Operations Strategy

Case Study: Managing Inventory at ALKO Inc

Irawati Cipto 1206186522

Dame Reiny Manalu - 1206185570
Ali Yudhi Hartanto - 1206185053
Azhar Harris 1206185356

Magister Manajemen
Fakultas Ekonomi, Universitas Indonesia
Jakarta, 2013
1

Case Synopsis
ALKO began in 1943 in a garage workshop set up by John Williams at his
Cleveland home. In February 1948, he obtained a patent for one of his lighting
design for lighting fixtures. He decided to produce it in his workshop and tried
marketing it in the Cleveland area. The product sold well and by 1957, ALKO had
grown to a $3 million company. Its lighting fixtures were well known for their
outstanding quality. By then, it sold a total of 5 products.
ALKO go public in 1963. Since then, ALKO has been very successful, and the
company has started distributing its products nationwide. As competition intensified
in the 1980s, ALKO introduced many new lighting fixture designs. Altough ALKO had
taken great care to ensure that product quality did not suffer, the companys
profitability began to worsen. The problem was that margins had begun to shrink as
competition in the market intensified.
The board decided to reorganized starting at the top. Gary Fisher was hired to
reorganize and restructure the company in 1999. Fisher found a company teetering
on the edge. Fisher then analyzed that the key was in the operating performance.
Altough the company had always been outstanding at developing and producing new
products, it had historically ignored its distribution system. Fisher set up a task force
to review the companys current distribution system.

Problems Identification
The problem identification for managing inventories at ALKO :
1) What is the annual inventory and distribution cost of the current distribution
system?
2) What are the savings that would result from following the task force
recommendation and setting up an NDC? Evaluate the savings as the
correlation coefficient of demand in any pair of regions varies from 0 to 0.5 to
1.0. Do you recommend setting up a NDC?
3) Suggest other options that Fisher should consider. Evaluate each option and
recommend a distribution system for ALKO that would be most profitable
2

Theory
Inventory is the stock of any item or resource used in an organization. An
inventory system is a set of policies and procedures that determines what inventory
levels should be maintained, when stock should be replenished and how large
orders should be.
Managing inventory types include :
a. Raw materials
b. Work in process inventory (include componet parts)
c. Finished products inventory
Inventory is created when supply exceeds the demand. The purpose of
holding inventory is to achieve economies of scale, protect suppliers from stockout
due to uneven and uncertain demand, and shelter demand variation during leadtime.
Inventory:
a. Cycle Inventory
Cycle inventory is the inventory that accrues in the supply chain as the result
of purchasing or producing larger lots than currently demanded by customers.
b. Safety Inventory
Safety inventory is created to protect against fluctuations and uncertainty in
demand, supply, and lead time. There are two major sources of uncertainty :
quantity and timing
c. Seasonal Inventory
When demand is seasonal, seasonal inventory is created to absorb uneven
rates of demand.
d. In Transit Inventory
In transit inventory is a function of demand during lead time. In transit
inventory provides a safeguard during supply delivery time.
Inventory Costs:
Inventory is used to improve customer Service Level. Money invested in inventory is
an opportunity cost to company and its supply chain. The supply chain manager
needs to balance the advantage and disadvantage of both low and high inventory.
There are two major costs associated with inventory. One is holding cost and the
3

other is ordering or set up cost. The primary reason for keeping inventory low is due
to the cost of holding inventory. Money invested in inventory cannot be used for
other investment. The primary reason for keeping inventory high is due to the cost of
replenishing inventory. Ordering cost or set up cost are the two major costs.
a. Managing Inventory Cost
Economic Order Quantity (EOQ)
EOQ is to minimize total annual ordering cost and inventory holding cost through
ordering an optimal lot size and achieve economies of scale. The EOQ is found
by determined the minimum cost point. Making holding cost equals ordering cost
will give the optimal quantity.
Q
D
H = S
2
Q

Economic Order Quantity (EOQ) =

2DS
H

Q = order quantity
D = annual demand
S = cost to place an order or set up cost in manufacturing/per order
H = annual holding cost per unit
Inventory Replenishment Reorder Point System
Reorder point system which is also known as Continuous Review System is an
inventory policy that tracks inventory position. Whenever inventory level reaches
the reorder point, an order is placed to replenish inventory. The reorder point has
two components :
(1) average demand during leadtime
(2) safety stock
Inventory Replenishment Periodic Review System
Periodic review system is to review inventory position in a fixed time interval. The
inventory system simplifies delivery schedule because it follows a routine
replenishing cycle. A periodic review system also has two components :

(1) average demand during lead time plus fixed time interval
(2) safety stock
b. Improving Customer Service Level Managing Safety Stock
There are two reasons to keep safety stock. The first reason for keeping safety
stock is to protect against demand variation. Safety stock is related to forecasting
error in demand. The second reason for keeping safety stock is to protect against
time and quantity variation from the supply side.

