SUPPLY CHAIN and LOGISTICS MANAGEMENT - 06 IP/IM 71

C K Nagendra Guptha
Assistant Professor
Industrial Engineering and Management Department
R V College of Engineering
Bangalore – 560059
cknguptha@yahoo.co.in

UNIT – 3: PLANNING & MANAGEING INVENTORIES IN A SUPPLY CHAIN

CHAPTER OUTLINE

Review of Inventory Concepts.

Trade Promotions.

Managing Multi-echelon Cycle Inventory.

Safety Inventory Determination.

Impact of Supply Uncertainty, Aggregation, & Replenishment Policies on Safety Inventory.

Optimum Level of Product Availability: Importance Factors.

Managerial Levers to Improve Supply Chain Profitability.

Inventory Build up

A Framework for Structuring Drivers

Components of Inventory Decisions

Cycle inventory:

Average amount of inventory used to satisfy demand between shipments.


Depends on lot size.

Safety inventory:

inventory held in case demand exceeds expectations.

costs of carrying too much inventory versus cost of losing sales.

Seasonal inventory:

inventory built up to counter predictable variability in demand.

cost of carrying additional inventory versus cost of flexible production.

Overall trade-off: Responsiveness versus efficiency

more inventory: greater responsiveness but greater cost.

less inventory: lower cost but lower responsiveness.

Cycle Inventory
TOPIC OUTLINE

• Role of Cycle Inventory in a Supply Chain.

• Economies of Scale to Exploit Fixed Costs.

• Economies of Scale to Exploit Quantity Discounts.

• Short-Term Discounting: Trade Promotions.

• Managing Multi-Echelon Cycle Inventory.

• Estimating Cycle Inventory-Related Costs in Practice.

Learning Objectives

• How are the appropriate costs balanced to choose the optimal amount of cycle inventory in the
supply chain?

• What are the effects of quantity discounts on lot size and cycle inventory?

• What are appropriate discounting schemes for the supply chain, taking into account cycle
inventory?

• What are the effects of trade promotions on lot size and cycle inventory?

• What are managerial levers that can reduce lot size and cycle inventory without increasing
costs?

Introduction to Inventory Management

Inventory management deals with ordering and stock keeping of goods for sale, production or
distribution. Inventories are idle goods waiting for use or sale. Inventories are kept in many
environments, for instance, in the mining-industry of minerals, in factories of raw materials,
parts, work in progress and finished products, and in warehouses, depots and wholesale dealers
of goods for distribution, and at shops and by retailers of goods for sale. The main reasons why
inventories are held are that it is uneconomical to produce, to handle or to transport units one by
one and that consumers often do not accept a delay in the delivery of goods or only want to buy
goods that are on display or available in a shop, supermarket or department store. Inventory
theory aims to develop models and algorithms as an aid to inventory management.

In this section inventory policies will be classified, inventory costs and concepts will be
described, and the main sources of uncertainty will be indicated. Next section contains a review
of models and results for single item inventory management. The following section provides an
overview of interactions that may occur in the control of inventories of multiple items and at
multiple stocking points.
Defnitions and concepts

In this section, general concepts in inventory management will be described and explained. The
main sources of uncertainty where inventory management has to deal with are;

Demand: the demand for items may fluctuate from day to day (due to stochastic behavior at
retailers, due to variations in the production plan in a manufacturing environment), from month
to month (due to a seasonal pattern) and during the lifetime of a product (an upward trend in the
beginning, a downward trend towards the end);

Lead time: the total time that elapses between the reorder instant and the instant when goods are
ready for use or sale. It consists of the handling time at the supplier (the time required for order
picking, packing, and loading), the shipping time from the supplier to the stocking point and the
handling time at the stocking point (the time required for unloading, unpacking, and placing on
the shelf). When the goods still have to be produced after the reorder instant, it also includes the
production time and possibly a set-up time for the production run. In the practical situation of
uncertain (stochastic) demand and nonnegligible lead times stockout occurrences cannot be
completely avoided. For customers arriving when an item is out of stock, two cases are often
distinguished:
• any demand is backordered and the backlog is ¯ lled as soon as a replenishment is
delivered; customers are willing to wait if it is difficult to obtain the item elsewhere;
• any demand is lost; customers go elsewhere to buy the item or give up the intention of
buying the item.
For some items, part of the demand may be backlogged and part may be lost. The distinction
between the two extreme cases becomes less important when stockouts occur more rarely.

A prerequisite for applying inventory policies is a good forecasting method for future demand. A
statistical analysis is required of historical demand and lead time data. Further, an ABC
classification is often carried out. In most companies, a relatively small percentage (5%{20%) of
all items account for a relatively large percentage (55%{65%) of all sales. These are called type
A items. Most effort of forecasting and inventory control should be concentrated on this type of
items. Further, there is a middle class of items consisting of 20%{30% of all items that account
for 20%{40% of all sales. These type B items require less attention and their inventory can often
be controlled by standard procedures. Finally, there are type C items consisting of 50%{75% of
all items and accounting for only 5%{25% of all sales which are to be controlled by simple and
safe procedures. In manufacturing environments, the classification of a raw material item may
also be based on how critical the item is for the continuation of work, beside on its value.

The three most important questions to be answered by an inventory policy are:

• When to review stocks?
o A distinction is made between periodic review policies where stocks are reviewed at
fixed time intervals, the review periods; continuous review policies where stocks are
reviewed after each transaction.
• When to order?
 o A distinction is made between periodic review policies where orders can only be
placed at the periodic review instants; continuous review policies which use reorder
points in inventory positions.
• What to order?
o A distinction is made between policies with a fixed xed order quantity; policies with a
fixed order-up-to
to level.

Role of Cycle Inventory in the Supply Chain

Lot, or batch size: quantity that a supply chain stage either produces or orders at a given time.

Cycle inventory: average inventory that builds up in the supply chain because a supply chain stage either
produces or purchases in lots that are larger than those demanded by the customer.

Q = lot or batch size of an order.

D = demand per unit time.

Cycle inventory = Q/2 (depends directly on lot size).

Average flow time = Avg. inventory / Avg. flow rate.

Average flow time from cycle inventory = Cycle Inventory / Dem
Demand = Q/(2D).

Q = 1000 units; D = 100 units/day

Cycle inventory = Q/2 = 1000/2 = 500 = Avg. inventory level from cycle inventory.

Avg flow time = Q/2D = 1000/(2)(100) = 5 days.

Cycle inventory adds 5 days to the time a unit spends in the supply chain.

Lower cycle inventory is better because:

Average flow time is lower.

Working capital requirements are lower.

Lower inventory holding costs.

Material Flow Time

Role of Cycle Inventory in the Supply Chain

Cycle inventory is held primarily to take advanta

advantage
ge of economies of scale in the supply chain.

Primary role of cycle inventory is to allow different stages to purchase product in lot sizes that minimize
the sum of material, ordering, and holding costs.

