Chapter 4: Individual Items with

Probabilistic Demand

¨ Characteristics

¨ The base-stock policy

¨ The (Q,r) or (Q,s) model

¨ The (R,r) or (s,S) model

¨ Periodic Review System – (S,T) model

 1. Characteristics

¨ Demand per unit time is a random variable X with

mean E(X) and standard deviation σ
¨ Possibility of overstocking (excess inventory) or
understocking (shortages)
¨ There are overage costs for overstocking and
shortage costs for understocking
 Types of Stochastic Models
¨ Single period models
¨ Fashion goods, perishable goods, goods with short lifecycles, seasonal
goods
¨ One time decision (how much to order).

¨ Multiple period models

¨ Goods with recurring demand but whose demand varies from period to
period
¨ Inventory systems with periodic review
¨ Periodic decisions (how much to order in each period)
¨ Continuous time models
¨ Goods with recurring demand but with variable inter-arrival times between
customer orders
¨ Inventory system with continuous review
¨ Continuous decisions (continuously deciding on how much to order)
 Stockout Probability
¨ If L is the order replenishment lead time, D is demand per unit
time, and r is the reorder point (in a continuous review system),
then:
Probability of stockout = 1- P(demand during lead time ≤ r)
 29

2. The Base Stock Model

5
 The Base-Stock Policy
¨ The base stock model: inventory is refilled one unit at a time and demand
is random. If there is only one replenishment, then the problem can be solved
with the newsvendor model.

¨ Start with an initial amount of inventory R. Each time a new demand arrives,
place an order with the supplier.

¨ An order placed with the supplier is delivered L units of time after it is placed.

¨ Because demand is stochastic, we can have multiple orders (inventory on-

order) that have been placed but not delivered yet

¨ The demand during the leadtime L: leadtime demand =inventory on order.

¨ When leadtime demand (inventory on-order)

6 exceeds R, we have backorders.
 Assumptions
¨ Products can be analyzed individually
¨ Demands occur one at a time (no batch orders)
¨ Unfilled demand is back-ordered (no lost sales)
¨ Replenishment lead times are fixed and known
¨ Replenishments are ordered one at a time
¨ Demand occurs continuously over time. Demand is modeled by a
continuous probability distribution
¨ Inventory is reviewed continuously
¨ There is no fixed cost associated with placing an order
¨ There is no constraint on the number of orders that can be placed
per year.
¨ leadtime demand and inventory on order are the same.
7
 Notation
¨ Q = 1, order quantity (fixed at one)
¨ r = reorder point
¨ R = r +1, base stock level
¨ L = supply lead time
¨  = mean demand during L
¨  = std dev of demand during L
¨ p(x) = Prob{demand during lead time L equals x}
¨ G(x) = Prob{demand during lead time L is less than or equal to x}
¨ h = unit holding cost
¨ b = unit backorder cost
¨ S(R) = average fill rate (service level)
¨ B(R) = average backorder level
¨ I(R) = average on-hand inventory level
 Inventory Balance Equations

¨ Balance Equation:

inventory position = on-hand inventory - backorders +

(inventory on) orders

¨ Under Base Stock Policy

inventory position = R
 Service Level (Fill Rate)
¨ Let:
X = (random) demand during lead time L

¨ So E[X] = . Consider a specific replenishment order. Since inventory

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

¨ Expected Service Level:

 Backorder Level
¨ Note: At any point in time, number of orders equals number demands during last l
time units (X) so from our previous balance equation:
R = on-hand inventory - backorders + (inventory on) orders
on-hand inventory - backorders = R - X

¨ Note: on-hand inventory and backorders are never positive at the same time, so if
X=x, then

simpler version for

¨ Expected Backorder Level: spreadsheet computing

Where:
mean  = E(D)L
 Inventory Level

¨ Observe:
¨ on-hand inventory - backorders = R-X
¨ E[X] =  from data
¨ E[backorders] = B(R) from previous slide

¨ Result:
I(R) = R -  + B(R)
 Base Stock Example

L = one month

 = 10 units (per month)

Assume Poisson demand, so

Note: Poisson
demand is a good
choice when no
variability data
is available.
Base Stock Example Calculations
 Base Stock Example Results

¨ Service Level: For fill rate of 90%, we must set R-1= r =

14, so R=15 and safety stock s = r -  = 4. Resulting
service is 91.7%.

