6.

Additional Inventory Management Processes and

Concepts

MULTI-ITEM INVENTORY MANAGEMENT

In Chapter 3, “Inventory Control,” we studied inventory models for a single
item. It was important to start with a single item because it is difficult to
understand multi-item inventory issues without understanding the single
item issues. Let’s consider some of the reasons to understand multi-item
inventory management decisions.
Consider a distribution center ordering 50 SKUs from a single supplier
where each SKU is on a continuous review (Q,ROP) replenishment process.
Hence, every time an SKU hits its ROP, an order is placed for that SKU and
the SKU is delivered by a parcel carrier. Now, if that SKU is expensive and
has a high inventory carrying cost factor, this process may be optimal
because this process keeps inventory to a minimum for all of the SKUs.
However, if it is an inexpensive SKU with a low inventory carrying cost
factor, this process might result in too much being spent on transportation.
So, instead of a (Q,ROP) model for all SKUs, the distribution center could
use a (T,OUL) replenishment process for all of the SKUs, where all SKUs
have the same T so that they could all be ordered together to reduce
transportation costs. Suppose that T were set to one week and that the
policy resulted in about two truckloads being ordered per week. Since
ordering two truckloads per week has about the same transportation cost
per year as ordering one truckload twice per week, it might make sense to
set T to three days (assuming the distribution center does business six days
per week), thus reducing the cycle stock of all the items by half and not
increasing the annual transportation costs. But perhaps some of the 50
SKUs have minimum order quantities and the distribution center just don’t
sell enough in three days to place an order twice per week. So, perhaps
some items should be ordered weekly, others should be ordered every other
week, and so on. Going back to the (Q,ROP) process, we could still have
every SKU on its own (Q,ROP), but then when an item hits an ROP, we
could hold its order until enough items had orders to fill a truckload. The
problem with this is that it creates additional uncertainty in the lead time,
which would need to be taken into account in setting the ROP. We could
also use a (T,Q,ROP) process where every T periods of time, we order all of
the SKUs that hit the ROP. But suppose this quantity was less than a
truckload. In that case, we could just go with poor transportation
utilization. But suppose that it was optimal to have full truckloads. We
could then force orders of additional SKUs.1 To do so, we would need a
process for determining which items to order next. For example, we could
have a rule that says, order all SKUs that have hit their ROP, but if this does
not fill a truck, then also order the item with the fewest days of supply.
Continue with this process until the truck is filled. Or we could calculate the
expected number of units out of stock between replenishments for each
SKU. Recall the loss integral from Chapter 3.

We could modify this to be

Where I is current on-hand inventory and g(x) is the probability density

function of demand from the current time until the next review. U(I) is the
expected number of units out of stock until the next review. We could then
order the item with the highest U(I), and continue to ordering the SKU with
the next highest U(I), and so on, until the truck is full. You can imagine
other heuristics. Any method or heuristic you can imagine can be simulated
and its performance evaluated. Many similar approaches have been
proposed in the literature.2
Regardless of how the orders are coordinated, there might be a fixed
amount of capital available for purchasing. The models we looked at
in Chapter 3 ignored the fact that there might be limited capital. For
example, if a company uses a (T,OUL) replenishment process for all of the
SKUs and the order quantity has a value of $50,000 and the company only
has $20,000 available for purchasing, then the company can’t really
implement the process. In this case, perhaps all of the SKUs could have
their order quantities reduced by the same ratio such that the order is
$20,000. Or, perhaps the most expensive items could have their purchases
delayed. Or, perhaps the company could only order items with the lowest
days of supply up until the $20,000 constraint is hit. Again, a number of
processes could be used similar to the ones we discussed previously, but
instead of trying to fill a truck, we are trying to stay within a budget
constraint. In addition to budget constraints, there could also be physical
space constraints. It is possible that the distribution center simply doesn’t
have enough space for another truckload of product. When this happens
opening another distribution center or expanding the current distribution
center may be considered. Other options include ordering less than the
amount recommended by the ordering process. So many idiosyncrasies are
possible, it is a good idea to apply discrete event simulation since the
method is so flexible.
It is possible that there are constraints requiring (1) filling the transport
unit, (2) not exceeding the capacity of the facility, (3) capital available for
purchases, and (4) inventory investment. In addition, there may be rules
that are combinations of periods of supply, service level, and cost. To
implement these may require the use of optimization, and testing the rules
may require discrete event simulation.
One could look at the literature on inventory management for multi-item
situations, often referred to as coordinated item inventory management,
and find a plethora of models. Unfortunately, many of them create
unrealistic assumptions, making them difficult to apply. Discrete event
simulation is a powerful tool for this type of decision.