Case Analysis
The current distribution system at Alco :

All production occured at 3 facilities located in the Cleveland area.

The plants scheduled production based on DC order.

Orders were transported from plants to the DCs in TL quantities because

order sizes tended to be large. In 1999, TL costs from the plants to DCs
averaged $0.09 per unit.

Customer placed orders with the DCs.

Shipment from DC to customers were LTL. LTL shipping costs from DC to

customer averaged $0.10 per unit.

DC ordered using a periodic review policy with a reorder interval of 6 days.

Lead time 5 days between the time a DC placed an order with a plant and the
time the order was delivered from the plant.

Holding cost $0.15 per unit per day.

All DCs carried safety inventories to ensure a CSL of 95%.

Alternative Distibution System for Alco :

ALKO closed its current 5 DC.

ALKO build a National Distribution Center (NDC) outside Chicago.

Costs from Plant to NDC $0.05 per unit.

Shipment cost from NDC to customer $ 0.24 per unit.

Total replenishment for NDC still five days.

The CLS out of NDC still continued 95%.

Solutions:

Summary of investment and annual cost for various options

Option

Investment Annual Cost Savings from Base Case Rate of return NPV(10% )

Decentralize all parts in five warehouses Base Case

960,326

Centralize all parts at NDC

$ 850,000 $

755,164 $

205,162

24.1% $ 1,406,777

Centralize parts 3, 7, decentralize part 1

$ 650,000 $

765,064 $

195,262

30.0% $ 1,497,884

v From the demand data and given data for the current distribution system, we can
calculate annual inventory and distribution cost of the current distribution system.
The worksheet for annual inventory and distribution cost is in Appendix. After we
calculate, the annual inventory and distribution cost for current distribution system
is $960.326 (see exhibit 1)
v Then we calculate the cost for NDC. After we calculate, the cost for centralized all
parts at NDC is $755.164. So we can have saving $205.162 compare with base
cost DC (see exhibit 2).
v Another option is proposed, Centralize parts 3, 7, decentralize part 1. Total cost =
$765.064. Saving from base cost DC = $960.326 - $765.064 = $ 195.262 (see
exhibit 3).

Conclusion and Recommendation

Conclusion:
Inventory is strategic importance to Supply Chain Management.
Inventory is created when supply exceeds the demand. The purpose of holding
inventory is to achieve economies of scale, protect suppliers from stockout due to
uneven and uncertain demand, and shelter demand variation during leadtime.
The supply chain manager needs to balance the advantage and disadvantage of
both low and high inventory. The primary reason for keeping inventory low is due
to the cost of holding inventory. Money invested in inventory cannot be used for
other investment. The primary reason for keeping inventory high is due to the
cost of replenishing inventory.

 In order to managing inventory cost, there are several ways : EOQ, Inventory
Replenishment Reorder point system, Inventory Replenishment periodic
review system.
There are two reasons to keep safety stock. The first reason for keeping safety
stock is to protect against demand variation. Safety stock is related to forecasting
error in demand. The second reason for keeping safety stock is to protect against
time and quantity variation from the supply side.
ALKO should review its current distribution system in order to reduce cost but still
maintain the CSL of 95%.
Recommendation:

After analyzed the calculation for current distribution system, we recommend

ALKO to build a National Distribution Center (NDC). If we compare the cost from
current distribution system and proposal for build NDC, we can conclude that
NDC will reduce the cost of distribution system for ALKO.

ALKO can also make several options to reduce cost of distribution system such
as combine : centralize parts 3, 7, decentralize part 1. But however this cost for
centralize and decentralize decision still higher than centralize all parts at NDC.

