Chapter 11.
Supply Chain & Inventory
Management
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
1
Outline





Healthcare Supply Chain
– Manufacturers/Suppliers
– Distributors, Wholesalers
– Group Purchasing Organizations (GPOs)
– e-Distributors
Flow of Materials in Supply Chain
Supply Chain Management Issues for Providers
Contemporary Issues in Medical Inventory Management
– Just-In-Time (JIT) & Stockless Inventories
– Single vs. Multiple Vendors
Traditional Inventory Management
– Requirements for Effective Inventory Management
– Inventory Accounting Systems
– Universal Product codes (UPCs)
– Lead Time
– Costs
– EOQ Model
– Reorder Point
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
2
Healthcare Supply Chain
In healthcare organizations, supply chain is a new way
of conceptualizing medical supply management.
A supply chain is defined as “a virtual network that
facilitates the movement of product from its
production, distribution and consumption” (McFadden
and Leahy, 2000).
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
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Need for Healthcare Supply Chain Management
Improve operations
 Increasing levels of outsourcing
 Increasing transportation costs
 Competitive pressures
 Increasing globalization
 Increasing importance of e-commerce
 Complexity of supply chains
 Manage inventories

Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
4
Figure 11.1 Healthcare Supply Chain
Downstream
Upstream
Manufacturers/
Suppliers
Distributors
Providers
End Users
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
Pharmaceutical
Medical-Surgical
Devices
Wholesalers
Group Purchasing Organization (GPOs)
e-Distributors
Hospitals
Hospital Systems
Physicians
Integrated Delivery Networks (IDNs)
Patients/Individuals
Employers
Insurers
HMOs
Drug Benefit Agencies
Government
5
Healthcare Supply Chain
Manufacturers/Suppliers. Manufacturers of medical
supplies can be classified in three categories:
1) drugs/pharmaceutical,
2) medical-surgical supplies, and
3) devices.
Some manufacturers produce supplies in more than one
category or in all categories.
Chapter 11: Quantitatve
Methods in Health Care
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Yasar A. Ozcan
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Healthcare Supply Chain
Well known pharmaceutical manufacturers include Abbott,
Aventis Pharma, Bristol-Myers Squibb, Eli Lilly, Merck,
GlaxoSmithKline, Hoffmann-La Roche, Janssen,
Johnson & Johnson, Pfizer, Schering-Plough and Wyeth.
Twenty-five percent of pharmaceutical products are
distributed to providers (hospitals and other institutional
settings) via distributors.
Medical-surgical companies produce items such as injection
syringes and needles, blood and specimen collection kits,
hospital laboratory products, wound management products,
and intravenous solutions.
3M, Abbot, Baxter, Johnson & Johnson are a few of the well
known medical-surgical companies that sell majority of
their products through distributors.
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
7
Healthcare Supply Chain
Medical devices can be described as very high priced,
technologically sophisticated and advanced apparatus that
are used for diagnosis and therapies.
Medical devices include surgical and medical instruments
And apparatus, orthopedic, prosthetic and surgical
appliances (for example, shoulder, knee, and hip
replacements), X-Ray apparatus, tubes, irradiation
apparatus, electro-medical and electro-therapeutic devices.
Dupuy, Ortho Biotech, Medtronic, and Zimmer are examples
of the companies that manufacture such devices (Burns,
2002; p.244).
Chapter 11: Quantitatve
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Yasar A. Ozcan
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Typical Supply Chain for a Healthcare Service
Supplier
}
Storage
Service
Patient
Supplier
Implants
Replacement knee
Replacement valve
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
Operating Room
9
Healthcare Supply Chain
Distributors
supplies are independent
Distributors for
andmedical-surgical
Wholesalers
intermediaries who operate their own warehouses; they
purchase the products from manufacturers/suppliers to sell
to providers.
Similarly, pharmaceutical intermediaries
purchase the drugs/pharmaceuticals from manufacturers
and wholesale them to pharmacies or to providers. Well
known distributors of pharmaceuticals include
AmriSource/Bergen Brunswig, Cardinal Health/Bindley
Western and McKesson.
The intermediaries are called distributor or wholesalers
depending on whether the products’ final resale has another
layer before reaching the customer (Burns, 2002; p.127).
Cardinal Health, Owens&Minor, and McKesson are major
distribution companies in hospital market.
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
10
Healthcare Supply Chain
Electronic Data Interchange (EDI)
Linking providers through electronic communication to their
distributors is formally defined as electronic data interchange
(EDI).
EDI provides direct, real-time computer to computer electronic
transmission of purchase orders, shipping notices, invoices and the
like between providers and distributors.
Over seventy-five percent of distributors use EDI, and seventy to
eighty percent of their business volume is handled through EDI
(Burns, 2002, pp.130-131).
EDI is also proliferating to manufacturer transactions with other
parts of the health care supply chain; more than one-third of their
business transactions use EDI.
The cost for standardized EDI transactions for a purchase order, as
compared to costs with manual systems, saves operational costs
for both providers and distributors.
Chapter 11: Quantitatve
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Management
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Electronic Data Interchange (EDI)
Increased productivity
 Reduction of paperwork
 Lead time and inventory reduction
 Facilitation of just-in-time systems
 Electronic transfer of funds
 Improved control of operations
 Reduction in clerical labor
 Increased accuracy

