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Inventory Management & Risk Pooling

Jerry Banks
Forms of inventory
• Inventory appears in the supply chain as
– Raw materials
– WIP
– FGI
• Must take into account the interactions at
various levels in the supply chain
Customers,
Field demand
Sources: Regional Warehouses: centers
plants Warehouses: stocking sinks
vendors stocking points
ports points

Supply

Inventory &
warehousing
costs
Production/
purchase Transportation Transportation
costs costs costs
Inventory &
warehousing
© Copyright 1999 D. Simchi-Levi, P. Kaminshy & E. Simchi-Levi costs
Why hold inventory?
• To protect from variations in demand
– Uncertainty has increased recently
• Short life cycles and an increasing number of
products implies that historical data about demand
may not be available
• One product group may have many different forms
Why hold inventory?
• Supplier unreliability
– Quantity delivered
– Quality of those delivered
– Lead time is variable
Why hold inventory?
• Economies of scale
– Shipping costs are not linear
– Quantity discounts
Managing inventory can be difficult

• In 1993, Dell Computer’s stock plunged


after the company predicted a loss
– Dell acknowledged that the company was
sharply off in its forecasts of demand resulting
in inventory write-downs
Managing inventory can be difficult

• In 1993, Liz Claiborne experienced an


unexpected earnings decline
– Caused by excess inventories
Managing inventory can be difficult

• In 1994, IBM struggled with shortages in


the ThinkPad line
– Caused by ineffective inventory management
Managing inventory can be difficult
• As reported in Business Week (May 20, 2002),
Boeing suffered parts shortages and overtime
surrounding the time they were in the merger
process with McDonnell Douglas
– Report of a special team,
• “Our production system is broken.”
• Supply problems prevented Boeing from getting
enough seats and electronic gear on time
Managing inventory can be difficult

• In 2001 Cisco Systems had losses in the


billions due to inventory write downs
– Routers were outdated
Managing inventory can be difficult
• Current profits (September 2002) for Shiseido, a
Japanese cosmetics maker
– US$81,000,000
• Year-ago profits
– US$12,000,000
• How did they do it?
– Networked factories, retailers, and sales force to reduce
inventory by 1/3rd
– Source: Business Week, company reports
Many problems are caused by
demand forecasts
• What is the relationship between demand
and inventory ordering?
What is an inventory policy?
• When to order
• How many to order
• From what source
What are the key factors in
developing an inventory policy?
• Demand
– Deterministic
– Random
• Forecasting techniques
– Exponential smoothing
– Trend
– Trend and seasonality
• Variability is often considered
What are the key factors in
developing an inventory policy?
• Lead time
– Deterministic
– Random
• Distribution
What are the key factors in
developing an inventory policy?
• Number of products in the warehouse
– Constraints on space
– Constraints on orders/year
What are the key factors in
developing an inventory policy?
• The planning horizon
– One period
– Infinite
What are the key factors in
developing an inventory policy?
• Costs
– Ordering
• Transportation
• Information technology
• Stocking
– Setup
• In a production system
What are the key factors in
developing an inventory policy?
• Costs
– Holding
• Taxes and insurance
• Maintenance
• Obsolescence
• Opportunity
– Money could have earned interest
What are the key factors in
developing an inventory policy?
• Service level requirements
– 90%
– 95%
– 99%
Poisson ( = 5)
x p(x) F(x)
0 0.006738 0.006738
1 0.03369 0.040428
2 0.084224 0.124652
3 0.140374 0.265026
4 0.175467 0.440493
5 0.175467 0.615961
6 0.146223 0.762183
7 0.104445 0.866628
8 0.065278 0.931906
9 0.036266 0.968172
10 0.018133 0.986305
11 0.008242 0.994547
12 0.003434 0.997981
13 0.001321 0.999302
14 0.000472 0.999774
Economic lot size model
• EOQ model
• Ford W. Harris in 1915
• Trades off ordering and storage costs
• Single item
Assumptions for the EOQ model
• Demand/day (D) is constant
• Order quantity (Q) is fixed
• Ordering cost/order (K)
• Inventory carrying cost/day (h) for every unit in
inventory
• Lead time is 0
• Starting at inventory level of 0
• Infinite planning horizon
Is the EOQ model realistic?
• D is not constant
• K is often hard to determine
• h can vary widely
• Lead time is positive and random
• However, we gain valuable insights from
the EOQ model
EOQ Model

