Risk Pooling

Customer management
Supplier management
Inventory management
ROI

Location management
𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 − 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪
𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨
Transport management

Value chain integration

Inv. Mgt.- Inventory Positioning
Introduction
1. Definition
• Ordering policies Learning outcomes
• EOQ, Economic order • Explain the risk pooling
2. Types
quantity effect and its benefits in a
3. Relevance:
1. Financial • Continuous review: Min- supply chain
2. Operational Max policy
• Interpret the relationship
ABC classification • Safety stock
1. Description • Average Inventory between demand variability
2. ABC classification procedure • Periodic review: Base-Stock and risk pooling
3. Classification criteria policy • Decide when centralized
4. Case study for a large distributor • Safety Stock stocking or distributed
Inventory Policy Factors • Average Inventory stocking is more appropriate
Inventory ordering costs, and inventory
• Inventory Positioning in the supply chain due to
•
holding costs
• Service level requirements
• Risk Pooling the risk pooling effect
• Forecast error
• Length of planning horizon • Centralized versus • Calculate the inventory costs
• Replenishment lead-time decentralized inventories associated with centralized
• Product variety
• Strategic Safety Stock the and decentralized inventory
•
•
Demand Variability and Forecasting error
Safety stocks supply chain: in the supply chain
• Push-pull boundary
CASE STUDY: Risk Pooling
Risk Pooling refers to the reduction in demand variability resulting from
aggregating demand streams from different locations.
To illustrate the concept, consider the case of ElecTex. The company has a
manufacturing plant in Temple, Texas. ElecTex sells around 900 different
products, through regional distribution warehouses in Dallas, Houston and San
Antonio; the warehouses deliver orders to 8,500 customers (retailers). The
company strategy is to provide with 98% fill-rate customer service level. The
warehouses use a max-min inventory review policy; and uses EOQ as the order
quantity. The plant’s delivery lead time to the warehouses is 2-weeks; and the
delivery from the warehouse to the retailers follows a same-day-delivery policy.
The company is evaluating the positioning of its inventory; specifically,
[ANIMATION 1] they would like to close the three regional warehouses and
consolidate the inventory into a single warehouse, called Centralized
Distribution Warehouse, CDW, that would serve all customers with the same
customer service level. The location of the new CDW would be in Cameron-
Texas close to the Manufacturing facility.
Management thinks this might result in reduced costs due to better forecasts
and reduced safety inventory levels for the same fill-rate, due to the risk pooling
effect, in addition to a reduction in staff and operators that would result from
reducing the number of warehouses, and automation in the new CDC.
Possible disadvantages from the CDW configuration are additional
transportation costs and delivery times from the warehouse to the customers,
and additional distance between sales workforce and customers.
Notice that, under the proposed idea, the distance from the manufacturer to
the warehouse is reduce; however, it is unclear whether this reduction and the
inventory reductions will exceed the additional transportation cost between the
warehouse and the customers.
 Risk Pooling Case Study - Analysis
Let’s first study the impact that will result from risk pooling reducing inventory. If the results are promising, the study would need to also
consider transportation costs.
All 900 products must be included in the study; however, here the analysis will be performed on two products V and W for clarity and brevity.
The data and calculations are available in the provided spreadsheet “Risk Pooling – Case Study.xlsx”.
The tables below show historical weekly demand for the two products, as recorder for each of the current warehouses.
Product V SUMMARY
Week 1 2 3 4 5 6 7 8 9 10 11 12 13 average std cv
Houston 44 40 56 26 89 38 48 38 59 40 34 55 45 47.08 15.64 0.33
Dallas 30 18 54 26 21 35 29 21 18 34 38 25 33 29.38 9.90 0.34
San Antonio 31 30 26 36 36 34 18 17 33 35 37 45 35 31.77 7.69 0.24
TOTAL 105 88 136 88 146 107 95 76 110 109 109 125 113 108.23 19.47 0.18

Product W SUMMARY
Week 1 2 3 4 5 6 7 8 9 10 11 12 13 average std cv
Houston ` 13 9 9 11 9 0 0 2 0 6 8 4 5.54 4.61 0.83
Dallas 4 0 0 1 3 2 3 0 5 1 0 9 4 2.46 2.63 1.07
San Antonio 0 3 0 0 0 0 2 0 4 3 0 0 6 1.38 2.02 1.46
TOTAL 5 16 9 10 14 11 5 0 11 4 6 17 14 9.38 5.14 0.55

