Mathematics (M) 950/3

17. Inventory models

18. Game theory

1
Deterministic Inventory Models
Purpose:
To determine rules that management
can use to minimize the costs associated with
maintaining inventory and meeting customer
demand.

Basic questions:
When should an order be placed for a
product ?
How large should each order be ?
INVENTORY MODELS
2
Costs involved:

Ordering and setup cost
Cost of paperwork and billing associated
with an order.
In a production situation, the ordering
cost is more correctly referred to as the
production setup cost.

Unit purchasing cost
Cost associated with purchasing and
producing a single unit.
3
Holding or carrying cost

Storage cost
Insurance cost
Taxes on inventory
Cost due to the possibility of
spoilage, theft, or obsolescence
Opportunity cost incurred by
tying up capital in inventory
4
Stockout or shortage cost

Back-order customer willing to accept
delivery at a later date

the cost of placing special orders
Customers go else where to meet
current and future demands
Lost sales
Lost goodwill

5
To minimized Total Cost:

Total Cost = Ordering and setup cost
+ Holding Cost
+ Shortage Cost
6
Assumptions of the Basic EOQ Model :

Number of units demanded (D) per unit
time is constant.

One type of item

Lead time the length of time between the
instant when an order is placed and the
instant at which the order arrives, L = 0

No out of stock. (Negative inventory policy
is not allowed) shortage not allowed.

.
7
Q
Q/2
Q/D
Q-Dt
8
D demand
c cost per item

0
- Setup cost
- Holding cost
- Shortage cost
h
b
C
C
C
9
Holding Cost/cycle:
2
2 2
h
h
C Q
Q Q
C
D D
| | | |
| |
\ . \ .
=
Setup cost/cycle: ( )
0
C cQ +
Time per cycle:
Q
D
10
Total cost/cycle = Setup cost + Holding cost
11
2
0
( ) ( )
2
h
C Q
T Q C cQ
D
| |
|
|
\ .
= + +
Total Cost per unit time:

12
2
0
0
2
( )
( )
2
h
h
C Q
C cQ
D
T Q
Q
D
C Q DC
T Q cD
Q
+ +
=
= + +
Differentiate wrt Q:
13
2
0
2
0
0
( )
2
2
( )
2
h
h
h
C
T Q DC Q
DC
Q
C
C Q DC
T Q cD
Q

'
= +
=
= + +
Thus, the optimum inventory policy for the
model is to order

*
2
o
h
DC
Q
C
=
units for every t
0
*
=Q
*
/D time units.

Total cost T(Q
*
).
14
EOQ with planned shortages.

Costs are incurred because of lost business, the cost of
placing special orders, loss of future goodwill and so on.

Q/D
Q
Q-Dt
M
Q - M
O A
B
15
M
OA
D
=
Q
OB
D
=
( )
Q M
AB
D

=
2
2 2
h
h
M C M M
C
D D
=
| || |
| |
\ .\ .
( )
2
2 2
b
b
Q M C
Q M Q M
C
D D

=
| || |
| |
\ .\ .
o
C cQ +
Assuming that C
b
be the cost of shortage,

Holding
Cost/cycle :
Shortage
Cost/cycle :
Order
Cost/cycle :
16
Total cost per unit time:
( )
( )
( )
( )
2
2
2
2
2 2
,
/
2 2
b
h
o
b
o h
C Q M
M C
C cQ
D D
T Q M
Q D
C Q M
M C DC
cD
Q Q Q
| |
| |
|
|
|
\ .
\ .

+ + +
=

= + + +
17
Minimum occur at
0
T T
M Q
c c
= =
c c
18
( )
1 1
0
h b
b
b h
T
MC Q C Q M Q
M
C
M Q
C C

| |
|
\ .
c
= =
c
=
+
19
( )
( )
2 2 2 1
0
2
2
2
0
0
1
2
1
0
2
2
2
h b
b
b h
h b
b h
h b
T
DC Q M C Q C Q M Q
Q
C Q M Q
DC C C
Q
C C
DC C C
Q
C C

c
= +
c
=
| || |
+
=
| |
\ .\ .
| || |
+
=
| |
\ .\ .
20
1/ 2
1/ 2
*
2
o b b
h h b h b
DC C C
M EOQ
C C C C C
(
| | | |
= =
(
| |
+ +
\ . \ .