MULTI-ECHELON INVENTORY MANAGEMENT

An echelon is the level of a supply chain and all levels below it. For
example, a collection of stores served by a collection of distribution centers
is a two-echelon inventory system. Multi-echelon inventory management
can be superior3 to single echelon inventory management but is often
difficult to model.
Suppose there are 100 stores and one distribution center that serves those
stores. For a given SKU, each of the stores and the distribution center can
all use a continuous review (Q,ROP) replenishment process, for example,
and each of them can be different. That is, the distribution center can take
the orders from the stores as demand in setting Q and ROP. On the other
hand, if the distribution center and the stores are all owned by the same
retailer, it would seem reasonable for the distribution center to look at the
demand each of the stores is experiencing rather than just using store
orders as the demand signal. Suppose demand started increasing rapidly at
all of the stores. It might take a while before stores place an order; then the
distribution center might stockout. On the other hand, if the distribution
center was monitoring the store level point-of-sale (POS), then it would
purchase earlier or in a larger quantity to replenish its own inventory and
satisfy store level demand. Since store orders have more noise than
aggregate POS from the stores, the distribution center will hold excess
safety stock than if it estimated demand uncertainty and magnitude from
POS. In addition to taking into account the actual POS, it seems that the
distribution center should also take into account not only how much
inventory it has, but also how much inventory is in the distribution center
echelon. The distribution center echelon inventory position includes all
inventory at the distribution center, all units on order to the distribution
center, all units in transit to the stores, and all inventory in the stores, less
back-orders.
If stores have a lot of inventory compared to demand at the store level,
perhaps the distribution center should not place an order even if it is
relatively low on inventory. The point is that the inventory in the stores and
distribution center could be managed centrally in which case it would be
implementing a multi-echelon inventory system. Sometimes it is better to
manage centrally, and sometimes it is better to manage decentralized.
Many variables go into the decision beyond simple demand and supply
characteristics and the structure of the replenishment process. Let’s
consider the example of retail stores served by a distribution center owned
by the same retailer. Mathematically it might be best to manage
replenishment timing and quantity decisions centrally. For example,
suppose 30 of 100 stores are out of stock of a particular SKU and that the
distribution center is out as well. All 30 stores order this SKU from the
distribution center as well as Store 31. However, Store 31 has plenty of
inventory of the SKU and is ordering because the SKU is at its reorder
point. Now the distribution center receives a shipment of the SKU that is
enough to bring the 30 out of stock stores up to a days of supply that is less
than the days of supply that Store 31 currently has on hand. In a centrally
managed distribution center echelon, these 30 stores would probably get all
of the inventory, but in a decentralized inventory replenishment system, the
inventory the distribution center received might just be equally rationed
over all the stores with outstanding orders. In this example it is easy to see
the benefit of centralization of inventory replenishment. However, if
corporate culture, competition, and management are taken into account, it
might call this benefit into question.
Here is an example to illustrate this idea. Suppose a retailer has a
decentralized inventory replenishment process where each store has its
own automated replenishment system and the distribution center also has
its own automated replenishment system. In other words, the distribution
center’s automated replenishment system views the orders from the stores
as demand and uses this to forecast demand for its replenishment system.
The stores use POS to forecast demand, and the system automatically
places orders on the distribution center when the store inventory position
reaches the reorder point and it is at a point in time when the store can
order from the distribution center. Department managers are allowed to
override the system. If a department manager thinks the forecast is too low
or too high, he or she can adjust the forecast. If the department manager
thinks the service level setting is wrong, he or she can change it. These
department managers can change any setting in the replenishment system
or they can even force an order or prevent the system from ordering.
Now, at this hypothetical retailer, department managers within the stores
served by the same distribution center compete against one another from
different stores. Department managers in the 30 stores that are out of stock
of the SKU in this example compete against one another on many different
performance metrics. But the department manager at Store 31 also
competes against them as well as the other department managers at the
other stores served by this distribution center. In fact, once per month all of
the department managers are on a conference call where they review each
store’s in stock levels, inventory turns, average margin, and so on. Each
month the top 10 percent of the department managers get a bonus and the
top department manager gets a significant bonus. These department
managers love this. In fact, over the years, competitive department
managers have been drawn to this particular retailer because they know
they can make a lot of money and be promoted if they perform well.
Department managers that are not competitive tend to go to other retailers.
These department managers can’t wait until the monthly conference call.
Game day! Even the ones who don’t win love it because they get to hear
about what the other department managers are doing well, and it gives
them a chance to improve their likelihood of winning in the future. These
department managers appreciate the bonuses, but they also love the
competitive atmosphere.
Now, suppose these managers are told that the company is moving to a
centralized inventory management system and they will not be permitted to
override the system. This will take away one point of competiveness from
them. Forecasting won’t be something they will need to pay attention to any
more. Even if they know something needs to be changed, they won’t be able
to do so anymore. It is easy to see in this example that there might be a
significant cost to centralizing the inventory decision-making. Even in this
example it might be worth it if the centralized system is that much better,
but it might not be as well. When changes to the inventory replenishment
process potentially affect the culture of the company, care must be taken in
making the changes. It is easy for outsiders, such as consultants, to see the
decentralized approach as being archaic, and in many cases it is because
there is no competitive situation such as the one described here. If a retailer
has a lot of turnover and there is no such competitive culture, moving to a
centralized system could be an easier choice. But if there is a lot of
competition and inventory has a small impact on the profitability of the
retailer, it might be good to keep the decentralized approach. This is
something that can easily be overlooked but should be carefully weighed in
the decision-making process.
One other important factor to consider is that many of the analytical
models of multi-echelon replenishment systems make unrealistic
assumptions that can dramatically impede their accuracy and effectiveness.
Many of these systems make assumptions such as arborescence, which
essentially means that you cannot have transshipments between stores. A
transshipment between stores would mean that inventory is taken from one
store and delivered to another. The mathematical assumptions in many of
the inventory models do not allow for this possibility. Other unrealistic
assumptions are often made to make the problem mathematically tractable.
We’re now going to describe a centralized heuristic described in
Zipkin4 (2000) for which there are claims that it performs well. This
heuristic fits the situation described earlier where you have one distribution
center and a number of stores served by this distribution center with
centralized inventory management. In this heuristic there is a difference
between how much inventory to send to a collection of stores and how
much to allocate to each store. In other words, you do not decide how much
to allocate until after you have decided how much to ship to the stores in
aggregate. This heuristic assumes that each store is using a base stock level.
A base stock level is similar to a periodic review system where each time a
review is done, the inventory position is raised to OUL. It is assumed that
each store has complete back-ordering as opposed to lost sales. That is,
when shoppers encounter stockouts, they back-order and will come in to
get their product when it becomes available. They will not just switch to
another brand or size or go to another store.5 So, each store has its OUL set
such that expected back-ordering costs plus inventory holding costs are
equal across all stores. The distribution center finds its optimal OUL
viewing orders from stores as demand and then places an order with the
supplier. View all of the stores together as one entity and set the optimal
OUL. Calculate the order based on this aggregate OUL and then allocate the
order to the stores based on the OULs set by the stores. Many other
heuristics have been developed. Pay careful attention to the assumptions
that are made prior to application and be sure to test them thoroughly with
discrete event simulation.
No Fixed Ordering Costs
A store is replenished from a retailer owned distribution center once per
week. A truck comes to the store every Wednesday and then returns to the
distribution center. It is usually between 30 percent and 60 percent
utilization but has never exceeded 65 percent utilization. A particular paper
towel SKU is ordered every week such that its inventory position is brought
back to the OUL. If no rolls of this paper towel have sold, then of course it is
not put on the truck because its inventory position is at its OUL. The
company will save no money if it isn’t put on the truck, and the company
will spend no extra money if it is. The reason for this is that the distribution
center has enough labor to handle a wide variety of number of SKUs
ordered, and the store has plenty of labor to handle receiving and put away.
This retailer puts a premium on in store shopper service, so it has plenty of
labor. When the truck arrives from the distribution center on Wednesday
mornings, there are few shoppers because most of the shopping occurs on
the weekend, and Wednesdays are the slowest day of the week and
mornings are the slowest part of the day for Wednesdays. The retailer has a
policy to have the same amount of labor every day of the week. All this
simply means there is no fixed ordering cost associated with placing an
order for this SKU of paper towels. In Chapter 3 we assumed there was a
fixed ordering cost associated with orders. These ordering costs included
incremental transportation costs, which we do not have in this example
because the truck is coming to the store anyway; incremental labor costs,
which we do not have in this example because the replenishment system
orders automatically and the labor will be in the distribution center and
store whether or not we order; incremental costs associated with invoice
match errors, which we do not have here because it is being ordered
internally, not from an external vendor. Is it possible that there is some
incremental ordering-related cost? Yes, but it is negligible and has no
material impact in this example. It turns out that in this situation an
optimal policy structure exists. The optimal policy is to bring the inventory
position up to the OUL each time an order is placed. The economic order
quantity model does not make sense here because there are no fixed
ordering costs and the economic order quantity balances the fixed ordering
costs against the inventory holding costs.
So, in this situation with a fixed review interval and no fixed ordering costs
the optimal replenishment process is for this SKU to be ordered up to the
OUL each time it is ordered. But the question remains, what is the optimal
OUL? It turns out that the optimal OUL depends on the optimal service
level. The optimal service level is estimated by the ratio of the cost of being
out of stock per unit and the sum of the cost of being out of stock and the
cost of holding a unit of inventory. We already defined m to be the cost of a
unit out of stock and h as the inventory holding cost factor, but h was
defined on an annualized basis, whereas now it is defined as the cost of
having a unit in stock at the end of the replenishment cycle. So the optimal
service level is given by

