3.

Inventory Management and Risk Pooling

Chapter 2
Designing and Managing the Supply Chain 3E
– D. Simchi-Levi – P. Kaminsky – E. Simchi-Levi

Source - https://wordart.com/edit/n95jpjggdijs
Supply Chain Management – Inventory Management and Risk Pooling by Punit Neb is licensed under
CC BY-NC 4.0
Contents

●
Introduction
●
Inventory
●
Inventory Costs
●
Inventory Control Systems
●
Reorder Level [ROL]
●
Safety Stock
●
Service Level
●
Selective Inventory Control Techniques
●
Supply Contracts
●
Risk Pooling ebooks/OM_Risk_Pooling_Strategies_2015.pdf https://issuu.com/ffurtado/
docs/ttom_fbf_rp_presentation
●
Centralized vs. Decentralized Systems
●
Review Policy
●
Inventory Management in Practice
●
Demand Forecasting
– Selecting the Appropriate Forecasting Technique

2
Introduction
Sources: Regional Field Customers,
plants Warehouses: Warehouses: demand
vendors stocking stocking centers
ports points points

Supply

Inventory &
warehousing
costs
Production/
purchase Transportation Inventory & Transportation
costs costs warehousing
costs
costs

Source: http://ind.ntou.edu.tw/~ericting/download/SCM/Simchi-Levi/3e/Chap002.ppt
3
… Introduction

Goals - Reduce Cost, Improve Service

●
By effectively managing inventory:
– Xerox eliminated $700 million inventory
from its supply chain
– Wal-Mart became the largest retail company
utilizing efficient inventory management
– GM has reduced parts inventory and
transportation costs by 26% annually

4
… Introduction

Goals - Reduce Cost, Improve Service

●
By not managing inventory successfully
– In 1994, “IBM continues to struggle with shortages
in their ThinkPad line” (WSJ, Oct 7, 1994)
– In 1993, “Liz Claiborne said its unexpected earning
decline is the consequence of higher than
anticipated excess inventory” (WSJ, July 15, 1993)
– In 1993, “Dell Computers predicts a loss; Stock
plunges. Dell acknowledged that the company was
sharply off in its forecast of demand, resulting in
inventory write downs” (WSJ, August 1993)

5
Inventory

●
The stock of any item or resource used in an organization
●
A stock of items kept by an organization to meet internal or external
customer demand
– Includes raw materials, finished products, component parts, supplies,
and work-in-process
– Virtually every type of organization maintains some type of inventory
– Whatever form of inventory an organization carries & whatever the
purpose of carrying the inventory, it often represents a significant cost
to an organization
– For many different organizations, inventory maybe the largest current
asset
– Inventory can be difficult to convert back into cash

– If a firm carries excessive inventory, it is estimated that the average

inventory carrying costs could be 30% of the inventory costs

6
… Inventory

●
Inventory is held
– By suppliers and manufacturers
– At warehouses and distribution centers
– By Retailers

7
... Inventory

Different types of inventories held at different points in the supply chain

Raw materials [RM]
●
Procured materials and components scheduled for use in production
Work in process [WIP]
●
Materials and components that have begun their transformation to finished goods
Finished goods [FG]
●
Goods ready for sale to customers at source or at distribution center
Maintenance, Repair and Operating Supplies [MRO]
●
Supplies which are consumed in the production process but which do not become
part of the end product or are not central to the organization’s saleable output
●
Includes items such as repair components, cutting fluids, lubricants, and tooling
as well as office supplies, cleaning products, safety supplies, and other
consumables that are not tied directly to the organization’s core products or
services

8
... Inventory

Purposes of inventory
●
To maintain independence of operations
●
To allow flexibility in production scheduling
●
To protect against uncertainties in
– Demand [FGs, MRO]
– Supply [RM, MRO]
– Lead times [RM or PP or MRO]
– Changes in production schedules [WIP]
●
To provide economic purchase and production [Discounts in purchase of
RM or PP]
●
To provide for anticipated changes in demand
●
To provide for in-transit inventories [Pipeline Inventories]

9
… Inventory

Inventory system
●
The set of policies and controls that monitor levels of inventory
– Determines what levels should be maintained, when stock should
be replenished, and how large orders should be
●
The inventory policy is affected by
– Demand Characteristics
– Lead Time
– Number of products
– Objectives
– Service level
– Minimize costs
– Cost Structure

10
Inventory Costs

●
Costs associated with inventory
– Carrying costs
– Ordering costs
– Shortage costs
– Setup costs
●
The objective of inventory management is to employ
an inventory control system that will indicate how
much should be ordered and when orders should take
place so that the sum of carrying costs, ordering costs
and shortage costs will be minimized

