CHAPTER 9

INVENTORY POLICY DECISIONS

1
The probability of finding all items in stock is the product of the individual probabilities.
That is,
(0.95)(0.93) (0.87) (0.85) (0.94) (0.90) = 0.55
2
(a) The order fill rate is the weighted average of filling the item mix on an order. We can
setup the following table.
(1)

(2)
Frequency
Order Item mix probabilities
of order
1
0.20
.95.95.95.90.90 = .69
2
0.15
.95.95.95 = .86
3
0.05
.95.95.90.90 = .73
4
0.15
.95.95.95.95.95.90.90 = .62
5
0.30
.95.95.90.90.90.90 = .59
6
0.15
.95.95.95.95.95 = .77
Order fill rate

(3)=(1)(2)
Marginal
probability
0.139
0.129
0.037
0.094
0.178
0.116
0.693

Since 69.3 percent is less than 92 percent, the target order fill rate is not met.
(b) The item service levels that will give an order fill rate of 92 percent must be found by
trial and error. Although there are many combinations of item service levels that can
achieve the desired service level, a service level of 99 percent for items A, B, C, D, E,
and F, and 97 percent to 98 percent for the remaining items would be about right.
The order fill rates can be found as follows.
(1)
Order
1
2
3
4
5
6

(2)
Frequency
of order
0.20
0.15
0.05
0.15
0.30
0.15
Order fill rate

Item mix probabilities

(.99)3(.975)2 = .922
(.99)3 = .970
(.99)2(.975)2 = .932
(.99)5(.975)2 = .904
(.99)2(.975)4 = .886
(.99)5 = .951

93

(3)=(1) (2)
Marginal
probability
0.184
0.146
0.047
0.136
0.266
0.143
0.922

3
This is a problem of push inventory control. The question is one of finding how many of
120,000 sets to allocate to each warehouse. We begin by estimating the total
requirements for each warehouse. That is,
Total requirements = Forecast + zForecast error
From Appendix A, we can find the values for z corresponding to the service level at each
warehouse. Therefore, we have:

Warehouse
1
2
3
4
Total

(1)
Demand
forecast, sets
10,000
15,000
35,000
25,000
85,000

(2)
Forecast
error, sets
1,000
1,200
2,000
3,000

(3)
Values
for z
1.28
1.04
1.18
1.41

(4)=(1)+(2)(3)
Total requirements, sets
11,280
16,248
37,360
29,230
94,118

We can find the net requirements for each warehouse as the difference between the
total requirements and the quantity on hand. The following table can be constructed:

Warehouse
1
2
3
4

(1)
Total
requirements
11,280
16,248
37,360
29,230
94,118

(2)

(3)=(1)(2)

(4)

(5)=(3)+(4)

On hand
quantity
700
0
2,500
1,800

Net requirements
10,580
16,248
34,860
27,430
89,118

Proration of
excess
3,633
5,450
12,716
9,083
30,882

Allocation
14,213
21,698
47,576
36,513
120,000

There is 120,000 89,118 = 30,882 sets to be prorated. This is done by assuming that
the demand rate is best expressed by the forecast and proportioning the excess in relation
to each warehouse's forecast to the total forecast quantity. That is, for warehouse 1, the
proration is (10,000/85,000)30,882 = 3,633 sets. Prorations to the other warehouses are
carried out in a similar manner. The allocation to each warehouse is the sum of its net
requirements plus a proration of the excess, as shown in the above table.
4
(a) The reorder point system is defined by the order quantity and the reorder point
quantity. Since the demand is known for sure, the optimum order quantity is:

Q * = 2 DS / IC = 2(3,200)(35) / ( 015
. )(55) = 164.78, or 165 cases

94

The reorder point quantity is:

ROP = d LT = (3,200 / 52) 15
. = 92 units

(b) The total annual relevant cost of this design is:

TC = D S / Q + I C Q * / 2
. )(55)(164.78) / 2
= (3,200)(35) / 164.78 + ( 015
= 679.69 + 679.97
= $1,359.66
(c) The revised reorder point quantity would be:
ROP = (3,200 / 52 ) 3 = 185 units .

The ROP is greater than Q*. It is possible under these circumstances the reorder
quantity may not bring the stock level above the ROP quantity. In deciding whether
the ROP has been reached, we add any quantities on order or in transit to the quantity
on hand as the effective quantity in inventory. Of course, we start with an adequate
in-stock quantity that is at least equal to the ROP quantity.
5
(a) The economic order quantity formula can be used here. That is,

Q * = 2 DS / IC = 2(300)(8,500) / ( 010
. )(8,500) = 77.5, or 78 students
(b) The number of times that the course should be offered is:
N * = D / Q* = 300 / 77.5 = 3.9, or about four times per year
6
This is a single-period inventory control problem. We have:

Revenue = $350/unit
Profit = $350 $250 = $100/unit
Loss = 0.2250 = $50/unit
Therefore,
CPn =

100
= 0.667
100 + 50

Developing a table of cumulative frequencies, we have:

95

Quantity
50
55
60
65
70
75

Frequency
0.10
0.20
0.20
0.30
0.15
0.05
1.00

Cumulative
frequency
0.10
0.30
0.50
0.80 Q*
0.95
1.00

CPn lies between quantities of 60 and 65. We round up and select 65 as the optimal
purchase order size.
7
This question can be treated as a single-order problem. We have:

Revenue = 1 + 0.01 = $1.01/$

Cost/Loss = 0.10(2/365) = $0.00055/$ which is the interest expense for two days
Profit = 1.01 1.00055 = $0.00945/$
and
CPn =

0.00945
= 0.945
0.00945 + 0.00055

For an area under the normal curve of 0.945 (see Appendix A), z = 1.60.
The planned number of withdrawals is:
Q* = D + z D = 120 + 1.60(20) = 152.00
The amount of money to stock in the teller machine over two days would be:
Money = Q*75 = 152.0075 = $11,400
8
This is a single-period inventory control problem.

(a) We have:
Profit = 400 320
Loss = 320 300
Then,

96

CPn =

400 320
= 0.80
( 400 320) + (320 300)

We now need to find the sales that correspond to a cumulative frequency of 0.80. In the
following table:

Sales
500
750
1,000
1,250
1,500

Frequency
0.2
0.2
0.3
0.2
0.1
1.0

Cumulative
frequency
0.2
0.4
0.7
0.9 Q*
1.0

Q* lies between 1,000 and 1,200 in the cumulative frequency table. We choose to
roundup to Q* = 1,250 units.
(b) Carrying the excess inventory to next year,
CPn =

80
= 0.556
80 + ( 0.2 320)

where the loss is the cost of holding a unit until the next year. The Q* now lies between
750 and 1,000 units. We choose 1,000 units. Holding the excess units means a potential
loss of 0.2320 = $64/unit, whereas discounting the excess units represents a loss of only
320 300 = $20/unit. Therefore, Cabot will need fewer units if they are held over in
inventory.
9
(a) The optimum order quantity is:

Q * = 2 DS / IC = 2(1,250)(52)( 40) /(0.3)(56) = 556 cases

and the reorder point quantity is:
ROP = d LT + z sd'
where
sd' = sd LT = 475 2.5 = 751

and z P=0.80 = 0.84.

