Supply Chain Management

Determining Optimal Level of

Product Availability
 Outline
 The importance of the level of product availability.
 Factors affecting the optimal level of product
availability.
 Managerial levers to improve supply chain
profitability.
 Supply chain contracts and their impact on
profitability.
 Setting optimal levels of product availability in
practice.
Dr. Srikanta Routroy 2
 Importance of the Level
of Product Availability
 Product availability measured by cycle service level or fill rate
 Also referred to as the customer service level.
 Product availability affects supply chain responsiveness
 Trade-off:
– High levels of product availability  increased responsiveness and higher
revenues
– High levels of product availability  increased inventory levels and higher
costs
 Product availability is related to profit objectives, and strategic
and competitive issues.
 What is the level of fill rate or cycle service level that will result
in maximum supply chain profits?

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 Factors Affecting the Optimal
Level of Product Availability
 Cost of overstocking

 Cost of under-stocking

 Possible scenarios
– Seasonal items with a single order in a season
– Continuously stocked items
» Demand during stock-out is backlogged
» Demand during stock-out is lost

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 The Newsvendor Approach
 ASSUMPTIONS
 Independent products
 Single period
 Random demand with known distribution
 Linear overage/shortage costs

 EXAMPLES:
– Newspapers
– PCs
– Christmas trees or
– Other seasonal items with rapid obsolescence or short-life products.

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 Newsvendor Model Notation
X = demand (in units), a random variable.

G ( x ) = P ( X  x ), cumulative distribution function of demand

(assumed to be continuous )

m , s = mean, standard deviation of demand

d
g ( x) = G ( x ) = density function of demand.
dx

c o = cost (in dollars) per unit left over after demand is realized.

c s = cost (in dollars) per unit of shortage.

Q = production /order quantity (in units). Decision Variable

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 Newsvendor Model
• Cost Function:
Y ( x) = expected overage + expected shortage cost

= co E[unitsover]+ cs E[unitsshort]

 
= co  max{Q - x,0}g ( x)dx + cs  max{x - Q,0}g ( x)dx
0 0


= co  (Q - x) g ( x)dx + cs  ( x - Q) g ( x)dx
Q

0 Q

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 Newsvendor Model (cont.)
• Optimal Solution: Taking derivative of Y(Q) with
respect to Q, setting equal to zero, and solving
yields:
Cs
G(Q ) = P (X Q) =
* *

co + cs
 as c  *
Notes: Q o
1
G(x)
cs
co + c s
Q  as cs 
*

Q*
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Newsvendor Model with Normal Demand
• Suppose demand is normally distributed with
mean m and standard deviation s. Then the
critical ratio formula reduces to:
 Q * -m  cs
G (Q ) =
*
   =
 s  co + cs 3.00

(z)
Q * -m cs
= z where ( z ) =
s co + cs
Q* = m + s z
0.00

0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103 109 115 121 127 133 139 145 151 157

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 Multiple Period Problems
• Difficulty: Technically, Newsvendor model is for a single
period.

• Extensions: But Newsvendor model can be applied to

multiple period situations, provided:
– demand during each period is iid, distributed according to
G(x).
– there is no setup cost associated with placing an order.
– stockouts are backordered.

• Key: make sure co and cs appropriately represent overage

and shortage cost.
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 Example
 The manager at Sport-mart, a sports store, has to decide on the
number of skis to purchase for the winter season.
 Considering past demand data and weather forecasts for the year,
management has forecast demand to be normally distributed with
a mean of 350 and standard deviation of 100.
 Each pair of skis costs $100 and retails for $250.
 Any unsold skis at the end of the season are disposed of for $85.
 Assume that it costs $5 to hold a pair of skis in inventory for the
seasons.
 Evaluate the number of skis that the manager should order to
maximize expected profits.
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 Solution of Example
 Salvage value s = $85 - $5 = $80
Cost of under-stocking = C = p – c = $250 - $100 = $150
Cost of overstocking = C = c – s = $100 - $80 = $20
CSL* = probability (demand <=R*) =(150)/(150+20)
=0.88
Q*= 350+ F-1(CSL)*100= 468

1.18
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 Demand during stock-out is
Backlogged
 Optimal Cycle service level:

»CSL* = 1-(HQ/DCu)