11
… Inventory Costs

Carrying Costs
●
AKA Holding Costs
●
The costs of holding an item in inventory
●
Vary with the level of inventory in stock and with the length of time an item is held
– The greater the level of inventory over a period of time, the higher the carrying
costs
●
In general, any cost that grows linearly with the number of units in stock is a
carrying cost
●
Can include the following items
– Facility storage (rent, depreciation, power, heat, cooling, lighting, security,
refrigeration, taxes, insurance, etc.)
– Labor, Material handling (equipment)
– Record keeping
– Borrowing to purchase inventory (interest on loans, taxes)
– Product deterioration, spoilage, breakage, obsolescence, pilferage

12
… Inventory Costs

Carrying Costs
●
Two ways of specifying carrying
– Expressed as a per-unit rupee amount on an annual basis
» Determined by summing all the individual costs on a per-unit
basis per time period, such as a month or year
» e.g. Rs. 60 per unit per year
– Expressed as a percentage of the value of an item or as a
percentage of average inventory value
●
Generally estimated that carrying costs range from 10 to 40% of the
value of a manufactured item
●
Average in India is estimated to be 25% per year
●
Businesses often tend to consider only cost of capital

13
… Inventory Costs

Ordering Costs
●
The costs associated with replenishing the stock of inventory being held
●
Normally expressed as a Rs. amount per order and are independent of
the order size
●
Annual ordering costs vary with the number of orders made - as the
number of orders increases, the ordering cost increases
●
In general, any cost that increases linearly with the number of orders is
an ordering cost
●
Includes cost the managerial and clerical costs to prepare the purchase
or production order, costs of counting items, calculating order quantities
●
Also includes costs associated with maintaining the system needed to
track orders

14
… Inventory Costs

Ordering costs
●
Ordering costs react inversely to carrying costs
– As the size of orders increases, fewer orders
are required, reducing ordering costs. However,
ordering larger amounts results in higher
inventory levels and higher carrying costs
●
In general, as the order size increases, ordering
costs decrease and carrying costs increase

15
… Inventory Costs

Shortage costs
●
AKA stockout costs
●
Occur when customer demand cannot be met because of
insufficient inventory
●
If these shortages result in a permanent loss of sales, shortage
costs include the loss of profits
●
Shortages can also cause customer dissatisfaction and a loss
of goodwill that can result in a permanent loss of customers
and future sales
●
Studies have shown that approximately 8% of shoppers will not
find the product they want to purchase in stock, which will
ultimately result in total lost sales of about 3%

16
… Inventory Costs

Shortage costs
●
The inability to meet customer demand or lateness in meeting
demand results in penalties in the form of price discounts or
rebates
●
When demand is internal, a shortage can cause work
stoppages in the production process and create delays,
resulting in downtime costs and the cost of lost production
(including indirect and direct production costs)
●
Costs resulting from lost sales because demand cannot be met
are more difficult to determine than carrying or ordering costs
●
Hence shortage costs are frequently subjective estimates and
sometimes an educated guess

17
… Inventory Costs

Shortage costs
●
Shortages occur because carrying inventory
is costly
●
Hence shortage costs have an inverse
relationship to carrying costs - as the
amount of inventory on hand increases, the
carrying cost increases, whereas shortage
costs decrease

18
Inventory Control Systems

An organization faces two main decisions

concerning the management of inventory
●
When should new stock be ordered
Determined by Reorder Level [ROL]
●
What quantities of new stock should be
ordered / replenished
Determined by Economic Order Quantity
[EOQ]

19
… Inventory Control Systems

●
Visual Systems
– Single-Bin System
– Two-Bin System
●
Replenishment Systems
– Economic Order Quantity [EOQ]
– Fixed-order quantity [Continuous] Review Policy
– Fixed-order period [Periodic] Review Policy
– Variable Order / Variable Period Review Policy [Optional Replenishment
System]
●
Materials Requirement Planning [MRP]
●
Manufacturing Resource Planning [MRP-II]
●
Enterprise Resource Planning [ERP]
●
JIT Systems [Zero-Stock Systems]
●
Response Based Techniques [ARP, QR, CR, VMI]
●
Selective Inventory Control Techniques

20
… Inventory Control Systems

Visual System
●
A system that allows employees to place
orders when inventory visibly reaches a
certain marker
Single-Bin System
●
Follows the concept of a P system
●
A maximum level is marked on the bin and
inventory is brought up to the mark
periodically

