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Product Availability

Level of product availability

Also referred as customer service level.

Is measured using the cycle service level or fill
rate.

Is high to improve the responsiveness and
attract customers.

But high level requires large inventories.
These large inventories tend to raise cost for SC.


Therefore, SC needs to balance between level of
inventory and cost of inventory.

Factors affecting optimal level of
product availability



Before understanding factors consider
one example of a storekeeper who sells
jacket.
He buys the stock for entire season’s
supply of jacket before start of selling
season.
High level of product availability requires
large number of jackets.
It is likely to satisfy all demands.
However, it results in a large number of
unsold jackets at the end of season.

Example…

On the other hand, low level of product
availability results in few unsold
jackets.

In this scenario, a loss of potential
customers has to bear.

Must balance the loss from having too
many unsold jackets and lost profit
from turning away customers.

Mattel, Inc. & Toys ‘R Us
Mattel was hurt last year by inventory cutbacks at Toys ‘R
Us, and officials are also eager to avoid a repeat of the 1998
Thanksgiving weekend. Mattel had expected to ship a lot of
merchandise after the weekend, but retailers, wary of
excess inventory, stopped ordering from Mattel. That led the
company to report a $500 million sales shortfall in the last
weeks of the year ... For the crucial holiday selling season
this year, Mattel said it will require retailers to place their full
orders before Thanksgiving. And, for the first time, the
company will no longer take reorders in December, Ms.
Barad said. This will enable Mattel to tailor production more
closely to demand and avoid building inventory for orders
that don't come.
- Wall Street Journal, Feb. 18, 1999
12-5

Key Questions
How much should Toys ‘R Us order
given demand uncertainty?
 How much should Mattel order?
 Will Mattel’s action help or hurt
profitability?
 What actions can improve supply chain
profitability?

12-6

Importance of the Level
of Product Availability
Product availability measured by cycle service level or fill rate
 Also referred to as the customer service level
 Product availability affects supply chain responsiveness
 Trade-off:

◦ High levels of product availability  increased responsiveness and
higher revenues
◦ High levels of product availability  increased inventory levels and
higher costs

Product availability is related to profit objectives, and strategic
and competitive issues (e.g., Nordstrom, power plants,
supermarkets, e-commerce retailers)
 What is the level of fill rate or cycle service level that will result
in maximum supply chain profits?

Factors Affecting the Optimal
Level of Product Availability


Cost of overstocking
Cost of understocking
Possible scenarios
◦ Seasonal items with a single order in a season
◦ One-time orders in the presence of quantity
discounts
◦ Continuously stocked items
◦ Demand during stockout is backlogged
◦ Demand during stockout is lost

Cost

of overstocking = C0
◦ Is the loss incurred by a firm for each unsold
unit at the end of selling season.

of understocking = Cu
◦ Is the margin lost by a firm for each lost sale
from current and future sales if customer does
not return.

Two factors that affect optimal level of
product availability.
◦ Cost of overstocking
◦ Cost of understocking

Optimal level of product
availability

Makes sense in the context of demand
uncertainty.

Firms have forecast a consensus estimate of
demand without any measure of uncertainty.

Now they have better appreciation for
uncertainty.

Incorporation of uncertainty and optimal level
of product availability can increase profit.

Example
Demand distribution for jackets
Demand Di (*100)

Probability

Cumulative probability of
demand being Di or less

probability of demand
being greater then Di

4

0.01

0.01

0.99

5

0.02

0.03

0.97

6

0.04

0.07

0.93

7

0.08

0.15

0.85

8

0.09

0.24

0.76

9

0.11

0.35

0.65

10

0.16

0.51

0.49

11

0.20

0.71

0.29

12

0.11

0.82

0.18

13

0. 10

0.92

0.08

14

0.04

0.96

0.04

15

0.02

0.98

0.02

16

0.01

0.99

0.01

17

0.01

1.00

0.00

Example

Expected profit from ordering a thousands of jacket
10

Expected profit    Di (p  c)  (1000  Di )(c  s)   (1  Pi )1000(p  c)
i4

=$49,900
Potential outcome to buy 100 more jackets
◦ If extra 100 are sold, then profit=$5,500
◦ If 100 units are send to outlet, then loss=$500

From table, there is 0.49 probability that demand is 1100 or higher
and a 0.51 probability that demand will be 1000 or less.

Expected profit=$5,500Xprob[Demand≥1,100]
-$500Xprob[Demand<1,100]

=$5,500*0.49-500*0.51=$2,440
 Expected profit from ordering 1,100 is 5% greater than that of
ordering 1,000.

Optimal cycle service level
for seasonal items
Focus on seasonal product where
leftover items must be disposed at the
end of season.
 Input:

C0: cost of overstocking = c-s
Cu: cost of understocking =p-c
CSL*=optimal cycle service level
O*=corresponding optimal order size
CSL*=probability that demand during season
will be at or below O*.

