RSM 1340

Term 2 2017
Problem Set 2: Inventory Management

SOLUTIONS
[These questions use specific numbers – yours may have been slightly different.]

1. Phineas and Ferb’s newest product is the SteinAway, a beer mug without a bottom, which
they buy for $5 from their supplier and sell for $5.99. The annual holding cost rate is 10%
(including cost of capital and warehousing costs). Per order, they pay a fixed cost of $8 for
shipping. Weekly demand is 100 mugs. Assume 50 weeks per year.
Their friend Perry suggests that they should maximize their profits by using the economic order
quantity model to manage their inventory.

a) What is the optimal order quantity to maximize profits?

K = $8,
R = 50 weeks/year x 100 mugs/week = 5000 mugs/year,
h = i x c = 10% x $5 = $0.5,
EOQ = √(2 x K x R / h) = √(2 x 8 x 5000 / 0.5) = 400.

b) Insert an Excel diagram that shows the inventory level over time.

What is the highest amount of inventory they are holding?

400
What is the smallest amount of inventory they are holding?
0

c) What is their annual profit (in dollars)?

R x (Price – Cost) – √(2 x h x K x R) = 5000 x ($5.99 - $5.00) - √(2 x 0.5 x 8 x 5000) = 4750.

d) What is the average number of inventory turns (per year)?

Inventory turns = 1/average flow time = average throughput rate/average inventory = R/(EOQ/2)
= 5000/(400/2) = 25.

Their enemy, the evil Dr. Doofenshmirtz, claims he has an even better idea. They should not
hold any inventory at all! Instead Phineas and Ferb should take orders from their customers,
and only place an order with their supplier when they have accumulated enough orders. Dr.
Doofenshmirtz believes that enormous profits will be possible.
e) Suppose that Phineas and Ferb use Dr. Doofenschmirtz’s idea and place an order with their
supplier once 400 units have been ordered by their customers. Insert an Excel diagram that
shows the number of outstanding customer orders over time.

What is the highest number of outstanding orders?

400
What is the smallest number of outstanding orders?
0

f) Phineas and Ferb realize that there is a good will cost of delaying fulfilling orders from their
customers. If the cost of delaying a customer’s order is $0.01 per unit per week, how many
customers’ orders should they take before placing an order?
h = $0.01 per week,
d = 100 mugs per week,
Economic backorder quantity, EBQ = √(2 x K x d / h) = √(2 x 8 x 100 / 0.01) = 400;
or h = $0.5 per year,
EBQ = √(2 x K x R / h) = √(2 x 8 x 5000 / 0.5) = 400.

g) What is their annual profit (in dollars)?

As above:
R x (Price – Cost) – √(2 x h x K x R) = 5000 x ($5.99 - $5.00) - √(2 x 0.5 x 8 x 5000) = 4750.

h) If the cost of delaying a customer is $0.64 per unit per week, how many customers’ orders
should they take before placing an order?
h = $0.64 per week,
d = 100 mugs per week,
Economic backorder quantity, EBQ = √(2 x K x d / h) = √(2 x 8 x 100 / 0.64) = 50;

i) What is their annual profit (in dollars)?

h = $0.64/week x 50 weeks/year = $32 per year
R x (Price – Cost) – √(2 x h x K x R) = 5000 x ($5.99 - $5.00) - √(2 x 32 x 8 x 5000) = 3350.
2. Jack sells newspapers on the streets of Toronto for a penny a piece ($0.01). (It is the late 19th
century. Jack is also a fine dancer and singer!) Each day he purchases 50 papers for a total of
30 cents from Mr. Pulitzer. Over two years he kept track of his sales. The following is a
distribution of what he observed.

Quantity Sold Relative Freq. Cumulative Freq.

1 0.02 0.02
2 0 0.02
3 0.01 0.03
4 0.01 0.04
5 0.02 0.06
6 0.02 0.08
7 0.02 0.10
8 0.04 0.14
9 0.02 0.16
10 0.03 0.19
11 0.01 0.20
12 0.01 0.21
13 0.02 0.23
14 0.01 0.24
15 0.03 0.27
16 0.03 0.30
17 0.01 0.31
18 0.03 0.34
19 0.02 0.36
20 0.02 0.38
21 0.01 0.39
22 0.03 0.42
23 0.02 0.44
24 0.02 0.46
25 0.02 0.48
26 0.01 0.49
27 0.03 0.52
28 0.02 0.54
29 0.02 0.56
30 0.02 0.58
31 0.02 0.60
32 0.01 0.61
33 0.01 0.62
34 0.02 0.64
35 0.02 0.66
36 0.01 0.67
37 0.04 0.71
38 0.03 0.74
 39 0.03 0.77
40 0.02 0.79
41 0.04 0.83
42 0.03 0.86
43 0.02 0.88
44 0 0.88
45 0.03 0.91
46 0.03 0.94
47 0.02 0.96
48 0.03 0.99
49 0.01 1.00
50 0 1.00

a) How many newspapers did Jack sell on average?

