MITx SCX KeyConcept SC1x FV

CTL.
SC1x - Supply Chain Fundamentals

Key Concepts Document
This document contains the Key Concepts for the SC1x course, version 3.
These are meant to complement, not replace, the lesson videos and slides. They are
intended to be references for you to use going forward and are based on the assumption
that you have learned the concepts and completed the practice problems.
The draft was updated and revised in the Summer of 2018.
This is a draft of the material, so please post any suggestions, corrections, or

recommendations to the Discussion Forum under the topic thread “Key Concept
Documents Improvements.
Thanks,
Chris Caplice, Eva Ponce and the SC1x Teaching Community
01-08-2020・CTL.SC1x – Supply Chain Fundamentals Key Concepts・MITx MicroMasters in Supply Chain Management
MIT Center for Transportation & Logistics・Cambridge, MA 02142 USA ・scm_mm@mit.edu
This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.
Table of Contents
Core Supply Chain Concepts ...............................................................................................................3
Demand Forecasting ..........................................................................................................................9
Time Series Analysis.................................................................................................................................12
Exponential Smoothing............................................................................................................................13
Exponential Smoothing with Holt-Winter ...............................................................................................15
Special Cases............................................................................................................................................17
Inventory Management ................................................................................................................... 22
Economic Order Quantity (EOQ)..............................................................................................................24
Economic Order Quantity (EOQ) Extensions............................................................................................27
Introduction to Stochastic Demand .........................................................................................................33
Single Period Inventory Models ...............................................................................................................35
Single Period Inventory Models-Expected Profitability ...........................................................................36
Multi Period Inventory Models ................................................................................................................40
Inventory Models for Multiple Items & Locations ...................................................................................47
Inventory Models for Class A & C Items ..................................................................................................52
Fundamentals of Transportation Management ................................................................................. 59
Lead Time Variability & Mode Selection .................................................................................................61
Operations of the transportation product...............................................................................................63
Underlying Economic Drivers...................................................................................................................63
Comparing Economic Modes ...................................................................................................................64
Transportation Problem Examples ..........................................................................................................64
Appendix A & B Unit Normal Distribution, Poisson Distribution Tables .............................................. 68
Winter 2020・CTL.SC1x – Supply Chain Fundamentals Key Concepts・MITx MicroMasters in Supply Chain Management
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Core Supply Chain Concepts
Summary
Virtually all supply chains are a combination of push and pull systems. A push system is where
execution is performed ahead of an actual order so that the forecasted demand, rather than
actual demand, has to be used in planning. A pull system is where execution is performed in
response to an order so that the actual demand is known with certainty. The point in the
process where a supply chain shifts from being push to pull is sometimes called the push/pull
boundary or push/pull point. In manufacturing, the push/pull point is also known as the
decoupling point (DP) or customer order decoupling point (CODP). The CODP coincides with an
important stock point, where the customer order arrives (switching inventory based on a
forecast to actual demand), and also allows to differentiate basic production systems: make-to-
stock, assemble-to-order, make-to-order, or engineer-to-order.
Postponement is a common strategy to combine the benefits of push (product ready for
demand) and pull (fast customized service) systems. Postponement is where the
undifferentiated raw or components are “pushed” through a forecast, and the final finished and
customized products are then “pulled”.
Segmentation is a method of dividing a supply chain into two or more groupings where the
supply chains operate differently and more efficiently and/or effectively. While there are no
absolute rules for segmentation, there are some rules of thumb, such as: items should be
homogenous within the segment and heterogeneous across segments; there should be critical
mass within each segment; and the segments need to be useful and communicable. A segment
only makes sense if it does something different (planning, inventory, transportation etc.) from
the other segments. The most common segmentation is for products using an ABC
classification.
In an ABC segmentation, the products driving the most revenue (or profit or sales) are Class A
items (the important few). Products driving very little revenue (or profit or sales) are Class C
items (the trivial many), and the products in the middle are Class B. A common breakdown is
the top 20% of items (Class A) generate 80% of the revenue, Class B is 30% of the products
generating 15% of the revenue, and the Class C items generate less than 5% of the revenue
while constituting 50% of the items.
Supply chains operate in uncertainty. Demand is never known exactly, for example. In order to
handle and be able to analyze systems with uncertainty, we need to capture the distribution of
the variable in question. When we are describing a random situation, say, the expected
demand for pizzas on a Thursday night, it is helpful to describe the potential outcomes in terms
of the central tendency (mean or median) as well as the dispersion (standard deviation, range).
We will often characterize the distribution of potential outcomes as following a well-known
function such as Normal and Poisson.
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Key Concepts
Pull vs. Push Process
• Push—work performed in anticipation of an order (forecasted demand)
• Pull—execution performed in response to an order (demand known with certainty)
• Hybrid or Mixed—push raw products, pull finished product (postponement or delayed
differentiation)
• Push/pull boundary point — point in the process where a supply chain shifts from being
push to pull
• In manufacturing, also known as “decoupling point” (DP) or “customer order decoupling
point” (CODP) — the point in the material flow where the product is linked to a specific
customer
• Mass customization / Postponement — to delay the final assembly, customization, or
differentiation of a product until as late as possible
Segmentation
• Differentiate products in order to match the right supply chain to the right product
• Products typically segmented on
o Physical characteristics (value, size, density, etc.)
o Demand characteristics (sales volume, volatility, sales duration, etc.)
o Supply characteristics (availability, location, reliability, etc.)
• Rules of thumb for number of segments
o Homogeneous—products within a segment should be similar
o Heterogeneous—products across segments should be very different
o Critical Mass—segment should be big enough to be worthwhile
o Pragmatic—segmentation should be useful and communicable
• Demand follows a power law distribution, meaning a large volume of sales is
concentrated in few products
Power Law
The distribution of percent sales volume to percent of SKUs (Stock Keeping Units) tends to
follow a Power Law distribution (y=axk) where y is percent of demand (units or sales or profit), x
is percent of SKUs, and a and k are parameters. The value for k should obviously be less than 1
since if k=1 the relationship is linear. In addition to segmenting according to products, many
firms segment by customer, geographic region, or supplier. Segmentation is typically done
using revenue as the key driver, but many firms also include variability of demand, profitability,
and other factors, to include:
• Revenue = average sales*unit sales price;
• Profit = average sales*margin;
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• Margin = unit sales price–unit cost.
Handling Uncertainty
Uncertainty of an outcome (demand, transit time, manufacturing yield, etc.) is modeled
through a probability distribution. We discussed two in the lesson: Poisson and Normal.
Normal Distribution ~N(µ,σ)

This is the Bell Shaped distribution that is widely used by both practitioners and academics.
While not perfect, it is a good place to start for most random variables that you will encounter
in practice such as transit time and demand. The distribution is both continuous (it can take
any number, not just integers or positive numbers) and is symmetric around its mean or
average. Being symmetric additionally means the mean is also the median and the mode. The
common notation that we will use to indicate that some value follows a Normal Distribution is
~N(µ, σ) where mu, µ, is the mean and sigma, σ, is the standard deviation. Some books use the
notation ~N(µ, σ2) showing the variance, σ2, instead of the standard deviation. Just be sure
which notation is being followed when you consult other texts.
The Normal Distribution is formally defined as:

-( x0 -m )2
2s x2
e
( )
f x x0 =
s x 2p
We will also make use of the Unit Normal or Standard Normal Distribution. This is ~N(0,1)
where the mean is zero and the standard deviation is 1 (as is the variance, obviously). The chart
below shows the standard or unit normal distribution. We will be making use of the
transformation from any Normal Distribution to the Unit Normal (See Figure 1).
Standard Normal Distribution (μ=0, σ2=1)

45%
40%
35%
30%
25% σ2=1
20%
15%
10%
5%
0% μ=0
-6 -4 -2 0 2 4 6
Figure 1. Standard Normal Distribution
We will make extensive use of spreadsheets (whether Excel or LibreOffice) to calculate

probabilities under the Normal Distribution. The following functions are helpful:
5
• In Excel 2007 and above, NORM.DIST(x, µ, σ, true) = the probability that a random
variable is less than or equal to x under the Normal Distribution ~N(µ, σ). So, that
NORM.DIST(25, 20, 3, 1) = 0.952 which means that there is a 95.2% probability that a
number from this distribution will be less than 25. For Excel 2003, use the above
function without the period, i.e, NORMDIST(25, 20, 3, 1).
• In Excel 2007 and above, NORM.INV(probability, µ, σ) = the value of x where the
probability that a random variable is less than or equal to it is the specified probability.
So, NORM.INV(0.952, 20, 3) = 25. For Excel 2003, use the above function without the
period, i.e NORMINV(0.952, 20, 3).
To use the Unit Normal Distribution ~N(0,1) we need to transform the given distribution by
calculating a k value where k=(x- µ)/σ. This is sometimes called a z value in statistics courses,
but in almost all supply chain and inventory contexts it is referred to as a k value. So, in our
example, k = (25 – 20)/3 = 1.67. Why do we use the Unit Normal? Well, the k value is a helpful
and convenient piece of information. The k is the number of standard deviations the value x is
above (or below if it is negative) the mean. We will be looking at a number of specific values
for k that are widely used as thresholds in practice, specifically:
• Probability (x ≤ 0.90) where k = 1.28
Because the Normal Distribution is symmetric, there are also some common confidence
intervals:
• μ ± σ 68.3% — meaning that 68.3% of the values fall within 1 standard deviation of the
mean,
• μ ± 2σ 95.5% — 95.5% of the values fall within 2 standard deviations of the mean, and
• μ ± 3σ 99.7% — 99.7% of the values fall within 3 standard deviations of the mean.
In a spreadsheets you can use the functions:

• NORM.S.DIST(k,1) = the probability that a random variable is less than k units above
(or below) mean. For example, NORM.S.DIST(2.0, 1) = 0.977 meaning the 97.7% of
the distribution is less than 2 standard deviations above the mean. For excel 2003,
use the function without period, i.e, NORMDIST(k).
• NORM.S.INV(probability) = the value corresponding to the given probability. So that
NORM.S.INV(0.977) = 2.0. If I then wanted to find the value that would cover 97.7% of a
specific distribution, say where ~N(279, 46) I would just transform it. Since k=(x- µ)/σ
for the transformation, I can simply solve for x and get: x = µ + kσ = 279 + (2.0)(46) =
371. This means that the random variable ~N(279, 46) will be equal or less than 371 for
97.7% of the time. For older versions of Excel, use NORMSINV(probability).
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Poisson distribution ~Poisson (λ)
We will also use the Poisson (pronounced pwa-SOHN) distribution for modeling things like
demand, stock outs, and other less frequent events. The Poisson, unlike the Normal, is discrete
(it can only be integers ≥ 0), always positive, and non-symmetric. It is skewed right – that is, it
has a long right tail. It is very commonly used for low value distributions or slow moving items.
While the Normal Distribution has two parameters (mu and sigma), the Poisson only has one,
lambda, λ.
Formally, the Poisson Distribution is defined as shown below:

e- l l 0
x
p[x0 ] = Prob éë x = x0 ùû = for x0 = 0,1,2,...
x0 !
x
e- l l x
F[x0 ] = Prob éë x £ x0 ùû = å
0
x=0 x!
The chart below (Figure 2) shows the Poisson Distribution for λ=3. The Poisson parameter λ is
both the mean and the variance for the distribution! Note that λ does not have to be an
integer.
Poisson Distribution (λ=3)
25%
20%
15%
P(x=x0)
10%
5%
0%
0 1 2 3 4 5 6 7 8 9
x
Figure 2. Poisson Distribution

