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**Lecture 2: Inventory Management
**

Source

Supplier

Supplier

Distributor

Distributor

Retailer

End-User

Converter

Converter

Consumers

Information Flow

Funds/Demand Flow

Value-Added Services

Material Flow

Reuse/Maintenance/After Sales Service Flow

What Is a Supply Chain?

2

Supply Chain Management

Simchi-Levi’s Definition:

Supply chain management is a set of

approaches utilized to efficiently

integrate suppliers, manufacturers, warehouses,

and stores, so that

merchandise is produced and distributed at the

right quantities, to the right locations, and at the

right time, in order to

minimize system wide costs while satisfying

service level requirements.

3

SCM Challenges:

Optimization, integration and synchronization with

development chain

complex, large scale network

facilities with difference, conflicting objectives

dynamic systems

4

5

Outline

Introduction

The Needs, the Costs, and the Challenges

Single Stage Inventory Control

Economic Lot Size Model

Demand Uncertainty

Single Period

Single Period Model

Initial Inventory

Multiple Order Opportunities

Continuous Review Policy

Periodic Review Policy

Service Level Optimization

Why Is Inventory Required?

Uncertainty in customer demand

Shorter product lifecycles

More competing products

Uncertainty in supplies

Quality/Quantity/Costs

Delivery lead times

Incentives for larger shipments

6

Inventory Costs

Costs

Order cost:

Product cost

Transportation cost

Inventory holding cost, or inventory carrying cost:

Property taxes, and insurance on inventories

Maintenance costs

Obsolescence cost

Opportunity costs

7

How Much Does It Cost?

Distribution and inventory 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

8

GM’s production and distribution network

20,000 supplier plants

133 parts plants

31 assembly plants

11,000 dealers

Freight transportation costs: $4.1 billion (60% for

material shipments)

GM inventory valued at $7.4 billion (70%WIP; Rest

Finished Vehicles)

Decision tool to reduce:

combined corporate cost of inventory and transportation.

26% annual cost reduction by adjusting:

Shipment sizes (inventory policy)

Routes (transportation strategy)

How Much Does It Cost?

9

Holding the right amount at the right

time is difficult!---Challenging

Dell Computer was sharply off in its forecast of

demand, resulting in inventory write-downs

1993 stock plunge

IBM’s ineffective inventory management

1994 shortages in the ThinkPad line

Cisco’s declining sales

2001 $ 2.25B excess inventory charge

10

Inventory Management

Inventory Management Decisions:

What to order?

When to order?

How much is the optimal order quantity?

Approach includes a set of techniques

INVENTORY POLICY!!

11

12

Outline

Introduction

The Needs, the Costs, and the Challenges

Single Stage Inventory Control

Economic Lot Size Model

Demand Uncertainty

Single Period

Single Period Model

Initial Inventory

Multiple Order Opportunities

Continuous Review Policy

Periodic Review Policy

Service Level Optimization

Model Description (Assumptions)

D items per day: Constant demand rate

Q items per order: Order quantities are fixed

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.

Lead time = 0

(the time that elapses between the placement of an

order and its receipt)

Initial inventory = 0

Planning horizon is long (infinite).

13

Economic Lot Size Model

Inventory level as a function of time

14

Deriving EOQ

(Economic Order Quantity)

Total cost at every cycle:

Average inventory holding in a cycle: Q/2

Cycle time T =Q/D

Average total cost per time unit:

2

hTQ

K

2

hQ

Q

KD

h

KD

Q

2

*

15

Economic lot size model : Costs

Economic lot size model: total cost per unit time

h

KD

Q

2

*

16

Sensitivity Analysis

b .5 .8 .9 1 1.1 1.2 1.5 2

Increase

in cost

25% 2.5% 0.5% 0 .4% 1.6% 8.9% 25%

Total inventory cost relatively insensitive to order quantities

Actual order quantity: Q

Q is a multiple b of the optimal order quantity Q*.

For a given b, the quantity ordered is Q = bQ*

17

What Did We Optimized?

Trade-off between:

Ordering costs

Storage costs

18

19

Outline

Introduction

The Needs, the Costs, and the Challenges

Single Stage Inventory Control

Economic Lot Size Model

Demand Uncertainty

Single Period

Single Period Model

Initial Inventory

Multiple Order Opportunities

Continuous Review Policy

Periodic Review Policy

Service Level Optimization

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

Aggregate forecasts are more accurate.

