Zappos

Key issues:
Increasing customer service They defined customer service as their core competency of their firm High cost of customer service

Zappos responses:
Relocating to Las Vegas Employee training and hiring program

2-1

Inventory driven Costs

Key issues:

Turning a dollar Short life cycle of products Component devaluation costs Price protection costs Product return costs Obsolescence costs Using a one stage supply chain Single central factory Airfreight to customers
2-2

HP responses:

Chapter 2
Inventory Management and Risk Pooling

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2.1 Introduction Why Is Inventory Important?

Distribution and inventory (logistics) costs are quite substantial
Total U.S. Manufacturing Inventories ($m): 1992-01-31: $m 808,773 1996-08-31: $m 1,000,774 2006-05-31: $m 1,324,108 Inventory-Sales Ratio (U.S. Manufacturers): 1992-01-01: 1.56 2006-05-01: 1.25
2-4

Why Is Inventory Required?

Uncertainty in customer demand

Shorter product lifecycles More competing products

Uncertainty in supplies

Quality/Quantity/Costs/Delivery Times

Delivery lead times Incentives for larger shipments

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Inventory Management-Demand Forecasts

Uncertain demand makes demand forecast critical for inventory related decisions:
What to order? When to order? How much is the optimal order quantity?

Approach includes a set of techniques

INVENTORY POLICY!!

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Supply Chain Factors in Inventory Policy

Estimation of customer demand Replenishment lead time The number of different products being considered The length of the planning horizon Costs

Order cost:

Product cost Transportation cost State taxes, property taxes, and insurance on inventories Maintenance costs Obsolescence cost Opportunity costs

Inventory holding cost, or inventory carrying cost:

Service level requirements

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2.2.1. Economic Lot Size Model

FIGURE 2-3: Inventory level as a function of time

2-8

Assumptions

D items per day: Constant demand rate Q items per order: Order quantities are fixed, i.e., each time the warehouse places an order, it is for Q items. K, fixed setup cost, incurred every time the warehouse places an order. h, inventory carrying cost accrued per unit held in inventory per day that the unit is held (also known as, holding cost) Lead time = 0 (the time that elapses between the placement of an order and its receipt) Initial inventory = 0 Planning horizon is long (infinite).
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EOQ: Costs

FIGURE 2-4: Economic lot size model: total cost per unit time

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Deriving EOQ

Total cost at every cycle:

K hTQ 2

Average inventory holding cost in a cycle: Q/2 Cycle time T =Q/D KD hQ Average total cost per unit time: Q 2

Q
*

2 KD h

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2.2.2. Demand Uncertainty

The forecast is always wrong

It is difficult to match supply and demand

The longer the forecast horizon, the worse the forecast

It is even more difficult if one needs to predict customer demand for a long period of time More difficult to predict customer demand for individual SKUs Much easier to predict demand across all SKUs within one product family
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Aggregate forecasts are more accurate.

2.2.5. Multiple Order Opportunities

REASONS To balance annual inventory holding costs and annual fixed order costs. To satisfy demand occurring during lead time. To protect against uncertainty in demand. TWO POLICIES Continuous review policy

inventory is reviewed continuously an order is placed when the inventory reaches a particular level or reorder point. inventory can be continuously reviewed (computerized inventory systems are used)

Periodic review policy

inventory is reviewed at regular intervals appropriate quantity is ordered after each review. it is impossible or inconvenient to frequently review inventory and place orders if necessary.

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2.2.6. Continuous Review Policy

Daily demand is random and follows a normal distribution. Every time the distributor places an order from the manufacturer, the distributor pays a fixed cost, K, plus an amount proportional to the quantity ordered. Inventory holding cost is charged per item per unit time. Inventory level is continuously reviewed, and if an order is placed, the order arrives after the appropriate lead time. If a customer order arrives when there is no inventory on hand to fill the order (i.e., when the distributor is stocked out), the order is lost. The distributor specifies a required service level.
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Continuous Review Policy

AVG = Average daily demand faced by the distributor STD = Standard deviation of daily demand faced by the distributor L = Replenishment lead time from the supplier to the distributor in days h = Cost of holding one unit of the product for one day at the distributor = service level. This implies that the probability of stocking out is 1 -
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Continuous Review Policy

(Q,R) policy whenever inventory level falls to a reorder level R, place an order for Q units What is the value of R?