Ideally, cycle inventory decisions should consider ccosts

osts across the entire supply chain, but in practice,
each stage generally makes its own supply chain decisions – increases total cycle inventory and total
costs in the supply chain.
Next, we will discuss costs that may play a role when ordering and storing goods:

Ordering cost: the fixed cost of placing an order; this cost includes the cost of paperwork and
accounting associated with an order which is independent of the size of an order; if the item is
made internally rather than ordered from an external supplier, this cost is often called set-up cost
and includes the cost of labor, material and idle time associated with setting up and shutting
down a machine for a production run; if goods are ordered from another location within the same
company, this cost may include internal shipping cost.

Purchasing cost: the variable cost associated with purchasing a single unit of a good; this cost
often includes variable labor cost, variable overhead cost and raw material cost associated with
producing of handling a single unit; if goods are ordered from an external supplier, it also
includes shipping cost; the external supplier may want to stimulate larger orders to save on
shipping cost by offering quantity discounts; these cost only depend on the inventory policy in
case of quantity discounts or lost sales.

Holding cost: the variable cost of holding a single unit of a good on stock during a unit time
period; this cost often includes variable opportunity cost incurred by investing capital in
inventory, storage cost, insurance cost, and cost due to possible theft, obsolescence, breakage and
spoilage; the opportunity cost is often assumed to be a certain percentage, the so called carrying
charge, of the purchasing cost; the carrying charge is strongly related to the interest rate.

Handling cost: the cost associated to the handling of goods in a warehouse; as far as this cost is
proportional to the number of items handled it does not influence the minimization of the total
inventory cost if all demand is satisfied; as far as this cost is proportional to the number of orders
handled it can be incorporated in the ordering cost; this cost is important in the design and
control of warehouses.
Shipping cost: the cost associated to the transport of goods from one stocking point to another; in case of
an external supplier, the shipping cost is often included in the purchasing cost.

Stockout cost: in case of backlog of demand it is the extra cost associated to the administration
and later delivery of goods; in case of lost sales it is the opportunity cost of lost profit on
unsatisfied demand; in all cases, it may include a penalty cost for loss of future goodwill; it may
also include extra cost for rush orders or overtime work; in many cases, stockout costs are
difficult to assess and are therefore replaced by service level constraints (see below).

Management cost: the cost incurred by keeping track of inventory levels and by computing order
quantities; this cost is usually not included in inventory models but should form an incentive to
choose for inventory policies that are simple to implement. In the stochastic demand models the
following two service level constraints will be considered:

Cycle service constraint: the probability of no stockout in a reorder cycle must be at least a
prescribed probability ®; the latter probability is called the cycle service level (this constraint is
also called P1- criterion);
Fill rate constraint: the fraction of the demand that is satisfied directly from stock must be at least
a prescribed fraction ¯ ; the latter fraction is called the target fill rate (this constraint is also called
P2-criterion).

The following inventory concepts will be used in the various models:

Inventory on hand: the number of units actually present at the stocking point; it is also called the
physical stock; this quantity plays a role in determining holding costs; Net inventory (net stock):
the inventory on hand minus the amount of backlog; this quantity can take positive and negative
values; Inventory position: the net stock plus the number of units on order but not yet delivered;
this quantity is required for determining a reorder instant; Safety stock: the average inventory
position just before a delivery instant; this quantity is used as a protection against uncertainty in
demand and against other irregularities like breakage and pilferage; it is related to the service
level constraint or the cost of stockouts or losses.

Some general considerations in inventory management are:

• choose a model in agreement with the availability and the reliability of data (according to
the general principle \garbage in ! garbage out");
• the robustness of a model is important: the resulting replenishment policy should not
depend too strongly on the assumptions (like the shape of the demand distribution): this
requires sensitivity analysis;
• in practice, quantities are usually rounded o® (reorder cycles are chosen in whole days or
weeks; order quantities are chosen in packing units): a complicated, time-consuming
algorithm for exact optimization then has little use;
• within companies, conflicts in interests or goals may exist between the purchasing
department (which strives for quantity discounts and delivery of goods at the beginning
of a season) and the logistics department (which has to cope with large quantities at the
same time, and which may be saddled with superfluous stocks at the end of a season);
such conflicts may be due to the remuneration system of a company;
uncertainty in demand and in lead times, and desired service levels lead to safety stocks; on the
other hand, risk of disappointing demand, technical obsolescence, going out of fashion or decay
compel to reservedness toward large stocks.

Supply chain costs influenced by lot size:

Material cost per unit = C

Fixed ordering cost per order = S

Holding cost per unit per year = H = h*C

Holding cost per year as a fraction of the product cost = h

Economies of Scale to Exploit Fixed Costs

Lot sizing for a single product (EOQ):

Annual demand = D

Number of orders per year = D/Q

Annual material cost = CD

Annual order cost = (D/Q)S

Annual holding cost = (Q/2)H = (Q/2)hC

Total annual cost = TC = CD + (D/Q)S + (Q/2)hC

Inventory Profile
Behavior of Inventory Costs:

ECONOMIC ORDER QUANTITY

D: Annual demand

S: Setup or Order Cost

C: Cost per unit

H: Holding cost per year as a fraction of product cost

H: Holding cost per unit per year

Q: Lot Size

T: Reorder interval

Material cost is constant

onstant and therefore is not considered in this model

H = hC
2 DS
Q * =
H
2 S
n* =
DH
EXAMPLE 1

Demand for Deskpro Computer at Best Buy is 1000 units per month. Best Buy incurs fixed order
placement, transportation and receiving cost of $ 4000 each time an order is placed. Each Computer
costs Best Buy $ 500 and the retailer has a holding cost of 20%. Evaluate the number of Computers that
the store manager should order in each replenishment lot?

Demand, D = 12,000 computers per year

d = 1000 computers/month

Unit cost, C = $500

Holding cost fraction, h = 0.2

Fixed cost, S = $4,000/order

Q* = Sqrt [(2)(12000)(4000)/(0.2)(500)] = 980 computers

Cycle inventory = Q/2 = 490

Number of orders per year = D/Q* =12.24

Avg. Flow time = Q/2d = 980/(2)(1000) = 0.49 month

Reorder interval, T = Q*/D = 0.98 month = 29.4 days

Annual ordering and holding cost =

= (12000/980)(4000) + (980/2)(0.2)(500) = $97,980

Suppose lot size is reduced to Q=200, which would reduce flow time:

Annual ordering and holding cost =

(12000/200)(4000) + (200/2)(0.2)(500)

= $250,000

To make it economically feasible to reduce lot size, the fixed cost associated with each lot would have to
be reduced.

EXAMPLE 2

The store manager at Best Buy would like to reduce the optimal lot size from 980 to 200. For this lot size
reduction to be optimal, the store manager wants to evaluate how much the order cost per lot to be
reduced?

If desired lot size = Q* = 200 units, what would S have

to be?

D = 12000 units

C = $500

h = 0.2

Use EOQ equation and solve for S:

S = [h C (Q*)2 ] / 2 D = [(0.2)(500)(200)2] / (2)(12000) = $166.67

To reduce optimal lot size by a factor of k, the fixed order cost must be reduced by a factor of k2.

Key Points from EOQ Model

In deciding the optimal lot size, the tradeoff is between setup (order) cost and holding cost.

If demand increases by a factor of 4, it is optimal to increase batch size by a factor of 2 and produce
(order) twice as often. Cycle inventory (in days of demand) should decrease as demand increases.

