stock
• The “risk of stockout” is the complement of
“service level”
Service level = 1 - Probability of stockout
• Higher service level means more safety stock
• More safety stock means higher ROP
ROP = expected demand during lead time + safety stock (SS)
Reorder Point with a Safety Stock
Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Time
Probabilistic Models to Determine
ROP and Safety Stock
(When Stockout Cost/Unit is known)

▶ Use safety stock to achieve a desired service level and avoid

stockouts

ROP = d x L + ss

Annual stockout costs =

The sum of the units short for each demand level
x the probability of that demand level
x the stockout cost/unit
x the number of orders per year
Safety Stock Example (Stochastic demand and constant lead time)

Q. David Rivera Optical has determined that its reorder point for eyeglass frames is 50
( dXL) units. Its carrying cost per frame per year is $5, and stockout (or lost sale)
cost is $40 per frame. The optimum number of orders per year is six. The store has
experienced the following probability distribution for inventory demand during the
lead time (reorder period).
NUMBER OF UNITS PROBABILITY
30 .2
40 .2
ROP  50 .3
60 .2
70 .1
1.0

Determining safety stock with probabilistic demand (95% service level) and
constant lead time
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year
We begin by looking at zero safety stock. For this safety stock, a shortage of 10 frames
will occur if demand is 60, and a shortage of 20 frames will occur if the demand is 70.

Thus the stockout costs for zero safety stock are:

(10 frames short) (0.2) ($40 per stockout)(6 possible stockouts per year)
+ (20 frames short)(.1)($40)(6) = $960

SAFETY ADDITIONAL TOTAL

STOCK HOLDING COST STOCKOUT COST COST
20 (20)($5) = $100 $0 $100
10 (10)($5) = $ 50 (10)(.1)($40)(6) = $240 $290
0 $ 0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960 $960

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
Q. David Rivera Optical has determined that its reorder point for eyeglass frames is 50
( d X L) units. Its carrying cost per frame per year is $20, and stockout (or lost sale)
cost is $30 per frame. The optimum number of orders per year is six. The store has
experienced the following probability distribution for inventory demand during the
lead time (reorder period).

NUMBER OF UNITS PROBABILITY

30 .2
40 .2
ROP  50 .3
60 .2
70 .1
1.0

Determining safety stock with probabilistic demand and constant lead time

Answer:

Safety stock = 10 now, with a total cost of $380, which is the lowest of the three.

ROP = 60 frames.
Q.12.6 Children’s art sets are ordered once each year by Ashok Kumar, Inc., and the
reorder point, without safety stock (dL) is 100 art sets. Inventory carrying cost is
$10 per set per year, and the cost of a stockout is $50 per set per year. Given the
following demand probabilities during the lead time, how much safety stock
should be carried?
Demand during Lead Time Probability
0 .1
50 .2
ROP : 100 .4
150 .2
200 .1
1.0
Probabilistic Models to Determine ROP
and Safety Stock
(when the cost of stockouts cannot be determined)

 Desired service levels are used to set safety stock

• Assuming that demand during lead time (the reorder period) follows a normal
curve, only the mean and standard deviation are needed to define the inventory
requirements for any given service level.

• Sales data are usually adequate for computing the mean and standard deviation.

• Let a normal curve with a known mean (μ) and standard deviation (σ) to
determine the reorder point and safety stock necessary for a 95% service level.

ROP = demand during lead time + ZsdLT

Where Z = Number of standard deviations below (or above) the mean

sdLT =Standard deviation of demand during lead time
•From non-standard
A z-score gives you annormal to standard
idea of how normal
far from the mean a data point is.

• But more technically it's a measure of how many standard deviations

below or above the population mean a raw score is.

• X is a normal random variable with mean μ, and standard deviation σ

Z=(X–μ)/σ

Z=standard unit or z-score of X

Q. Memphis Regional Hospital stocks a “code blue” resuscitation kit that has a normally
distributed demand during the reorder period. The mean (average) demand during
the reorder period is 350 kits, and the standard deviation is 10 kits. The hospital
administrator wants to follow a policy that results in stockouts only 5% of the time.
(a) What is the appropriate value of Z?
(b) How much safety stock should the hospital maintain?
(c) What reorder point should be used?