Refferences:
1. Chopra, S. & Meindl, P. (2007). Supply Chain Management: Strategy,
Planning & Operations, 3rd Edition, New Jersey: Pearson Prentice Hall
2. Li, L. (2007). Supply Chain Management: Concepts, Techniques & Practices,
Singapore: World Scientific Publishing Co

Appendix
Exhibit 1. The annual inventory and distribution cost of the current distribution system
Inputs
Holding cost, H =
TL costs from plants to DCs =
LTL costs from DC to customers =
TL costs from plants to central whse. =
LTL cost from central whse. to cust. =
Reorder Interval, T =
Lead Time, L =
Target cycle service level, CSL =
Correlation Coefficient =

Demand data by part and region

# of parts
Part 1 Mean, R
10
Part 1 SD
Part 3 Mean
20
Part 3 SD
Part 7 Mean
70
Part 7 SD

$
$
$
$
$

0.15
0.09
0.10
0.05
0.24
6
5
0.95
0

per unit and day

per unit
per unit
per unit
per unit
days
days

Region 1
Region 2
Region 3
Region 4
Region 5 All Regions
35.48
22.61
17.66
11.81
3.36
90.92
6.98
6.48
5.26
3.48
4.49
NA
2.48
4.15
6.15
6.16
7.49
26.43
3.16
6.20
6.39
6.76
3.56
NA
0.48
0.73
0.80
1.94
2.54
6.49
1.98
1.42
2.39
3.76
3.98
NA

Coefficient of variation by part and region

Region 1
Region 2
Region 3
Part 1
0.20
0.29
0.30
Part 3
1.27
1.49
1.04
Part 7
4.13
1.95
2.99

Region 4
Region 5 All Regions
0.29
1.34
NA
1.10
0.48
NA
1.94
1.57
NA

Demand during reorder interval and replenishment lead time

Region 1
Region 2
Region 3
Region 4
Region 5
All Regions
Part 1 Mean
390.28
248.71
194.26
129.91
36.96
1000.12
Part 1 SD
23.15
21.49
17.45
11.54
14.89
NA
Part 3 Mean
27.28
45.65
67.65
67.76
82.39
290.73
Part 3 SD
10.48
20.56
21.19
22.42
11.81
NA
Part 7 Mean
5.28
8.03
8.80
21.34
27.94
71.39
Part 7 SD
6.57
4.71
7.93
12.47
13.20
NA

Outputs
Cycle stock and required safety stock by part and region
Region 1
Region 2
Part 1Cycle Inventory
106.44
67.83
Part 1 SS
38.08
35.35
Part 3 Cycle Inventory
7.44
12.45
Part 3 SS
17.24
33.82
Part 7 Cycle Inventory
1.44
2.19
Part 7 SS
10.80
7.75

Region 3
52.98
28.70
18.45
34.86
2.40
13.04

Region 4
35.43
18.98
18.48
36.88
5.82
20.51

Region 5 All Regions

10.08
272.76
24.49
145.60
22.47
79.29
19.42
142.22
7.62
19.47
21.71
73.81

Costs per unit by region and part

Inventory cost
Transportation cost
Total cost part 1
Inventory cost
Transportation cost
Total cost part 3
Inventory cost
Transportation cost
Total cost part 7

Region 1
$
0.61
$
0.19
$
0.80
$
1.49
$
0.19
$
1.68
$
3.83
$
0.19
$
4.02

Region 2
$
0.68
$
0.19
$
0.87
$
1.67
$
0.19
$
1.86
$
2.04
$
0.19
$
2.23

Total Annual Inventory and Distribution Cost

# of parts Region 1
Region 2
Part 1
10
$103,729
$72,171
Part 3
20
$30,463
$56,425
Part 7
70
$49,246
$41,626
All Parts
$183,439
$170,223