If lot size is to be reduced, one has to reduce fixed order cost. To reduce lot size by a factor of 2, order
cost has to be reduced by a factor of 4.
Aggregating Multiple Products in a Single Order

Transportation is a significant contributor to the fixed cost per order.

Can possibly combine shipments of different products from the same supplier:

 same overall fixed cost.

 shared over more than one product.

 effective fixed cost is reduced for each product.

 lot size for each product can be reduced.

 Can also have a single delivery coming from multiple suppliers or a single truck delivering to
multiple retailers.

 Aggregating across products, retailers, or suppliers in a single order allows for a reduction in lot
size for individual products because fixed ordering and transportation costs are now spread across
multiple products, retailers, or suppliers.

Example

Suppose there are 4 computer products in the previous example: Deskpro, Litepro, Medpro, and
Heavpro,

Assume demand for each is 1000 units per month.

If each product is ordered separately:

Q* = 980 units for each product

Total cycle inventory = 4(Q/2) = (4)(980)/2 = 1960 units

Aggregate orders of all four products:

Combined Q* = 1960 units

For each product: Q* = 1960/4 = 490

Cycle inventory for each product is reduced to 490/2 = 245

Total cycle inventory = 1960/2 = 980 units

Average flow time, inventory holding costs will be reduced.

Lot Sizing with Multiple Products or Customers

In practice, the fixed ordering cost is dependent at least in part on the variety associated with an order
of multiple models:

• A portion of the cost is related to transportation (independent of variety).

• A portion of the cost is related to loading and receiving (not independent of variety).

Three scenarios:

1. Lots are ordered and delivered independently for each product.

2. Lots are ordered and delivered jointly for all three models.

3. Lots are ordered and delivered jointly for a selected subset of models.

Example

Demand per year: DL = 12,000; DM = 1,200; DH = 120

Common transportation cost, S = $4,000

Product specific order cost

sL = $1,000; sM = $1,000; sH = $1,000

Holding cost, h = 0.2

Unit cost: CL = $500; CM = $500; CH = $500

Delivery Options:

• No Aggregation: Each product ordered separately.

• Complete Aggregation: All products delivered on each truck.

• Tailored Aggregation: Selected subsets of products on each truck.

 No Aggregation

Litepro Medpro Heavypro

Demand per year 12,000 1,200 120
Fixed cost / order $5,000 $5,000 $5,000
Optimal order size 1,095 346 110
Cycle inventory 548 173 55
Annual holding cost $54,772 $17,321 $5,477
Order frequency 11.0 / year 3.5 / year 1.1 / year
Annual ordering cost $54,772 $17,321 $5,477
Ave. flow time 2.4 weeks 7.5 weeks 23.7 weeks
Annual cost $109,544 $34,642 $10,954
Total Annual cost = $155,140

Aggregation: Order All Products Jointly

S* = S + sL + sM + sH =

4000+1000+1000+1000 = $7000

n* = Sqrt [(DL h CL+ DM h CM+ DH h CH)/2S*] = 9.75

QL = DL/n* = 12000/9.75 = 1230

QM = DM/n* = 1200/9.75 = 123

QH = DH/n* = 120/9.75 = 12.3

Cycle inventory = Q/2

Average flow time = (Q/2)/(weekly demand)

Litepro Medpro Heavypro

Demand per year 12,000 1,200 120
Order frequency 9.75/year 9.75/year 9.75/year
Optimal order size 1,230 123 12.3
Cycle inventory 615 61.5 6.15
Annual holding cost $61,512 $6,151 $615
Ave. flow time 2.67 weeks

Annual order cost = $68,250

Total Annual cost = $1,36,528

Comparison of Lot Sizing with Multiple Products

Options Total Annual Cost in $

No Aggregation 155,140

Complete Aggregation 1,36,528

Tailored Aggregation 1,30,767

Lessons from Aggregation

• Aggregation allows firm to lower lot size without increasing cost.

• Complete aggregation is effective if product specific fixed cost is a small fraction of joint fixed
cost.
• Tailored aggregation is effective if product specific fixed cost is a large fraction of joint fixed
cost.
Quantity Discounts

Why quantity discounts?

Coordination in the supply chain.

Price discrimination to maximize supplier profits.

How should buyer react?

What are appropriate discounting schemes?

1. Lot size based quantity discounts.

a. All units.
b. Marginal units.
2. Volume based quantity discounts.
All Unit Quantity Discounts

Pricing schedule has specified quantity break points q0, q1, …, qr, where q0 = 0

If an order is placed that is at least as large as qi but smaller than qi+1, then each unit has an average unit
cost of Ci

The unit cost generally decreases as the quantity increases, i.e., C0>C1>…>Cr.

c0 0 ≤ q ≤ q1

Unit price =  c1 q1 ≤ q < q2
c q2 ≤ q < q3
 2

The objective for the company (a retailer in our example) is to decide on a lot size that will minimize the
sum of material, order, and holding costs.

Procedure:

Step 1: Calculate the EOQ for the lowest price. If it is feasible (i.e., this order quantity is in the range for
that price), then stop. This is the optimal lot size. Calculate TC for this lot size.

Step 2: If the EOQ is not feasible, calculate the TC for this price and the smallest quantity for that price.
Step
tep 3: Calculate the EOQ for the next lowest price. If it is feasible, stop and calculate the TC for that
quantity and price.

Step 4: Compare the TC for Steps 2 and 3. Choose the quantity corresponding to the lowest TC.

Step 5: If the EOQ in Step 3 is not feasible, repeat Steps 2, 3, and 4 until a feasible EOQ is found.

Example

Order quantity Unit Price

0-5000 $3.00

5001-10000 $2.96

Over 10000 $2.92

q0 = 0, q1 = 5000, q2 = 10000

C0 = $3.00, C1 = $2.96, C2 = $2.92

D = 120000 units/year, S = $100/lot, h = 0.2

Step 1: Calculate Q2 = Sqrt. [(2DS)/hC2]

= Sqrt. [(2)(120000)(100) / (0.2)(2.92)]

= 6410
Not feasible (6410 < 10001)

Calculate TC2 using C2 = $2.92 and q2 = 10001

TC2 = (120000/10001)(100)+ (10001/2)(0.2)(2.92) +(120000)(2.92)

= $354,520

Step 2: Calculate Q1 = Sqrt. [(2DS)/hC1]

=Sqrt. [(2)(120000)(100)/(0.2)(2.96)]

= 6367

Feasible (5000<6367<10000)  Stop

TC1=(120000/6367)(100)+(6367/2)(0.2)(2.96)+ (120000)(2.96)

= $358,969

TC2 < TC1  The optimal order quantity Q* is q2 = 10001

Suppose fixed order cost were reduced to $4 Without discount, Q* would be reduced to 1265 units With
discount, optimal lot size would still be 10001 units.

What is the effect of such a discount schedule?

Retailers are encouraged to increase the size of their orders Average inventory (cycle inventory) in the
supply chain is increased, Average flow time is increased.

Is an all-unit quantity discount an advantage in the supply chain?

Marginal Unit Quantity Discounts:

It is also referred to as multi-block tariffs.

It is the marginal cost of a unit that decreases at the specified breakpoints.

Vi is the cost of ordering qi units.