Avg Inv

Time
T
Costs for one cycle
• Ordering cost
–K
• Holding cost
– hT [Q/2]
• Total cost
– K + hT[Q/2]
Total cost per day
• TC = K/T + h [Q/2]
• But, T = Q/D
• So, TC = [KD]/Q + h[Q/2]
Finding the optimal
• Take the derivative of TC wrt Q and set it to
zero
– d(TC)/dQ = -[KD]/Q2 + h/2 = 0
• Solve for Q
– [KD]/Q2 = h/2
– Q2 = 2KD/h
– Q* = SQRT(2KD/h)
Example
• Mug sales
• D = 20/week
• K = $12
• Lead time = 0
• h = .25 of inventory value
• Mugs cost $1, sell for $5
• Find Q*
Solution
• Q* = SQRT{2(12)(20)]/[(.25)/52]}
• Q* = 316
Relative Insensitivity of Q
Q TC/week
250 1.560962
275 1.533785
300 1.521154
316 1.519109
325 1.519712
350 1.52706
375 1.541442
Even when Q is far away
• Q = 200
– TC = $1.68
• Q = 400
– TC = $1.56
Shaped like the letter U
1.7

1.65

1.6

1.55 TC

1.5

1.45

1.4
200 250 300 350 400
But, demand is uncertain
• Even though many firms treat it as
predictable
– Production decisions are made on the basis of
forecasts made far in advance
• Forecasts are always wrong
• The longer the horizon, the worse the forecast
• Aggregate forecasts are more accurate
Case: Swimsuit production
• Six months in advance, production
quantities are set
• Overestimating results in unsold units
• Underestimating demand leads to shortage
costs
• Historical data is available for the past five
years
Demand forecast
30% 28%
25%
22%
20% 18%
15%
11% 11% 10%
10%

5%

0%
8000 10000 12000 14000 16000 18000
Unit sales
Additional information
• Fixed production cost of $100,000
• Variable production cost of $80/unit
• Sales price of $125/unit
• Salvage value of $20/unit
Profit model
• D = Demand, Q = Production Quantity
– Q > D, 125D - 80Q + 20 (Q - D) - 100000
– = 105D - 60Q - 100000
– D > Q, 125Q - 80Q - 100000
– = 45Q - 100000
For example
• D = 12000, Q = 10000
– Profit = 45(10000) - 100000 = 350000
• D = 8000, Q = 10000
– Profit = 105(8000) - 60(10000) -100000 =
140000
When Q = 12000

Probability Demand Profit


.11 8000 Q>D 20000
.11 10000 Q>D 230000
.28 12000 D=Q 440000
.12 14000 D>Q 440000
.18 16000 D>Q 440000
.10 18000 D>Q 440000
Which is better?
• Profit of 20000 with probability of .11
• Profit of 440000 with probability of .68
Expected profit when Q = 12000
• Expected profit = .11(20000) + … + .10(440000)
• Expected profit = 326700
Expected profit as a function of Q
350000

300000

250000
Exp Profit
200000

150000

100000
8000 10000 12000 14000 16000 18000
Production Quantity
Insight
• Since there is a marginal profit of $45 for each
unit short, but a marginal loss of $60 for each unit
of excess production, the production should be
less than the average demand
– Average demand is .11(8000) + …+ .10(18000)
– Or, 12008
– Profit when Q = 10000 is $326900
– Profit when Q = 12000 is $326700
Questions
• Profit for Q = 8000 is about the same as
profit for Q = 15000
• Which one would you choose?
• Profit for Q = 16000 has a .11 probability of
a loss of $220,000 (if D = 8000)
• What about that?
More insights
• Q* is not necessarily equal to average
demand
– Depends on the relationship between marginal
profit and marginal cost
• As Q increases, average profit typically
increases until Q reaches a maximum then
begins to increase
More insights
• As Q increases, the probability of large
losses increases
– At the same time, the probability of large gains
also increases
More interesting with shortage cost

• D = Demand, Q = Production Quantity


– Q > D, 125Q - 80Q + 20 (Q - D) - 100000
– = 105D - 60Q - 100000
– D = Q, 125Q - 80Q - 100000
– = 45Q - 100000
– D > Q, 125Q - 80Q - 100000 - 45(D - Q)
– = 90Q - 45D - 100000
When Q = 12000 with shortage cost