97

Now,
ROP = (1,250)( 2.5) + ( 0.84 )( 751) = 3,756 cases

Policy: When the amount of inventory on hand plus any quantities on order or in
transit falls below ROP, reorder an amount Q*.
(b) For the periodic review system, we first estimate the order review time:
T * = Q * / d = 556 / 1,250 = 0.44 weeks
The max level is:
M * = d (T * + LT ) + z sd'
where sd' now is:
sd' = sd T * + LT = 475 0.44 + 2.5 = 814 cases
Hence,
M * = 1,250( 0.44 + 2.5) + 0.84(814 ) = 4,359 cases
Policy: Find the amount of stock on hand every 0.44 weeks and place a reorder for
the amount equal to the difference between the quantity on hand and the max level
(M*) of 4,359 cases.
(c) The total annual relevant cost for these policies is:
TC = DS / Q + ICQ / 2 + ICzsd' + kDs d' E( z ) / Q
For the reorder point system:
TCQ = 1250(52)(40)/556 + .3(56)(556)/2
+ .3(56)(.84)(751) + 10(1250)(52)(751)(.1120)/556
= 4,676.26 + 4,670.40 + 10,598.11 + 98,332.37
= $118,277.14
For the periodic review system:
TCP = 1250(52)(40)/556 + .3(56)(556)/2

98

+ .3(56)(.84)(814) + 10(1250)(52)(814)(.1120)/556
= 4,676.26 + 4,670.40 + 11,487.17 + 106,581.29
= $127,415.12
(d) The actual service level achieved is given by:
SL = 1

sd' E( z )
Q

For the reorder point system:

SLQ = 1

751( 01120
.
)
= 1 015
.
556

or demand is met 85 percent of the time.

For the periodic review system:
SLP = 1

814( 01120
.
)
= 1 016
.
556

or demand is met 84 percent of the time.

(e) This requires an iterative approach as follows:
Compute Q = 2 DS / IC

Compute P = 1 QIC / Dk , then z, then E (z)

Compute Q = 2 D( S + ksd' E( z ) ) / IC
Go back and stop when there is no change
in either P or Q
After the initial value of Q = 556.3, the process can be summarized in tabular form.

99

Step
1
2
3
4
5
6

Q
778.4
860.0
889.9
899.6
902.8
902.8

P
0.9856
0.9799
0.9778
0.9777
0.9767
0.9767

z
2.19
2.06
2.01
2.00
1.99
1.99

E(z)
0.0050
0.0072
0.0083
0.0085
0.0087
0.0087

Now, for P = 0.9767, z = 1.99

ROP = 1,250(2.5) + 1.99(751) = 4,620 cases
and the total relevant cost is:
TCQ = DS / Q + ICQ / 2 + ICzsd' + kDsd' E( z ) / Q
= 65,000( 4 ) / 902.8 + 0.3(56)(902.8 ) / 2
+0.3(56 )(199
. )( 751)
+10( 65,000 )( 751)( 0.0087 ) / 902.8
= $40,275

This is considerably less than the $118,277.14 for the preset P at 0.80.
If you solve this problem using INPOL, you will get a slightly different answer. That
is, Q* = 858. This simply is because z is carried to two significant digits rather than
the four significant digits used in the above calculations.
10
Refer to the solution of problem 10-9 for the general approach.

(a) Q* = 556.3 cases

and
2
ROP = d LT + z LT sd2 + d 2 sLT

= 1,250( 2.5) + 0.84 2.5 4752 + 1,250 2 0.52

= 3125
+ 0.84(977.08 )
,
= 3,946 cases

(b) An approximation for T* = Q*/d, or

T* = 556/1,250 = 0.44 weeks
and approximating sd' as
100

2
sd' = (T * + LT )sd2 + d 2 sLT

= ( 0.44 + 2.5)( 4752 ) + 1,250 2 ( 0.5) 2

= 1,027 cases
So,

Max = d (T * + LT ) + z sd'
= 1,250( 0.44 + 2.5) + 0.84(1,027)
= 4,537 cases
(c) According to INPOL,
TC = 4,686 + 4,686 + 128,195 + 13,862 = $151,429
Q

TC = 4,686 + 4,686 + 134,751 + 14,571 = $158,694

P

(d) According to INPOL,

SL = 80.28 percent
Q

SL = 79.27 percent
P

(e) According to INPOL,

Q* = 930 cases, ROP = 5,128 cases,
TC = $49,532, SLQ = 99.22 percent
Q

T* = 0.76 weeks, MAX = 6,257 cases

TC = $52,894, SLP = 99.18 percent
P

11
(a) The production run quantity is:
Q *p =

p
2 DS

=
IC
pd

2(100 )( 250 )( 250 )

300

= 1,000 units
0.25( 75)
300 10

(b) The production run cycle is:

Q *p = 1,000 / 300 = 333
. days

101

(c) The number of production runs is:

D / Q *p = 100( 250 ) / 1,000 = 25 runs per year
12
(a) The order quantity is:

Q * = 2 DS / IC = 2( 2,000)( 250 )(100

. ) / ( 0.30 )(35) = 309 valves
and the reorder point quantity is:
ROP = d LT + z sd LT

but sd = 0 . Therefore,
ROP = ( 2,000 / 8 )(1) = 250 valves

(b) Boxes are set up that contain 309 valves - the optimum order quantity. When an
order arrives from a supplier, 250 valves are set aside in a separate box and are
treated as the backup stock. The residual 309 250 = 59 valves are used on the
production line. When the 59 valves at the production line are used up, the backup
box containing 250 valves is brought to the production line and the empty box is sent
to the supplier refilling. One hour later when the order arrives, there will be zero
valves remaining at the production line. Then, 250 valves are set aside and 59 are
sent to the production line. The cycle is then repeated.
This problem approach is similar to that of the KANBAN system. Lead times are
very short so that lead times are virtually certain. Demand is certain, since it is fixed
by the production schedule. Boxes or cards are used to assure movement of the most
economic quantity. KANBAN is essentially classic economic reorder point inventory
control under certainty.
13
(a) The economical quantity of cars to be called for at a time is found by the economic
order quantity formula:

Q * = 2 DS / IC = 2( 40 )(52 )(500 ) / ( 0.25)(90,000)(30 ) / 2,000 = 78.5, or 79 cars

(b) This is the reorder point quantity:
ROP = d LT + z sd LT

where z = 1.28 from Appendix A for an area under the curve equal to 0.90.
Therefore,

102

ROP = 40(1) + 128

. (333
. ) 1
= 44.3 cars, or 44.3(90,000 / 2,000)
= 1,994 tons of soda ash
14
(a) This is a reorder point design under conditions of uncertainty for both demand and
lead-time. We assume that the probability of an out of stock is given. Therefore, the
order quantity is:

Q * = 2 DS / IC = 2(50)(365)(50) / ( 0.30)( 45) = 367.7 units

and
ROP = d LT + z sd'
where
z = 1.04 (see Appendix A) for the area under the curve equal to 0.85 and
2
sd' = sd2 LT + d 2 sLT
= 152 ( 7 ) + (50 2 )( 2 2 ) = 107.6 units

Therefore,
ROP = 50( 7) + 104
. (107.6 ) = 4619
. units

(b) This is the periodic review system design under uncertainty. The complexity requires
us to make some approximations here. The time interval for review of the stock level
is:
T * = Q * / d = 367.7 / 50 = 7.35 days
The MAX level is:
MAX = d (T * + LT ) + z sd'
where z = 1.04 and sd' is approximated as:
2
sd' = (T * + LT )( sd2 ) + d 2 ( sLT
)

= ( 7.35 + 7)(152 ) + 50 2 ( 2 2 )
= 115.0 units
Therefore,
103

MAX = 50(7.35 + 7) + 1.04(115.0)

= 837.1 units
(c) Since the service level is specified, the probability is not set at the optimum level.
Knowing the out-of-stock cost allows us to find the most appropriate service level.
Since this is an iterative process, we use INPOL to carry out the calculations.
The optimized service level yields a reorder point design of
Q* = 410 units and ROP = 571 units
and the total relevant cost drops from $12,642 in part a to $8,489. The demand in
stock in part a was 97.74 percent, and it now increases to 99.81 percent.
15
(a) Find the common review time:

T * = 2( O + s I ) / I Ci Di
= 2(100 + 0) / [( 0.3 / 52 )( 2 25 2,000 + 1 90 500 )]
= 2.5 weeks
Then,

M *A = d A (T * + LT ) + z A sd A T * + LT
where z = 1.282 for P = 0.90
A

M *A = 2,000( 2.5 + 15
. ) + 1282
. (100) 2.5 + 15
. = 8,256 units

and
M B* = 500( 2.5 + 15
. ) + 0.842( 70) 2.5 + 15
. = 2,118 units

where z = 0.842 for P = 0.80.