¨ Backorder Level:
B(r) = 0.187
¨ Inventory Level:

I(R) = R -  + B(R) = 15 - 10 + 0.187 = 5.187

 “Optimal” Base Stock Levels
¨ Objective Function:

Y(R) = hI(R) + bB(R) holding plus backorder cost

= h(R -  +B(R)) + bB(R)
= h(R - ) + (h+b)B(R)

¨ Solution: if we assume G is continuous, we can use calculus to

get
Implication: set base stock
level so fill rate is b/(h+b).
Note: R* increases in b and
decreases in h.
 Base Stock Normal Approximation

¨
  If G is normal(, ), then

where (z)=b/(h+b)  z = NORMSINV(b/(h+b)})

¨ So: R* =  + z 
 “Optimal” Base Stock Example
¨
  Data: Approximate Poisson by normal with mean 10
units/month and standard deviation  = 3.16 units/month.
Set h=$15, b=$25.

¨ Calculations:
since , z =0.32 and hence
R* =  + z = 10 + 0.32(3.16) = 11.01 ~ 11
¨ Observation: from previous table fill rate is G(10) = 0.583, so
maybe backorder cost is too low.
3. The (Q,r) or (Q,s) Model
 Assumptions
¨Demand occurs continuously over time
¨Times between consecutive orders are stochastic but independent and identically
distributed (i.i.d.)
¨Inventory is reviewed continuously
¨Supply leadtime is a fixed constant L
¨ Orders that cannot be fulfilled immediately from on-hand inventory are
backordered
¨Fixed cost associated with replenishment orders and cost per backorder.
¨Constraint on number of replenishment orders per year and service constraint

20
 The (Q, r) Policy
¨Start with an initial amount of inventory R. When inventory level reaches
level r, place an order in the amount Q = R-r to bring inventory position
back up to level R. Thereafter whenever inventory position drops to r,
place an order of size Q.
¨The base-stock policy is the special case of the (Q, r) policy where Q =
1.
¨Objective:

As in EOQ, this makes

batch production attractive.
21
(Q,r) Notation
 (Q,r) Notation (cont.)
¨ Decision Variables:

¨ Performance Measures:
 Inventory versus Time

2
 Demand during Leadtime

2
 Demand during Leadtime

r r)

2
 Costs in (Q,r) Model

¨ Fixed Setup Cost: AF(Q)

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

¨ Backorder Cost: bB(Q,r)

¨ Inventory Carrying Costs: cI(Q,r)

 Fixed Setup Cost in (Q,r) Model

¨ Observation: since the number of orders per year

is D/Q,
 Stockout Cost in (Q,r) Model

¨ Key Observation: inventory position is uniformly distributed

between r+1 and r+Q. So, service in (Q,r) model is
weighted sum of service in base stock model.

¨ Result:

Note: this form is easier to use

in spreadsheets because it does
not involve a sum.
 Service Level Approximations

¨ Type I (base stock):

Note: computes number
of stockouts per cycle,
underestimates S(Q,r)

¨ Type II:
Note: neglects B(r,Q)
term, underestimates S(Q,r)
 Backorder Costs in (Q,r) Model

¨ Key Observation: B(Q,r) can also be computed by

averaging base stock backorder level function over the
range [r+1,r+Q].

¨ Result:

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

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

then we can compute stockout and backorder costs in (Q,r) model.
 Inventory Costs in (Q,r) Model

¨ Approximate Analysis: on average inventory declines from

Q+s to s+1 so

¨ Exact Analysis: this neglects backorders, which add to

average inventory since on-hand inventory can never go
below zero. The corrected version turns out to be
 (Q,r) Model with Backorder Cost

¨ Objective Function:

¨ Approximation: B(Q,r) makes optimization complicated

because it depends on both Q and r. To simplify,
approximate with base stock backorder formula, B(r):
Results of Approximate Optimization

¨ Assumptions:
¨ Q,r can be treated as continuous variables
¨ G(x) is a continuous cdf

¨ Results:

