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Exercise on Demand Planning and Inventory Management

Operations and Supply Chain Management ( ESCP Business School)

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Exercise on Demand Planning and Inventory Management

ABC Group is one of the largest companies in the electronic and digital systems segment in the
infrastructure area, owns several brands with more than four thousand patents and one hundred
seventy thousand items, is present in over one hundred and eighty countries. Due to the high flow
material handling, it can be said that inventory management is crucial to the organization of
products and control of entrance and exit of goods, thus avoiding losses and obtaining the profits
of such stock. Moreover, proper demand forecasting is needed to minimize the total cost of
reordering critical components to suppliers while maintaining a good level of service to the
customers.

The product at issue is manufactured at the assembly line of the company and is composed by
several components. The most critical among those components is sourced from a tier-1 supplier,
who can guarantee a 2-month lead time and provides the component for a selling price of 0,1 €
per unit.
The component comes from China and it is very delicate, hence it requires transportation with
refrigerated containers and low volume loading. Cost for each order, including administrative costs,
shipping, insurance and other costs amount to 100’000 €. Inventory carrying cost per unit is equal
to 0,25 €.
After the arrival, one unit of component is used in the assembly of one final product. You can
assume that production is able to manufacture the final product immediately after the reception
of the component (I.e., the only lead time you have to consider is the supplier’s lead time).
The company must guarantee a 95% service level to its customers with the stock available within
that lead time.

The final demand from the customers for the previous 2 years is the following:

Month Demand Month Demand

1 500000 13 520000
2 430000 14 450000
3 440000 15 455000
4 400000 16 422000
5 405000 17 415000
6 410000 18 450000
7 480000 19 460000
8 400000 20 445000
9 420000 21 420000
10 425000 22 425000
11 450000 23 395000
12 400000 24 430000

Questions set

1. The company wants to revisit its demand forecasting technique. Hence, the management
has asked your team to test and compare different methods and techniques. Measure the

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performance of different time-series forecasting technique and compare it with the results
obtained through the naïve technique used by the company. For the exponential smoothing
you may consider different initialization strategies.
2. Calculate the total cost incurred by using an EOQ inventory management policy for Year 3.
To this end you’ll have to use the appropriate average demand based on the previously
identified forecasts, and include a safety stock in the calculation.
3. Reflect on the results: in what way do the service level and cost items affect the total cost?

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Addendum 1: Initialization and parameters tuning for the exponential

smoothing technique

Demand Forecasting through exponential smoothing requires a parameter (α) and it has a
recursive nature, since it generates new forecast through previous expectations. Hence, this
method needs both a starting point (Initialization) and setting the parameter (Tuning or
Calibration).

A fairly un-biased method for the Initialization involves using the average of the first l periods to
initialize the first forecast. Fine tuning of the parameters instead involves estimating the value of
the parameter α which minimizes the Root Mean Squared Error.

For example, see below the monthly demand collected in the previous 24 months.

An exponential smoothing algorithm has been chosen as the best forecasting technique. To
initialize the procedure, it has been decided to use the first 12 months to level the demand, and
the following months to fine tune the parameter.

Hence, the first forecast (for month 13) is equal to the level demand accrued in the first 12 months.
Note that in order to be fair and make sure our forecasting does not contain any data we have
used to initialize the exponential smoothing, the first forecast must not be used to measure the
performance of the method.

In the following table the results from the application of the exponential smoothing technique are
shown, with α= 0,1.

Month Actual Forecast Error Absolute Error squared

demand error
1 100
2 120
3 110
4 90
5 95
6 105
7 100
8 109
9 99
10 96
11 107
12 91
13 111 101,83

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14 97 102,75 -5,8 5,8 33,1

15 105 102,18 2,8 2,8 8,0
16 110 102,46 7,5 7,5 56,9
17 93 103,21 -10,2 10,2 104,3
18 118 102,19 15,8 15,8 249,9
19 105 103,77 1,2 1,2 1,5
20 113 103,89 9,1 9,1 82,9
21 106 104,80 1,2 1,2 1,4
22 108 104,92 3,1 3,1 9,5
23 96 105,23 -9,2 9,2 85,2
24 103 104,31 -1,3 1,3 1,7
ME MAD MSE
1,3 6,1 57,7

Fine-tuning the parameter alpha requires analyzing how sensitive the error measures are to any
changes in the parameters. In the following table the impact on the Root Mean Squared Error of
different levels of alpha are shown.

alpha 0 0,05 0,1 0,2 0,3 0,5 0,8

RMSE 7,78 7,60 7,59 7,80 8,11 8,91 10,67

The values are charted in this graph. It can be noted that the value of alpha which minimizes the
RMSE lies ranges within the values of 0,05 and 0,1.

Solving for the best value of αrequires linear programming or other optimization algorithm. The
Solver add-in function of Excel can be used to this end.

Addendum 2: Setting the safety stock

Safety stock protects against uncertainties which may arise either in the customers’ demand or in
the production and distribution lead time. When uncertainty is involved in the customers’ demand,

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we need to raise the reorder point to account for a potential extra demand during the lead time.
Hence, we need to add the safety stock to the equation of the reorder point.

Reorder point = Demand * Lead time + Safety Stock

To set the safety stock we need two things:

1. A description of the uncertainty of the demand during the lead time;

2. A level of quality we are willing to offer to our customers, in terms of the ability to meet
our customers’ demand with the available stock.

The uncertainty of the demand during the lead time is best represented through the standard
deviation of the demand distribution. If we do not have actual demand data a good estimator for
the standard deviation is the RMSE of the chosen demand forecasting technique.

The simplest way to set the level of quality is to introduce a probability constraint on the stockout
(I.e., not being able to serve a customer with the available stock). This probability (α) is usually
relatively small, and the service level is defined as 1 - α.

The reorder point thus stands at the 1-α quantile of a normal distribution, where µ LT equals the
average forecasted demand over the lead time and σ LT equals the RMSE over the lead time.
Calculating this quantile boils down to calculating the correspondent quantile for a standard
normal distribution, namely the variable z1-α (see figure below).

Hence, the reorder point R is calculated as follows:

R = µLT + z1-α * σLT

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And the safety stock is set at z1-α times the standard deviation over the lead time.

If the demand is distributed over a time bucket and the lead time exceeds that time bucket (as in
the exercise proposed here) we can assume that each demand observation is independent. To
estimate the variance of the demand over the lead time we can simply add the variances of each
demand observation. Hence:

σLT 2= σD 2 * Lead Time

σLT = σD * Sq. Root (Lead Time)

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