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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

Sources: plants vendors ports

Regional Warehouses: stocking points

Field Warehouses: stocking points

Customers, demand centers sinks

Supply

**Inventory & warehousing costs
**

Transportation costs Inventory & warehousing © Copyright 1999 D. Simchi-Levi, P. Kaminshy & E. Simchi-Levi costs Production/ purchase costs Transportation 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 .

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.

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 .

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.Managing inventory can be difficult • As reported in Business Week (May 20.” • 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can be difficult • In 2001 Cisco Systems had losses in the billions due to inventory write downs – Routers were outdated .

company reports . and sales force to reduce inventory by 1/3rd – Source: Business Week.000 • How did they do it? – Networked factories.000.000. retailers.Managing inventory can be difficult • Current profits (September 2002) for Shiseido. a Japanese cosmetics maker – US$81.000 • Year-ago profits – US$12.

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% .

040428 0.000472 F(x) 0.008242 0.146223 0.762183 0.124652 0.036266 0.001321 0.065278 0.018133 0.968172 0.104445 0.Poisson (l = 5) x 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 p(x) 0.006738 0.003434 0.084224 0.03369 0.866628 0.175467 0.999774 .175467 0.986305 0.265026 0.615961 0.931906 0.440493 0.999302 0.006738 0.994547 0.997981 0.140374 0.

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 .

we gain valuable insights from the EOQ model .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.

EOQ Model Q Avg Inv T Time .

Costs for one cycle • Ordering cost –K • Holding cost – hT [Q/2] • Total cost – K + hT[Q/2] .

T = Q/D • So. TC = [KD]/Q + h[Q/2] .Total cost per day • TC = K/T + h [Q/2] • But.

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 .

560962 1.Relative Insensitivity of Q Q 250 275 300 316 325 350 375 TC/week 1.541442 .533785 1.519109 1.52706 1.519712 1.521154 1.

Even when Q is far away • Q = 200 – TC = $1.56 .68 • Q = 400 – TC = $1.

45 1.5 1.4 200 250 300 350 400 TC .55 1.65 1.6 1.Shaped like the letter U 1.7 1.

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 .But.

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% 25% 20% 15% 10% 5% 0% 8000 10000 12000 14000 16000 18000 Unit sales 11% 11% 10% 28% 22% 18% .

Additional information • • • • Fixed production cost of $100.000 Variable production cost of $80/unit Sales price of $125/unit Salvage value of $20/unit .

D) .60Q .100000 = 45Q . 125Q .100000 D > Q. 125D .80Q + 20 (Q . Q = Production Quantity – – – – Q > D.100000 .Profit model • D = Demand.80Q .100000 = 105D .

Q = 10000 – Profit = 45(10000) .For example • D = 12000.60(10000) -100000 = 140000 . Q = 10000 – Profit = 105(8000) .100000 = 350000 • D = 8000.

10 Demand 8000 10000 12000 14000 16000 18000 Q>D Q>D D=Q D>Q D>Q D>Q Profit 20000 230000 440000 440000 440000 440000 .12 .11 .28 .18 .11 .When Q = 12000 Probability .

11 • Profit of 440000 with probability of .Which is better? • Profit of 20000 with probability of .68 .

10(440000) • Expected profit = 326700 .Expected profit when Q = 12000 • Expected profit = .11(20000) + … + .

Expected profit as a function of Q 350000 300000 250000 Exp Profit 200000 150000 100000 8000 10000 12000 14000 16000 18000 Production Quantity .

12008 Profit when Q = 10000 is $326900 Profit when Q = 12000 is $326700 .10(18000) Or.Insight • Since there is a marginal profit of $45 for each unit short. the production should be less than the average demand – – – – Average demand is .11(8000) + …+ . but a marginal loss of $60 for each unit of excess production.

11 probability of a loss of $220.000 (if D = 8000) • What about that? .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 .

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 .

the probability of large losses increases – At the same time. the probability of large gains also increases .More insights • As Q increases.

80Q .80Q + 20 (Q .45D .Q) = 90Q .More interesting with shortage cost • D = Demand.100000 D = Q.45(D .100000 . Q = Production Quantity – – – – – – Q > D.100000 . 125Q .60Q .D) .80Q . 125Q .100000 D > Q. 125Q .100000 = 105D .100000 = 45Q .

12 .11 .11 .10 Demand 8000 10000 12000 14000 16000 18000 Profit 20000 230000 440000 350000 260000 170000 Q>D Q>D D=Q D>Q D>Q D>Q .18 .28 .When Q = 12000 with shortage cost Probability .

s. S policy • When the inventory is at or below the level s. order-up-to S .

reordering is possible – TV sets • Random demand occurs • Random lead times occur . etc. Valentine Day Cards.Multiple order opportunities • Single order models – Swimsuits. – No opportunity to reorder • In many practical situations.