Where F is the cumulative distribution function of the demand during the

protection interval. If OUL* is not an integer, then you round up. This
approach works whether a continuous or discrete probability distribution is
used.

THE NEWSVENDOR MODEL

Joe sells newspapers on the corner of 10th and Grand. He pays $1.50 for
each newspaper and sells them for $4.00 each. If he doesn’t buy enough, he
loses sales and that costs him $4.00–$1.50=$2.50 in profit for every sale he
loses, which in this case is m. On the other hand, if he buys too many, they
go bad at the end of the day because people don’t want to buy day old
newspapers the next day, and he loses his $1.50, which is v. So the optimal
service level is

The horizontal axis of Figure 6-1 is the market price the newsvendor can
sell the newspapers for, and the vertical axis is the optimal service level.
You can see that the line crosses the optimal service level of 0.5 at a price of
$3 per newspaper because at that price the cost of being over and the cost
of being under are equal. Notice that the marginal benefit of a higher
market price has diminishing returns in terms of the optimal service level.
In fact, the optimal service level does not hit 0.90 in this example until the
price is $15 per newspaper. At that price, the profit is $13.50 per
newspaper, and the cost of having too many is still $1.50 per newspaper.
Even at a market price of $100 per newspaper, the optimal service level is
0.985.
Figure 6-1 Optimal service level for the newsvendor

The OUL* depends on the distribution of demand. In this example suppose

that the demand is normally distributed with a mean of 50 newspapers per
day and a standard deviation of 10 newspapers per day. Then OUL* is
found from the inverse of the normal distribution.
= NORMINV (0.625,50,10) ≈ 53
So, it would be optimal to order 53 newspapers.
For this example, Figure 6-2 shows different levels of ordering for different
costs v.

Figure 6-2 Optimal orders for the newsvendor

In Figure 6-2, the horizontal axis is the cost to the newsvendor per
newspaper, v, and the vertical axis is the optimal order quantity, OUL*. At a
cost of $2 per newspaper, the cost of having too many and the cost of
having too few, per unit, is equal so the OUL* is 50 units, the mean of the
demand distribution. As the cost gets extremely low, say between 0.1 and
0.4, you can see that the line becomes more noticeably nonlinear, and the
benefit of selling one more unit becomes relatively high, making it
worthwhile to buy even more newspapers.
Instead of using a normal distribution, you could also use a discrete
empirical distribution. One challenge with that is if you ever ran out of
newspapers early, you wouldn’t know what demand was that day; you
would only know what demand was when you had enough newspapers. Of
course, that would be true even for the normal distribution because your
sample mean and standard deviation would not include the demand that
exceeded the newspapers you had available.

CENSORED DISTRIBUTIONS
Let’s suppose that the newsvendor on 10th and Grand always buys 53
newspapers and on average has sold 50 newspapers, but has sold all of his
newspapers 45 percent of the time. The actual mean of the demand
distribution is probably higher than 50 because we were never able to
observe more than 53 newspapers being sold. This is known as a censored
distribution, and it is possible, with information on the average sales,
percentage of time we sold all of the papers, and the maximum number of
papers available each day, to estimate the mean and standard deviation of
demand, assuming it is a normal distribution. To do so we solve two
equations:6

