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InventoryMgmt RiskPooling II|Views: 5|Likes: 0

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- Inventory Management & Risk Pooling Part II
- Supply Contracts
- Demand Scenarios
- Supply Contracts (cont.)
- Buy back contract
- Revenue Sharing Contract
- Supply Chain Profit
- Supply Contracts: Key Insights
- Other Contracts
- (s, S) Policies
- A Multi-Period Inventory Model
- The Normal Distribution
- A View of (s, S) Policy
- The (s,S) Policy
- Notation
- Analysis
- TV Distributor
- Example
- Example, Cont
- Periodic Review
- Base-Stock Policy
- Periodic Review Policy
- Risk Pooling: Important Observations
- Types of Risk Pooling*
- Centralized Systems*
- Centralized Distribution Systems*
- Changes In Inventory Turnover
- Inventory Turnover Ratio
- Factors that Drive Reduction in Inventory
- Forecasting
- Judgment Methods
- Time Series Methods
- Causal Methods

Prepared by Dr. A. K. Dey Based on Third Chapter of Simchi-Levi, Kaminsky & Simchi-Levi

Dr. A. K. Dey

1

Supply Contracts

Fixed Production Cost =$100,000 Variable Production Cost=$35

**Wholesale Price =$80 Selling Price=$125 Salvage Value=$20
**

Manufacturer

Manufacturer DC

Retail DC

Stores

Dr. A. K. Dey 2

Demand Scenarios

Demand Scenarios

30% 25% 20% 15% 10% 5% 0%

Probability

80 00

10 00 0

12 00 0

14 00 0

16 00 0

Sales

Dr. A. K. Dey 3

18 00 0

**Retailer Expected Profit
**

Expected Profit

500000 400000 300000 200000 100000 0 6000

8000

10000

12000

14000

16000

18000

20000

Order Quantity

Dr. A. K. Dey

4

**Retailer Expected Profit
**

Expected Profit

500000 400000 300000 200000 100000 0 6000

8000

10000

12000

14000

16000

18000

20000

Order Quantity

Dr. A. K. Dey

5

**Retailer orders for 12000 swimsuits
**

Revenue 125 Whole Sale Price 80 Fixed Cost Salvage Value 20 Retailer Profit Weighted Retail Average Manuf Profit Weighted Average Manuf Profit

Demand

Prob

8000 10000 12000 14000

0.11 0.11 0.275 0.225

1000000 1250000 1500000 1500000

960000 960000 960000 960000

100000 100000 100000 100000

80000 40000 0 0

120000 330000 540000 540000

13200 36300 148500 121500

440000 440000 440000 440000

48400 48400 121000 99000

16000

18000

0.185

0.095

1500000

1500000

960000

960000

100000

100000

0

0

540000

540000

99900

51300 470700

440000

440000

81400

41800 440000 910700

Total Expected Profit Total Supply Chain Profit

Dr. A. K. Dey

6

**Supply Contracts (cont.)
**

• Retailer optimal order quantity is 12,000 units • Retailer expected profit is $470,000 • Manufacturer profit is $440,000 • Total Supply Chain Profit is $910,000

–Is there anything that the distributor and manufacturer can do to increase the profit of both?

Dr. A. K. Dey 7

Supply Contracts

Fixed Production Cost =$100,000 Variable Production Cost=$35

**Wholesale Price =$80 Selling Price=$125 Salvage Value=$20
**

Manufacturer

Manufacturer DC

Retail DC

Stores

Dr. A. K. Dey 8

**Buy back contract
**

• Retailer proposes that unsold goods should be taken back by the manufacturer under ‘Buy back’ arrangement for $55 per unit

Dr. A. K. Dey

9

Retailer orders for 12000 swimsuits with buy back arrangement Sales Price 125 8000 10000 12000 14000 16000 18000 0.11 0.11 0.275 0.225 0.185 0.095 1000000 1250000 1500000 1500000 1500000 1500000 Buy Back 55 220000 110000 0 0 0 0 Wholes le Price 80 960000 960000 960000 960000 960000 960000 Variale cost 35 420000 420000 420000 420000 420000 420000 Fixed cost 100000 100000 100000 100000 100000 100000 100000