Notice that, the total demand in each week would represent the aggregate demand that the centralized warehouse would have received if
implemented. We will use the aggregate weekly demands to evaluate the performance of the CDW.
One can immediately observe that product V exhibit more stable, and higher demand than product W.
As we have learned, we can quantify these observations by characterizing the demand in terms of average, standard deviation and coefficient
of variability. [ANIMATION] These calculated statistics are displayed in green.
Observing the CV values, confirms our observations. Product V has CV values between .24 to .34, corresponding to a low demand variability
product; on the other hand product W’s Cv is between 0.83 to 1.46 suggesting, currently the warehouses might be having large forecast errors
and higher safety stocks for product W.
Risk Pooling Case Study – Analysis (contd.)
Observing the CV values, confirms our observations. Product V has CV values between .24 to .34, corresponding to a low demand variability
product; on the other hand product W’s Cv is between 0.83 to 1.46 suggesting, currently the warehouses might be having large forecast errors
and higher safety stocks for product W.
The Risk Pooling effect is evident when observing the CV for the aggregate demand. Product V aggregate demand is 0.18 that is noticeable
lower than the .24 to .34 CV observed by each warehouse. The effect is even more pronounced for Product W, where the aggregate demand
CV is 0.55 that is much less than the 0.83 to 1.46 CV experienced by the individual warehouses. In fact, product W’s demand is highly variable
for the individual warehouses, but is only borderline low and moderate variability for the proposed centralized warehouse!
How is this possible, if the same data is used to calculate these values? By carefully observing what happens with the random ups-and-downs
of the individual demands from week to week across each warehouse, when the demand of one warehouse increases, the other can decrease,
and vice-versa. As a result, when added the sum of the individual demands resembles the value of the aggregate demand average. This effect
tends to be more noticeable when the variability of the individual demands is higher. However, if the different demand streams tend to
increase or decrease simultaneously, then the variability cancellation effect will not work. More formally, the risk pooling effect diminishes as
the correlation between the different demands increases. The plot below shows a line plot of the weekly demands for product W.

Product W Risk pooling causes the centralized warehouse to experience a demand that is the
sum of the individual warehouses, but with a much lower variability. This will
18
16
result in lower safety stocks for the same customer service level!
14
12
10
8
6
4
2
0
1 2 3 4 5 6 7 8 9 10 11 12 13

Houston Dallas San Antonio TOTAL

Risk Pooling Case Study – Analysis (contd.)
The total inventory for the current and centralized strategies can be estimated by comparing the corresponding average inventories. The
average inventory, I-bar, is calculated as Q/2 + Safety Stock.
𝑄𝑄 2𝐴𝐴𝐴𝐴
Since ElecTex uses min-max inventory policy, then 𝐼𝐼 ̅ = + 𝑘𝑘 𝑠𝑠𝑑𝑑 𝐿𝐿. Also in ElecTex the order quantity used is Q = EOQ = . In this case
2 ℎ
both products have the same ordering and holding costs.
[Animation] The average inventory calculations are shown in the following table.