V0=0, for 0<=i<=r

Vi = C0 (q1 − q0 ) + C1 (q2 − q1 ) + ... + Ci −1 (qi − qi −1 )

D D
Total Cost =   S + [Vi + (Q − qi )Ci ]h / 2 + [Vi + (Q − qi )Ci ]
1Q  144424443 Q
23 Total Holding Cost 144 42444 3
Total order cost Total Material Cost
 2 D ( S + Vi − qi Ci )
Optimal lot size for price Ci = Qi =
hCi
If qi ≤ Qi ≤ qi +1

 D  D 
TCi = Min   S + [Vi + (Qi − qi )Ci ]h / 2 + [Vi + (Qi − qi )Ci ]
 Qi  Qi 
Otherwise, the values will lie in a different range

Example

ORDER QUANTITY MARGINAL PRICE

0-5000 $3.00

5001-10000 $2.96

OVER 10000 $2.92

D=12000 units/year,

S=$100, h=0.2/year

q0 = 0, q1 = 5000, q2 = 10,000
C0 = 3, C1 = 2.96, C2 = 2.92
V0 = 0, V1 = 3(5000 − 0) = $15,000
V2 = 3(5000 − 0) + 2,96(10,000 − 5,000) = $29,800
 2 D( S + V0 − q0C0 )
Q0 = = 6,324 not feasible
hC0
2 D( S + V1 − q1C1 )
Q1 = = 11,028 not feasible
hC1
2 D( S + V2 − q2C2 )
Q2 = = 16,961 feasible
hC2

 D  D 
TC2 = Min   S + V2 + (Q2 − q2 )C2 ]h / 2 + [V2 + (Q2 − q2 )C2 ] = $360,365
 Q2  Q2 

The lot size increases by offering a marginal unit quantity discount

 Will this be advantageous to the supply chain?

If the order cost is decreased, then the optimal lot size will increase

 Lot size increases if fixed order cost is minimized

Why Quantity Discounts:

There are two main reasons why quantity discounts are used, they are:

 Improved coordination as to increase total supply chain profits.

 Extraction of surplus through price discrimination.

Quantity Discounts for Commodity Products

D=120,000 bottles/year

SR = $100, hR = 0.2, CR = $3 Lot Size =6,324

SM = $250, hM = 0.2, CM = $2

Retailer Manufacturer

Holding Cost $1,897 $1,265

Ordering Cost $1,898 $4,744

Total Cost $3,795 $6,009

Supply chain Cost = $9,804

What can be done by the supplier do to decrease supply chain costs?

Coordinated lot size: 9,165 (= 2(100 + 250)120,000 /(0,2 * (2 + 3)) )

 Retailer cost = $4,059

 Supply chain cost= $9,165

  Manufacturer cost = $5,106

When the commodity price is set by the market, quantity discounts are the best to achieve
coordination, but they increase the cycle inventory.

Coordination is required as efforts to decrease order costs increase the inventory

inventor

Quantity discounts for products for which firm has market power

If a new product is invented by a manufacturer, then there is little or no competition.

The two stages coordinate the pricing decision p = $4, CR=2, Demand = 120,000 bottles, Profit =
PM+PR=0+240,000 = $240,000 ($60,000 higher.)

There are two pricing schemes hat a manufacturer may use to achieve coordination.

 Two part tariffs.

 Volume based quantity discounts.

Two part tariffs

Manufacturer charges its entire profit as an up

up-front franchise fee and then sells it to the retailer at a
cost.

Ex: With coordination SC Profit=$240,000

Without Coordination PR=$60,000

Manufacturer charges up-front

front fee of $180,000 and set CR=2.
Volume based quantity discounts

Two part tariff plan if observed, is a type of volume based quantity discount.

Average material cost for DO declines as it increases the average quantity purchased in a year.

Objective is to price in a way that the retailer buys the full volume sold when two stages
coordinate pricing.

Ex: With coordination demand=$120,000 bottles /year.

Manufacturer offers

 $4 if yearly purchase quantity < 120,000

CR = 
$3.5 if yearly purchase quantity ≥ 120,000

Then it is optimal for DO to order 120,000 units at set p=$4/unit. So, PR= $60,000, PM= $180,000
and SC Profit=$240,000.

Price discrimination to maximize supplier profits

Price discrimination is a practice where companies charge differential prices to maximize profits.

Ex: In an airline, passengers travelling on the same plane pay different rates for their seats.

Fixed price for all units does not maximize profits.

Short term discounting: trade promotions

Trade promotions are used to offer a discounted price and a time period over which the
discount lasts.

Sometimes, manufacturers require the retailers to put up displays, advertize, etc to qualify for
trade promotion

Goal is to influence retailers to act in a way which would help the manufacturer achieve its
objectives.
Key Goals of Trade Promotions

Induce retailers to use displays, advertisements, and discount

discountss to increase sales

Shift inventory from manufacturer to the retailer to the customer

Defend a brand against competition

Short term discounting: trade promotions

Q*: Normal order quantity

C: Normal unit cost

d: Short term discount

D: Annual demand

h: Cost of holding $1 per year

Qd: Short term order quantity

Qd :can
can not exceed the demand during discount period, Q1

*
d dD CQ
Q = +
(C - d ) h C - d
Forward buy = Qd - Q* ; Qd =
Min{Qd, Q1}
Forward Buying

Normal order size, Q* = 6,324 bottles

Normal cost, C = $3 per bottle

Discount per tube, d = $0.15

Annual demand, D = 120,000

Holding cost, h = 0.2

d 0.15 × 120,000 3 × 6,324

Q = +
(3 − 0.15)0.20 3 − 0.15
= 38,236

Forward buy = Qd - Q*

=38,236 - 6,324

= 31,912 bottles

Promotion pass through to customers

Demand curve at retailer: 300,000 - 60,000p

Normal supplier price, CR = $3.00

 Optimal retail price = $4.00

 Customer demand = 60,000

 Promotion discount = $0.15

 Optimal retail price = $3.925

 Customer demand = 64,500

Only half the discount id passed through by the retailer, the demand increases by 7.5%

Managing multi-echelon cycle inventory

Multi-echelon supply chains have multiple stages and multiple players per stage

Lack of coordination could result in high costs and more cycle inventory than necessary

Overall supply chain inventory is reduced if production is complete just in time to be shipped to
the customer.

It is assumed that production is instantaneous

Sequential Approach

Multi-echelon Approach
Inventory Reduction

Multi-echelon supply chains have multiple stages and multiple players per stage

Lack of coordination could result in high costs and more cycle inventory than necessary

Overall supply chain inventory is reduced if production is complete just in time to be shipped to
the customer.

It is assumed that production is instantaneous.

Inventory Profile At Retailer and Manufacturer with no Synchronization
Illustration of an Integer Replenishment Policy

A Multi-echelon
echelon Distribution Supply Chain
Estimating cycle inventory-costs involved

Inventory holding cost

 Cost of capital

 Obsolescence cost

 Handling cost

 Occupancy cost

 Miscellaneous costs

Order cost

 Buyer time

 Transportation costs

 Receiving costs

 Other costs

Levers to Reduce Lot Sizes Without Hurting Costs

Cycle Inventory Reduction

• Reduce transfer and production lot sizes

• Aggregate fixed costs across multiple products, supply points, or delivery points

• Are quantity discounts consistent with manufacturing and logistics operations?

