Chapter 10

:
Inventory Decision Making

Learning Objectives 

After reading this chapter, you should be able to do the following: Understand the fundamental differences among approaches to managing inventory. Appreciate the rationale and logic behind the Economic Order Quantity (EOQ) approach to inventory decision making, and be able to solve some problems of a relatively straightforward nature. Understand alternative approaches to managing inventory --- JIT, MRP, and DRP.
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Learning Objectives   

Realize how variability in demand and order cycle length affects inventory decision making. Know how inventory will vary as the number of stocking points decreases or increases. Recognize the contemporary interest in and relevance of time-based approaches to inventory management.
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Learning Objectives 

Make needed adjustments to the basic EOQ approach to respond to several special types of applications.

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Fundamental Approaches to Managing Inventory    

Basic issues are simple how much to order and when to order. Additional issues are where to store inventory and what items to order. Traditionally, conflicts were usually present as customer service levels increased, investment in inventory also increased. Recent emphasis is on increasing customer service and reducing inventory investment.
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Fundamental Approaches to Managing Inventory 

Four factors might permit this apparent paradox, that is, the firm can achieve higher levels of customer service without actually increasing inventory:  More responsive order processing  Ability to strategically manage logistics data  More capable and reliable transportation  Improvements in the location of inventory
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Figure 10-1 Relationship between Inventory and Customer Service Level

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Key Differences among Approaches to Managing Inventory 

Dependent versus Independent Demand  Dependent demand is directly related to the demand for another product.  Independent demand is unrelated to the demand for another product.  For many manufacturing processes, demand is dependent.  For many end-use items, demand is independent.
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Key Differences among Approaches to Managing Inventory  

Of the inventory management processes in this chapter, JIT, MRP and MRPII are generally associated with items having dependent demand. Alternatively, DRP and the EOQ models are generally associated with items exhibiting independent demand.

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Key Differences among Approaches to Managing Inventory 

Pull versus Push  Pull approach is a reactive system, relying on customer demand to pull product through a logistics system. MacDonald s is an example.  Push approach is a proactive system, and uses inventory replenishment to anticipate future demand. Catering businesses are examples of push systems.
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Key Differences among Approaches to Managing Inventory 

Pull versus Push  Pull systems respond quickly to sudden or abrupt changes in demand, involve one-way communications, and apply more to independent demand situations.  Push systems use an orderly and disciplined master plan for inventory management, and apply more to dependent demand situations.
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On the Line: American Cancer Society    



ACS constructed a world class automated order fulfillment center in Atlanta. Order cycle time was reduced to five business days. Centralized storage reduced waste and obsolescence of educational materials. Centralized shipment reduced freight rates. The new center saved $8 million in the first year alone.
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Fixed Order Quantity Approach (Condition of Certainty): Inventory Cycles 

In this example, each cycle starts with 4,000 units:  Demand is constant at the rate of 800 units per day.  When inventory falls below 1,500 units, an order is placed for an additional 4,000 units.  After 5 days the inventory is completely used.  Just as the 4,000th unit is sold, the next order of 4,000 units arrives and a new cycle begins.
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Figure 10-2 Fixed Order Quantity Model under the Condition of Certainty

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Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model 

Simple EOQ Model Assumptions  

  



Continuous, constant, known and infinite rate of demand on one item of inventory. A constant and known replenishment time. Satisfaction of all demand. Constant cost, independent of order quantity or time. No inventory in transit costs. No limits on capital availability.
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Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model 

Simple EOQ Model Variables 
      

R = annual rate of demand Q = quantity ordered (lot size in units) A = order or setup cost V = value or cost of one unit in dollars W = carrying cost per dollar value in percent S = VW = annual storage cost in $/unit per year t = time in days TAC = total annual costs in dollars per year
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Figure 10-3 Inventory Carrying Cost

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Figure 10-4 Order or Setup Cost

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Figure 10-5 Inventory Costs

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Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model
TAC = QVW + AR 2 Q or TAC = QS + AR 2 Q

