Case 3 LL Bean Solution

Item
Forecas,ng and Inventory

Management

Case:
L. L. Bean, Inc.

L. L. Bean, Inc.
• Founded by Leon Leonwood Bean
• L L Bean invented the Maine Hun,ng Shoe in 1912
• He obtained the list of hun,ng license holders in Maine
and started the mail-‐order business
• L.L. Bean Inc. is now a major cataloger and retailer in
the outdoor spor,ng specialty field
• Most of the sales came from telephone order in the
90’s. Today, online channel majority of the sales
originate majority of the sales
• They had a single retail outlet in Freeport
• Today L.L. Bean has mul,ple outlets

Synopsis of the L.L. Bean Inc. Case
• L.L. Bean makes stocking decisions on thousands of items sold through its
catalogs:
– Inevitable losses due to stock-‐outs/liquida,on of extra inventory
• L.L. Bean implements standard cri,cal-‐frac,le methodology

• Operates based on the following considera,ons:
– Gain in stocking an incremental unit that is demanded and the loss in failing
to do so
– Effects of subs,tu,on and complementarity on inventory decisions
– Prac,cali,es of probability assessment of demand distribu,ons
Analysis
Which issues are cri,cal to successful implementa,on of item
forecas,ng under uncertainty at L.L Bean?
• The significance of the supply-‐demand mismatch

• Demand versus sales data
• Deriving probability distribu,ons of demand from rela,ve-‐frequency
distribu,ons of A/F, i.e. Actual/Forecast
• Compu,ng appropriate values of
Co = Cost of over-‐stocking a unit
Cu = Cost of under-‐stocking a unit
• Buyer’s point forecasts
• Behavioral considera,ons
Analysis

The significance of the supply-‐demand
mismatch
•

Annual costs of lost sales and back orders: $11M (conserva,ve
es,mate)
• Annual costs of overstocking: $10M
• Total annual cost of supply-‐demand mismatch: $21M
• Compare to annual sales of $528M, this cost amounts to 4%
of annual sales
• This figure is significant

Analysis

• Deriving probability distribu,ons of demand from rela,ve-‐frequency distribu,ons
of A/F, i.e. Actual/Forecast
Demand versus Sales
• The case says that true demand is known. Is this really true?
– Do they really record those requests which are not sa,sfied as actual
demand?
• Telemarketer to whom request comes needs to use a code to check whether the
item is in stock. Does the MIS system capture that even if the sale is not realized?
• In the online channel, customers may decide not to purchase or backorder if they
see that the item is unavailable.
– What about subs,tutes?
• A customer asks for a green shirt, which is out of stock and accepts a purple one
– Does the MIS system capture the demand for green one as an actual demand and the
purple one as a subs,tute?
Demand versus Sales
• Availability of the demand data or the sales data?
– Censored demand
– Subs,tutes
• How serious is failure to record a demand for an out-‐of-‐stock item?
– If an item with a cri,cal frac,le of .6 stocks out, and only thing we know about
the demand for that item is that it exceeds .6 frac,le, then we don’t know how to
calculate the .75 frac,le of A/F distribu,on
– If all items have the same cri,cal frac,le, the censoring may not be a very serious
problem.
– What if the overage and underage costs of different items dictate different
cri,cal ra,os?
• What about the mul,-‐item order cancella,ons?
– There is no way of knowing whether, and how oden, that occurs?
Analysis

Deriving Probability Distribu,ons of
Demand
• Approach behind the theory of A/F:
– If past point forecasts take into account those factors that are known
to affect demand, what is led is indis,nguishable “noise”
– The distribu,on of this “noise” is applicable to point forecasts of
future demand
Demand
• Approach behind the theory of A/F:
– If past point forecasts take into account those factors that are known
to affect demand, what is led is indis,nguishable “noise”
– The distribu,on of this “noise” is applicable to point forecasts of
future demand
• L.L. Bean observed that the A/F distribu,ons for new items and
never outs are dis,nguishable.
– A/F distribu,on for new items is more spread out (more difficult to forecast)
– Thus, it makes sense to segment in accordance with these two designa,ons
Demand
• Why use A/F? Why not A-‐F?
• Does it make sense that this works?
• Why do you think that they use this system?
• What kind of training would you like to give buyers?
Actual (A) versus Forecast (F)
30,000
25,000
20,000
Actual Demand
15,000
10,000

5,000
0
0
5,000
10,000
15,000
20,000
25,000
30,000
Forecast Demand
A-‐F versus Forecast
10,000
8,000
6,000
4,000
A -‐ F
2,000
0