2-16

Continuous Review Policy

Average demand during lead time: L x AVG z STD L Safety stock:

Reorder Level, R: L AVG z STD L

Order Quantity, Q:

2 K AVG Q h
2-17

Inventory Level Over Time

FIGURE 2-9: Inventory level as a function of time in a (Q,R) policy

Inventory level before receiving an order = z STD L Inventory level after receiving an order = Q z STD L Average Inventory =
Q 2

z STD L
2-18

Service Level & Safety Factor, z

Service Level
z

90% 91% 92% 93% 94%

95% 96% 97% 98% 99% 99.9%

1.29

1.34

1.41

1.48

1.56

1.65

1.75

1.88

2.05

2.33

3.08

z is chosen from statistical tables to ensure that the probability of stockouts during lead time is exactly 1 -

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Continuous Review Policy Example

A distributor of TV sets that orders from a manufacturer and sells to retailers Fixed ordering cost = $4,500 Cost of a TV set to the distributor = $250 Annual inventory holding cost = 18% of product cost Replenishment lead time = 2 weeks Expected service level = 97%

2-20

Continuous Review Policy Example

Month Sales Sept 200 Oct 152 Nov. 100 Dec. 221 Jan. 287 Feb. 176 Mar. 151 Apr. 198 May 246 June 309 July 98 Aug 156

Average monthly demand = 191.17 Standard deviation of monthly demand = 66.53

Average weekly demand = Average Monthly Demand/4.3 Standard deviation of weekly demand = Monthly standard deviation/4.3

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Continuous Review Policy Example

Parameter Average weekly demand Standard deviation of weekly demand 32.08 Average demand during lead time 89.16 Safety stock Reorder point

Value

44.58

86.20

176

Weekly holding cost =

0.18 250 0.87 52

Optimal order quantity =

2 4,500 44 .58 679 .87

Average inventory level = 679/2 + 86.20 = 426

2-22

2.2.7. Variable Lead Times

Average lead time, AVGL Standard deviation, STDL. Reorder Level, R:

R AVG AVGL z AVGL STD2 AVG2 STDL2

2 2 2 z AVGL STD AVG STDL Amount of safety stock=

Order Quantity =

2 K AVG h

2-23

2.2.8. Periodic Review Policy

Inventory level is reviewed periodically at regular intervals An appropriate quantity is ordered after each review Two Cases:

Short Intervals (e.g. Daily)

Define two inventory levels s and S During each inventory review, if the inventory position falls below s, order enough to raise the inventory position to S. (s, S) policy May make sense to always order after an inventory level review. Determine a target inventory level, the base-stock level During each review period, the inventory position is reviewed Order enough to raise the inventory position to the base-stock level. Base-stock level policy

Longer Intervals (e.g. Weekly or Monthly)

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(s,S) policy
Calculate the Q and R values as if this were a continuous review model Set s equal to R Set S equal to R+Q.

2-25

Base-Stock Level Policy

Determine a target inventory level, the basestock level Each review period, review the inventory position is reviewed and order enough to raise the inventory position to the base-stock level Assume: r = length of the review period L = lead time AVG = average daily demand STD = standard deviation of this daily demand.

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Base-Stock Level Policy

Average demand during an interval of r + L days= (r L) AVG

Safety Stock= z STD r L

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Base-Stock Level Policy

FIGURE 2-10: Inventory level as a function of time in a periodic review policy

2-28

Base-Stock Level Policy Example

Assume:

distributor places an order for TVs every 3 weeks Lead time is 2 weeks Base-stock level needs to cover 5 weeks

Average demand = 44.58 x 5 = 222.9 Safety stock = 1.9 32 .8 5 Base-stock level = 223 + 136 = 359 .58 1.9 32.08 5 203.17 Average inventory level = 344 2

Distributor keeps 5 (= 203.17/44.58) weeks of supply.

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2.2.9. Service Level Optimization

Optimal inventory policy assumes a specific service level target. What is the appropriate level of service?

May be determined by the downstream customer

Retailer

may require the supplier, to maintain a specific service level Supplier will use that target to manage its own inventory

Facility may have the flexibility to choose the appropriate level of service
2-30

Service Level Optimization

FIGURE 2-11: Service level inventory versus inventory level as a function of lead time

2-31

Trade-Offs

Everything else being equal:

the higher the service level, the higher the inventory level. for the same inventory level, the longer the lead time to the facility, the lower the level of service provided by the facility. the lower the inventory level, the higher the impact of a unit of inventory on service level and hence on expected profit

2-32

Retail Strategy
Given a target service level across all products determine service level for each SKU so as to maximize expected profit. Everything else being equal, service level will be higher for products with:

high profit margin high volume low variability short lead time

2-33

Profit Optimization and Service Level

FIGURE 2-12: Service level optimization by SKU

2-34

Profit Optimization and Service Level

Target inventory level = 95% across all products. Service level > 99% for many products with high profit margin, high volume and low variability. Service level < 95% for products with low profit margin, low volume and high variability.