First term is the average carrying cost Second term is order or setup costs per year

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Figure 10-6 Sawtooth Model

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Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model
TAC = QVW + AR 2 Q or TAC = QS + AR 2 Q

Solving for Q gives the following expressions: Q= 2 RA or Q = VW or S 2RA or Q = VW 2RA S
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Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model
Where R = 3600 units V = $100; W = 25%; S (or VW)= $25; A = $200 per order Q= 2 RA VW or S or Q= 2RA VW 2*3600*$200 $100*25% Q = 240 units or Q= 2RA S 2*3600*$200 $25 Q = 240 units
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Figure 10-7 Sawtooth Models

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Table 10-1 Total Costs for Various EOQ Amounts

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Figure 10-8 Graphical Representation of the EOQ Example

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Fixed Order Quantity Approach (Condition of Certainty) 

Summary and Evaluation of the Fixed Order Quantity Approach: 
 

 

EOQ is a popular inventory model. EOQ doesn t handle multiple locations as well as a single location. EOQ doesn t do well when demand is not constant. Minor adjustments can be made to the basic model. Newer techniques will ultimately take the place of EOQ.
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Fixed Order Quantity Approach (Condition of Uncertainty)  

Uncertainty is a more normal condition.  Demand is often affected by exogenous factors---weather, forgetfulness, etc.  Lead times often vary regardless of carrier intentions. Examine out Figure 10-9.  Note the variability in lead times and demand.
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Figure 10-9 Fixed Order Quantity Model under Conditions of Uncertainty

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Fixed Order Quantity Approach (Condition of Uncertainty) 

Reorder Point A Special Note  With uncertainty of demand, the reorder point becomes the average daily demand during lead time plus the safety stock.  Examine Figure 10-9 again.

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Fixed Order Quantity Approach (Condition of Uncertainty) 

Uncertainty of Demand Affects Simple EOQ Model Assumptions: 
 

 



a constant and known replenishment time. constant cost/price, independent of order quantity or time. no inventory in transit costs. one item and no interaction among the inventory items. infinite planning horizon. no limit on capital availability.
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Table 10-2 Probability Distribution of Demand during Lead Time
Demand 100 units 110 120 130 140 150 160 Probability 0.01 0.06 0.24 0.38 0.24 0.06 0.01
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Table 10-3 Possible Units of Inventory Short or in Excess during Lead Time with Various Reorder Points
Actual Demand 100 100 110 120 130 140 150 160 0 -10 -20 -30 -40 -50 -60 110 10 0 -10 -20 -30 -40 -50 Reorder Points 120 130 140 20 10 0 -10 -20 -30 -40 30 20 10 0 -10 -20 -30 40 30 20 10 0 -10 -20 150 50 40 30 20 10 0 -10 160 60 50 40 30 20 10 0
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Table 10-3 Possible Units of Inventory Short or in Excess during Lead Time with Various Reorder Points
Actual Demand Probability

Reorder Points 100 0.0 -0.6 -4.8 -9.6 -3.0 -0.6 110 0.1 0 -2.4 -7.2 -2.4 -0.5 120 0.2 0.6 0 -3.8 -4.8 -1.8 -0.4 130 0.3 1.2 2.4 0 -2.4 -1.2 -0.3 140 0.4 1.8 4.8 3.8 0 -0.6 -0.2 150 0.5 2.4 7.2 7.6 2.4 0 -0.1 160 0.6 3.0 9.6 11.4 4.8 0.6 0
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100 110 120 130 140 150 160

0.01 0.06 0.24 0.38 0.24 0.06 0.01

-11.4 -7.6

Table 10-4 Calculation of Lowest-Cost Reorder Point Dmnd (e) (VW) (g) G=gw GR/Q TAC 100 0.0 0 30 $300 110 0.1 $2.50 20.1 $201 120 0.8 $20 10.8 $108 130 3.9 $97.50 3.9 $39 $585 140 10.8 150 20.1 160 30.0