In spreadsheets, the following functions are helpful:
• POISSON(x0, λ, false) => P(x = x0) = the probability that a random variable is equal to x 0
under the Poisson Distribution ~P(λ). So, that POISSON(2, 1.56, 0) = 0.256 which means
that there is a 25.6% probability that a number from this distribution will be equal to 2.
• POISSON(x0, λ, true) => P(x ≤ x0) = the probability that a random variable is less than or
equal to x0 under the Poisson Distribution ~P(λ). So, that POISSON(2, 1.56, 1) = 0.793
which means that there is a 79.3% probability that a number from this distribution will
be less than or equal to 2. This is simply just the cumulative distribution function.
7
Uniform distribution ~U (a,b)
We will sometimes use the Uniform distribution, which has two parameters: a minimum value a
and a maximum value b. Each point within this range is equally likely to occur. To find the
cumulative probability for some value C, the probability that x≤c = (c-a) / (b-a), that is, the area
from a to c minus the total area from a to b. The expected value or the mean is simply (a+b)/2
while the standard deviation is = (𝑏 − 𝑎)/√12.
Learning Objectives
• Identify and understand differences between push and pull systems.
• Understand why and how to segment supply chains by products, customers, etc.
• Ability to model uncertainty in supply chains, primarily, but not exclusively, in demand
uncertainty.
References
Push/Pull Processes: Chopra & Meindl Chpt 1; Nahmias Chpt 7;
Segmentation: Nahmias Chpt 5; Silver, Pyke, & Peterson Chpt 3; Ballou Chpt 3
Probability Distributions: Chopra & Meindl Chpt 12; Nahmias Chpt 5; Silver, Pyke, & Peterson
App B
Fisher, M. (1997) “What Is the Right Supply Chain for Your Product?,” Harvard Business Review.
Olavson, T., Lee, H. & DeNyse, G. (2010) “A Portfolio Approach to Supply Chain Design,” Supply
Chain Management Review.
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Demand Forecasting
Summary
Forecasting is one of three components of an organization’s Demand Planning, Forecasting, and
Management process. Demand Planning answers the question “What should we do to shape
and create demand for our product?” and concerns things like promotions, pricing, packaging,
etc. Demand Forecasting then answers “What should we expect demand for our product to be
given the demand plan in place?” The final component, Demand Management, answers the
question, “How do we prepare for and act on demand when it materializes?” This concerns
things like Sales & Operations Planning (S&OP) and balancing supply and demand.
Within the Demand Forecasting component, you can think of three levels, each with its own
time horizon and purpose. Strategic forecasts (years) are used for capacity planning,
investment strategies, etc. Tactical forecasts (weeks to months to quarters) are used for sales
plans, short-term budgets, inventory planning, labor planning, etc. Finally, operations forecasts
(hours to days) are used for production, transportation, and inventory replenishment decisions.
The time frame of the action dictates the time horizon of the forecast.
Forecasting methods can be divided into being subjective (most often used by marketing and
sales) or objective (most often used by production and inventory planners). Subjective
methods can be further divided into being either Judgmental (someone somewhere knows the
truth), such as sales force surveys, Delphi sessions, or expert opinions, or Experimental
(sampling local and then extrapolating), such as customer surveys, focus groups, or test
marketing. Objective methods are either Causal (there is an underlying relationship or reason)
such as leading indicators, etc. or Time Series (there are patterns in the demand) such as
exponential smoothing, moving average, etc. All methods have their place and their role. We
will spend a lot of time on the objective methods but will also discuss the subjective ones as
well.
Regardless of the forecasting method used, you will want to measure the quality of the
forecast. The two major dimensions of quality are bias (a persistent tendency to over- or
under-predict) and accuracy (closeness to the actual observations). No single metric does a
good job capturing both dimensions, so it is worth having multiple.
Key Concepts
Forecasting is both an art and a science. There are many “truisms” concerning forecasting
including:
Forecasting Truisms
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1. Forecasts are always wrong – Yes, point forecasts will never be completely perfect. The
solution is to not rely totally on point forecasts. Incorporate ranges into your forecasts.
Also you should try to capture and track the forecast errors so that you can sense and
measure any drift or changes.
2. Aggregated forecasts are more accurate than dis-aggregated forecasts – The idea is that
combining different items leads to a pooling effect that will in turn lessen the variability.
The peaks balance out the valleys. The coefficient of variation (CV) is commonly used to
measure variability and is defined as the standard deviation over the mean (𝐶𝑉 = 𝜎/𝜇).
Forecasts are generally aggregated by SKU (a family of products versus an individual
one), time (demand over a month versus over a single day), or location (demand for a
region versus a single store).
3. Shorter horizon forecasts are more accurate than longer horizon forecasts – Essentially
this means that forecasting tomorrow’s temperature (or demand) is easier and probably
more accurate than forecasting for a year from tomorrow. This is not the same as
aggregating. It is all about the time between making the forecast and the event
happening. Shorter is always better. This is where postponement and modularization
helps. If we can somehow shorten the forecasting time for an end item, we will
generally be more accurate.
Forecasting Metrics
There is a cost trade-off between cost of errors in forecasting and cost of quality forecasts
that must be balanced. Forecast metric systems should capture bias and accuracy.
Notation
At: Actual value for observation t
Ft: Forecasted value for observation t
et: Error for observation t, 𝑒𝑡 = 𝐴𝑡 − 𝐹𝑡
n: number of observations
µ: mean
σ: standard deviation
𝜎
CV: Coefficient of Variation – a measure of volatility – 𝐶𝑉 = 𝜇
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Formulas:
∑𝑛
𝑡=1 𝑒𝑡
Mean Deviation: 𝑀𝐷 = 𝑛
∑𝑛
𝑡=1|𝑒𝑡 |
Mean Absolute Deviation: 𝑀𝐴𝐷 = 𝑛
∑𝑛 2
𝑡=1 𝑒𝑡
Mean Squared Error: 𝑀𝑆𝐸 = 𝑛
∑𝑛 2
𝑡=1 𝑒𝑡
Root Mean Squared Error: 𝑅𝑀𝑆𝐸 = √ 𝑛
𝑒𝑡
∑𝑛
𝑡=1 𝐴𝑡
Mean Percent Error: 𝑀𝑃𝐸 = 𝑛
|𝑒𝑡 |
∑𝑛
𝑡=1 𝐴𝑡
Mean Absolute Percent Error: 𝑀𝐴𝑃𝐸 = 𝑛
2
Statistical Aggregation: 𝜎𝑎𝑔𝑔 = 𝜎12 + 𝜎22 + 𝜎32 + ⋯ + 𝜎𝑛2
𝜎𝑎𝑔𝑔 = √𝜎12 + 𝜎22 + 𝜎32 + ⋯ + 𝜎𝑛2
𝜇𝑎𝑔𝑔 = 𝜇1 + 𝜇2 + 𝜇3 + ⋯ + 𝜇𝑛
Statistical Aggregation of n Distributions of Equal Mean and Variance:
𝜎𝑎𝑔𝑔 = √𝜎12 + 𝜎22 + 𝜎32 + ⋯ + 𝜎𝑛2 = 𝜎𝑖𝑛𝑑 √𝑛
𝜇𝑎𝑔𝑔 = 𝜇1 + 𝜇2 + 𝜇3 + ⋯ + 𝜇𝑛 = 𝑛𝜇𝑖𝑛𝑑
𝜎 √𝑛 𝜎 𝐶𝑉𝑖𝑛𝑑
𝐶𝑉𝑎𝑔𝑔 = = =
𝜇𝑛 𝜇 √𝑛 √𝑛
11
Time Series Analysis
Time Series is an extremely widely used forecasting technique for mid-range forecasts for items
that have a long history or record of demand. Time series is essentially pattern matching of
data that are distributed over time. For this reason, you tend to need a lot of data to be able to
capture the components or patterns. Business cycles are more suited to longer range, strategic
forecasting time horizons.
Three important time series models:
• Cumulative – where everything matters and all data are included. This results in a very
calm forecast that changes very slowly over time – thus it is more stable than
responsive.
• Naïve – where only the latest data point matters. This results in very nervous or volatile
forecast that can change quickly and dramatically – thus it is more responsive than
stable.
• Moving Average – where we can select how much data to use (the last M periods). This
is essentially the generalized form for both the Cumulative (M = ∞) and Naïve (M=1)
models.
All three of these models are similar in that they assume stationary demand. Any trend in the
underlying data will lead to severe lagging. These models also apply equal weighting to each
piece of information that is included. Interestingly, while the M-Period Moving Average model
requires M data elements for each SKU being forecast, the Naïve and Cumulative models only
require 1 data element each.
Components of time series
• Level (a)
o Value where demand hovers (mean)
o Captures scale of the time series
o With no other pattern present, it is a
constant value
• Trend (b)
o Rate of growth or decline
o Persistent movement in one direction
o Typically linear but can be exponential,
quadratic, etc.
12
• Season Variations (F)
o Repeated cycle around a known and fixed
period
o Hourly, daily, weekly, monthly, quarterly, etc.
o Can be caused by natural or man-made forces
• Random Fluctuation (e or ε)
o Remainder of variability after other components
o Irregular and unpredictable variations, noise
Notation
xt: Actual demand in period t
𝑥̂𝑡,𝑡+1 : Forecast for time t+1 made during time t
a: Level component
b: Linear trend component
Ft: Season index appropriate for period t
et : Error for observation t, 𝑒𝑡 = 𝐴𝑡 − 𝐹𝑡
t: Time period (0, 1, 2,…n)
Level Model: 𝑥𝑡 = 𝑎 + 𝑒𝑡
Trend Model: 𝑥𝑡 = 𝑎 + 𝑏𝑡 + 𝑒𝑡
Mix Level-Seasonality Model: 𝑥𝑡 = 𝑎𝐹𝑡 + 𝑒𝑡
Mix Level-Trend-Seasonality Model: 𝑥𝑡 = (𝑎 + 𝑏𝑡)𝐹𝑡 + 𝑒𝑡
Formulas
Time Series Models (Stationary Demand only):
∑𝑡 𝑥𝑖
Cumulative Model: 𝑥̂𝑡,𝑡+1 = 𝑖𝑡
Naïve Model: 𝑥̂𝑡,𝑡+1 = 𝑥𝑡
𝑖 ∑𝑡 𝑥
M-Period Moving Average Forecast Model: 𝑥̂𝑡,𝑡+1 = 𝑖=𝑡+1−𝑀
𝑀
• If M=t, we have the cumulative model where all data is included
• If M=1, we have the naïve model, where the last data point is used to predict the
next data point
Exponential Smoothing
Exponential smoothing, as opposed to Cumulative, Naïve, and Moving Average, treats data
differently depending on its age. The idea is that the value of data degrades over time so that
newer observations of demand are weighted more heavily than older observations. The
weights decrease exponentially as they age. Exponential models simply blend the value of new
and old information.
13
The alpha factor (ranging between 0 and 1) determines the weighting for the newest
information versus the older information. The “α” value indicates the value of “new”
information versus “old” information:
• As α → 1, the forecast becomes more nervous, volatile, and naïve
• As α → 0, the forecast becomes more calm, staid, and cumulative
• α can range from 0 ≤ α ≤ 1, but in practice, we typically see 0 ≤ α ≤ 0.3
The most basic exponential model, or Simple Exponential model, assumes stationary demand.
Holt’s Model is a modified version of exponential smoothing that also accounts for trend in
addition to level. A new smoothing parameter, β, is introduced. It operates in the same way as
the α.
We can also use exponential smoothing to dampen trend models to account for the fact that
trends usually do not remain unchanged indefinitely as well as for creating a more stable
estimate of the forecast errors.
Notation
x̂t,t+1 : Forecast for time t+1 made during time t
α: Exponential smoothing factor for level (0 ≤ α ≤ 1)
β: Exponential smoothing factor for trend (0 ≤ β ≤ 1)
φ: Exponential smoothing factor for dampening (0 ≤ φ ≤ 1)
ω: Mean Square Error trending factor (0.01 ≤ ω ≤ 0.1)
Forecasting Models
Simple Exponential Smoothing Model (Level Only) – This model is used for stationary
demand. The “new” information is simply the latest observation. The “old” information is
the most recent forecast since it encapsulates the older information.
𝑥̂𝑡,𝑡+1 = 𝛼𝑥𝑡 + (1 − 𝛼)𝑥̂𝑡−1,𝑡
Damped Trend Model with Level and Trend – We can use exponential smoothing to
dampen a linear trend to better reflect the tapering effect of trends in practice.
𝜏
𝑥̂𝑡,𝑡+𝜏 = 𝑎̂𝑡 + ∑ 𝜑 𝑖 𝑏̂𝑡

𝑖=1
𝑎̂𝑡 = 𝛼𝑥𝑡 + (1 − 𝛼)(𝑎̂𝑡−1 + 𝜑𝑏̂𝑡−1 )
𝑏̂𝑡 = 𝛽(𝑎̂𝑡 − 𝑎̂𝑡−1 ) + (1 − 𝛽)𝜑𝑏̂𝑡−1
14
Exponential Smoothing for Level & Trend – also known as Holt’s Method, assumes a linear
trend. The forecast for time t+τ made at time t is shown below. It is a combination of the
latest estimates of the level and trend. For the level, the new information is the latest
observation and the old information is the most recent forecast for that period – that is, the
last period’s estimate of level plus the last period’s estimate of trend. For the trend, the new
information is the difference between the most recent estimate of the level minus the
second most recent estimate of the level. The old information is simply the last period’s
estimate of the trend.
𝑥̂𝑡,𝑡+𝜏 = 𝑎̂𝑡 + 𝜏𝑏̂𝑡
𝑎̂𝑡 = 𝛼𝑥𝑡 + (1 − 𝛼)(𝑎̂𝑡−1 + 𝑏̂𝑡−1 )
𝑏̂𝑡 = 𝛽(𝑎̂𝑡 − 𝑎̂𝑡−1 ) + (1 − 𝛽)𝑏̂𝑡−1
Mean Square Error Estimate – We can also use exponential smoothing to provide a more
robust or stable value for the mean square error of the forecast.
𝑀𝑆𝐸𝑡 = 𝜔(𝑥𝑡 − 𝑥̂𝑡−1,𝑡 )2 + (1 − 𝜔)𝑀𝑆𝐸𝑡−1
Exponential Smoothing with Holt-Winter

Seasonality
• For multiplicative seasonality, think of the Fi as “percent of average demand” for a
period i
• The sum of the Fi for all periods within a season must equal P
• Seasonality factors must be kept current or they will drift dramatically. This requires a
lot more bookkeeping, which is tricky to maintain in a spreadsheet, but it is important to
understand
Forecasting Model Parameter Initialization Methods

• While there is no single best method, there are many good ones
• Simple Exponential Smoothing
o Estimate level parameter 𝑎̂0 by averaging demand for first several periods
• Holt Model (trend and level)—must estimate both 𝑎̂0 and 𝑏̂0
o Find a best fit linear equation from initial data
o Use least squares regression of demand for several periods
▪ Dependent variable = demand in each time period = xt
▪ Independent variable = slope = β1
▪ Regression equation: xt = β0 + β1t
• Seasonality Models
o Much more complicated, you need at least two season of data but preferably
four or more
o First determine the level for each common season period and then the demand
for all periods
o Set initial seasonality indices to ratio of each season to all periods
15
Notation
x̂t,t+1 : Forecast for time t+1 made during time t
α: Exponential smoothing factor (0 ≤ α ≤ 1)
β: Exponential smoothing trend factor (0 ≤ β ≤ 1)
γ: Seasonality smoothing factor (0 ≤ γ ≤ 1)
Ft: Multiplicative seasonal index appropriate for period t
P: Number of time periods within the seasonality (note: ∑Pi=1 F̂i = P)
Forecasting Models
Holt-Winter Exponential Smoothing Model (Level, Trend, and Seasonality) – This model
assumes a linear trend with a multiplicative seasonality effect over both level and trend. For
the level estimate, the new information is again the “de-seasoned” value of the latest
observation, while the old information is the old estimate of the level and trend. The
estimate for the trend is the same as for the Holt model. The Seasonality estimate is the
same as the Double Exponential smoothing model.
𝑥̂𝑡,𝑡+𝜏 = (𝑎̂𝑡 + 𝜏𝑏̂𝑡 )𝐹̂𝑡+𝜏−𝑃
𝑥𝑡
𝑎̂𝑡 = 𝛼 ( ) + (1 − 𝛼)(𝑎̂𝑡−1 + 𝑏̂𝑡−1 )
𝐹̂𝑡−𝑃
𝑏̂𝑡 = 𝛽(𝑎̂𝑡 − 𝑎̂𝑡−1 ) + (1 − 𝛽)𝑏̂𝑡−1
𝑥𝑡
𝐹̂𝑡 = 𝛾 ( ) + (1 − 𝛾)𝐹̂𝑡−𝑃
𝑎̂𝑡
Double Exponential Smoothing (Seasonality and Level) – This is a multiplicative model in
that the seasonality for each period is the product of the level and that period’s seasonality
factor. The new information for the estimate of the level is the “de-seasoned” value of the
latest observation; that is, you are trying to remove the seasonality factor. The old
information is simply the previous most recent estimate for level. For the seasonality
estimate, the new information is the “de-leveled” value of the latest observation; that is, you
try to remove the level factor to understand any new seasonality. The old information is
simply the previous most recent estimate for that period’s seasonality.
𝑥̂𝑡,𝑡+𝜏 = 𝑎̂𝑡 𝐹̂𝑡+𝜏−𝑃
𝑥𝑡
𝑎̂𝑡 = 𝛼 ( ) + (1 − 𝛼)(𝑎̂𝑡−1 )
𝐹̂𝑡−𝑃
𝑥𝑡
𝐹̂𝑡 = 𝛾 ( ) + (1 − 𝛾)𝐹̂𝑡−𝑃
𝑎̂𝑡
16
Normalizing Seasonality Indices – This should be done after each forecast to ensure the
seasonality does not get out of synch. If the indices are not updated, they will drift
dramatically. Most software packages will take care of this – but it is worth checking.
𝑃
𝐹̂𝑡𝑁𝐸𝑊 = 𝐹̂𝑡𝑂𝐿𝐷 ( 𝑡 )
∑𝑖=𝑡+1−𝑃 𝐹̂𝑖𝑂𝐿𝐷
Special Cases
There are different types of new products and the forecasting techniques differ according to
their type. The fundamental idea is that if you do not have any history to rely on, you can look
for history of similar products and build one.
When the demand is very sparse, such as for spare parts, we cannot use traditional methods
since the estimates tend to fluctuate dramatically. Croston’s method can smooth out the
estimate for the demand.
New Product Types