Optimal cycle service level
for seasonal items

Rise in quantity from O* to O*+1 is with
probability 1-CSL*
◦ Expected profit of purchasing extra unit= (1CSL*)(p-c)
◦ If additional unit remains unsold if demand is
below O*
◦ Expected cost of purchasing cost of extra
unit=CSL*(c-s)

Expected marginal contribution of raising the
order size from O* to O*+1=(1-CSL*)(p-c)CSL*(c-s)

Optimal cycle service
level for seasonal items

Expected marginal cost=0
◦ CSL*=probability (demand≤O*)= (p-c)/(p-s)
◦ C0/(Cu+C0)=1/{1+(C0/Cu)}
◦ Optimal CSL* is referred as critical fractile

If demand during season is normally distributed with
mean µ and standard deviation σ, optimal order
quantity
◦ O*=F-1(CSL*, µ, σ)  p  s  Fs  O      p  s  fs  O    
  
  
◦ Expected profit=

O(c  s)F(O, , )  O(p  c)[1  F(O, , )]

◦ Fs is the standard normal cumulative distribution function and
fs is the standard normal density function

Desired cycle service level for
continuously stocked items
Focus on products such as detergent that are
ordered repeatedly.
 Organization uses safety inventory to increase the
level of safety inventory to avoid stocking out.
 Left over detergent can be sold in next cycle.
 However, holding cost is incurred form one cycle to
next cycle.
 Two extreme scenarios

◦ All demands that arises when the product is out of stock is
backlogged and filled later
◦ All demand arising when product is out of stock is lost.

When Demand during stockout
is backlogged
No demand is lost, minimizing costs is
equivalent to maximizing profit.
 When store is out of stock, discount of Cu is
provided to each customer.
 Ensures that each customer will return.

◦ Increase in safety inventory satisfies more orders
resulting in less backlogs
◦ Cost of holding inventory increases.
◦ Level of safety inventory that minimizes backlogs
and holding cost??

Optimal cycle service level
CSL*=1-(HQ/DCu)

Example

Input
◦ Q=400 gallons, ROP= 300 gallons, D=100
gallons, σD=20, unit cost=$3, holding cost
as a fraction of cost h=0.2, cost of holding
one unit for one year=0.6 Lead time =2
weeks
◦ Cost of stocking out?? If all unfilled
demand is backlogged and carried over to
next cycle.

Solution
Mean demand over lead time DL=DL=200
gallons
 Standard
deviation
of demand in lead time
L  D L
 20 2  28.3

CSL=F(ROP, DL, σL) =F(300, 200, 28.3)
 CSL=NORMDIST(300, 200, 28.3, 1)=0.9998
 Imputed cost of stocking out Cu=HQ/(1CSL)Dyear=0.6*400/0.0002*5,200=230.8 per
gallon

When Demand during stock out is lost

Optimal cycle service level CSL*
CSL*=1-HQ/(HQ+DCu)
Cu is the cost of loosing one unit of
demand during stockout period.

Managerial levers to improve
SC profitability

Focus on actions that can be taken to improve
the SC profitability
Two obvious managerial levers
1. Increasing the salvage value of each unit increases
profitability.
2. Decreasing the margin lost from a stockout
increases profitability.

Strategies to
1. Increase to salvage value include selling outlet
stores so that left units are not merely discarded.
2. To decrease the margin lost in a stockout include
arranging the backup sourcing so that customers
are not lost forever.

Importance of the Ratio of cost of
overstocking and understocking

If this gets smaller, optimal level of
product availability increases.

Another lever
Is to reduction of demand uncertainty.
 By this, better supply and demand can
be matched by reducing over and
understocking.
 Means to reduce demand uncertainty.




Improved forecasting
Quick response
Postponement
Tailored sourcing

Improving forecast
Helps the demand planning information
systems.
 Can help a firm to increase its
profitability while decreasing excess
inventory overstock and sales lost due
to understocking.

Improved Forecasts
Improved forecasts result in reduced
uncertainty
 Less uncertainty (lower R) results in
either:

◦ Lower levels of safety inventory (and costs) for
the same level of product availability, or
◦ Higher product availability for the same level
of safety inventory, or
◦ Both lower levels of safety inventory and
An increase
in forecast
decreases
both the overstocked
higher
levels accuracy
of product
availability
and understocked quantity and increases a firm’s profits.

Impact of Improving Forecasts
(Example)
Demand: Normally distributed with a mean
of R = 350 and standard deviation of R =
100
Purchase price = $100
Retail price = $250
Disposal value = $85
Holding cost for season = $5
How many units should be ordered as R
changes?