B

The control system works as follows: the stock levels of both items are reviewed
every 2.5 weeks. The reorder size for A is the difference between the amount on hand
and 8,256 units. The reorder size for B is the difference between the amount on hand
and 2,118 units.

(b) The average amount in inventory is expected to be:

104

AIL = d T * / 2 + z sd T * + LT
For A:
AIL A = 2,000( 2.5) / 2 + 128
. (100 ) 2.5 + 15
. = 2,756 units

For B:
AILB = 500( 2.5) / 2 + 0.842( 70 ) 2.5 + 15
. = 743 units

(c) The service level is given by:

SL = 1 sd' E( z ) / d T *
For A:
SLA = 1 100 2.5 + 15
. ( 0.0475) / 2,000( 2.5) = 0.998

For B:
SLB = 1 70 2.5 + 15
. ( 01120
.
) / 500( 2.5) = 0.987

(d) We set T* = 4 and cycle through the previous calculations. Thus, we have:
M *A = 11,301 units

M B* = 2,888 units

AIL = 4,301

AIL = 1,138

SL = 0.999

SL =0 .991

16
This problem is one of comparing the combined cost of transportation and in-transit
inventory. In tabular form, we have the following annual costs:

Cost type
Transportation

Formula
RD

In-transit
inventory

ICDT/365

Total

Rail
Truck
6(40,000)(1.25)
11(40,000)(1.25)
= $300,000
= $550,000
0.25( 250 )( 40,000 )( 21) 0.25( 250 )( 40,00 )( 7 )
365
365
= $47,945
= $143,836
$597,945
$443,836

You should select rail.

17

105

The two transport options from the consolidation point are diagrammed in Figure 9-1.
Whether to choose one mode over the other depends more than transportation costs alone.
Because the transport modes differ in the time in transit, the cost of the money tied up in
the goods while in transit must be considered in the choice decision. This in-transit
ICDt
. The following design matrix can be developed.
inventory cost is estimated from
365
Cost type
Transportation
In-transit inventory

Method
RD
ICDt/365
Total

Air
$180,800
3,447*
$184,247

Ocean
$98,800
34,467
$133,267

ICDt/365 = 0.17(185)(20,000)(2)/365= 3,447

Ocean appears to be the lowest cost option even when a substantial in-transit inventory
cost is included. The ocean option assumes that the trucking cost to move the goods from
the consolidation point to the Port of Baltimore is included in the ocean carrier rate.
FIGURE 9-1 The
Consolidation Operation for a
Hydraulic Equipment
Manufacturer

Multiple sourcing points

Consolidation
point

Baltimore

20 days
2 days
Sao
Paolo

18
The demand pattern is definitely lumpy, since s = 327 > d = 169. To develop the minmax system of inventory control, we first find Q*. That is,
d

Q * = 2 DS / IC = 2(169)(12)(10) / 0.20( 0.96 + 0.048) = 448.5 units

The ROP is
ROP = d LT + z sd' + ED
where
z = 1.04 from Appendix A,
106

ED = 8 unitsthe average daily demand rate,

and
2
sd' = sd2 LT + d 2 sLT

= 327 2 ( 4) + 169 2 ( 0.8 2 )

= 667.8 units
So,
ROP = 169(4) + 1.04(667.8) + 8
= 1,378.5 units
The max level is:
M* = ROP + Q* ED
= 1,378.5 + 448.5 8
= 1,819 units
19
(a) The basic relationship is:
IT = I i n

We know that I = $5,000,000. If there are 10 warehouses, the amount of inventory in

a single one would be:
T

I1 = I T / 10 = 5,000,000 / 3162
.
= 1,581139
,

The inventory in all 10 warehouses would be $1,581,13910 = $15,811,390.

(b) The inventory in a single warehouse would be:
IT = 1,000,000 9 = 3,000,000

In each of three warehouses, we would have:

I = 3,000,000 / 3 = $1,732,051

107

and in all three warehouses, we would have $1,732,0513 = $5,196,152.

20
(a) The turnover ratio is the annual demand (throughput) divided by the average
inventory level. These ratios for each warehouse and for the total system are shown
in the table below.

Warehouse
21
24
20
13
2
11
4
1
23
9
18
12
15
14
6
7
22
8
17
16
10
19
3
5

Annual
warehouse
thruput
2,586,217
4,230,491
6,403,349
6,812,207
16,174,988
16,483,970
17,102,486
21,136,032
22,617,380
24,745,328
25,832,337
26,368,290
28,356,369
28,368,270
40,884,400
43,105,917
44,503,623
47,136,632
47,412,142
48,697,015
57,789,509
75,266,622
78,559,012
88,226,672
818,799,258

Average
inventory
level
504,355
796,669
1,009,402
1,241,921
2,196,364
1,991,016
2,085,246
2,217,790
3,001,390
2,641,138
3,599,421
2,719,330
4,166,288
3,473,799
5,293,539
6,542,079
2,580,183
5,722,640
5,412,573
5,449,058
6,403,076
7,523,846
9,510,027
11,443,489
97,524,639

Turnover
ratio
5.13
5.31 Avg. = 5.59
6.34
5.49
7.36
8.28
8.20
9.53
7.54
9.37
7.18
9.70
6.81
8.17
7.72
6.59
17.25
8.24
8.76
8.94
9.03
10.00
8.26 Avg. = 8.66
7.71
8.40

The overall turnover ratio is 8.40. Ranking the warehouses by throughput and
averaging turnover ratios for the top three and the bottom three warehouses shows
that the lowest volume warehouses have a lower turnover ratio (5.59) than the highest
volume warehouses (8.66). There are several reasons why this may be so:

The larger warehouses contain the higher-volume items such as the A items in the
line. These may carry less safety stock compared with the sales volume.
Conversely, the low-volume warehouses may have more dead stock in them.

108

There may be start-up (fixed) stock in the warehouses, needed to open them, that
becomes less dominant with greater throughput.