21
… Inventory Control Systems

Two-Bin System
●
A technique used to determine when items or materials used in production
should be replenished
●
Methodology
– Each inventory item is maintained in two bins
– The first bin contains the working stock and the second bin contains
enough items to last until the placed order arrives
– When production starts material is taken from the first bin. When
exhausted,
» An order is placed to refill or replace these items
» Production continues by utilizing contents of second bin
– When the order arrives, the second bin is restored to its original level and
the rest is put in the first bin
●
Mainly used for small or low-value items

22
… Inventory Control Systems

Economic Order Quantity [EOQ]

●
Model developed by Ford W. Harris in 1913
●
The order size which balances the inventory ordering cost and
inventory carrying cost as there is trade-off between the order
frequency (order size) and inventory level
– Small lot size

» More the number of orders and higher the ordering costs

» Lower the average inventory and lower the carrying costs
– Large lot size
» Lesser the number of orders and lower the ordering costs
» Larger the average inventory and higher the carrying costs
●
The point at which the sum of ordering costs & inventory carrying
costs is minimized represents the lowest total cost - EOQ

23
… Inventory Control Systems

Economic Order Quantity [EOQ]

Assumptions
●
Demand for the product is constant and uniform
throughout the period
●
Lead time (time from ordering to receipt) is constant
●
Price per unit of product is constant
●
Inventory holding cost is based on average inventory
●
Ordering or setup costs are constant
●
All demands for the product will be satisfied

24
 … Inventory Control Systems
Economic Order Quantity [EOQ]

25
 … Inventory Control Systems
Economic Order Quantity [EOQ]
2 XDXS
Q =
√ H
D Q
TotalCost [TC] = (D X C) + ( X S) + ( X H)
Q 2
QXH
Holding Cost =
2 Where
Annual cost of item = D X C Q = EOQ
D = Annual demand
DXS
Ordering Cost = S = Cost per order
Q H = Inventory holding cost per unit per year
D C = Unit cost of item
No of orders =
Q
No. of working days in the year
Time between orders or Order Cycle =
No of orders
NOTE
If inventory carrying cost is mentioned as a percentage of unit value of the item
[i] then
H=iXC 26
… Inventory Control Systems

Fixed-order quantity Review Policy

●
AKA Continuous Inventory System / Q System / Q-
Model / Perpetual System
●
Based on continuous review policy - A continual record
of the inventory level for every item is maintained
●
Whenever the inventory on hand decreases to a
predetermined level, referred to as the reorder point, a
new order is placed to replenish the stock of inventory
●
The order placed is for a fixed quantity (EOQ) that
minimizes the total inventory costs

27
… Inventory Control Systems

Fixed-order Quantity Review Policy

●
Advantage - inventory level is continuously monitored, so
management always knows the inventory status
●
Drawback - maintaining a continual record of the amount of
inventory on hand can also be costly
●
Systems often incorporate information technology tools to
improve the speed and accuracy of data entry simultaneously
provide management with continuously updated information
on the status of inventory levels
●
Many manufacturing companies, suppliers and distributors
also use bar code systems and handheld laser scanners to
record inventory materials, supplies, equipment, in-process
parts, and finished goods

28
 … Inventory Control Systems
Fixed-order Quantity Review Policy
Always order Q units when Inventory is consumed at a constant rate,
inventory reaches reorder with a new order placed when the reorder
point (R) point (R) is reached once again
D Q
TC=DC+( X S)+( X H)
 
Q 2

Inventory arrives after lead

time (L) TC = Annual purchase cost
Inventory is raised to + Annual ordering cost
maximum level (Q) + Annual holding cost 29
… Inventory Control Systems

Fixed-order Period Review Policy

●
AKA Fixed-time Period System / Periodic Inventory System / P System / P-Mode /
Periodic Review System / Fixed-order Interval System
●
Periodic review policy - Inventory on hand is counted at specific time intervals
e.g. weekly, fortnightly, or monthly
●
After the inventory in stock is determined, an order is placed for an amount that will
bring inventory back up to a desired level
●
In this system, the inventory level is not monitored at all during the time interval
between orders
●
Advantage - little or no record keeping required
●
Drawback
– Less direct control
– Typically results in larger inventory levels for a periodic inventory system than in
a continuous system to guard against unexpected stock-outs early in the fixed
period
– System requires that a new order quantity be determined each time a periodic
order is made

30
 … Inventory Control Systems
Fixed-order Period Review Policy

Time periods are Reorder quantity

equal, but ending
inventory varies
varies, depending
upon ending
inventory level.
Beginning inventory
is always the same 31
… Inventory Control Systems