Discount
per unit

Cost of holding one Replenishment Average demand

unit for unit time Lot size Per unit time

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 Demand during Stock-out is lost
Optimal cycle service level (CSL*):
»CSL*= 1- (HQ/(HQ+DCu))

Cost of losing one unit of demand

during the the stock-out period

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 Managerial Levers to Improve Supply
Chain Profitability
• “Obvious” actions
– Increase salvage value of each unit
– Decrease the margin lost from a stock-out

• Improved forecasting
• Quick response
• Postponement
• Tailored sourcing
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 Improved Forecasts
• Improved forecasts result in reduced uncertainty.
• Less uncertainty (lower sR) results in either:
– Lower levels of safety inventory (and costs) for the same level
of product availability, or
– Higher product availability for the same level of safety
inventory, or
– Both lower levels of safety inventory and higher levels of
product availability.

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 Impact of Improving Forecasts
(Example)
Demand: Normally distributed with a mean of R
= 350 and standard deviation of sR = 100

Purchase price = $100

Retail price = $250
Disposal value = $85
Holding cost for season = $5

How many units should be ordered as sR changes?

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Impact of Improving Forecasts
sR O* Expected Expected Expected
Overstock Understock Profit
150 526 186.7 8.6 $47,469
120 491 149.3 6.9 $48,476
90 456 112.0 5.2 $49,482
60 420 74.7 3.5 $50,488
30 385 37.3 1.7 $51,494
0 350 0 0 $52,500

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Variation of profit and inventories with
forecast accuracy

Expected overstock

Expected profit

Expected under stock

Standard deviation of forecast error

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 Quick Response
• Set of actions taken by managers to reduce lead time.
• Reduced lead time results in improved forecasts:
– Typical example of quick response is multiple orders in one season for
retail items (such as fashion clothing)
– For example, a buyer can usually make very accurate forecasts after the
first week or two in a season
– Multiple orders are only possible if the lead time is reduced – otherwise
there wouldn’t be enough time to get the later orders before the season
ends
• Benefits:
– Lower order quantities  less inventory, same product availability
– Less overstock
– Higher profits

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 Quick Response: Multiple
Orders Per Season
• Ordering shawls at a department store
– Selling season = 14 weeks
– Cost per Cashmere Shawls = $40
– Sale price = $150 Fifth Avenue, a high-
– Disposal price = $30 end department store,
– Holding cost = $2 per week purchasing cashmere
Shawls from India and
Nepal. The demand and cost
• Expected weekly demand = 20 Information as given

• SD of weekly demand = 15

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 Simulation Result with no improvement in
forecast Accuracy in the second order

Single Order Two Orders in Season

Service Order Average Expect. Initial OUL Average Average Expect.
Level Size Over- Profit Order for 2nd Total Over-
Profit
stock stock
Order Order
0.96 378 97 $23,624 209 209 349 69 $26,590
0.94 367 86 $24,034 201 201 342 60 $27,085
0.91 355 73 $24,617 193 193 332 52 $27,154
0.87 343 66 $24,386 184 184 319 43 $26,944
0.81 329 55 $24,609 174 174 313 36 $27,413
0.75 317 41 $25,205 166 166 302 32 $26,916

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Forecast Improves for Second Order
(SD=3 Instead of 15)

Single Order Two Orders in Season

Service Order Avg. Expect. Initial OUL Average Avg. Expect.
Level Size Over- Profit Order for 2nd Total Over- Profit
stock. Order Order stock.
0.96 378 96 $23,707 209 153 292 19 $27,007
0.94 367 84 $24,303 201 152 293 18 $27,371
0.91 355 76 $24,154 193 150 288 17 $26,946
0.87 343 63 $24,807 184 148 288 14 $27,583
0.81 329 52 $24,998 174 146 283 14 $27,162
0.75 317 44 $24,887 166 145 282 14 $27,268

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 Leftover Inventory Versus Number of
Order Cycles per Season

Unsold
inventory
at end of
season

Number of order cycles per season

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 Expected Profit Versus Number of Order
Cycles per Season

Expected
Profit

Number of order cycles per season

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 Postponement
• Delay of product differentiation until closer to the time of the
sale of the product.
• All activities prior to product differentiation require aggregate
forecasts more accurate than individual product forecasts.
• Individual product forecasts are needed close to the time of sale
– demand is known with better accuracy (lower uncertainty).
• Results in a better match of supply and demand.
• Valuable in e-commerce – time lag between when an order is
placed and when customer receives the order (this delay is
expected by the customer and can be used for postponement).
• Higher profits, better match of supply and demand.
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 Value of Postponement: Example
 A large fraction of Benetton's sales are from knit garments in solid
colours.