• Not all new products are the same. We can roughly classify them into the following
six categories (listed from easiest to forecast to hardest):
o Cost Reductions: Reduced price version of the product for the existing
market
o Product Repositioning: Taking existing products/services to new markets or
applying them to a new purpose (aspirin from pain killer to reducing effects
of a heart attack)
o Line Extensions: Incremental innovations added to complement existing
product lines (Vanilla Coke, Coke Zero) or Product Improvements: New,
improved versions of existing offering targeted to the current market—
replaces existing products (next generation of product)
o New-to-Company: New market/category for the company but not to the
market (Apple iPhone or iPod)
o New-to-World: First of their kind, creates new market, radically different
(Sony Walkman, Post-it notes, etc.)
• While they are a pain to forecast and to launch, firms introduce new products all the
time – this is because they are the primary way to increase revenue and profits (See
Table 1)
17
*Major revisions/incremental improvements about evenly split
Table 1. New product introductions. Source: Adapted from Cooper, Robert (2001) Winning at New Products, Kahn, Kenneth
(2006) New Product forecasting, and PDMA (2004) New Product Development Report.)
New Product Development Process

All firms use some version of the process shown below to introduce new products. This is
sometimes called the stage-gate or funnel process. The concept is that lots of ideas come in on
the left and very few final products come out on the right. Each stage or hurdle in the process
winnows out the winners from the losers and is used to focus attention on the right products.
The scope and scale of forecasting changes along the process as noted in Figure 3.
Figure 3. New product development process
Forecasting Models Discussed

New Product – “Looks-Like” or Analogous Forecasting
• Perform by looking at comparable product launches and create a week-by-week or
month-by-month sales record.
18
• Then use the percent of total sales in each time increment as a trajectory guide.
• Each launch should be characterized by product type, season of introduction, price,
target market demographics, and physical characteristics.
Intermittent or Sparse Demand – Croston’s Method

• Used for products that are infrequently ordered in large quantities, irregularly ordered,
or ordered in different sizes.
• Croston’s Method separates out the demand and model—unbiased and has lower
variance than simple smoothing.
• Cautions: infrequent ordering (and updating of model) induces a lag to responding to
magnitude changes.
Notation
xt: Demand in period t
yt: 1 if transaction occurs in period t, =0 otherwise
zt : Size (magnitude) of transaction in time t
nt: Number of periods since last transaction
α: Smoothing parameter for magnitude
β: Smoothing parameter for transaction frequency
Formulas
Croston’s Method
We can use Croston’s method when demand is intermittent. It allows us to use the traditional
exponential smoothing methods. We assume the Demand Process is
xt = ytzt and that demand is independent between time periods, so that the probability that a
transaction occurs in the current time period is 1/n:
1 1
𝑃𝑟𝑜𝑏(𝑦𝑡 = 1) = 𝑎𝑛𝑑 𝑃𝑟𝑜𝑏(𝑦𝑡 = 0) = 1 −
𝑛 𝑛
Updating Procedure for 𝑧̂𝑡 and 𝑛̂𝑡 :
If xt = 0 (no transaction occurs), then
𝑧̂𝑡 = 𝑧̂𝑡−1 𝑎𝑛𝑑 𝑛̂𝑡 = 𝑛̂𝑡−1
If xt > 0 (transaction occurs), then
𝑧̂𝑡 = 𝛼𝑥𝑡 + (1 − 𝛼)𝑧̂𝑡−1
𝑛̂𝑡 = 𝛽𝑛𝑡 + (1 − 𝛽)𝑛̂𝑡−1
Updating Procedure for nt:
1 𝑖𝑓 𝑥𝑡−1 > 0
𝑛𝑡 = {
𝑛𝑡−1 + 1 𝑖𝑓 𝑥𝑡−1 = 0
Forecast:
𝒛̂𝒕
̂𝒕,𝒕+𝟏 =
𝒙
̂𝒕
𝒏
19
Learning Objectives
• Forecasting is part of the entire Demand Planning and Management process.
• Range forecasts are better than point forecasts, aggregated forecasts are better than
dis-aggregated, and shorter time horizons are better than longer.
• Forecasting metrics need to capture bias and accuracy.
• Understand how to initialize a forecast.
• Understand that Time Series is a useful technique when we believe demand follows
certain repeating patterns.
• Recognize that all time series models make a trade-off between being naïve (using only
the last most recent data) or cumulative (using all of the available data).
• Understand how exponential smoothing treats old and new information differently.
• Understand how changing the alpha or beta smoothing factors influences the forecasts.
• Understand how seasonality can be handled within exponential smoothing.
• Understand why demand for new products need to be forecasted with different
techniques.
• Learn how to use basic Diffusion Models for new product demand and how to forecast
intermittent demand using Croston’s Method.
• Understand how the typical new product pipeline process (stage-.‐gate) works and how
forecasting fits in.
References
General Demand Forecasting
• Makridakis, Spyros, Steven C. Wheelwright, and Rob J. Hyndman. Forecasting: Methods
and Applications. New York, NY: Wiley, 1998. ISBN 9780471532330.
• Hyndman, Rob J. and George Athanasopoulos. Forecasting: Principles and Practice.
OTexts, 2014. ISBN 0987507109.
• Gilliland, Michael. The Business Forecasting Deal: Exposing Bad Practices and Providing
Practical Solutions. Hoboken, NJ: Wiley, 2010. ISBN 0470574437.
Within the texts mentioned earlier: Silver, Pyke, and Peterson Chapter 4.1; Chopra & Meindl
Chapter 7.1-7.4; Nahmias Chapter 2.1-2.6.
Also, I recommend checking out the Institute of Business Forecasting & Planning
(https://ibf.org/) and their Journal of Business Forecasting.
For Time Series Analysis

20
Within the texts mentioned earlier: Silver, Pyke, and Peterson Chapter 4.2-5.5.1 & 4.6; Chopra
& Meindl Chapter 7.5-7.6; Nahmias Chapter 2.7.
Also, I recommend checking out the Institute of Business Forecasting & Planning
(https://ibf.org/) and their Journal of Business Forecasting.
• Makridakis, Spyros, Steven C. Wheelwright, and Rob J. Hyndman.Forecasting: Methods
and Applications. New York, NY: Wiley, 1998. ISBN 9780471532330.
• Hyndman, Rob J. and George Athanasopoulos. Forecasting: Principles and Practice.
OTexts, 2014. ISBN 0987507109.
For Exponential Smoothing

• Silver, E.A., Pyke, D.F., Peterson, R. Inventory Management and Production Planning and
Scheduling. ISBN: 978-0471119470. Chapter 4.
• Chopra, Sunil, and Peter Meindl. Supply Chain Management: Strategy, Planning, and
Operation. 5th edition, Pearson Prentice Hall, 2013. Chapter 7.
• Nahmias, S. Production and Operations Analysis. McGraw-Hill International Edition.
ISBN: 0-07-2231265-3. Chapter 2.
For Special Cases

• Cooper, Robert G. Winning at New Products: Accelerating the Process from Idea to
Launch. Cambridge, MA: Perseus Pub., 2001. Print.
• Kahn, Kenneth B. New Product Forecasting: An Applied Approach. Armonk, NY: M.E.
Sharpe, 2006.
• Adams, Marjorie. PDMA Foundation NPD Best Practices Study: The PDMA Foundation’s
2004 Comparative Performance Assessment Study (CPAS). Oak Ridge, NC: Product
Development & Management Association, 2004.
21
Inventory Management
Summary
Inventory management is at the core of all supply chain and logistics management. There are
many reasons for holding inventory including minimizing the cost of controlling a system,
buffering against uncertainties in demand, supply, delivery and manufacturing, as well as
covering the time required for any process. Having inventory allows for a smoother operation
in most cases since it alleviates the need to create product from scratch for each individual
demand. Inventory is the result of a push system where the forecast determines how much
inventory of each item is required.
There is, however, a problem with having too much inventory. Excess inventory can lead to
spoilage, obsolescence, and damage. Also, spending too much on inventory limits the
resources available for other activities and investments. Inventory analysis is essentially the
determination of the right amount of inventory of the right product in the right location in the
right form. Strategic decisions cover the inventory implications of product and network design.
Tactical decisions cover deployment and determine what items to carry, in what form (raw
materials, work-in-process, finished goods, etc.), and where. Finally, operational decisions
determine the replenishment policies (when and how much) of these inventories.
We seek the Order Replenishment Policy that minimizes these total costs and specifically the
Total Relevant Costs (TRC). A cost component is considered relevant if it impacts the decision
at hand and we can control it by some action. A Replenishment Policy essentially states two
things: the quantity to be ordered, and when it should be ordered. As we will see, the exact
form of the Total Cost Equation used depends on the assumptions we make in terms of the
situation. There are many different assumptions inherent in any of the models we will use, but
the primary assumptions are made concerning the form of the demand for the product
(whether it is constant or variable, random or deterministic, continuous or discrete, etc.).
Key Concepts
Reasons to Hold Inventory
• Cover process time
• Allow for uncoupling of processes
• Anticipation/Speculation
• Minimize control costs
• Buffer against uncertainties such as demand, supply, delivery, and
manufacturing.
22
Inventory Decisions
• Strategic supply chain decisions are long term and include decisions related to
the supply chain such as potential alternatives to holding inventory and product
design.
• Tactical are made within a month, a quarter or a year and are known as
deployment decisions such as what items to carry as inventory, in what form to
carry items and how much of each item to hold and where.
• Operational level decisions are made on daily, weekly or monthly basis and
replenishment decisions such as how often to review inventory status, how
often to make replenishment decisions and how large replenishment should be.
The replenishment decisions are critical to determine how the supply chain is set
up.
Inventory Classification
• Financial/Accounting Categories: Raw Materials, Work in Progress (WIP),
Components/Semi-Finished Goods and Finished Goods. This category does not
help in tracking opportunity costs and how one may wish to manage inventory.
• Functional (See Figure 4):
o Cycle Stock – Amount of inventory between deliveries or replenishments
o Safety Stock – Inventory to cover or buffer against uncertainties
o Pipeline Inventory – Inventory when order is placed but has not yet
arrived
Figure 4. Inventory chart: Depiction of functional inventory classifications
23
Relevant Costs
The Total Cost (TC) equation is typically used to make the decisions of how much inventory to
hold and how to replenish. It is the sum of the Purchasing, Ordering, Holding, and Shortage
costs. The Purchasing costs are usually variable or per-item costs and cover the total landed
cost for acquiring that product – whether from internal manufacturing or purchasing it from
outside.
Total cost = Purchase (Unit Value) Cost + Order (Set Up) Cost + Holding (Carrying) Cost +
Shortage (stock-out) Cost
• Purchase: Cost per item or total landed cost for acquiring product.
• Ordering: It is a fixed cost and contains cost to place, receive and process a
batch of good including processing invoicing, auditing, labor, etc. In
manufacturing this is the set up cost for a run.
• Holding: Costs required to hold inventory such as storage cost (warehouse
space), service costs (insurance, taxes), risk costs (lost, stolen, damaged,
obsolete), and capital costs (opportunity cost of alternative investment).
• Shortage: Costs of not having an item in stock (on-hand inventory) to satisfy a
demand when it occurs, including backorder, lost sales, lost customers, and
disruption costs. Also known as the penalty cost.
A cost is relevant if it is controllable and it applies to the specific decision being made.
Notation
c: Purchase cost ($/unit)
ct: Ordering Costs ($/order)
h: Holding rate – usually expressed as a percentage ($/$ value/time)
ce: Excess holding Costs ($/unit-time); also equal to ch
cs: Shortage costs ($/unit)
TRC: Total Relevant Costs – the sum of the relevant cost components
TC: Total Costs – the sum of all four cost elements
Economic Order Quantity (EOQ)

The Economic Order Quantity or EOQ is the most influential and widely used (and sometimes
misused!) inventory model in existence. While very simple, it provides deep and useful insights.
Essentially, the EOQ is a trade-off between fixed (ordering) and variable (holding) costs. It is
often called Lot-Sizing as well. The minimum of the Total Cost equation (when assuming
demand is uniform and deterministic) is the EOQ or Q*. The Inventory Replenishment Policy
becomes “Order Q* every T* time periods” which under our assumptions is the same as “Order
Q* when Inventory Position (IP)=0”.
24
Like Wikipedia, the EOQ is a GREAT place to start, but not necessarily a great place to finish. It
is a good first estimate because it is exceptionally robust. For example, a 50% increase in Q
over the optimal quantity (Q*) only increases the TRC by ~ 8%!
While very insightful, the EOQ model should be used with caution as it has restrictive
assumptions (uniform and deterministic demand). It can be safely used for items with relatively
stable demand and is a good first-cut “back of the envelope” calculation in most situations. It is
helpful to develop insights in understanding the trade-offs involved with taking certain
managerial actions, such as lowering the ordering costs, lowering the purchase price, changing
the holding costs, etc.
EOQ Model
• Assumptions
o Demand is uniform and deterministic.
o Lead time is instantaneous (0) – although this is not restrictive at all since
the lead time, L, does not influence the Order Size, Q.
o Total amount ordered is received.
• Inventory Replenishment Policy
o Order Q* units every T* time periods.
o Order Q* units when inventory on hand (IOH) is zero.
• Essentially, the Q* is the Cycle Stock for each replenishment cycle. It is the
expected demand for that amount of time between order deliveries.
Notation
ce: Excess holding Costs ($/unit/time); equal to ch
D: Demand (units/time)
DA: Actual Demand (units/time)
D F: Forecasted Demand (units/time)
h: Carrying or holding cost ($/inventory $/time)
Q: Replenishment Order Quantity (units/order)
Q*: Optimal Order Quantity under EOQ (units/order)
Q*A: Optimal Order Quantity with Actual Demand (units/order)
Q*F: Optimal Order Quantity with Forecasted Demand (units/order)
T: Order Cycle Time (time/order)
T*: Optimal Time between Replenishments (time/order)
N: Orders per Time or 1/T (order/time)
TRC(Q):Total Relevant Cost ($/time)
TC(Q): Total Cost ($/time)
25
Formulas
Total Costs: TC = Purchase + Order + Holding + Shortage
This is the generic total cost equation. The specific form of the different elements depends on
the assumptions made concerning the demand, the shortage types, etc.
𝐷 𝑄
𝑇𝐶(𝑄) = 𝑐𝐷 + 𝑐𝑡 ( ) + 𝑐𝑒 ( ) + 𝑐𝑠 𝐸[𝑈𝑛𝑖𝑡𝑠 𝑆ℎ𝑜𝑟𝑡]
𝑄 2
Total Relevant Costs: TRC = Order + Holding