Review Policy Review Policy

32
… Inventory Control Systems

Using P and Q system in practice

●
Use P system
– When orders must be placed at specified intervals
– When multiple items are ordered from the same supplier (joint-
replenishment)
– Items are inexpensive
●
P may be easier to use since levels are reviewed less often
●
P requires more safety stock since we only order at fixed points
●
P is more likely to run out since cannot respond to increases in
demand immediately
●
Either may be more costly - P in terms of safety stock, Q in
terms of monitoring cost

33
… Inventory Control Systems

Variable Order / Variable Period System

[Optional Replenishment System]
●
A system used to review the inventory position at fixed time
intervals
●
If inventory level drops to (or below) a predetermined level,
an order of variable-sized quantity is placed to cover
expected needs

35
… Inventory Control Systems

Manufacturing Resource Planning [MRP – II]

●
A method for the effective planning of all resources of a manufacturing company
●
Developed in the 1980s, a more comprehensive tool that seeks to address
some of the shortcomings of MRP
●
Allows a firm to integrate financial planning, engineering, operations & logistics
●
Incorporation of other functional areas allows all areas of the firm to focus on a
common set of goals
●
Benefits of MRP – II include
– Improved customer service through fewer shortages & stock-outs
– Better delivery performance
– Responsiveness to change in demand
– Reduced inventory costs
– Fewer production line stoppages
– More planning flexibility

36
… Inventory Control Systems

Response Based Methods

●
The issue of buyer-seller relationships in supply-chain
management research is becoming increasingly critical
●
Global competition and maturing domestic markets have driven
supply-chain members to reassess their distribution techniques to
remain competitive in the market
●
Firms need inventory replenishment systems that enhance
customer service whereas at the same time reduce inventory costs
●
Retailers demand time-phased replenishment viz delivery should
be made just as they need the stock for sale
●
This has lead to response based techniques which are based on
the pull approach

37
… Inventory Control Systems

Response Based Methods

Automatic Replenishment Programs [ARP]
●
ARP-type systems are still relatively new and based on the
pull approach
●
Are designed to streamline the flow of goods within the
channel, while simultaneously allowing the retailer to sustain
effective customer service
●
Possible on account of EDI, bar code readers, electronic
point of sale (EPOS) etc
●
Point-of-sale data are typically collected at the retail level
through bar code readers, electronic point of sale (EPOS)
systems and transmitted to the supplier via EDI

38
… Inventory Control Systems

Response Based Methods

Automatic Replenishment Programs [ARP]
●
Hence demand is captured as close to the final
consumer as possible
●
Thus the supplier is able to respond to demand on
a just-in-time basis
●
Replenishment is triggered by actual sales rather
than by manual ordering based on stock counts
●
Requires a high degree of coordination between
retailers and manufacturers

39
… Inventory Control Systems

Response Based Methods

Automatic Replenishment Programs [ARP]
●
Approach enables manufacturers to
– Effectively schedule factors of production
– Reduce inventory uncertainties
– Reduce total cost and improve performance in both
domestic & international markets
●
Approach results in replacing inventory with information
●
Approach results in retailers carrying lower inventory
levels & yet fewer stock-outs

40
… Inventory Control Systems

Automatic Replenishment Programs [ARP]

●
A number of different terms are used to designate ARP-
type inventory systems
●
ECR & QR are industry specific programs
– Efficient Consumer Response [ECR] programs
within the FMCG industry were among the first
replenishment programs to use EDI and barcoding as
demand smoothing tools
– Quick Response [QR] was introduced by the apparel
industry to pull stock into the stores when needed
based on point-of-sale data

41
… Inventory Control Systems

Automatic Replenishment Programs [ARP]

●
Another common method of classifying ARPs is based upon where
the replenishment decision is made, viz by the buyer or the seller
– Continuous Replenishment Programs [CRP]
The retailer makes the decisions regarding inventory
replenishment
– Vendor-Managed Inventory [VMI]
The vendor or supplier does not just make the decisions
regarding inventory replenishment but actually manages
inventory levels at the retail outlet
●
With both CRP and VMI, replenishment is triggered by sales data
and communicated to supplier through EDI

42
Reorder Level [ROL]

●
AKA Reorder Point
●
Determines when a replenishment order is initiated
●
Can be specified in term of units or days' supply
Reorder Level = (average demand X lead time)
R=dXT
Where R = Reorder level in units
d = Average daily demand in units
T = Lead time in days

43
… Reorder Level [ROL]

●
When uncertainty exists, in either delivery schedule or
performance, safety stock is required
●
In that case, ROL formula is
Reorder Level = (average demand X lead time) + Safety Stock
R = (d X T) + SS
Where R = Reorder level in units
d = Average daily demand in units
T = Lead time in days
SS = Safety stock in units