Probability Demand Profit


.11 8000 Q>D 20000
.11 10000 Q>D 230000
.28 12000 D=Q 440000
.12 14000 D>Q 350000
.18 16000 D>Q 260000
.10 18000 D>Q 170000
s, S policy
• When the inventory is at or below the level
s, order-up-to S
Multiple order opportunities
• Single order models
– Swimsuits, Valentine Day Cards, etc.
– No opportunity to reorder
• In many practical situations, reordering is
possible
– TV sets
• Random demand occurs
• Random lead times occur
Why hold inventory?
• To satisfy demand during the lead time
• To protect against uncertainty in demand
• To minimize the total cost
Additional assumptions
• Demand is random and follows a normal
distribution
• The ordering costs are proportional to the
quantity ordered
• Inventory holding cost is charged per item
per unit time
• Lost sales occur
• Distributor specifies a required service level
Service level
• Probability of not stocking out during lead
time
– For example, if the service level is 95%,
demand will be satisfied from stock in 95% of
lead times
Notation
• AVG = average daily demand
• STD = standard deviation of demand
• L = lead time, in days
• h = cost of holding one unit for one day
• and  = service level
• inventory position = on hand + on order
Policy
• Whenever the inventory position drops
below S, order enough to raise it to S
Order up-to-level
• Average demand during lead time
– L*AVG
Poisson distribution
• A Poisson distribution can be used to
estimate a normal distribution if the mean is
> 10
– Average (mean) = Variance
Order up-to-level
• Safety stock
– z* SQRT(L*AVG)
– But, SQRT(AVG) = STD
– Thus, safety stock is z*STD*SQRT(L)
– So, order up-to-level is
• L*AVG + z*STD*SQRT(L)
Selection of z
• 5% in the tail
– z = 1.65
• 3% in the tail
– z = 1.88
• 1% in the tail
– z = 2.33
1-
• Prob{D during L > L*AVG + z*STD*SQRT(L)} = 1 - 
Example
• Distributor of TV sets
• Monthly demand for the past year
– AVG = 191.17
– STD = 66.53
• L = 2 weeks
• Service level = 97%
– z = 1.88
Example
• Average weekly demand
– Average monthly demand/4.3 = 44.46
• Monthly variance = (66.53)2
• Average weekly variance
– Average monthly variance/4.3
• Average weekly STD
– SQRT(Average weekly variance)
– 66.53/SQRT(4.3) = 32.08
Example
• Average demand during lead time
– L*AVG
– 2*44.46 = 88.92
• Safety stock
– z*STD*SQRT(L)
– 1.88*32.08*SQRT(2) = 85.29
Example
• Reorder point
– L*AVG + z*STD*SQRT(L)
– 88.92 + 85.29 = 174.21
– When the inventory position (on hand + on
order) falls below 175, order enough to raise it
to 175
• Weeks of supply
– 174.21/44.46 = 3.92
Fixed order costs
• Suppose that a fixed cost, K, is paid every time an
order is placed
• Use an (s, S) policy where s and S are different
• s is as in the previous case
– s = L*AVG + z*STD*SQRT(L)
• Order-up-to level
– S = {max (Q, L*AVG)} + z*STD*SQRT(L)
(s, S) policy

Inventory position
S

s
0 Time

Lead time
Example
• Continue the previous example and assume
that there is a fixed ordering cost of $4500
– Independent of the order size
• Cost of a TV set is $250
• Annual inventory holding cost is 18% of
$250, or, on a weekly basis
– [.18*250]/52 = .87
Example
• Order quantity, Q
– Q = SQRT{[2*4500*44.46]/.87} = 679
• Order up-to-level, S
– S = 679 + 86 = 765
• The distributor should place an order to
raise the inventory position to 765 TV sets
whenever the inventory is below 175 units
Which system is better and why?

Warehouse One Market One


Supplier
Warehouse Two Market Two

Market One
Supplier Warehouse

Market Two
Risk pooling
• Which of the systems will require more
inventory?
– Why?
• With the same total inventory level, which
of the systems provides better service?
– Why?
Compare the two systems shown
in the earlier figure with:
– Two products
– Maintain a 97% service level
– Order cost is US$60
– Holding cost is US$.27/unit/week
– Transportation cost (averages)
• Centralized system US$1.05/unit
• Decentralized system US$1.10/unit
– Lead time is 1 week
Data
Week 1 2 3 4 5 6 7 8
Prod A 33 45 37 38 55 30 18 58
Mkt 1
Prod A 46 35 41 40 26 48 18 55
Mkt 2
Prod B 0 2 3 0 0 1 3 0
Mkt 1
Prod B 2 4 0 0 3 1 0 0
Mkt 2
Prod A 79 80 78 78 81 78 36 113
Cntrl
Prod B 2 6 3 0 3 2 3 0
Cntrl
Descriptive statistics