The purchasing cost and the shortage costs are not relevant for the EOQ because the purchase
price does not change the optimal order quantity (Q*) and since we have deterministic
demand, we will not stock out.
𝐷 𝑄
𝑇𝑅𝐶(𝑄) = 𝑐𝑡 ( ) + 𝑐𝑒 ( )
𝑄 2
Optimal Order Quantity (Q*)

Recall that this is the First Order condition of the TRC equation – where it is a global minimum.
2𝑐𝑡 𝐷
𝑄∗ = √
𝑐𝑒
Optimal Time between Replenishments

Recall that T* = Q*/D. That is, the time between orders is the optimal order size divided by the
annual demand. Similarly, the number of replenishments per year is simply N* = 1/T* = D/Q*.
Plugging in the actual Q* gives you the formula below.
2𝑐𝑡
𝑇∗ = √
𝐷𝑐𝑒
Note: Be sure to put T* into units that make sense (days, weeks, months, etc.). Don’t leave it in
years!
Optimal Total Costs

Adding the purchase cost to the TRC(Q*) costs gives you the TC(Q*). We still assume no stock
out costs.
𝑇𝐶(𝑄 ∗ ) = 𝑐𝐷 + √2𝑐𝑡 𝑐𝑒 𝐷
Optimal Total Relevant Costs

Plugging the Q* back into the TRC equation and simplifying gives you the formula below.
𝑇𝑅𝐶(𝑄∗ ) = √2𝑐𝑡 𝑐𝑒 𝐷
26
Sensitivity Analysis
The EOQ is very robust. The following formulas provide simple ways of calculating the impact
of using a non-optimal Q, an incorrect annual Demand D, or a non-optimal time interval, T.
EOQ Sensitivity with Respect to Order Quantity

The equation below calculates the percent difference in total relevant costs to optimal when
using a non-optimal order quantity (Q):
𝑇𝑅𝐶(𝑄) 1 𝑄∗ 𝑄
= ( ) ( + ∗)
𝑇𝑅𝐶(𝑄 ∗ ) 2 𝑄 𝑄
Note: If optimal quantity does not make sense, it is always better to order little more rather
ordering little less.
EOQ Sensitivity with Respect to Demand

assuming an incorrect annual demand (DF) when in fact the actual annual demand is DA:
𝑇𝑅𝐶(𝑄𝐹∗ ) 1 𝐷𝐴 𝐷𝐹
= ( ) (√ + √ )
𝑇𝑅𝐶(𝑄𝐴∗ ) 2 𝐷𝐹 𝐷𝐴
EOQ Sensitivity with Respect to Time Interval between Orders

using a non-optimal replenishment time interval (T). This will become very important when
finding realistic replenishment intervals. The Power of Two Policy shows that ordering in
increments of 2k time periods, we will stay within 6% of the optimal solution. For example, if
the base time period is one week, then the Power of Two Policy would suggest ordering every
week (20) or every two weeks (21) or every four weeks (22) or every eight weeks (23) etc. Select
the interval closest to one of these increments.
𝑇𝑅𝐶(𝑇) 1 𝑇 𝑇∗
= ( )( + )
𝑇𝑅𝐶(𝑇 ∗ ) 2 𝑇∗ 𝑇
Economic Order Quantity (EOQ) Extensions

The Economic Order Quantity can be extended to cover many different situations, three
extensions include: lead-time, volume discounts, and finite replenishment or EPQ.
We developed the EOQ previously assuming the rather restrictive (and ridiculous) assumption
that lead-time was zero. That is, instantaneous replenishment like on Star Trek. However,
including a non-zero lead time while increasing the total cost due to having pipeline inventory
will NOT change the calculation of the optimal order quantity, Q*. In other words, lead-time is
not relevant to the determination of the needed cycle stock.
27
Volume discounts are more complicated. Including them makes the purchasing costs relevant
since they now impact the order size. We discussed three types of discounts: All-Units (where
the discount applies to all items purchased if the total amount exceeds the break point
quantity), Incremental (where the discount only applies to the quantity purchased that exceeds
the breakpoint quantity), and One-Time (where a one-time-only discount is offered and you
need to determine the optimal quantity to procure as an advance buy). Discounts are
exceptionally common in practice as they are used to incentivize buyers to purchase more or to
order in convenient quantities (full pallet, full truckload, etc.).
A price break point is the minimum quantity required to get a price discount.
Finite Replenishment is very similar to the EOQ model, except that the product is available at a
certain production rate rather than all at once. In the lesson we show that this tends to reduce
the average inventory on hand (since some of each order is manufactured once the order is
received) and therefore increases the optimal order quantity.
• Lead time is greater than 0 (order not received instantaneously)
o Inventory Policy:
▪ Order Q* units when IP=DL
▪ Order Q* units every T* time periods
• Discounts
o All Units Discount—Discount applies to all units purchased if total amount exceeds
the break point quantity
o Incremental Discount—Discount applies only to the quantity purchased that exceeds
the break point quantity
o One-Time-Only Discount—A one-time-only discount applies to all units you order
right now (no quantity minimum or limit)
• Finite Replenishment
o Inventory becomes available at a rate of P units/time rather than all at one time
o If Production rate approach infinity, model converges to EOQ
Notation
ci: Discounted purchase price for discount range i ($/unit)
e
c i: Effective purchase cost for discount range i ($/unit) [for incremental discounts]
ce: Excess holding Costs ($/unit/time); Equal to ch
cg: One Time Good Deal Purchase Price ($/unit)
Fi: Fixed Costs Associated with Units Ordered below Incremental Discount
Breakpoint i
28
D: Demand (units/time)
DA: Actual Demand (units/time)
D F: Forecasted Demand (untis/time)
L: Order Lead time
Q*: Optimal Order Quantity under EOQ (units/order)
Qi: Breakpoint for quantity discount for discount i (units per order)
Qg: One Time Good Deal Order Quantity
P: Production (units/time)
T*: Optimal Time between Replenishments (time/order)
TRC(Q):Total Relevant Cost ($/time)
Formulas
Inventory Position
Inventory Position (IP) = Inventory on Hand (IOH) + Inventory on Order (IOO) – Back Orders (BO)
– Committed Orders (CO)
Inventory on Order (IOO) is the inventory that has been ordered, but not yet received. This is
inventory in transit and also knows as Pipeline Inventory (PI).
Average Pipeline Inventory

Average Pipeline Inventory (API), on average, is the annual demand times the lead time.
Essentially, every item spends L time periods in transit. Both D and L should have consistent
time units.
𝐴𝑃𝐼 = 𝐷𝐿
Total Cost including Pipeline Inventory

The TC equation changes slightly if we assume a non-zero lead time and include the pipeline
inventory.
𝐷 𝑄
𝑇𝐶(𝑄) = 𝑐𝐷 + 𝑐𝑡 ( ) + 𝑐𝑒 ( + 𝐷𝐿) + 𝑐𝑠 𝐸[𝑈𝑛𝑖𝑡𝑠 𝑆ℎ𝑜𝑟𝑡]
𝑄 2
Note that as before, though, the purchase cost, shortage costs, and now pipeline inventory is
not relevant to determining the optimal order quantity, Q*:
2𝑐𝑡 𝐷
𝑄∗ = √
𝑐𝑒
29
Discounts
If we include volume discounts, then the purchasing cost becomes relevant to our decision of
order quantity.
All Units Discounts

Discount applies to all units purchased if total amount exceeds the break point quantity.
The procedure for a single range All Units quantity discount (where new price is c 1 if ordering at
least Q1 units) is as follows:
1. Calculate Q*C0, the EOQ using the base (non-discounted) price, and Q*C1, the EOQ using
the first discounted price
2. If Q*C1 ≥ Q1, the breakpoint for the first all units discount, then order Q*C1 since it
satisfies the condition of the discount. Otherwise, go to step 3.
3. Compare the TRC(Q*C0), the total relevant cost with the base (non-discounted) price,
with TRC(Q1), the total relevant cost using the discounted price (c1) at the breakpoint for
the discount. If TRC(Q*C0)< TRC(Q1), select Q*C0, otherwise order Q1.
Note that if there are more discount levels, you need to check this for each one.
𝑐 = 𝑐0 𝑓𝑜𝑟 0 ≤ 𝑄 ≤ 𝑄1 𝑎𝑛𝑑 𝑐 = 𝑐1 𝑓𝑜𝑟 𝑄1 ≤ 𝑄
𝐷 ℎ𝑄
𝑇𝑅𝐶 = 𝐷𝑐0 + 𝑐𝑡 ( ) + 𝑐0 ( ) 𝑓𝑜𝑟 0 ≤ 𝑄 ≤ 𝑄1
𝑄 2
𝐷 ℎ𝑄
𝑇𝑅𝐶 = 𝐷𝑐1 + 𝑐𝑡 ( ) + 𝑐1 ( ) 𝑓𝑜𝑟 𝑄1 ≤ 𝑄
𝑄 2
Note: All units discount tend to raise cycle stock in the supply chain by encouraging retailers to
increase the size of each order. This makes economic sense for the manufacturer, especially
when he incurs a very high fixed cost per order.
Incremental Discounts
Discount applies only to the quantity purchased that exceeds the break point quantity.
The procedure for a multi-range Incremental quantity discount (where if ordering at least Q1
units, the new price for the Q-Q1 units is c1) is as follows:
1. Calculate the Fixed cost per breakpoint, Fi,
2. Calculate the Q*i for each discount range i (to include the Fi)
3. Calculate the TRC for all discount ranges where the Qi-1 < Q*i < Qi+1, that is, if it is in
range.
4. Select the discount that provides the lowest TRC.
The effective cost, cei, can be used for the TRC calculations.
𝐹0 = 0 ; 𝐹𝑖 = 𝐹𝑖−1 + (𝑐𝑖−1 − 𝑐𝑖 )𝑄𝑖
30
2𝐷(𝑐𝑡 + 𝐹𝑖 )
𝑄∗ = √
ℎ𝑐𝑖
𝐹𝑖
𝑐𝑖𝑒 = 𝑐𝑖 + ∗
𝑄𝑖
One Time Discount

This is a less common discount – but it does happen. A one time only discount applies to all
units you order right now (no minimum quantity or limit).
Simply calculate the Q*g and that is your order quantity. If Q*g =Q* then the discount does not
make sense. If you find that Q*g < Q*, you made a mathematical mistake – check your work!
𝑄𝑔 𝑄𝑔
𝑇𝐶 = (𝐶𝑦𝑐𝑙𝑒𝑇𝑖𝑚𝑒)(𝑇𝐶 ∗ + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝐶𝑜𝑠𝑡) = ( ) √2𝑐𝑡 ℎ𝑐𝐷 + ( ) 𝑐𝐷
𝐷 𝐷
𝑆𝑎𝑣𝑖𝑛𝑔𝑠 = 𝑇𝐶 − 𝑇𝐶𝑆𝑃
𝑄𝑔 𝑄𝑔 𝑄𝑔 𝑄𝑔
𝑆𝑎𝑣𝑖𝑛𝑔𝑠 = (( ) √2𝑐𝑡 ℎ𝑐𝐷 + ( ) 𝑐𝐷) − (𝑐𝑔 𝑄𝑔 + ℎ𝑐𝑔 ( ) ( ) + 𝑐𝑡 )
𝐷 𝐷 2 𝐷
∗
𝑄 𝑐ℎ + 𝐷(𝑐 − 𝑐𝑔 )
𝑄𝑔∗ =
ℎ𝑐𝑔
Finite Replenishment or Economic Production Quantity

One can think of the EPQ equations as generalized forms where the EOQ is a special case where
P=infinity. As the production rate decreases, the optimal quantity to be ordered increases.
However, note that if P<D, this means the rate of production is slower than the rate of demand
and that you will never have enough inventory to satisfy demand.
𝐷
𝑐𝑡 𝐷 𝑄 (1 − 𝑃 ) ℎ𝑐
𝑇𝑅𝐶[𝑄] = +
𝑄 2
2𝑐𝑡 𝐷 𝐸𝑂𝑄
𝐸𝑃𝑄 = √ =
𝐷
ℎ𝑐 (1 − 𝑃 ) √(1 − 𝐷 )
𝑃
31
EOQ with Planned Back Orders
A planned backorder is where we stock out on purpose knowing that customers will wait,
although we do incur a penalty cost, cs, for stocking out. Why do we accept to stock out?
Because, sometimes it is very costly to have enough inventory on hand to always satisfy
demand, and customers are willing to wait. From this, we develop the idea of the critical ratio
(CR), which is the ratio of the cs (the cost of shortage or having too little product) to the ratio of
the sum of cs and ce (the cost of having too much or an excess of product). The critical ratio, by
definition, ranges between 0 and 1 and is a good metric of level of service. A high CR indicates
a desire to stock out less frequently. If cs is infinity, it means we do not allow for shortage and
the model becomes the conventional EOQ. As cs gets smaller, the Q*PBO gets larger and a
larger percentage is allowed to be backordered – since the penalty for stocking out gets
reduced.
Formulas
EOQ with Planned Backorders
This is an extension of the standard EOQ with the ability to allow for backorders at a penalty of
cs.
𝐷 (𝑄 − 𝑏)2 𝑏2
𝑇𝑅𝐶(𝑄, 𝑏) = 𝑐𝑡 ( ) + 𝑐𝑒 ( ) + 𝑐𝑠 ( )
𝑄 2𝑄 2𝑄
∗
2𝑐𝑡 𝐷 𝑐𝑠 +𝑐𝑒 (𝑐𝑠 + 𝑐𝑒 ) 1
𝑄𝑃𝐵𝑂 =√ √ = 𝑄∗ √ = 𝑄∗ √
𝑐𝑒 𝑐𝑠 𝑐𝑠 𝐶𝑅
∗
𝑐𝑒 𝑄𝑃𝐵𝑂 𝑐𝑠
𝑏∗ = = (1 − ) 𝑄∗
(𝑐𝑠 + 𝑐𝑒 ) (𝑐𝑠 + 𝑐𝑒 ) 𝑃𝐵𝑂
∗
∗
𝑄𝑃𝐵𝑂
𝑇𝑃𝐵𝑂 =
𝐷
Order Q∗PBO when IOH = -b*; Order Q∗PBO every TPBO

∗
time periods.
Where:
Q∗PBO is the Optimal Order Quantity with Planned backorders
32
Introduction to Stochastic Demand
Deterministic versus Probabilistic Demand: Differences and Implications
Figure 5 Inventory Under Deterministic vs Stochastic Demand
Empirical Distribution
𝑛
𝑛
𝜇 = ∑ 𝑝𝑖 𝑥𝑖 𝜎 = √∑ 𝑝𝑖 (𝑥𝑖 − 𝜇)2 = √𝐸[𝑋 2 ] − 𝐸[𝑋]2
𝑖 𝑖
Theoretical Probability Distributions
Type of Distribution Probability Density Function Cumulative Density Function

