Chapter 13: Determining the optimal level of product availability

Case 1: Retailers were also hit hard, with some, such as Saks Fifth Avenue, slashing prices by 70 percent
during the holiday season to spur demand. The excess inventories and the drop-in demand led to
several retailers, such as Steve & Barry’s and Circuit City, declaring bankruptcy during this period. In
contrast, Nintendo missed out on an estimated $1.3 billion in sales during the 2007 holiday season
because of a failure to meet soaring global demand for its Wii video game console. These examples
make clear that having too high or too low a level of product availability has a significant impact on
supply chain profits.

Case 2: Strategies to increase the salvage value include selling to outlet stores so leftover units are not
merely discarded. Some companies, such as Sport Obermeyer, which sells winter wear in the United
States, sell the surplus in South America, where the winter corresponds to the North American
summer. The increased salvage value of the surplus allows Sport Obermeyer to provide a higher
level of product availability in the United States and increase its profits. The growth of online
liquidators such as Overstock.com helps retailers by increasing their salvage value for overstocked
products. Increasing the salvage value of leftover units allows a firm to increase profits by providing a
higher level of product availability because the cost of excess inventory has been reduced.

Case 3: Consider the example of Saks Fifth Avenue, a high-end department store, which purchases
cashmere shawls from India and Nepal. The selling season for cashmere shawls is about 14 weeks.
Historically, replenishment lead times have been on the order of 25 to 30 weeks. With a 30-week lead
time, the buyer at Saks must place the entire order well before the start of the sales season. It is
difficult for a buyer to make an accurate forecast of demand this far in advance. This results in high-
demand uncertainty, leading the buyer to order either too many or too few shawls each year.
Typically, buyers are able to make accurate forecasts once they have observed sales for the first week
or two in the season. If lead times can be shortened to facilitate the use of actual sales when placing
part of the seasonal order, there can be significant benefits for the supply chain. Consider the situation
in which manufacturers are able to reduce replenishment lead time to six weeks. This reduction allows
the buyer at Saks to break up the entire season’s purchase into two orders, each covering seven weeks
of demand. The first order is placed six weeks before the start of the sales season. The buyer orders
what the store expects to sell over the first seven weeks of the season. The first order must be
placed without observing any sales. Once the season starts, the buyer observes sales for the first week
and places a second order after the first week for the final seven weeks of the season. When placing
the second order, the buyer can use sales information from the first week of the season. The improved
accuracy of the buyer’s predictions allows Saks to use the second order to better match supply and
demand, resulting in higher profits.

Case 4: My Zara, the Spanish apparel retailer, has built its entire strategy around quick response. At a
time when most of its competitors were cutting costs by outsourcing production to low-cost countries,
Zara focused on reducing response time by setting up production facilities in Spain. While competitors
had lead times that ranged from three to nine months, Zara was able to reduce its design-to-shelf lead
time to three to four weeks. Given a three-month sales season (for each of fall, winter, spring, and
summer), competitors were forced to make sourcing decisions well before the start of a season. In
contrast, Zara divided the three-month sales season into three one-month periods. For the first
month, Zara decided on quantities without knowing what sales would be. These quantities, however,
were much lower than what the competition was required to order for the entire three-month season.
For the second month, Zara made its production decisions after observing the first week of demand
(Zara also observed demand at its competition). For the third month, Zara made its production
decisions after observing the entire first month of sales. In each instance, observing sales allowed Zara
to significantly improve its forecast accuracy. The result was that Zara was able to bring in more of
what was selling without wasting precious production capacity on what was not likely to sell. Quick
response allowed Zara to respond to trends rather than have to predict them. This resulted in higher
profits for Zara because it produced what was selling and had less overstock and understock. The New
York Times reported in 2006 that “Zara books 85 percent of the full ticket price for its merchandise
while the industry average is 60 percent.”

Case 5: Allon and Van Mieghem (2010) describe a high-tech manufacturer of wireless transmission
components with facilities in China and Mexico. The Chinese facility was cheaper but had lead times
that were five to ten times longer than those from Mexico. A simulation study indicated that the use
of tailored sourcing was the most effective strategy in this case. Allon and Van Mieghem (2010)
recommend a tailored base-surge (TBS) inventory policy, under which a constant base load is
sourced from the cheaper source (China, in this case), with the responsive source (Mexico, in this
case) being used any time inventory drops below a threshold. Their simulations indicate that sourcing
roughly 75 percent of the demand from the cheaper source as base load, with the rest coming from
the responsive source as needed, is a fairly effective tailored sourcing policy in practice. Their results
show that the fraction of demand allocated as base load to the cheaper source increases as the
demand and the cost difference with the responsive facility grow. The fraction of demand allocated
as base load to the cheaper source decreases as the reliability of the cheaper source decreases or the
volatility of demand and the holding cost of inventory grow.

Factors affecting the optimal level of product availability

 Cost of overstocking the product, Co: The cost of overstocking, denoted by Co, is the loss incurred
by a firm for each unsold unit at the end of the selling season. Co: Cost of overstocking by one
unit.
 Cost of understocking the product, Cu: The cost of understocking, denoted by Cu, 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.
 Critical Fractile (CSL- Optimal cycle service level)- Optimal cycle service level the probability that
demand during the season will be at or below O (Corresponding optimal order size).
CF: Cu/ (Cu + Co); If CF> 0.5 then then the retailer will overorder as it signifies Cu>Co and vice c
versa.