Note: this is just the EOQ formula

Note: this is just the
base stock formula
if G is normal(q,s),
where F(z)=b/(h+b)
 (Q,r) Example
D = 14 units per year
c = $150 per unit
h = 0.1 × 150 = $15 per unit
l = 45 days
 = (14 × 45)/365 = 1.726 units during replenishment lead time
A = $10
b = $40
Demand during lead time is Poisson
Values for Poisson(θ) Distribution
Calculations for Example
Performance Measures for Example
 Observations on Example

¨ Orders placed at rate of 3.5 per year

¨ Fill rate fairly high (90.4%)
¨ Very few outstanding backorders (0.049 on
average)
¨ Average on-hand inventory just below 3 (2.823)
 Varying the Example
¨ Change: suppose we order twice as often so F=7 per year, then
Q=2 and:

which may be too low, so increase r from 2 to 3:

¨ This is better. For this policy (Q=2, r=4) we can compute

B(2,3)=0.026, I(Q,r)=2.80.

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

¨ Objective Function:

¨ Approximation: Assume we can still use EOQ to compute

Q* but replace S(Q,r) by Type II approximation and B(Q,r)
by base stock approximation:
Results of Approximate Optimization

¨ Assumptions:
¨ Q,r can be treated as continuous variables
¨ G(x) is a continuous cdf

¨ Results:

Note: this is just the EOQ formula

Note: another version

of base stock formula
if G is normal(q,s), (only z is different)
where F(z)=kD/(kD+hQ)
 Backorder vs. Stockout Model
¨ Backorder Model
¨ when real concern is about stockout time
¨ because B(Q,r) is proportional to time orders wait for backorders
¨ useful in multi-level systems

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

¨ Note:
¨ We can use either model to generate frontier of solutions
¨ Keep track of all performance measures regardless of model
¨ B-model will work best for backorders, S-model for stockouts
 Lead Time Variability

¨ Problem: replenishment lead times may be variable, which

increases variability of lead time demand.

¨ Notation:
L = replenishment lead time (days), a random variable
l = E[L] = expected replenishment lead time (days)
L = std dev of replenishment lead time (days)
Dt = demand on day t, a random variable, assumed i.i.d.
d = E[Dt] = expected daily demand
D = std dev of daily demand (units)
Including Lead Time Variability in Formulas

¨ Standard Deviation of Lead Time Demand:

if demand is Poisson

Inflation term due to

lead time variability
¨ Modified Base Stock Formula (Poisson demand case):

Note: s can be used in any

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

¨ Basic Insights:
¨ Safety stock provides a buffer against stockouts.
¨ Cycle stock is an alternative to setups/orders.

¨ Other Insights:
1. Increasing D tends to increase optimal order quantity Q.
2. Increasing  tends to increase the optimal reorder point. (Note: either
increasing D or l increases .)
3. Increasing the variability of the demand process tends to increase the
optimal reorder point (provided z > 0).
4. Increasing the holding cost tends to decrease the optimal order quantity
and reorder point.
 Uncertain Demand
IP
IP
Order
Order
Order received
Order received
received
On-hand inventory

received
Q
Q Q
On
Hand
r
Order Order Order
placed placed placed

L1 L2 L3 Time
TBO1 TBO2 TBO3
47
 Expected Inventory (Assumptions)

I(t)

Q Slope
-D

Q
SS T=
D

Time
48
 Expected cost function
¨ Include expected: holding (h), setup (A), penalty (p
– e.g. backorder) and ordering (per unit) costs (c)
¨ Average Holding Cost:

 Q
h  SS  
¨ Average Set-up Cost:  2

A AD
=
T Q

49
 Expected cost function
 Expected Shortage per Cycle:
¥
E(max(X - r, 0)) = ò(x - r) g(x) dx =n(r)
r

 Interpret n(r) as the expected number of stockouts per cycle given

by the loss integral formula.
 The unit normal loss integral values appear in Table A-4.