44
… Reorder Level [ROL]

45
Safety Stock

46
... Safety Stock

●
AKA Buffer Stock
●
In practical situations, there is uncertainty in the customer
demand level and lead-time for supply of inventory
●
To buffer against this uncertainty, firms maintain a level of extra
stock known as safety stock
●
Safety stock is employed when the lead time of manufacturing is
too long to satisfy the customer demand at the right cost /
quality / waiting time
●
Safety stocks absorb the variability of the customer demand
improving the customer service level
●
Safety stock is used as a buffer to protect organizations from
stock-outs caused by inaccurate planning or poor schedule
adherence by suppliers

47
... Safety Stock

●
How much safety stock to maintain is a inventory
policy decision & finding the right balance between
too much and too little safety stock is essential
●
The amount of safety stock a firm chooses to keep on
hand can dramatically affect a firm's business
●
Too much safety stock can result in high holding costs
of inventory
●
Products which are stored for too long a time can get
spoilt or damaged
●
Too little safety stock can result in lost sales and, thus,
a higher rate of customer turnover

48
... Safety Stock

Methods adopted to reduce safety stock

●
Increased collaboration with suppliers
●
Adopting statistical & mathematical techniques which
help managers to plan the levels of safety stock
Factors that influence the level of safety stock
Category of Item
●
'A' category items – Since better inventory control is
exercised, a low level of buffer stock would be sufficient
●
Other category items may require a relatively higher
safety stock

49
... Safety Stock

Safety Stock
Factors that influence the level of safety stock
Lead-time
●
Longer the lead-time, more the safety stock
No. of suppliers
●
Lesser the no. of suppliers for a particular item, higher the
safety stock
Criticality of item
●
More critical a particular item, higher the safety stock
Availability of Substitutes
●
If substitutes for a particular item are available, a low safety
stock maybe maintained

50
... Safety Stock

Possibility of making the item in-house

●
If it is possible to make the item in-house, a lower
safety stock would suffice
Risk of obsolescence or deterioration
●
If there is risk of obsolescence or deterioration over
time, it is better to maintain a low safety stock
Space restrictions
●
If the available storage space is small, it is better to
maintain a low safety stock

51
Service Level

●
Several definitions of service levels are used in
supply-chain management and inventory
management to measure the performance of
inventory replenishment policies
– Probability that all orders will be filled while
waiting for an order to arrive
– Percentage of customer demand filled from
stock in a time period [e.g. order fill rate, line
fill rate, case fill rate]
– Percentage of time system has stock on hand

52
… Service Level

If an organization wants to measure readiness to deliver

according to the number of units sold, the formula is
the quantities delivered in time
Service level =
the total quamtity demanded by customers

53
… Service Level

●
The probability that the amount of inventory on hand during the lead time is
sufficient to meet expected demand
●
The probability that a stockout will not occur
●
Meaning of the term service - higher the probability that inventory will be on
hand, the more likely that customer demand will be met viz that the
customer can be served
●
e.g.
– Service level = 90% → the probability that customer demand will be met
during lead time = 0.90
– Probability that a stockout will occur = 10%
●
Service level is typically a policy decision based on a number of factors
which also includes carrying costs for the extra safety stock and lost sales if
customer demand cannot be met
●
When demand is uncertain, reorder point with a safety stock must be
computed to meet specific service levels

54
 … Service Level

R = d̄ + z σ d √ L
where
d̄ = average daily demand
L = lead time
σ d = the standard deviation of daily demand
z = number of standard deviations corresponding to the service level probability
z σ d √ L = safety stock
55
Source – Operations Management Creating Value Along the Supply Chain 7E by - Russell – Taylor Page 575
Selective Inventory Control Techniques

●
The objective of inventory control is to decide
? How much inventory to reorder
? When to reorder inventory
●
Inventory control is essential to enable a firm to
maintain appropriate levels of inventory to provide
maximum customer service at minimum cost
●
Every organization maintains a large number of
inventory items
●
In order to exercise proper inventory control, firms
must first rank inventories

56
… Selective Inventory Control Techniques

●
AKA Inventory Ranking Methods / Inventory
Classification Methods
●
To facilitate management decisions, inventory
classification / ranking becomes essential
●
Need to classify inventory was first recognized in
1951 by H. Ford in GE
●
General criterion adopted and corresponding
inventory classification techniques are as shown in
the figure overleaf
●
Based on the principle of Pareto's Law vital few and
trival many viz the 80/20 rule