Probability of Risk of a stockout

no stockout (5% of area of
95% of the time normal curve)

Mean ROP = ? kits Quantity

demand
350
Safety
stock
0 z Number of standard deviations
below or above the mean
m =Average demand during lead time = 350 resuscitation kits
sdLT =Standard deviation of demand during lead time = 10 kits
Z =5% stockout policy (service level = 95%)

Using Appendix I, for an area under the curve of 95%,

the Z = 1.65

Safety stock = ZsdLT = 1.65(10) = 16.5 kits

Reorder point = Expected demand during lead time + Safety stock

= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits
Probabilistic Demand

Minimum demand during lead time

Inventory level

Maximum demand during lead time

Mean demand during lead time

ROP = 350 + safety stock of 16.5 = 366.5

ROP 
Normal distribution probability of
demand during lead time
Expected demand during lead time (350 kits)

Safety stock 16.5 units

0 Lead
time Time
Place Receive
order order
Q. What safety stock should Ron Satterfield Corporation maintain if mean sales are
80 during the reorder period, the standard deviation is 7, and Ron can tolerate
stockouts 10% of the time?
Q. Memphis Regional Hospital stocks a “code blue” resuscitation kit that has a normally
distributed demand during the reorder period. The mean (average) demand during the
reorder period is 350 kits, and the standard deviation is 10 kits. The hospital
administrator wants to follow a policy that results in stockouts only 10 % of the time.
(a) What is the appropriate value of Z?
(b) How much safety stock should the hospital maintain?
(c) What reorder point should be used?

Answer: a) Z – 1.28
b) safety stock =12.8
c) ROP = 363 kits.
Other Probabilistic Models to determine SS and ROP

▶ When data on demand during lead time is not available, there

are other models available
1. When demand per day is variable and lead time (in days) is
constant

2. When lead time (in days) is variable and demand per day is
constant

3. When both demand per day and lead time (in days) are variable
1. Demand per day is variable and lead time (in
days) is constant

ROP =(Average daily demand)

* Lead time in days) + ZsdLT

where sdLT = sd Lead time

sd= standard deviation of demand per day
2. Lead time (in days) is variable and demand per day is
constant

ROP = (Daily demand * Average lead time in days) +Z *

(Daily demand) * sLT

where sLT = Standard deviation of lead time in days

3. Both demand per day and lead time (in days) are
variable

ROP = (Average daily demand x Average lead time) + ZsdLT

Where sd = Standard deviation of demand per day

sLT = Standard deviation of lead time in days
sdLT = (Average lead time x sd2)
+ (Average daily demand)2s2LT
Q. The average daily demand for Apple iPods at a Circuit Town store is 15,
with a standard deviation of 5 units. The lead time is constant at 2 days.
Find the reorder point if management wants a 90% service level (i.e., risk
stockouts only 10% of the time). How much of this is safety stock?

Solution:
Average daily demand (normally distributed) = 15
Lead time in days (constant) = 2 Z for 90% = 1.28
Standard deviation of daily demand = 5 From Appendix I
Service level = 90%

ROP = (15 units x 2 days) + ZsdLT

= 30 + 1.28(5) ( 2)
= 30 + 9.02 = 39.02 ≈ 39

Safety stock is about 9 computers

Q. The Circuit Town store sells about 10 digital cameras a day (almost a constant
quantity). Lead time for camera delivery is normally distributed with a mean time
of 6 days and a standard deviation of 3 days. A 98% service level is set. Find the
ROP.

Solution:

Daily demand (constant) = 10

Average lead time = 6 days
Standard deviation of lead time = sLT = 3
Service level = 98%, so Z (from Appendix I) = 2.055

𝑳𝑻

ROP = (10 units x 6 days) + 2.055(10 units)(3)

= 60 + 61.65 = 121.65

Reorder point is about 122 cameras

Q. The Circuit Town store’s most popular item is six-packs of 9-volt batteries. About
150 packs are sold per day, following a normal distribution with a standard
deviation of 16 packs. Batteries are ordered from an out-of-state distributor; lead
time is normally distributed with an average of 5 days and a standard deviation of 1
day. To maintain a 95% service level, what ROP is appropriate?