(b) A plot of the inventory-throughput data is shown in Figure 9-2. A linear regression
line is also shown fitted to the data. The equation for this line is:
Inventory = 200,168 + 0.1132Throughput
FIGURE 9-2

Plot of Inventory and Warehouse Thruput for California Fruit

Growers Association

12

Average inventory level, $ (Millions)

10

8
E s t im a t in g lin e

0
0

20

40

60

80

100

A n n u a l w a r e h o u s e t h r u p u t , $ ( M il lio n s )

(c) The total throughput for the three warehouses is:

Warehouse
1
12
23
Total

Throughput
$21,136,032
26,368,290
22,617,380
$70,121,702

Using this total volume and reading the inventory level from Fig. 9-2 or using the
regression equation, we have:
Inventory = 200,168 + .01132(70,121,702)
= $8,137,945
109

(d) Warehouse 5 has a throughput of $88,226,672. Splitting this throughput by 30

percent and 70 percent, we have:
0.3088,226,672 = 26,468,002
0.7088,226,672 = 61,758,670
88,226,672
Estimating the inventory for each of the new warehouses using the regression
equation, we have:
Inventory = 200,168 + 0.113226,468,002 = $3,196,346
and
Inventory = 200,168 + 0 .113261,758,670 = $7,191,249
for at total inventory in the two warehouses of $10,387,595
21
The order quantity for each item when there is no restriction on inventory investment is:
Q * = 2 DS / IC

We first find the unrestricted order quantities.

Q A* = 2(51,000)(10) / 0.25(17
. ) = 1,527 units
QB* = 2( 25,000)(10) / 0.25(325
. ) = 784 units
QC* = 2(9,000)(10) / 0.25( 2.50) = 537 units
The total inventory investment for these items is:
IV = C A ( Q A / 2) + CB ( QB / 2) + CC ( QC / 2)
= 175
. (1,527 / 2) + 3.25( 784 / 2) + 2.50(537 / 2)
= $3,28138
.
Since the total investment limit is exceeded, we need to revise the order
quantities. For each product:
Q * = 2 DS / [C( I + )]

110

For product A:
Q *A = 2(51,000)(10) / [175
. ( 0.25 + )]
For product B:
QB* = 2( 25,000)(10) / [3.25( 0.25 + )]
For product C:
QC* = 2(9,000)(10) / [2.50( 0.25 + )]
Now, the investment limit must be respected so that:
3,000 = C A ( Q A / 2 ) + CB ( QB / 2 ) + CC ( QC / 2 )

Expanding we have:
3,000 = 175
.
2(51,000)(10) / [175
. ( 0.25 + )]
2( 25,000)(10) / [3.25( 0.25 + )]
+325
.
+2.50 2(9,000)(10) / [2.50( 0.25 + )]
We now need to find an value by trial and error that will satisfy this equation. We
can set up a table of trial values.
Investment in

0.03
0.04
0.045
0.049
0.05
0.10

A
1,262.44
1,240.48
1,229.92
1,221.67
1,219.63
1,129.16

B
1,204.53
1,183.58
1,173.51
1,165.63
1,163.69
1,077.36

C
633.87
622.84
617.54
613.40
612.37
566.95

Total
inventory
value, $
3,100.84
3,046.90
3,020.97
3,000.70
2,995.69
2,773.47

When the term I+ is the same for all products, as in this case, may be found
directly from Equation 10-30.
We can substitute the value for = 0.049 into the equation for Q* and solve.
Hence, we have:

111

Q A* = 2(51000)(10) / [175
. ( 0.25 + 0.049)] = 1,396 units
QB* = 2( 25,000)(10) / [3.25( 0.25 + 0.049)] = 717 units
QC* = 2(9,000)(10) / [2.50( 0.25 + 0.049)] = 491 units
Checking:
1.75(1,396)/2 + 3.25(717)/2 + 2.50(491)/2 = $3,000
22
We first check to see whether truck capacity will be exceeded. Since three items are to
be placed on the truck at the same time, the items are jointly ordered. The interval for
ordering follows Equation 9-23, or:

2( O + S i )

T* =

I Ci Di

2( 60 + 0)
0.25[50(100)(52) + 30(300)(52) + 25( 200)(52)]

120
= 0.022 years, or 1.144 weeks
0.25(988,000)

=
Now, from

DT
i

wi Truck capacity

[100(70) + 300(60) + 200(25)][1.144] = 34,320 lb.

The truck capacity of 30,000 lb. has been exceeded, and the order quantity or the order
interval must be reduced. Given the revised Equation 9-31, the increment to add to I can
be found. That is,

2O
Truck capacity

Di wi

C D
i

2( 60)
2

30,000

(50(10)(52) + 30(30)(52) + 25( 20)(52))

[100(52)( 70) + 300(52)( 60) + 200(52)(10)]
120
2

30,000
(988,000)

2,340,000

0.25

= 0.73895 0.25 = 0.48895

Revise T*, the order interval by:

112

0.25

2( O + S i )

T* =

( I + ) Ci Di

2( 60 + 0)
( 0.25 + 0.48895)[50(100)(52) + 30(300)(52) + 25( 200)(52)]

120
= 0.01282 years, or 0.6667 weeks
0.73895(988,000 )

Once again, we check that the truck capacity has not been exceeded.
[100(70) + 300(60) + 200(25)][0.66667] = 30,000 lb.
Therefore, place an order every 4.7, or approximately five days.
23
The average inventory for each item is given by:

Q*
AIL =
+ z sd'
2

2 DS
. z@ 95% = 1.65 from the normal
IC
distribution in Appendix A. The results of these computations can be tabulated.
where sd' = sd LT and Q* is found by Q * =

sd'
Q*

AIL

A
7.75
188.38
106.98

B
15.49
238.28
144.70

C
19.36
421.23
242.56

D
11.62
361.98
200.16

E
27.11
565.14
327.30

Summing the AIL for each product gives a total inventory of 1,022 cases.
24
The peak quantity of an item to appear on a shelf can be approximated as the order
quantity plus safety stock, or

Q + z sd' 250 boxes

where z@93% = 1.48 from Appendix A and sd' = sd LT = 19 1 = 19 boxes. The
economic order quantity is
Q* =

2 DS
=
IC

2(123 52 )(125
. )
= 255.42 boxes
019
. (129
. )

Checking to see if the shelf space limit will be exceeded by this order quantity

113

255.42 + 1.48(19) = 283.54 boxes

The quantity is greater than the 250 allowed. Subtracting the safety stock from the limit
gives 250 28 = 222 boxes. The order quantity should be limited to this amount.
25
The plot of average inventory to period facility throughput (shipments) gives an overall
indication of how the company is managing collectively its inventory for all stocked
items. We can see that the relationship is linear with a zero intercept. This suggests that
the company is establishing its inventory levels directly to the level of demand
(throughput). An inventory policy, such as stocking to a number of weeks of demand,
may be in effect.
Overall, the inventory policy seems to be well executed in that the regression line fits
the point for each warehouse quite well. The terminal with an inventory level of $6,000
seems to be an outlier and it should be investigated. If its high turnover ratio were
brought in line with the other terminals, an inventory reduction from $6,000 to $4,000 on
the average could be achieved.
The stock-to-demand inventory policy should be challenged. An appropriate
inventory policy should show some economies of scale, i.e., the inventory turnover ratio
should increase as terminal throughput increases. Whereas the current policy is of the
form I = 0.012 D , a better policy would be I = kD 0.7 , where D represents terminal
throughput and I is the average inventory level. The coefficient 0.012 for the current
policy is found as the ratio of 6,000/500,000 = 0.0.12 for the last data point in the plot.
The k value for the improved policy needs to be estimated. From the cluster of the lowest
throughput facilities, the average inventory level is approximately $2,000 with an average
throughput of about $180,000. Therefore, from
I = kD 0.7
2,000 = k (180,000) 0.7
2,000 = k ( 4,771.894)
2,000
k=
4,771.894
k = 0.419

Reading values from the plot, the following table can be developed showing the
inventory reduction that might be expected from revised inventory policy. (Note: If the
inventory-throughput values cannot be adequately read from the plot, the values in the
following table may be provided to the students.)