2-35

2.3 Risk Pooling

Demand variability is reduced if one aggregates demand across locations. More likely that high demand from one customer will be offset by low demand from another. Reduction in variability allows a decrease in safety stock and therefore reduces average inventory.

2-36

Demand Variation

Standard deviation measures how much demand tends to vary around the average

Gives an absolute measure of the variability

Coefficient of variation is the ratio of standard deviation to average demand

Gives a relative measure of the variability, relative to the average demand

2-37

Acme Risk Pooling Case

Electronic equipment manufacturer and distributor 2 warehouses for distribution in New York and New Jersey (partitioning the northeast market into two regions) Customers (that is, retailers) receiving items from warehouses (each retailer is assigned a warehouse) Warehouses receive material from Chicago Current rule: 97 % service level Each warehouse operate to satisfy 97 % of demand (3 % probability of stock-out)
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New Idea

Replace the 2 warehouses with a single warehouse (located some suitable place) and try to implement the same service level 97 % Delivery lead times may increase But may decrease total inventory investment considerably.

2-39

Historical Data
PRODUCT A
Week Massachusetts New Jersey Total 1 33 46 79 2 45 35 80 3 37 41 78 4 38 40 78 5 55 26 81 6 30 48 78 7 18 18 36 8 58 55 113

PRODUCT B
Week Massachusetts New Jersey Total 1 0 2 2 2 3 4 6 3 3 3 3 4 0 0 0 5 0 3 3 6 1 1 2 7 3 0 3 8 0 0 0

2-40

Summary of Historical Data

Statistics Product Average Demand Standard Deviation of Demand 13.2 1.36 12.0 1.58 Coefficient of Variation 0.34 1.21 0.31 1.26 Massachusetts Massachusetts New Jersey New Jersey A B A B 39.3 1.125 38.6 1.25

Total
Total

A
B

77.9
2.375

20.71
1.9

0.27
0.81

2-41

Inventory Levels
Product Average Demand During Lead Time 39.3 1.125 38.6 1.25 77.9 2.375 Safety Stock Reorder Point Q

Massachusetts Massachusetts New Jersey New Jersey Total Total

A B A B A B

25.08 2.58 22.8 3 39.35 3.61

65 4 62 5 118 6

132 25 31 24 186 33

2-42

Critical Points

The higher the coefficient of variation, the greater the benefit from risk pooling The higher the variability, the higher the safety stocks kept by the warehouses. The variability of the demand aggregated by the single warehouse is lower The benefits from risk pooling depend on the behavior of the demand from one market relative to demand from another risk pooling benefits are higher in situations where demands observed at warehouses are negatively correlated

Reallocation of items from one market to another easily accomplished in centralized systems. Not possible to do in decentralized systems where they serve different markets
2-43

2.4 Centralized vs. Decentralized Systems

Safety stock: lower with centralization Service level: higher service level for the same inventory investment with centralization Overhead costs: higher in decentralized system Customer lead time: response times lower in the decentralized system Transportation costs: not clear. Consider outbound and inbound costs.

2-44

2.5 Managing Inventory in the Supply Chain

Inventory decisions are given by a single decision maker whose objective is to minimize the system-wide cost The decision maker has access to inventory information at each of the retailers and at the warehouse Echelons and echelon inventory Echelon inventory at any stage or level of the system equals the inventory on hand at the echelon, plus all downstream inventory (downstream means closer to the customer)

2-45

Echelon Inventory

FIGURE 2-13: A serial supply chain

2-46

Reorder Point with Echelon Inventory

Le = echelon lead time,

lead time between the retailer and the distributor plus the lead time between the distributor and its supplier, the wholesaler.