0
5,000
10,000
15,000
20,000
25,000
30,000
-2,000
-4,000
-6,000
Forecast Demand
A/F versus Forecast
4.0
3.5
3.0
2.5
A / F
2.0
1.5
1.0
0.5
0.0
0
5,000
10,000
15,000
20,000
25,000
30,000
Forecast Demand
Log (A/F) versus Log (Forecast)

1.5

1.0

Log(A / F)
0.5

0.0
5 6 7 8 9 10 11
-0.5
-1.0
-1.5
-2.0
Log (Forecast)
Forecast Errors on 71 Items
A/F: Freq. Dist. & Probability Approxima?ons
Actual
Normal
Lognormal

1.0

0.9

0.8
Cumula?ve Probability

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
0.0
0.5 1.0 1.5
2.0
2.5
A/F
Analysis

Economics of Over and Under Stocking
• How much is gained by ordering one addi,onal unit?
– It is the revenue less the marginal cost of the item
– If the item must be paid for when delivered, and the revenue is received only
when it is sold, the “carrying cost” -‐-‐-‐ marginal warehousing cost plus interest
-‐-‐-‐ is part of the marginal cost
• How much is lost by ordering one addi,onal unit?
– Assuming the item is liquidated, it is the cost less the liquida,on revenue
– Liquida,on revenue may depend on how many items are liquidated
– If revenue from an overstocked unit depends on the total number of units
overstocked, the standard cri,cal-‐frac,le method is no longer appropriate
• Single item with a single ordering opportunity and one selling
season with random demand
– Selling price = p= $45
– Cost = c= $25
– End of season discount price = v= $15
– Demand forecast = 12,000 units
• What are the relevant costs?

Underage cost = Cu= p–c= 45 –25 = 20
Overage cost = Co= c–v= 25 –15 = 10
Cri,cal ra,o = Cu/ (Co+ Cu) = 20 / 30 = 0.6667
• What is the relevant demand data?

Pick Q with the A/F ra,o distribu,on
• Evaluate the A/F ratios for the nitems and sort them in ascending order
• Rank each item for 1 to n
• Evaluate the distribution function for each item, F(A/F) = item’s rank /n
• Use the distribution function table like the Standard Normal table to find an A/F
ratio that corresponds to the critical ratio
• F(1.16) = 0.6620 and F(1.18) = 0.6761, so choose a/f = 1.18
• Order quantity = A/F ratio x Forecast = 1.18 x 12000 = 14,160
L. L. Bean, Inc.: Pick Q with the A/F
ra,o distribu,on (graphical method)
• Are there any fixed costs that are to be considered?
– The fixed costs associated with the delivery of the order to L.L. Bean are
irrelevant unless one is considering whether to drop the item from catalog
• What about the joint costs?

– What should be charged for warehouse use?
• Nothing if the warehouse is not at capacity. Marginal cost of excluding one unit of the next-‐
most beneficial item (or the cost of outside retail space) is warehouse is full.
– How about postage?

• How to allocate the delivery cost in orders containing mul,ple items?
Joint costs and the intangible costs
• How about subs,tu,on ?
– If one more unit of an item is ordered and is needed, is the gain really the
difference between the selling price and cost?
• Not if the customer would voluntarily switch to another item that was in stock?
• What are the intangible costs?

– What if having an item at hand prevents
• The cancella,on of an order for mul,ple items
• Permanent loss of customer
– Monetary gain associated with that item is much greater than its margin
Mark Fasold’s concerns
• Cu> Co
• This means that Cu+ Co< Cu+ Cu= 2Cu
• Therefore, Cri,cal ra,o = Cu/(Cu+ Co) > Cu/(2Cu) = ½
• Marks’ concern is well posed, but if Cu> Co, ordering more than mean
demand is appropriate, unless there is reason to believe that the
model of demand is not accurate
Rol Fessenden’s concern
• Contribu,on margin es,ma,on does not include
– Holding cost: relevant for unsold items or those sold toward the end of the
season
– Quan,ty discounts on larger orders
• Liquida,on cost does not account for how many items are led
unsold and, consequently, where they are sent for liquida,on
– Where do you think the salvage value will be higher, at the Freeport LL Bean
outlet or at a TJ Max store?