µ = ∑xf(x)
(Sum each of the values from 1 to 50 multiplied by their relative frequency)
Mean = 26.38.
b) What is the standard deviation of newspapers sold?
Var(x) = σ 2 = ∑(x - µ)2f(x)
(Subtract the mean 26.73 from each value, square the difference, multiply the relative
frequency, and them sum up to get the variance.)
σ2 = 192.0,
σ = 13.86.

c) Realizing he is losing money and slowly starving to death, Jack decides to purchase fewer
papers. How many newspapers should Jack buy each day to maximize his expected profit?
(Assume he would never sell more than 50.)
Price = 1.
Cost per unit = 30/50 = 0.6.
Underage cost, Cu = Price – Cost = 1 – 0.6 = 0.4.
Overage cost, Co = Cost – Salvage value = 0.6 – 0 = 0.6.
Prob(D≤Q) = Cu / (Cu + Co) = 0.4 / (0.4 + 0.6) = 0.4.
Determine Q such that probability that the demand is less than Q, Prob(D≤Q).
Consider the cumulative frequency distribution above instead.
Find the first number of papers for which the cumulative frequency exceeds 0.4.
(This is not a Normal distribution.)
Q = 22.
d) What are his expected lost sales?
50
Expected Lost Sales = ∑ Pr( Demand = d ) × (d − Q)
d =Q

That is sum (22 -22) x Prob(Demand = 22) + (23-22) x Prob (Demand = 23) + … +
Prob(Demand=50) x Prob(Demand = 50)
= 0 x 0.02 + 1 x 0.03 + … + 27 x 0.01 + 28 x 0.00 = 8.45.
e) What are his expected sales?
Expected Sales = Expected Demand – Expected Lost Sales = 26.38 – 8.45 = 17.93.

f) What is Jack’s expected profit per day?

Expected leftover inventory = Q – Expected Sales = 22 – 17.93 = 4.07.
Expected profit = (Price-Cost) × (Exp. Sales) – (Cost-Salvage Value) × (Exp. leftover inventory)
= 0.4 × 17.93 – 0.6 × 4.07 = 4.73.

g) What is Mr. Pulitzer's expected revenue per day?

Expected Revenue = Q x Cost = 22 x 0.6 = 13.2.

Jack proposes that Mr. Pulitzer should buy back extra copies of the paper for $0.005 (1/2 cent)
a piece.

h) What will be Jack’s expected profit per day under the proposal?
Salvage = 0.5.
Co = 0.6 – 0.5 = 0.1.
Therefore, Prob(D≤Q) = Cu / (Cu + Co) = 0.4 / (0.4 + 0.1) = 0.8, and Q = 41.
Expected Lost Sales = 0.75.
Expected Sales = 26.38-0.75 = 25.63.
Expected leftover inventory = 41 – 25.63 = 15.37.
Expected profit = 0.4 x 25.64 – 0.1 x 15.37 = 8.715.

i) What will be Mr. Pulitzer’s expected revenue per day under the proposal?
Expected Revenue = Q x Cost – Expected leftover inventory x Salvage value
= 41 x 0.6 – 15.37 x 0.5 = 16.915.

j) Should Mr. Pulitzer accept the proposal?

Yes. 16.915 > 13.2.

See that Jack’s profit has increased by 3.99 (from 4.73 to 8.72) and Mr. Pulitzer’s profit has
increased by 3.72. By agreeing to buy back the papers, Pulitzer is giving an incentive to Jack to
take more papers and increase the total market.
3. Jacob and Jacob is a furniture retailer. As opposed to many large furniture retailers, they sell
a limited line of product, holding inventory of each of their products in a warehouse for quick
delivery. They generally turn over their inventory about twice a year, selling at discount items
not sold during their regular season.

For the Fall/Winter collection Jacob and Jacob are selling The Hesterfield sofa. It retails for
$500. They purchase it for $300 from their supplier. The discounted price at the end of the
season is $250. They expect to sell 50 units, but assume a standard deviation of 10 units,
Normally distributed.

NOTE: The standard lost sales function, L(z) for the Normal distribution, is given in Excel by:
L(z)=NORM.DIST(z,0,1,0)-z*(1-NORM.S.DIST(z,1)) for a given z-value.

a) What is Jacob and Jacob’s cost of underage?

Underage cost, Cu = Price – Cost = $500 – $300 = $200.

b) How many Hesterfields should Jacob and Jacob stock at the beginning of the Fall/Winter
season in order to maximize their profit?
Overage cost, Co = Cost – Salvage value = $300 – $250 = $50.
F(z) = Prob(D≤Q) = Cu / (Cu + Co) = $200 / ($200 + $50) = 0.8.
The corresponding z-score is 0.84.
Q = µ + z x σ = 50 + 0.84 x 10 = 58.4.
Order Q = 59. (Round up)

c) What is their expected profit?

