&
Risk Pooling
Introduction
Operational
Need
Inventory
0
1000 2000 3000 4000 5000 6000
Assuming demand certainty
Single Period Model
Without Initial Inventory
Case: Swimsuit Production
5%
0%
8000 10000 12000 14000 16000 18000
Unit sales
Scenario Two:
Suppose you make 12,000 jackets and demand ends up
being 11,000 jackets.
Profit = 125(11,000) - 80(12,000) - 100,000 + 20(1000) =
$ 335,000
Swimsuit Best Questions ?
Expected Profit
$400,000
$300,000
Profit
$200,000
$100,000
$0
8000 12000 16000 20000
Order Quantity
Expected Profit
$400,000
$300,000
Profit
$200,000
$100,000
$0
8000 12000 16000 20000
Order Quantity
Case: Swimsuit Production
60%
50%
40%
0.28 0.28
30% 0.22
20%
0.11 0.11 0.11
10%
00 0 0 00 00 0 0 00
0%
-1E+05
-3E+05
-2E+05
10000
20000
40000
60000
30000
50000
0
Cost
Key Points from this Case
The optimal order quantity is not necessarily equal to
average forecast demand
The optimal quantity depends on the relationship between
marginal profit and marginal cost
As order quantity increases, average estimated profit first
increases and then decreases
As production quantity increases, risk increases. In other
words, the probability of large gains and of large losses
increases
Single Period Model With
Initial Inventory
Initial Inventory
Suppose that one of the jacket designs is a
model produced last year.
Some inventory is left from last year
Assume the same demand pattern as before
If only old inventory is sold, no setup cost
200000
100000
0
5000
7000
8000
6000
9000
10000
11000
12000
13000
14000
15000
16000
P r oduc tion Q ua ntity
The case motivates a powerful (s,S) inventory policy (or a min max
policy): s is the reorder point and S is the order-up-to-level
Multi-Order Opportunities
under Uncertainties
Inventory Policies
Continuous review policy
in which inventory is reviewed every day (or every unit of
time) and a decision is made about whether and how much
to order.
Q
Inventory level
Reorder
point, R
0
LT LT
Time
Result of
uncertainty
Reorder Point with a Safety Stock
Inventory level
Q
Reorder
point, R
Safety Stock
0
LT LT
Time
The amount of safety stock needed is based on the degree of
uncertainty in the lead time demand and desired customer service level
Determinants of the Reorder Point
Market One
Supplier Warehouse
Market Two
ns:
the same service level, which system will require more inventor
the same total inventory level, which system will have better se
What is Risk Pooling?
• Product pooling
• Capacity pooling
Lead Time Pooling
Store 1
Supplier
Store 100
Lead Time Pooling
Store 1
Retail DC
Store 100
Capacity Pooling
3 Links – no flexibility
Capacity Pooling
Location Pooling reduce demand variability creates distance between inventory and
customers
Lead Time Pooling decrease lead time extra costs of operating distribution center
Market 1
D1+D2: (µ , σ 2)
Warehouse
Market 2
σσ ≤≤ σσ 1+ σ 2
1+σ
2
µ = µ 1+ µ 2
σ = ??1. If D1, D2 positively correlated, ρ > 0
2. If D1, D2 are independent, ρ = 0
nclusions:
nclusions: 3. If D1, D2 negatively correlated, ρ < 0
tdev of
Stdev ofaggregated
aggregateddemand
demandisis σ
ess
essthan
thanthe
thesum
sumofofstdev
stdevof
ofindividual
individual
emands σ 1+σ 2
emands
fdemands
demandsare areindependent
independentor or σ 12 + σ 22
egatively correlated,
negatively correlated, the
thestd
stdofof
ggregated demand
aggregated demandisismuch
muchless
less
ρ
As (safety) stock is based on standard deviation -1 0 1
Square Root Law: stock for combined demands N.C. Ind. P.C.
usually less than the combined stocks
Risk Pooling –
Effect of Coefficient of Variation
The higher the C.V. of demand observed in one
market, the greater the benefit from risk pooling
Service Level
Overhead
Costs Facility/Labor cost
Responsiveness to customers
(lead time)
Inbound transportation cost
(from factories to warehouses)
PART 6 8 PART 4
32 55
CHARLESTON ($2) BALTIMORE ($220)
32 5
8
PART 7
14
CHARLESTON ($30)
14
PART 6 8 PART 4
32 55
CHARLESTON ($2) BALTIMORE ($220)
32 5
8
PART 7
14
CHARLESTON ($30)
14
Produce to order
Long CST to customer
No inventory held in system
A Pure Push System
PART 2
14
CHARLESTON ($7)
8
14
PART 6 8 PART 4
32 55
CHARLESTON ($2) BALTIMORE ($220)
32 5
8
PART 7
14
CHARLESTON ($30)
14
Produce to forecast
Zero CST to customer
Hold lots of finished goods inventory
A Hybrid Push-Pull System
PART 2
7
CHARLESTON ($7)
8
14
PART 6 8 PART 4
32 5
CHARLESTON ($2) BALTIMORE ($220)
32 5
8
PART 7
CHARLESTON ($30)
14
push/pull boundary
14
$6,000
$4,000
Supplier
Warehouse
echelon
inventory
Warehouse
echelon lead
time Warehouse
Retailers
Managing Inventory in the Supply
Chain
How should the reorder point associated with the warehouse
echelon inventory position be calculated? The reorder point
is
s = L × AVG + z × STD
e e
L
where Le = echelon lead time, defined as the lead time between the
retailers and the warehouse plus the lead time between the
warehouse and its supplier
AVG = average demand across all retailers (i.e., the
average of the aggregate demand)
STD = standard deviation of (aggregate) demand across
all retailers
Forecasting
Isnever accurate
Nevertheless, forecast is critical
General Overview:
Judgment methods
Market research methods
Causal methods
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