• Volume discounts on rolling horizon

• Two-part tariff

• Are trade promotions essential?

• EDLP

• Based on sell-thru rather than sell-in

 Safety Inventory
TOPIC OUTLINE

The role of safety inventory in a supply chain

Determining the appropriate level of safety inventory

Impact of supply uncertainty on safety inventory

Impact of aggregation on safety inventory

Impact of replenishment policies on safety inventory

Managing safety inventory in a multi-echelon supply chain

Estimating and managing safety inventory in practice

Learning Objectives

What is the role of safety inventory in a supply chain?

What are the factors that influence the required level of safety inventory?

What are the different measures of product availability?

What managerial levers are available to lower safety inventory and improve product
availability?

Role of Safety Inventory in the Supply Chain

Forecasts are rarely completely accurate.

If average demand is 1000 units per week, then half the time actual demand will be greater than
1000, and half the time actual demand will be less than 1000; what happens when actual
demand is greater than 1000?

If you keep only enough inventory in stock to satisfy average demand, half the time you would
run out.

Safety inventory: Inventory carried for the purpose of satisfying demand that exceeds the
amount forecasted in a given period.

Average inventory is therefore cycle inventory plus safety inventory.

There is a fundamental tradeoff:


Raising the level of safety inventory provides higher levels of product availability and
customer service.

Raising the level of safety inventory also raises the level of average inventory and therefore
increases holding costs.

Very important in high-tech or other industries where obsolescence is a significant risk (where
the value of inventory, such as PCs, can drop in value).

Compaq and Dell in PCs.

Two Questions to Answer in Planning Safety Inventory

What is the appropriate level of safety inventory to carry?

What actions can be taken to improve product availability while reducing safety inventory?

Determining the Appropriate Level of Safety Inventory

Measuring demand uncertainty.

Measuring product availability.

Replenishment policies.

Evaluating cycle service level and fill rate.

Evaluating safety level given desired cycle service level or fill rate.

Impact of required product availability and uncertainty on safety inventory.

Appropriate level of safety inventory determined by:

supply or demand uncertainty.

desired level of product availability.

Higher levels of uncertainty require higher levels of safety inventory given a particular desired
level of product availability.

Higher levels of desired product availability require higher levels of safety inventory given a
particular level of uncertainty.

Measuring Demand Uncertainty

Demand has a systematic component and a random component.

The estimate of the random component is the measure of demand uncertainty.

Random component is usually estimated by the standard deviation of demand.

Notation:

D = Average demand per period.

sD = Standard deviation of demand per period.

L = Lead time = time between when an order is placed and when it is received.

cv = Coefficient of variation = m/s = mean/(std dev) = size of uncertainty relative to demand.

Uncertainty of demand during lead time is what is important

Measuring Product Availability

Product availability: a firm’s ability to fill a customer’s order out of available inventory.

Stockout: a customer order arrives when product is not available.

Product fill rate (fr): fraction of demand that is satisfied from product in inventory.

Order fill rate: fraction of orders that are filled from available inventory.

Cycle service level: fraction of replenishment cycles that end with all customer demand met.

Replenishment Policies

Replenishment policy decisions regarding when to reorder and how much to reorder:

Continuous review: inventory is continuously monitored and an order of size Q is placed when
the inventory level reaches the reorder point ROP.

Periodic review: inventory is checked at regular (periodic) intervals and an order is placed to
raise the inventory to a specified threshold (the “order-up-to” level).

Continuous Review Policy: Safety Inventory and Cycle Service Level

L: Lead time for replenishment.

D: Average demand per unit time.

σD:Standard deviation of demand per period.

DL: Mean demand during lead time.

σL: Standard deviation of demand during lead time.

CSL: Cycle service level.

ss: Safety inventory.

ROP: Reorder point.

Average Inventory = Q/2 + ss

D L
= DL

σ L
= Lσ D
−1
ss = F S (CSL) ×σ L
ROP = D L + ss
CSL = F ( ROP, D L ,σ L )

Continuous Review Policy: Estimating Safety Inventory

Assume that weekly demand for Palms at B & M Computer World is normally distributed. The
manufacturer takes two weeks to fill an order placed by the B & M manager. The store manager
currently orders 10000 Palms when the inventory on hand drops to 6000.Evaluate the safety inventory
carried by B & M, the average inventory and also the average time spent by a Palm at B & M.

D = 2,500/week; σD = 500; L = 2 weeks; Q = 10,000; ROP = 6,000

DL = DL = (2500)(2) = 5000

ss = ROP - DL = 6000 - 5000 = 1000

Cycle inventory = Q/2 = 10000/2 = 5000

Average Inventory = cycle inventory + ss = 5000 + 1000 = 6000

Average Flow Time = Avg. inventory / throughput = 6000/2500 = 2.4 weeks

Weekly demand for Palms at B & M is normally distributed, with a mean of 2500 and a standard
deviation of 500. The replenishment lead time is 2 weeks. Assume that the demand is independent from
one week to the next. Evaluate the CSL resulting from a policy of ordering 10000 Palms when there are
6000 Palms in inventory.

D = 2,500/week; σD = 500; L = 2 weeks; Q = 10,000; ROP = 6,000

σ =σ L R
L = (500) 2 = 707
Cycle service level, CSL = F(DL + ss, DL, σL) =

= NORMDIST (DL+ ss, DL, σL)

= NORMDIST (6000,5000,707,1)

(Z = (6000-5000) / 707 = 1.4144)

= 0.92 (from Normal Distribution tables)

Continuous Review Policy: Fill Rate

Proportion of customer demand satisfied from stock.

Stock-out occurs when the demand during lead time exceeds the reorder point.

ESC is the expected shortage per cycle (average demand in excess of reorder point in each
replenishment cycle).

ss - is the safety inventory

Q - is the order quantity

ESC = - ss {1- NORMDIST (ss /σL, 0, 1, 1)} + σL NORMDIST(ss / σL, 0, 1, 0)

ESC
fr = 1 −
Q
 ss 
= − ss { 1 −  }
ESC F S  
σ L 
 ss 
+ σ f  
L S  
σ L 

Probability Density Function

Cumulative Distribution Function

Continuous Review Policy: Evaluating Fill Rate

From the previous example recall that weekly demand for Palm s at B & M is normally
distributed, with a mean of 2500 and a standard deviation of 500. The replenishment lead time is 2
weeks. Assume that the demand is independent from one week to the next. Evaluate the fill rate
resulting from the policy of ordering 10000 Palms when there are 6000 Palms in inventory.

ss = 1,000, Q = 10,000, sL = 707, Fill Rate (fr) = ?

ESC = -ss {1-NORMDIST(ss/σL, 0, 1, 1)} + σL NORMDIST(ss/σL, 0, 1, 0)

= -1,000{1-NORMDIST(1,000/707, 0, 1, 1)} + 707 NORMDIST(1,000/707, 0, 1, 0)

= 25.13

fr = (Q - ESC)/Q = (10,000 - 25.13)/10,000 = 0.9975

Factors Affecting Fill Rate

Safety inventory: Fill rate increases if safety inventory is increased. This also increases the cycle
service level.