0
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Healthcare Supply Chain
Group Purchasing Organizations (GPOs).
Group purchasing organizations provide a critical financial
advantage to providers, especially hospitals and hospital systems,
by negotiating purchasing contracts for products and non-labor
services.
A typical GPO has many hospital organizations as its members and
uses this as collective buying power in negotiating contracts with
many suppliers: of pharmaceuticals, medical-surgical, supplies,
laboratory, imaging, durable medical equipment, facility
maintenance, information technology, insurance, food and dietary
products and services.
The contracts usually last three to five years, giving providers price
protection (Burns, 2002, pp. 60-64).
Chapter 11: Quantitatve
Methods in Health Care
Management
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Healthcare Supply Chain
Group Purchasing Organizations (GPOs).
Over 600 GPOs operate in the United States; perhaps half of them
focus their business on hospitals.
The two largest GPOs are Novation and Premier, which are
nonprofit. AmeriNet, HSCA and Consorta are the other sizable nonprofit GPOs.
The two investor-owned, for-profit GPOs are HCA/Health Trust and
Tenet/BuyPower.
A provider may be member of multiple GPOs. The average Hospital
GPO membership ranges 1.6 to 2.6 GPOs in US.
Chapter 11: Quantitatve
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Management
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Healthcare Supply Chain
e-Distributors.
e-commerce in health care can be viewed from different
perspectives. Here we will concentrate on two aspects:
business to business (B2B) commerce and business to
customer (B2C) commerce.
Examples of B2B firms are: Medibuy, Neoforma, MedAssets,
OmniCell, and Promedix.
These firms provide e-Catalog, e-Request for Proposal (eRFP),
e-Auction, and e-Specials.
Chapter 11: Quantitatve
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Healthcare Supply Chain
Flow of Materials
It is important to note that depending upon the type of
medical supply, the flow of materials in the supply chain
may take more direct routes to providers or end users.
Suppliers may bypass GPOs by not contracting or
negotiating price arrangements.
High-end implants and medical devices, specialty items of
low volume but high price, are good examples of such
medical supplies for which suppliers use direct delivery,
usually via express services (like FedEx, UPS, or DHL) or
have their own local/regional sales representatives make
the just-in-time (JIT) delivery and serve as consultants to
physicians. In some cases, the company’s representatives
provide technical participation with surgeons in implanting
devices surgically.
Other cases in which suppliers may bypass GPOs in
contracting are for small-volume, esoteric items, and for the
brand-name, specialty drugs used to treat cancer and
cardiovascular problems.
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
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Contemporary Issues in Medical Inventory Management
Just-In-Time (JIT) and Stockless Inventories.
Inventory management in healthcare organizations is
becoming increasingly decentralized. JIT means that
goods arrive just before they are needed.
Stockless inventory means obtaining most of supplies
from a single source (a prime vendor) in small
packaging units ready to be taken to the user
departments.
Single versus Multiple Vendors. The essence of the
purchasing function is to obtain the right equipment,
supplies and services, and of the right quality, in the
right quantity from the right source at the right price
at the right time.
Chapter 11: Quantitatve
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Management
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Traditional Inventory Management
Inventory Is. . .
STOCK OR STORE OF GOODS
Or Stock Keeping Items (SKUs)
Chapter 11: Quantitatve
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Management
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An Inventory Disaster!
Imagine the following scenario, in which the healthcare
supply chain manager has to explain to a member of senior
management why the emergency room found itself without
the syringes.
..Sorry sir, but when she (the patient) came into the ER,
we were out of syringes. Our anticipation stocks were
depleted because we hadn’t corrected the ordering
patterns for seasonal variations. Then, the snow delayed
shipments from supplier, and our safety stocks just weren’t
good enough! You know we usually order in bulk to take
advantages of large economic lot size and lower our
ordering cycle. Our last order was especially large because
we wanted to hedge against predicted price increases! In
the final analysis, our inventory just wasn’t sufficient to
permit smooth operations…
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
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The COO’s Response
(i.e., Inventory objectives and requirements)
I hope you do realize that it is
your duty to both maintain a high
level of customer service and
minimize the costs of ordering and
carrying inventory! All I ask of
you is that you make two
fundamental decisions-- when to
order and how much to order.
Chapter 11: Quantitatve
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Effective Inventory Management
The requirements for effective inventory include:
– A system to keep track of inventory
– A reliable forecast of demand
– Knowledge of lead times and lead time variability
– Reasonable estimates of inventory holding costs,
ordering costs, and shortage costs
– A classification system for inventory items
Chapter 11: Quantitatve
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Effective Inventory Management
 Inventory
either:
counting systems can be
– Periodic
– Perpetual