Terminal
1
2
3
4

Actual
Inventory, $
2,000
1,950
2,000
2,050

Shipments, $
150,000
195,000
200,000
200,000

Estimated inventory, $
I = 0.012 D
1,800
2,340
2,400
2,400

114

Revised inventory, $
I = 0.419 D 0.7
1,760
2,115
2,152
2,152

5
6
7
8
9
Totals

3,900
6,000
4,500
4,300
5,500
32,200

320,000
330,000
390,000
410,000
500,000
2,695,000

3,840
3,960
4,680
4,920
6,000
32,340

2,991
3,056
3,435
3,558
4,088
25,307

Revising the inventory control policy has the potential of reducing inventory from the
32,340 25,307
linear policy by
x100 = 21.7% .
32,340
26
We can use the decision curves of Figure 9-23 in the text answer this question since it
applies to a fill rate of 95 percent and an = 0.7. First, determine K for an inventory
throughput curve for the item, which is

K=

D1 (117 x12) 0.3

=
= 1.466
6
TO

Next,
X =

12(117 x12) 0.3

tD10.7
=
= 0.90
0.20( 400)(1.466)
ICK

and with z 1.96 from Appendix A

Y =

zs LT
1.96(15) 2
=
= 0.18
a
KD
(1.466)(117 x12) 0.7

The demand ratio r is 42/177 = 0.36. The intersection of r and X lies below the curve Y
(use curve Y = 0.25), so do not cross fill.
27
Regular stock
For two warehouses, estimate the regular stock for the three products.

115

Product A

Product B

2dS
Q
RS = = IC
2
2
2(3,000)( 25)
0.02(15)
RS A1 =
= 354 units
2
2(5,000)( 25)
0.02(15)
RS A2 =
= 457 units
2

RS B1 =
RS B 2 =

Product C

RSC1 =
RSC 2 =

2(8,000)( 25)
0.02(30)
= 408 units
2
2(9,500)( 25)
0.02(30)
= 445 units
2

2(12,500)( 25)
0.02( 25)
= 559 units
2
2(15,000)( 25)
0.02( 25)
= 612 units
2

Regular system inventory for two warehouses is RS2W = 354 + 457 + 408 + 445 + 559 +
612 = 2,835.
Regular stock for a central warehouse

RS A =
RS B =
RSC =

2(8,000)( 25)
0.02(15)
= 577 units
2
2(17,500)( 25)
0.02(30)
= 604 units
2
2( 27,500)( 25)
0.02( 25)
= 829 units
2

Total central warehouse regular stock is RS1W =577 + 604 + 828 = 2,009 units.

116

Safety Stock
Product A
SS = zsd LT
SS A1 = 1.65(500) 0.75 = 714 units
SS A2 = 1.65(700) 0.75 = 1,000 units

where z@0.95 = 1.65 from Appendix A

Product B
SS B1 = 1.65( 250) 0.75 = 357 units
SS B 2 = 1.65(335) 0.75 = 479 units
Product C
SS = zsd LT
SS C1 = 1.65(3,500) 0.75 = 5,001 units
SS C 2 = 1.65(2,500) 0.75 = 3,572 units
System safety stock is SS2W = 714 + 1,000 + 357 + 479 + 5,001 + 3,572 = 11,123 units
For each product, the estimated standard deviation of demand on the central warehouse
is:
s A = s12 + s22 = 500 2 + 700 2 = 860 units
s B = 250 2 + 3352 = 418 units
s B = 3,500 2 + 2,500 2 = 4,301 units

The safety stock is:

SS = zs LT
SS A = 1.65(860) .75 = 1,229 units
SS B = 1.65(418) .75 = 597 units
SSC = 1.65(4,301) .75 = 6,146 units
Total safety stock in the central warehouse SS1W = 1,229 + 597 + 6,146 = 7,972 units.
Total inventory with two warehouses RS2W + SS2W = 2,835 + 11,123 = 13,958 units and
for a central warehouse RS1W + SS1W = 2,009 + 7,972 = 9,981 units. Centralizing
inventories reduces them by 13,958 9,981 = 3,977 units.
28
The solution to this multi-echelon inventory control problem is approached by using the
base-stock control system method. The idea is that inventory at any echelon is to plan its
inventory position plus the inventory from all downstream echelons.

117

First, compute the average inventory levels for each customer. This requires finding
Q and the safety stock. Q is found from the EOQ formula.
For customer 1
Q1 =

2( 425 x12)(50)
= 270 units
0.2(35)

AIL1 =

Q1
270
+ zs d1 LT3 =
+ 1.65(65) 0.5 = 211 units
2
2

where z@0.95 =1.65 from Appendix A

For customer 2
Q2 =

2(333 x12)(50)
= 239 units
0.2(35)

AIL2 =

Q2
239
+ zs d 2 LT3 =
+ 1.65(52) 0.5 = 180 units
2
2

For customer 3
Q3 =

2( 276 x12)(50)
= 218 units
0.2(35)

AIL3 =

Q3
218
+ zsd 3 LT3 =
+ 1.65(43) 0.5 = 159 units
2
2

Total customer echelon inventory is AILC = 211 + 180 + 159 = 550 units
For the distributors echelon
Q D = 2,000 units
AILD =

QD
2,000
+ zsd D LTD =
+ 1.28(94) 1.0 = 1,120 units
2
2

where z@0.90 =1.28 from Appendix A

The expected inventory that the distributor will hold is the distributor echelon inventory
less the combined inventory for the customers, or 1,120 - 550 = 570 units.

118

COMPLETE HARDWARE SUPPLY, INC.

Teaching Note
Strategy
Complete Hardware Supply is an exercise involving the control of inventoried items
collectively. Data for a random sample of 30 items from the company's total of 500 items
held in inventory are given. The objective is to manage the total dollar value allowed to
be held as inventory. Several alternatives can be considered for changing inventory
levels, some of which require an investment other than in inventory.
The number of items that must be analyzed and the multiple scenarios that are to be
examined can be computationally time consuming. It is strongly suggested that students
use the INPOL module within LOGWARE to aid analysis. The current database has
been prepared and is available in the LOGWARE software.
The Base Case
We begin with the current data optimized as a reorder point design. The optimum order
quantities and associated inventory levels are found. The base case costs are shown as
follows:

Fixed order quantity policy

Purchase cost
Transport costa
Carrying cost
Order processing cost
Out-of-stock cost
Safety stock cost
Total cost
Total investment

$556,912
0
4,425
4,425
0
2,529
$568,291
$27,801

aIncluded in the purchase cost

We note that optimizing the current design shows that investment of $27,801 exceeds
the allowed investment level of $18,000. Ways need to be explored to reduce this.
Transmit Orders More Rapidly
Instead of mailing orders to vendors, Tim O'Hare can buy a facsimile machine and
transmit orders electronically. This scenario can be tested by reducing the lead times in
the base case by two days, or (2/5) = 0.40 weeks and increasing order processing costs by
two dollars, and then optimizing again. INPOL shows that there will be a slight increase
in operating costs from $568,291 to $568,640, an incremental increase of $349.
Projecting this to all 500 items, we have 349(500/30) = $5,817. Since both operating cost
and inventory investment level increase, there is no economic incentive to implement this
change.
Faster Transportation
Suggesting that vendors who are located some distance (>600 miles) from the warehouse
use premium transportation is a possible way of reducing lead times, and therefore safety