Demand

Prob

Profit

Average Profit

Retailer 260000 400000 540000 540000 540000 540000

Manuf 220000 330000 440000 440000 440000 440000

Retailer 28600 44000 148500 121500 99900 51300

Manuf 24200 36300 121000 99000 81400 41800

Total Expected Profit TotalSupply Chain Profit

493800

403700 897500

Dr. A. K. Dey

10

**Retailer orders for 14000 swimsuits with buy back arrangement Demand Prob Sales Price
**

125

Buy Back

55

**Whole sale Price
**

80

Variable cost

35

Fixed cost

100000 Retailer

Profit

Average Profit

Manuf

Retailer

Manuf

8000 10000

0.11 0.11

1000000 1250000

330000 220000

1120000 1120000

490000 490000

100000 100000

210000 350000

200000 310000

23100 38500

22000 34100

12000

14000 16000 18000

0.275

0.225 0.185 0.095

1500000

1750000 1750000 1750000

110000

0 0 0

1120000

1120000 1120000 1120000

490000

490000 490000 490000

100000

100000 100000 100000

490000

630000 630000 630000

420000

530000 530000 530000

134750

141750 116550 59850 514500

115500

119250 98050 50350 439250 953750

Total Expected Profit Total Supply Chain Profit

Dr. A. K. Dey

11

Retailer orders for 16000 swimsuits with buy back arrangement

Demand

Prob

Sales Price

Buy Back

Whole Sale Price

Variable cost

Fixed cost

Profit

Average Profit

125 8000 10000 12000 14000 16000 18000 0.11 0.11 0.275 0.225 0.185 0.095 1000000 1250000 1500000 1750000 2000000 2000000

55 440000 330000 220000 110000 0 0

80 1280000 1280000 1280000 1280000 1280000 1280000

35 560000 560000 560000 560000 560000 560000

100000 100000 100000 100000 100000 100000 100000

Retailer 160000 300000 440000 580000 720000 720000

Manuf 180000 290000 400000 510000 620000 620000

Retailer 17600 33000 121000 130500 133200 68400 503700

Manuf 19800 31900 110000 114750 114700 58900 450050 953750

Best case – Profits for both increase. With buy back arrangement manufacturer should push for 16000 units order.

Total Expected Profit Total Supply Chain Profit

Dr. A. K. Dey

12

Supply Contracts

Fixed Production Cost =$100,000 Variable Production Cost=$35

**Wholesale Price =$?? Selling Price=$125 Salvage Value=$20
**

Manufacturer

Manufacturer DC

Retail DC

Stores

Dr. A. K. Dey 13

**Revenue Sharing Contract
**

• Manufacturer and retailer have a revenue sharing contract • Manufacturer agrees to decrease the whole sale price from $80 to $60 • In return retailer provides 15% of the product revenue to the manufacturer

Dr. A. K. Dey

14

**Retailer orders for 12000 swimsuits with revenue sharing arrangement
**

Sales Price Rev Share Wholesale Price Variable cost Fixed cost

Demand

Prob

Profit

Average Profit

125

15%

60

35

100000

Retailer

ManuF

Retailer

Manuf

8000 10000 12000 14000 16000 18000

0.11 0.11 0.275 0.225 0.185 0.095

1000000 1250000 1500000 1500000 1500000 1500000

150000 187500 225000 225000 225000 225000

720000 720000 720000 720000 720000 720000

420000 420000 420000 420000 420000 420000

100000 100000 100000 100000 100000 100000

130000 342500 555000 555000 555000 555000

350000 387500 425000 425000 425000 425000 SUM

14300 37675 152625 124875 102675 52725 484875

38500 42625 116875 95625 78625 40375 412625 897500

Total SC Profit

Dr. A. K. Dey

15

**Retailer orders for 14000 swimsuits with revenue sharing arrangement
**

Wholesale Price Variable cost Fixed cost

Demand

Prob

Sales Price

Rev Share

Profit

Average Profit

125 8000 10000 12000 14000 16000 0.11 0.11 0.275 0.225 0.185 1000000 1250000 1500000 1750000 1750000

15% 150000 187500 225000 262500 262500

60 840000 840000 840000 840000 840000

35 490000 490000 490000 490000 490000

100000 100000 100000 100000 100000 100000

Retailer 10000 222500 435000 647500 647500

Manuf 400000 437500 475000 512500 512500

Retailer 1100 24475 119625 145688 119788

Manuf 44000 48125 130625 115313 94813

18000

0.095

1750000

262500

840000

490000

100000

647500

512500

SUM

61513

472188

48688

481563 953750

Best case. Profits for both increase. Retailer should negotiate for reduction in the wholesale price to $60 by committing to lift 14000 units.