[Animation] The average inventory for the current system and the
DATA Costs Lead Time, wk
proposed centralized system:
Order Holding Supply Delivery fill rate k
Product V 55 0.32 2 0 0.98 2.05 Centralized versus Current (descentralized) Warehouse (units)
Product W 55 0.32 2 0 0.98 2.05 Decentralized Centralized %Change
Product V (units) 297.3 153.1 -0.5
INVENTORY POLICY CALCULATIONS Product W (units) 74.4 43.4 -0.4
Location Product DDLT SS Q r Ave I TOTALS 371.7 196.5 -0.5
Houston V 94.2 45.4 127 139.6 108.9
Houston W 11.1 13.4 44 24.5 35.4 Holding cost ($/yr) 118.9 62.9 -0.5
Dallas V 58.8 28.8 101 87.5 79.3
Dallas W 4.9 7.6 29 12.6 22.1
San Antonio V 63.5 56.6 105 120.1 109.1
[Animation] It can be observed that the reduction in inventory by
San Antonio W 2.8 5.9 22 8.6 16.9 implementing a centralized distribution warehouse is about 50% of the
San Antonio V 216.5 56.6 193 273.0 153.1 current inventory.
Cameron (Central) W 18.8 14.9 57 33.7 43.4
We will study how to analyze transportation costs later.
Risk Pooling’s Square-Root Rule
There is a useful relationship between the individual demands and the aggregate
demand parameters. Let 𝜎𝜎1 , 𝜎𝜎2 , … 𝜎𝜎𝑛𝑛 be the standard deviation of 𝑛𝑛 independent
demand streams; the standard deviation of the aggregate sum of these
demands,𝜎𝜎𝐴𝐴 , is the square-root of the sum of squares of the individual standard
deviations:
𝜎𝜎𝐴𝐴 = 𝜎𝜎12 + 𝜎𝜎22 + ⋯ + 𝜎𝜎𝑛𝑛2
This is known as the “Square-Root Rule”.
Let 𝜇𝜇1 , 𝜇𝜇2 , … 𝜇𝜇𝑛𝑛 , be the mean values of the corresponding demands, then the
aggregate mean demand is sim ply the sum of the individual means:
𝜇𝜇𝐴𝐴 = 𝜇𝜇1 + 𝜇𝜇2 + ⋯ + 𝜇𝜇𝑛𝑛
In practice, 𝜎𝜎 and 𝜇𝜇 values are estimated by the sample average and standard
deviation, 𝑥𝑥̅ and 𝑠𝑠, respectively.
 Example: Apply the Square root rule to the ElecTex demand in the Risk
Pooling case study data.
Applying the square-root formula to the individual standard deviations for Product V we
obtain:
2 2 2
𝑠𝑠𝐶𝐶𝐶𝐶𝐶𝐶,𝑉𝑉 = 𝑠𝑠𝐻𝐻𝐻𝐻𝐻𝐻,𝑉𝑉 + 𝑠𝑠𝐷𝐷𝐷𝐷𝐷𝐷,𝑉𝑉 + 𝑠𝑠𝑆𝑆𝑆𝑆,𝑉𝑉

= 15.642 + 9.902 + 7.692 = 20.05 ≈ 19.47 units

Applying the square-root formula to the individual standard deviations for Product V we
obtain:
2 2 2
𝑠𝑠𝐶𝐶𝐶𝐶𝐶𝐶,𝑊𝑊 = 𝑠𝑠𝐻𝐻𝐻𝐻𝐻𝐻,𝑊𝑊 + 𝑠𝑠𝐷𝐷𝐷𝐷𝐷𝐷,𝑊𝑊 + 𝑠𝑠𝑆𝑆𝑆𝑆,𝑊𝑊

= 4.612 + 2.632 + 2.022 = 5.68 ≈ 5.14 units

In both cases the result obtained is similar to the one calculated from data; the differences
are caused by random sampling error.
Characteristics of Risk Pooling
From the case study we have learned the following characteristic of risk
pooling:
1. Centralizing inventory reduces both safety stock and average inventory in
the supply chain.
2. The higher the coefficient of variation, the greater the benefit obtained
from centralized systems. This is because the average inventory depends
on the order quantity and the safety stock. Most of the reduction in
inventory comes from the safety stock, therefore, the larger the CV the
larger the reduction in inventory.
3. The effect of risk pooling is diminished if the individual demand streams
are positively correlated because, if they are, the demands will tend to
go up and down simultaneously rather than in opposite directions.
Positive correlation attenuates the variance reduction effect.
Centralized versus decentralized Inventory
system trade-offs
Attribute Trade-off
Safety stock Safety stocks decrease with centralized inventory systems.
Service level For the same level of inventory, centralized systems offer a better service level.
Overhead costs Overhead costs tend to be much higher in decentralized system because of
reduced economies of scale.
Customer lead time With decentralized inventories, the product can be stocked closer to the customer
resulting in faster response times to the customer.
Transportation costs It depends on the geographic location of warehouses, manufacturers and markets.
Inbound transportation costs tend to decrease, while outbound transportation
costs tend to increase; which one is greater depend on the specific situation.
Assignment: Risk Pooling Case Study
Use the Case Study data provided in a spreadsheet file to answer the following questions
1) Verify the calculations for Products V and W in Table INVENTORY POLICY CALCULATIONS by
solving the two rows for Dallas. Your answer must include your solution procedure.
2) Define risk pooling and explain why it works.
3) Explain the relationship between risk pooling and centralized inventory systems.
4) Why does risk pooling work better when there is high variability?