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Inventory Management

&
Risk Pooling
Introduction

General Motors in 1984:


 Logistic network consisted of 20,000 supplier plants, 133
parts plants, 31 assembly plants, and 11,000 dealers.
 Freight transportation costs were about $4.1 billion, of
which 60 percent for material shipments.
 GM inventory was valued at $7.4 billion, of which 70
percent was WIP and the rest was finished vehicles.
Response:-
Inventory Management in Supply Chain
Goals of Inventory Management

Reduce Cost, Improve Service


 By effectively managing inventory:
 GM has reduced parts inventory and transportation costs
Inventory Levels Financial
by 26% annually Investment
 Xerox eliminated $700 million inventory from its supply
chain
 Wal-Mart became the largest retail company utilizing
efficient inventory management

Operational
Need
Inventory

 Where do we hold inventory?


 Suppliers and manufacturers
 warehouses and distribution centers
 retailers

 Types of Inventory: General classification


 WIP
 raw materials
 finished goods
Functions of Inventory

To meet anticipated demand


To smooth production requirements
To decouple operations
To protect against stock-outs
To take advantage of order cycles
To help hedge against price increases
To take advantage of quantity discounts
Factors Affecting Inventory Policy

 Demand Characteristics: known in advance or random


 Lead Time
 Number of Different Products Stored in the Warehouse
 Economies of scale offered by suppliers & transport
companies
 Length of Planning Horizon
 Service level desired
Economic Order Quantity Model

Economic Order Quantity ts


350 l C os
a
300 Tot
o sts
250 g C
r y in
r
200 r Ca
Trade-offs o
between setup costs and iinventory
g holding costs,
n
150 o ld
but ignores issues such as demand
H uncertainty and forecasting.
100
50 Ordering (Acquisition)Costs

0
1000 2000 3000 4000 5000 6000
Assuming demand certainty
Single Period Model
Without Initial Inventory
Case: Swimsuit Production

■ A company designs, produces, and sells summer fashion


items such as swimsuits.
■ The company has to commit itself six months before summer
to specific production quantities for all its products
– predicting demand for each product.
■ The trade-offs are clear: overestimating customer demand
will result in unsold inventory while underestimating
customer demand will lead to inventory stockouts and
loss of potential customers.
Demand forecast
30%
■The marketing department
28%
uses historical data from the last
25%
five years, current economic
22% conditions, and other factors to
20%
construct a probabilistic forecast
18%of the demand.
15%
11% 11% 10%
10%

5%

0%
8000 10000 12000 14000 16000 18000
Unit sales

forecast averages about 13,000


Swimsuit Costs

 Production cost per unit (C): $80

 Selling price per unit (S): $125

 Salvage value per unit (V): $20

 Fixed production cost (F): $100,000

 Q is production quantity, D: demand

 Profit = Revenue - Variable Cost - Fixed Cost + Salvage


Swimsuit Two Scenarios
 Scenario One:
 Suppose you make 12,000 jackets and demand ends up
being 13,000 jackets.
 Profit = 125(12,000) - 80(12,000) - 100,000 = $440,000

 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 ?

 Findorder quantity that maximizes


weighted average profit?

 Willthis quantity be less than, equal to, or


greater than average demand?
How much to Make?

 Marginal cost Vs. marginal profit


 if extra jacket sold, profit is 125-80 = 45

 if not sold, cost is 80-20 = 60

 So we will make less than average


Swimsuit Expected Profit

Expected Profit

$400,000
$300,000
Profit

$200,000
$100,000
$0
8000 12000 16000 20000
Order Quantity

If Quantity ordered is 12000, hence the Profit is

= (0.78)*12000*125+ 0.11*8000*125+0.11* 10000*125+4000*0.11*20+2000*0.11*20-80*12000-100000


= 1170000+247500 – 960000 -100000 + 13200= 3070700
Swimsuit : Important Observations
 Tradeoff between ordering enough to meet demand
and ordering too much
 Several quantities have the same estimated profit
 Estimated profit does not tell the whole story
 9000 and 16000 units lead to about the same
estimated profit, so which do we prefer?
Swimsuit Expected Profit

Expected Profit

$400,000
$300,000
Profit

$200,000
$100,000
$0
8000 12000 16000 20000
Order Quantity
Case: Swimsuit Production

 But Need to understand risk associated with certain


decisions.
A frequency histogram provides information about
potential profit for the two given production
quantities, 9,000 units and 16,000 units. The
possible risk and possible reward increases as we
increase the production size.
Probability of Outcomes
100%
0.89 Q=9000
90%
Q=16000
80%
70%
Probability

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

 Question: If there are 7000 units remaining,


what should the company do? What should
they do if there are 10,000 remaining?
Initial Inventory and Profit
Assuming Inventory holding cost is negligible.
500000
400000
300000
Profit

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.