57
... Selective Inventory Control Techniques

ABC Analysis
●
Based on the principle of Pareto's Law vital few and
trival many viz the 80/20 rule
●
Usually 20% of items contribute to 80% of the value of
material held in stores
●
Focus should be these 20% vital few items
●
Balance 80% are trivial many
●
ABC analysis further refines 80/20 rule into a
classification based on annual consumption value viz
value of item X its unit price. This results in 3 classes A,
B&C

58
... Selective Inventory Control Techniques

ABC Analysis

59
... Selective Inventory Control Techniques

ABC Analysis

60
... Selective Inventory Control Techniques

ABC Analysis
Advantages
●
Technique is simple and easy to implement
●
Helps managers exercise selective control by focusing higher
levels of attention on Class A items, moderate levels of
attention on Class B items & low levels of attention on Class C
items
Limitations
●
Importance is given to items based only on annual
consumption value not on its criticality for production
●
Method should be reviewed periodically to taken into account
changes in prices & consumption

61
... Selective Inventory Control Techniques

62
... Selective Inventory Control Techniques

MUSIC – 3D (Multi-Unit Selective Inventory Control – Three

Dimensional)
●
Three dimensions are finance, operations and lead-time of
materials
●
HCV – High consumption value
●
LCV – Low consumption value
●
LLT – Long lead-time
●
SLT – Short lead-time

MUSIC-3D HCV LCV

LLT SLT LLT SLT

Critical 1 2 3 4

Non-Critical 5 6 7 8

63
... Selective Inventory Control Techniques

# Category Management
1 1 and 2 a. Service level- 100% to be maintained
b. Cannot go for bulk purchase
c. Inventory control-top management
d. Reorder level is to be maintained
2 3 and 4 a. Stockless purchasing
b. Safety stock can be maintained using long lead time.
c. Can go for bulk discount during purchasing
3 5 a. Strict inventory control
b. Frequent order
c. Consult reorder plan
4 6 a. Purchase order
5 7 a. Bulk purchase
6 8 a. Purchase at regular interval
b. Bulk purchase
c. Avoid expiry
64
Supply Contracts

●
Effective procurement strategies require developing relationships with suppliers
which can take many forms, formal and informal
●
To ensure adequate and timely deliveries, buyers and suppliers agree on supply
contracts
●
Buyer and supplier will agree on
– Pricing and volume discounts
– Minimum and maximum purchase quantities
– Delivery lead times
– Product or material quality
– Product or material return policies
– Freight or transportation charges
– Packaging requirement
– Statutory levies
●
Supply contracts can have two perspectives
– Sequential supply chain optimization
– Global optimization

65
… Supply Contracts

2-Stage sequential supply chain

●
Comprises of a buyer and a supplier
●
Buyer’s activities
– Generating a forecast
– Determining how many units to order from the supplier
– Placing an order with the supplier so as to optimize
buyer’s own profit
– Purchase based on forecast of customer demand
●
Supplier’s activities
– Producing according to the order placed by the buyer
– Make-To-Order (MTO) policy

66
… Supply Contracts

Sequential supply chain optimization

Risk sharing
●
Buyer assumes all of the risk of having more inventory than sales
●
Buyer limits his order quantity because of the huge financial risk
●
Supplier does not bear any risk
●
Supplier would like the buyer to order as much as possible
●
Since the buyer limits his order quantity, there is a significant increase in
the likelihood of out of stock
●
If the supplier shares some of the risk with the buyer
– It may be profitable for buyer to order more resulting in reduction of out
of stock probability
– Increases the profit for both the supplier and the buyer
– Supply contracts enable this risk sharing

67
… Supply Contracts

Sequential supply chain optimization

Buy-Back Contract
●
Seller agrees to buy back unsold goods from the
buyer at an agreed-upon price
●
Buyer has incentive to order more
●
Supplier’s risk clearly increases
●
Increase in buyer’s order quantity
– Decreases the likelihood of out of stock
– Compensates the supplier for the higher risk

68
… Supply Contracts

Sequential supply chain optimization

Revenue Sharing Contract
●
Buyer shares some of its revenue with the supplier in return for a
discount on the wholesale price
●
Buyer transfers a portion of the revenue from each unit sold back
to the supplier
Quantity-Flexibility Contracts
●
Supplier provides full refund for returned (unsold) items so long as
the number of returns is not more than a certain quantity
Sales Rebate Contracts
●
Provides a direct incentive to the retailer to increase sales by
means of a rebate paid by the supplier for any item sold above a
certain quantity

69
… Supply Contracts

Global optimization
●
Effective supply contracts provide incentives for supply chain
partners to replace traditional strategies, in which each partner
optimizes its own profit, with global optimization wherein supply
chain profit is maximized
●
Allows for buyers and suppliers to share the risk and potential
benefit
●
Drawback – Does not provide a mechanism to allocate supply
chain profit between partners
●
Provide information on the best, or optimal, set of actions that need
to be taken by the supply chain to improve profit, supply contracts
allocate this profit among supply chain members
●
Allocation of profit in such a manner that there is no incentive for
either buyer or seller to deviate from the set of actions that will
achieve the global optimal solution

70
Risk Pooling
●
For the same service level, which system will require more
inventory? Why?
●
For the same total inventory level, which system will have better
service? Why?
●
What are the factors that affect these answers?