 Quantity discounts: Here a buyer who has to make a single order when the seller offers a price
discount based on the quantity purchased.
 Study the EOQ and EPQ model of inventory to identify how much amount to order to optimize the
cost.
 Study the P and Q type model to identify the amount of ordering quantity for maintaining the
inventory position.
Managerial levers to improve the availability

1. To increase the salvage value: It can be increased by increased the outlets in diverse localities.
Refer case 2.
2. Decrease the margin lost in a stockout include arranging for backup sourcing (which may be
more expensive) so customers are not lost forever. The practice of purchasing product from
a competitor on the open market to satisfy customer demand is observed and justified by the
earlier reasoning. The cost of understocking can also be decreased by providing the customer
with a substitute product. Decreasing the cost of understocking allows a firm to increase
profits by providing a lower level of product availability (because there are alternatives
available to serve the customer), thus decreasing the amount of excess inventory at the end
of the season.
3. To cope with the demand uncertainty: A manager can decrease the demand uncertainty by
improving the demand forecast, by decreasing the lead times, by postponement of product
differentiation and by tailor sourcing (going for a supplier with shorter lead time and a higher
cost for a particular period).

1. Improving profits by reducing forecast error: As a firm improves its forecast accuracy,
expected quantity overstocked and understocked declines and expected profit increases.
2. Quick response: Impact on profits and Inventories: If quick response allows multiple
replenishment orders in the season, profits increase and the overstock and understock
quantities decrease. Multiple replenishments allow the supply chain to better match supply
and demand by being able to respond to trends rather than having to forecast them.
“Quick response is clearly advantageous to a retailer in a supply chain—with one caveat. As
the manufacturer reduces replenishment lead times, allowing for a second order, we have
seen that the retailer’s order size drops. In effect, the manufacturer sells less to the retailer.
Thus, quick response results in the manufacturer making a lower profit in the short term if all
else is unchanged. This is an important point to consider, because decreasing replenishment
lead times requires tremendous effort from the manufacturer, yet seems to benefit the
retailer at the expense of the manufacturer. The benefits resulting from quick response should
be shared appropriately across the supply chain. This was easier for Zara, which was vertically
integrated into responsive manufacturing and retailing. It can be a challenge, however, for
retailers that outsource manufacturing.”
Postponement impact on profits and inventories: Postponement refers to the delay of product
differentiation until closer to the sale of the product. With postponement, all activities prior to product
differentiation require aggregate forecasts that are more accurate than individual product forecasts.
Individual product forecasts are required close to the time of sale when demand is known with greater
accuracy. As a result, postponement allows a supply chain to better match supply with demand.

It can be particularly applied when customers are willing to wait for the delivery.

“But postponement has its cons as it leads to increase in the product cost. For example, if the paints
are mixed at the retailer store rather than at manufacturing it will increase the cost by 10 percent
because of reduction in economies of scale.”

Postponement may reduce overall profits for a firm if a single product contributes the majority of the
demand because the increased manufacturing expense due to postponement outweighs the small
benefit that aggregation provides in this case for the dominant product.

Tailored postponement: Impact on profits and Inventories

In tailored postponement, a firm uses production with postponement to satisfy a part of its demand,
with the rest being satisfied without postponement. Tailored postponement produces higher profits
than when no postponement is used or all products are manufactured using postponement. Under
tailored postponement, a firm produces the amount that is predictable using the lower-cost
production method without postponement. The firm produces the portion of demand that is
uncertain using postponement.

A more sophisticated approach to postponement separates all demand into base load and variation.
The base load is manufactured using the low-cost method without postponement, and only the
variation is made using postponement.

Tailored sourcing: Impact on profits and Inventories

In tailored sourcing, firms use a combination of two supply sources, one focusing on cost but unable
to handle uncertainty well, and the other focusing on flexibility to handle uncertainty, but at a higher
cost.

The low-cost source must focus on being efficient and should be required to supply only the
predictable portion of the demand. The flexible source should focus on being responsive and be
required to supply the uncertain portion of the demand.

Tailored sourcing may be volume based or product based, depending on the source of uncertainty.

Volume based: Predictable part of volume is obtained from the efficient source and the unpredictable
from the responsive source.

Product based: Product with variety and customization is obtained from the responsive source as its
volumes are low whereas the products of standard configurations are obtained from the efficient
source as its volumes are high.

Setting product availability for multiple products under capacity constraints

When ordering multiple products under a limited supply capacity, the allocation of capacity to
products should be based on their expected marginal contribution to profits. This approach allocates
a relatively higher fraction of capacity to products that have a high margin relative to their cost of
overstocking.

Setting optimal Levels of product availability in practice

1. Target levels of availability should have a rationale behind them. As slight increase or decrease in
targets of availability can impact the company’s bottom line.
2. Tailor your response to uncertainty.
3. Use estimates of costs and stockouts to save time and effort instead of going for a very precise
values of the same.