𝑃[𝑋 ≤ 𝑥] = 𝐹(𝑥|𝑎, 𝑏)
1 Discrete Uniform Distribution ì 1
ï for a £ x £ b
Notation: U(a,b) P éë X = x ùû = f (x | a,b) = í n (𝑥 − 𝑎 + 1)
𝑓𝑜𝑟 𝑎 ≤ 𝑥 ≤ 𝑏
ï 0 𝑛
a is minimum î otherwise
b is maximum = 0 𝑖𝑓 𝑥 < 𝑎
1 𝑖𝑓 𝑥 > 𝑏
n is number of values
{
33
2 Poisson Distribution ì -l x
ï e l for x = 0,1,2,...
𝑥 𝜆𝑖
é ù
P ë X = xû = f (x | l ) = í x! 𝑃[𝑋 ≤ 𝑥] = 𝐹(𝑥|𝜆) = 𝑒 −𝜆 ∑
Notation: P () ï 𝑖=0 𝑖!
otherwise
 is mean î 0
3 Continuous Uniform Distribution 1 0 𝑖𝑓 𝑥 < 𝑎

Notation U(a,b) 𝑓(𝑥|𝑎, 𝑏) = {𝑏 − 𝑎 𝑖𝑓𝑎 ≤ 𝑥 ≤ 𝑏 𝑥−𝑎
𝐹(𝑥|𝑎, 𝑏) = 𝑃[𝑋 ≤ 𝑥] = { 𝑖𝑓 𝑎 ≤ 𝑥 ≤ 𝑏
a is minimum 0 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒 𝑏−𝑎
1 𝑖𝑓 𝑥 > 𝑏
b is maximum
4 Normal Distribution In Excel & Libre Office: In Excel & Libre Office:
Notation: N(,) PDF = NORM.DIST(X, μ, σ, 0) CDF = NORM.DIST(X, μ, σ, 1)
 = Mean
 = Std Deviation ê- ç
é 1 æ x - m ö2 ù
÷ ú
1 ê 2è s ø úû
f ( x | m ,s ) = eë
(2p ) s
1/ 2
5 Triangle Distribution
Notation: T(a, b, c)
a is minimum
b is maximum
2(𝑥 − 𝑎)
c is mode (𝑏 − 𝑎)(𝑐 − 𝑎)
𝑖𝑓 𝑎 ≤ 𝑥 ≤ 𝑐
𝑓(𝑥|𝑎, 𝑏, 𝑐) = 2(𝑏 − 𝑥)
𝑖𝑓 𝑐 ≤ 𝑥 ≤ 𝑏
𝑎+𝑏+𝑐 (𝑏 − 𝑎)(𝑏 − 𝑐)
𝐸[𝑥] = { 0 𝑖𝑓 𝑥 < 𝑎 𝑜𝑟 𝑥 > 𝑏
3
𝑎 2 + 𝑏2 + 𝑐 2 − 𝑎𝑏 − 𝑎𝑐 − 𝑏𝑐
𝑉𝑎𝑟[𝑥] = ( )
18
Type of Units Sold: E[sold] Units Short: E[short]

Distribution
1 𝑸𝟐 − 𝒂𝟐 𝑸(𝒃 − 𝑸) (𝒃 − 𝑸)𝟐
Continuous Uniform = + =
𝟐(𝒃 − 𝒂) (𝒃 − 𝒂) 𝟐(𝒃 − 𝒂)
Distribution
2 Normal Distribution = E[Mean/Demanded]-E[short] = σ G(k)
3 Triangle Distribution
Table 2 Theoretical Probability Distributions
34
Rules of Thumb for Selecting Demand Distributions
1. If Demand is all positive integers of low value (e.g., 1, 2, 3, 4 etc.) then use Poisson.
2. If Demand is larger numbers (says >20), integrality is not critical and CV is small (~<=0.3)
then use Normal.
3. Looks relatively even over a specified range then use Uniform.
4. Has no reliable data or there is only anecdotal memories, then use Triangle.
Single Period Inventory Models

The single period inventory model is second only to the economic order quantity in its
widespread use and influence. Also referred to as the Newsvendor (Newsboy) model, the
single period model differs from the EOQ in three main ways. First, while the EOQ assumes
uniform and deterministic demand, the single-period model allows demand to be variable and
stochastic (random). Second, while the EOQ assumes a steady state condition (stable demand
with essentially an infinite time horizon), the single-period model assumes a single period of
time. All inventories must be ordered prior to the start of the time period and they cannot be
replenished during the time period. Any inventory left over at the end of the time period is
scrapped and cannot be used at a later time. If there is extra demand that is not satisfied
during the period, it too is lost. Third, for EOQ we are minimizing the expected costs, while for
the single period model we are actually maximizing the expected profitability.
The critical ratio applies directly to the single period model as well. We show that the optimal
order quantity, Q*, occurs when the probability that the demand is less than Q* = the Critical
Ratio. In other words, the Critical Ratio tells me how much of the demand probability that
should be covered in order to maximize the expected profits.
Marginal Analysis: Single Period Model

Two costs are associated with single period problems
• Excess cost (ce) when D<Q ($/unit) i.e. too much product
• Shortage cost (cs) when D>Q ($/unit) i.e. too little product
If we assume continuous distribution of demand
• ce P[X≤Q] = expected excess cost of the Qth unit ordered
• cs (1-P[X≤Q]) = expected shortage cost of the Qth unit ordered
This implies that if E[Excess Cost] < E[Shortage Cost] then increase Q and that we are at Q*
𝑐𝑠
when E[Shortage Cost] = E[Excess Cost]. Solving this gives us: 𝑃[𝑥 ≤ 𝑄] = (𝑐 +𝑐 ) 𝑒 𝑠
In words, this means that the percentage of the demand distribution covered by Q should be
equal to the Critical Ratio in order to maximize expected profits.
Notation
B: Penalty for not satisfying demand beyond lost profit ($/unit)
35
b: Backorder Demand (units)
b*: Optimal units on backorder when placing an order (unit)
cs: Shortage Costs ($/unit)
D: Average Demand (units/time)
g: Salvage value for excess inventory ($/unit)
L: Replenishment Lead Time (time)
∗
Q PBO : Optimal Order Quantity with Planned backorders
TRC(Q): Total Relevant Cost ($/time)
Single Period (Newsvendor) Model

To maximize expected profitability, we need to order sufficient inventory, Q, such that the
probability that the demand is less than or equal to this amount is equal to the Critical Ratio.
Thus, the probability of stocking out is equal to 1 – CR.
𝑐𝑠
𝑃[𝑥 ≤ 𝑄] =
(𝑐𝑒 + 𝑐𝑠 )
For the simplest case where there is neither salvage value nor extra penalty of stocking out,
these become:
cs = p – c, that is the lost margin of missing a potential sale and,
ce = c, that is, the cost of purchasing one unit.
𝑐𝑠 (𝑝−𝑐) 𝑝−𝑐
The Critical Ratio becomes: 𝐶𝑅 = 𝑐 +𝑐 = (𝑝−𝑐+𝑐) = 𝑝 which is simply the margin divided by
𝑠 𝑒
the price!
When we consider also salvage value (g) and shortage penalty (B), these become:
cs = p – c + B, that is the lost margin of missing a potential sale plus a penalty per item
short and
ce = c – g, that is, the cost of purchasing one unit minus the salvage value I can gain back.
Now the critical ratio becomes
𝑐𝑠 (𝑝 − 𝑐 + 𝐵) (𝑝 − 𝑐 + 𝐵)
𝐶𝑅 = = =
𝑐𝑠 + 𝑐𝑒 (𝑝 − 𝑐 + 𝐵 + 𝑐 − 𝑔) (𝑝 + 𝐵 − 𝑔)
Single Period Inventory Models-Expected Profitability

We expand our analysis of the single period model to be able to calculate the expected
profitability of a given solution. In the previous lesson, we learned how to determine the
optimal order quantity, Q*, such that the probability of the demand distribution covered by Q*
is equal to the Critical Ratio, which is the ratio of the shortage costs divided by the sum of the
shortage and excess costs.
36
In order to determine the profitability for a solution, we need to calculate the expected units
sold, the expected cost of buying Q units, and the expected units short, E[US]. Calculating the
E[US] is tricky, but we show how to use the Normal Tables as well as spreadsheets to determine
this value.
Notation
B: Penalty for not satisfying demand beyond lost profit ($/unit)
ce: Excess holding Costs ($/unit); For single period problems this is not necessarily
equal to ch, since that assumes that you can keep the inventory for later use.
g: Salvage value for excess inventory ($/unit)
k: Safety Factor
x: Units Demanded
E[x]: Expected units demanded
E[US]: Expected Units Short (units)
TRC(Q): Total Relevant Cost ($/period)
TC(Q): Total Cost ($/period)
Formulas
Profit Maximization
In words, the expected profit for ordering Q units is equal to the sales price, p, times the
expected number of units demanded, E[x]), minus the cost of purchasing Q units, cQ, minus
the expected number of units I would be short times the sales price. The difficult part of this
equation is the expected units short, or the E[US].
𝐸[𝑃𝑟𝑜𝑓𝑖𝑡(𝑄)] = 𝑝𝐸[𝑥] − 𝑐𝑄 − 𝑝𝐸[𝑈𝑛𝑖𝑡𝑠𝑆ℎ𝑜𝑟𝑡]
37
Expected Profits with Salvage and Penalty
If we include a salvage value, g, and a shortage penalty, B, then this becomes:
−𝑐𝑄 + 𝑝𝑥 + 𝑔(𝑄 − 𝑥) 𝑖𝑓 𝑥 ≤ 𝑄
𝑃(𝑄) = {
−𝑐𝑄 + 𝑝𝑄 − 𝐵(𝑥 − 𝑄)𝑖𝑓 𝑥 ≥ 𝑄
𝐸[𝑃(𝑄)] = (𝑝 − 𝑔)𝐸[𝑥] − (𝑐 − 𝑔)𝑄 − (𝑝 − 𝑔 + 𝐵)𝐸[𝑈𝑆]
Rearranging this becomes:
𝐸[𝑃(𝑄)] = 𝑝(𝐸[𝑥] − 𝐸[𝑈𝑆]) − 𝑐𝑄 + 𝑔(𝑄 − (𝐸[𝑥] − 𝐸[𝑈𝑆])) − 𝐵(𝐸[𝑈𝑆])
In words, the expected profit for ordering Q units is equal to four terms. The first term is the
sales price, p, times the expected number of units demanded, E[x]), minus the expected
units short. The second term is simply the cost of purchasing Q units, cQ. The third term is
the expected number of items that I would have left over for salvage, times the salvage
value, g. The fourth and final term is the expected number of units short times the shortage
penalty, B.
Expected Values
E[Units Demanded]
∞
Continuous: ∫𝑥=0 𝑥𝑓𝑥 (𝑥)𝑑𝑥 = 𝑥̂ Discrete: ∑∞
𝑥=0 𝑥𝑃[𝑥] = 𝑥
̂
E[Units Sold]
𝑄 ∞
Continuous: ∫𝑥=0 𝑥𝑓𝑥 (𝑥)𝑑𝑥 + 𝑄 ∫𝑥=𝑄 𝑓𝑥 (𝑥)𝑑𝑥 Discrete: ∑𝑄𝑥=0 𝑥𝑃[𝑥] +
𝑄 ∑∞
𝑥=𝑄+1 𝑃[𝑥]
E[Units Short]
∞
Continuous: ∫𝑥=𝑄(𝑥 − 𝑄)𝑓𝑥 (𝑥)𝑑𝑥 Discrete: ∑∞
𝑥=𝑄+1(𝑥 − 𝑄)𝑃[𝑥]
38
E[Excess]
E[Excess] and E[US]/E[Units Short] are different things but they are related to each
other.
E[Excess] is a distance from Q. So, on average, how much of Q we have left after we
have sold all the units to be sold. E[Units Short] is a distance from the Demand. So, on
average, how many units short of the Demand were we once we've sold all the units
that were sold that period.
You don't have to use E[Excess]. Every problem can be solved using either one, and
you can use either to calculate profits. If you want to see how we get from one to the
other, here are some steps:
Expected Units Short E[US]

This is a tricky concept to get your head around at first. Think of the E[US] as the average
(mean or expected value) of the demand ABOVE some amount that we specify or have on
hand. As my Q gets larger, then we expect the E[US] to get smaller, since I will probably not
stock out as much.
Luckily for us, we have a nice way of calculating the E[US] for the Normal Distribution. The
Expected Unit Normal Loss Function is noted as G(k). To find the actual units short, we
simply multiply this G(k) times the standard deviation of the probability distribution.
∞
𝑄−𝜇
𝐸[𝑈𝑆] = ∫ (𝑥 − 𝑄)𝑓𝑥 (𝑥)𝑑𝑥 = 𝜎𝐺 ( ) = 𝜎𝐺(𝑘)
𝑥=𝑄 𝜎
You can use the Normal tables to find the G(k) for a given k value or you can use
spreadsheets with the equation below:
New Excel Version: 𝐺(𝑘) = 𝑁𝑂𝑅𝑀. 𝑆. 𝐷𝐼𝑆𝑇(𝑘, 0) − 𝑘 ∗ (1 − 𝑁𝑂𝑅𝑀. 𝑆. 𝐷𝐼𝑆𝑇(𝑘, 1))

