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Inventory Management

Session 16
April 9th, 2018
EOQ Model Summary

• The optimal batch size trades off setup cost and holding cost.
• Square-root relationship between Q and (D, S):
• Assumptions:
o Deterministic Demand
o The Role of lead time?

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Newsvendor Problem Summary
critical fractile
Pr ( D ≤ Q ) = cu / (cu+co)
Profits Just right!

Too little!

Too much!

Inventory
Key idea of marginal analysis: At the optimal order quantity, the expected value
(profit) of ordering one more unit is zero
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Special Cases: Continuous and Discrete
• If demand D is continuous, normally distributed with mean µ and
standard deviation s, what is the optimal stocking level?
o P(D ≤ X) = cu / (cu+co)
o Transform to standard normal and use table

• If demand D is discrete, then the optimal order quantity is the


smallest !" that satisfies:

"
-.
# ! ≤ !" = & '( ≥
-. + -0
()*

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Example: SnowTime Sporting Goods
Design Production Retailing

Feb 09 Sep 09 Feb 10 Sep 10

Production

Properties of SnowTime Sporting Goods:


• New designs are completed
• One production opportunity
• Based on past sales, knowledge of the industry, and economic
conditions, the marketing department has a probabilistic forecast
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SnowTime Revenue and Costs Information

• Production cost per unit (C): $80


• Selling price per unit (S): $125
• Salvage value per unit (V): $20

• Profit = Revenue - Variable Cost + Salvage

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Optimal Solution for SnowTime
Demand Probability
$

! "#
• Production cost per unit (C): $80 #%&

• Selling price per unit (S): $125 8,000 0.11 0.11


• Salvage value per unit (V): $20 10,000 0.11 0.22
12,000 0.28 0.50
Underage Cost: if extra jacket sold, profit is $125- 14,000 0.22 0.72
$80 = $45 16,000 0.18 0.90
18,000 0.10 1
Overage Cost: if not sold, cost is $80-$20 = $60

./ 23
Smallest '$ such that ) ' ≤ '$ = ∑$#%& "# ≥ . = 23045 = 0.429
/0.1

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Demand Management
Forecasting

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Outline

• Qualitative forecasting techniques

• Qualitative forecasting techniques


o Moving average approaches
o Regression based approach

• Measuring forecast accuracy

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Forecasting Demand
SUPPLY

Process/value DEMAND
Inputs Product/service
creation

Demand models needed for:


• Inventory/Production decisions
• Pricing of product/service

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Forecasting

Hong Kong
Weather Forecast

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Principles of Demand Forecasting
• Forecasting is only forecasting
o Not perfect

• The longer the forecast horizon, the


worse the forecast

• Aggregate forecasts are more


accurate
o Products
o Geographical Regions
o Time

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Components of Demand: Trend + Random Variation

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Components of Demand: Trend

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Components of Demand: Random Variation

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Qualitative Forecasting Methods (1)
• Market research
o Sets out to collect data in a variety of ways (surveys, interviews, etc.) to test
hypothesis about the market
o Typically used to forecast long-range and new-product sales

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Qualitative Forecasting Methods (2)
• Historical analogy
o Ties what is being forecast to an existing product (such as complementary
product, substitutable product)
o Important in planning new products where a forecast may be derived by using
the history of a similar product

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Qualitative Forecasting Methods (3)

• Panel consensus
o Free open exchange at meetings
o The idea is that discussion by the group will produce better forecasts than any
one individual
o Participants may be executives, salespeople or customers

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Qualitative Forecasting Methods (4)

• Delphi method
o Experts respond to questions
o A moderator compiles results and formulates a new questionnaire which is
submitted to the group (perhaps with new set of questions)
o There is a learning process for the group as it receives new information and
there is no influence of group pressure or dominating individuals

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Qualitative Forecasting Methods – Pros and Cons

• Advantage of qualitative forecasting methods


o Does not require extensive historical data
• Disadvantage of qualitative forecasting methods
o Subjective
• When to use?
o When historical data are scarce or not available at all
o Use expert and/or customers opinion to predict future events subjectively
o Example: sales of new product, environment and technology change over the
long term

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Quantitative Forecasting Methods
Forecasting

Time Series Associative Models


Forecasting

ü Moving Average
ü Weighted Moving
ü Linear regression
Average
ü Exponential
smoothing

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Simple Moving Average (SMA)
Week Demand
1 650
2 678 A t-1 + A t-2 + A t-3 +...+A t- n
3 720
Ft =
4 785
n
5 859
6 920
Question: What are the 3-week and 6-week moving average
7 850 forecasts for demand week 13?
8 758
9 892
10 920
11 789
12 844

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Choosing ! in SMA

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Weighted Moving Average
• A weighted moving average allows any weights to be placed on each
element.
• Model:

Ft = w1 At -1 + w2 At -2 + ... + wn At -n
n

åw
i =1
i =1

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Example
Question: Given the weekly demand and weights, what is the forecast for the 4th
period or Week 4?
Week Demand Weights:
1 650
t-1 .5
2 678
3 720 t-2 .3
4 t-3 .2