and

 = average sales
Q = number of newspapers available each day
Fs(z) = cumulative standard normal distribution at z standard deviations
above the mean
fs(z) = standard normal density function at z standard deviations above the
mean
μ = mean of the uncensored demand distribution
σ = standard deviation of the uncensored demand distribution
In this case, since we sold all of the newspapers 45 percent of the time, it
means that we didn’t sell them all 1–45 percent or 55 percent of the time.
Consequently, Fs (z) = 0.55. Now, we can find z by taking the inverse of the
standard normal cumulative distribution at 0.55,  . So
in this example,
= 50 newspapers per day
Q = 53 newspapers per day
Fs(z) = 0.55
fs(z) = 0.396
To get the value of the standard normal probability density function in
Excel, fs(z) use NORMINV(z, 0, 1, FALSE). The last argument, FALSE, tells
us that we want the value of the density function, not the cumulative
distribution.
Substituting all of this into the previous equations, we have

and

So, we have two equations and two unknowns so we can solve for the mean
and standard deviation of the uncensored normal distribution of demand.
In this example, solving the two equations, we find μ = 52, σ = 6. Recall,
earlier we found that the optimal service level was 0.625, so to find the
optimal OUL* we have
= NORMINV (0.625,52,6) ≈ 54)
Although the newsvendor has been buying 53 newspapers per day, he
should be buying 54 newspapers per day. That is a small difference. Using
all of the same numbers except suppose that he was selling out 75 percent
of the time, then in that case the OUL* = 73, which is a significant
difference from 53. This points out the potential sensitivity to the
percentage of time he is selling out. In this case, the mean of the
uncensored distribution is 67 newspapers per day.
This uncensoring can work in other situations as well. Let’s consider one
other example. Suppose Joe owns a vending machine and he replenishes it
once per week. Suppose he analyzes one particular candy bar in the vending
machine. In this case, since Joe sold all of the candy bars 49 percent of the
time, it means that he didn’t sell them all 1–49 percent or 51 percent of the
time. Consequently, Fs (z) = 0.51. Now, we can find z by taking the inverse
of the standard normal cumulative distribution at
0.51,  . Suppose Joe sells an average of 20 candy bars
per day and each slot holds 25 candy bars. Suppose this candy bar only has
one slot. So in this example,
= 20 candy bars per week
Q = 25 candy bars per week
Fs(z) = 0.51
fs(z) = 0.399
Solving the two equations and two unknowns we find μ = 25, σ = 12.
Suppose the building Joe has the vending machine in requires a 0.98 in
stock level; then NORMINV(0.98,25,12) returns a value of 50. This means
that to reach the in stock level requirement, Joe needs to allocate two slots
to this candy bar. Achieving this required in stock level could potentially
result in an assortment reduction. Prior to such decisions it would make
sense to determine the mean and standard deviation of the uncensored
demand distribution.
The newsvendor model can also be useful in fashion apparel because in
many situations, a garment in the fashion apparel industry is purchased by
a department store or boutique only one time. The buyer or merchant
designs the garment, such as a new women’s dress and makes a decision
regarding how many to purchase. Using the newsvendor model in this
situation is not obvious because there is no historical data so the question
is: How do you find the mean and standard deviation of the demand? One
method that has been used in the industry7 is to use a panel of subject
matter experts such as buyers, salespeople, and others, to estimate the level
of demand. The average that they come up with is used as the estimate of
the mean, and the standard deviation of their estimates is used as the
estimate of the level of uncertainty of demand. Then the newsvendor model
is applied.
ABC INVENTORY CLASSIFICATION
The classification of SKUs for the purposes of inventory management is
often referred to as ABC inventory classification. ABC classification is
based on the 80/20 rule that 80 percent of the revenue is from 20 percent
of the products, or 80 percent of the profit is from 20 percent of the SKUs,
or 80 percent of the inventory is from 20 percent of the items in inventory.
Whatever it is applied to, it is often found to be fallacious or inaccurate in
practice. The purpose is to classify SKUs so all of the SKUs do not have to
be treated equally. Some SKUs require careful inventory management,
using a continuous review system, and some less important SKUs require
less careful inventory management so they can be reviewed periodically.
That line of reasoning is passé today; however, such classifications are still
desired, but for other reasons, such as the need to set different service
levels or fill rates for SKUs. The idea is that we shouldn’t set all service
levels to the same fill rates since they have different stockout costs, but that
begs the question as to why only three different levels? Why not just the
optimal level for each SKU? Perhaps ABC classification is an artifact of days
without computers or days where memory was expensive or processing was
slow. The other purpose of ABC classification is to determine which SKUs
should receive the most attention in terms of managing their lead times and
making sure the product is delivered on time. It has also been used as a
method to determine where to begin process improvement initiatives. For
example, suppose there are business process execution errors in a number
of SKUs at various points in the supply chain. The question becomes one of
where to focus in terms of process improvement initiatives and so ABC
classification helps to answer that question: Start with the A items since
they drive most of the problems or have the most benefit from improving,
or some similar reason.