Old Excel Version: 𝐺(𝑘) = 𝑁𝑂𝑅𝑀𝐷𝐼𝑆𝑇(𝑘, 0,1,0) − 𝑘 ∗ (1 − 𝑁𝑂𝑅𝑀𝑆𝐷𝐼𝑆𝑇(𝑘))
39
Multi Period Inventory Models
We develop inventory replenishment models when we have uncertain or stochastic demand.
We built off of both the EOQ and the single period models to introduce three general inventory
policies: the Base Stock Policy, the (s,Q) continuous review policy and the (R,S) periodic review
policy (the R,S model will be explained in the next lesson). These are the most commonly used
inventory policies in practice. They are imbedded within a company’s ERP and inventory
management systems.
To put them in context, here is the summary of the five inventory models covered so far:
• Economic Order Quantity —Deterministic Demand with infinite horizon
o Order Q* every T* periods
o Order Q* when IP = μDL
• Single Period / Newsvendor — Probabilistic Demand with finite (single period) horizon
o Order Q* at start of period where P[x ≤ Q]=CR
• Base Stock Policy — Probabilistic Demand with infinite horizon
o Essentially a one-for-one replenishment
o Order what was demanded when it was demanded in the quantity it was
demanded
• Continuous Review Policy (s,Q) — Probabilistic Demand with infinite horizon
o This is event-based – we order when, and if, inventory passes a certain threshold
o Order Q* when IP ≤ s
• Periodic Review Policy (R,S) — Probabilistic Demand with infinite horizon
o This is a time-based policy in that we order on a set cycle
o Order up to S units every R time periods
All of the models make trade-offs: EOQ between fixed and variable costs, Newsvendor
between excess and shortage inventory, and the latter three between cost and level of service.
The concept of level of service, LOS, is often murky and specific definitions and preferences vary
between firms. However, for our purposes, we can break them into two categories: targets
and costs. We can establish a target value for some performance metric and then design the
minimum cost inventory policy to achieve the level of service. The two metrics covered are
Cycle Service Level (CSL) and Item Fill Rate (IFR). The second approach is to place a dollar
amount on a specific type of stock out occurring and then minimize the total cost function. The
two cost metrics we covered were Cost of Stock Out Event (CSOE) and Cost of Item Short (CIS).
They are related to each other.
Regardless of the metrics used, the end result is a safety factor, k, and a safety stock. The
safety stock is simply kσDL. The term σDL is defined as the standard deviation of demand over
lead time, but it is more technically the root mean square error (RMSE) of the forecast over the
lead time. Most companies do not track their forecast error to the granular level that you
40
require for setting inventory levels, so defaulting to the standard deviation of demand is not
too bad of an estimate. It is essentially assuming that the forecast is the mean.
Notation
B1: Cost associated with a stock out event ($/event)
D S: Demand over short time period (e.g. week)
DL: Demand over long time period (e.g. month)
μDL: Expected Demand over Lead Time (units/time)
σDL: Standard Deviation of Demand over Lead Time (units/time)
k: Safety Factor
s: Reorder Point (units)
S: Order up to Point (units)
R: Review Period (time)
IP: Inventory Position = Inventory on Hand + Inventory on Order – Backorders
IOH: Inventory on Hand (units)
IOO: Inventory on Order (units)
IFR: Item Fill Rate (%)
CSL: Cycle Service Level (%)
CSOE: Cost of Stock Out Event ($ / event)
CIS: Cost per Item Short
G(k): Unit Normal Loss Function
41
Base Stock Policy
The Base Stock policy is a one-for-one policy. If I sell four items, I order four items to
replenish the inventory. The policy determines what the stocking level, or the base stock, is
for each item. The base stock, S*, is the sum of the expected demand over the lead time
plus the RMSE of the forecast error over lead time multiplied by some safety factor k. The
LOS for this policy is simply the Critical Ratio. Note that the excess inventory cost, c e, in this
case (and all models here) assumes you can use it later and is the product of the cost and the
holding rate, ch.
• Optimal Base Stock, S*: S ∗ = μDL + k LOS σDL
cs
• Level of Service (LOS): LOS = P[μDL ≤ S*] = CR = c
s +ce
Continuous Review Policies (s,Q)

This is also known as the Order-Point, Order-Quantity policy and is essentially a two-bin
system. The policy is “Order Q* units when Inventory Position is less than the re-order point
s”. The re-order point is the sum of the expected demand over the lead-time plus the RMSE
of the forecast error over lead-time multiplied by some safety factor k.
• Reorder Point: 𝑠 = 𝜇𝐷𝐿 + 𝑘𝜎𝐷𝐿
• Order Quantity (Q): Q is typically found through the EOQ formula
Formulas
Level of Service Metrics
Here are four methods for determining the appropriate safety factor, k, for use in any of the
inventory models. They are Cycle Service Level, Cost per Stock Out Event, Item Fill Rate, and
Cost per Item Short.
Cycle Service Level (CSL)

The CSL is the probability that there will not be a stock out within a replenishment cycle.
This is frequently used as a performance metric where the inventory policy is designed to
minimize cost to achieve an expected CSL of, say, 95%. Thus, it is one minus the probability
of a stock out occurring. If I know the target CSL and the distribution (we will use Normal
most of the time) then we can find the s that satisfies it using tables or a spreadsheet where
s = NORM.INV (CSL, Mean, StandardDeviation) and k=NORM.S.INV(CSL).
CSL = 1 − P[Stockout] = 1 − P[X > s] = P[X ≤ s]
Note that as k increases, it gets difficult to improve CSL and it will require enormous
amount of inventory to cover the extreme limits.
42
Cost Per Stock out Event (CSOE) or B1 Cost
The CSOE is related to the CSL, but instead of designing to a target CSL value, a penalty is
charged when a stock out occurs within a replenishment cycle. The inventory policy is
designed to minimize the total costs – so this balances cost of holding inventory explicitly
with the cost of stocking out. Minimizing the total costs for k, we find that as long as
𝐵1 𝐷
>1, then we should set:
𝑐 𝜎 𝑄√2𝜋
𝑒 𝐷𝐿
𝐵1 𝐷
𝑘 = √2 ln ( )
𝑐𝑒 𝜎𝐷𝐿 𝑄√2𝜋
𝐵1 𝐷
If 𝑐 <1, we should set k as low as management allows.
𝑒 𝜎𝐷𝐿 𝑄√2𝜋
Item Fill Rate (IFR)

The IFR is the fraction of demand that is met with the inventory on hand out of cycle stock.
This is frequently used as a performance metric where the inventory policy is designed to
minimize cost to achieve an expected IFR of, say, 90%. If I know the target IFR and the
distribution (we will use Normal most of the time) then we can find the appropriate k value
by using the Unit Normal Loss Function, G(k).
𝐸[𝑈𝑆] 𝜎𝐷𝐿 𝐺[𝑘]
𝐼𝐹𝑅 = 1 − = 1−
𝑄 𝑄
𝑄
𝐺(𝑘) = (1 − 𝐼𝐹𝑅)
𝜎𝐷𝐿
G(k) is the Unit Normal Loss Function, which can be calculated in Spreadsheets as
New Excel Version: 𝐺(𝑘) = 𝑁𝑂𝑅𝑀. 𝑆. 𝐷𝐼𝑆𝑇(𝑘, 0) − 𝑘 ∗ (1 − 𝑁𝑂𝑅𝑀. 𝑆. 𝐷𝐼𝑆𝑇(𝑘, 1))
Old Excel Version: 𝐺(𝑘) = 𝑁𝑂𝑅𝑀𝐷𝐼𝑆𝑇(𝑘, 0,1,0) − 𝑘 ∗ (1 − 𝑁𝑂𝑅𝑀𝑆𝐷𝐼𝑆𝑇(𝑘))
Once we find the k using unit normal tables, we can plug the values in 𝑠 = 𝜇𝐷𝐿 +
𝑘𝜎𝐷𝐿 to frame the policy.
Cost per Item Short (CIS)

The CIS is related to the IFR, but instead of designing to a target IFR value, a penalty is
charged for each item short within a replenishment cycle. The inventory policy is designed
to minimize the total costs – so this balances cost of holding inventory explicitly with the
𝑄𝑐
cost of stocking out. Minimizing the total costs for k, we find that as long as 𝐷𝑐𝑒 ≤ 1 , then
𝑠
we should find k such that:
𝑄𝑐𝑒
𝑃[𝑆𝑡𝑜𝑐𝑘𝑂𝑢𝑡] = 𝑃[𝑥 ≥ 𝑘] =
𝐷𝑐𝑠
Otherwise, we should set k as low as management allows. In a spreadsheet, this
𝑄𝑐 𝑄𝑐
becomes k=NORM.S.INV(1 - 𝐷𝑐𝑒 ) or (k = NORMSINV(1 - 𝐷𝑐𝑒 ) for older versions)
𝑠 𝑠
Summary of the Metrics Presented:

43
Metric How to find k
% Service Based Cycle Service Level (CSL) K = NORM.S.INV(1 − P[X > s])
% Service Based Item Fill Rate (IFL) 𝑄
Find k from 𝐺(𝑘) = 𝜎 (1 − 𝐼𝐹𝑅)
𝐷𝐿
$ Cost Based Cost per Stock Out Event
𝐵1 𝐷
(CSOE) 𝑘 = √2 ln ( )
𝑐𝑒 𝜎𝐷𝐿 𝑄√2𝜋
Cost per Item Short (CIS) 𝑄𝑐𝑒
$ Cost Based K = NORM.S.INV(1 - )
𝐷𝑐𝑠
Table 3. Summary of metrics presented
A Tip on Converting Times

You will typically need to convert annual forecasts to weekly demand or vice versa or
something in between. This is generally very easy – but some students get confused at times:
Converting long to short (n is number of short periods within long):

𝐸[𝐷𝑆 ] = 𝐸[𝐷𝐿 ]/𝑛
𝑉𝐴𝑅[𝐷𝑆 ] = 𝑉𝐴𝑅[𝐷𝐿 ]/𝑛
𝜎𝑠 = 𝜎𝐿 /√𝑛
Converting from short to long:
𝐸[𝐷𝐿 ] = 𝑛𝐸[𝐷𝑆 ]
𝑉𝐴𝑅[𝐷𝐿 ] = 𝑛𝑉𝐴𝑅[𝐷𝑆 ]
𝜎𝐿 = √𝑛𝜎𝑠
Periodic Review Policies

There are trade-offs between the different performance metrics (both cost- and service-based).
We demonstrate that once one of the metrics is determined (or explicitly set) then the other
three are implicitly set. Because they all lead to the establishment of a safety factor, k, they are
dependent on each other. This means that once you have set the safety stock, regardless of the
method, you can calculate the expected performance implied by the remaining three metrics.
Periodic Review policies are very popular because they fit the regular pattern of work where
ordering might occur only once a week or once every two weeks. The lead-time and the review
period are related and can be traded-off to achieve certain goals.
Notation
B1: Cost associated with a stock out event
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μDL+R: Expected Demand over Lead Time plus Review Period (units/time)
σDL+R: Standard Deviation of Demand over Lead Time plus Review Period (units/time)
k: Safety Factor
S: Order up to Point (units)
IP: Inventory Position = Inventory on Hand + Inventory on Order – Backorders
CSOE: Cost of Stock Out Event ($ / event)
CIS: Cost per Item Short
Formulas
Inventory Performance Metrics
Safety stock is determined by the safety factor, k. So that: 𝑠 = 𝜇𝐷𝐿 + 𝑘𝜎𝐷𝐿 and the expected
cost of safety stock = 𝑐𝑒 𝑘𝜎𝐷𝐿 .
Two ways to calculate k: Service based or Cost based metrics:
• Service Based Metrics—set k to meet expected level of service
o Cycle Service Level (𝐶𝑆𝐿 = 𝑃[𝑥 ≤ 𝑘])
𝜎𝐷𝐿 𝐺[𝑘]
o Item Fill Rate (𝐼𝐹𝑅 = 1 − )
𝑄
Note: IFR is always higher than CSL for the same safety stock level.
• Cost Based Metrics—find k that minimizes total costs

𝐷
o Cost per Stock out Event (E[CSOE] = (𝐵1 )𝑃[𝑥 ≥ 𝑘] (𝑄))
𝐷
o Cost per Items Short (𝐸[𝐶𝐼𝑆] = 𝑐𝑠 𝜎𝐷𝐿 𝐺(𝑘) (𝑄))
Safety Stock Logic – relationship between performance metrics

45
The relationship between the four metrics (2 cost and 2 service based) is shown in the
flowchart below (Figure 6). Once one metric (CSL, IFR, CSOE, or CIS) is explicitly set, then the
other three metrics are implicitly determined.
Figure 6. Relationship among the four metrics
Periodic Review Policy (R,S)

This is also known as the Order Up To policy and is essentially a two-bin system. The policy is
“Order Up To S* units every R time periods”. This means the order quantity will be S*-IP. The
order up to point, S*, is the sum of the expected demand over the lead-time and the
replenishment time plus the RMSE of the forecast error over lead plus replenishment time
multiplied by some safety factor k.
• Order Up To Point: 𝑆 = 𝜇𝐷𝐿+𝑅 + 𝑘𝜎𝐷𝐿+𝑅
Periodic (R,S) versus Continuous (s, Q) Review

• There is a convenient transformation of (s, Q) to (R, S)
o (s,Q) = Continuous, order Q when IP ≤ s
o (R, S) = Periodic, order up to S every R time periods
• Allows for the use of all previous (s, Q) decision rules
o Reorder point, s, for continuous becomes Order Up To point, S, for periodic
system
o Q for continuous becomes D*R for periodic
o L for a continuous becomes R+L for periodic
• Approach
o Make transformations
o Solve for (s, Q) using transformations
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o Determine final policy such that 𝑆 = 𝑥𝐷𝐿+𝑅 + 𝑘𝜎𝐷𝐿+𝑅
(s, Q) (R, S)
s ↔ S
Q ↔ D*R
L ↔ R+L
Relationship Between L & R

The lead time, L, and the review period, R, both influence the total costs. Note that the average
𝐷𝑅
inventory costs for a (R,S) system is = 𝑐𝑒 [ 2 + 𝑘𝜎𝐷𝐿+𝑅 + 𝐿𝐷]. This implies that increasing Lead
Time, L, will increase Safety Stock non-linearly and Pipeline Inventory linearly while increasing
the Review Period, R will increase the Safety Stock non-linearly and the Cycle Stock linearly.
Inventory Models for Multiple Items & Locations

There are several problems with managing items independently, including:
• Lack of coordination—constantly ordering items
• Ignoring of common constraints such as financial budgets or space
• Missed opportunities for consolidation and synergies
• Waste of management time
Managing Multiple Items

There are two issues to solve in order to manage multiple items:
1. Can we aggregate SKUs to use similar operating policies?
a. Group using common cost characteristics or break points
b. Group using Power of Two Policies
2. How do we manage inventory under common constraints?
a. Exchange curves for cycle stock
b. Exchange curves for safety stock
Aggregation Methods
When we have multiple SKUs to manage, we want to aggregate those SKUs where we can use
the same policies.
Grouping Like Items—Break Points

• Basic Idea: Replenish higher value items faster
• Used for situations with multiple items that have
o Relatively stable demand
o Common ordering costs, ct, and holding charges, h
o Different annual demands, Di, and purchase cost ci
• Approach
o Pick a base time period, w0, (typically a week)
o Create a set of candidate ordering periods (w1, w2, etc.)
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o Find Dici values where TRC(wj)=TRC(wj+1)
o Group SKUs that fall in common value (Dici) buckets
Grouping Like Items Example

Selected w0 = 1 week
Number of weeks of supply (WOS) to order for item i ordering at time period j = Q ij =
Di(wj/52)
Selecting between options w1 & w2 (where w1<w2<w3 etc.) becomes:
ctDi/Qi1 + (cihQi1)/2 = ctDi/Qi2 + (cihQi2)/2
52ctDi/Diw1 + cihDiw1/104 = 52ctDi/Diw2 + cihDiw2/104
(cihDi/104)(w1-w2) = (52ct)(1/w2 – 1/w1)
Dici = [(104)(52ct)/(h(w1-w2))] (1/w2 – 1/w1)
Dici = 5408ct / (hw1w2)
Rule if Dici ≥ 5408ct /(hw1w2) then select w1

Else: if Dici ≥ 5408ct /(hw2w3) then select w2
Else: if Dici ≥ 5408ct /(hw3w4) then select w3
Else: . . . . . .
Grouping Like Items Example

Suppose you need to set up replenishment schedules for several hundred parts that have
relatively stable (yet not necessarily the same) demand. They all have similar order costs (ct
= $5) and holding charge (h = 0.20).You have the following potential ordering periods (in
weeks): w1=1, w2=2, w3=4, w4=13, w5=26, and w6=52.
What break-even ordering points should you establish?

