Logistics Strategy & Logistics Systems

Lecture 22
Inventory Policy Decisions

Course Instructor: Sayda Uzma Tahira

UCP Business School, University of Central Punjab Lahore
 Multi-Echelon Inventories
Control the entire channel inventory levels, not just a
single echelon.
How much stock here when
retailers also carry stock?
Warehouse
echelon
R1

End customer demand

d 1 , s d1
Warehouse
lead-time, LTw R2
S W
d 2 , sd2
Supplier Warehouse

R3
d 3 , sd3
Retailer

9-2
 Multi-Echelon Inventories (Cont’d)
Example
An item has the following cost characteristics. Item
values are CR=$10/unit and CW=$5/unit. Carrying cost
is I = 20%/year. Ordering costs are SR=$40/order and
SW=$75/order. Lead times are LTR=0.25 month and
LTW=0.5 months. In-stock probability for retailers and
warehouses is 90%. Monthly demand statistics are:
Monthly Std. dev.,
avg., units units
Retailer 1 202.5 16.8
Retailer 2 100.5 15.6
Retailer 3 302.5 18.0
Combined 605.5 32.4
9-3
 Multi-Echelon Inventories (Cont’d)
Solution
Based on reorder point inventory control, the retailers’
inventory statistics are
Retailer 1 Retailer 2 Retailer 3
Reorder qty, Q 312 220 381
Reorder point, ROP 61 35 87
Avg. inv., AIL 167 120 202

The warehouse echelon order quantity is

2DW SW
QW   2(605.5x12)(75)  1,043.98, or 1,044 units
ICW 0.20(5)
ROPW  dW xLTW  zsW LTW  605.5(.5) 1.28(32.4) .5
 332 units
9-4
 Multi-Echelon Inventories (Cont’d)
The warehouse echelon inventory is
QW
AILW   zsW LTW
2
 1,043.98 1.28(32.4) 0.5
2
 551.32. or 551units
The average warehouse inventory is the warehouse
echelon inventory less the retailers’ inventory, or 551
– 167 –120 – 202 = 62 units.
Rule
Rule When
Whenthe thetotal
totalwarehouse
warehouseinventory
inventory(sum
(sumofof
retailers’
retailers’inventory,
inventory, inventory
inventoryat
at the
thewarehouse
warehouseandandon
on
order,
order, and
andretailers’
retailers’orders
ordersless
lessany
anyinventory
inventory committed
committed
to
tocustomers
customersdrops
dropsbelow
below332
332units,
units,order
order1,044
1,044units.
units.
9-5
 Aggregate Inventory Control
Product items can be grouped according to 80-20
curve, each with different stocking policies
100
90
80
Total sales (%)

70
60
50
40
30
A items B items C items
20
10
0
0 20 40 60 80 100
CR (2004) Prentice Hall, Inc.
Total items (%) 9-6
9-72
 Inventory Consolidation
(“Risk Pooling”)
Illustration of risk pooling

Suppose there is a product stocked in two warehouses.

The replenishment quantities are determined by the
economic order quantity formula. The replenishment
lead-time is 0.5 months, the cost for a replenishment
order is $50, the inventory carrying cost is 2% per
month, and the item value is $75 per unit. The
probability of an out of stock during the lead-time period
is 2.5%. The demand is normally distributed with
typical demand over six months as follows.

9-7
 Risk Pooling (Cont’d)
Combined
Demand Demand Demand in a
in Whse in Whse Central
Month A B Whse
1 35 67 102
2 62 83 145
3 46 71 117
4 25 62 87
5 37 55 92
6 43 66 109
Avg. (D) 41.33 67.33 108.66
6
Std. Dev. (sd) 11.38 8.58 19.07

Estimate the average inventory levels for two-

warehouse and one-warehouse supply channels.
9-8
 Risk Pooling (Cont’d)
Regular stock