Region 3
$
0.69
$
0.19
$
0.88
$
1.30
$
0.19
$
1.49
$
2.89
$
0.19
$
3.08

Region 3
$56,964
$66,904
$63,051
$186,920

Region 4
$
0.69
$
0.19
$
0.88
$
1.35
$
0.19
$
1.54
$
2.04
$
0.19
$
2.23

Region 4
$37,982
$69,161
$110,336
$217,479

Region 5
$
1.54
$
0.19
$
1.73
$
0.84
$
0.19
$
1.03
$
1.73
$
0.19
$
1.92

All Regions
$
0.69
$
0.19
$
0.88
$
1.26
$
0.19
$
1.45
$
2.16
$
0.19
$
2.35

Region 5 All Regions

$21,260
$292,107
$56,259
$279,213
$124,747
$389,005
$202,266 $960,326

Exhibit 2. The savings that would result from following the task force recommendation

and setting up an NDC

Inputs
Holding cost, H =
TL costs from plants to DCs =
LTL costs from DC to customers =
TL costs from plants to central whse. =
LTL cost from central whse. to cust. =
Reorder Interval, T =
Lead Time, L =
Target cycle service level, CSL =
Correlation Coefficient =

$
$
$
$
$
$
$
$
$

0.15
0.09
0.10
0.05
0.24
6.00
5.00
0.95
-

per unit and day

per unit
per unit
per unit
per unit
days
days

Demand data by part and region

# ofRegion
parts 1 Region 2 Region 3 Region 4 Region 5 All Regions
Part 1 Mean
#
35.48
22.61
17.66
11.81
3.36
90.92
Part 1 SD
6.98
6.48
5.26
3.48
4.49
NA
Part 3 Mean
#
2.48
4.15
6.15
6.16
7.49
26.43
Part 3 SD
3.16
6.20
6.39
6.76
3.56
NA
Part 7 Mean
#
0.48
0.73
0.80
1.94
2.54
6.49
Part 7 SD
1.98
1.42
2.39
3.76
3.98
NA

Central
90.91
12.27
26.43
12.15
6.49
6.45

Demand during reorder interval and replenishment lead time

Region 1 Region 2 Region 3 Region 4 Region 5 All Regions
Part 1 Mean
390.28
248.71
194.26
129.91
36.96
1000.12
Part 1 SD
23.15
21.49
17.45
11.54
14.89
NA
Part 3 Mean
27.28
45.65
67.65
67.76
82.39
290.73
Part 3 SD
10.48
20.56
21.19
22.42
11.81
NA
Part 7 Mean
5.28
8.03
8.80
21.34
27.94
71.39
Part 7 SD
6.57
4.71
7.93
12.47
13.20
NA

Central
1000.01
40.71
290.73
40.30
71.39
21.40

Outputs
Cycle stock and required safety stock by part and region
Region 1 Region 2 Region 3 Region 4 Region 5 All Regions
Part 1Cycle Inventory
106.44
67.83
52.98
35.43
10.08
272.76
Part 1 SS
38.08
35.35
28.70
18.98
24.49
145.60
Part 3 Cycle Inventory
7.44
12.45
18.45
18.48
22.47
79.29
Part 3 SS
17.24
33.82
34.86
36.88
19.42
142.22
Part 7 Cycle Inventory
1.44
2.19
2.40
5.82
7.62
19.47
Part 7 SS
10.80
7.75
13.04
20.51
21.71
73.81

Central
272.73
66.96
79.29
66.28
19.47
35.20

Costs per unit by region and part

Region 1
Inventory cost
$
0.61
Transportation cost
$
0.19
Total cost part 1
$
0.80
Inventory cost
$
1.49
Transportation cost
$
0.19
Total cost part 3
$
1.68
Inventory cost
$
3.83
Transportation cost
$
0.19
Total cost part 7
$
4.02