Break-point for selecting between 1 week or 2 weeks is:
Dici = 5408ct / (hw1w2) = 5408(5) / (.2)(1)(2) = $67,600
If Dici ≥ $67,600 then order 1 week’s worth each week
Break-point for selecting between 2 weeks or 4 weeks is:
Dici = 5408ct / (hw2w3) = 5408(5) / (.2)(2)(4) = $16,900
If $67,600 > Dici ≥ $16,900 then order 2 week’s worth every 2 weeks
Final Ordering Break Points:

Order every 1 week if Dici ≥ $67,600
Order every 2 weeks if D ici ≥ $16,900
Order every 4 weeks if D ici ≥ $2,600
Order every 13 weeks if Dici ≥ $400
Order every 26 weeks if D ici ≥ $100
Order every 52 weeks otherwise
Power of Two Formula

48
• Order in time intervals of powers of two
• Select a realistic base period, Tbase (day, week, month)
• Guarantees that TRC will be within 6% of optimal!
Managing Under Common Constraints

There is typically a budget or space constraint that limits the amount of inventory that you can
actually keep on hand. Managing each inventory item separately could lead to violating this
constraint. Exchange curves are a good way to use the managerial levers of holding charge,
ordering cost, and safety factor to set inventory policies to meet a common constraint.
Exchange Curves: Cycle Stock

• Helps determine the best allocation of inventory budget across multiple SKUs
• Relevant Cost parameters
o Holding Charge (h)
▪ There is no single correct value
▪ Cost allocations for time and systems differ between firms
▪ Reflection of management’s investment and risk profile
o Order Cost (ct)
▪ Not know with precision
▪ Cost allocations for time and systems differ between firms
• Exchange Curve
o Depicts trade-off between total annual cycle stock (TACS) and number of
replenishments (N)
o Determines the ct/h value that meets budget constraints
Exchange Curves: Safety Stock

• Need to trade-off cost of safety stock and level of service
• Key parameter is safety factor (k) – usually set by management
• Estimate the aggregate service level for different budgets
• The process is as follows:
1. Select an inventory metric to target
2. Starting with a high metric value calculate:
a. The required ki to meet that target for each SKU
b. The resulting safety stock cost for each SKU and the total safety stock
(TSS)
c. The other resulting inventory metrics of interest for each SKU and total
3. Lower the metric value, go to step 2
4. Chart resulting TSS versus Inventory Metrics
Managing Multiple Locations

Managing the same item in multiple locations will lead to a higher inventory level than
managing them in a single location. Consolidating inventory locations to a single common
location is known as inventory pooling. Pooling reduces the cycle stock needed by reducing the
number of deliveries required and reduces the safety stock by risk pooling that reduces the CV
49
of the demand. This is also called the square root “law” – which is insightful and powerful, but
also makes some restrictive assumptions, such as uniformly distributed demand, use of EOQ
ordering principles, and independence of demand in different locations.
Notation
ci: Purchase cost for item i ($/unit)
Di: Average Demand for item i (units/time)
TPractical: Practical Order Cycle Time (time/order)
k: Safety Factor
w0: Base Time Period (time)
N: Number of Inventory Replenishment Cycles
TACS: Total Annual Cycle Stock
TSS: Total Value of Safety Stock
TVIS: Total Value of Items Short
Formulas
Power of Two Policy
The process is as follows:
1. Create table of SKUs
2. Calculate T* for each SKU
3. Calculate Tpractical for each SKU
2𝑐𝑡 𝐷
𝑄 ∗ √ 2𝑐𝑡
𝑐𝑒
𝑇∗ = = =√
𝐷 𝐷 𝐷𝑐𝑒
𝑇∗
ln( )/ ln(2)
𝑇𝑝𝑟𝑎𝑐𝑡𝑖𝑐𝑎𝑙 = 2 √2
In a spreadsheet this is: Tpractical = 2^(ROUNDUP(LN(Toptimal / SQRT(2)) /LN(2)))
50
Exchange Curves: Cycle Stock
𝑄𝑖 𝑐𝑖 𝑐 1 𝐷 ℎ 1
𝑇𝐴𝐶𝑆 = ∑𝑛𝑖=1 = √ ℎ𝑡 ∑𝑛𝑖=1 √𝐷𝑖 𝑐𝑖 𝑁 = ∑𝑛𝑖=1 𝑄𝑖 = √𝑐 ∑𝑛𝑖=1 √𝐷𝑖 𝑐𝑖
2 √2 𝑖 𝑡 √2
Process
• Create a table of SKUs with “Annual Value” (D ici) and √Di ci
• Find the sum of √Di ci term for SKUs being analyzed
• Calculate TACS and N for range of (ct/h) values
• Chart N vs TACS
Exchange Curves: Safety Stock
𝐷
𝑇𝑆𝑆 = ∑𝑛𝑖=1 𝑘𝑖 𝜎𝐷𝐿𝑖 𝑐𝑖 𝑇𝑉𝐼𝑆 = ∑𝑛𝑖=1(𝑄𝑖 𝑐𝑖 𝜎𝐷𝐿𝑖 𝐺(𝑘𝑖 ))
𝑖
Process:
1. Select an inventory metric to target
2. Starting with a high metric value calculate:
a. The required ki to meet that target for each SKU
b. The resulting safety stock cost for each SKU and the total safety stock
(TSS)
c. The other resulting inventory metrics of interest for each SKU and total
3. Lower the metric value, go to step 2
4. Chart resulting TSS versus Inventory Metrics
Pooled Inventories
Chart 1. Comparison between independent and pooled inventories
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Inventory Models for Class A & C Items
Inventory Management by Segment
A Items B Items C Items
Type of Records Extensive, Transactional Moderate None-use a rule
Level of Management Frequent (Monthly or Infrequently— Only as Aggregate
Reporting More) Aggregated
Interaction with Demand Direct Input, High Data Modified Forecast Simple Forecast at Best
Integrity, Manipulate (promotions, etc.)
(pricing, etc.)
Interaction with Supply Actively Manage Manage by Exception Non
Initial Deployment Minimize Exposure (high Steady State Steady State
v)
Frequency of Policy Very Frequent (Monthly Moderate Very Infrequent
Review or More) (Annually/Event Based)
Importance of Parameter Very High—Accuracy Moderate—Rounding Very Low
Precision Worthwhile and Approximation ok
Shortage Strategy Actively Manage Set Service Level & Set & Forget Service Levels
(Confront) Manage by Exception
Demand Distribution Consider Alternatives to Normal N/A
Normal as Situation Fits
Management Strategy Active Automatic Passive
Table 4. Inventory management by segment
Inventory Policies (Rules of Thumb)

Type of Item Continuous Review Periodic Review
A Items (s, S) (R, s, S)
B Items (s, Q) (R, S)
C Items Manual ~(R, S)
Table 5. Inventory policies (rules of Thumb)
Managing Class A Items

There are two general ways that items can be considered Class A:
• Fast Moving but Cheap (Large D, Small c → Q > 1)
• Slow Moving but Expensive (Large c, Small D → Q = 1
This dictates which Probability Distribution to use for modeling the demand
• Fast Movers
o Normal or Lognormal Distribution
o Good enough for B items
o OK for A items if µDL or μDL+R ≥ 10
• Slow Movers
o Poisson Distribution
52
o More complicated to handle
o OK for A items if µDL or μDL+R < 10
Managing Class C Items

Class C items have low cD values but comprise the lion-share of the SKUs. When managing
them we need to consider the implicit & explicit costs. The objective is to minimize
management attention. Regardless of policy, savings will most likely not be significant, so try to
design simple rules to follow and explore opportunities for disposing of inventory.
Alternatively, try to set common reorder quantities. This can be done by assuming common c t
and h values and then finding Dici values for ordering frequencies.
Disposing of Excess Inventory

• Why does excess inventory occur?
o SKU portfolios tend to grow
o Poor forecasts - Shorter lifecycles
• Which items to dispose?
o Look at DOS (days of supply) for each item = IOH/D
o Consider getting rid of items that have DOS > x years
• What actions to take?
o Convert to other uses
o Ship to more desired location
o Mark down price
o Auction
Real World Inventory Challenges

While models are important, it is also important to understand where there are challenges
implementing models in real life.
• Models are not used exactly as in textbooks
• Data is not always available or correct
• Technology matters
• Business processes matter even more
• Inventory policies try to answer three questions:
o How often should I check my inventory?
o How do I know if I should order more?
o How much to order?
• All inventory models use two key numbers
o Inventory Position
o Order Point
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Notation
B1: Cost Associated with a Stock out Event
c: Purchase Cost ($/unit)
ce: Excess Holding Costs ($/unit/time); Equal to ch
h: Carrying or Holding Cost ($/inventory $/time)
L[Xi]: Discrete Unit Loss Function
μDL+R: Expected Demand over Lead Time plus Review Period (units/time)
σDL+R: Standard Deviation of Demand over Lead Time plus Review Period (units/time)
k: Safety Factor
S: Order Up to Point (units)
IP: Inventory Position = Inventory on Hand + Inventory on Order (IOO) – Backorders
54
Formulas
Fast Moving A Items

𝐷 𝑄 𝐷
𝑇𝑅𝐶 = 𝑐𝑡 ( ) + 𝑐𝑒 ( + 𝑘𝜎𝐷𝐿 ) + 𝐵1 ( ) 𝑃[𝑥 > 𝑘]
𝑄 2 𝑄
𝐵1 𝑃[𝑥 > 𝑘]
𝑄 ∗ = 𝐸𝑂𝑄√1 +
𝑐𝑡
𝐷𝐵1
𝑘 ∗ = √2 ln ( )
√2𝜋𝑄𝑐𝑒 𝜎𝐷𝐿
• Iteratively solve the two equations
• Stop when Q* and k* converge within acceptable range
Slow Moving A Items

Use a Poisson distribution to model sales
• Probability of x events occurring within a time period
• Mean = Variance = λ
𝑒 −𝜆 𝜆𝑥0
]
𝑝[𝑥0 = 𝑃𝑟𝑜𝑏[𝑥 = 𝑥0 = ] 𝑓𝑜𝑟 𝑥0
𝑥0 !
𝑥0
𝑒 −𝜆 𝜆𝑥
𝐹[𝑥0 ] = 𝑃𝑟𝑜𝑏[𝑥 ≤ 𝑥0 ] = ∑
𝑥!
𝑥=0
For a discrete function, the loss function L[Xi] can be calculated as follows (Cachon &
Terwiesch)
𝐿[𝑋𝑖 ] = 𝐿[𝑋𝑖−1 ] − (𝑋𝑖 − 𝑋𝑖−1 )(1 − 𝐹[𝑋𝑖−1 ])
Learning Objectives
• Understand the reasons for holding inventory and the different types of inventory.
• Understand the concepts of total cost and total relevant costs.
• Identify and quantify the four major cost components of total costs: Purchasing,
Ordering, Holding, and Shortage.
• Able to estimate the Economic Order Quantity (EOQ) and to determine when it is
appropriate to use.
• Able to estimate sensitivity of EOQ to underlying changes in the input data and
understanding of its underlying robustness.
55
• Understand how to determine the EOQ with different volume discounting schemes.
• Understand how to determine the Economic Production Quantity (EPQ) when the
inventory becomes available at a certain rate of time instead of all at once.
• Ability to use the Critical Ratio to determine the optimal order quantity to maximize
expected profits.
• Ability to established inventory policies for EOQ with planned backorders as well as
single period models.
• Ability to determine profitability, expected units short, expected units sold of a single
period model.
• Understanding of safety stock and its role in protecting for excess demand over lead
time.
• Ability to develop base stock and order-point, order-quantity continuous review policies.
• Ability to determine proper safety factor, k, given the desired CSL or IFR or the
appropriate cost penalty for CSOE or CIS.
• Able to establish a periodic review, Order Up To (S,R) Replenishment Policy using any of
the four performance metrics.
• Understand relationships between the performance metrics (CSL, IFR, CSOE, and CIS)
and be able to calculate the implicit values.
• Able to use the inventory models to make trade-offs and estimate impacts of policy
changes.
• Understand how to use different methods to aggregate SKUs for common inventory
policies.
• Understand how to use Exchange Curves.
• Understand how inventory pooling impacts both cycle stock and safety stock.
• Understand how to use different inventory models for Class A and C items.
References
For General Inventory Management
There are more books that cover the basics of inventory management than there are grains of
sand on the beach! Inventory management is also usually covered in Operations Management
and Industrial Engineering texts as well. A word of warning, though. Every textbook uses
different notation for the same concepts. Get used to it. Always be sure to understand what
the nomenclature means so that you do not get confused.
ISBN: 0-07-2231265-3. Chapter 4.
Scheduling. ISBN: 978-0471119470. Chapter 1
• Ballou, R.H. Business Logistics Management. ISBN: 978-0130661845. Chapter 9.
56
For EOQ
• Schwarz, Leroy B., “The Economic Order-Quantity (EOQ) Model” in Building intuition :
insights from basic operations management models and principles, edited by Dilip
Chhajed, Timothy Lowe, 2007, Springer, New York, (pp 135-154).
Scheduling. ISBN: 978-0471119470. Chapter 5
For EOQ Extensions

ISBN: 0-07-2231265-3. Chapter 4.
• Schwarz, Leroy B., “The Economic Order-Quantity (EOQ) Model” in Building intuition :
insights from basic operations management models and principles, edited by Dilip
Chhajed, Timothy Lowe, 2007, Springer, New York, (pp 135-154).
• Muckstadt, John and Amar Sapra "Models and Solutions in Inventory Management".,
2006, Springer New York, New York, NY. Chapter 2 & 3.
For Single Period Inventory Models

ISBN: 0-07-2231265-3. Chapter 5.
• Porteus, Evan L., “The Newsvendor Problem” in Building intuition: insights from basic
operations management models and principles, edited by Dilip Chhajed, Timothy Lowe,
2007, Springer, New York, (pp 115-134).
2006, Springer New York, New York, NY. Chapter 5.
For Probabilistic Inventory Models

ISBN: 0-07-2231265-3. Chapter 5.
2006, Springer New York, New York, NY. Chapter 9, 10
For Inventory Models with Multiple Items and Locations
57
Scheduling. ISBN: 978-0471119470. Chapter 7 & 8.
For Inventory Models for Class A & Class C Items