MATERIAL REQUIREMENTS PLANNING

Up to this point in the book we have focused on independent demand
items, items whose demand comes directly from users, shoppers, or
consumers. There are also items whose demand is derived from the
demand for end items. For example, if a factory makes chairs, there is
demand for the arms of the chairs, but that demand is derived from the
demand for the chairs. Material requirements planning8or MRP is used to
manage the demand and inventory for items with derived demand. The
three key components of MRP are the master production schedule (MPS),
inventory status file (ISF), and the bill of materials (BOM). The MPS is a
time-phased plan of when an end product must be available for sale or
shipment; the ISF is a listing of the components, their lead times, order
quantities, suppliers, on-hand inventory, on order inventory, and other
information; and the BOM is a recipe for the final product in the MPS. For
example, a BOM would say that for each chair you need two arms and for
each arm you need six screws and so on. MRP takes the MPS, ISF, and
BOM and creates a time-phased plan for producing or ordering parts,
components, subassemblies, and assemblies that go into making the final
product in the MPS.
An MPS has time buckets, which are the intervals of time used in planning,
such as a week. If an MPS said that in Week 4 100 chairs must be produced,
then the ISF would be checked for on-hand inventory that will be available
in Week 4. If no chairs will be available in Week 4, then they must be
produced for Week 4. From the BOM, the system would know that two
arms are needed for each chair, so for Week 4, two arms must be available
for assembly of each chair. That would mean that we would need a total of
200 arms. Since there are 6 screws for each arm, it would indicate that 6 ×
200 or 1,200 screws must be available. This process is referred to as a BOM
explosion. In addition, if the 200 arms need to be available one week in
advance and the screws need to be available one week prior to that, then
MRP would take that into account and create a plan for ordering the
screws. It would do all of this taking into account any on-hand inventory. In
this example, if the calculations showed that 400 screws would already be
on hand, then MRP would only order 1,200 – 400 = 800 screws, but it
would order then based on the lead time in the ISF.
There are many different lot-sizing methods in MRP, including lot-for-lot
(L4L), fixed order quantity (FOQ), periodic order quantity (POQ), and
more. L4L is reminiscent of just-in-time (JIT) in the sense that you only
order the amount demanded. With FOQ you order some fixed amount
every time your order, and with POQ you might order, for example, once
every four weeks but when you order, you order up to some amount. L4L
minimizes inventory but maximizes fixed ordering-related costs. With FOQ
and POQ you can attempt to balance and therefore minimize the total costs.
When demands are uneven, it is more difficult to minimize costs with FOQ
and POQ, so part period balancing (PPB) is used, where time buckets are
accumulated such that inventory costs and ordering costs are balanced.
If the MPS is changed, it has a ripple effect through all of the MRP plans for
each part, component, subassembly, and assembly. It is possible that these
changes could affect orders or job releases that have already been
authorized based on the previous MPS. For this reason, some MPSs have a
time fence. The time fence is the period of time over which an MPS cannot
be changed, and that part of the schedule is referred to as a frozen schedule.
Within the MPS, some of the demand is based on a forecast, and some of it
is based on firm planned orders. Firm planned orders are orders that have
already been received from customers. One other issue that must be
addressed with MRP is the time horizon—that is, how far into the future do
you want to plan? The farther into the future you plan, the more uncertain
the plans.
MRP can give the impression of a lot of certainty and stability with all of the
structured planning. The alternative would be to used something like a
(Q,ROP) model or a (T,OUL) model or some hybrid. But why use one of
those when you can just use the demand for the end product and plan
backward? If it is true that the demand for the end product is fixed, which
might be the result of a contractual agreement with a customer, it would
clearly be better than using a traditional independent demand inventory
management process. However, keep in mind that not all of the plans are
fixed, and it is possible that in some cases all of the MPS is based on a
forecast and forecasts change. When you have new information you want to
include that in the MPS; however, doing so changes all of the MRP plans for
items in the BOM. On the other hand, you can use a forecast you know is
not right just to keep the MRP plans steady. Change and uncertain forecasts
are not the only sources of instability in MRP plans that could lead a
company to use a traditional independent demand replenishment model;
lead time is too. The longer the lead time for items used in manufacturing
and the more levels in the BOM, the more the MRP plans are built on
uncertain forecasts. For example, if a subassembly below the final product
has a lead time of five weeks and the item below it has a lead time of five
weeks and the item below it has a lead time of five weeks, and continuing
until we get to an item with a total of 25 weeks below the top level item
(finished product) of the BOM, then the MRP plans based on the forecast in
the MPS are most likely highly uncertain. If these items are used in many
different end products, then perhaps the low level components in bottom
level of the BOM should be treated as facing independent demand.
Another source of error that can be encountered in MRP is that there may
be engineering changes resulting in changes in the BOM, while the BOM is
not changed. For example, suppose instead of using screws for the arms of
the chair, glue should be used based on an engineering change order. The
glue may be introduced to the assembly floor and the assembly associates
even trained in how to use the glue instead of screws, but the BOM might
not be changed. This could result in screws continuing to be ordered
unnecessarily. On the other hand, the engineering change order may have
called for seven screws instead of six. In that case, if the change was not
entered into the BOM, eventually there would be stockouts of screws. In
general, information in the MRP system must be updated and accurate, and
this is a major challenge in any inventory or planning system. Suppose a
batch of screws are purchased that are too brittle, and they break
periodically. If this is not entered into the ISF, there eventually will be
stockouts of screws.

DISTRIBUTION REQUIREMENTS PLANNING

MRP is often referred to as a method of time-phased planning. Another
method of time-phased planning that uses a similar logic in a different
situation is distribution requirements planning (DRP). Imagine a factory
serving ten regional distribution centers. The factory’s demand can be
viewed as derived demand from the independent demand the distribution
centers face. That is, if we knew the demand of the distribution centers, we
could then calculate the demand on the factory. The structure of the
distribution network is like an upside down BOM. In the BOM, a single
item faces independent demand while many items have calculated
dependent demand, whereas in DRP many distribution centers face
independent demand while a few items face calculated dependent demand.
DRP’s logic is similar to MRP’s, including using something similar to an
MPS for end demand faced by the distribution centers and then applying
on-hand inventory and lead times from the factory to the distribution
centers, and then making the calculations of the time-phased demands on
the factory. These time-phased demands on the factory can then become
inputs to the MPS in the factory’s MRP system.

AGGREGATE INVENTORY CONTROL:

INVENTORY THROUGHPUT FUNCTIONS
Inventory must also be managed in aggregate, as we discussed in the multi-
item inventory management section earlier in this chapter. In the multi-
item inventory management discussion we examined issues associated with
inventory investment constraints and space constraints, but there are also
other issues associated with aggregate inventory management, such as the
need to compare the inventory management performance of various
distribution centers or retail stores or even items. There is also the need to
estimate how much inventory will be held in a location if sales increase or
how much inventory will be required in a new distribution center. We
discuss a method to address this referred to as the Inventory Throughput
Functions (ITFs). The ITF method also allows for comparison of different
distribution centers. The problem is that if one distribution center has a
throughput of 1,000,000 units per year and another has a throughput of
100,000 units per year, it is difficult to compare them because we would
expect them to have different levels of inventory and there should not be a
linear relationship. In this example, just because one distribution center
has ten times the throughput of another distribution center does not mean
that it should have ten times the amount of inventory; we would expect less
than ten times the inventory.
Inventory9 and sales or throughput can be modeled empirically using
regression. Let S = Sales, and I = Inventory. You can estimate the
functional form of an ITF I = αSθ by taking the natural log of both sides of
the equation to get lnI = Inα + θlnS. Then use ordinary least squares (OLS)
regression to estimate lnI = β0 + β1lnS +   where   is the random error
term. Once the ITF is estimated, you can find α by exponentiation of  ,
that is  ; and find directly from the estimate of  , that is  . In I =
αS , α can be thought of as the scale parameter, and θ can be thought of as
θ