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. demand will be satisfied from stock in 95% of lead times . if the service level is 95%.

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 a = service level inventory position = on hand + on order .

order enough to raise it to S .Policy • Whenever the inventory position drops below 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 .

safety stock is z*STD*SQRT(L) So. order up-to-level is • L*AVG + z*STD*SQRT(L) .Order up-to-level • Safety stock – – – – z* SQRT(L*AVG) But. SQRT(AVG) = STD Thus.

65 • 3% in the tail – z = 1.33 .88 • 1% in the tail – z = 2.Selection of z • 5% in the tail – z = 1.

a .1-a • 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

92 + 85. order enough to raise it to 175 • Weeks of supply – 174.46 = 3.21/44.92 .29 = 174.21 – When the inventory position (on hand + on order) falls below 175.Example • Reorder point – L*AVG + z*STD*SQRT(L) – 88.

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) . K. is paid every time an order is placed • Use an (s.Fixed order costs • Suppose that a fixed cost.

(s. S) policy Inventory position S s 0 Lead time Time .

87 . on a weekly basis – [.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.18*250]/52 = .

46]/.Example • Order quantity. 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 .87} = 679 • Order up-to-level. Q – Q = SQRT{[2*4500*44.

Which system is better and why? Warehouse One Supplier Market One Warehouse Two Market Two Market One Supplier Warehouse Market Two .

which of the systems provides better service? – Why? .Risk pooling • Which of the systems will require more inventory? – Why? • With the same total inventory level.

05/unit • Decentralized system US$1.10/unit – Lead time is 1 week .27/unit/week Transportation cost (averages) • Centralized system US$1.Compare the two systems shown in the earlier figure with: – – – – – Two products Maintain a 97% service level Order cost is US$60 Holding cost is US$.

Data Week Prod A Mkt 1 Prod A Mkt 2 Prod B Mkt 1 Prod B Mkt 2 Prod A Cntrl Prod B Cntrl 1 33 46 0 2 79 2 2 45 35 2 4 80 6 3 37 41 3 0 78 3 4 38 40 0 0 78 0 5 55 26 0 3 81 3 6 30 48 1 1 78 2 7 18 18 3 0 36 3 8 58 55 0 0 113 0 .

Descriptive statistics Warehouse Market 1 Market 2 Market 1 Market 2 Cntrl Cntrl Product A A B B A B AVG 39.38 STD 13.81 .34 .62 1.58 20.88 2.71 1.26 .36 1.21 1.12 1.18 12.25 38.92 CV .05 1.27 .32 1.25 77.

78 = 156.25]/.78 • Order-up-to-level = max (132.25 + 1.25) + 24.88*13.25 + 24. reorder point = 65 • Safety stock = 1.78 = 64. 39.03 – or.08 + 24.08 – or Q = 132 • Reorder point = 1*39.27} = 132. 157 .08.88*13.78 – 132.18*SQRT(1) = 24.Some calculations Market 1: Product A • Q = SQRT{[2*60*39.18*SQRT(1) = – 39.86 – or.

Inventory levels Warehouse Product Market 1 Market 2 Market 1 Market 2 Central Central A A B B A B Safety Stock 24.80 3 39.35 3.58 22.61 Reorder Point 65 4 62 5 118 6 Q 132 25 131 24 186 33 Order-upto-level 157 26 154 27 226 37 .78 2.

78 • Q = 132 • Average inventory = 90.78 .Average inventory • Average inventory = Q/2 + Safety stock Analysis for product A – Market 1 • Safety stock = 24.

Average inventory • Average inventory = Safety stock + Q/2 • Analysis for product A – Market 2 • Safety stock = 22.80 • Q = 131 • Average inventory = 88.30 .

35 .Average inventory • Average inventory = Safety stock + Q/2 • Analysis for product A – Central • Safety stock = 39.35 • Q = 186 • Average inventory = 132.

35 • Product A with a central warehouse • Savings – 100% .9% = 26.78 88.1% .08 132.Average inventory • Product A with two warehouses – Market 1 – Market 2 – Total – Average 90.30 179.73.

that inventory will be available to be reallocated .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.

or risk pooling – Higher cv means greater safety stock – The cv is decreased as pooling occurs . the greater the benefit obtained from centralized systems.Point 2 • The higher the cv.

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

Warehouse echelon lead time

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 Electronic components Computers Books: Publisher Household A/V Industrial chemicals Household electrical appliances • • • • • • • 19.4 3.7 5.3 5.3 2.0 .4 6.6 5.

End .

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