Module 4

Logistics and Supply Chain Management

ROLE OF CYCLE INVENTORY IN A SUPPLY
CHAIN
• The demand for a product is relatively stable at D = 100 units per day. The store manager currently
purchases in lots of Q = 1,000 units.
Cycle Inventory
• The larger the cycle inventory, the longer the lag time between when a product is
produced and when it is sold.
• A lower level of cycle inventory is always desirable, because long time lags leave
a firm vulnerable to demand changes in the marketplace.
• A lower cycle inventory also decreases a firm’s working capital requirement.
Economic Order Quantity
Inventory Holding Cost
Holding cost is estimated as a percentage of the cost of a product and is the sum of the following
major components:

• Cost of capital
• Obsolescence (or spoilage) cost
• Handling cost
• Occupancy cost
• Miscellaneous costs
Cost of Capital
• The appropriate approach is to evaluate the weighted-average cost of capital (WACC), which takes
into account the required return on the firm’s equity and the cost of its debt
Obsolescence (or spoilage) cost:
• The obsolescence cost estimates the rate at which the value of the stored product drops because its
market value or quality falls.
• This cost can range dramatically, from rates of many-thousand percent to virtually zero, depending
on the type of product.
• Perishable products have high obsolescence rates. Even nonperishables can have high obsolescence
rates if they have short life cycles.
• At the other end of the spectrum are products such as crude oil that take a long time to spoil or
become obsolete. For such products, a low obsolescence rate may be applied.
Handling cost
• Handling cost should include only incremental receiving and storage costs that vary with the
quantity of product received.
• Quantity-independent handling costs that vary with the number of orders should be included in the
order cost.
• The quantity dependent handling cost often does not change if quantity varies within a range.
• If the quantity is within this range (e.g., the range of inventory a crew of four people can unload
per period of time), incremental handling cost added to the holding cost is zero.
• If the quantity handled requires more people, an incremental handling cost is added to the holding
cost.
Occupancy cost
• The occupancy cost reflects the incremental change in space cost due to changing cycle inventory.
• If the firm is being charged based on the actual number of units held in storage, we have the direct
occupancy cost.
• Firms often lease or purchase a fixed amount of space. As long as a marginal change in cycle
inventory does not change the space requirements, the incremental occupancy cost is zero.
• Occupancy costs often take the form of a step function, with a sudden increase in cost when
capacity is fully utilized and new space must be acquired.
Miscellaneous costs
• The final component of holding cost deals with a number of other relatively small costs.
• These costs include theft, security, damage, tax, and additional insurance charges that are incurred.
• Once again, it is important to estimate the incremental change in these costs on changing cycle
inventory
Ordering Cost
The ordering cost includes all incremental costs associated with placing or receiving an extra
order that are incurred regardless of the size of the order. Components of ordering cost include
the following:

• Buyer time
• Transportation costs
• Receiving costs
Buyer time
• Buyer time is the incremental time of the buyer placing the extra order.
• This cost should be included only if the buyer is utilized fully.
• The incremental cost of getting an idle buyer to place an order is zero and does not add to the
ordering cost.
• Electronic ordering can significantly reduce the buyer time to place an order.
Transportation costs
• A fixed transportation cost is often incurred regardless of the size of the order.
• For instance, if a truck is sent to deliver every order, it costs the same amount to send a half-empty
tuck as it does a full truck.
• Less-than-truckload pricing also includes a fixed component that is independent of the quantity
shipped and a variable component that increases with the quantity shipped. The fixed component
should be included in the ordering cost.
Receiving costs
• Some receiving costs are incurred regardless of the size of the order.
• These include any administration work such as purchase order matching and any effort associated
with updating inventory records. Receiving costs that are quantity dependent should not be
included here.

Other Costs:
Each situation can have costs unique to it that should be considered if they are incurred for each order
regardless of the quantity of that order.
MANAGING MULTIECHELON CYCLE
INVENTORY
Replenishment Policy
Replenishment Policy
Integer replenishment policies for the supply
chain
• Divide all parties within a stage into groups such that all parties within a group order from the same
supplier and have the same reorder interval.
• Set reorder intervals across stages such that the receipt of a replenishment order at any stage is
synchronized with the shipment of a replenishment order to at least one customer.
• The synchronized portion can be cross-docked.
• For customers with a longer reorder interval than the supplier, make the customer’s reorder interval an
integer multiple of the supplier’s interval and synchronize replenishment at the two stages to facilitate
cross-docking. In other words, a supplier should cross-dock all orders from customers that reorder less
frequently than the supplier.
• For customers with a shorter reorder interval than the supplier, make the supplier’s reorder interval an
integer multiple of the customer’s interval and synchronize replenishment at the two stages to facilitate
cross-docking. In other words, a supplier should cross-dock one out of every k shipments to a customer
that orders more frequently than the supplier, where k is an integer.
• The relative frequency of reordering depends on the setup cost, holding cost, and demand at different
parties.
Multi-echelon Inventory Optimization—Major
Challenges
• Efficient management of complex multilevel distribution networks
• Network-wide optimization of inventory to maximize customer service while minimizing system-
wide inventories and costs
• Integrated solutions for both local and global optimization
• Development of a high degree of responsiveness to changing customer demands, thus ensuring
continual and speedy replenishments to minimize stock out costs.
• Substitution of stock-based with velocity-based customer service.
• Transformation of the culture of local link-level efficiency into system-level efficiency.
Economic Production Quantity (EPQ)
• Same assumptions as the EOQ except: inventory arrives in increments & is
drawn down as it arrives
EPQ Equations
• Total cost: TC EPQ
 D   I MAX 
=  S +  H
Q   2 