More difficult to predict customer demand for

individual SKUs

Much easier to predict demand across all SKUs

within one product family

20

Single Period: The Model

Short lifecycle products

One ordering opportunity only

Order quantity to be decided before demand

occurs

Order Quantity > Demand => Dispose excess

inventory

Order Quantity < Demand => Lose sales/profits

21

Single Period: The Approach

Using historical data

identify a variety of demand scenarios

determine probability each of these scenarios will

occur

Given a specific inventory policy

determine the profit associated with a particular

scenario

given a specific order quantity

weight each scenario’s profit by the likelihood that it will

occur

determine the average, or expected, profit for a particular

ordering quantity.

Order the quantity that maximizes the average

profit.

22

Swimsuit: Single Period Model Example

Probabilistic forecast

23

Additional Information

Fixed production cost: $100,000

Variable production cost per unit: $80.

During the summer season, selling price: $125

per unit.

Salvage value: Any swimsuit not sold during the

summer season is sold to a discount store for

$20.

24

Two Scenarios

Manufacturer produces 10,000 units while

demand ends at 12,000 swimsuits

Profit

= 125(10,000) - 80(10,000) - 100,000

= $350,000

Manufacturer produces 10,000 units while

demand ends at 8,000 swimsuits

Profit

= 125(8,000) + 20(2,000) - 80(10,000) -

100,000

= $140,000

25

Probability of Profitability Scenarios

with Production = 10,000 Units

Probability of demand being 8000 units = 11%

Probability of profit of $140,000 = 11%

Probability of demand being 12000 units = 27%

Probability of profit of $350,000 = 27%

Total profit = Weighted average of profit

scenarios

26

Order Quantity that Maximizes

Expected Profit

Average profit as a function of production quantity

27

What Did We Optimized?

Expected (average) Profit

28

Risk-Reward Tradeoffs

Optimal production quantity maximizes average

profit is about 12,000

Producing 9,000 units or producing 16,000 units

will lead to about the same average profit of

$294,000.

If we had to choose between producing 9,000

units and 16,000 units, which one should we

choose?

29

Risk-Reward Tradeoffs

A frequency histogram of profit

30

Risk-Reward Tradeoffs

Production Quantity = 9000 units

Profit is:

either $200,000 with probability of about 11 %

or $305,000 with probability of about 89 %

Production quantity = 16,000 units.

Distribution of profit is not symmetrical.

Losses of $220,000 about 11% of the time

Profits of at least $410,000 about 50% of the time

With the same average profit, increasing the production

quantity:

Increases the possible risk

Increases the possible reward

31

Observations

The optimal order quantity is not necessarily

equal to forecast, or average demand.

As the order quantity increases, average profit

typically increases until the production quantity

reaches a certain value, after which the average

profit starts decreasing.

Risk/Reward trade-off: As we increase the

production quantity, both risk and reward

increases.

32

33

Outline

Introduction

The Needs, the Costs, and the Challenges

Single Stage Inventory Control

Economic Lot Size Model

Demand Uncertainty

Single Period

Single Period Model

Initial Inventory

Multiple Order Opportunities

Continuous Review Policy

Periodic Review Policy

Service Level Optimization

What If the Manufacturer Has an Initial

Inventory?

Trade-off between:

Using on-hand inventory to meet demand and avoid

paying fixed production cost: need sufficient

inventory stock

Paying the fixed cost of production and not have as

much inventory

34

Initial Inventory Solution

Profit and the impact of initial inventory

35

Manufacturer Initial Inventory = 5,000

If nothing is produced, average profit =

225,000 (from the figure: 125k+100k) + 5,000 x

80 = 625,000

If the manufacturer decides to produce

Production should increase inventory from 5,000 units

to 12,000 units.

Average profit =

371,000 (from the figure) + 5,000 • 80 =

771,000

36

No need to produce anything

average profit > profit achieved if we produce to

increase inventory to 12,000 units

If we produce, the most we can make on

average is a profit of $370,700.

Same average profit with initial inventory of 8,500

units and not producing anything.

If initial inventory < 8,500 units => produce to raise

the inventory level to 12,000 units.

If initial inventory is at least 8,500 units, we should

not produce anything

Manufacturer Initial Inventory =

10,000

37

38

Outline

Introduction

The Needs, the Costs, and the Challenges

Single Stage Inventory Control

Economic Lot Size Model

Demand Uncertainty

Single Period

Single Period Model

Initial Inventory

Multiple Order Opportunities

Continuous Review Policy

Periodic Review Policy

Service Level Optimization

Multiple Order Opportunities

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.