For an order quantity Q = 59 we get a z-score of (59 – 50)/10 = 0.9, i.e., it lies 0.9 standard
deviation above the mean.
Expected Lost Sales = σ x L(z) = 10 x 0.1 = 1.0
Expected Sales = Expected Demand – Expected Lost Sales = 50 – 1.0 = 49.
Expected leftover inventory = Q – Expected Sales = 59 – 49 = 10.
Expected profit = (Price-Cost)×(Exp. Sales) – (Cost-Salvage Value)×(Exp. leftover inventory)
= $200 × 49 – $50 × 10 = $9300.

Jacob and Jacob sometimes stock out of an item before the end of the season. In this case, if a
customer wants to buy a sofa model when they are out of stock, Jacob and Jacob have
arranged to place an order from their supplier for the unit. The customer typically needs to wait
4 to 6 weeks for delivery in this case. While Jacob and Jacob charge the customer the same
price, the supplier charges Jacob and Jacob $350 for the Hesterfield sofa for such a late season
order.
d) Suppose that all customers that find Jacob and Jacob out of stock are willing to wait for a
delayed delivery.

i) What is Jacob and Jacob’s cost of underage in this case?

Underage cost, Cu = New Cost – Orig. Cost = $350 – $300 = $50.

ii) How many Hesterfields should Jacob and Jacob stock at the beginning of the Fall/Winter
season in order to maximize their profit?
Overage cost, Co = Cost – Salvage value = $300 – $250 = $50.
F(z) = Prob(D≤Q) = Cu / (Cu + Co) = $50 / ($50 + $50) = 0.5.
The corresponding z-score is 0.
Q = µ + z x σ = 50 + 0 x 10 = 50.
Order Q = 50.

iii) What is their expected profit?

For an order quantity Q = 50 we get a z-score of (50 – 50)/10 = 0.
Expected Lost Sales = σ x L(z) = 10 x 0.399 = 3.99.
Expected Sales = Expected Demand – Expected Lost Sales = 50 – 3.99 = 46.01.
Expected leftover inventory = Q – Expected Sales = 50 – 46.01 = 3.99.
Expected lost sales equals the number of items we order late, so expected late sales = 3.99.
Expected profit = (Price - Orig. Cost)×(Exp. Sales) + (Price - New Cost)×(Exp. Late Sales) –
(Orig. Cost - Salvage Value)×(Exp. leftover inventory)
= $200 × 46.01 + $150 x 3.99 – $50 × 3.99 = $9601.

Alternatively, the Maximum Profit = $200 x 50 = $10000

The Mismatch Cost is the backorder cost of $50 x 3.99 plus the excess inventory cost of $50 x
3.99 = 50 x 3.99 + 50 x 3.99 = $399.
Expected profit = $10000 – 399 = $9601.

e) Suppose that exactly half of the customers that find Jacob and Jacob out of stock are willing
to wait for a delayed delivery and half of the customers choose not to wait and do not purchase
one.

i) What is Jacob and Jacob’s average cost of underage in this case?

(Hint: For any given customer that finds Jacob and Jacob out of stock, how much will it cost
Jacob and Jacob?)

Two cases:
1) If a customer does not wait for a delayed delivery, then as in part (a) of the question:
Underage cost, Cu = Price – Cost = $500 – $300 = $200.
2) If a customer does wait for a delayed delivery, then as in part (d,i) of the question:
Underage cost, Cu = New Cost – Orig. Cost = $350 – $300 = $50.
Both cases occur half of the time, so the average Cu = ($200 + $50)/2 = $125.
ii) How many Hesterfields should Jacob and Jacob stock at the beginning of the Fall/Winter
season in order to maximize their profit?

Overage cost, Co = Cost – Salvage value = $300 – $250 = $50.

F(z) = Prob(D≤Q) = Cu / (Cu + Co) = $125 / ($125 + $50) = 0.71.
The corresponding z-score is 0.57.
Q = µ + z x σ = 50 + 0.57 x 10 = 55.7.
Order Q = 56.

iii) What is their expected profit?

For an order quantity Q = 56 we get a z-score of (56 – 50)/10 = 0.6.

Expected Lost Sales = σ x L(z) = 10 x 0.169 = 1.69.
Expected Sales = Expected Demand – Expected Lost Sales = 50 – 1.69 = 48.31.
Expected leftover inventory = Q – Expected Sales = 56 – 48.31 = 7.69.
Half of the expected lost sales are turned into late sales, so expected late sales = 1.69/2 =
0.845.
Expected profit = (Price - Orig. Cost)×(Exp. Sales) + (Price - New Cost)×(Exp. Late Sales) –
(Orig. Cost - Salvage Value)×(Exp. leftover inventory)
= $200 × 48.31 + $150 x 0.845 – $50 × 7.69 = $9404.

Alternatively, Maximum Profit = $200 x 50 = $10000.

Mismatch Cost = Cu x Expected Lost Sales + Co x Expected Leftover Inventory

= $125 x 1.69 + $50 x 7.69
= $606.

Expected Profit = $10000 - $606 = $9404.