• Maximum inventory:
 d
• d=avg. daily demand rate I MAX = Q 1 − 
• p=daily production rate  p

• Calculating EPQ EPQ =

2DS
 d
H
1 − p 

 
EPQ Problem: HP Ltd. Produces its premium plant food in 50 bags. Demand is 100,000 kgs. per week
and they operate 50 wks. each year and HP can produce 250,000 kgs. per week. The setup cost is Rs.
200 and the annual holding cost rate is Rs. 0.55 per bag. Calculate the EPQ. Determine the maximum
inventory level. Calculate the total cost of using the EPQ policy.

2DS
EPQ =
 d
H
 1 − 
 p


 d
I MAX = Q
1 − p 

 

 D   I MAX 
TC EPQ =  S +  H
Q   2 
EPQ Problem: HP Ltd. Produces its premium plant food in 50 bags. Demand is 100,000 kgs. per week
and they operate 50 wks. each year and HP can produce 250,000 kgs. per week. The setup cost is Rs.
200 and the annual holding cost rate is Rs. 0.55 per bag. Calculate the EPQ. Determine the maximum
inventory level. Calculate the total cost of using the EPQ policy.

2DS 2(50)(100,000)(200)
EPQ = EPQ = = 77,850Bags
 d   100,000 
H
 1 − 
 .551 − 
 p   250000 

 d  
I MAX = Q
1 − p 
 I  100 , 000 
MAX = 77 , 850  1−
 250 , 000
 = 46 , 710 bags

 

 D   I MAX   5,000,000   46,710 

TC EPQ =  S +  H TC =  (200) +  (.55) = $25,690
Q   2   77,850   2 
ROLE OF SAFETY INVENTORY IN A SUPPLY CHAIN
Safety Inventory
For any supply chain, three key questions need to be considered when planning safety inventory:

1. What is the appropriate level of product availability?

2. How much safety inventory is needed for the desired level of product availability?
3. What actions can be taken to reduce safety inventory without hurting product availability?
FACTORS AFFECTING THE LEVEL OF SAFETY INVENTORY

The appropriate level of safety inventory is determined by the following two factors:
• The uncertainty of both demand and supply
• The desired level of product availability
Safety Stock and Service Levels

• If demand or lead time is uncertain, safety stock can

be added to improve order-cycle service levels
• R = dL +SS
• Where SS =zσdL, and Z is the number of
standard deviations and σdL is standard deviation
of the demand during lead time

• Order-cycle service level

• The probability that demand during lead time
will not exceed on-hand inventory
• A 95% service level (stockout risk of 5%) has a
Z=1.645
Periodic Review Systems
• Orders are placed at specified, fixed-time intervals (e.g. every Friday), for a order
size (Q) to bring on-hand inventory (OH) up to the target inventory (TI), similar
to the min-max system.
• Advantages are:
• No need for a system to continuously monitor item
• Items ordered from the same supplier can be reviewed on the same day saving purchase order
costs
• Disadvantages:
• Replenishment quantities (Q) vary
• Order quantities may not quality for quantity discounts
• On the average, inventory levels will be higher than Q systems-more stockroom space needed
Role of IT in Inventory Management

Two most significant contributions of IT systems can be

• improved inventory visibility and
• better coordination in the supply chain
Another area in which improved visibility could play a significant role is locating
in-store or in-warehouse inventory.
ESTIMATING AND MANAGING SAFETY INVENTORY IN PRACTICE

• Account for the fact that supply chain demand is lumpy

• Adjust inventory policies if demand is seasonal
• Use simulation to test inventory policies
• Start with a pilot
• Monitor service levels
• Focus on reducing safety inventories
Determining the Optimal Level of Product Availability

The two key factors that influence the optimal level of product availability are
• Cost of overstocking the product
• Cost of understocking the product

• The cost of overstocking, denoted is the loss incurred by a firm for each unsold
unit at the end of the selling season.
• The cost of understocking is the margin lost by a firm for each lost sale because
there is no inventory on hand. The cost of understocking should include the
margin lost from current sales, as well as future sales if the customer does not
return.
MANAGERIAL LEVERS TO IMPROVE SUPPLY CHAIN
PROFITABILITY
• Two obvious managerial levers to increase profitability are
1. Increasing the salvage value of each unit increases profitability (as well as the
optimal cycle service level).
2. Decreasing the margin lost from a stockout increases profitability (by allowing a
lower optimal cycle service level).
• Improved forecasting: Use better market intelligence and collaboration to reduce
demand uncertainty.
• Quick response: Reduce replenishment lead time so multiple orders may be placed
during the selling season.
• Postponement: In a multiproduct setting, postpone product differentiation until
closer to the point of sale.
• Tailored sourcing: Use a supplier with a short lead time, but perhaps higher cost,
as a backup for a supplier that has a low cost but perhaps a long lead time.
SETTING OPTIMAL LEVELS OF PRODUCT AVAILABILITY IN
PRACTICE
• Beware of preset levels of availability
• Use approximate costs because profit-maximizing solutions are quite robust
• Estimate a range for the cost of stocking out
• Tailor your response to uncertainty