2DS
RS  Q  IC
2 2
2(41.33)(50)
RSA  0.02(75)  52.49  26.25 units
2 2
2(67.33)(50)
RSB  0.02(75)  67.00  33.50 units
2 2
Regular stock in system is
R S s  R S A  R S B  2 6 . 2 5  3 3 . 5 0  5 9 . 7 5 u n its
9-9
 Risk Pooling (Cont’d)
Regular stock if item is entirely in one warehouse

2(108.66)(50)
RSC  0.02(75)  85.11 42.56 units
2 2
Safety stock
SS  z(sd ) LT

SSA  1.96(11.38) 0.5  15.77 units

SSB  1.96(8.58) 0.5  11.89 units
System safety stock in 2 warehouses
S S A  S S B  1 5 . 7 7  1 1 . 8 9  2 7 . 6 6 u n its
9-10
 Risk Pooling (Cont’d)
Safety stock in 1 warehouse
S S c  1.96(19.07) 0.5  26.43 units

Total inventory
Two
AIL = Regular stock + Safety stock warehouses

AIL = 59.75 + 27.66 = 87.41 units

In a one-warehouse channel
AIL = 42.56 + 26.43 = 68.99 units
Conclusion
Conclusion ThereThereisisaa reduction
reductionin
inthe
theaverage
average
inventory
inventorylevel
levelof
of an
anitem
itemasas the
thenumber
numberof of stocking
stocking
points
pointsin
in the
thesupply
supplychannel
channelisis decreased.
decreased. InInthis
this
example,
example, both
bothregular
regularstock
stockand
andsafety
safetystock
stock decline.
decline. 9-11
9-77
 Virtual Inventories
•Stockouts are filled from other stocking locations in
the distribution network
• Customers assigned to a primary stocking location
• Backup locations are usually determined by
“zoning” rules
• Expectation is that lower system-wide inventories
can be achieved while maintaining or improving
stock availability levels
• Total distribution costs should be lower to support
the cross filling of customer demand

9-12
Cross Filling Among 2
Stocking Locations
Stock Stock
location A location B
assignment

assignment
Primary

Primary
Secondary
assignment
Demand 1 Demand 2
9-13
 Potential Benefit
of Cross Filling
Suppose that an item is stocked at a fill rate of 80% in
4 stocking locations. If cross filling is used, what is
the effective fill rate for the customer?
Fill rate = [1 – (.20)(.20)(.20)(.20)] x 100 = 99.8%

Customer service levels can be quite high

even if the item fill rate is low!
But are inventory costs lower?
Virtual Inventories
9-14
 Regular Stock in 2 Locations

•Meaning of regular stock Stock

location A
Stock
location B

•How it varies with:

assignment

assignment
Primary

Primary
Demand dispersion Secondary
assignment

Demand 1 Demand 2

Method of stock control

Fill rate

Virtual Inventories
9-15
9-82
 Stock Control Methods
and Regular Stock
If control is EOQ-based, average inventory level (AIL) is
EOQ
formula 0.5
2S D






AIL  Q  IC
 
   kD0.5
2 2
AIL is a function of
demand with
If stock-to-demand control exponents ranging
from 0.5 to 1.0
A IL  k D 1 .0
Virtual Inventories
9-16
 Observation about
Regular Stock
A system of multiple stocking locations
will carry its maximum regular stock
when demand is balanced among them

Virtual Inventories
9-17
 Fill Rate and Regular Stock
Cross filling increases regular stock as lower fill rates
are specified

Example

•2 locations
•Demand is dispersed 50 and 150
•Fill rate is 90%
•Stocking policy is D with k=1
0.5