Warehouse One Market One

Supplier
Warehouse Two Market Two

Market One
Supplier Warehouse

Market Two
71
… Risk Pooling

●
A powerful tool used to address variability in the
supply chain
●
Demand variability is reduced if the demand across
locations is aggregated
– When demand is aggregated across different
locations, it becomes more likely that high demand
from one location will be offset by low demand
from another location
– Results in reduction in variability
– Allows a decrease in safety stock and therefore
reduces average inventory

72
… Risk Pooling

●
Centralizing inventory reduces both safety stock and
average inventory in the system, explained as follows
– In a centralized distribution system, whenever
demand from one market area is higher than
average while demand in another market area is
lower than average
– Items in the warehouse that were originally allocated
for one market can be reallocated to the other
– The process of reallocating inventory is not possible
in a decentralized distribution system where different
warehouses serve different markets

73
… Risk Pooling

●
Benefits of risk pooling depend on the behavior of
demand function
– Benefits from risk pooling are reduced when
» Demand from two markets is positively
correlated viz it is very likely that whenever
demand from one market is greater than
average, the demand from the other market is
also greater than average and vice versa is
also true
– Benefits from risk pooling are far more when
markets are negatively correlated

74
… Risk Pooling

Risk pooling strategies

●
Redesign the supply chain, the production process, or
the product to either reduce the uncertainty the firm faces
or to hedge uncertainty so that the firm is in a better
position to mitigate the consequence of uncertainty
●
There are many types of risk pooling such as
– Risk pooling across markets
– Risk pooling across products
– Risk pooling across time [Lead Time Pooling]
– Risk pooling across capacity

75
 … Risk Pooling
Risk pooling across time [Lead Time Pooling]

Source - https://www.researchgate.net/publication/337693488_Spreadsheet-
based_supply_chain_simulation_for_teaching_risk_pooling_combined_with_facility_location/fulltext/5de5c756299bf10bc33a7448/Spreadsheet-
based-supply-chain-simulation-for-teaching-risk-pooling-combined-with-facility-location.pdf?origin=publication_detail 76
… Risk Pooling

In conclusion
●
Risk pooling is most effective when demands are negatively
correlated as the uncertainty in the total demand is much
less than the uncertainty with any individual location
●
Risk pooling does not help to reduce pipeline inventories
●
Risk pooling can be used to
– Reduce inventory while maintaining the same service
level
Or
– Increase the service level while holding the same
inventory

77
Centralized vs. Decentralized Systems

Trade-offs
●
Safety Stock
– Decreases as an organization moves from a decentralized to a centralized system
●
Service level
– When the centralized and decentralized systems have the same safety stock,
service level provided by centralized system is higher
●
Overhead Costs
– Much higher in a decentralized system as there are fewer economies of scale
●
Customer Lead Time
– Much shorter for decentralized systems as the warehouses are in close proximity
to customers
●
Transportation Costs
– Depends on the specific situation
– Generally, as number of warehouses increase, cost of short haul decreases and
cost of long haul increases and vice versa

78
Inventory Management in Practice

●
Perform periodic inventory review
– Since inventory is reviewed at a fixed time interval and every time it is
reviewed, a decision is made on the order size
– Makes it possible to identify slow-moving and obsolete products and
allows management to continuously reduce inventory levels
●
Provide tight management of usage rates, lead times, and safety
stock
– Allows the firm to make sure inventory is kept at the appropriate level
●
Reduce safety stock levels
●
Introduce or enhance cycle counting practice
– This process replaces the annual physical inventory count by a
system where part of the inventory is counted every day, and each
item is counted several times per year

79
… Inventory Management in Practice

●
Follow ABC approach
●
Shift more inventory or inventory
ownership to suppliers
●
Follow quantitative approaches
– Focus on the right balance between
inventory holding and ordering costs
– Organizations make a significant effort to
increase the inventory turnover ratio
Annual Sales
Inventory turnover ratio =
Average inventory level