the shape parameter. The most important parameter is the shape

parameter, θ, because it describes how efficiently inventory is used in
supporting sales.
Figure 6-3 shows inventory on the vertical axis and sales on the horizontal
axis with the functional form of the ITF as I = αSθ where α = .5 for three
different values of θ   {{0.5,1.0,2.0}. For a given level of the shape
parameter, we see that the scale parameter magnifies the amount of
inventory.
Figure 6-3 Inventory as a function of sales

Figure 6-4 shows inventory on the vertical axis and sales on the horizontal
axis with the functional form of the ITF as I = αSθ where θ = .5 for three
different values of α   {0.6,1.0,1.4}.

Figure 6-4 Effect of the shape parameter

For a given level of the scale parameter, we see that the shape parameter
changes the nature of the relationship between sales and inventory. If a
firm used the EOQ, the shape parameter would be 0.5.

Which is the same as

Taking the natural log of both sides we have

So, if a firm used the EOQ, the scale parameter would be   and the
shape parameter would be 0.5.
Figure 6-5 shows an estimate of an ITF I = αSθ where the scale parameter
was found to be 2.0 and the shape parameter was found to be 0.5. Again,
inventory is on the vertical axis and sales is on the horizontal axis.

Figure 6-5 Estimate of the inventory throughput function

We see that most of them fall relatively close to the estimated curve, but
some fall significantly above or below. If they are significantly below, it is
possible that they are just managing their inventory extremely efficiently;
however, it is probably worth investigating their fill rate, because they
might be experiencing a lot of out of stocks. On the other hand, if they are
significantly above, they might be managing very poorly; however, it is
probably worth investigating their lead times and other factors that might
affect the amount of inventory they carry. Although our discussion here
focuses on the level of analysis at the inventory holding location, this type
of analysis can also be done at the firm level.10Using this method at a firm
level can allow a company to benchmark itself against its competitors and
aspirant companies. It can serve as a method of monitoring performance
over time as well. Up to this point we have talked about using this method
in aggregate for inventory holding locations such as distribution centers
and at the firm level, but it can also be applied at the SKU level. That is,
within a distribution center it can be applied to a number of different SKUs
or subsets of SKUs to benchmark performance. In addition it can be applied
to a single SKU across distribution centers. Finally, it can also be used at
the store and factory level as well.
We have discussed ITFs from the perspective of benchmarking, but it can
also be used for other purposes, such as estimating the amount of inventory
requirements in a new location. For example, suppose a distribution center
is at capacity, and hence a new one is being planned. The new distribution
center will serve markets from several distribution centers that are near
capacity. Using an ITF you could estimate the inventory investment
required in the new distribution center as well as the reduction in inventory
investment at the existing distribution centers that will have reduced
market coverage.
The inputs and outputs to an ITF can be units of currency or units of
inventory. For example, suppose the following ITF were estimated with
dollars:
I = 6S.7
Then for sales of $100,000, it would estimate the inventory requirement to
be about $19,000. Such estimates are important for cash flow management.
They can also be helpful when trying to get buy-in on new inventory
management approaches, new forecasting methods, new network designs,
and other changes to the supply chain network. On the other hand, suppose
the following ITF were estimated in tons:
I =18S.85
Then for 500,000 tons, it would estimate the inventory requirement to be
about 1.3 million tons. Such estimates can be useful for space management
decisions as well as facility design decisions.
One caution regarding the use of ITFs has to do with the range of estimate.
If an IFT were estimated on outputs from, say, $50,000 to $1,000,000, it
should not be considered reliable to make estimates outside that range.
Even if you are using an ITF to make estimates within the range for which
the ITF was estimated, you still need to be concerned with accuracy. One
quick and easy approach is to look at the R-square from the regression
output. R-square is the percentage of variation in the dependent variable
that is explained by the model. Another approach is to use the forecasting
error metrics discussed in Chapter 4, “The Link Between Inventory
Management and Forecasting,” such as bias, MAD, and MAPE.
One nice feature of the ITF is the interpretation of the shape coefficient—
namely, for a 1 percent increase in sales, there is estimated to be a θ percent
increase in inventory.11 For example, if a firm used the EOQ, a 1 percent
increase in sales would result in a 0.5 percent increase in inventory since θ
= 0.5 in the EOQ model.
Other variables such as lead time can also be included with the following
model:
lnI = β0 +β1lnS + β2LeadTime
Such a model would allow you to explain difference in inventory more
accurately, not entirely relying on sales volume to explain the changes in
inventory. We could go even further and include other variables such as
number of SKUs in the distribution center NSKU, number of stores served
NSTORES, and other variables.
lnI = β0 +β1 lnS + β2LeadTime + β3NSKU + β4NSTORES
The point of this is to account for as many of the drivers of inventory as
possible so that what is left is a difference in how well inventory is being
managed. Such an approach works well internally, but if it is being used to
benchmark against other firms, many of the other input variables might not
be available.
Another benefit to this expanded approach to ITF estimation is that it can
be used to test hypotheses that might be important in decision-making. For
example, perhaps there is a hypothesis that if the company could reduce the
number of SKUs held by a given distribution center, it could reduce total
inventory requirements in the company. The company might be
considering going to more specialized distribution centers with longer lead
times and fewer SKUs per distribution center. For such a significant change
it would be worth not only checking R-square, bias, MAD, and MAPE, but
also checking other metrics and assumptions. At the very least you should
check the F-test to make sure the model is statistically significant and the p-
values of each of the coefficients you will be using. In this example, you
would want to be sure the coefficient estimates for LeadTime and NSKU
were statistically significant. If such a coefficient is not significant, you
might want to check for multicollinearity. Multicollinearity is a problem in
regression where two or more independent variables are highly correlated.
Continuing with this example, if it were the case that for distribution
centers that had higher SKU variety, they had higher lead times, then it is
possible that we could end up with multicollinearity, and it might make one
of the variables fail the statistical significance test. Even for benchmarking
purposes it is a good idea to check the assumptions of regression. For
example, if there is heteroscedasticity, it will create difficulty in comparing
observations at different levels of inventory. Recall that homoscedasticity is
an assumption of regression that means the variance of the residuals is
constant for various levels of the dependent variable.
Figure 6-6 is a scatter plot of annual U.S. retail sales and inventory,
excluding automotive from 1992 to 2011 based on data from the United
States Census Bureau.