 Periodic review policy


 in which the inventory level is reviewed at regular intervals
and an appropriate quantity is ordered after each review.
Variable Demand with a Fixed ROP

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

 The rate of demand


 The lead time
 Demand and/or lead time variability
 Stockout risk (safety stock)
Continuous Review Policy
AVG = Average daily demand faced
STD = Standard deviation of daily demand faced
L = Replenishment lead time
h = Cost of holding one unit of the product per unit time
α = service level (the probability of stocking out is 1 – α)
p
p =shortage cost α=
p+h
Continuous Review Policy
 The inventory position at any point in time is the actual
inventory at the warehouse plus items ordered by the
distributor that have not yet arrived minus items that are
backordered.
 The reorder level, R consists of two components: the
average inventory during lead time, which is the product of
average daily demand and the lead time; and the safety
stock, which is the amount of inventory that the distributor
needs to keep at the warehouse and in the pipeline to protect
against deviations from average demand during lead time.
Continuous Review Policy –
Variable demand & fixed lead time

 Average demand during lead time is exactly L × AVG


 Safety stock is z × STD × L
where z is a constant, referred to as the safety factor.
This constant is associated with the service level.
 The reorder level is L × AVG + z × STD × L
 Economic lot size is 2 K × AV G
Q=
h
Continuous Review Policy –
Variable demand & fixed lead time
■ The expected level of inventory before receiving the order
is z × STD × L (lowest level i.e. Safety Stock)

■ The expected level of inventory immediately after receiving


the order is Q + z × STD × L (highest level)

■ The average inventory level is the average of these two


values Q
+ z × STD × L
2
Continuous Review Policy –
Variable demand & lead time
 In many situation, the lead time to the warehouse must be
assumed to be normally distributed with average lead time
denoted by AVGL and standard deviation denoted by STDL.
In this case, the reorder point is calculated as

where AVG x AVGL represents average demand during lead


time, &
AVGL × STD 2 + AVG 2 × STDL2

is the standard deviation of demand during lead time. The


amount of safety stock that has to be kept is equal to
z AVGL × STD 2 + AVG 2 × STDL 2
Periodic Review Policy
 Inventory level is reviewed periodically at regular
intervals and an appropriate quantity so as to arrive at
base stock level is ordered after each review .
 Since inventory levels are reviewed at a periodic interval, the fixed
cost of placing an order is a sunk cost and hence can be ignored.
 This level of the inventory position should be enough to
protect the warehouse against shortages until the next order
arrives, that is to cover demand during a period of r + L days,
with r being the length of review period and L being the lead
time.
Periodic Review Policy
 Thus, the base-stock level should include two
components: average demand during an interval of r + L
days, which is equal to ( r + L ) × AVG
 and the safety stock, which is calculated as
where z is a safety factor. z × STD × r +L
Periodic Review Policy (with
SS)
Periodic Review Policy
■ Maximum inventory level is achieved immediately after
receiving an order, while the minimum level of inventory
is achieved just before receiving an order.
■ It is easy to see that the expected level of inventory after
receiving an order is
r × AVG + z × STD × r + L
while the expected level of inventory before an order
arrives is just the safety stock
z × STD × r + L
■ Hence, the average inventory level is the average of these
two values r × AVG
+ z × STD × r + L
2
RISK POOLING
Risk Pooling
 Consider these two systems:
Warehouse One Market One
Supplier
Warehouse Two Market Two

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?