Lot size: Fill rate increases on increasing the lot size even though cycle service level does not
change.

Evaluating Safety Inventory Given CSL

Weekly demand for Lego at Wal-Mart store is normally distributed, with a mean of 2500 boxes and a
standard deviation of 500. The replenishment lead time 2 weeks. Assuming a continuous-review
replenishment policy, evaluate the safety inventory that the store should carry to achieve a CSL of 90 %.

D = 2,500/week; σD = 500

L = 2 weeks; Q = 10,000; CSL = 0.90

DL = 5000, σL = 707 (from earlier example)

ss = FS-1(CSL)σL = [NORMSINV(0.90)](707) = 906

(Normal probability distribution table)

ROP = DL + ss = 5000 + 906 = 5906

Evaluating Safety Inventory Given Desired Fill Rate

Weekly demand for Legos at a Wal-Mart store is normally distributed with a mean of 2500 boxes and a
standard deviation of 500. The replenishment lead time is 2 weeks. The store manager currently orders
replenishment lots of 10000 boxes from Lego. Assuming a continuous review replenishment policy,
Evaluate the safety inventory the store should carry to achieve a fill rate of 97.5 percent.
D = 2500, sD = 500, Q = 10000; fr = 0.975; ss = ?

ESC = (1 - fr)Q = 250

  ss   ss 
ESC = 250 = − ss 1 − F S   + σ f  
   L  
 σ L 
S
 σL 

  ss   ss 
250 = − ss 1 − NORMSDIST   
 + σ L NORMDIST  ,1,1,0 
   
 σ L   σL 

Fill Rate Safety Inventory

97.5% 67
98.0% 183
98.5% 321
99.0% 499
99.5% 767

Impact of Required Product Availability and Uncertainty on Safety Inventory

Desired product availability (cycle service level or fill rate) increases, required safety inventory
increases.

Demand uncertainty (sL) increases, required safety inventory increases.

Managerial levers to reduce safety inventory without reducing product availability:

reduce supplier lead time, L (better relationships with suppliers).

reduce uncertainty in demand, sL (better forecasts, better information collection and

use).
Impact of Supply Uncertainty

D: Average demand per period

σD: Standard deviation of demand per period

L: Average lead time

sL: Standard deviation of lead time

D L
= DL
2 2 2
σ L
= Lσ D + D s L

Daily demand for PCs at Dell is normally distributed with a mean of 2500 and a standard deviation of
500. A key component of PC assembly is the hard drive. The hard drive supplier takes an average of L=7
days to replenish inventory at Dell. Dell is targeting a CSL of 90% ( providing a fill rate close to 100 %) for
its hard drive inventory.

Evaluate the safety inventory of hard drives that Dell must carry if the standard deviation of the lead
time is seven days. Dell is working with the supplier to reduce the standard deviation to zero. Evaluate
the reduction in safety inventory that Dell can expect as a result of this initiative.

D = 2,500/day; σD = 500; L = 7 days; Q = 10,000; CSL = 0.90; sL = 7 days

DL = DL = (2500)(7) = 17500

2 2 2
σL = L σ D + D sL
= (7) 5002 + (2500)2 (7)2 = 17500
ss = F-1s(CSL)sL = NORMSINV(0.90) x 17550 = 22,491

Safety inventory when sL = 0 is 1,695

Safety inventory when sL = 1 is 3,625

Safety inventory when sL = 2 is 6,628

Safety inventory when sL = 3 is 9,760

Safety inventory when sL = 4 is 12,927

Safety inventory when sL = 5 is 16,109

Safety inventory when sL = 6 is 19,298

Impact of Aggregation on Safety Inventory

Methods of aggregation

Information centralization

Specialization

Product substitution

Component commonality

Postponement

Impact of Aggregation on Safety Inventory

Notations:

Di – Mean weekly demand in region i, i=1,…,k

σi – Standard Deviation of weekly demand in region i, i=1,…,k

ρij – Correlation of weekly demand for regions i,j, 1≤ i ≠ j ≤k

DC – Mean aggregate demand

σDC - Standard Deviation of aggregate demand

σLC – Standard deviation of aggregate demand during lead time

var (DC) - Variance aggregate demand

 n

∑ D
C
D =
i=1
i

∑ σ
C 2
σ D
=
i=1
i

C C
σ L
= L σ D
−1 C
ss = F s
( CSL )× σ L

A BMW dealership has four retail outlets serving the entire Chicago area (disaggregate option). Weekly
demand at each outlet is normally distributed with a mean of D = 25 cars and a standard deviation of σD
= 5. The lead time for replenishment from the manufacturer is L = 2 weeks. Each outlet covers a
separate geographic area, and the correlation of demand across any pair of areas is ρ. The dealership is
considering the possibility of replacing the four outlets with a single large outlet (aggregate option).

Assume that the demand in the central outlet is the sum of the demand across all four areas. The
dealership is targeting a CSL of 0.90. Compare the level of safety inventory in the two options as the
correlation coefficient ρ varies between 0 and 1.

Car Dealer : 4 dealership locations (disaggregated)

D = 25 cars; sD = 5 cars; L = 2 weeks; desired CSL=0.90

What would the effect be on safety stock if the 4 outlets are consolidated into 1 large outlet
(aggregated)?

At each disaggregated outlet:

For L = 2 weeks, sL = 7.07 cars

ss = Fs-1(CSL) x sL = Fs-1(0.9) x 7.07 = 9.06

Each outlet must carry 9 cars as safety stock inventory, so safety inventory for the 4 outlets in total is
(4)(9) = 36 cars

One outlet (aggregated option):

DC = D1 + D2 + D3 + D4 = 25+25+25+25 = 100 cars/wk

sDC = Sqrt.(52 + 52 + 52 + 52) = 10

sLC = sDC Sqrt.(L) = (10) Sqrt.(2) = (10)(1.414) = 14.14

ss = Fs-1(CSL) x sLC = Fs-1(0.9) x 14.14 =18.12 or about 18 cars

If r does not equal 0 (demand is not completely independent), the impact of aggregation is not as great.

ρ Disaggregate Safety Inventory Aggregate Safety Inventory

0 36.24 18.12

0.2 36.24 22.92

0.4 36.24 26.88

0.6 36.24 30.32

0.8 36.24 33.41

1.0 36.24 36.24

If number of independent stocking locations decreases by n, the expected level of safety

inventory will be reduced by square root of n (square root law).

Many e-commerce retailers attempt to take advantage of aggregation (Amazon) compared to

bricks and mortar retailers (Borders).

Aggregation has two major disadvantages:

Increase in response time to customer order

Increase in transportation cost to customer

Some e-commerce firms (such as Amazon) have reduced aggregation to mitigate these
disadvantages

Information Centralization

Virtual aggregation.

Information system that allows access to current inventory records in all warehouses from each
warehouse.

Most orders are filled from closest warehouse.

In case of a stock out, another warehouse can fill the order.

Better responsiveness, lower transportation cost, higher product availability, but reduced safety
inventory.

Examples: McMaster-Carr, Gap, Wal-Mart.

Specialization

Stock all items in each location or stock different items at different locations?

Different products may have different demands in different locations.

There can be benefits from aggregation.