Figure 6-6 U.S. retail sales and inventory

The vertical axis in Figure 6-6 is inventory in millions of dollars, and the
horizontal axis is sales in millions of dollars. An ITF was estimated for the
retail sector of the economy and was found to be
I = 17.9S0.65
Based on the F-test, the model is significant at the <0.001 level, and the R-
square is 0.98, meaning that about 98 percent of the variance in inventory
is explained by sales. The retail industry as a whole seems to be relatively
efficient at managing inventory, as can be seen from the estimated shape
factor of 0.65. We can speculate as to why it seems the retail sector is
efficient at managing inventory. Perhaps it is due to the fierce competition
in the industry, including the emergence of e-commerce during the past
two decades, as well as improved decision support technology for
forecasting and inventory management.

STORAGE OF INVENTORY
The storage of inventory within a facility is often a topic in material
handling and warehousing books, but not typically a focus of inventory
management books. However, we briefly look at this topic, particularly
from the perspective of inventory management, and less from the
perspective of material handling and warehousing. In a factory, the idea of
storing inventory, especially raw material inventory, components,
subassemblies, and assemblies, at point of use makes sense in terms of
production lead time minimization and also errors in using the wrong parts
and damage. If parts inventory is held centrally within a factory, every time
a part is needed for production the worker or robot has to leave the
workstation to retrieve it, or there is labor dedicated to keeping
workstations in stock. Sometimes this is necessary when parts are used in
common among many different workstations within the factory. If
inventory comes into a factory and is stored in a central location and then
retrieved for a workstation when needed, there is an additional “touch” in
comparison to storing the inventory at the workstation that will need it for
production. The number of times inventory is touched is often correlated
with shrink, damage, and labor.
Within a warehouse, keeping inventory in a fixed location minimizes errors
in terms of put away and picking. However, it does not minimize the
amount of space required for inventory storage. The alternative to fixed
location storage is random location storage. In this approach, when space is
available, it is used for the inventory. In a retail store, backroom space is
expensive and therefore, most of the storage in retail backrooms is based on
the random location strategy. This makes it difficult to find specific SKUs in
retail backrooms because there are typically so many different SKUs in a
retail store, and many times these SKUs are rotating, new products are
introduced, and some SKUs are discontinued. Storage of inventory in retail
backrooms is one of the most difficult inventory storage management
problems in the industry.
Inventory storage decisions and management effectiveness affect inventory
holding costs because a component of the inventory holding cost factor is
storage space costs, shrinkage, and damage, to name a few. In turn, the
inventory holding cost factor affects the optimal level of inventory to hold,
which affects the optimal order quantity and/or the optimal order up to
level. Similarly, inventory management process decisions affect inventory
storage decisions. For example, if safety stock increases in retail stores
without increasing shelf capacity for a given SKU, it is possible that the
additional inventory will need to be stored in the backroom of the retail
store. Within a retail store, you will not only see inventory stored in the
backroom but sometimes on the top of the gondolas. Sometimes you will
notice that inventory stored on the top of the gondolas doesn’t even
correspond to the inventory on the shelf below. This seems to happen often
in retail wholesale clubs.

INVENTORY RECORD MANAGEMENT

Inventory records are a salient part of any inventory management system.
For automated inventory systems, there exist perpetual inventory systems.
A perpetual inventory system keeps track of on-hand inventory using point
of sale (POS) information and bar code scans as inventory is received.
Every time a case or pallet of product is received, it is scanned and the
perpetual inventory system increases by the number of units in the case or
on the pallet. Every time a unit is purchased or shipped, the perpetual
inventory system is reduced by that amount.
If inventory records are inaccurate12 and if the firm uses a (Q,ROP)
inventory replenishment process, it will not order at the correct time. If the
firm uses a (T,OUL) process, it will not order the correct quantity. If
inventory records are off in the negative direction, it will cause excess
inventory. If inventory records are off in the positive direction, there will be
stockouts. Some products tend to have inventory records off consistently in
the positive direction. For example, in retail stores small expensive items
tend to be stolen more often. When they are stolen, the inventory records
tend to suggest the retail store has more inventory than it actually does. For
these items there is a positive bias in the inventory records. For items that
have high return rates, sometimes those returns are not recorded properly
and the retail store winds up with more inventory than the inventory
records suggest, creating a negative bias in inventory records. For other
items, the inventory records are unbiased but may still have many errors
over time.
Error can enter the inventory record system in many ways, two of which
have already been mentioned: namely, theft and returns that are
misreported or not reported. Here is a list of possible ways errors can enter
the inventory record system: theft, damage, failure to record upon
receiving, misplaced inventory, mislabeled SKUs, and many others. In
addition, for automated perpetual inventory systems, the error can enter
the inventory record system through the point of sale system (POS). For
example, if a shopper puts 2 cans of chicken noodle soup on the check stand
along with 3 cans of bean and bacon soup, 2 cans of clam chowder soup, 5
cans of creamy mushroom soup, 1 can of tomato soup, and 17 cans of split
pea soup, and the cashier scans a can of chicken noodle soup and then hits
“× 30,” the chicken noodle soup inventory record will be much lower than it
actually is, and the other cans of soup will have inventory records that are
too high.
Another way error can enter the perpetual inventory system is through
errors in the item file data. For example, suppose the item file says that
there are 24 units per case, but the manufacturer changed the case pack
quantity to 12. Then each time a case is received, it will appear as though
the on-hand inventory has increased by 24 units when it has actually only
increased by 12 units. This type of problem, as well as any positive bias in
the inventory records, can lead to phantom inventory. Phantom inventory
exists when the inventory records suggest an amount of inventory on hand
that is above the reorder point. When phantom inventory exists, the
automated inventory system will not place orders for the product even
when the product runs out. This leads to stockouts that persist until the
error is corrected.
One would think that with current information technology all issues
associated with accurate inventory records have been addressed. This is
definitely not the case. Inventory record inaccuracy is still a major problem
in industry, particularly in the retail industry. Given the level of the
problem, what can be done? On the extreme, wall-to-wall inventory audits
are possible. This is where all of the inventory is counted. Imagine a
superstore that has both groceries and general merchandise. There may be
as many as 150,000 SKUs in 200,000 square feet. Think of how many man-
hours that would take and how much that would cost. For a retailer, how
many times could it afford that per year per store? It would take an army of
people to do it on a regular basis for all stores. Cycle counts are an
alternative to wall-to-wall audits. With cycle counts only small sets of items
are counted. In a retail setting some SKUs may only sell once every few
weeks. In those situations it doesn’t make sense to count them very often.
But for high value and or high volume SKUs, especially those that
consistently have problems, it might make more sense to take a physical
inventory more often. Similarly, random samples of SKUs can have cycle
counts taken. Similarly, if some items have not sold for too long, possibly as
a result of phantom inventory, then cycle counts can be taken of those
SKUs.