Solution:
Average daily demand (normally distributed) = 150
Standard deviation = sd = 16 𝒅𝑳𝑻
Average lead time 5 days (normally distributed)
Standard deviation = sLT = 1 day 𝟐 𝟐 𝟐
𝒅𝑳𝑻 𝒅 𝑳𝑻
Service level = 95%, so Z = 1.65 (from Appendix I)

ROP = (150 packs ´ 5 days) +1.65s dLT

s dLT = ( ) (
5 days ´162 + 1502 ´12 = ) (5 ´ 256) + (22,500 ´1)
= (1,280) + (22,500) = 23,780 @ 154
ROP = (150 ´ 5) +1.65(154) @ 750 + 254 = 1,004 packs
PROBLEM 12.7
What safety stock should Ron Satterfield Corporation maintain if mean sales are 80
during the reorder period, the standard deviation is 7, and Ron can tolerate stockouts
10% of the time?
PROBLEM 12.8
The daily demand for 52′′ plasma TVs at Sarah’s Discount Emporium is normally
distributed, with an average of 5 and a standard deviation of 2 units. The lead time for
receiving a shipment of new TVs is 10 days and is fairly constant. Determine the reorder
point and safety stock for a 95% service level.
PROBLEM 12.9
The demand at Arnold Palmer Hospital for a specialized surgery pack is 60 per week,
virtually every week. The lead time from McKesson, its main supplier, is normally
distributed, with a mean of 6 weeks for this product and a standard deviation of 2
weeks. A 90% weekly service level is desired. Find the ROP.

SOLUTION
Here the demand is constant and lead time is variable, with data given in weeks, not
days. We apply Equation (12-16):

ROP = (Weekly demand * Average lead time in weeks) + Z (Weekly demand) σLT

Where
σLT = standard deviation of lead time in weeks = 2

So, with Z = 1.28 for a 90% service level:

ROP = (60 * 6) + 1.28(60)(2)

= 360 + 153.6 = 513.6 = 514 surgery pack
Example 9
A restaurant uses an average of 50 jars of a special sauce each week. Weekly usage of
sauce has a standard deviation of 3 jars. The manager is willing to accept no more
than a 10 percent risk of stockout during lead time, which is two weeks. Assume the
distribution of usage is normal. Determine the ROP.

Solution:
d¯ = 50 jars per week LT = 2 weeks
σ d = 3 jars per week Acceptable risk = 10 percent, so service level is .90

Using a service level of .9000, z = +1.28

= 50 × 2 + 1.28(3)√2
= 100 + 5.43 = 105.43.

Because the inventory is discrete units (jars), we round this amount to 106.
FIXED-ORDER-INTERVAL MODEL

• The fixed-order-interval (FOI) model is used when orders must be placed at fixed
time intervals (weekly, twice a month, etc.)

• In some cases, a supplier’s policy might encourage orders at fixed intervals.

• Furthermore, some situations do not readily lend themselves to continuous

monitoring of inventory levels. The alternative for them is to use fixed-interval
ordering.

• The timing of orders is set. The question, then, at each order point, is how much
to order.

• Fixed-interval ordering systems are widely used by retail businesses. (e.g.,

drugstores, small grocery stores).

• If demand is variable, the order size will tend to vary from cycle to cycle.
• If both the demand rate and lead time are constant, the fixed-interval model and
the fixed quantity model function identically.

• The differences in the two models become apparent only when examined under
conditions of variability.

• Like the ROP model, the fixed-interval model can have variations in demand only, in
lead time only, or in both demand and lead time.

• However, for the sake of simplicity and because it is perhaps the most frequently
encountered situation, the discussion here will focus only on variable demand and
constant lead time.

• In the fixed-quantity arrangement, orders are triggered by a quantity (ROP), while

in the fixed-interval arrangement orders are triggered by a time.

• Therefore, the fixed-interval system must have stockout protection for lead time
plus the next order cycle, but the fixed-quantity system needs protection only
during lead time because additional orders can be placed at any time and will be
received shortly (lead time) thereafter.