119

stock levels. Of course, the increase in transportation cost for those affected vendors is
likely to lead to a price increase to cover these costs. This scenario is tested by reducing
the lead-time in weeks to 2.2 for those vendors over 600 miles from the warehouse. For
these same vendors, a five percent price increase is made.
Compared with the base case, there is little change in the inventory investment
($27,801 vs. $27,746); however, operating costs increase. The total costs now are
$585,490 compared with the base case of $568,291, an increase of $27,199. The major
portion ($17,159) of this comes from the increase in price. We conclude that this is not a
good option for Tim.
Reduce Forecast Error
Reducing the forecast error involves reducing the standard deviation of the forecast error.
Testing this option requires taking 70 percent of the base-case forecast error standard
deviations and optimizing the design once again.
These changes have a positive impact on operating costs and inventory investment.
Operating cost now is $567,529 and inventory investment is $24,739. This is a saving in
operating costs of $762 per year. For all 500, we can project the savings to be
762(500/30) = $12,700. Based on a simple return on investment, we have:

ROI =

12,700
0.25, or 25% / year
50,000

This would appear to be attractive since carrying costs are 25 percent per year and the
company's return on investment probably makes up about 80 percent of this value.
Reduce Customer Service
At this point, we have only accepted the idea of reducing the forecast error. However,
inventory investment remains too high. We can now try to reduce it by reducing the
service levels. This is tested by dropping the service index from its current 0.98 level to a
level where inventory investment approximates $18,000. This is done, assuming the
forecast software will be purchased and the forecast error reduced by 30 percent. By trial
and error, the service index is found to be 0.54, which gives an investment level of
$18,028. The revised service level compared with the base case is summarized below for
the 30 items.

120

Item
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Base
case
99.88%
99.92
99.96
99.98
99.98
99.96
99.97
99.96
99.92
99.98
99.99
99.99
99.92
99.98
99.96

Revised
96.26%
98.02
98.54
99.15
99.45
98.60
98.84
98.61
97.29
99.26
99.70
99.43
97.30
99.14
98.84

Item
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30

Base
case
99.98%
99.90
99.95
99.89
99.97
99.69
99.97
99.97
99.96
99.92
99.97
99.93
99.89
99.97
99.91

Revised
99.56%
97.57
97.81
95.96
98.15
89.53
98.96
98.96
97.58
99.33
96.68
97.45
98.78
96.92
96.78

Notice how little the service level changes, even with a substantial reduction in the
service index.
Conclusions
Tim can make a good economic argument for purchasing software that will reduce the
forecast error. The only questions here are whether the software can truly produce at
least the error reduction noted and whether a 25 percent return on investment is adequate
for the risks involved.
Arguing to accept a service reduction in order to lower the investment level is a little
less obvious since we do not know the effect that service levels have on sales. However,
Tim may point out that the service levels need to be changed so little that it is unlikely
that customers will detect the change. He might also raise the question as to whether
customer service levels were too high initially, and suggest that customers be surveyed as
to the service levels that they do need.

121

AMERICAN LIGHTING PRODUCTS

Teaching Note
Strategy
American Lighting Products is a manufacturer of fluorescent lamps in various sizes for
industrial and consumer use. As frequently happens in business, top management has
requested that inventories be reduced across the board, but it does not want to sacrifice
customer service. Sue Smith and Bryan White have been asked to eliminate 20 percent
of the finished goods inventory. Their plan is to reduce the number of stocking locations
and, thereby, eliminate the amount of inventory needed. Of course, they must recognize
that with fewer stocking points, transportation costs are likely to increase and customer
delivery times may increase as well. On the other hand, facility fixed cost may be
reduced.
The purpose of this case is to allow students to examine inventory policy and
planning through aggregate inventory management procedures. They also can see the
connection between location and inventory levels.
Answers to Questions
(1) Evaluate the companys current inventory management procedures.

The companys procedures for controlling inventory levels are at the heart of whether
inventory reductions are likely to be achieved through inventory consolidation. The
company appears to be using some form of reorder point control for the entire system
inventory, but it is modified by the need to produce in production lot sizes. It is not clear
how the reorder point is established. If it is based on economic order quantity principles,
then the effect of the principles becomes distorted by the need to produce to a lot size that
is different from the economic order quantity. Therefore, average inventory levels in a
warehouse will not be related to the square root of the warehouses throughput (demand),
i.e., throughput raised to the 0.5 power.1 Rather, the throughput will be raised to a higher
exponent between 0.5 and 1.0.
The above ideas can be verified by plotting the data given in Table 1 of the case and
then fitting a curve of the form I = TP . Note: The curve can be found from standard
linear regression techniques when the equation is converted to a linear form through a
logarithmic transformation, i.e., lnI = ln + lnTP. The results are shown in Figure 1.
The inventory curve is I = 2.99TP 0.816 with r = 0.86, where I and TP are in lamps. The
projected inventory reduction can be calculated by using this formula.
From the plot of the inventory data, we can see that there is substantial variation
about the fitted inventory curve. There is not a consistent turnover ratio between the
warehouses. This probably results from the centralized control policy. On the other
hand, improved control may be achieved by using a pull procedure at each MDC. The
data available in the case do not let us explore this issue.

Based on the economic order quantity formula, the average inventory level (AIL) for an item held in
inventory can be estimated as AIL = Q / 2 = 2 DS / IC / 2 . Collecting all constants into K, we have
AIL=K(D)0.5, where D is demand, or throughput.

122

FIGURE 1 Plot of
MDC average
inventory vs. annual
throughput.

(2) Should establishing the LOC be pursued?

One of the ideas proposed in the case is to consolidate all Consumer product line items
into one large order center (LOC). Evaluating the impact of the LOC on inventory
reduction requires that an assumption be made as to how much demand and associated
inventory of the total belongs to Consumer products. Table 2 of the case gives the order
and back order breakdown by sales channel. Using this data, total consumer demand is
312,211 line items, or 33.4 percent of the total line items. The assumption is that the
same percentage applies to total demand.
Hence, Consumer demand is
33.4%169,023,000 = 56,453,682 lamps. From the inventory-throughput curve, we can
estimate the amount of inventory needed at the single LOC.
That is, I =
2.997(56,453,682)0.816 = 6,339,684 lamps. If Consumer products account for 33.4% of
total inventory, then there are 33.4%23,093,500 = 7,713,229 lamps in Consumer
inventory. The reduction that can be projected is 7,713,229 6,339,684 = 1,373,545
lamps for a reduction of
Reduction =

1,373,545
100 = 17.8%
7,713,229

in Consumer inventory levels, but only a 6 percent reduction in overall inventory levels.
The 20 percent reduction goal is not achieved. Other alternatives need to be explored.
(3) Does reducing the number of stocking locations have the potential for reducing
system inventories by 20 percent? Is there enough information available to make a good
inventory reduction decision?
The second alternative proposed in the case is to reduce the number of MDCs from eight
to a smaller number. In order to evaluate this proposal, it needs to be determined which
MDCs will be consolidated and the associated total demand flowing through the
consolidated facilities. The inventory-throughput relationship can then be used to
estimate the resulting inventory levels. For example, if the Seattle and Los Angeles
MDCs are combined, the consolidated demand would be 4,922,000 + 21,470,000 =
26,392,000 lamps. The combined inventory is projected to be I = 2.997(26,392,000)0.816 =