If aggregation reduces the required safety inventory for a product by a large amount, it is better
to carry the product in one central location.

If aggregation reduces the required safety inventory for a product by a small amount, it is may
be best to carry the product in multiple decentralized locations to reduce response time and
transportation cost.

Benefits of aggregation can be affected by:

coefficient of variation of demand (higher cv yields greater reduction in safety inventory

from centralization).

value of item (high value items provide more benefits from centralization).

Assume that W W Grainger, a supplier of MRO products, has 1600 stores distributed throughout the
United States. Consider two products-large electric motors and industrial cleaners. Large electric motors
are high-value items with low demand, where as the industrial cleaner is a low-value item with high
demand. Each motor costs $500 and each can of cleaner costs $30. Weekly demand for motors at each
store is normally distributed with a mean of 20 and a standard deviation of 40.

Weekly demand for cleaner at each store is normally distributed with a mean of 1000 and a standard
deviation of 100. Demand experienced by each store is independent, and supply lead time for both
motors and cleaner is 4 weeks. W W Grainger has a holding cost of 25%. For each of the two products,
evaluate the reduction in safety inventory that will result if they are removed from retail stores and
carried only in a centralized DC. Assume a desired CSL of 0.95.

Motors Cleaner
Mean demand 20 1,000
SD of demand 40 100
Disaggregate cv 2 0.1
Value/Unit $500 $30
Disaggregate ss $105,600,000 $15,792,000
Aggregate cv 0.05 0.0025
Aggregate ss $2,632,000 $394,770
Holding Cost Saving $25,742,000 $3,849,308
Saving / Unit $7.74 $0.046
Product Substitution

Substitution: use of one product to satisfy the demand for another product.

Manufacturer-driven one-way substitution.

Customer-driven two-way substitution.

Component Commonality

Using common components in a variety of different products.

Can be an effective approach to exploit aggregation and reduce component inventories.

Assume that Dell used to manufacture 27 different PCs with 3 distinct components: Processor, Memory
and Hard drive. Under the disaggregate option Dell designs specific components for each PC resulting in
3x27 = 81 distinct components. Under the common-component option Dell designs PCs such that three
distinct processors, three distinct memory units and three distinct hard drives can be combined to
create 27 different PCs. Each component is thus used in 9 different PCs. Monthly demand for each of the
27 different PCs is normally distributed with a mean of 5000 and a standard deviation of 3000.

The replenishment lead time for each component is one month. Dell is targeting a CSL of 95% for
component inventory. Evaluate the safety inventory requirements with and without the use of
component commonality. Also evaluate the change in safety inventory requirements as the number of
finished products of which a component is a part varies from 1 to 9.

The graph illustrates the evaluation of benefits in terms of reduction in safety inventory as a result
increasing component commonality.
 500000
400000
300000
S
200000
100000
0
1 2 3 4 5 6 7 8 9
Number of finished products per component

Postponement

The ability of a supply chain to delay product differentiation or customization until closer to the
time the product is sold.

Goal is to have common components in the supply chain for most of the push phase and move
product differentiation as close to the pull phase as pos
possible.

Examples: Dell, Benetton

Impact of Replenishment Policies on Safety Inventory - Continuous review policy

Impact of Replenishment Policies on Safety Inventory Periodic review policy

Estimating and Managing Safety Inventory in Practice

Account for the fact that supply chain demand is lumpy.

Adjust inventory policies if demand is seasonal.

Use simulation to test inventory policies.

Start with a pilot.

Monitor service levels.

Focus on reducing safety inventories.

 Product Availability
TOPIC 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.

Learning Objectives

What are 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?

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 (e.g.,
Nordstrom, power plants, supermarkets, e-commerce retailers).

What is the level of fill rate or cycle service level that will result in maximum supply chain
profits?
Factors Affecting the Optimal Level of Product Availability

Cost of over-stocking.

Cost of under-stocking.

Possible scenarios.

Seasonal items with a single order in a season.

Quantity discounts.

Continuously stocked items.

Demand during stock-out is backlogged.

Demand during stock-out is lost.

Evaluating the optimal service level for seasonal items

Notation:

p – Retail price per unit

c – Cost per unit

s – Salvage value per unit

Cu – Cost of under-stocking by one unit, Cu = p - c

Co – Cost of over-stocking by one unit, Co = c – s

CSL* - Optimal cycle service level

O* - Corresponding optimal order size

Evaluating the optimal service level for seasonal items

The manager at Sportmart, a sporting goods store, has to decide on the number of skis to purchase for
the winter season.

Based on past demand data and weather forecast for the year, management has forecast demand to be
normally distributed with a mean of µ=350 and standard deviation of σ=100 each pair of skis costs
c=$100 and retails for p =250. and unsold skis at the end of season are disposed for $85. Assume that it
costs $5 to hold a pair of skis in inventory for the season. How many skis should be manager order to
maximize expected profits?

Salvage value s=$85-$5=80

Cost of under-stocking= Cu=p-c= $250-$100= $150

Cost of over-stocking= Co= c-s= $100-$80=$20

Using equation we deduce that the optimal CSL is

CSL*= Prob(Demand<=O*)= Cu/Cu+Co= 150/150+20= 0.88

Using Equation the optimal order size is

O*= NORMINV(CSL*, µ, σ) = NORMINV(0.88,350,100)=468

Thus it is optimal for the manager at sportmart to order 468 pairs of skis even though the expected
number of sales is 350. In this case, because the cost of under stocking is much higher than the cost of
overstocking, management is better off ordering more than the expected value to cover for the
uncertainty of demand.

Using Equation the expected profits from ordering O* units are

Expected Profits= (p-s) µ NORMDIST((O*- µ ))/σ,0,1,1)- (p-s) σ NORMDIST((O*- µ ))/σ,0,1,0)-

O*(c-s) NORMDIST(O* µ,σ,1 )+ O*(p-c)[1- NORMDIST (O* µ,σ,1)]

=59.500 NORMDIST (1.18,0,1,1) - 17,000 NORMDIST (1.18,0,1,0) -

9360 NORMDIST(468,350,100,1) + 70200[1- NORMDIST(468,350,100,1)]

= $49146

The expected profit from ordering 350 pairs of skis can be evaluated as $45718. Thus ordering 468 pairs
results in an expected profit that is almost 8 percent higher than the profit obtained from ordering the
expected value of 350 pairs.

Demand for skis at Sportmart is normally distributed with a mean of µ = 350 and a standard deviation of
σ = 100. The manager has decided to order 450 pairs of skis for the upcoming season.

Evaluate the expected over- and under-stock as a result of this policy?

In this case we have an order size O = 450. An overstock results if demand during the season is less than
450.

The expected overstock can be obtained using Equation below.

Expected overstock = (0 -µ)NORMDIST((O - µ)/σ, 0, 1,1) + σ NORMDIST((0 — µ )/σ, 0,1,0)

= (450 — 350) NORMDIST((450 -350)/100, 0,1,1) + 100 NORMDIST((450 — 350)/100, 0, 1,0)

= 108
Thus, the policy of ordering 450 pairs of skis results in an expected overstock of 108.

An undertook occurs if demand during the season is higher than 450 pairs.