Central
$
0.56
$
0.29
$
0.85
$
0.83
$
0.29
$
1.12
$
1.26
$
0.29
$
1.55

10

Region 2
$
0.68
$
0.19
$
0.87
$
1.67
$
0.19
$
1.86
$
2.04
$
0.19
$
2.23

Region 3
$
0.69
$
0.19
$
0.88
$
1.30
$
0.19
$
1.49
$
2.89
$
0.19
$
3.08

Region 4
$
0.69
$
0.19
$
0.88
$
1.35
$
0.19
$
1.54
$
2.04
$
0.19
$
2.23

Region 5
$ 1.54
$ 0.19
$ 1.73
$ 0.84
$ 0.19
$ 1.03
$ 1.73
$ 0.19
$ 1.92

All Regions
$
0.69
$
0.19
$
0.88
$
1.26
$
0.19
$
1.45
$
2.16
$
0.19
$
2.35

Total Annual Inventory and Distribution Cost

# ofRegion
parts 1 Region 2 Region 3 Region 4 Region 5 All Regions
Central Savings
Part 1
$103,729 $72,171 $56,964 $37,982 $21,260
$292,107
$282,208
$9,899
Part 3
$30,463 $56,425 $66,904 $69,161 $56,259
$279,213
$215,356 $63,857
Part 7
$49,246 $41,626 $63,051 $110,336 $124,747
$389,005
$257,600 $131,405
$755,164
All Parts
$183,439 $170,223 $186,920 $217,479 $202,266 $960,326
Savings: $205,162
Cost Savings from Centralization as a function of the correlation coefficient and target cycle service level
Correlation Cofficiant
0.25

0.9

0.50

$144,599

$74,213

$19,155 -$27,633

-$69,035

0.91

$154,468

$80,830

$23,229 -$25,720

-$69,035

0.92

$165,190

$88,019

$27,655 -$23,642

-$69,035

0.93

$176,979

$95,924

$32,521 -$21,357

-$69,035

0.94

$190,145 $104,752

$37,956 -$18,806

-$69,035

0.95

$205,162 $114,821

$44,155 -$15,896

-$69,035

0.96

$222,804 $126,651

$51,438 -$12,477

-$69,035

0.97

$244,493 $141,194

$60,391

-$8,273

-$69,035

0.98
0.99

$273,324 $160,526
$318,766 $190,996

$72,293
$91,052

-$2,686
$6,121

-$69,035
-$69,035

Type 1 only

1.00

$9,899
0.9
0.91
0.92
0.93
0.94
0.95
0.96
0.97
0.98
0.99

0.00
$389
$1,939
$3,622
$5,474
$7,541
$9,899
$12,670
$16,076
$20,603
$27,739

Correlation Cofficient
0.25
0.50
0.75
-$10,751 -$19,388 -$26,701
-$9,716 -$18,752 -$26,403
-$8,591 -$18,061 -$26,079
-$7,355 -$17,301 -$25,722
-$5,974 -$16,453 -$25,324
-$4,399 -$15,485 -$24,871
-$2,548 -$14,348 -$24,337
-$273 -$12,950 -$23,682
$2,751 -$11,091 -$22,810
$7,517
-$8,162 -$21,437

1.00
-$33,159
-$33,159
-$33,159
-$33,159
-$33,159
-$33,159
-$33,159
-$33,159
-$33,159
-$33,159

$63,857
0.9
0.91
0.92
0.93
0.94
0.95
0.96
0.97
0.98
0.99

0.00
$45,492
$48,484
$51,736
$55,311
$59,304
$63,857
$69,207
$75,785
$84,528
$98,308

Correlation Cofficient
0.25
0.50
0.75
$24,074
$7,384
-$6,776
$26,077
$8,616
-$6,197
$28,254
$9,955
-$5,569
$30,647
$11,427
-$4,878
$33,319
$13,071
-$4,107
$36,368
$14,947
-$3,227
$39,949
$17,150
-$2,193
$44,352
$19,858
-$922
$50,205
$23,458
$767
$59,429
$29,133
$3,430

1.00
-$19,294
-$19,294
-$19,294
-$19,294
-$19,294
-$19,294
-$19,294
-$19,294
-$19,294
-$19,294

$131,405
0.9
0.91
0.92
0.93
0.94
0.95
0.96
0.97
0.98
0.99

Correlation Cofficient
0.00
0.25
0.50
0.75
$98,719
$60,890
$31,159
$5,844
$104,045
$64,469
$33,365
$6,880
$109,832
$68,357
$35,761
$8,006
$116,194
$72,632
$38,395
$9,243
$123,300
$77,407
$41,338 $10,626
$131,405
$82,852
$44,693 $12,202
$140,927
$89,250
$48,636 $14,054
$152,632
$97,115
$53,483 $16,331
$168,193 $107,571
$59,926 $19,357
$192,719 $124,050
$70,081 $24,128

1.00
-$16,582
-$16,582
-$16,582
-$16,582
-$16,582
-$16,582
-$16,582
-$16,582
-$16,582
-$16,582