Virtual Inventories
9-18
 Example (Cont’d)
No cross filling Cross filling

Location A Location B Location A Location B

Demand 1 50 0 45a 5b
Demand 2 0 150 15 135
Total 50 150 60 140
Regular stock 7.1 12.2 7.7 11.8
System inv. 19.3 19.5
a
50x.90=45
b
[50x(1-0.90)]x0.905 Regular stock increases
with cross filling
Virtual Inventories
9-19
9-87
 Safety Stock in 2 Locations Stock Stock
locationA
location A locationB
location B

assignment

assignment
Primary

Primary
•Meaning of safety stock Secondary

•Safety stock depends on

assignment

Demand 1 Demand 2

Demand dispersion (variance is proportional

to (demand)
Fill rate
Observation
A system of multiple stocking
locations will carry its minimum
safety stock when demand is
balanced among them
Virtual Inventories
9-20
9-89
 Safety Stock Estimation
Safety stock is estimated by

s s  zs * L T
where s* is the demand standard deviation at
location N

When cross filling,

s*  F R 2 s d2
where sd is the demand standard deviation at the
primary location

At any location N
s N*  [ F R (1  F R ) N  1 ] 2 s d2
Virtual Inventories 9-21
 Safety Stock in 2 Locations
Example

•2 locations
•Weekly demand and std. dev. are (50,5) and
(150,15)
•Lead time is 1 week
•Fill rate (FR) is 95%
•z is 1.65 for 95% stocking level (demand normally
distributed)
•Inventory control is EOQ based
Virtual Inventories 9-22
Safety Stock for 2 Locations
No cross filling Cross filling

Location A Location B Location A Location B

Std. Dev. 1 5 0 4.7500 0.2375
Std. Dev. 2 0 15 0.7125 14.2500
Combined 5 15 4.8 14.3
Safety stock 8.3 24.8 7.9 23.5
System inv. 33.1 31.4

Safety stock decreases

with cross filling

s s  zs * L T
9-23
9-92
 Turnover Ratio
A nnua l sale s
Turno ver ratio 
A ve ra g e inve ntory
A fruit grower stocks its dried fruit products in 12 warehouses
around the country. What is the turnover ratio for the
distribution system?

Ware- Annual Average Ware- Annual Average

house warehouse inventory house warehouse inventory
no. throughput, $ level, $ no. throughput, $ level, $
1 21,136,032 2,217,790 7 43,105,917 6,542,079
2 16,174,988 2,196,364 8 47,136,632 5,722,640
3 78,559,012 9,510,027 9 24,745,328 2,641,138
4 17,102,486 2,085,246 10 57,789,509 6,403,076
5 88,228,672 11,443,489 11 16,483,970 1,991,016
6 40,884,400 5,293,539 12 26,368,290 2,719,330
Totals 425,295,236 43,701,344

$425,295,236
TO ratio   9.7 $ are at cost
$43,701,344 9-24
 A table entry is the proportion of the

Areas under area under the curve from a z of 0 to a

positive value of z. To find the area
from a z of 0 to a negative z, subtract the
tabled value from 1.

Standardized z
0.0
0.1
.00
0.5000
0.5398
.01
0.5040
0.5438
.02
0.5080
0.5478
.03
0.5120
0.5517
.04
0.5160
0.5557
.05
0.5199
0.5596
.06
0.5239
0.5636
.07
0.5279
0.5675
.08
0.5319
0.5714
.09
0.5359
0.5753

Normal
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224

Distribution 0.6
0.7
0.8
0.9
0.7257
0.7580
0.7881
0.8159
0.7291
0.7611
0.7910
0.8186
0.7324
0.7642
0.7939
0.8212
0.7357
0.7673
0.7967
0.8238
0.7389
0.7704
0.7995
0.8264
0.7422
0.7734
0.8023
0.8289
0.7454
0.7764
0.8051
0.8315
0.7486
0.7794
0.8078
0.8340
0.7517
0.7823
0.8106
0.8365
0.7549
0.7852
0.8133
0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3.0 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
3.1 0.9990 0.9991 0.9991 0.9991 0.9992 0.9992 0.9992 0.9992 0.9993 0.9993
3.2 0.9993 0.9993 0.9994 0.9994 0.9994 0.9994 0.9994 0.9995 0.9995 0.9995
3.3 0.9995 0.9995 0.9995 0.9996 0.9996 0.9996 0.9996 0.9996 0.9996 0.9997 9-25
9-104
3.4 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9998
Unit Normal
Loss
Integrals

9-26
9-105