$270 $502.50 $750 0.8 $8 $120 0.1 $1 $15 0.0 $0 $0

$4500 $3015 $1620

$4500 $3018 $1640 $682.50 $390 $517.50 $750
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Fixed Order Quantity Approach (Condition of Certainty): Expanded EOQ Model
Where R = 3600 units V = $100; W = 25%; A = $200 per order; G = 8 Q= 2 R(A + G) VW 2 * 3600 * ($200 + 8) $100 * 25% Q = approximately 242 units
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Fixed Order Quantity Approach (Condition of Certainty): Expanded EOQ Model
Where R = 3600 units V = $100; W = 25%; A = $200 per order; G = 8; Q = 242; e = 10.8
TAC = QVW + AR + eVW + GR 2 Q Q TAC = (242*$100*25%) + (200*3600) + (10.8*$100*25%) + (8*3600) 2 242 242 TAC = TAC = $3025 + $2975 + $270 + $119

$6389 (New value for TAC when uncertainty introduced)

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Fixed Order Quantity Approach (Condition of Uncertainty): Conclusions  

Following costs will rise to cover the uncertainty:  Stockout costs.  Inventory carrying costs of safety stock Results may or may not be significant.  In text example, TAC rose $389 or approximately 6.5%.  The greater the dispersion of the probability distribution, the greater the cost disparity.
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Figure 10-10 Area under the Normal Curve

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Table 10-5 Reorder Point Alternatives and Stockout Possibilities

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Fixed Order Interval Approach 
 

 

A second basic approach Involves ordering at fixed intervals and varying Q depending upon the remaining stock at the time the order is placed. Less monitoring than the basic model Examine Figure 10-11. Amount ordered over each five weeks in the example varies each week.
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Figure 10-11 Fixed Order Interval Model (with Safety Stock)

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Summary and Evaluation of EOQ Approaches to Inventory Management 

Four basic inventory models: 
  

Fixed quantity/fixed interval Fixed quantity/irregular interval Irregular quantity/fixed interval Irregular quantity/irregular interval  

Where demand and lead time are known, basic EOQ or fixed order interval model best. If demand or lead time varies, then safety stock model should be used
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Summary and Evaluation of EOQ Approaches to Inventory Management  

Relationship to ABC analysis  A items suited to a fixed quantity/irregular interval approach.  C items best suited to a irregular quantity/fixed interval approach. Importance of trade-offs  Familiarity with EOQ approaches assists the manager in trade-offs inherent in inventory management.
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Summary and Evaluation of EOQ Approaches to Inventory Management  

New concepts  JIT, MRP, MRPII, DRP, QR, and ECR also take into account a knowledge and understanding of applicable logistics trade-offs. Number of DCs  The issue of inventory at multiple locations in a logistics network raises some interesting questions concerning the number of DCs, the SKUs at each, and their strategic positioning.
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Additional Approaches to Inventory Management 

Three approaches to inventory management that have special relevance to supply chain management:  JIT (Just in Time)  MRP (Materials Requirements into Planning)  DRP (Distribution Resource Planning)

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Time-Based Approaches to Replenishment Logistics: JIT 

Definition and Components of JIT Systems - designed to manage lead times and eliminate waste.  Kanban - refers to the informative signboards on carts in a Toyota system of delivering parts to the production line. Each signboard details the exact quantities and necessary time of replenishment.  JIT operations - Kanban cards and light warning system communicate possible production interruptions.  Fundamental concepts - JIT can substantially reduce inventory and related costs.
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Time-Based Approaches to Replenishment Logistics: JIT 

Definition and Components of JIT Systems designed to manage lead times and eliminate waste.  Goal is zero inventory, and zero defects.  Similarity to the two-bin system - one bin fills demand for part, the other is used when the first is empty.  Reduces lead times through requiring small and frequent replenishment.
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Time-Based Approaches to Replenishment Logistics: JIT   