1/ 2
*
h b
b
C C
Q EOQ
C
+
=
| |
|
\ .
Optimal policy:
Notes: May use different value of lead time.
21
If then
T T
L C s
e T
L L =
If then
T T
L C >
T
e T T
T
L
L L C
C
=
(
(

lead time cycle time
T T
L C
22
Example 1: Bart's Barometer Business (BBB) is
a retail outlet which deals exclusively with
weather equipment. Currently BBB is trying to
decide on an inventory and reorder policy for
home barometers. Barometers cost BBB $50
each and demand is about 500 per year
distributed fairly evenly throughout the year.
Reordering costs are $80 per order and holding
costs are figured at 20% of the cost of the item.
BBB is open 300 days a year (6 days a week and
closed two weeks in August). Lead time is 60
working days.
23
c = RM50 per barometer

D = 500 of barometers per year

C
0
= RM80

L = 60 working days

Open = 300 days a year

C
h
= 20% of the cost of item
24
( )
0
500
500 50
2
h
Q
C C
Q
| |
| |
+ +
|
|
\ .
\ .
500
80 0.2 50 25000
2
Q
Q
| |
| |
= + +
|
|
\ .
\ .
Number of cycles per year:
500
Q
Total cost per year:
25
( )
*
0
2 2(500)(80)
0.2 50
80000
8000 89.44
10
h
DC
Q
C
= =

= = =
Optimal Reorder Quantity
Approx. 90 barometers
26
Number of Orders Per Year

Number of reorder times per year is
(500/90) = 5.56
or
once every, (300/5.56) = 54 working days
or about every 9 weeks.
Cycle time is 54 working days.
27
Daily demand:
500
1.6667
300
=
Reorder point:
500
60 100
300
=
Bart should reorder 90 barometers when
his inventory position reaches 100 (that
is 10 on hand and one outstanding order).
!!! Lead-time (60 days) is longer than
cycle time (54 days).
28
If then
T T
L C s
e T
L L =
If then
T T
L C >
T
e T T
T
L
L L C
C
=
(
(

lead time cycle time
T T
L C
29
Since 60 54
T T
L C = > =
60
60 54
54
60 (1 54)
60 54 6 days
e
L
(
=
(

=
= =
then
Reorder point:
500
6 10 barometers
300
e
L demand = =
!!! Needs to make one reorder 60 days before
start-up.
30
If lead time is less than cycle time,
lets say 45 days, what will be the
policies?
500
45 75
300
=
Bart should reorder 90 barometers
when his inventory position reaches 75.
45
e T
L L = =
31
Example 2:

Hervis Rent-a-Car EOQ with Planned Shortages
Model
Hervis Rent-a-Car has a fleet of 2,500 Rockets serving
the Los Angeles area. All Rockets are maintained at a
central garage. On the average, eight rockets per month
require a new engine. Engines cost $850 each. There is
also a $120 order cost (independent of the number of
engines ordered). Hervis has an annual holding cost
rate of 30% on engines. It takes two weeks to obtain the
engines after they are ordered. For each week a car is
out of service, Hervis loses $40 profit.
32
Question:

1.How many days after receiving an order
does Hervis run out of engines?

2. How long is Hervis without any
engines per cycle?
33
Optimal Order Policy:
* * *
h
h b
C
Q M Q
C C
| |
=
|
+
\ .
*
2 96 120 255 2080
10.07 10
0.30 850 2080
Q
+
= = ~

* *
255
10 1.09 1
255 2080
Q M
| |
|
\ .
= = ~
+
Needs to order 10 units. 1 unit backorder.
34
Lead-time:
2
T
L =
2 2 4 =
4 1 3 =
2 weeks x 2 rockets per week:
Demand during lead-time minus back order:
Hence, the order should be placed
when there are 3 engines remaining in
inventory.
35
GAME THEORY
Two-person zero-sum game
Saddle point: 1
Pure strategy: (A plays II, B plays I)
Value of the game: v = 1
0 10
1 2

| |
|
\ .
Player A
Player B
I II
I
II
Max{min} = 1
Min{max} = 1
36
A two-person zero-sum game is a two-player
game in which, for any choice of both players
strategies, the row players reward and the
column players reward add up to zero.
37
If some entry a
ij
of the matrix A has the
property that

(1)a
ij
is the minimum of the i
th
row, and
(2) a
ij
is the maximum of the j
th
column,

then we say a
ij
is a saddle point. If a
ij
is a
saddle point, then Player I can then win at
least a
ij
by choosing row i, and Player II can
keep her loss to at most a
ij
by choosing
column j. Hence a
ij
is the value of the game.
38
2 by 2 game:
Two-person zero-sum game
Since two values not equal then no saddle point
Needs, mixed strategy
2 3
3 4

| |
|
\ .
Player A
Player B
I II
I
II
Max{min}=-2
Min{max}=3
39
2 3
3 4

| |
|
\ .
Player A
Player B
I II
I
II
a b
d c

| |
|
\ .
40
Assume no saddle point.
Assume a > b.
If b > c then b is the saddle point, b < c
If c < d then c is the saddle point, c > d
If d > a then d is the saddle point, a > d
a > b,b < c ,c > d and a > d (test 1)
Testing for saddle point
41
Assume no saddle point.
Assume a < b.
If a > d then a is the saddle point, a < d
If c > d then d is the saddle point, c < d
If b < c then c is the saddle point, b > c
a < b ,b > c , c< d and a < d (test 2)
Testing for saddle point
42
Equalizing strategies:
Player A
Player B
q 1 - q
p
1 p
a b
d c
| |
|