Batch
Line
Chapter 11: Quantitatve
Methods in Health Care
Management
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22
Inventory Counting Systems
 Periodic
System
Physical count of items made at
periodic intervals
 Perpetual
Inventory System
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item
Chapter 11: Quantitatve
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Inventory Counting Systems (Cont’d)
 Two-Bin
System - Two containers
of inventory; reorder when the first
is empty
 Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached
0
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Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
24
Inventory Counting Systems (Cont’d)
The UPCs have
been around since late 1970s and are used in
industry. A UPC can have up to 20 character
numbers that uniquely identify a product, for
example, of pharmaceutical or medical-surgical
supply, using bars with different variety and
thickness that can be read by scanners. The
order of the information in UPCs identifies the
type of product, its manufacturer, and the
product itself.
Universal Product Codes (UPCs).
0
Chapter 11: Quantitatve
Methods in Health Care
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25
Effective Inventory Management
Universal Product Codes (UPCs).
Only 26 percent of medical-surgical products can be scanned on nursing
units, and only fifty percent of drugs have bar codes for unit doses.
According to the final regulation issued by the Food and Drug
Administration (FDA) in 2004, drug manufacturers must adopt bar coding
to single-dose units within two years, and hospitals must eventually
implement bedside scanning systems.
The FDA estimates, however, that it may take up to two decades for all
hospitals to implement such systems because of their high costs: from $.5
to $1 million. Only a few more than 100 hospitals currently them.
Yet bar code systems would significantly improve the quality of patient
care through reduction of medication errors. It is estimated that over a 20year period, fully implemented bar code systems would prevent about .5
million medical errors. Moreover, by improving the cost-efficiency of
medical supply management, hospitals would also reap $90 billion in
savings, which would help to pay for the technology (Becker, 2004).
Chapter 11: Quantitatve
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Management
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Effective Inventory Management
Lead Time
Inventories are used to satisfy demand requirements, so
reliable estimates of the amounts and timing of demand are
essential. It is also essential to know how long it will take for
orders to be delivered (Stevenson, 2002, p.547).
Now that healthcare organizations increasingly rely on their
vendors to maintain adequate inventory levels in their
facilities, their data relevant to demand must be transferred to
their vendors.
Healthcare managers also need to know the extent to which
demand and lead time (the time between submitting an order
and receiving it) may vary; the greater the potential
variability, the greater the need for additional stock to avoid a
shortage between deliveries.
Chapter 11: Quantitatve
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Effective Inventory Management