123

3,408,852 lamps, compared with the inventory for the two locations of 4,626,333, as
shown in Table 1. This yields a 26.3 percent reduction from current levels.
Table 1 shows other possible MDC consolidations and the resulting inventory
reductions that can be projected.
TABLE 1 Inventory Reduction for Selected MDC Combinations, in Lamps
Combined
Combined
Inventory
MDC combination
demand
inventory
reduction
Seattle/Los Angeles
26,392,000
3,408,852
1,217,481
Kansas City/Dallas
29,194,000
3,701,403
50,181
Chicago/Ravenna
49,174,000
5,664,257
-557,590
Atlanta/Dallas
39,314,000
4,718,862
1,224,721
Kansas City/Chicago
39,271,000
4,714,650
-933,900
Ravenna/Hagerstown
64,046,000
7,027,231
1,715,607
K City/Dallas/Chicago
52,515,000
5,976,377
-36,377
Ravenna/Htown/Chicago
87,367,000
7,508,054
3,423,196
Atlanta/Dallas/K City
55,264,000
5,242,351
2,293,566

From the MDC combinations in Table 1, proximity to each other is a primary

consideration in order to not increase transportation costs or jeopardize delivery service
any more than necessary. Several options can be identified that yield a 20 percent
inventory reduction. These are:

Option
1

Inventory
reduction,
lamps
1,217,481
3,423,196
4,640,677

MDC combinations
LA/Seattle
Ravenna/Htown/Chicago
Total reduction

Total
inventory
reduction

20.1%

LA/Seattle
Kansas City/Hagerstown
Ravenna/Hagerstown
Total reduction

1,217,481
1,224,721
1,715,602
4,157,804

18.0%

LA/Seattle
Ravenna/Hagerstown
Atlanta/Dallas/K City
Total reduction

1,217,481
1,715,602
2,293,566
5,226,649

22.6%

Options 1 and 3 achieve the 20 percent reduction goal, although other MDC
combinations not evaluated may also do so. The maximum reduction would be achieved
with one MDC. The total inventory would be I = 2.997(169,023,000)0.816 = 15,512,812
lamps, for a system reduction of 32.8 percent. However, we must recognize that as the
number of warehouses is decreased, outbound transportation costs will increase. Inbound
transportation costs to the combined MDC will remain about the same, since

124

replenishment shipments are already in truckload quantities. Some difference in cost will
result from differences in the length of the hauls to the warehouses. On the other hand,
outbound costs may substantially increase, since the combined MDC locations are likely
to be more removed from customers then they are at present. Outbound transportation
rates will be higher, as they are likely to be for shipments of less-than-truckload
quantities. If the sum of the inbound and outbound transportation cost increases is
greater than the inventory carrying cost reduction, then the decision to reduce inventories
must be questioned.
Calculating all transportation cost changes is not possible, since the case study does
not provide sufficient data on outbound transportation rates. However, they should be
determined before and after consolidation to assess the tradeoff between inventory
reduction and transportation costs increases. On the other hand, inbound transportation
costs can be found, as shown below for option 1, where the consolidation points are Los
Angeles and Hagerstown.
Annual
demand,
lamps
Location
Seattle
4,922,000
Los Angeles
21,470,000
Ravenna
25,853,000
Hagerstown
38,193,000
Chicago
23,321,000
Total
113,759,000
a
(4,922,000/35,000)1800 = 253,131
TL rate,
$/TL
1800
1800
250
475
350

Transport
cost, $
253,131a
1,104,171
184,664
518,334
233,210
2,293,510

Combined
annual
demand, lamps

Transport
cost, $

26,392,000

1,357,302

87,367,000

1,185,695

113,759,000

2,542,997

There will be a net increase in inbound transportation costs of $2,542,997 2,293,510 =

$249,487 for option 1.
In addition, the annual fixed costs for the MDCs will be less, since the total space
needed in the consolidated facilities should be less than that for the existing facilities.
Again, the case study does not estimate the fixed costs for existing or potential locations.
We do know that taking them into account would favor consolidation.
In summary, the costs associated with option 1, that just meets the 20 percent
inventory reduction goal, would be:
Cost type
Inventory carrying cost reduction
Warehouse cost
Warehouse fixed cost
Outbound transportation cost
Inbound transportation cost

Cost savings, $
0.200.8824,640,677 = 818,615
0.104,640,677 = 464,068
Unknown, but may be included in warehouse cost
Unknowndata not given
(249,487)

Although Sue and Bryan could report a substantial savings in inventory related costs,
they should be encouraged to include fixed costs and transportation costs so as to report
the true benefits of the inventory reduction plan.

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(4) How might customer service be affected by the proposed inventory reduction?
The general effect of inventory consolidation is to reduce the number of stocking points
and make them more remote from customers. That is, the delivery distance will be
increased if inventory consolidation is implemented. Therefore, delivery customer
service may be jeopardized and must be considered before deciding to consolidate
inventories.
From Table 3 of the case, it can be seen that customer lead times remain constant for
a variety of locations with the exception of Kansas City. Since consolidation points will
be selected among the existing locations, outbound lead times will remain unaffected.
Customer service due to location should be constant, at least for a moderate degree of
consolidation.
Customer service due to stock availability will be affected if safety stock levels are
reduced after consolidation. Although the inventory-throughput relationship projects
adequate safety stock to maintain the current first-time delivery levels, it does not account
for any increase in lead times that may occur between the current system of MDCs and
the consolidated ones. By comparing the weighted inbound lead times for the existing
distribution system and option 1, as shown in Table 2, the average inbound lead-time is
slightly reduced through consolidation. Lead-time variability is usually related to
average lead-time. This should have a favorable affect on inventory levels since
uncertainty is reduced. First-time deliveries should not be adversely affected by
consolidation, according to option 1.
TABLE 2

A Comparison of Inbound Lead Times for the Existing Distribution

System and a Consolidated Distribution System (Option 1)
(a) Current Distribution System
Inbound
Weighted
lead time,
lead time,
Master Distribution Center
Shipments
days
days
Atlanta
26,070,000
2
0.308
Chicago
23,321,000
1
0.138
Dallas
13,244,000
3
0.235
Hagerstown
38,193,000
1
0.226
Kansas City
15,950,000
2
0.094
Los Angeles
21,470,000
5
0.635
Ravenna
25,853,000
1
0.153
Seattle
4,922,000
6
0.175
Total
169,023,000
1.964

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(b) Consolidation Option 1

Master Distribution Centera
Atlanta
Dallas
Htown/Ravenna/Chicago
Kansas City
Los Angeles/Seattle
Total
a

Shipments
26,070,000
13,244,000
87,367,000
15,950,000
26,392,000
169,023,000

Inbound
lead time,
days
2
3
1
2
5

Weighted
lead time,
days
0.308
0.235
0.517
0.094
0.781
1.935

Consolidation is assumed to take place at the MDC with the largest number of current shipments.

127

AMERICAN RED CROSS: BLOOD SERVICES

Teaching Note
Strategy
The American Red Cross Blood Services has a mission to provide the highest quality
blood components at the lowest possible cost. High quality blood products are provided
to regional hospitals, but managing the inventory to meet demand as it occurs is a
difficult problem. Blood is considered a precious product, especially by those who give it
voluntarily. So, managing this perishable product carefully is a foremost concern.
Blood is a vital product to those in need of it for emergencies and a precious product
to those requiring it for elective surgery and other treatments. The goal is to always have
what is needed but never so much that this perishable product has to outdated. Managing
the blood inventory is quite difficult because (1) forecasting demand is not particularly
accurate, (2) the planning horizon for collections can be up to a year long with uncertain
yields, (3) the life of blood products ranges from 42 days to as short as five days, (4) once
scheduled, blood donors are never turned away except for medical reasons, and (5) there
is a limited opportunity to sell blood outside of the local region if too much is on hand.
Overall, this situation has many characteristics of a supply driven inventory
management problem, which requires inventory management techniques different from
those for typical consumer products.
The intended purpose of this case study is for students to examine an inventory
situation where there is limited control over the amount of the product flowing into
inventory. This supply-driven inventory situation is likely to be quite different from that
discussed on the introductory level. Students are encouraged to consider the various
elements that affect inventory levels of individual products and how they interact. These
elements are (1) demand forecasting, (2) collections, (3) decision rules for creating blood
derivatives, (4) product prices, and (5) inventory policy. It is expected that students will
be able to make general suggestions for improvement.
Questions
(1) Describe the inventory management problem facing blood services at the American
Red Cross.