The idea behind risk pooling is to redesign the supply chain,


the production process, or the product to either reduce the
uncertainty the firm faces or to hedge uncertainty so that
the firm is in a better position to mitigate the consequence
of uncertainty.
• Location pooling

• Product pooling

• Lead Time pooling

• Capacity pooling
Lead Time Pooling

Store 1
Supplier

8-week lead time

Store 100
Lead Time Pooling

Store 1

8-week lead time


Supplier

Retail DC

1-week lead time

Store 100
Capacity Pooling

3 Links – no flexibility
Capacity Pooling

9 Links – Total Flexibility


Advantages / Disadvantages
Advantages Disadvantages

Location Pooling reduce demand variability creates distance between inventory and
customers

reduce expected inventory investment


needed to achieve a target service
level

Product Pooling reduction in demand variability potentially degrades product functionality

better performance in terms of matching


supply and demand

Lead Time Pooling decrease lead time extra costs of operating distribution center

keep inventory closer to customer additional transportation costs

reduce inventory investment

Capacity Pooling accommodate demand uncertainty large costs to have flexibility


Summary Risk Pooling
 Risk-pooling strategies are most effective when demands are
negatively correlated because then the uncertainty with total
demand is much less than the uncertainty with any
individual item/location
 Risk-pooling strategies do not help reduce pipeline inventory
 Risk-pooling strategies can be used to reduce inventory while
maintaining the same service or they can be used to increase
service while holding the same inventory
Example
Q/2+SS
Order- Average
AVG STD SS R Q up-to Level
Inventory
Warehouse 1 39.3 13.2 25.08 65 132 197 91

Warehouse 2 38.6 12.0 22.8 62 131 193 88


Centralized
77.9 20.7 39.35 118 186 304 132
Warehouse

Safety StockSS = z ·STD · L


Reorder PointR = AVG·L + SS Decentralized system:
Order QuantityQ = sqrt(2*C0*AVG/h)
total SS = 47.88
Order-up-to-levelR + Q total avg. invent. = 179
Average Inventory ≈ SS + Q/2

Lead Time= 1 week Service Level:97% k=1.88


Risk Pooling – Effect of Correlation
 The benefits of risk pooling depend on the
behavior of demand from one market relative
to the demand from another market.
Calculating demand variability
of centralized systemρ : correlation coefficient of D , 1
Warehouse 1 Market 1 D1: (µ 1, σ 2
)
σσ 2 ==σσ 121 ++σσ 222 ++2ρ
2ρ σσ σ1σ ,2,
1 2 2 2
1 2
Warehouse 2 Market 2 D2: (µ 2, σ 2
2
) where-1
where -1≤≤ ρρ ≤≤ 11

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

 COV= Standard deviation/Avg. demand


Centralized vs. Decentralized
Centralized Decentralized
Safety Stock

Service Level
Overhead
Costs Facility/Labor cost

Responsiveness to customers
(lead time)
Inbound transportation cost
(from factories to warehouses)

Outbound transportation cost


(from warehouses to retailers)
(Adapted from Simchi-Levi, Chen, and Bramel,
Case Study The Logic of Logistics, Springer, 2004)
PART 2
14
CHARLESTON ($7)
8
14

PART 5 PART 3 6 PART 1


45 14 0
CHICAGO ($155) AUSTIN ($2) DALLAS ($260)
5
45 14 15
7

PART 6 8 PART 4
32 55
CHARLESTON ($2) BALTIMORE ($220)
32 5
8

PART 7
14
CHARLESTON ($30)

14

# below stage = processing time


 # in white box = CST
 In this solution, inventory is held of finished
product and its raw materials
A Pure Pull System
PART 2
14
CHARLESTON ($7)
8
14

PART 5 PART 3 6 PART 1


45 14 77
CHICAGO ($155) AUSTIN ($2) DALLAS ($260)
5
45 14 15
7

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 5 PART 3 6 PART 1


45 14 0
CHICAGO ($155) AUSTIN ($2) DALLAS ($260)
5
45 14 15
7

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 5 PART 3 6 PART 1


45 9 27
CHICAGO ($155) AUSTIN ($2) DALLAS ($260)
5
45 14 15
7

PART 6 8 PART 4
32 5
CHARLESTON ($2) BALTIMORE ($220)
32 5
8

PART 7
CHARLESTON ($30)
14
push/pull boundary
14

 Part of system operated produce-to-


stock, part produce-to-order
 Moderate lead time to customer
CST vs. Inventory Cost

$14,000 Push System


$12,000
Inventory Cost ($/year)

$10,000 Push-Pull System


$8,000

$6,000

$4,000

$2,000 Pull System


$0
0 10 20 30 40 50 60 70 80
Committed Lead Time to Customer (days)
Echelon Inventory System

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

 Time Series methods

 Causal methods
THANKYOU

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