 Expected Penalty Cost :

( ) * ( )
=( )
50
 Cost Minimization

 Expected Cost Function:

Q D pDn(r)
Y (Q, r) =h( + r - Dℓ) + A + + Dc
2 Q Q
 Partial Derivatives:
(1)

¶Y h D pDn(r) 2D [ A + p n(r)]
= - A 2- 2
=0 => Q =
¶Q 2 Q Q h
(2) This is the first equation
¶Y pD we will use to determine
=h + n¢(r) optimal values Q and r
¶r Q
 Cost Minimization

 Partial Derivatives:
(2)
¶Y pD
=h + n¢(r)
¶r Q
¥
Note: n(r) = ò(x - r)g(x)dx
r

n¢(r) =- (1- G(r))

Qh
1- G(r) = This is the second equation
pD we will use to determine
optimal values Q and r
 Solution Procedure

 The optimal solution procedure requires iterating between

the two equations for Q and r until convergence occurs

 A cost effective approximation is to set Q=EOQ and find R

from the second equation.
 Finding Q and r, iteratively
1. Compute Q = EOQ.
2. Substitute Q in to Equation (2) and compute r.
Qh
1- G(r) =
pD
3. Use r to compute n(r) in Equation (1).
¥
n(r) = ò(x - r)g(x)dx
4. Solve for Q in Equation
r
(1).
2D [ A + p n(r)]
Q=
h
5. Go back to Step 2, continue until convergence.
 Example
 A company purchases air filters at a rate of 800 per year
 $10 to place an order
 Unit cost is $25 per filter
 Inventory carry cost is $2/unit per year
 Shortage cost is $5
 Lead time is 2 weeks
 Assume demand during lead time follows a uniform distribution from 0
to 200
 Find (Q,r)
 Solution

 Partial derivative outcomes:

2 éë + ( )ùû 2(800)(10 +5 ( ))
= =
2
= 8000 + 4000 ( )
2
1- ( )= = =
5(800) 2000

56
 Solution
 From Uniform U(0,200) distribution:

1 1
U(0,200): g(x) = =
b-a 200
200
¥
1
n(r) = ò(x - r)g(x)dx = ò(x - r) dx
r r 200
æ 2 x=200 ö
æ200 2 2 ö
1 çx 1 r 2
=
ç
- rx ÷=
÷ ç - 200r - + r ÷
200 è 2 x=r ø
200 è 2 2 ø
r2
=100 + -r
400
57
 r2
Solution n(r) =
400
- r +100

Qi = 8000 + 4000n(r)
Q
 Iteration 1: 1- G(r) =
2000

2AD 2(10)(800)
EOQ = = = 8000 =89.44 =Qo
h 2
G(r)
Qo h 89
1- G(ro ) = = =.04
pD 2000
G(ro ) =.96
ro =(.96)(200 - 0) =192 0 200

R
58
 r2
Solution n(r) =
400
- r +100

Qi = 8000 + 4000n(r)
Q
 Iteration 2: 1- G(r) =
2000

2
(192)
n(r0 ) = - 192 +100 =.198
400
Q1 = 8000 + 4000(.198) =93.76
94
1- G(r1 ) = =.05
2000
Þ r1 =(.95)(200) =190

59
 r2
Solution n(r) =
400
- r +100

Qi = 8000 + 4000n(r)
Q
 Iteration 3: 1- G(r) =
2000

190 2
n(r1 ) = - 190 +100 =.2197
400
Q2 = 8000 + 4000(.2197) =94.228
94
(1- G(r2 )) = =.05
2000
r2 =190

60
 Solution
 r didn’t change => CONVERGENCE
 (Q*,r*) = (94,190)

I(t)
253
Slope
190
-800

With lead time equal to 2 weeks:

159
SS = r – Dl =190-800(2/52)=159

61
 Example
 Demand is Normally distributed with mean of 40 per week and
a weekly variance of 8

 The ordering cost is $50

 Lead time is two weeks

 Shortages cost an estimated $5 per unit short to expedite

orders to appease customers

 The holding cost is $0.0225 per week

 Find (Q,r)

62
 Solution
 Demand is N (40,2 2 ) per week.
 Lead time is two weeks long. Thus, during the lead
time:
 Mean demand is 2(40) = 80
 Variance is (2*8) = 16
 Demand observed in one week is independent from
demand observed in any other week:
 E(demand over 2 weeks) = E (2*demand over week 1)
= 2 E(demand in a single week) = 2 μ = 80

Standard deviation over 2 weeks is σ = (2*8)0.5 = 4

63
 Solution
 Iteration 1:
2AD 2(50)(40)
EOQ = = =421.6 =Qo
h .0225
Qo h 421.6(.0225)
1- G(ro ) = = =.0473
pD 5(40)
G(ro ) =.9527
 From the standard normal table:
( ) =.9527
( £1.67) =0.9527
=m + s =80 +1.67(4) =86.68
64
 Solution
 Iteration 2: This is the unit normal loss function L.

