(CHAPTER 2: INVENTORY MANAGEMENT AND RISK POOLING 49 Risk Pooling Obviously, the current distribution system with ‘two warehouses has an important advantage over the single warehouse system because each warehouse is close to a particular subset of customers, decreasing ACME, a company that produces and distributes delivery time. However, the proposed change alee electronic equipment in the Northeast of the United has an important advantage; it allows ACME to States, faces a distribution problem, The current dis- achieve either the same service level of 97 percent tribution system partitions the Northeast into two With much lower inventory or a higher service level markets, each of which has a single warehouse. One With the same amount of total inventory. warehouse is located in Paramus, New Jersey, and __ Intuitively this is explained as follows, With random the second is located in Newton, Massachusetts, demand, it is very likely that a higher-than-average Customers, typically retailers, receive items directly demand at one retailer will be offset by a lower-than. from the warehouses; in the current distribution average demand at another. As the number of retailers _ system, each customer is assigned to a single market served by a warehouse goes up, tis likelihood also and receives deliveries from the corresponding 20€S up. Indeed, this is precisely the third principle of E archouse, all forecasts described at the beginning of Section ‘The warehouses receive items from a manufacturing 2.2.2: aggregate forecasts are more accurate. facility in Chicago. Lead time for delivery toeach ofthe How much can ACME reduce inventory if the tschouses is about one week and the manufacturing Company decides to switch tothe centralized system facility has sufficient production capacity to satisfy any but maintain the same 97 percent service level? Warehouse order. The current distribution strategy To answer that question, we need to perform a more rovides 97 percent service level; that is, the inventory rigorous analysis of the inventory policy that ACME employed by each warehouse is designed so that should use in both the current system and the cen- the robabilty ofa stockout is 3 percent. OF course, alized system, We will explain this analysis for two Untlled orders are lost to the competition and thus specific products, Product A and Product B, although te satisfied by future deliveries, the analysis must be conducted for all products. ince the original distribution system was designed _For both products, an order from the factory costs seven years ago, the company’s newly appointed $60 per order and holding inventory costs are $0.27 has decided to review the current logistics and Pet unit per week. In the current distribution. system, bution system. ACME handles about 1,500 the cost of transporting a product from a warehouse nt products in its supply chain and serves about (0 @ customer is, on average, $1.05 per product. It is accounts in the Northeast. ACME is con- estimated that in the centralized distribution system, 3 the following alternative strategy: Replace the transportation cost from the central warehouse _Warchouses with a single warehouse located Will be, on average, $1.10 per product. For this ‘2 Paramus and Newton that will serve all analysis, we assume that delivery lead time is not © orders. We will refer to this proposed system Significantly diferent in the two systems. fe rized distribution system. The CEO insists _ Tables 2-5 and 2-6 provide historical data for idles ne "Vice level, 97 percent, be maintained Products A and B, respectively. The tables include MIPS Of the logistics strategy employed. weekly demand information for each product for the