Dr. A. K. Dey

Total SC Profit

16

**Retailer orders for 16000 swimsuits with revenue sharing arrangement
**

Wholesale Price Variable cost Fixed cost

Demand

Prob

Sales Price

Rev Share

Profit

Average Profit

125

15%

60

35

100000

Retailer

Manuf

Retailer

Manuf

8000

0.11

1000000

150000

960000

560000

100000

-110000

450000

-12100

49500

10000

0.11

1250000

187500

960000

560000

100000

102500

487500

11275

53625

12000

0.275

1500000

225000

960000

560000

100000

315000

525000

86625

144375

14000

0.225

1750000

262500

960000

560000

100000

527500

562500

118688

126563

16000

0.185

2000000

300000

960000

560000

100000

740000

600000

136900

111000

18000

0.095

2000000

300000

960000

560000

100000

740000

600000 SUM

70300 411688

57000 542063 953750

Total SC Profit

Dr. A. K. Dey

17

Supply Contracts

Strategy Sequential Optimization Buyback Revenue Sharing Retailer Manufacturer 470,700 440,000 503,700 450,050 472,188 481,573 Quantity Sequential Optimization 12000 Buyback 16000 Revenue Sharing 14000 Total 910,700 953,750 953,761

Dr. A. K. Dey

18

Supply Contracts

Fixed Production Cost =$100,000 Variable Production Cost=$35

**Wholesale Price =$80 Selling Price=$125 Salvage Value=$20
**

Manufacturer

Manufacturer DC

Retail DC

Stores

Dr. A. K. Dey 19

**Supply Chain Profit
**

1,200,000

Supply Chain Profit

1,000,000 800,000 600,000 400,000 200,000 0

60 00 70 00 80 00 90 00 10 00 0 11 00 0 12 00 0 13 00 0 14 00 0 15 00 0 16 00 0 17 00 0 18 00 0

Production Quantity

Dr. A. K. Dey 20

**Supply Chain Profit
**

Global Optimization Strategy - Marginal Profit 90 (=125-35) vs Marginal loss 15 (=35-20) Make 16000

Demand Prob Sales Price Variable Cost Fixed cost Salvage Value Over all Profit Average Profit

125 8000 10000 0.11 0.11 1000000 1250000

35 560000 560000

100000 100000 100000

20 160000 120000 500000 710000 55000 78100

12000

14000 16000 18000

0.275

0.225 0.185 0.095

1500000

1750000 2000000 2000000

560000

560000 560000 560000

100000

100000 100000 100000

80000

40000 0 0

920000

1130000 1340000 1340000

253000

254250 247900 127300 1015550

Total Supply Chain Profit

Dr. A. K. Dey

21

Supply Contracts

Strategy Sequential Optimization Buyback Revenue Sharing Global Optimization Retailer Manufacturer 470,700 440,000 503,700 450,050 472,188 481,573 Total 910,700 953,750 953,761 1,015,550

Quantity Sequential Optimization 12000 Buyback 16000 Revenue Sharing 14000 Global Optimization 16000

Dr. A. K. Dey

22

**Supply Contracts: Key Insights
**

• Effective supply contracts allow supply chain partners to replace

– sequential optimization by – global optimization

**• Buy Back and Revenue Sharing contracts achieve this objective through
**

– risk sharing

Dr. A. K. Dey

23

**Supply Contracts: Case Study
**

• Example: Demand for a movie newly released video cassette typically starts high and decreases rapidly

– Peak demand last about 10 weeks

**• Blockbuster purchases a copy from a studio for $65 and rent for $3
**

– Hence, retailer must rent the tape at least 22 times before earning profit

**• Retailers cannot justify purchasing enough to cover the peak demand
**

– In 1998, 20% of surveyed customers reported that they could not rent the movie they wanted