Impact of Improving Forecasts
R

O*

150

526

120

491

149.3

6.9

$48,476

90

456

112.0

5.2

$49,482

60

420

74.7

3.5

$50,488

30

385

37.3

1.7

$51,494

0

350

0

0

$52,500

Expected Expected Expected
Overstock Understock Profit
186.7
8.6
$47,469

Quick response
Is the set of actions a supply chain takes that
leads in the reduction of lead time.
 Decrease in lead time results in increase in
forecast accuracy.
 This allows them to better match with the
demand and increase in profitability.
 Typically, buyers are able to make accurate
forecasts once they have observed demand
in first or second week in season.

Quick Response
Set of actions taken by managers to reduce lead time
 Reduced lead time results in improved forecasts

◦ Typical example of quick response is multiple orders in one season
for retail items (such as fashion clothing)
◦ For example, a buyer can usually make very accurate forecasts after
the first week or two in a season
◦ Multiple orders are only possible if the lead time is reduced –
otherwise there wouldn’t be enough time to get the later orders before
the season ends

Benefits:
◦ Lower order quantities  less inventory, same product availability
◦ Less overstock
◦ Higher profits

If quick response allows multiple orders in the season, profits
increase and the overstock quantity decreases.

Example




Selling season is of 14 weeks.
Replenishment time is 25 to 30 weeks.
Difficult for a buyer to make a accurate
forecast of demand this far in advance.
This results in high demand uncertainty,
leading the buyer in too many or too less units
each year.
Consider a case where replenishment time
can reduce upto 6 weeks.
Its results in entire seasons purchase in two
orders.

Variation of profit and inventories with
forecast accuracy

Expected over stock

Expected profit

Expected understock

Standard deviation of forecast error

Quick Response: Multiple
Orders Per Season

Ordering shawls at a department store




Selling season = 14 weeks
Cost per handbag = $40
Sale price = $150
Disposal price = $30
Holding cost = $2 per week

Expected weekly demand = 20
 SD of weekly demand = 15

Comparison of two policies
A single order must arrive at the beginning
of the season to cover the entire seasons
demand.
Two orders are placed in the season, one
arriving at the beginning of the season and
other arriving at the beginning of the eight
week.
Now consider two instances

1.

2.

3.

One where buyers forecast accuracy does not
improve for the second order and where it
improves and the SD can be reduced.

Comparison
Single order: consists of a quantity ordered at
the beginning of season.
 Two orders: consists of initial order quantity for
first seven weeks followed by an order upto
level for the second week.
 Second round quantity should account for sales
during the first week and inventory remaining.
 The quantity ordered in second round it the
difference between order up-to-level and
inventory remaining after first week.

Consequences of being able to
place a second order
1.

Consequences
1.
2.
3.

The expected total quantity ordered during the season
with two orders is less than that with a single order for the
same cycle service level.
The average overstock to be disposed of at the end of the
sales season is less if two orders are allowed.
The profits are higher when a second order is allowed
during the sales season.

Total quantity is broken up into
multiple smaller orders, the buyer is
better able to match supply and
demand and increase profitability.

Impact of Quick Response
Single Order

Two Orders in Season

Service Order Ending Expect. Initial OUL
Level
Size Invent. Profit
Order for 2nd
Order
0.96
378
97
$23,624 209
209

Average Ending Expect.
Total
Invent. Profit
Order
349
69
$26,590

0.94

367

86

$24,034 201

201

342

60

$27,085

0.91

355

73

$24,617 193

193

332

52

$27,154

0.87

343

66

$24,386 184

184

319

43

$26,944

0.81

329

55

$24,609 174

174

313

36

$27,413

0.75

317

41

$25,205 166

166

302

32

$26,916

Forecast Improves for Second
Order (SD=3 Instead of 15)
Single Order

Two Orders in Season

Service Order Ending Expect. Initial OUL
Level
Size Invent. Profit
Order for 2nd
Order
0.96
378
96
$23,707 209
153

Average Ending Expect.
Total
Invent. Profit
Order
292
19
$27,007

0.94

367

84

$24,303 201

152

293

18

$27,371

0.91

355

76

$24,154 193

150

288

17

$26,946

0.87

343

63

$24,807 184

148

288

14

$27,583

0.81

329

52

$24,998 174

146

283

14

$27,162

0.75

317

44

$24,887 166

145

282

14

$27,268

Postponement




Delay of product differentiation until closer to the time of the sale
of the product
All activities prior to product differentiation require aggregate
forecasts more accurate than individual product forecasts
Individual product forecasts are needed close to the time of sale
– demand is known with better accuracy (lower uncertainty)
Results in a better match of supply and demand
Valuable in e-commerce – time lag between when an order is
placed and when customer receives the order (this delay is
expected by the customer and can be used for postponement)
Higher profits, better match of supply and demand

Postponement allows a firm to increase profits and better match supply and
demand if the firm produces a large variety of products whose demand is not
positively correlated and is of about the same size.