• Rol Fessenden’s concerns are valid ones
Economics of Over and Under Stocking:
Summary
• The cri,cal frac,le economics are only a rough approxima,on to the
real world cash flows.
• Even where the approxima,on is quite good, deciding on what the
values of understocking and overstocking cost should be for a
par,cular item is far from trivial
• Nevertheless, it seems to be an appropriate way of taking into
account most of the factors that make it desirable to have an order
size that differs from the forecast
Analysis

The explosion in the number of
needed forecasts
Buyers need to generate point forecasts for about 6000 items!
Modeling forecast errors only at the level of “new” and “never out” items makes sense
Point Forecasts
• The A/F methodology permits forecastors to provide just point
forecasts
– The point forecasts are converted to a probability distribu,on by the use of
forecast errors
• What are the advantages of the current prac,ce?
– Buyers do not think probabilis,cally, and even if they did, it is unlikely that
they would give well-‐calibrated probabilis,c forecasts
– Each buyer must make a large number of forecasts per catalog.
• It is hard enough to think of a single item. Thinking of five or more
frac,les of the distribu,on of demand is just not prac,cal
Point Forecasts
• What should a buyer be thinking about when she makes a
forecast?
– Symmetry of the forecast errors: If the distribu,on of forecast errors
were symmetric around zero, then the “most likely” value makes
sense
– Most likely values:
• Unfortunately, A/F distribu,ons tend to be mul,plica,vely symmetric
• The distribu,on of log(A/F) is symmetric
– Mean, median, or mode: The buyer should think carefully which one
of these represents her point forecast
• Median is the easiest to teach people to assess
• Median also has drawbacks: Sum of the medians is not equal to the median
of the sum. Hence not useful if you are trying to triangulate the forecast
Analysis

Behavioral Considera,ons
• There is considerable evidence that buyers tend to be
op,mis,c at the item level:
– Evidence: The roll-‐up of an individual item forecast usually exceeds a
reasonable es,mate of the demand for the aggregate
– There is virtue in thinking about forecasts at different levels of
aggrega,on
• Preferably having those forecasts made by different people, reconciling the
differences
• There is also evidence that feeding back forecast errors

improves the process
– However, such feedback may cause overcorrec,on
Conclusion
• The mismatch between supply and demand is costly
– $21M on sales $528M (4%)
• Systema,c methods for choosing order quan,,es are needed

when managing hundreds or thousands of items
• Implementa,on of the Newsvendor model requires data on
forecast errors, i.e., you must quan,fy your uncertainty
– Keep track of past forecasts and actual demand to so that historical forecast
errors can be evaluated
– Keep in mind that actual demand does not equal sales if you stockout
• Opera,onal issues related to

– Standard cri,cal-‐frac,le methodology
– Gain in stocking an incremental unit that is demanded and the loss in failing
to do so
– Effects of subs,tu,on and complementarity on inventory decisions
– Prac,cali,es of probability assessment of demand distribu,ons
Conclusion -‐-‐-‐ System Improvement
• Use the following informa,on to arrive at demand
forecasts for new catalog items:
– Market research on consumer preferences
– Demand for similar items in the past
– Subs,tu,on and cannibaliza,on between products

Conclusion -‐-‐-‐ System Improvement
• Improve the current forecas,ng process via

– Taking individual forecasts instead of gevng a consensus, so that the
variability of a specific item can be obtained
– Establishing bewer supplier rela,onships and partnerships
– Calcula,ng A/F distribu,on for different item categories with similar risk, not
only for never-‐outs and new items
– Training buyers in forecas,ng and the meaning of infla,ng their forecast up
to the frac,le
– Assessing understocking and overstocking costs bewer
– Tracking data on subs,tu,on an cancella,on
– Capturing real demand, not sales

Case 3 LL Bean Solution

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Item

Forecas,ng and Inventory

• L.L. Bean implements standard cri,cal-­‐frac,le methodology

• The signiﬁcance of the supply-­‐demand mismatch

• The signiﬁcance of the supply-­‐demand mismatch

• Annual costs of overstocking: $10M

• Total annual cost of supply-­‐demand mismatch: $21M

• This ﬁgure is signiﬁcant

• Demand versus sales data

• Does it make sense that this works?

• Why do you think that they use this system?

• Demand versus sales data

• What are the relevant costs?

• What is the relevant demand data?

• What about the joint costs?

– How about postage?

• What are the intangible costs?

• Demand versus sales data

• Demand versus sales data

• There is also evidence that feeding back forecast errors

• Systema,c methods for choosing order quan,,es are needed

• Opera,onal issues related to

– Demand for similar items in the past

– Subs,tu,on and cannibaliza,on between products

– Establishing bewer supplier rela,onships and partnerships

– Assessing understocking and overstocking costs bewer

– Tracking data on subs,tu,on an cancella,on

– Capturing real demand, not sales

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• L.L. Bean implements standard cri,cal-‐frac,le methodology

• The signiﬁcance of the supply-‐demand mismatch

• The signiﬁcance of the supply-‐demand mismatch

• Total annual cost of supply-‐demand mismatch: $21M