Costs of Inventory:
– Holding (carrying costs)-- interest,
insurance, depreciation, obsolescence,
deterioration, spoilage, pilferage,
warehousing costs
– Ordering costs-- associated with ordering
and receiving inventory
– Shortage costs-- when demand > supply
on hand; opportunity costs of lost
customers loss of goodwill; death of a
patient and potential lawsuits
Chapter 11: Quantitatve
Methods in Health Care
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Effective Inventory Management
The A-B-C Approach: Classifying inventory according to some
measure of importance and allocating control efforts
accordingly.
60
% of
Annual 40
dollar
volume 20
A
0
20
% of
Items 40
B
C
A relative importance
classification system
– A - very important (1520% of items; 60-70%
of $$$s)
– B - moderate
– C - least important (6070% of items; 10%
$$$s)
Tightest controls and
management should be on
A items
60
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
29
Table 11.1 A-B-C Classification Analysis
Item
Annual
Demand
Unit
Cost
Annual
costs
Percent
of Total
A-B-C
Classification
1
20800
2.50
52000
1.2%
C
2
83200
0.50
41600
1.0%
C
3
9100
37.50
341250
8.0%
B
4
13000
3.50
45500
1.1%
C
5
13000
1.75
22750
0.5%
C
6
790
1290.00
1019100
24.0%
A
7
78000
2.25
175500
4.1%
B
8
114400
0.65
74360
1.8%
C
9
66040
0.95
62738
1.5%
C
10
6240
12.50
78000
1.8%
C
11
11440
2.00
22880
0.5%
C
12
18200
1.50
27300
0.6%
C
13
910
1300.00
1183000
27.9%
A
14
315
2700.00
850500
20.1%
A
15
65000
3.75
243750
5.7%
B
Total Annual Costs
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EOQ Model
ECONOMIC ORDER QUANTITY model-It answers the question, “How much
should I order?” by allowing you to
determine an optimal order quantity in
terms of minimizing the sum of certain
annual costs that vary with order costs.
Remember what the costs are?
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
31
Figure 11.2 The Inventory Order Cycle for Basic EOQ Model
Order Quantity, Q
Level of Inventory
Cycle 1
Cycle 2
Cycle 3
Cycle 4
Q
Depletion or
Demand Rate
Average inventory
Q
2
Q
2
R
(ROP)
0
Required
safety stock
Reorder Point
Reorder Time
Lead Time
Chapter 11: Quantitatve
Methods in Health Care
Management
Time (days)
Order Received
Yasar A. Ozcan
32
Average inventory level and number of orders per year are
inversely related. WHY?
Q
Average Inventory
0
Many orders, but low average inventory.
1 year
Q
Average Inventory
0
Few orders but high average inventory.
Chapter 11: Quantitatve
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Management
Yasar A. Ozcan
33
To refresh memory. .


Basic EOQ models minimize the sum of the
holding and ordering costs of inventory.
Several assumptions are important to use for
the model:
– Only one product is involved
– Annual usage (demand) requirements are
known
– Usage is spread evenly throughout the year
so that usage rates are fairly constant
– Lead time does not vary
– Each order is received as a single delivery
– There are no quantity discounts.
Chapter 11: Quantitatve
Methods in Health Care
Management
Yasar A. Ozcan
34
Holding & Ordering Costs Conceptualized
QH
2
DS
Q
Order Quantity
Carrying costs (H) are linearly
related to order size (Q).
Annual Carrying Cost =
Chapter 11: Quantitatve
Methods in Health Care
Management
Q
H
2
Order Quantity
Ordering costs (S) are inversely
and nonlinearly related to
order size (Q).
Annual ordering costs =
Yasar A. Ozcan
D
S
Q
35
Figure 11.3 The Economic Ordering Quantity Model
Total cost TC  Q H  D S
Annual cost
2
Minimum
TC
Q
Q
Holding cost 2 H
C o'
Co
Qo Flexibility zone for
Packaging requirements
Qo
D
Ordering cost Q S
Order Quantity, Q
Marginal cost for
packaging requirements
Chapter 11: Quantitatve
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Economic Ordering Quantity (EOQ)
Yasar A. Ozcan
36
EOQ Model
ECONOMIC ORDER
QUANTITY model-It answers the
question, “How much
should I order?” by
allowing you to
determine an optimal
Q0.
Chapter 11: Quantitatve
Methods in Health Care
Management
2DS
Qo 
H
Yasar A. Ozcan
37
Example 11.1: Syringe Inventory
An orthopedic physician group practice uses 12cc syringes from
Sherwood for their cortisone injections. During the each of last two
years, 40000 of them were used in the office. Each syringe costs
$1.50. The physician’s office annually discards, on average, 500 of the
syringes that have became inoperable (broken, wrong injection
material, lost). The syringes are stored in a room that occupies 2% of
the storage area. The storage area constitutes 10% of the leased
space. The annual office lease costs $60,000. The group practice can
secure loans from a local bank at 6% interest to purchase the syringes.
For each placed order, it takes about three hours for an office assistant
(whose hourly wage is $9.00 and who receives $3.25 in fringe benefits)
to prepare, and communicate the order, and place its shipment in
storage. In addition, each order’s overhead share of equipment and
supplies (phone, fax, computer, stationary paper) is approximately
$4.50. In the past, the office assistant always placed 5,000 syringes in
each order. The deliveries are made in boxes of 1000 syringes and are
always received three working days after the order is placed.
What should be the EOQ for the 12cc syringe?
What are the inventory management costs for these syringes?
What are the investment costs?
How many times in a year should an order be placed?
Chapter 11: Quantitatve
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Solution:
To calculate EOQ, we need to estimate the holding and ordering costs.
Annual holding cost
1) Cost of inoperable syringes – 1.50 * 500 = $750.
2) Storage cost – (60000 Lease) * .10 (storage area) * .02 (syringe) = $120.
3) Interest on a loan used to purchase 5000 syringes: 5000 *1.5*.06 = $450.
Total annual holding costs = 750 + 120 + 450 = 1320.
Annual holding cost per syringe: 1320 ÷ 40000 = $.033.
Ordering cost
Office assistant’s time – 3 hours * (9.00+3.25) = $36.75.
Overhead – $4.50.
Total ordering cost – $36.75 + $4.50 = $41.25.
Using formula the EOQ formula:
Qo 
Q0 
Chapter 11: Quantitatve
Methods in Health Care
Management
2DS
H
2 * 40000 * 41.25
 10,000
.033
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Solution:
Total inventory management cost calculated using formula:
TC 
10000
40000
.033 
41.25 or
2
10000
TC  165.00  165.00  $330.00.
Investment cost:
Investment costs = Order quantity * price of the item, or
= Qo * p = 10000 * 1.50 = $15,000.00.
Investment cost is the amount committed to purchase the
syringes. It is cycled as the cost of the syringes is recovered
from patients and/or third party payers.
Order Frequency is calculated using formula:
Length  of  Order  Cycle 
Q0 10000