Dr. A. K. Dey 24

**Supply Contracts: Case Study
**

• Starting in 1998 Blockbuster entered a revenue sharing agreement with the major studios

– Studio charges $8 per copy – Blockbuster pays 30-45% of its rental income

• Even if Blockbuster keeps only half of the rental income, the breakeven point is 6 rental per copy • The impact of revenue sharing on Blockbuster was dramatic

– Rentals increased by 75% in test markets – Market share increased from 25% to 31% (The 2nd largest retailer, Hollywood Entertainment Corp has 5% market share)

Dr. A. K. Dey 25

Other Contracts

• Quantity Flexibility Contracts

– Supplier provides full refund for returned items as long as the number of returns is no larger than a certain quantity

**• Sales Rebate Contracts
**

– Supplier provides direct incentive for the retailer to increase sales by means of a rebate paid by the supplier for any item sold above a certain quantity

Dr. A. K. Dey 26

(s, S) Policies

• For some starting inventory levels, it is better to not start production • If we start, we always produce to the same level • Thus, we use an (s,S) policy. If the inventory level is below s, we produce up to S. • s is the reorder point, and S is the order-up-to level • The difference between the two levels is driven by the fixed costs associated with ordering, transportation, or manufacturing

Dr. A. K. Dey 27

**A Multi-Period Inventory Model
**

• Often, there are multiple reorder opportunities • Consider a central distribution facility which orders from a manufacturer and delivers to retailers. The distributor periodically places orders to replenish its inventory

Dr. A. K. Dey 28

Reminder:

**The Normal Distribution
**

Standard Deviation = 5

Standard Deviation = 10

Average = 30

0 10 20 30

Dr. A. K. Dey

40

50

60

29

The DC holds inventory to:

• Satisfy demand during lead time • Protect against demand uncertainty • Balance fixed costs and holding costs

Dr. A. K. Dey

30

**The Multi-Period Continuous Review Inventory Model
**

• Normally distributed random demand • Fixed order cost plus a cost proportional to amount ordered. • Inventory cost is charged per item per unit time • If an order arrives and there is no inventory, the order is lost • The distributor has a required service level. This is expressed as the likelihood that the distributor will not stock out during lead time. • Intuitively, how will this effect our policy?

Dr. A. K. Dey 31

A View of (s, S) Policy

S

Inventory Position

Inventory Level

Lead Time

s 0 Time

Dr. A. K. Dey 32

The (s,S) Policy

• (s, S) Policy: Whenever the inventory position drops below a certain level, s, we order to raise the inventory position to level S. • The reorder point is a function of:

– – – – The Lead Time Average demand Demand variability Service level

Dr. A. K. Dey 33

Notation

• • • • • • AVG = average daily demand STD = standard deviation of daily demand LT = replenishment lead time in days h = holding cost of one unit for one day K = fixed cost SL = service level (for example, 95%). This implies that the probability of stocking out is (100%-SL) (for example, 5%) • Also, the Inventory Position at any time is the actual inventory plus items already ordered, but not yet delivered.

Dr. A. K. Dey 34

Analysis

• The reorder point (s) has two components:

– To account for average demand during lead time: LTAVG – To account for deviations from average (we call this safety stock) z STD LT where z is chosen from statistical tables to ensure that the probability of stockouts during leadtime is 100%-SL.

• Since there is a fixed cost, we order more than up to the reorder point: Q=(2 K AVG)/h • The total order-up-to level is: S=Q+s

Dr. A. K. Dey 35

TV Distributor

• Trying to set inventory policies • Fixed ordering cost of $4500 • Cost of TV set $250 and annual inventory holding cost 18% of product cost • Replenishment lead time is 2 weeks • Average weekly demand is 44.58 and the standard deviation of monthly demand is 32.08 • Desired CSL 97%

Dr. A. K. Dey 36

Example

• The distributor has historically observed weekly demand of: AVG = 44.58 STD = 32.08 Replenishment lead time is 2 weeks, and desired service level SL = 97% • Average demand during lead time is: 44.6 2 = 89.2 (or 90) • Safety Stock is: 1.88 32.1 2 = 85.3 (or 86) • Reorder point is thus 176, or about 3.9 weeks of supply at warehouse and in the pipeline

Dr. A. K. Dey 37

Example, Cont.

