A Product Has a Reorder Point of 110 Units, and Is

question 175

Essay

A product has a reorder point of 110 units, and is ordered four times a year. The following table shows the historical distribution of demand values observed during the reorder period.
$$\begin{array} { | c | c | } \hline \text { Demand } & \text { Probability } \\\hline 100 & .3 \\\hline 110 & .4 \\\hline 120 & .2 \\\hline 130 & .1 \\\hline\end{array}$$ Managers have noted that stockouts occur 30% of the time with this policy, and question whether a change in inventory policy, to include some safety stock, might be an improvement. The managers realize that any safety stock would increase the service level, but are worried about the increased costs of carrying the safety stock. Currently, stockouts are valued at $20 per unit per occurrence, while inventory carrying costs are $10 per unit per year. What is your advice? Do higher levels of safety stock add to total costs, or not? What level of safety stock is best?

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Definitions:

Risk Aversion

The tendency to prefer avoiding losses over acquiring equivalent gains; the degree of variability in investment returns that an investor is willing to withstand.

Possible Losses

Potential or anticipated losses, which could be in terms of finances, opportunities, well-being, or other valuable aspects.

Possible Gains

The potential benefits or positive outcomes that might be achieved from a particular action or decision.

Error Management Theory

A theory suggesting that humans are evolved to favor strategies that minimize the more costly type of errors in the dual nature of decision-making errors: false positives and false negatives.