• Cachon, Gérard, and Christian Terwiesch. Matching Supply with Demand: An
Introduction to Operations Management. Boston, MA: McGraw-Hill/Irwin, 2005.
Scheduling. ISBN: 978-0471119470. Chapter 8 & 9.
58
Fundamentals of Transportation
Management
Summary
The fundamentals of freight transportation provides and overview of different modes of
transportation and some different ways to make decisions of the mode choice, analyzing the
trade-offs between cost and level of service.
There are different levels of transportation networks (from strategic to physical). Physical
network represents how the product physically moves, the actual path from origin to
destination. Costs and distances calculations are made based on this level. Decisions from
nodes (decision points) and arcs (a specific mode) are made in the Operational network. The
third network, the strategic or service network, represents individual paths from end-to-end,
and those decisions that tie into the inventory policies are made in the Strategic or Service
network level.
Freight transportation also includes the important component of packaging. The Primary
packaging, has direct contact with the product and is usually the smallest unit of distribution
(e.g. a bottle of wine, a can, etc.). The Secondary packaging contains product and also a middle
layer of packaging that is outside the primary packaging, mainly to group primary packages
together (e.g. a box with 12 bottle of wines, cases, cartons, etc.). The Tertiary packaging is
designed thinking more on transport shipping, warehouse storage and bulk handling (e.g.
pallets, containers, etc.).
Freight transportation analysis introduces the concept of the transportation product and
economic transportation modes. The transportation product contains four fundamental
operations: loading/unloading, vehicle routing, linehaul moves and facility sorting. There are 3
main types of transportation discussed in this module, namely one to one, one to many and many
to many. Freight transportation is also broken down into economic modes, namely consolidated
operations and direct operations. Each mode type has a different economic characteristic, in
terms of scale, scope and density.
Key Concepts
Trade-offs between Cost and Level of Service (LOS):
• Provides path view of the Network
• Summarizes the movement in common financial and performance terms
• Used for selecting one option from many by making trade-offs
Packaging
59
• Level of packaging mirrors handling needs
• Pallets—standard size of 48 x 40 in in the USA (120 x 80 cm in Europe)
• Shipping Containers
o TEU (20 ft) 33 m3 volume with 24.8 kkg total payload
o FEU (40 ft) 67 m3 volume with 28.8 kkg total payload
o 53 ft long (Domestic US) 111 m3 volume with 20.5 kkg total payload
Transportation Networks
• Physical Network: The actual path that the product takes from origin to destination
including guide ways, terminals and controls. Basis for all costs and distance calculations
– typically only found once.
• Operational Network: The route the shipment takes in terms of decision points. Each arc
is a specific mode with costs, distance, etc. Each node is a decision point. The four
primary components are loading/unloading, local-routing, line-haul, and sorting.
• Strategic Network: A series of paths through the network from origin to destination.
Each represents a complete option and has end-to-end cost, distance, and service
characteristics.
Four fundamental operations of the transportation product:

• Loading/Unloading
• Vehicle Routing
• Linehaul Moves
• Facility Sorting
Underlying economies for transportation:

• Economies of scale
• Economies of scope
• Economies of density
Economic vs technical transportation modes:

• Direct: 1:1 moves with strong economies of scope (balance)
• Consolidated: 1:∞, ∞:1, and ∞:∞ moves with strong economies of
• scale and density
Notation
TL: Truckload
TEU: Twenty Foot Equivalent (cargo container)
FEU: Forty Foot Equivalent (cargo container)
60
Lead Time Variability & Mode Selection
Lead Time Variability
Variability in transit time impacts the total cost equation for inventory. There are important
linkages between transportation reliability, forecast accuracy, and inventory levels. Mode
selection is heavily influenced not only by the value of the product being transported, but also
the expected and variability of the lead-time.
Impact on Inventory
Transportation affects total cost via
• Cost of transportation (fixed, variable, or some combination)
• Lead time (expected value as well as variability)
• Capacity restrictions (as they limit optimal order size)
• Miscellaneous factors (such as material restrictions or perishability)
Transportation Cost Functions

Transportation costs can take many different forms, to include:
• Pure variable cost / unit
• Pure fixed cost / shipment
• Mixed variable & fixed cost
• Variable cost / unit with a minimum quantity
• Incremental discounts
Lead/Transit Time Reliability

There are two different dimensions of reliability that do not always match:
• Credibility (reserve slots are agreed, stop at all ports, load all containers, etc.)
• Schedule consistency (actual vs. quoted performance)
Contract reliability in procurement and operations do not always match as they are typically
performed by different parts of an organization. Contract reliability differs dramatically across
different route segments (origin port dwell vs. port-to-port transit time vs. destination port
dwell for instance). For most shippers, the most transit variability occurs in the origin inland
transportation legs and at the ports.
61
Random Sums of Random Variables
𝑁
𝐸[𝑆] = 𝐸 [∑ 𝑋𝑖 ] = 𝐸[𝑁]𝐸[𝑋]
𝑖=1
𝑁
𝑉𝑎𝑟[𝑆] = 𝑉𝑎𝑟 [∑ 𝑋𝑖 ] = 𝐸[𝑁]𝑉𝑎𝑟[𝑋] + (𝐸[𝑋])2 𝑉𝑎𝑟[𝑁]

𝑖=1
Lead Time Variability

𝜇𝐷𝐿 = 𝜇𝐿 𝜇𝐷
𝜎𝐷𝐿 = √𝜇𝐿 𝜎𝐷2 + (𝜇𝐷 )2 𝜎𝐿2
Mode Selection
Transportation modes have specific niches and perform better than other modes in certain
situations. Also, in many cases, there are only one or two feasible options between modes.
Criteria for Feasibility

• Geography
o Global: Air versus Ocean (trucks cannot cross oceans!)
o Surface: Trucking (TL, LTL, parcel) vs. Rail vs. Intermodal vs. Barge
• Required speed
o >500 miles in 1 day—Air
o <500 miles in 1 day—TL
• Shipment size (weight/density/cube, etc.)
o High weight, cube items cannot be moved by air
o Large oversized shipments might be restricted to rail or barge
• Other restrictions
o Nuclear or hazardous materials (HazMat)
o Product characteristics
Trade-offs within the set of feasible choices

Once all feasible modes (or separate carrier firms) have been identified, the selection within
this feasible set is made as a trade-off between costs. It is important to translate the “non-
cost” elements into costs via the total cost equation. The typical non-cost elements are:
• Time (mean transit time, variability of transit time, frequency)
• Capacity
• Loss and Damage
62
Operations of the transportation product
Four main types of transportation products; the costs and times associated with each one
depend on a different set of variables.
Loading/Unloading
• Cost is function of time and labor
• Time is a function of quantity, ease and stowability
• Fixed and variable costs with respect to quantity
• Can be 1:1, 1: ∞ and ∞:∞
Linehaul moves
• Cost is function of time, distance and balance
• Time is a function of distance
• Fixed and variable costs with respect to distance and time
• Can be 1:1, 1: ∞ and ∞:∞
Vehicle routing
• Cost is function of distance, number of stops and time
• Time is a function of density of stops
• Fixed and variable costs with respect to number of stops and distance
• Different types:
o One-to-Many (1:∞ ) – single origin w/multiple stops
o Many-to-One (∞:1) – multiple origins w/single stop
o Interleavened – multiple pickups and deliveries enroute
Facility sorting
• Cost is function of quantity, ease and stowability
• Fixed and variable costs with respect to quantity
• Only ∞:∞
Underlying Economic Drivers

Economies of Scale
• A firm’s average production cost decreases as total volume (scale) increases
• Present when there is a fixed cost
• Seen in loading/unloading, linehaul moves (in vehicle) and facility sorting
Economies of Scope
• A firm’s average production cost for one product decreases if another product is
• also produced
63
• Related to subadditivity and cost complementarity
• Seen in linehaul moves
Economies of Density
• A firm’s average cost is reduced as the density of customers or production in a
• region is increased
• Both shipment and location density
• Seen in vehicle routing
Comparing Economic Modes

Modes can be split between consolidated or direct modes. Direct carriers are involved with
linehaul moves, to transport goods from one location to another, directly or without any
stops/processing. Consolidates operations involve several linehaul moves and sorting of goods
at hubs or sorting centers. Sometimes, direct operations can operate on consolidated
operations carriers, such as rail cars and air “igloos.”
Consolidated Modes
• Economies of scale – very strong
• Economies of scope – weak
• Economies of density – Strong
• Number of vendors – fewer (big barriers)
• Size of carrier base – few to one
• Design - focus on aggregating low volume lanes
• Procure - engineered negotiation; leverage scale when possible
• Manage - deeper relations with few
Direct Modes
• Economies of scale – weak, lane based
• Economies of scope – very strong
• Economies of density – moderate
• Number of vendors – many (perfectly competitive)
• Size of carrier base – dozens to hundred
• Design - focus on linehauls and corridors
• Procure – auction/bid
• Manage – tiered by management by exception
Transportation Problem Examples

One to Many (1: ∞) – Vehicle Routing Problem
64
• Objective is to find minimum cost tours from single origin to multiple destinations using
multiple vehicles
• Parties of interest to solve the problem:
o Shippers – retailers, distributors, manufacturers
o Carriers – LTL, package
o Service companies – repair, waste, utility, postal, snow removal
• Types of problems:
o Commercial delivery
o Commercial pickup
o Mixed pickup and delivery
o Residential appointment
o Residential sweep
• Solution approaches: Many approaches available, tradeoffs are between speed and
solution qualuty
o Simple heuristics – fast solution but quality can vary (example: sweep
method)
o Optimization – finds optimal, but can take a lot of time (example: mixed
integer linear programming)
o Advance heuristics – not as fast as simple, but usually better quality
(example: Clark-Wright savings algorithm)
• Clark-Wright Approach:
o Start with complete solution
o Identify nodes to form a common tour by calculating savings
▪ si,j = co,i + co,j – ci,j
o Calculate savings for every pair of nodes (all i and j)
o Sort savings si,j by highest savings first
o Obtain solution as long as vehicle capacity is not violated and interior
tour nodes are not added
Many to Many (∞:∞) – Hubs, Terminals and Networks

• Hub Characteristics:
o Advantages:
▪ Lower costs through fewer conveyances needed with greater
utilization
▪ Higher LOS with similar or even fewer resources
▪ Extended reach into smaller and more locations
o Disadvantages:
▪ Costs of operating the hub
65
▪ Higher level on circuity
▪ Impact on service levels
▪ Productivity/utilization loss
o Economic Factors:
▪ Relative O-D versus Hub distances
▪ Conveyance and shipment sizes
▪ Demand patterns
▪ Location of freight versus pax hubs
• Terminal Bypass Operations:
o Freight travels to hub, but doesn’t travel “through” hub
o Stays on conveyance, generally not handled or touch
o Beneficial for goods which can easily be damaged – reduces number of
hands touching the good
o Examples: through flight in air, head loading in LTL or block placement in
rail
Notation
ci: Purchase cost for item i ($/unit)
μD: Expected Demand (Items) during One Time Period
σ D: Standard Deviation of Demand (Items) during One Time Period
μL: Expected Number of Time Periods for Lead Time (Unitless Multiplier)
σL: Standard Deviation of Time Periods for Lead Time (Unitless Multiplier)
μDL: Expected Demand (Items) over Lead Time
σDL: Standard Deviation of Demand (Items) over Lead Time
N: Random Variable Assuming Positive Integer Values (1, 2, 3…)
xi: Independent Random Variables such that E[xi] = E[X]
S: Sum of xi from i = 1 to N
Learning Objectives
• Understand common terminology and concepts of global freight transportation.
• Understanding of physical, operational, and strategic networks.
66
• Ability to select mode by trading off Level of Service (LOS) and cost.
• Understand the impact of transportation on cycle, safety, and pipeline stock.
• Understand how the variability of transportation transit time impacts inventory
• Able to use continuous approximation to make quick estimates of costs using a minimal
amount of data.
• Understand different transportation products and characteristics of each
• Understand different transportation problems, and different approaches (simple
heuristics, optimization and advanced heuristics) available to solve each of them
References
• Ballou, Ronald H., Business Logistics: Supply Chain Management, 3rd edition, Pearson
Prentice Hall, 2003. Chapter 6.
• Chopra, Sunil and Peter Meindl, Supply Chain Management, Strategy, Planning, and
Operation, 5th edition, Pearson Prentice Hall, 2013. Chapter 14.
67
Appendix A & B Unit Normal Distribution,
Poisson Distribution Tables
Table 6 Poisson Distribution
68
Table 7 Normal Distribution
69
70

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CTL.

SC1x - Supply Chain Fundamentals

The draft was updated and revised in the Summer of 2018.

This is a draft of the material, so please post any suggestions, corrections, or

Normal Distribution ~N(µ,σ)

The Normal Distribution is formally defined as:

Standard Normal Distribution (μ=0, σ2=1)

Figure 1. Standard Normal Distribution

We will make extensive use of spreadsheets (whether Excel or LibreOffice) to calculate

In a spreadsheets you can use the functions:

Formally, the Poisson Distribution is defined as shown below:

Figure 2. Poisson Distribution

Components of time series

𝑥̂𝑡,𝑡+𝜏 = 𝑎̂𝑡 + ∑ 𝜑 𝑖 𝑏̂𝑡

Exponential Smoothing with Holt-Winter

Forecasting Model Parameter Initialization Methods

New Product Types

New Product Development Process

Figure 3. New product development process

Forecasting Models Discussed

Intermittent or Sparse Demand – Croston’s Method

For Time Series Analysis

For Exponential Smoothing

For Special Cases

Figure 4. Inventory chart: Depiction of functional inventory classifications

Economic Order Quantity (EOQ)

Total Relevant Costs: TRC = Order + Holding

Optimal Order Quantity (Q*)

Optimal Time between Replenishments

Optimal Total Costs

Optimal Total Relevant Costs

EOQ Sensitivity with Respect to Order Quantity

EOQ Sensitivity with Respect to Demand

EOQ Sensitivity with Respect to Time Interval between Orders

Economic Order Quantity (EOQ) Extensions

Average Pipeline Inventory

Total Cost including Pipeline Inventory

All Units Discounts

One Time Discount

Finite Replenishment or Economic Production Quantity

Order Q∗PBO when IOH = -b*; Order Q∗PBO every TPBO

Figure 5 Inventory Under Deterministic vs Stochastic Demand

Theoretical Probability Distributions

Type of Distribution Probability Density Function Cumulative Density Function

3 Continuous Uniform Distribution 1 0 𝑖𝑓 𝑥 < 𝑎

Type of Units Sold: E[sold] Units Short: E[short]

2 Normal Distribution = E[Mean/Demanded]-E[short] = σ G(k)

Table 2 Theoretical Probability Distributions

Single Period Inventory Models

Marginal Analysis: Single Period Model

Single Period (Newsvendor) Model

Single Period Inventory Models-Expected Profitability

Expected Units Short E[US]

New Excel Version: 𝐺(𝑘) = 𝑁𝑂𝑅𝑀. 𝑆. 𝐷𝐼𝑆𝑇(𝑘, 0) − 𝑘 ∗ (1 − 𝑁𝑂𝑅𝑀. 𝑆. 𝐷𝐼𝑆𝑇(𝑘, 1))

Continuous Review Policies (s,Q)

Cycle Service Level (CSL)

CSL = 1 − P[Stockout] = 1 − P[X > s] = P[X ≤ s]

Item Fill Rate (IFR)

Cost per Item Short (CIS)