• Weekly inventory holding cost: 0.87

– Therefore, Q=679

**• Order-up-to level thus equals:
**

– Reorder Point + Q = 176+679 = 855

• Distributor should place order to raise the inventory position to 855 TV sets whenever the inventory level is below or at 176 • Average inventory level is (679/2)+86= 426

Dr. A. K. Dey 38

Periodic Review

• Suppose the distributor places orders every month • What policy should the distributor use? • What about the fixed cost?

Dr. A. K. Dey 39

**Base-Stock Policy
**

r r L

L

Inventory Position

L

Inventory Level

Base-stock Level

0 Time

Dr. A. K. Dey 40

**Periodic Review Policy
**

• Each review echelon, inventory position is raised to the base-stock level. • The base-stock level includes two components:

– Average demand during r+L days (the time until the next order arrives): (r+L)*AVG – Safety stock during that time: z*STD* r+L

Dr. A. K. Dey 41

TV Distributor ….

• Suppose the distributor places order every three weeks • Average demand during five weeks is 223 • Standard deviation is (1.88x32.1xSqRt 5) = 134.94 (or 135) • Base stock level is (223+135) = 359 TVs • Average inventory level 202

Dr. A. K. Dey 42

Risk Pooling

• Consider these two systems:

Warehouse One

Supplier Warehouse Two Market Two Market One

**Market One Supplier Warehouse Market Two
**

Dr. A. K. Dey 43

Risk Pooling

• For the same service level, which system will require more inventory? Why? • For the same total inventory level, which system will have better service? Why? • What are the factors that affect these answers?

Dr. A. K. Dey

44

**Risk Pooling Example
**

• Compare the two systems:

– – – – – two products maintain 97% service level $60 order cost $0.27 weekly holding cost $1.05 transportation cost per unit in decentralized system, $1.10 in centralized system – 1 week lead time

Dr. A. K. Dey 45

**Risk Pooling Example
**

Week Prod A, Market 1 Prod A, Market 2 Total A Prod B, Market 1 Product B, Market 2 Total B 1 33 46 79 0 2 2 2 45 35 80 2 4 6 3 37 41 78 3 0 3

Dr. A. K. Dey

4 38 40 78 0 0 0

5 55 26 81 0 3 3

6 30 48 78 1 1 2

7 18 18

8 58 55

36 113 3 0 3 0 0 0

46

**Risk Pooling Example
**

Warehouse Product Market 1 Market 2 A A AVG 39.3 38.6 STD 13.2 12.0 CV .34 .31

Market 1

B

1.125

1.36

1.21

Market 2

B

1.25

1.58

1.26

Dr. A. K. Dey

47

**Risk Pooling Example
**

Product Average Demand Std Dev Coeff Var Safety Stock Reorder Point EOQ Order upto level Average Inventory Round Up % Decline

Mkt 1 Mkt 1

A B A B A B

39.3 1.1

13.2 1.4

0.34 1.21

25.08 2.58

64.4 3.7

132.2 22.4

196.5 26.1

91.16 13.76

92 14

Mkt 2

38.6

12.0

0.31

22.80

61.4

131.0

192.4

88.29

89

Mkt 2

1.3

1.6

1.26

3.00

4.3

23.6

27.8

14.79

15

Total

77.9

20.7

0.27

39.35

117.2

186.1

303.3

132.38

133

36

Total

2.4

1.9

0.80

3.61

6.0

32.5

38.5

19.85

20

45

Dr. A. K. Dey

48

**Risk Pooling: Important Observations
**

• Centralizing inventory control reduces both safety stock and average inventory level for the same service level. • This works best for

– High coefficient of variation, which increases required safety stock. – Negatively correlated demand. Why?

• What other kinds of risk pooling will we see? Dr. A. K. Dey

49

**Risk Pooling: Types of Risk Pooling*
**

• Risk Pooling Across Markets • Risk Pooling Across Products • Risk Pooling Across Time – Daily order up to quantity is:

• LTAVG + z AVG LT

Orders

10

11

Dr. A. K. Dey

12

13

14

15

50

Demands

**To Centralize or not to Centralize
**

• What is the effect on:

– – – – – Safety stock? Service level? Overhead? Lead time? Transportation Costs?