JIT is a widely used and effective strategy for managing the movement of parts, materials, semi-finished products from points of supply to production facilities. Product should arrive exactly when a firm needs it, with no tolerance for early or late deliveries. JIT systems place a high priority on short, consistent lead times.
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JIT versus EOQ Approaches to Inventory Management 

Six major differences:  First, JIT attempts to eliminate excess inventories for both buyer and seller.  Second, JIT systems involve short production runs with frequent changeovers.  Third, JIT minimizes waiting lines by delivering goods when and where needed.
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JIT versus EOQ Approaches to Inventory Management   

Fourth, JIT uses short, consistent lead times to satisfy inventory needs in a timely manner. Fifth, JIT relies on high-quality incoming products and on exceptionally high-quality inbound logistics operations. Sixth, JIT requires a strong, mutual commitment between buyer and seller, emphasizing quality and win-win outcomes for both partners.
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Table 10-6 EOQ versus JIT Attitudes and Behaviors

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Time-Based Approaches to Replenishment Logistics: JIT 

JIT versus Traditional Inventory Management  Reduces excess inventories  Shorter, more frequent production runs  Minimize waiting lines by delivering materials when and where needed  Short, consistent lead times through proximate location  Quality stressed throughout supply chain  Win-win relationships necessary to a healthy supply chain
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Time-Based Approaches to Replenishment Logistics: JIT 

Examples of JIT Successes:    

Apple Computer s increase in IT from 10 weeks to 2 weeks resulted in 18-month $20 million payback on plant. GM increased production by 100%, but inventories increased by only 6%. Norfolk Southern mini-train hauls direct from one GM plant to another without switching delays. Ryder handles all inbound logistics for Saturn.
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Figure 10-12 The Orderly Pickup Concept

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Time-Based Approaches to Replenishment Logistics: MRP  

A Materials Requirements Planning (MRP) system consists of a set of logically related procedures, decision rules, and records designed to translate a master production schedule into time-phased net inventory requirements for each component item needed to implement this schedule. MRPs re-plan net requirements based on changes in schedule, demand, etc.
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Time-Based Approaches to Replenishment Logistics: MRP 

Goals of an MRP:  Ensure the availability of materials, components, and products for planned production.  Maintain lowest possible inventory level.  Plan manufacturing activities, delivery schedules, and purchasing activities.
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Time-Based Approaches to Replenishment Logistics: MRP 

Key elements of an MRP:  Master production schedule  Bill of materials file  Inventory status file  MRP program  Outputs and reports

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Figure 10-13 An MRP System
Customer Orders Master Production Schedule Bill of Material File MRP Program Output and Reports Inventory Status File Demand Forecasts

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Figure 10-14 Relationship of Parts to Finished Product: MRP Egg Timer Example

1 Egg Timer 2 Ends 1 Bulb 1 Gram of Sand 3 Supports

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Table 10-7 Inventory Status File: MRP Egg Timer Example
Product Egg Timers Ends Supports Bulbs Sand Gross Req. Inventory 1 2 3 1 1 0 0 2 0 0 Net Req. 1 2 1 1 1 Lead Time 1 5 1 1 4
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Figure 10-15 Master Schedule: MRP Egg Timer Example

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Time-Based Approaches to Replenishment Logistics: MRP 

Principal advantages of MRP:  Maintain reasonable safety stock.  Minimize or eliminate inventories.  Identification of process problems.  Production schedules based on actual demand.  Coordination of materials ordering.  Most suitable for batch or intermittent production schedules.
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Time-Based Approaches to Replenishment Logistics: MRP 

Principal shortcomings of MRP:  Computer intensive.  Difficult to make changes once operating.  Ordering and transportation costs may rise.  Not usually as sensitive to short-term fluctuations in demand.  Frequently become quite complex.  May not work exactly as intended.
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Time-Based Approaches to Replenishment Logistics: Distribution Resource Planning   

MRP sets a master production schedule and explodes into gross and net requirements. DRP starts with customer demand and works backwards toward establishing a realistic system-wide plan for ordering the necessary finished products. Then DRP works to develop a time-phased plan for distributing product from plants and warehouses to the consumer.
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Time-Based Approaches to Replenishment Logistics: Distribution Resource Planning 

DRP develops a projection for each SKU and requires17:  Forecast of demand for each SKU.  Current inventory level for each SKU.  Target safety stock.  Recommended replenishment quantity.  Lead time for replenishment.