80
Demand Forecasting

Definition
●
Demand forecasting is predicting the future demand
of the product or services of an organization
– AKA Demand Estimation
– To forecast is to estimate or calculate in
advance
– Corporate decisions often depend on managerial
forecasts, yet there is never a guarantee of the
reliability or accuracy of the forecast

81
… Demand Forecasting

●
According to Simchi, there are three rules of forecasting
– The forecast is always wrong
– The longer the forecast horizon, the worse the forecast
– Aggregate forecasts are more accurate
●
Nevertheless, forecasting is a critical tool in the management toolbox
●
By correctly managing inventory, managers can make the best possible
use of forecasts, in spite of the inherent difficulties of forecasting
●
Apart from inventory decision making, forecasts aid decisions about
whether to enter a particular market at all, about whether to expand
production capacity, or about whether to implement a given promotional
plan
●
All planning for factors of production is dependent on demand forecasts
●
A variety of demand forecasting techniques can be used, separately or in
combination, to create forecasts

82
… Demand Forecasting

●
Although there are many different
forecasting tools and methods, they can be
split into four general categories
– Judgment Methods
– Market Research Methods
– Time-Series Methods
– Causal Methods

83
… Demand Forecasting

Judgment Methods
●
Qualitative / Subjective methods of demand forecasting
●
Involves assimilating the opinions of a variety of experts in a systematic way
●
Experts could be salespeople (or dealers)
– They frequently have a good understanding of expected sales, since they
are close to the market.
– A sales-force composite can be assembled that combines each
salesperson’s sales estimate in a logical way
●
Panels of experts can be assembled in order to reach a consensus about a
demand forecast
– Approach assumes that by communicating and openly sharing
information, a superior forecast can be agreed upon
– Experts can be external experts, or internal experts, from a variety of
functional areas within an organization company

84
… Demand Forecasting

Judgment Methods
●
Delphi method is a structured technique for reaching a
consensus with a panel of experts without gathering them in a
single location
– The technique is designed to eliminate the risks of one or a
few strong-willed individuals dominating the decision-making
process
– Each member of the group of experts is surveyed for his or
her opinion, typically in writing
– Opinions are compiled and summarized, and each individual
is given the opportunity to change his or her opinion after
seeing the summary
– This process is repeated until consensus is achieved

85
… Demand Forecasting

Market Research Methods

●
Particularly valuable for developing forecasts of newly
introduced products
●
Market testing
– Focus groups assembled
– Responses tested
– Extrapolations to rest of market made
●
Market surveys
– Data is gathered from potential customers through
interviews, phone-surveys, written surveys, etc

86
… Demand Forecasting

Time Series Methods

●
Quantitative methods of demand forecasting
●
Past data is used to estimate future demand
●
Techniques include
– Moving Averages – average of historical / past data
– Exponential Smoothing – more recent data receive more weight
– Methods for data with trends
» Regression analysis – fits line to data
» Holt’smethod – combines exponential smoothing concepts with the ability to
follow a trend
– Methods for data with seasonality
» Seasonal decomposition methods (seasonal patterns removed)
» Winter’s method is an advanced approach based on exponential smoothing
– Other complex methods
» These are not used in practice and there is some evidence that these methods
don’t outperform simpler methods

87
… Demand Forecasting

Causal Methods
●
Quantitative method of demand forecasting
●
Causal - there is a causal (cause - effect)
relationship between the variable to be forecast
and another variable or a series of variables
●
Forecasts are generated based on data other than
the data being predicted
●
Often economic indicators such as inflation rates,
GNP, unemployment rates, weather and sales of
other products are used to generate a demand
forecast

88
… Demand Forecasting

Selecting the appropriate forecasting technique

●
Since a wide variety of demand forecasting techniques are available, to select
the appropriate technique, experts suggest that 3 questions can be posed to
help with this decision
– What is the purpose of the forecast?
» Gross or detailed estimates?
» For gross estimates simpler techniques whereas for detailed estimates
more complex techniques would be necessary
– What are the dynamics of the system being forecast?
» Is it sensitive to economic data?
» Is it seasonal?
» Is it trending?
– How important is the past in estimating the future?
» If past is very important, time series methods are suitable
» If there are significant changes, judgment or market research methods
are suitable

89
… Demand Forecasting

Selecting the appropriate forecasting technique

●
Experts also suggest that different approaches may be
appropriate for different stages of the product lifecycle
– Product development stage - market research methods
could indicate the potential sales
– Testing and introduction stage - market research
methods and judgment methods are suitable
– Rapid growth stage - time series methods are preferable
– Maturity stage - time series and causal methods
(particularly for long-range planning)
●
The quality of demand forecasts can be frequently
improved by combing a variety of techniques

90