One of the major problems facing the American Red Cross (ARC) is that the availability
of blood is supply-driven, meaning that quantities of blood received for processing to
meet demand in the short term are unknown, yet they must be placed in inventory if
demand is less than the collected quantities. Blood availability is a function of number of
factors that cannot be well-controlled by the regional blood center in the short run,
causing wide variability in supply. The usage of blood at hospital blood banks, which
creates the demand on ARCs blood inventories, is also uncertain and varies from day to
day and between hospital facilities.
The yield of blood at the point of collection is random and does not necessarily give
the product mix needed to meet demand. Different blood types can only be known by a
probability distribution as to the percentage of the blood types that exist in the general
population. In the short term, the demand for blood types may differ from the collected

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quantities, resulting in a potential for under- and over-stocking, since blood is drawn
from all qualified donors as they arrive at collection sites.
Forecasting demand for blood products will likely be reasonably accurate for a base
load. Surgery loads on hospitals are scheduled in advance so that blood needs will be
known with a fair degree of certainty, although each operation will not typically use the
full amount of blood allocated to it. However, emergency blood needs are not well
predicted, and they can cause spikes in demand and unplanned draws on inventory. A
problem is establishing how much accuracy is needed for good inventory management.
Inventory policy for managing inventory levels is a mixed strategy of product pricing,
derivative product selection for processing at the time of collection, conversion to other
products later in the product life cycle, product sell off, emergency supply (call for
blood), discount pricing, and stocking rules for hospitals. Although there are many
avenues to controlling inventory levels, shortages and outdating cannot always be
avoided. It is not clear that these procedures lead to an optimal control of inventory
levels.
Competition from local independent blood banks that sell selected blood products at
low prices makes it difficult for ARC to cover costs. ARC provides a wider range of
products, but it has difficulty-differentiating price among derivative products so that it
might compete effectively. Given pressures for hospitals to increase efficiency, they will
shop around for the lowest-priced blood products. ARC is having difficulty maintaining
its position as the dominant supplier of blood products in the region, which results in the
greater uncertainty in managing inventory levels.
In summary, blood is a precious product given by volunteers for the benefit of others.
Donors have the right to expect that their contribution will be handled responsibly. To
ARC, this means managing the blood supply so that recipients receive a high-quality
product at the lowest possible price. To achieve this goal, ARC manages the blood
supply through four inter-connected elements: (1) estimating the blood product needs
over time, (2) planning the collection of whole blood, (3) deciding which derivative
products and their amounts should be created from whole blood, and (4) controlling the
inventory levels to avoid outdating. The volunteer nature of the blood giving and donor
attitudes surrounding it, long planning lead times and the associated uncertainties, rising
competition among some products from local blood banks, and the uncertainties of blood
needs all make blood supply management a unique inventory management problem.
(2) Evaluate the current inventory management practices in light of ARCs mission.
Performance of blood management can be evaluated on two levels: customer service and
cost. Tables 8 and 9 of the case show that in March standards were not quite met overall.
Within specific product types, there was up to an eight percent deficit. Both order fill
rate and item fill rate were less than 100 percent for most products. There would seem to
be some room for improvement, especially in managing the variation among product
types.
From a cost standpoint, it is not known how efficiently the blood supply is managed
since no costs are reported. In addition, the revenue that the blood products generate is
not known. We would like to know how prices of the various products are set so that
revenues might be maximized, considering competition among some of the product line.

129

We do expect that demand is price elastic, since hospitals do shop around for blood
products that are available from local, commercial, and community blood banks. On the
other hand, ARC is the sole regional supplier of certain products such as platelets.
Setting product fill-rate standards at various levels can influence costs. We do not
know this effect.
Setting inventory levels by a number of days of inventory rule of thumb is simple
but not as effective as planning inventory levels based on the uncertainties that occur in
demand forecasts and supply lead times. The number-of-days of inventory rule does tend
to lead to too much inventory or to too many out-of-stock situations.
The plan for evaluation, if enough data were available, would be to establish a base
case of cost and service. This, then, would provide a basis for evaluating the effect of
change in the supply procedures.
(3) Can you suggest any changes in ARCs inventory planning and control practices that
might lead to cost reduction or service improvement?
Suggestions for improvement in blood supply management stem from a basic
understanding of the nature of the demand-supply relationship. When supply is uncertain
and all supply must be taken that is available, there is the possibility that significant
excess inventory will occur. The goal is to manage the demand in the short run to
reduce inventory levels when overstocking occurs, rather than focusing on managing
supply. Several approaches for doing this are:
Aggressively price selected products that are in excess supply and are nearing their
expiration dates, e.g. run a sale or offer price discounts.
Sell off excess supply to secondary demand sources or other regions of the ARC.
Temporarily adjust return rules for hospitals.
Bring demand more in line with supply by converting products into derivative ones
that have excess demand, e.g., reprocess whole blood into plasma.
Encourage hospitals to buy certain products in excess supply for a more favorable
status in buying other products that are in short supply, such as phersis platelets and
rare whole blood types.
Try to create excess demand for all products, especially those items that are
available from local blood banks, through promotion of ARCs distinct advantages,
such as quality, high service levels, and a wide range of blood derivative products.
Offer two-for-one sales, such that if a hospital buys one blood product, it may
receive another at a favorable price.
Pool the risk of uncertain demand by maintaining a central inventory for all
hospitals, or managing the inventories at all hospitals, as well at ARC, collectively.
Provide quick deliveries or transfers among inventory locations.
ARC should attempt to be the premier provider of blood products and leverage the
advantage. This will allow it to maintain a degree of control over the demand for blood.
Effectively controlling demand in turn allows it to control its costs and avoid product
outdating.

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(4) Is pricing policy an appropriate mechanism to control inventory levels? If so, how
should price be determined?
From the previous discussion, it can be seen that price plays a role in controlling demand.
Since there appears a relationship between demand and price for some products,
especially among those products offered by local blood banks that compete with ARC
blood products, price may be an effective weapon to meet competition. Rather than
setting price based on the cost of production, ARC might consider raising the price on
products for which it is the sole provider, such as platelets, and then meeting the price of
competitors on whole blood. Although ARC strives to be a nonprofit organization, the
increased volume that an effective pricing strategy promotes would allow more of the
fixed costs to be covered. This may lead to lower overall average prices for ARCs
products.
Blood could also be priced as a function of its freshness at two or more levels.
Although blood that has been donated within 42 days legally can be utilized, the quality
of blood does not remain the same for the entire 42-day period. A chemical compound
found in blood, called 2,3-DPG, decreases with the age of the stored blood, and is
believed to be important in oxygen delivery. For this reason, certain procedures such as
heart transplants and neonatal procedures require that blood be fresh, usually donated
within 10 days or less. Thus, a simple pricing policy could be to charge a higher price for
blood that is less than 10 days old, and a lower price for blood that is between 10 and 42
days old. Price differences here are based on product quality.

131