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Table 10-8 DRP Table for Chicken Noodle Soup
Columbus Distribution Center Distribution Resource Planning Month Week CN Soup Forecast 1 January 2 3 4 5 February 6 7 8 March 9

Current BOH=4314; Q=3800; SS=1956; LT=1
974 974 974 974 989 1002 1002 3800 5025 0 1002 0 4023 0 1061 0 2962 3800
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Schedule 0 0 3800 0 0 0 Receipt BOH-End 3340 2366 5192 4218 3229 2227 Planned Order
0 3800 0 0 0 3800

Figure 10-16 Combining DRP Tables

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Inventory at Multiple Locations The Square Root Law (SQL) 
 

Used to reduce inventory at multiple locations. As locations increase, inventory also increases, but not in the same ratio as the growth in facilities. The square root law (SRL) states that total safety stock can be approximated by multiplying the total inventory by the square root of the number of future facilities divided by the current number of facilities.
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Inventory at Multiple Locations The Square Root Law 


X2= (X1) *

(n2/n1)

Where:  n1 = number of existing facilities  n2 = number of future facilities  X1 = total inventory in existing facilities  X2 = total inventory in future facilities

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Square Root Law Example 
 

Current distribution 40,000 units Eight facilities shrinking to two Using the square root law: 


X2 = (40,000) * X2 = 20,000 units

(2/8)

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Table 10-9 Example Impacts of Square Root Law on Logistics Inventories
Warehouses 1 2 3 4 5 10 15 20 23 25 n 1.0000 1.4142 1.7321 2.0000 2.2361 3.1623 3.8730 4.4721 4.7958 5.0000 Total Av Inv 3,885 5,494 6,729 7,770 8,687 12,285 15,047 17,374 18,632 19,425 % Change --141% 173% 200% 224% 316% 387% 447% 480% 500%
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Figure 10-17 Four Directions for Replenishment Logistics

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Time-Based Approaches to Replenishment Logistics: Quick Response (QR) 

Structure of QR  Shorter, compressed time horizons.  Real-time information available by SKU.  Seamless, integrated logistics networks with rapid transportation, cross-docking and effective store receipt and distribution systems.

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Time-Based Approaches to Replenishment Logistics: Quick Response (QR) 

Structure of QR  Partnership relationships present among supply chain members.  Redesign of manufacturing processes to reduce lot sizes, changeover times and enhanced flexibility.  Commitment to TQM.

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Figure 10-18 Basic Elements of Quick Response (QR)

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Time-Based Approaches to Replenishment Logistics: Efficient Consumer Response (ECR) 

Structure of ECR  

Grocery industry estimates U.S. savings at approximately $30 billion. Ultimate goal is a responsive, consumer-driven system in which distributors and suppliers work together as business allies to maximize consumer satisfaction and minimize cost. Accurate information and high-quality products flow through a paperless system between manufacturing and check-out counter with minimum degradation or interruption
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Figure 10-19 Efficient Consumer Response: Broad Operating Capabilities Tailored to Each Unique Partner

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Chapter 10: Summary and Review Questions
Students should review their knowledge of the chapter by checking out the Summary and Study Questions for Chapter 10. This is the last slide for Chapter 10

Figure A10-1 Sawtooth Model Modified for Inventory in Transit

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Figure A10-2 EOQ Costs Considering Volume Transportation Rate

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Table 10A-1 Annual Savings, Annual Cost, and Net Savings by Various Quantities Using Incentive Rates

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Figure A10-3 Net Savings Function for Incentive Rate

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End of Chapter 10 and 10A Slides
Inventory Decision Making

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