• Consequently, there is a greater need for safety stock in the fixed-interval model
than in the fixed-quantity model.
Fixed-Period (P) Systems
▶ Orders placed at the end of a fixed period
▶ Inventory counted only at the end of period
▶ Order brings inventory up to target level
▶ Only relevant costs are ordering and holding
▶ Lead times are known and constant
▶ Items are independent of one another
• In the fixed-quantity model, a higher-than-normal demand causes a shorter time
between orders, whereas in the fixed-interval model, the result is a larger order size.

• Another difference is that the fixed-quantity model requires close monitoring of

inventory levels in order to know when the amount on hand has reached the
reorder point.

• The fixedinterval model requires only a periodic review (i.e., physical count) of
inventory levels just prior to placing an order to determine how much is needed.

• Order size in the fixed-interval model is determined by the following computation:

• As in previous models, we assume that demand during the protection interval is

normally distributed.
Q. Given the following information, determine the amount to order.
= 30 units per day Desired service level = 99 percent
σd = 3 units per day Amount on hand at reorder time = 71 units
LT = 2 days OI = 7 days

Solution:

z = 2.33 for 99 percent service level

Amount of order = -A

Q = 30(7 + 2) + 2.33(3) − 71

= 220 units
Q. Given the following information:
LT = 4 days A = 43 units
OI = 12 days Q = 171 units
= 10 units/day σd = 2 units/day
Determine the risk of a stockout at
a. The end of the initial lead time.
b. The end of the second lead time.
Solution:
a. For the risk of stockout for the first lead time, we use Formula 13–13.

Substituting we get 43 = 10 × 4 + z(2)(2). Solving, z = +.75.

From Appendix B, Table B, the service level is .7734. The risk is 1 – .7734 = .2266,
which is fairly high.
b. For the risk of a stockout at the end of the second lead time, we use Formula 13–16.
Amount of order = -A
Substituting the given values we get 171 = 10 × (4 + 12) + z(2)(4) − 43.
Solving, z = 16.75.
This value is way out in the right tail of the normal distribution, making the service
level virtually 100 percent, and, thus, the risk of a stockout at this point is essentially
equal to zero.
Benefits
• The fixed-interval system results in tight control.
• In addition, when multiple items come from the same supplier, grouping orders
can yield savings in ordering, packing, and shipping costs.
• Moreover, it may be the only practical approach if inventory withdrawals cannot
be closely monitored.

Disadvantages
• It necessitates a larger amount of safety stock for a given risk of stockout because
of the need to protect against shortages during an entire order interval plus lead
time (instead of lead time only), and this increases the carrying cost.
• Also, there are the costs of the periodic reviews.
Single-Period Inventory Model
Used to handle ordering of perishables (fresh fruits, flowers) and other
items with limited useful lives (newspapers, spare parts for specialized
equipment).

• In a single-period model, items are received in the beginning of a period

and sold during the same period. The unsold items are not carried over
to the next period.
• The unsold items may be a total waste, or sold at a reduced price, or
returned to the producer at some price less than the original purchase
price.
• The revenue generated by the unsold items is called the salvage value.
Single Period Model
• Only one order is placed for a product
• Units have little or no value at the end of the sales period

Cs = Cost of shortage = Cost of understocking

= Sales price/unit – Cost/unit = lost profit
Co = Cost of overage = Cost of overstocking
= Cost/unit – Salvage value

Service level =
Q. Chris Ellis’s newsstand, just outside the Smithsonian subway station in
Washington, DC, 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 that quantity.

Solution:

Average demand = m = 120 papers/day

Standard deviation = sd = 15 papers

Cs = cost of shortage = Sales price/unit – Cost/unit = lost profit

= $1.25 - $.70 = $.55

Co = cost of overage = Cost/unit – Salvage value

= $.70 - $.30 = $.40
 Cs
Service level =
Cs + C o
Service
.55 level
= 57.8%
.55 + .40
.55
= = .578 m = 120
.95
Optimal stocking level

From Appendix I, for the area .578, Z @ .20

The optimal stocking level

= 120 copies + (.20)(s) = 120 + (.20)(15) = 120 + 3 = 123 papers

The stockout risk = 1 – service level = 1 – .578 = .422 = 42.2%

Assignment