39

Continuous Review Policy: Model

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.

40

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

α = service level. This implies that the

probability of stocking out is 1 - α

Continuous Review Policy

41

(Q,R) policy – whenever inventory level falls to a

reorder level R, place an order for Q units

What is the value of R?

Continuous Review Policy

42

Continuous Review Policy

Average demand during lead time: L x AVG

Safety stock:

A combination of lead time and demand

uncertainty

Reorder Level, R:

Order Quantity, Q:

L STD z

L STD z AVG L

h

AVG K

Q

2

43

Service Level & Safety Factor, z

Service

Level

90% 91% 92% 93% 94% 95% 96% 97% 98% 99% 99.9%

z 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 - α

44

Service Level & Safety Factor, z

45

Inventory Level Over Time

L STD z

Inventory level before receiving an order =

Inventory level after receiving an order =

Average Inventory =

L STD z Q

L STD z

Q

2

Inventory level as a function of time in a (Q,R) policy

46

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%

47

Month Sept Oct Nov. Dec. Jan. Feb. Mar. Apr. May June July Aug

Sales 200 152 100 221 287 176 151 198 246 309 98 156

Continuous Review Policy Example

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

48

Parameter Average weekly

demand

Standard

deviation of

weekly demand

Average

demand

during lead

time

Safety

stock

Reorder

point

Value 44.58 32.08 89.16 86.20 176

87 . 0

52

250 18 . 0

Weekly holding cost

Optimal order quantity

679

87 .

58 . 44 500 , 4 2

Q

Average inventory level 679/2 + 86.20 = 426

Continuous Review Policy Example

49

50

Outline

Introduction

The Needs, the Costs, and the Challenges

Single Stage Inventory Control

Economic Lot Size Model

Demand Uncertainty

Single Period

Single Period Model

Initial Inventory

Multiple Order Opportunities

Continuous Review Policy

Variable Lead Times

Periodic Review Policy

Service Level Optimization

Inventory level is reviewed periodically at regular

intervals

An appropriate quantity is ordered after each review

Two Cases:

Short Intervals (e.g. Daily)

(s, S) policy

Longer Intervals (e.g. Weekly or Monthly)

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

Periodic Review Policy

51

(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.

52

Base-Stock Level Policy

Determine a target inventory level, the base-

stock level

Each review period, review the inventory

position 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.

53

Average demand during an interval of r + L

days=

Safety Stock=

L r STD z

AVG L r ) (

Base-Stock Level Policy

54

Base-Stock Level Policy

Inventory level as a function of time in a periodic

review policy

55

Ordering Receiving

Next Receiving

Summary: Economic Lot Size Model

Inventory level as a function of time

56

Summary: Lead Time

Inventory level as a function of time

57

Base-stock Level

Summary: Safety Stock

Inventory level as a function of time

58

Q+R

Safety Stock

Average Inventory

R

Base-Stock Level Policy

Inventory level as a function of time in a periodic

review policy

59

Ordering Receiving

Next Receiving

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 =

Base-stock level = 223 + 136 = 359

Average inventory level =

Base-Stock Level Policy Example

5 8 . 32 9 . 1

17 . 203 5 08 . 32 9 . 1

2

58 . 44 3

60

3 weeks cycle + 2 weeks lead time

Inventory level as a function of time in a periodic

review policy

61

62

Outline

Introduction

The Needs, the Costs, and the Challenges

Single Stage Inventory Control

Economic Lot Size Model

Demand Uncertainty

Single Period

Single Period Model

Initial Inventory

Multiple Order Opportunities

Continuous Review Policy

Periodic Review Policy

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

Service Level Optimization

63

Service Level Optimization

Service level

inventory

versus

inventory level

as a function

of lead time

64

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

65

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

66

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.

Profit Optimization and Service Level

67

68

Outline

Introduction

The Needs, the Costs, and the Challenges

Single Stage Inventory Control

Economic Lot Size Model

Demand Uncertainty

Single Period

Single Period Model

Initial Inventory

Multiple Order Opportunities

Continuous Review Policy

Periodic Review Policy

Service Level Optimization

Materials of some slides are taken from David Simchi-Levi; Philip Kaminsky; Edith Simchi-Levi.

"Designing and Managing the Supply Chain". McGraw-Hill Higher Education, 2008. ISBN-13:

9780073341521 (ISBN-10: 0073341525)

Used by Permission.

69

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