Dr. A. K. Dey

51

Centralized Systems*

Supplier

Warehouse

Retailers

• Centralized Decision

Dr. A. K. Dey 52

**Centralized Distribution Systems*
**

• Question: How much inventory should management keep at each location? • A good strategy: – The retailer raises inventory to level Sr each period – The supplier raises the sum of inventory in the retailer and supplier warehouses and in transit to Ss – If there is not enough inventory in the warehouse to meet all demands from retailers, it is allocated so that the service level at each of the retailers will be equal.

Dr. A. K. Dey

53

**Inventory Management: Best Practice
**

• Periodic inventory reviews • Tight management of usage rates, lead times and safety stock • ABC approach • Reduced safety stock levels • Shift more inventory, or inventory ownership, to suppliers • Quantitative approaches

Dr. A. K. Dey 54

**Changes In Inventory Turnover
**

• Inventory turnover ratio = annual sales/avg. inventory level • Inventory turns increased by 30% from 1995 to 1998 • Inventory turns increased by 27% from 1998 to 2000 • Overall the increase is from 8.0 turns per year to over 13 per year over a five year period ending in year 2000.

Dr. A. K. Dey 55

**Inventory Turnover Ratio
**

Industry

Dairy Products Electronic Component Electronic Computers Books: publishing Household audio & video equipment Household electrical appliances Industrial chemical

Upper Quartile 34.4 9.8 9.4 9.8 6.2 8.0 10.3

Median 19.3 5.7 5.3 2.4 3.4 5.0 6.6

Lower Quartile 9.2 3.7 3.5 1.3 2.3 3.8 4.4

56

Dr. A. K. Dey

**Factors that Drive Reduction in Inventory
**

• • • • Top management emphasis on inventory reduction Reduce the Number of SKUs in the warehouse Improved forecasting Use of sophisticated inventory management software • Coordination among supply chain members • Others

Dr. A. K. Dey

57

**Factors that Drive Inventory Turns Increase
**

• • • • • • • Better software for inventory management Reduced lead time Improved forecasting Application of SCM principals More attention to inventory management Reduction in SKU Others

Dr. A. K. Dey 58

Forecasting

• Recall the three rules • Nevertheless, forecast is critical • General Overview:

– – – – Judgment methods Market research methods Time Series methods Causal methods

Dr. A. K. Dey 59

Judgment Methods

• Assemble the opinion of experts • Sales-force composite combines salespeople’s estimates • Panels of experts – internal, external, both • Delphi method

– Each member surveyed – Opinions are compiled – Each member is given the opportunity to change his opinion

Dr. A. K. Dey 60

**Market Research Methods
**

• Particularly valuable for developing forecasts of newly introduced products • Market testing

– Focus groups assembled. – Responses tested. – Extrapolations to rest of market made.

• Market surveys

– Data gathered from potential customers – Interviews, phone-surveys, written surveys, etc.

Dr. A. K. Dey 61

**Time Series Methods
**

• Past data is used to estimate future data • Examples include

– Moving averages – average of some previous demand points. – Exponential Smoothing – more recent points receive more weight – Methods for data with trends:

• Regression analysis – fits line to data • Holt’s method – combines exponential smoothing concepts with the ability to follow a trend

**– Methods for data with seasonality
**

• Seasonal decomposition methods (seasonal patterns removed) • Winter’s method: advanced approach based on exponential smoothing

**– Complex methods (not clear that these work better)
**

Dr. A. K. Dey 62

Causal Methods

• Forecasts are generated based on data other than the data being predicted • Examples include:

– – – – – Inflation rates GNP Unemployment rates Weather Sales of other products

Dr. A. K. Dey 63

**Selecting the Appropriate Approach:
**

• What is the purpose of the forecast?

– Gross or detailed estimates?

**• What are the dynamics of the system being forecast?
**

– Is it sensitive to economic data? – Is it seasonal? Trending?

• How important is the past in estimating the future? • Different approaches may be appropriate for different stages of the product lifecycle:

– Testing and intro: market research methods, judgment methods – Rapid growth: time series methods – Mature: time series, causal methods (particularly for long-range planning)

**• It is typically effective to combine approaches.
**

Dr. A. K. Dey 64

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