 Traditionally, thread was dyed and garment was knitted (Option 1).

 Benetton developed a procedure whereby dyeing was postponed

until after the garment was knitted (Option 2).

 With option 1, Benetton makes the buying decision for each colour
20 weeks before the sale period and holds separate inventories for
each colour.

 With option 2, Benetton forecasts only the aggregate uncoloured

thread to purchase 20 weeks in advance.
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 Value of Postponement
• For each color
– Mean demand = 1,000; SD = 500
• For each garment
– Sale price = $50
– Salvage value = $10
– Production cost using Option 1 (long lead time) = $20
– Production cost using Option 2 (uncolored thread) = $22
• What is the value of postponement?
– Expected profit increases from $94,576 to $98,092

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 Option 1 without Postponement
 Optimum CSL=30/40=0.75
 O*= 0.674*500+1000=1,337
(p-c)/(p-s)
 Expected profit for each color: $23,644
 Total Expected profit: $94,576
 Expected under-stock: 75*4=300

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 Option 2 with Postponement
 Optimum CSL=28/40=0.70
 O*= 2*0.524*500+4000=4,524
 Total Expected profit: $98,092
 Expected under-stock: 190

Conclusion: Postponement allows a firm to increase profits and

better match supply and demand if firm produces a large variety
of products whose demand is not positively correlated and
is of about the same size.

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 Value of Postponement with
Dominant Product
• Color with dominant demand: Mean = 3,100, SD
= 800
• Other three colors: Mean = 300, SD = 200
• Expected profit without postponement = $102,205
• Expected profit with postponement = $99,872

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 Tailored Postponement: Benetton
• Tailored postponement allows a firm to increase profits by
postponing differentiation only for products with the most uncertain
demand; products with more predictable demand are produced at
lower cost without postponement
• Produce Q1 units for each color using Option 1 and QA units
(aggregate) using Option 2
• Results:Q1=800 QA=1,550 Profit=$104,603 (results from simulation)

Tailored postponement allows a firm to increase its profitability

By only postponing the uncertain part of the demand and
producing the predictable part at a lower cost without
postponement
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 Tailored Sourcing
• A firm uses a combination of two supply sources.
• One is lower cost but is unable to deal with uncertainty
well.
• The other is more flexible, and can therefore deal with
uncertainty, but is higher cost.
• The two sources must focus on different capabilities.
• Depends on being able to have one source that faces
very low uncertainty and can therefore reduce costs.
• Increase profits, better match supply and demand.
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 Tailored Sourcing

• Sourcing alternatives:
– Low cost, long lead time supplier
• Cost = $245, Lead time = 9 weeks

– High cost, short lead time supplier

• Cost = $250, Lead time = 1 week

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 Tailored Sourcing Strategies

Fraction of demand from Annual Profit

overseas supplier
0% $37,250

50% $51,613

60% $53,027

100% $48,875

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 Tailored Sourcing
 Volume based tailored
sourcing
– Predictable part of the product
demand from efficient facility.
– Uncertain part from flexible
facility.
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 Product based tailored
sourcing
– Low volume product with
uncertain demand from
flexible source.
– High volume product with
certain demand from efficient
source.
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 Supply Chain Contracts and
Their Impact on Profitability
 Contract

 Returns policy: Buyback contracts

 Revenue Sharing contracts

 Quantity flexibility contracts
 Vendor-managed inventories

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 Contracts
 Specifies the parameters within which a buyer places
orders and a supplier fulfills them.
 Example parameters: quantity, price, time, quality.
 Double marginalization: buyer and seller make
decisions acting independently instead of acting
together – gap between potential total supply chain
profits and actual supply chain profits results.
 Buyback contracts can be offered that will increase
total supply chain profit.

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 Returns Policy: Buyback Contracts
 A manufacturer specifies a wholesale price and a buyback price at
which the retailer can return any unsold items at the end of the
season.
 Results in an increase in the salvage value for the retailer, which
induces the retailer to order a larger quantity.