IMPLEMENTATION CHALLENGES AND

CHALLENGING THE INCUMBENT PROCESS
It is not unusual to encounter situations that do not neatly fit into the topics
we have discussed, including the replenishment processes and other topics.
However understanding these topics is crucial in being able to understand
more complex processes because in many situations one of the models does
work for estimation purposes even though it doesn’t appear to fit on the
surface. Let’s look at an example.
A distribution center (DC) orders a large number of products from a
supplier’s factories. Every week, the DC reviews the inventory position (IP)
of each product. The review starts with products that are out of stock or
very low in IP. If the product’s IP is below the reorder point (ROP), then an
order is placed for the item and the quantity ordered (Q) is fixed. However,
if Q + IP is less than the order up to level (OUL), then multiples of Q are
ordered (k) until kQ + IP > OUL. The total amount ordered of all products
together cannot exceed 40,000 lbs. So, if 40,000 lbs. is reached before all
items have been reviewed, an order is placed and another one won’t be
placed until the next week, even if some other items are below their reorder
point. On the other hand, if all the products that are at their reorder point
or below add up to less than 40,000 lbs., then additional products are
ordered to get as close to 40,000 lbs. as possible. The supplier ships these
orders from five different factories to a supplier DC where one dock door is
dedicated to this customer. One factory takes one day to ship an order,
another takes two days, another takes three days, another takes four days,
and another takes five days. The transit time from each of the factories to
the supplier DC is one day. As product arrives to the supplier DC, product is
staged in front of the dock door whose destination is the customer’s DC.
This staging process takes one day. Once all of the products from the five
factories arrive, the order is shipped from the supplier’s DC to the
customer’s DC. This takes one day. It takes one day for the customer DC to
receive the product and get it in its slot in the DC. How would you
determine the time between reviews for a given product in this process?
What is the lead time for a given product?
This example looks more complicated than it actually is. In this example,
since the supplier doesn’t ship until the truck load is built, the retail DC
only needs to consider the lead time of the longest item. So, one factory
takes five days to ship the product to its own DC and the transit time from
the factory to the supplier DC is a day, one day for staging in the supplier
DC, one day for shipping to the retailer DC, and one day for receiving and
put away. In total, the lead time is nine days because the slowest factory is
the bottleneck and is used to determine the total lead time. The rest of the
process can be modeled using discrete event simulation.
ENDNOTES
1. This essentially increases the safety stock.
2. Carlson, M., and J. Miltenburg. “Using the Service Point Model to
Control Large Groups of Items.”OMEGA 16(5) (1998): 481-489.
3. Especially from a mathematical perspective.
4. Zipkin, P. H. Chapter 8 in Foundations of Inventory Management. New
York: Irwin, 2000.
5. Back-ordering is another typical assumption in mathematical inventory
models.
6. See Greene, William H. Econometric Analysis, 5th ed. Pearson
Education India, 2003, for a more complete discussion of the censored
normal distribution.
7. Fisher, Marshall L., and J. H. Hammond. “Coping with Demand
Uncertainty at Sport Obermeyer.”Harvard Business Review 72.3 (1994):
90.
8. For a thorough treatment see Vollman, T. E., W. L. Berry, and D. C.
Whybark. Manufacturing Planning and Control Systems, 3rd ed.
Homewood, IL: Irwin, 1992.
9. Ballou, Ronald H. “Expressing Inventory Control Policy in the Turnover
Curve.” Journal of Business Logistics 26.2 (2005): 143-164. Ballou, Ronald
H. “Estimating and Auditing Aggregate Inventory Levels at Multiple
Stocking Points.” Journal of Operations Management 1.3 (1981): 143-153.
10. Eroglu, Cuneyt, and Christian Hofer. “Lean, Leaner, Too Lean? The
Inventory-Performance Link Revisited.” Journal of Operations
Management 29.4 (2011): 356-369. Eroglu, Cuneyt, and Christian Hofer.
“Inventory Types and Firm Performance: Vector Autoregressive and Vector
Error Correction Models.” Journal of Business Logistics 32.3 (2011): 227-
239.
11. This is a log-log regression model so the regression coefficients can be
interpreted as elasticity estimates.
12. Waller, Matthew A., Heather Nachtmann, and Justin Hunter.
“Measuring the Impact of Inaccurate Inventory Information on a Retail
Outlet.” International Journal of Logistics Management 17.3 (2006): 355-
376.