Postponement
Refers to the delay of product
differentiation until closer to the sale of
product.
 Aggregate forecasts are more accurate
then individual product forecasts.
 Individual forecasts are required close to
the time of sale when demand is known
with greater accuracy.
 Allows a SC to better match SC demand.

Postponement…
A powerful managerial tool to increase
profitability.
 However, while using it production cost
would be higher than the case where
there is no postponement.
 Is valuable to for a firm that sells a
large variety of products with demand.

Value of Postponement:
Benetton

For each color

◦ Mean demand = 1,000; SD = 500

For each garment
◦ Sale price = $50
◦ Salvage value = $10
◦ Production cost using Option 1 (long lead time) =
$20
◦ Production cost using Option 2 (uncolored
thread) = $22

What is the value of postponement?
◦ Expected profit increases from $94,576 to
$98,092

Value of Postponement
with Dominant Product
Color with dominant demand: Mean =
3,100, SD = 800
 Other three colors: Mean = 300, SD = 200
 Expected profit without postponement =
$102,205
 Expected profit with postponement =
$99,872

Tailored postponement


A firm uses production with postponement to satisfy a
part of demand with the rest being satisfied without it.
Produces higher profits then when no postponements
is used or all are produced using postponement.
A firm produces a portion of demand which is
uncertain, postponement significantly improves the
forecasts accuracy.
Thus, allows a firm to increase its profitability by only
postponing the uncertain part of the demand and
producing the predictable part at a lower cost without
postponement.

Tailored Postponement:
Benetton

Produce Q1 units for each color using Option 1 and QA
units (aggregate) using Option 2
Results:
◦ Q1 = 800
◦ QA = 1,550
◦ Profit = $104,603
Tailored postponement allows a firm to increase profits by
postponing differentiation only for products with the most
uncertain demand; products with more predictable
demand are produced at lower cost without postponement

Tailored Sourcing
A firm uses a combination of two supply
sources
 One is lower cost but is unable to deal with
uncertainty well
 The other is more flexible, and can therefore
deal with uncertainty, but is higher cost
 The two sources must focus on different
capabilities
 Depends on being able to have one source
that faces very low uncertainty and can
therefore reduce costs
 Increase profits, better match supply and
demand

Tailored sourcing
Firms uses a combination of two supply sources

1.
2.

Focusing on cost but unable to handle the uncertainty.
Focusing on flexibility to handle uncertainty but at higher cost.

But, to be effective, having supply sources where one
serves as the backup to other is not sufficient.



The first should be required to supply the predictable portion
of demand.
The second should be responsive and be required to supply
the uncertain portion of demand.
Allows to better match supply and demand and increase of
profit.

Tailored sourcing…

Value depends on the reduction in cost
that can be achieved.

Small benefit— it may not be ideal.

May be volume based or product based
depending on source depending on the
source of uncertainty.

Volume based

Tailored sourcing, the predictable part of a
product’s demand is produced at an efficient
facility.

Should be considered by firms that have
moved a lot of their production overseas to
take advantage of lower costs.

In this condition source with shorter lead time
is more profitable even if he is more
expensive.

Product based

Low volume product with uncertain demand are
obtained from a flexible source while high volume
product with less demand uncertainty are obtained form
an efficient source.

New products have a very uncertain demand while well
established products have more stable demand.

May be implemented with a flexible facility focusing on
new products and efficient facilities focusing on well
established products.

Tailored Sourcing

Sourcing alternatives
◦ Low cost, long lead time supplier
 Cost = $245, Lead time = 9 weeks

◦ High cost, short lead time supplier
 Cost = $250, Lead time = 1 week

Tailored Sourcing Strategies
Fraction of demand from
overseas supplier
0%

Annual Profit
$37,250

50%

$51,613

60%

$53,027

100%

$48,875

Tailored Sourcing: Multiple
Sourcing Sites
Characteristic

Primary Site

Secondary Site

Manufacturing High
Cost
Flexibility
High
(Volume/Mix)
Responsiveness High

Low

Engineering
Support

Low

High

Low
Low

Dual Sourcing Strategies
Strategy

Primary Site

Volume based Fluctuation
dual sourcing
Product based Unpredictable
dual sourcing products,
Small batch
Model based Newer
dual sourcing products

Secondary Site
Stable demand
Predictable,
large batch
products
Older stable
products

Setting Product Availability for Multiple
Products under Capacity Constraints
Single product order
 Multiple product order
 Decrease the order size
 Allocating the products

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




Use an analytical framework to increase
profits
Beware of preset levels of availability
Use approximate costs because profitmaximizing solutions are very robust
Estimate a range for the cost of stocking
out
Ensure levels of product availability fit with
the strategy