AVG = average demand at the retailer STD = standard deviation of demand at the retailer e e R L AVG z STD L Reorder point

2-47

4-Stage Supply Chain Example

Average weekly demand faced by the retailer is 45 Standard deviation of demand is 32 At each stage, management is attempting to maintain a service level of 97% (z=1.88) Lead time between each of the stages, and between the manufacturer and its suppliers is 1 week

2-48

Costs and Order Quantities

K D H Q

retailer distributor wholesaler manufacturer

250 200 205 500

45 45 45 45

1.2 .9 .8 .7

137 141 152 255

2-49

Reorder Points at Each Stage

For the retailer, R=1*45+1.88*32*1 = 105 For the distributor, R=2*45+1.88*32*2 = 175 For the wholesaler, R=3*45+1.88*32*3 = 239 For the manufacturer, R=4*45+1.88*32*4 = 300

2-50

More than One Facility at Each Stage

Follow the same approach Echelon inventory at the warehouse is the inventory at the warehouse, plus all of the inventory in transit to and in stock at each of the retailers. Similarly, the echelon inventory position at the warehouse is the echelon inventory at the warehouse, plus those items ordered by the warehouse that have not yet arrived minus all items that are backordered.
2-51

Warehouse Echelon Inventory

FIGURE 2-14: The warehouse echelon inventory

2-52

Chapter 5

The Value of Information

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

5.1 Introduction
Value of using any type of information technology Potential availability of more and more information throughout the supply chain Implications this availability on effective design and management of the integrated supply chain

2-54

Information Types
Inventory levels Orders Production Delivery status

2-55

More Information

Helps reduce variability in the supply chain. Helps suppliers make better forecasts, accounting for promotions and market changes. Enables the coordination of manufacturing and distribution systems and strategies. Enables retailers to better serve their customers by offering tools for locating desired items. Enables retailers to react and adapt to supply problems more rapidly. Enables lead time reductions.

2-56

5.2 Bullwhip Effect

While customer demand for specific products does not vary much Inventory and back-order levels fluctuate considerably across their supply chain P&Gs disposable diapers case

Sales quite flat Distributor orders fluctuate more than retail sales Supplier orders fluctuate even more

2-57

4-Stage Supply Chain

FIGURE 5-5: The supply chain

2-58

Effect of Order Variability

FIGURE 5-6: The increase in variability in the supply chain

2-59

Factors that Contribute to the Variability - Demand Forecasting

Periodic review policy Characterized by a single parameter, the base-stock level. Base-stock level = Average demand during lead time and review period + a multiple of the standard deviation of demand during lead time and review period (safety stock) Estimation of average demand and demand variability done using standard forecast smoothing techniques. Estimates get modified as more data becomes available Safety stock and base-stock level depends on these estimates Order quantities are changed accordingly increasing variability

2-60

Factors that Contribute to the Variability Lead Time

Increase in variability magnified with increasing lead time. Safety stock and base-stock levels have a lead time component in their estimations. With longer lead times:

a small change in the estimate of demand variability implies a significant change in safety stock and base-stock level, which implies significant changes in order quantities leads to an increase in variability
2-61

Factors that Contribute to the Variability Batch Ordering

Retailer uses batch ordering, as with a (Q,R) or a min-max policy Wholesaler observes a large order, followed by several periods of no orders, followed by another large order, and so on. Wholesaler sees a distorted and highly variable pattern of orders. Such pattern is also a result of:

Transportation discounts with large orders Periodic sales quotas/incentives

2-62

Factors that Contribute to the Variability Price Fluctuations

Retailers often attempt to stock up when prices are lower.

Accentuated by promotions and discounts at certain times or for certain quantities. Such Forward Buying results in:

Large

order during the discounts Relatively small orders at other time periods

2-63

Factors that Contribute to the Variability Inflated Orders

Inflated orders during shortage periods Common when retailers and distributors suspect that a product will be in short supply and therefore anticipate receiving supply proportional to the amount ordered. After period of shortage, retailer goes back to its standard orders

leads to all kinds of distortions and variations in demand estimates

2-64

Quantifying the Bullwhip

Consider a two-stage supply chain:

Retailer who observes customer demand Retailer places an order to a manufacturer.

order placed at the end of period t Order received at the start of period t+L. retailer reviews inventory every period places an order to bring its inventory level up to a target level. the review period is one

Retailer faces a fixed lead time

Retailer follows a simple periodic review policy

2-65

Quantifying the Bullwhip

Base-Stock Level = L x AVG + z x STD x L t L z LSt Order up-to point = If the retailer uses a moving average technique,

t Di
t 1 i t p

S t2

2 ( D i t p i t )
t 1

p 1

2-66

Quantifying the Increase in Variability

Var(D), variance of the customer demand seen by the retailer Var(Q), variance of the orders placed by that retailer to the manufacturer

Var(Q) 2 L 2 L2 1 2 Var( D) p p

When p is large and L is small, the bullwhip effect is negligible. Effect is magnified as we increase the lead time and decrease p.
2-67

Lower Bound on the Increase in Variability Given as a Function of p

FIGURE 5-7: A lower bound on the increase in variability given as a f unction of p