Type 3 only

Type 7 only

11

0.75

Target Cycle Service Level

0.00

Target Cycle Service Level

$205,162

Target Cycle Service Level

Target Cycle Service Level

All parts

Exhibit 3. Other option to be considered: building NDC while keeping the Regional DCs open
Inputs
Holding cost =
TL costs from plants to DCs =
LTL costs from DC to customers =
TL costs from plants to central whse. =
LTL cost from central whse. to cust. =
Reorder Interval =
Lead Time =
Target cycle service level =
Correlation Coefficient =

$
$
$
$
$

0.15
0.09
0.10
0.05
0.24
6
5
0.95
0

per unit and day

per unit
per unit
per unit
per unit
days
days

Demand data by part and region

# of partsRegion 1
Region 2
Region 3
Region 4
Region 5
All Regions
Part 1 Mean
10
35.48
22.61
17.66
11.81
3.36
90.92
Part 1 SD
6.98
6.48
5.26
3.48
4.49
NA
Part 3 Mean
20
2.48
4.15
6.15
6.16
7.49
26.43
Part 3 SD
3.16
6.20
6.39
6.76
3.56
NA
Part 7 Mean
70
0.48
0.73
0.80
1.94
2.54
6.49
Part 7 SD
1.98
1.42
2.39
3.76
3.98
NA

Coefficient of variation by part and region

Region 1
Region 2
Region 3
Region 4
Region 5
All Regions
Part 1
0.20
0.29
0.30
0.29
1.34
NA
Part 3
1.27
1.49
1.04
1.10
0.48
NA
Part 7
4.13
1.95
2.99
1.94
1.57
NA

Demand during reorder interval and replenishment lead time

Region 1
Region 2
Region 3
Region 4
Region 5
Part 1 Mean
390.28
248.71
194.26
129.91
36.96
Part 1 SD
23.15
21.49
17.45
11.54
14.89
Part 3 Mean
Part 3 SD
Part 7 Mean
Part 7 SD

12

Central

290.73
40.30
71.39
21.40

Outputs
Cycle stock and required safety stock by part and region
Region 1
Region 2
Part 1Cycle Stock
106.44
67.83
Part 1 SS
38.08
35.35
Part 3 Cycle Stock
Part 3 SS
Part 7 Cycle Stock
Part 7 SS

Region 3
52.98
28.70

Region 4
35.43
18.98

Region 5 Central
10.08
24.49
79.29
66.28
19.47
35.20

Costs per unit by region and part

Region 1
Region 2
Region 3
Region 4
Region 5
Inventory cost
$
0.61 $
0.68 $
0.69 $
0.69 $
1.54
Transportation cost
$
0.19 $
0.19 $
0.19 $
0.19 $
0.19
Total cost part 1
$
0.80 $
0.87 $
0.88 $
0.88 $
1.73
Inventory cost
Transportation cost
Total cost part 3
Inventory cost
Transportation cost
Total cost part 7

Total Annual Inventory and Distribution Cost

# of parts Region 1
Region 2
Part 1
10
$103,729
$72,171
Part 3
20
Part 7
70
All Parts
$103,729
$72,171

Target Cycle Service Level

Benchmark:

13

All parts in the field:

All partscentralized:

$765,064
0.9
0.91
0.92
0.93
0.94
0.95
0.96
0.97
0.98
0.99

0.00
$701,631
$711,968
$723,197
$735,545
$749,335
$765,064
$783,542
$806,259
$836,457
$884,053

Costs
$960,326
$755,164

Region 3
$56,964

$56,964

Region 4
$37,982

Region 5
$21,260

$37,982
$21,260
Total logistic system:

Savings
$195,262
-$9,899

Correlation Cofficient
0.25
0.50
0.75
$760,877
$807,298
$846,772
$773,951
$822,516
$863,814
$788,154
$839,049
$882,328
$803,771
$857,228
$902,685
$821,213
$877,530
$925,421
$841,106
$900,686
$951,351
$864,477
$927,890
$981,815
$893,209
$961,335 $1,019,267
$931,403 $1,005,794 $1,069,054
$991,601 $1,075,866 $1,147,523

1.00
$881,717
$900,373
$920,641
$942,926
$967,815
$996,202
$1,029,552
$1,070,552
$1,125,054
$1,210,956

Central

$
$
$
$
$
$

0.83
0.29
1.12
1.26
0.29
1.55

Central
$0
$215,356
$257,600
$472,956

$765,064