Note that the weights place more emphasis on the most recent data, that is time
period “t-1”

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Choosing Weights

• Most recent data with higher weighting


• Seasonal data
• Experience and trial and error

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Simple vs. Weighted Moving Average

• Simple Moving Average


o When changes in demand is caused by random variations
• Weighted Moving Average
o Seasonal Demand
o Trend in the Demand

• Disadvantage of Moving Average


o Every individual element must be carried as data

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Exponential Smoothing
• Model: Where :
Ft = Demand Forcast for the coming time period
Ft = Ft -1 + a ( At -1 - Ft -1 ) Ft - 1 = Demand forecast in the past time period
At - 1 = Actual demand in the past time period
a = Alpha smoothing constant
• Data
o The most recent forecast
o The most recent demand
o A smoothing constant a

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Example: Exponential Smoothing with a=0.6
Week Demand Forecast Forecast Error
1 820 820 0
2 775
3 680
4 655
5 750
6 802
7 798
8 689
9 775
10

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Choosing a

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Does Exponential Smoothing use Distant Data?
Ft = Ft -1 + a ( At -1 - Ft -1 )
= (1 - a ) Ft -1 + aAt -1
= (1 - a )[(1 - a ) Ft - 2 + aAt - 2 ] + aAt -1
= (1 - a ) 2 Ft - 2 + a (1 - a ) At - 2 + aAt -1
= (1 - a ) 3 Ft -3 + a (1 - a ) 2 At -3 + a (1 - a ) At - 2 + aAt -1

a Past period Two periods Three periods Ft-3


ago ago
0.1 0.1 0.09 0.081 0.729
0.5 0.5 0.25 0.125 0.125
0.9 0.9 0.09 0.009 0.001
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Credit Analysis
• A bank wants to know whether the credit amount is higher for new customers or
for old customers
DURATION of Credit Amount
credit (months)
6 1169
48 5951
12 2096
42 7882
24 4870
36 9055
24 2835
36 6948
12 3059
30 5234
12 1295
48 4308
12 1567
24 1199
15 1403
24 1282
24 2424
30 8072
24 12579
24 3430
9 2134
6 2647
10 2241
12 1804
10 2069
6 1374
6 426

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Simple Linear Regression Model
Linear Regression
• Independent variables (x) and dependent variable (y) have a linear relationship
• Causal relationship
• Time series forecasting (when x has lagged-y variables)

Y = a + bx

x (Independent variable) Y (Dependent variable)


Duration of credit Credit amount
Week Demand
Rainfall Demand

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Simple Linear Regression Analysis
• There are ! data points: {("# , %# ): & = 1, … , !}
• Minimize square error

Y = a + bx

n
min å ( Actual - Forecast ) 2
a ,b
i =1
n n
or min å [ yi - Yi ]2 = å [ yi - (a + bxi )]2
a ,b
i =1 i =1

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Least Squares Method
The least squares method determines the parameters a and b such that the sum
of the squared errors is minimized

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Least Squares Method
Optimal Coefficients a* and b* that minimize the sum of the squared
errors:

! data points: {("# , %# ): & = 1, … , !}


"̅ , %, average of "# , %# , respectively

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Example: Credit Analysis (continued)
20000

18000

16000

14000

12000
Credit Amout

10000

8000

6000

4000

2000 y = 146.3x + 213.22


0
0 10 20 30 40 50 60 70 80
Duration of Credit (in months)

We can perform multi-variable linear regression:


Credit Amount = a + b1(Duration)+b2(Salary)+b3(Age)…

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Measuring Forecast Accuracy
You are a marketing analyst for McDonalds and have the following sales forecasts ($M)
using two methods.

Month Actual Demand Method 1 Forecast Method 2 Forecast

1 110 100 130


2 140 70 100
3 140 150 180
4 160 110 150
5 210 230 250

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Two Methods

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Measuring Forecast Accuracy
Forecast error is the difference between the actual value and the
predicted value
• Error = Actual – Forecast

Mean absolute deviation (MAD)


• MAD = ∑|Actual – Forecast| / n

Tracking signal
• Ratio of cumulative error and MAD
• TS = ∑(Actual – Forecast) / MAD

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Method 1: Tracking signal

Month Actual Forecast Error ∑|Error| MAD ∑(Error) TS

1 100 60

2 100 130

3 200 200

4 200 270

5 400 340

Error = Actual – Forecast MAD = ∑|Error| / n TS = ∑(Error) / MAD

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Method 2: Tracking signal

Month Actual Forecast Error ∑|Error| MAD ∑(Error) TS

1 100 100 0 0 0 0 0.00

2 100 100 0 0 0 0 0.00

3 200 150 50 50 16.7 50 3.00

4 200 200 0 50 12.5 50 4.00

5 400 250 150 200 40 200 5.00

Error = Actual – Forecast MAD = ∑|Error| / n TS = ∑(Error) / MAD

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Interpreting Tracking Signals
Method 2

3
2 Actual exceeds forecast
Tracking Signal

1
0
-1 Actual is less than forecast
Method 1
-2
-3
0 1 2 3 4 5
Month

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