2-68

Impact of Variability Example

Assume p = 5, L=1
Var (Q ) 1.4 Var ( D )

Assume p = 10, L=1

Var (Q) 1.2 Var ( D )

Increasing the number of observations used in the moving average forecast reduces the variability of the retailer order to the manufacturer
2-69

Impact of Centralized Information on Bullwhip Effect

Centralize demand information within a supply chain

Provide each stage of supply chain with complete information on the actual customer demand Creates more accurate forecasts rather than orders received from the previous stage

2-70

Variability with Centralized Information

Var(D), variance of the customer demand seen by the retailer Var(Qk), variance of the orders placed by the kth stage to its Li, lead time between stage i and stage i + 1
Var(Q ) 1 Var( D)
k

2i 1 Li
k

2(i 1 Li ) 2
k

p2

Variance of the orders placed by a given stage of a supply chain is an increasing function of the total lead time between that stage and the retailer

2-71

Variability with Decentralized Information

Retailer does not make its forecast information available to the remainder of the supply chain Other stages have to use the order information
k 2Li 2L2 Var(Q k ) (1 2i ) Var( D) p p i 1

Variance of the orders:

becomes larger up the supply chain increases multiplicatively at each stage of the supply chain.

2-72

Managerial Insights
Variance increases up the supply chain in both centralized and decentralized cases Variance increases:

Additively with centralized case Multiplicatively with decentralized case

Centralizing demand information can significantly reduce the bullwhip effect

Although not eliminate it completely!!

2-73

Increase in Variability for Centralized and Decentralized Systems

FIGURE 5-8: Increase in variability for centralized and decentralized systems

2-74

Methods for Coping with the Bullwhip

Reducing uncertainty. Centralizing information Reducing variability.

Reducing variability inherent in the customer demand process. Everyday low pricing (EDLP) strategy.

2-75

Methods for Coping with the Bullwhip

Lead-time reduction

Lead times magnify the increase in variability due to demand forecasting. Two components of lead times:

order lead times [can be reduced through the use of crossdocking] Information lead times [can be reduced through the use of electronic data interchange (EDI).]

Strategic partnerships

Changing the way information is shared and inventory is managed Vendor managed inventory (VMI)

Manufacturer manages the inventory of its product at the retailer outlet VMI the manufacturer does not rely on the orders placed by a retailer, thus avoiding the bullwhip effect entirely.

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5.5 Information for the Coordination of Systems

Many interconnected systems

manufacturing, storage, transportation, and retail systems the outputs from one system within the supply chain are the inputs to the next system trying to find the best set of trade-offs for any one stage isnt sufficient. need to consider the entire system and coordinate decisions
each facility in the supply chain does what is best for that facility the result is local optimization.
2-77

Systems are not coordinated

Global Optimization

Issues:
Who will optimize? How will the savings obtained through the coordinated strategy be split between the different supply chain facilities?

Methods to address issues:

Supply contracts Strategic partnerships

2-78

5.6 Locating Desired Products

Meet customer demand from available retailer inventory What if the item is not in stock at the retailer?

Being able to locate and deliver goods is sometimes as effective as having them in stock If the item is available at the competitor, then this is a problem

2-79

5.7 Lead-Time Reduction

Numerous benefits:

The ability to quickly fill customer orders that cant be filled from stock. Reduction in the bullwhip effect. More accurate forecasts due to a decreased forecast horizon. Reduction in finished goods inventory levels

Many firms actively look for suppliers with shorter lead times Many potential customers consider lead time a very important criterion for vendor selection. Much of the manufacturing revolution of the past 20 years led to reduced lead times

2-80

5.8 Information and Supply Chain Trade-Offs

Conflicting objectives in the supply chains Designing the supply chain with conflicting goals

2-81

Trade-Offs:

Inventory-Lot Size Inventory-Transportation Costs Lead Time-Transportation Costs Product Variety-Inventory Cost-Customer Service

2-82

5.9 Decreasing Marginal Value of Information

Obtaining and sharing information is not free. Many firms are struggling with exactly how to use the data they collect through loyalty programs, RFID readers, and so on. Cost of exchanging information versus the benefit of doing so.

May not be necessary to exchange all of the available information, or to exchange information continuously. Decreasing marginal value of additional information

In multi-stage decentralized manufacturing supply chains many of the performance benefits of detailed information sharing can be achieved if only a small amount of information is exchanged between supply chain participants. Exchanging more detailed information or more frequent information is costly.

Understand the costs and benefits of particular pieces of information How often this information is collected How much of this information needs to be stored How much of this information needs to be shared In what form it needs to shared

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