 .25 yearsor everythreemonths
40000
D
In other words, order frequency is four times a year.
Chapter 11: Quantitatve
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Summary
The two decisions were how much to order, and
when to order. To determine how much to order,
you use an EOQ model that minimizes the sum of
the total ordering and carrying costs.
When to order?
Should we order when you are almost out
of inventory?!
Chapter 11: Quantitatve
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When to Order?



The reorder point occurs when the
quantity on hand drops to a
predetermined amount.
There are 4 determinants of the
reorder point quantity:
– Rate of demand
– Length of lead time
– Extent of demand and lead
time variability
– Degree of stock-out risk
acceptable to management.
Demand Rates and Lead Times
can be constant or variable.
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Constant Demand Rate and Lead Time
There is no risk of a stock-out created by increased demand of
lead times longer than expected. Thus, ROP equals the
product of usage rate and lead time; no cushion stock is
necessary.
Example 11.2
An orthopedist surgeon replaces two hips per day. The
implants are delivered two days after an order is
placed, via express delivery. When should the supply
chain manager order the implants?
Solution:
Usage = 2 implants daily.
Lead Time = 2 days.
ROP = Usage  Lead Time = 2 * 2 = 4.
Thus, order should be placed when 4 implants are left!
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Variable Demand Rates and/or Variable Lead Times
Safety Stock-- stock held in excess of expected demand
when demand rate and/or lead time is variable
ROP = Expected demand during lead time + safety stock
Example 11.3
A dentist office uses an average of 2 boxes of
gloves (100-glove boxes) per day, and lead
times average 5 days. Because both the
usage rate and lead times are variable, the
office carries a safety stock of 4 boxes of gloves.
Determine the ROP.
Solution:
ROP = 2 boxes/daily  5 day lead time + 4 boxes
ROP = 14 boxes.
Chapter 11: Quantitatve
Methods in Health Care
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Variable Demand Rates and/or Variable Lead Times

Service Level-- probability that demand will not exceed
supply during lead time.

Service level is the complement of stock-out risk; 95%
service level means a 5% risk of stock-out.

The greater the variability in either demand rate or lead
time, the greater the amount of safety stock needed to
achieve that service level.
Chapter 11: Quantitatve
Methods in Health Care
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Summary Again



The two decisions were how
much to order, and when to
order.
To determine how much to order,
you use an EOQ model that
minimizes the sum of the total
ordering and carrying costs.
When to order is determined by
a reorder point model, and varies
according to knowledge of lead
times and demand.
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The End
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