¥
( 0 ) = ò( - ) ( )
2
1æ - m ö
¥
1 - ç ÷
( 0 ) = ò( - ) 2è s ø

2p s
æ - mö æ86.68 - 80 ö
=s ç ÷=4 ç ÷=4 (1.67)
è s ø è 4 ø
=4(.0197) =.0788
65
Ref.
 Solution
Iteration 2:
n(r0 ) =.0788
2D ( A + pn(r)) 2(40) ( 50 + 5(.0788))
Q1 = = =423.3
h .0225
Q1h 423.3(.0225)
1- G(r1 ) = = =.0476
pD 5(40)
G(r1 ) =.9523
r1 =86.68
Convergence!
67
 Service Levels in (Q,r) Systems
¨ In many circumstances, the penalty cost, p, is
difficult to estimate.
¨ For this reason, it is common business practice to set
inventory levels to meet a specified service objective
instead.
1) Type 1 service: Choose r so that the probability of not
stocking out in the lead time is equal to a specified
value.
¨ Appropriate when a shortage occurrence has the same consequence
independent of its time and amount.
2) Type 2 service: Choose both Q and r so that the
proportion of demands satisfied from stock equals a
specified value.
¨ In general, β is interpreted as the fill rate.

68
 Solution to (Q,r) Systems
with Type 1 Service Constraint
 For type 1 service, if the desired service level is α
then one finds r from G(r)= α and Q=EOQ
 Specify a , which is the proportion of cycles in
which no stockouts occur.
 This is equal to the probability that demand is
satisfied.
G(r) =a ® probability demand is satisfied
2AD
Set Q =EOQ =
h

69
 Solution to (Q,r) Systems
with Type 2 Service Constraint
¨ Type 2 service requires a complex iterative solution
procedure to find the best Q and r

¨ However, setting Q=EOQ and finding r to satisfy

n(r) = (1-β)Q will generally give good results

Average Stockouts per Cycle n(r) n(r)

= =
Average Demand per Cycle DT Q
n(r)
=1- b ,
Q
n(r) =( 1- b ) Q
70
 Service Constraints: Type 2
 May specify fill rate b, and use EOQ for Q to compute r
 Or, solve for p (penalty caused by shortage) : 1- ( )=
and substitute into the equation:

æ Qhn(r) ö
2D çA + ÷
2D ( A + pn(r)) è (1- G(r))D ø
Q= =
h h
hQ 2 hn(r)
=A + Q
2D (1- G(r))D
hQ 2 hn(r)
- Q - A =0
2D (1- G(r))D

71
 Service Constraints: Type 2

 Result:

2
n(r) 2AD æ n(r) ö
Q= + +ç ÷
1- G(r) h è1- G(r) ø
n(r) =(1- b )Q

72
 4. The (R, r) Model

¨This is usually called the (s, S) model

¨Each demand order can be for multiple units
¨Demand orders are stochastic
¨A replenishment order is placed to bring inventory position back to R
¨Decision variables are R (instead of Q) and r

73
 Order-Up-To-Level (s, S) vs (Q, r) System

SS • If all demand
transactions are
unit-sized, two
systems are the
ss same S= r+Q
• (s,S)~ “min-max”
(s,S) (s,
system
S) system rR+Q
+Q

rR

(Q,,R)
(Q,r) system
system
74
 Alternative Periodic Review Policy: (s, S)

Define two levels, s < S, and let u be the starting inventory at the
beginning of a period.

Then, if u is less or equal to s, order (S – u),

if u is more than s, do not place an order.

In general, computing the optimal values of s and S is extremely

difficult, so few systems operate using optimal (s,S) values.