\ .
43
For p:
pa + (1 p)d = pb + (1 p)c
(a b)p = (c d)(1 p)
[(a b) + (c d)]p = (c d)
p = (c d)/[(a b) + (c d)]
For q:
qa + (1 q)b = qd + (1 q)c
(a d)q = (c b)(1 q)
[(a d) + (c b)]q = (c b)
q = (c b)/[(a b) + (c d)]
44
( ) ( )
c d
p
a b c d

=
+
( ) ( )
c b
q
a b c d

=
+
Player A
Player B
Mixed strategy: Player A: (p,1-p)
Player B: (q,1-q)
where
45
46
( ) ( )
(1 )
( )
1
( ) ( ) ( ) ( )
v pa d p
a
ac bd
a b c d
c d c d
d
a b c d a b c d
= +
=

+
| | | |
+
| |
+ +
\ . \ .
=
Value of the game:
p = q = 7/12 and v = 1/12
Many larger games can be reduced to 2 by 2 games.
Definition:

Let A = (a
ij
) be an m by n matrix.

(i) Row i dominates row j if a
ik
a
jk
for all k.

(ii) Column i dominates column j if a
ki
a
kj
for all k.
47
Removal of a dominated row or column
does not change the value of a game
2 0 4
1 2 3
4 1 2
A =
| |
|
|
|
\ .
2 0
1 2
4 1
| |
|
|
|
\ .
1 2
4 1
| |
|
\ .
Column 2 dominates
column 3
Column Deleted:
Choose larger
Row 3 dominates row 1
Row Deleted:
Choose smaller
48
A row (column) may also be removed if it is
dominated by a probability combination of
other rows (columns).
49
Steps:

Reduce the matrix (dominance)
Check for saddle point
Equalizing strategy
(use formula for 2 x 2)
Solving 2 x n and m x 2 games
with the aid of graphical interpretation


50
2 3 1 5
4 1 6 0
| |
|
\ .
Consider 2 x 4 game:
p

(1 p)
51
( )
( )
( )
= +
= +
= + =
=
Column 1 (expected payoff) : 1 2 4 1- =4-2p
Column 2 (expected payoff) : 2 3 1- =2p+1
Column 3 (expected payoff) : 3 6 1- 6 - 5
Column 4 (expected payoff) : 4 5
y p p
y p p
y p p p
y p
52
p = 5/7
0
1
y3
y1
y2
y4
{Intersection of y2 and y3}
53
Strategy for player A: (5/7,2/7)

Strategy for player B: (0,5/7,2/7,0)

Value of the game is v = 17/7.

From the graph, column 1 is dominated by column
2 and column 3 taken with probability each.
Delete column 1.
54
3 1
1 6
| |
|
\ .
Reduced to 2 x 2 game:
x1

x2
y2 y3
Player A
Player B
Strategy for player A: (5/7,2/7)

Strategy for player B: (0,5/7,2/7,0)

Value of the game is v = 17/7.
( ) ( )
6 1
5/ 7
2 5
c b
q
a b c d

=
+

= =
+
55
19 6 7 5
7 3 14 6
12 8 18 4
8 7 13 1
| |
|
|
|
|

\ .
larger
Left with column 2 and column 4.
56
6 5
3 6
8 4
7 1
| |
|
|
|
|

\ .
6 5
3 6
8 4
| |
|
|
|
\ .
smaller
57
( )
( )
( )
= +
= +
= + = +
Row 1 (expected payoff) : x1 6 5 1- = 5 + q
Row 2 (expected payoff) : x2 3 6 1- = 6 - 3q
Row 3 (expected payoff) : x3 8 4 1- 4 4
q q
q q
q q q
58
{Intersection of x2 and x1}
5 + q = 6 - 3q
q = 1/4
59
q = 1/4
0
5
3
6
8
4
1
6
6 5
3 6
| |
|
\ .
( ) ( )
6 3
3/ 4
1 3
c d
p
a b c d

=
+

= =
+
60
( ) ( )
36 15
21/ 4
4
ac bd
v
a b c d

=
+

= =
Game value:
Optimal strategies are:

Player A (3/4,1/4,0,0)

Player B (0,1/4,0,3/4)
61
62