Warehouse Product AVG STD CV


Market 1 A 39.25 13.18 .34
Market 2 A 38.62 12.05 .32
Market 1 B 1.12 1.36 1.21
Market 2 B 1.25 1.58 1.26
Cntrl A 77.88 20.71 .27
Cntrl B 2.38 1.92 .81
Some calculations
Market 1: Product A
• Q = SQRT{[2*60*39.25]/.27} = 132.08
– or Q = 132
• Reorder point = 1*39.25 + 1.88*13.18*SQRT(1) =
– 39.25 + 24.78 = 64.03
– or, reorder point = 65
• Safety stock = 1.88*13.18*SQRT(1) = 24.78
• Order-up-to-level = max (132.08, 39.25) + 24.78
– 132.08 + 24.78 = 156.86
– or, 157
Inventory levels

Warehouse Product Safety Reorder Q Order-up-


Stock Point to-level
Market 1 A 24.78 65 132 157
Market 2 A 2.58 4 25 26
Market 1 B 22.80 62 131 154
Market 2 B 3 5 24 27
Central A 39.35 118 186 226
Central B 3.61 6 33 37
Average inventory
• Average inventory = Q/2 + Safety stock
Analysis for product A
– Market 1
• Safety stock = 24.78
• Q = 132
• Average inventory = 90.78
Average inventory
• Average inventory = Safety stock + Q/2
• Analysis for product A
– Market 2
• Safety stock = 22.80
• Q = 131
• Average inventory = 88.30
Average inventory
• Average inventory = Safety stock + Q/2
• Analysis for product A
– Central
• Safety stock = 39.35
• Q = 186
• Average inventory = 132.35
Average inventory
• Product A with two warehouses
– Market 1 90.78
– Market 2 88.30
– Total 179.08
• Product A with a central warehouse
– Average 132.35
• Savings
– 100% - 73.9% = 26.1%
Point 1
• Centralizing inventory reduces both safety
stock and average inventory in the system
– If inventory is higher in one market and lower
in the other, that inventory will be available to
be reallocated
Point 2
• The higher the cv, the greater the benefit
obtained from centralized systems, or risk
pooling
– Higher cv means greater safety stock
– The cv is decreased as pooling occurs
Types of risk pooling
• Across markets
• Across products
• Across time
Centralized versus Decentralized
• Effect on
– Safety stock
• Decreases when moving from decentralized to
centralized system (depending on the parameters)
– Service level
• Is higher for the centralized system (depending on
the parameters)
Centralized versus Decentralized
• Effect on
– Overhead costs
• Are less in a centralized system
– Customer lead time
• Is lower for a decentralized system
– Transportation costs
• Outbound are usually lower for decentralized
• Can’t say about inbound costs
Echelon Inventory System

Supplier
Warehouse
echelon
inventory
Warehouse
echelon lead
time Warehouse

Retailers
How much inventory at each location?

• The retailer raises inventory to level Sr each period


• The supplier raises the sum of inventory in the
retailer and supplier warehouses and in transit to
Ss
• If there is not enough inventory in the warehouse
to meet all demands from retailers, it is allocated
so that service level at each retailer will be equal
Top 5 strategies in a recent survey

• Periodic review policy (59%)


– Inventory is reviewed at a fixed interval at
which time a decision is made on the order size
Top 5 strategies in a recent survey

• Tight management of usage rates, lead


times, and safety stock (46%)
– Allows the firm to keep a close watch on
inventory levels
Top 5 strategies in a recent survey

• ABC approach (37%)


– Class A represents about 80% of annual sales
and about 20% of SKUs
• Weekly review
– Class B represents about 15% of annual sales
• Less than a weekly review, say monthly
– Class C represents about 5% of annual sales
• Lots of these inexpensive items are kept (or zero)
Inventory turnover ratio
• Annual sales/Average inventory level
Median inventory turnover ratios
(by industry)
• Dairy products • 19.3
• Electronic components • 5.7
• Computers • 5.3
• Books: Publisher • 2.4
• Household A/V • 3.4
• Industrial chemicals • 6.6
• Household electrical • 5.0
appliances
End

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