 The manufacturer is willing to take on some of the cost of

overstocking because the supply chain will end up selling more on
average.

 Manufacturer profits and supply chain profits can increase.

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 Impact of Supply Chain Contracts
on Profitability: Buyback Contracts

 Buybacks by publishers
 Tech Fiber produces jacket at v = $10 and charges a
wholesale price of c = $100. Ski Adventure sells jacket
for p = $200.
 Unsold jackets have no salvage value.
 Should TF be willing to buy back unsold jackets? Why?

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 Buyback Contracts
Wholesale Buy Optimal Expected Expected Expected Expected
Price c Back Order size Profit for Returns Profit for Supply
Price b for SA SA to TF TF Chain Profit
$100 $0 1,000 $76,063 120 $90,000 $166,063
$100 $30 1,067 $80,154 156 $91,338 $171,492
$100 $60 1,170 $85,724 223 $91,886 $177,610
$100 $95 1,501 $96,875 506 $86,935 $183,810
$110 $78 1,191 $78,074 239 $100,480 $178,555
$110 $105 1,486 $86,938 493 $96,872 $183,810
$120 $96 1,221 $70,508 261 $109,225 $179,733
$120 $116 1,501 $77,500 506 $106,310 $183,810

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 Revenue Sharing Contracts
 The manufacturer charges the retailer a low wholesale price
and shares a fraction of the revenue generated by the retailer.
 The lower wholesale price decreases the cost to the retailer in
case of an overstock.
 The retailer therefore increases the level of product
availability, which results in higher profits for both the
manufacturer and the retailer.

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 Quantity Flexibility Contracts
 Manufacturer allows retailer to change order quantity
after observing demand.
 No returns are required.
 The manufacturer bears some of the risk of excess
inventory.
 Retailer increases order quantity.
 Can result in higher manufacturer and supply chain
profits
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 Quantity Flexibility Contracts
 If a retailer order O units, the manufacturer commits
to supplying up to (1+)O and the retailer commits to
buying (1-)O.

 How can quantity flexibility contracts help increase

profitability?

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 Quantity Flexibility Contracts
  Wholesale Order Expected Expected Expected Expected Expected
price c size O purchase sale by profits profits for supply
by SA SA for SA TF chain profit
0.00 0.00 $100 1,000 1,000 880 $76,063 $90,000 $166,063
0.20 0.20 $100 1,050 1,024 968 $91,167 $89,830 $180,997
0.40 0.40 $100 1,070 1,011 994 $97,689 $86,122 $183,811
0.00 0.00 $110 962 962 860 $66,252 $96,200 $162,452
0.15 0.15 $110 1,014 1,009 945 $78,153 $99,282 $177,435
0.42 0.42 $110 1,048 1,007 993 $87,932 $95,879 $183,811
0.00 0.00 $120 924 924 838 $56,819 $101,640 $158,459
0.2 0.2 $120 1,000 1,000 955 $70,933 $108,000 $178,933
0.5 0.5 $120 1,040 1,003 996 $78,874 $104,803 $183,677

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Vendor-Managed Inventories (VMI)
 Manufacturer or supplier is responsible for all decisions regarding
inventory at the retailer.
 Control of replenishment decisions moves to the manufacturer.
 Requires that the retailer share demand information with the
manufacturer.
 Manufacturer can increase its profits and total supply chain profits
by reducing effects of double marginalization.
 Having final customer demand data also helps manufacturer plan
production more effectively.
 Campbell’s Soup, Proctor & Gamble.
 Potential drawback – when retailers sell products that are
substitutes in customers’ minds.
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 Setting Optimal Levels of
Product Availability in Practice
 Use an analytical framework to increase profits.
 Beware of preset levels of availability.
 Use approximate costs because profit-maximizing
solutions are very robust.
 Estimate a range for the cost of stocking out.
 Ensure that levels of product availability fit with the
strategy.

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 Summary of Learning Objectives

 Whatare the factors affecting the optimal level of

product availability?
 How is the optimal cycle service level estimated?
 What are the managerial levers that can be used to
improve supply chain profitability through optimal
service levels?
 How can contracts be structured to increase supply
chain profitability?

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