Approximation:
Compute optimal values for (Q,r) model and set s=r
and S = r + Q

75
Dealing with Lead Time Variability

L = replenishment lead time (a random variable)

E(L) = expected replenishment leadtime
Var(L) = variance of lead time
D = demand per period
E(D) = expected demand per period
Var(D) = variance demand

E(X)=E(L)E(D)
Var(X)=E(L)Var(D) + E(D)2Var(L)
76
 Dealing with Lead Time Variability

Under the Normal approximation, the optimal reorder can be

obtained as

77
Expected Leadtime Demand

78
Variance of Leadtime Demand

79
Variance of Leadtime Demand

80
Variance of Leadtime Demand

81
5. Order-Up-To-Level (S, T) System

T T

82
 Periodic Review Systems
 Continuous Review Systems
 Always knew level of on-hand inventory
 Could place an order at any time

 Often, we are constrained by WHEN we can order -- and it

may be periodically
 Train dispatched once a week
 Delivery truck arrives each morning

 Thus, we do not need to continuously review inventory,

just check periodically

83
 Periodic Review Systems
 If demand were known and constant, we would just resort
to our EOQ solution, possibly modifying it to meet
shipping date
 Now: demand is random variable
 Setting:
 Place an order every T periods
 Policy: Order up to S
 The value of Q (order quantity) will now change periodically
 Previous concern: demand exceeding supply during the
lead time
 Now: demand exceeding supply during the period and lead
time, or T + l

84
 Periodic Review Systems
Order up to S
every T periods of
time.
I(t) Order arrives.
S Cycle continues.
Demand
Q

Lead Time passes…

l l
Time
T
85
 Expected Cost Function
 Include expected holding, setup, penalty
and ordering (per unit) costs
 Average Inventory Level:
S
At level r*,on average,
order Q = S-r* units.
r* l periods later, units arrive.
Inventory level?
l

T
86
 Expected Cost Function
 Include expected: holding, setup, penalty
and ordering (per unit) costs
 Average Inventory Level:
S
S-Dl units present when
Q arrive (expected) as
Dl units consumed over
leading time.

87
 Expected Cost Function
 Include expected: holding, setup, penalty
and ordering (per unit) costs
 Average Inventory Level:
S S - Dl
D*T units
removed
(expected) from
inventory over
time T.
T

88
 Expected Cost Function
 Include expected: holding, setup, penalty
and ordering (per unit) costs
 Average Inventory Level:
S S-Dl

D*T/2 D*T

S-Dl-D*T
T

DT DT
Average Inventory Level = ( S - Dℓ- DT ) + =S - Dℓ-
89
2 2
 Expected Cost Function
 Include expected:
holding, setup, penalty and ordering (per unit) costs

 Average Holding Cost:

æ DT ö
h çS - Dℓ- ÷
è 2 ø
 Average Set-up Cost: A
T
90
 Expected Cost Function
 Expected Shortage per Cycle:
 f(x)dx = P(demand in T + l is between x and x + dx)

(max( ( + ℓ) - ,0))
¥
= ò( - ) ( ) = ( )

 Expected Penalty Cost :

n(S)
p
T
91
 Cost Minimization
 Expected Cost Function:

DT A pn(S)
Y (S, T ) =h(S - Dℓ- )+ + + Dc
2 T T

 Derivative:
 Recall that T and l are given:

dY p
=h + n¢(S)
dS T
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 Cost Minimization
 Derivative:
dY p
=h + n¢(S) =0
dS T
¥
Note: n(S) = ò(x - S)g(x)dx
S

n¢(S) =- (1- G(S))

hT
Þ 1- G(S) =
p
 or:
p - hT
G(S) =
p
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 Example
¨ A special control board is used in a version of a
product on the production line
¨ The board cost is $122.50
¨ The holding cost rate is 30% per year
¨ Reorders are placed at the start of each week, and
the supplier delivers these parts in one week
¨ The shortage cost is $100 per board due to
worker downtime
¨ Weekly demand is N (μ=125, σ2=104.17)
¨ Set up cost (A) is $120
¨ Find S

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 Solution
 Holding cost is:
h = Ic = .30 (122.50) = 36.75 / 52 = $.7067 per week
 Compute:
p - hT 100 - (.7067)1
G(S) = = =0.993
p 100
 Demand Distribution is Normal
 mean = 125 variance = 104.17
 Z = 2.455 from Normal table
 S = 125+(2.455)(104.17)1/2 = 150.06
 S    z

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 Solution

 If penalty cost drops to $10 per unit:

 Compute:
p - hT 10 - (.7067)1
G(S) = = =0.929
p 10
 S = 125+(1.47)(104.17)1/2 = 140
 p = 1? S = 125+(-.54)(104.17)1/2 = 119.49

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