The expected under stock can be evaluated using Equation is as follows:

Expected under-stock = (µ-o) [1- NORMDIST((o- µ)/σ, 0, 1, 1)] + σ NORMDIS T ((O-µ)/σ, 0, 1, 0)

= (350 450)11 – [ NORMDIST((450 -350)/100,0, 1, 1)] 100 [NORMDIST((4 50-350)/l00, 0, 1,0)]

=8

Thus the policy of ordering 450 pairs results in an expected under-stock of 8 paws.

Note that there is a positive expected under-stock and overstock in virtually every case.

This result may seem counterintuitive initially, but it makes sense because the values used to calculate
an expected under-stock or over-stock are always greater than or equal to zero.

Evaluating service level with quantity discounts

SparesRUs. an auto parts retailer must decide on the order size for a 20 year-old model of brakes. The
manufacturer plans to discontinue production of these brakes after the last production run.

SparesRUs has forecast remaining demand for the brakes to be normally distributed, with a mean of 150
and a standard deviation of 40. The brakes have a retail price of$200.

Any unsold brakes are useless and have no salvage value. the manufacturer plans to sell each brake for
$50 if the order is for less than 200 brakes and $45 if the order is for at least 200 brakes. How many
brakes should SparesRUs order?

The first step is to calculate the optimal order quantity if the discount is not used. In this case we have

Cost of under stocking Cu = p-c= $200- $50=$150

Cost of overstocking = Co = c - s =$50- $0= $50

Using Equation we deduce that the optimal CSL is

CSL* = Prob(Demand<R*)= Cu/Cu+Co= 150/150+50

Using Equation the optimal order size is,

Q*= NORMINV(CSL*,µ,σ)

=NORM1NV(0.75, 150,40)

= 177
Using Equation the expected profit if SparesRUs does not go after the discount is,

Expected profit from ordering 177 units= $19,958

We next consider the discount and obtain

Cost of under-stocking = Cu = p- Cd = $200 — $45= $155

Cost of over-stocking =Co = Cd — s = $45 — $0 = $45

Using Equation we deduce that the optimal CSL is,

CSLd* = Prob(Demand <= R*) = Cu/Cu+Co

= 155/155+45 = 0.775

Using Equation , the optimal order size is

Qd* = NORMINV(CSLd,µ, σ) = NORMINV(0.775, 150,40)

= 180

Given that 180<200, the retailer must order at least 200 brakes to benefit from the discount.

Thus we calculate the expected profit from ordering 200 units using equation expected profits from
ordering 200 units at $45 each= $20,595

It is thus optimal for SparesRUs to order 200 units to take advantage of the quantity discount. The
expected overstock can be calculated.

Demand during Stock-out is backlogged

Weekly demand for a detergent at Wal-mart is normally distributed ,mean = 100 gallons and SD = 20.
The replenishment lead time is L=2 weeks.

The store manager orders for 400 gallons when the available inventory drops to 300 gallons. Each gallon
costs $3.The holding cost incurs 20.If unfilled demand is backlogged and carried over to next cycle,
evaluate cost of stocking out implied by the current replenishment policy.

Lot size Q=400 gallons

Reorder point ROP=300 gallons

Average demand per week D=100 gallons

Avg. demand per year D(year)=100*52 = 5200

SD of demand per week = 20

Unit cost C = $3

Holding cost as fraction of product cost per year h = 0.2

Cost of holding one unit for one year H = h*c = $0.6

Lead time L = 2 weeks

Mean demand over lead time DL= D*L = 200 gallons

S D of demand over lead time =√L* σL =20* √2=28.3

CSL = F (ROP, DL, σL )=f(300,200,28.3)

Thus we can use equation:

CSL=NORMDIST(300,200,28.3,1)= 0.9998

Cost of stocking out - Cu= HQ / (1CSL)* Dyear = 0.6*400 / (0.00002*5200)

= $230.8 per gallon

Demand during Stock-out is lost

The data is the same as in the previous problem. The only assumption to be made is that all demand
during a stock-out is lost.

Assume that cost of losing one unit of demand is $2.Evaluate optimal cycle service level that the store
manager at Wal- mart should target.

Lot size Q = 400 gallons

Average demand per year Dyear = 100*52 = 5200

Cost of holding one unit for one year H = $0.6

Cost of under-stocking Cu=$2

We use the below formula to calculate optimal service level:

CSL* = 1-HQ/(HQ + DCu)

= 1-(0.6*400) / (0.6*400+2*5200)

=0.98

In this case the store manager should target a cycle service level of 98%
Managerial Levers to Improve Supply Chain Profitability

“Obvious” actions.

Increase salvage value of each unit.

Decrease the margin lost from a stock-out.

Means to reduce demand uncertainty:

Improved forecasting.

Quick response.

Postponement.

Tailored sourcing.

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

Impact of Improving Forecasts (Example)

Consider a buyer at Bloomingdale’s who is responsible for purchasing dinnerware with Christmas
patterns. The dinnerware sells only during Christmas the buyer places an order for delivery in early
November. Each dinnerware set costs c=$100 and sells for a retail price of p=$250.Any sets unsold by
Christmas are heavily discounted in the post Christmas sales and are sold for a salvage of s=$80.The
buyer has estimated that demand is normally distributed with mean of 350.

Historically forecast errors have had a standard deviation 150. The buyer has decided to conduct
additional forecast accuracy on profitability and inventories as buyer reduces mean from 150 to 0 in
increments of 30.

Demand: Normally distributed with a mean of D = 350 and standard deviation of σD = 100

Holding cost for season = $5

Purchase price = $100

Retail price = $250

Disposal value = $85

How many units should be ordered as σR changes?

Cost of under-stocking = Cu = p-c

=$250-$100 = $150

Cost of over-stocking = Co = c-s

=$100-$80 = $20

σD 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

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.

Quick Response: Multiple Orders Per Season

Ordering shawls at a department store

Selling season = 14 weeks

Cost per handbag = $40

Sale price = $150

Disposal price = $30

Holding cost = $2 per week

Expected weekly demand = 20

SD of weekly demand = 15

Single Order Two Orders in Season

Service Order Ending Expect. Initial OUL Averag Ending Expect.
Level Size Invent. Profit Orde for e Total Invent. Profit
r 2nd 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

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.

BENETTON

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

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

Tailored Postponement: Benetton

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

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

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.

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

Tailored Sourcing Strategies

Fraction of demand from Annual Profit

overseas supplier
0% $37,250

50% $51,613

60% $53,027

100% $48,875
Tailored Sourcing: Multiple Sourcing Sites

Characteristic Primary Site Secondary

Site
Manufacturing High Low
Cost
Flexibility High Low
(Volume/Mix)
Responsiveness High Low

Engineering High Low

Support

Dual Sourcing Strategies

Strategy Primary Site Secondary

Site
Volume based Fluctuation Stable demand
dual sourcing
Product based Unpredictable Predictable,
dual sourcing products, Small large batch
batch products
Model based Newer Older stable
dual sourcing products products
Setting Optimal Levels of Product Availability in Practice

1. Use analytic framework in this chapter to increase profits.

2. Beware of present levels of availability.

3. Use approximate costs because profit maximizing solutions are quite robust.

4. Estimate a range for the cost of stocking out.

5. Ensure levels of product availability fit with strategy.